Friday, September 26, 2008

Some Thoughts on the Bailout

The bailout is meant to stop the downward spiral in asset pricing. Right now, what you have right now is forced sellers vs. opportunistic (vulture) buyers. So let’s use a typical scenario. I have to sell a bond, i get bids, best bid is 50 and I sell it. Now everyone else who owns a bond like mine has to "value" their security at or near 50. That triggers other who now have a huge loss to sell, so they sell except this time it sells at 40, and that triggers...........

You see where I'm going with this - it's a downward spiral. Now keep in mind that these "losses" come thru people's balance sheets, they have less capital, and now have to go to the market and raise capital (that generally means selling stock in their company or other similar securities). Selling stock dillutes the value of current stock holders which send their shares down, and pushes the prices of stock indexes (the Dow, the S&P, etc) down as well.

Now don't get me wrong, it's not just mark-to-market accounting that's causing the problems, banks won't lend to each other any more either. If I don't know what's on your balance sheet, if I think you're insolvent, why should I lend to you? If you can't get money in the door, you can't send it out and if you can't pay your debts, you go bankrupt. Something has/had to be done to stop this vicious cycle - unless you want the financial world to topple.

Ok but lets move on to the plan and how you value these securities....

These securities are backed by mortgages and as you know, people pay (or don't pay) their mortgage every MONTH. So as time goes by these securities get payments of principal and interest every month.

The point of this program is to clear these bonds off of balance sheets so that money can start flowing in the system and banks/financial institutions can start lending again. My guess is that there will also be language in the bill to help prevent what does all this do? REFINANCINGS!! And why is that good for this program... Well if you buy an asset for 50-60cents on the dollar, and then the person whose mortgage you own pays you back, you just doubled your money (paid 50c and got paid back $1).

But forget about all that -- when you pay 50c for $1 in assets, you don't even need all your money back to make a good return! Think of it this way, if you pay $10,000,000 for a set of mortgages with a face value of $20,000,000 and lets say for the sake of argument that your bonds represent 100 loans and each of them was worth $200,000. Lets say half of them are deadbeats and won't pay you, OK, so you foreclose on them and now you've got their house, is their house worthless? Of course not! Ostensibly (Even if they put very little money down) it was worth more than the $200,000 loan they took out at the time of purchase, maybe it's only worth $150,000 now, maybe only $100,000 but it still has value to SOMEONE!

So you probably get half your money back on half your loans through foreclosures, short-sales, loan modifications, etc etc, but that's $5mm and presumably the other half is still paying you (for the next 20-30yrs, since they probably took out 30yr mortgages). So tell me, how is your $700mm going down the drain? If the government were paying $1 for $1 in shitty assets, I would have a problem with that. They simply are not.

Furthermore, given that the government will own all these securities (plus the fact that they're...the government) they'll be able to get some leverage over servicers to stop the foreclosure process for many of these borrowers, rework their loans, keep people in their homes etc etc. That will further protect the government's investment in these crappy mortgages.

The Government will be paying "cash for trash" but they certainly aren't paying top dollar for the trash....

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