Why You Should Hate the Treasury Bailout Proposal (1 Viewer)

[gboudx]

Interesting read from Time.

http://www.time.com/time/nation/article/0,8599,1843168,00.html?cnn=yes

How We Became the United States of France

By Bill Saporito Sunday, Sep. 21, 2008


This is the state of our great republic: We've nationalized the financial system, taking control from Wall Street bankers we no longer trust. We're about to quasi-nationalize the Detroit auto companies via massive loans because they're a source of American pride, and too many jobs — and votes — are at stake. Our Social Security system is going broke as we head for a future where too many retirees will be supported by too few workers. How long before we have national healthcare? Put it all together, and the America that emerges is a cartoonish version of the country most despised by red-meat red-state patriots: France. Only with worse food.

 

[City Champ]

there isn't a damn thing we can do to stop any of this either. why do i feel like we are being railroaded, and our democracy just got sold?
I have a pit in my stomach about this...

 

[varanook]

there isn't a damn thing we can do to stop any of this either. why do i feel like we are being railroaded, and our democracy just got sold?
I have a pit in my stomach about this...

Write your senator and congressman because it has to be approved by congress.

This is nonsense and not needed.

 

[rich70116]

The only way to end this financial trend is to let the cards fall where they may. It will have to happen sooner or later. These attempts to stop the hemorrhaging are band-aid approaches that will simply delay the inevitable collapse.

If I'm correct, this trillion dollar deal will raise our national debt to near $11trillion. Bad news for all of us.

Back in May, I was traveling and I had the pleasure of sharing a couple of beers with a true financial VIP in a hotel bar. This guy did nothing but travel the world in search of new investments; they buy big businesses in emerging markets. He was from Boston. I usually don't get to meet people like him but he was traveling with his son for a sporting event and you wouldn't believe how nice he was; very forthcoming and open. We just happened to hit it off and he was very straightforward in his opinion that the US economy will never rebound to where it was pre-Bear Stearns because we lost our manufacturing base. He was furious that this country had allowed its' manufacturing base to move overseas.

 

[dapperdan]

Here is a proposal that is much less expensive, and might ultimately prove to be more effective. I seriously suspect that Secretary Paulson's solution is going to be much more difficult to pass than he imagined last Thursday evening when he gathered in Nancy Pelosi's office.

http://bigpicture.typepad.com/comments/2008/09/fixing-housing.html#more

I call it the "30/20/10" solution to the credit crisis:

30: Takes up to 30% of any current delinquent mortgage and separates it from the “main” mortgage; it goes into a 2nd, interest free-balloon mortgage, and stays on the books of the present mortgage holder;

20: The plan’s goal should be saving at least 20% or so of the current delinquent and potential foreclosure properties; Of the 5 million homes that may be late in making payments, (the first step along the road to delinquency, default and foreclosure) the process should make 20%, or 1 million homes eligible;

10: The Balloon payment comes due in 10 years, and will be treated as a 2nd mortgage, with interest charges only accruing as of October 1, 2018; it can be refinanced or paid off in full.

The 30/20/10 option allows the lending entity (or its equivalent) to pull aside up to 30% of the mortgage as a separate interest-free balloon payment. The remaining mortgage is refinanced at a fixed rate for 30 years. The balloon payment will "restart" fresh in 10 years. Between now and then, there will be no interest costs or penalties for this separate loan.

Consider the advantages of this plan: It would prevent a significant number of foreclosures from further roiling the markets; it takes bad loans and avoids the write down so long as thy are performing; and it allows many people to stay in homes they can afford. Moral Hazard poses no problem in this plan.

Here are additional specifics: At least 70% of the existing mortgage becomes a new, refinanced, fixed rate, 30 year traditional mortgage. And, a loan payment for up to 30% of the original mortgage, not accruing interest, with repayment of principal and interest due beginning 10 years hence, makes the present house affordable. In other words, this would look like an ordinary mortgage plus a balloon payment, one that would not begin accruing interest until year 10.

Congressional action is required to exempt the balloon payment from causing a tax issue, as this is essentially an interest free loan might be a taxable event.

The securitization of mortgages creates its own additional difficulties in attempting to resolve defaults and delinquencies. Residential mortgages get bundled into RMBS, which were then sold and resold to various Wall Street purchasers. One of the current problems in resolving the situation is identifying who is the actual owner of the mortgage in question. This can be resolved with a clever little act changing notification provisions, requiring further Congressional approval.

Any entity that identifies a potentially problematic mortgage, i.e., delinquent and in risk of default, can start the process by evaluating the property value and the borrower's ability to repay the loan. If they believe a mortgage would be suitable for a 30/20/10 workout, they would then send notice to the current recipients of the mortgages interest and principal payment. This entity would have 30 days to reject the workout, and failing to do so in that time Is deemed to be an approval.

In our solution, it is the financing party – a private equity firm, a real estate fund, or even a US capital pool created for this purpose – that can make this request for a 30/20/10 solution. Notice is sent by to the current loan servicer, i.e., the firm processing the mortgage payments, and forwarding them to the mortgage owner. The servicer is in the best situation to send the 30 day notice, and if no written objection is received, from the whoever currently owns the mortgage – be it bank, mortgage pool, or other securitized owner – the refinancing process begins.

Instead of a foreclosed property, the former mortgage holder is left with an interest free, 10 year balloon on up to 30% of the mortgage. They also have a lien on the property, and no writedown on the delinquent mortgage for at least 10 years.

There are other details that need to be worked out -- the priority in case of sales, what happens if there is an eventual default, how to avoid fraud, etc.

The end result of the 30/20/10 workout would be the following: Homeowners who can afford to make payments on the refinance home get to continue living in them. Neighborhoods are spared the negative impacts that Foreclosure has on property values and the blight of abandoned houses. Lenders get to avoid writing down up to 30% of suitable but problematic mortgages. The balloon payment stays on the books as a liability, but it is not written down until, if and when it defaults 10 years later.

The upside of this proposal is that it serves a variety of interests with a minimum of congressional market interference. Those homeowners that can afford to stay in their house with a little bit of help avoid foreclosure. Banks and mortgage holders get to avoid writing down delinquencies that could be avoided. Neighborhoods are spared the negative impacts that Foreclosure is known to have. Loan servicers can expand their business to process saying the 30/20/10 workout papers. I would expect a variety of private equity funds will leap into the void and begin looking for mortgages to rewrite as 30/20/10s.

Congressional action required would be to 1) Eliminate the tax issue for the interest-free portion of these loan; 2) Create a Legal standing and guidelines for this notification and waiver policy. The goal here is to insure that the complexities of determining who actually owns a a mortgage dozen not interfere in its work out; 3) Create any required exemption for banks and lending entities to avoid taking a write-down during the period of the 10 year in balloon forbearance.

Weaknesses and criticism: I would expect several objections to be raised to this proposal. From those representing homeowners who face potential foreclosure, the complaint will be that this plan fails to save more than 20-30% of those who might lose their homes. For the various funds and investors that own the underlying mortgages, there will be a complaint that notification provisions are insufficient. Lastly, given the enormous size of the Federal free lunch proferred by the Treasury Secretary, the banking industry will be reluctant to embrace any such workout that might be perceived as interfering with their ability to feast at the public trough to the tune of a trillion dollars.

 

[JimEverett]

Another solution is to allow re-working of mortgage contracts in bankruptcy.
Primarily you allow untraditional loans to be reworked into a traditional loan model that is affordable for the homeowner and the holder of the mortgage still makes money. You can do it with cars in bankruptcy so it seems like applying to homes isn;t a great leap.

 

[JimEverett]

A question I have though is how could the foreclosure of homes have this much of an impact? Doesn;t this go far beyond any mortgage crisis? The default rate is still relatively low - although much higher than normal.
Can a foreclosure rate of 3% or so cause the need for over $1 trillion in bailouts?
Or does the "crisis" come from the fact that investors don;t want to invest money with people who can be so stupid as to buy these mortgage backed securities?
Or is it something else entirely?

 

[City Champ]

i dont know what the hell it is, but it smells funny...

 

[gboudx]

i dont know what the hell it is, but it smells funny...

Got this link from an investment mailing list I'm subscribed to here at Cisco.

http://market-ticker.denninger.net/archives/587-The-Mother-Of-All-Frauds.html

 

[efil4stnias]

A question I have though is how could the foreclosure of homes have this much of an impact? Doesn;t this go far beyond any mortgage crisis? The default rate is still relatively low - although much higher than normal.
Can a foreclosure rate of 3% or so cause the need for over $1 trillion in bailouts?
Or does the "crisis" come from the fact that investors don;t want to invest money with people who can be so stupid as to buy these mortgage backed securities?
Or is it something else entirely?

from what i heard this am is that outside investors ( Japan, China etc ) who thorw BIG MONEY INVESTMENTS in our country, may lose faith in our financial system, thereby halting thier investing, in turn starting a financial meltdown that would dwarf 1929. What the FEDS are trying to do is stop the bleeding with a band aid and telling the International Community just dont look at the cut and it wont hurt...unfortunately, they have seen the "cut"- its deep, needs stitching and time to heal, not a band aid.

 

[JimEverett]

Its obvious that there are problems getting foreign investment into the country - that is exactly why the dollar has weakened this decade.
But that doesn't explain, imo, a crisis requiring a $1 trillion+ bailout.

 

[gboudx]

http://money.cnn.com/2008/09/22/markets/oil/index.htm?postversion=2008092214

Oil skyrockets

Futures spike over $20 on the bailout plan and falling dollar.


NEW YORK (CNNMoney.com) -- Oil prices jumped more than $20 a barrel Monday in biggest dollar jump ever as the dollar falls following the government's $700 billion Wall Street bailout plan.



Oil surged $22.46 to $127.01 a barrel, after reaching as high as $128.55 - a $24 gain - at these levels it will be oil's biggest gain ever in dollar terms.



The rally reached a fevered pitch as the session neared its close, partly due to the fact that Monday is the last day of trading in the October oil futures contract, which typically results in volatile trading.



As of Tuesday, the front-month contract will be November. That contract showed prices up $6.44 to $109.19 a barrel.


"The biggest news is that people are looking at the $700 billion plan as supportive of demand, supportive of the economy," said Peter Beutel. "Everything we are looking at right now says demand has a chance to come back if the economy starts to strengthen."

 

[rich70116]

Jim Everett, just read where Congress is trying to do the very thing you suggested -- give judges the right to change mortgage rates and terms in order to avoid foreclosure.

 

[dapperdan]

Its obvious that there are problems getting foreign investment into the country - that is exactly why the dollar has weakened this decade.
But that doesn't explain, imo, a crisis requiring a $1 trillion+ bailout.

JE, I get an email newsletter from this fellow John Mauldin, usually 2-3 times per week. He doesn't have a website, to my knowledge, but this last newsletter was very interesting, going into detail about the mortgage business, how the traunches are created and securitized. Imo, the only way to really understand why we're in such a mess, is to understand how the mortgages are sliced up and sold, and Mauldin's letter does an outstanding job of doing this. Because he sends this information in a newsletter format and doesn't post it on a website, the only way I can provide this information is to cut and paste it into my website and provide the link. I've never done this before (linked to my website) because I don't want to come across as pimping my own little business, that's definitely not the intent as I cannot do business in Louisianna. It's simply the only way I can link this information, so forgive me in advance.

For anyone who wants the original email, pm me an email address and I'll forward it along.

Here's the link.

http://www.waterfrontmtgdirect.com/John_20_Mauldin_20_Financial_20_Armageddon_20_Sep_20_19.html
Inside a RMBS
Let's look at a RMBS. As Berg points out, when you are buying a mortgage backed security, there are really only three questions you need to know the answers to:

How many mortgages will default?
How much will I get back on a defaulted loan?
How much credit enhancement is there in the security?
Let's set the table by looking at a few terms and definitions. Using his example, let's take a mortgage where the home was originally appraised for $400,000 and there is a $300,000 mortgage on the home. Let's assume a default and the bank takes back the home. If they sell the home and recover $240,000 that means they lose $60,000. This is called a 20% severity. If they sold and recovered $150,000 it would be said to have a 50% severity.

Next, let's look at how the rating agencies come up with the AAA rating. First they model the expected losses, with emphasis on the word model. If they figure that worst case that 8% of the loans default at a severity of 50%, then the security would lose 4% of its value. To get an AAA rating you have to have at least two times the coverage of the "modeled" loss. In this illustration, that means that 92% of the loans would be put into the AAA tranche. An A rating assumes a coverage of more than 1 times but less than 2. B means you expect to get your money back and if they model that you will get below 100% back then the rating would be at junk levels.

Now, this next fact is important. All ratings assume a par value of 100. The rating of these bonds has nothing to do with price. After the presentation, Rich sat down with me and pulled up an actual mortgage backed security that was being offered that day on his screen. It was once a AAA rated Alt-A security. If I remember correctly it was a 2006 vintage security.

As of the latest reporting, a little over 5% of the mortgages were over 60 days past due or in foreclosure. In this security, there are no toxic option ARMS. The numbers of mortgages in this security that are in trouble are rising. S&P has downgraded that AAA tranche to BBB, which of course means its value is going down.

And sure enough, the offered price of the security is 70 cents on the dollar, or 70% of the original par value. Now remember, this particular AAA bond will only start to lose money after the lower tranches take up the first 8% of losses. Thus, this bond can be said to have an 8% credit enhancement.

Pricing in Financial Armageddon
Now, let's stress test that loan. For the AAA portion of the loan to lose money, that would mean that 16% of the loans would have to default with a severity of 50% losses. Could that happen? Sure.

But let's look at what buying that loan at 70 cents on the dollar does for the new owner. First, you are getting a much higher yield (interest rate) because you are buying the security at a lower valuation. But something else even more interesting happens.

Even though the security sold at 70 cents, it still gets all of the first of the proceeds of the home owners who pay their mortgages, up to 92% of the original value in the security. How many loans would have to default in order to make the buyer at 70 cents lose money? Remember, we already had credit enhancement of 8%. But at 70 cents, we just "bought" or priced in another 30%. Let's think Armageddon and that 50% of the mortgages default and they only recover 50% of the loans. That would only be a total loss of 25% to the entire collateral of the deal, but it would mean that the new investor still get all of my 70 cents plus another 13% back! The proud new owner could get up to 92% of the monies paid. Even in a pretty bad scenario, you get more than you paid for the security.

Let's walk through the math. Let's say the original security was $100 million (which would be a very small RMBS). The AAA tranche would have cost $92 billion. If you have it at 70 cents on the dollar you paid approximately $64 billion. In my Armageddon scenario above, the security loses 25% or $250 million. The lower rated tranches are completely wiped out losing $8 billion. Your tranche loses the remaining $17 billion which means you get $75 billion and you only paid $64 billion.

So, how bad would things have to get to lose money on this security? If I am doing the math right, 72% of the loans would have to default with a severity of 50% before your investment of $64 billion was impaired by even so much as 1 dollar. If that happened, it would be Armageddon.

So, why is it rated BBB? Because the rating is over the entire tranche and it is made at a par price of 100. The rating is not affected by the current price. As of today, assuming that even double the number of mortgages currently delinquent default with a 50% severity, your returns over the life of the security would be well over 12%. You would get back $92 million for your $64 billion dollar investment along with interest payments.

The reason this presentation was being made to banks and institutions? Because if you are a bank, you can generally only get prime plus 2% on a loan you make. But if you buy this security with your capital, you can make prime plus 6%. That is a large difference to a bank. Performance Trust has sold billions of this type of paper to banks and institutions.

If this is such a good deal, then why isn't everyone hitting the bid? Because these securities are very difficult to analyze. It is time consuming. You need to analyze every loan and develop your own valuations. You simply can't trust the ratings, as they are measuring something completely different.

And the real truth is that many of the various RMBS securities will in fact be totally wiped out or lose a great deal. Many are seeing default rates of 30% or more. You have to be very careful when you walk through this minefield. And in a time of crisis, it is not clear what the new rules will be. What if the government forces lenders to re-set mortgages at some loss level? What if the housing crisis gets worse? On the other hand, what if the government comes in and buys up all the bad mortgages in an attempt to stop the erosion in the home markets. The level of uncertainty in these times makes people a lot more cautious.

 

[varanook]

Seems to me just having some time to figure what these RMBS's are worth would be better than printing 500 billion dollars from what Dapperdan has put out there.

That much money would some serious inflationary effects imho.

This is being pushed too quickly.