Krugman Commences To Backpedal From Dodd?

I explained last night that Krugman's call for direct equity investment to prop up troubled financial firms bore only the dimmest relationship to Dodd's equity dilution proposal meant to compensate taxpayers for losses on troubled assets purchased by the Treasury.

I also predicted that Krugman would endorse the Dodd proposal since it came from a reliable lib.  Here is Krugman's initial endorsement,.  This morning Krugman has posted what I think is the beginning of his backpedaling, necessary because the Dodd plan is nothing like the Krugman plan:

The premise of the Paulson plan– though never stated bluntly — is that these assets are hugely underpriced, so that Uncle Sam can buy them at prices that help the financial industry a lot, without big losses for taxpayers. Are you prepared to bet $700 billion on that premise?

But how can we help the financial situation without making that bet? By taking an equity stake. That way, if it turns out that the feds are pumping money in at above-fair prices, at least they get ownership, just as a private white knight would have.

There is no, repeat no justification for refusing to grant equity warrants that provide some taxpayer protection. This is, for me, an absolute deal or no-deal point.

No mention whatsoever of Dodd.  An inadvertent oversight?  Well, maybe.  But in fact, the Dodd plan does almost nothing to address Krugman's concern.

Dodd does not focus on direct investment in financial services firm as an alternative to buying troubled assets from these firms.

Instead, Dodd's plan is to have Treasury buy the troubled assets, as with Paulson.  The Treasury may choose to simply hold and fund these assets, losing (or making!) money on a cash flow basis over time.

However, *if* in subsequent years the assets is sold at a loss then the Dodd plan gives the Treasury the right to recoup 125% of the loss by claiming a dilutive equity stake in the seller.  No cash changes hand at this time, however, so this does not represent a capital infusion (as illustrated by example in this post). 

So - no new capital beyond the initial purchase price of the asset; no specific assurance that Treasury is protected if they overpay, since they may never actually sell the asset and formally recognize a loss; no assurance that the losses realized by Treasury represent overpayment rather than broad market moves affecting all assets - is that what Krugman was hoping to achieve by direct equity investment upfront?

And beyond that, remember that the Treasury has an ongoing right to dilute current shareholders by booking a loss and claiming an equity slice based on price movements in these troubled assets.  In such a scenario, will firms be able to attract new equity investors?

A direct equity investment as suggested by Krugman is at least quick and simple, and other investors can evaluate it.

An issuance of conventional equity warrants giving Treasury a right to subscribe for new shares in a known amount and at a known price could give taxpayers the upside participation Krugman is looking for.

But I defy anyone who understands his plan to tell me that the Dodd proposal targets and will achieve similar objectives.

BONUS:  Why my focus on Krugman?  Because he is a shepherd among the sheep.  Here is Matt Yglesias, who has made no attempt to evaluate the Dodd and Krugman proposals independently:

Krugman says the Dodd proposal “is a big improvement over the Paulson plan” and I agree. The appropriate focus is on further improving the bill, not on worrying about what the mean ol’ Republicans might say about an improved bill.

Krugman reached that conclusion by misunderstanding and misrepresenting the Dodd proposal.  We will see where this goes.

AT THE HEARING:  A flicker of common sense from Paulson - the best protection for the taxpayer is a healthy, recovering economy.

Comments

[Charlie (Colorado)]

The premise of the Paulson plan– though never stated bluntly — is that these assets are hugely underpriced, so that Uncle Sam can buy them at prices that help the financial industry a lot, without big losses for taxpayers. Are you prepared to bet $700 billion on that premise?

I think this is key. Rick Ballard and I, independently, have estimated that these securities are worth in excess of 90 percent of their face values. Paulson's plan makes the most sense if he thinks so too, and he's not known for being stupid about money.

Is Krugman's issue that he just knows it must be wrong because he doesn't support the Administration? Or is there something we've missing?

[MayBee]

This is one thing that amuses me about the blogosphere, and it was noticeable during the beginning of the Russia-Georgia hostilities as well.
Bloggers are turned to, and give, opinions for which they have no qualifications other than the ability to form an opinion.
(Obviously TM is an exception on finance and economics).

Ezra Klein announced yesterday that he was going to be on MSNBC to discuss bailouts. Yglesias is actually paid by some think tank to ditto what Krugman says.
Next we'll get a link to Andrew Sullivan's opinion via Time magazine.
It's just....weird.

[Charlie (Colorado)]

Maybee, look at the regular punditry.

Krauthammer, for example, is a psychiatrist --- maybe not a bad specialty to talk about politics, but hardly an expert on wars or the military, yet they go to him all the time.

People get these jobs because they're good writers, not because they have some specialized expertise other than writing.

[steve sturm]

Why not combine the two? Have the Treasury buy these distressed securities AND receive some form of immediate equity stake in the firm coming to the feds for a bailout?

This avoids the problems TM has outlined while still giving the taxpayers a way of benefiting from their 'generosity'. And it's not just situations where the government overpays that I'm thinking of, as far as I'm concerned, even if the government pays 'fair' value (or underpays, based on subsequent activity), I want a reward for the taxpayers agreeing to help the firm out of its (mostly) self-imposed troubles.

As for the valuation of the equity stake, I'd peg it as X% (25%?) of the face value of the purchased assets. For example, if the taxpayers buy $2 billion of distressed securities, they'd get a $500 million stake in the entity, and based on the market value of the time of the transaction.

Companies that think that is too steep a price are welcome to weather the storm on their own.

[MayBee]

Good point.
I don't mind it so much if people are called in to give their opinions, and it is clearly stated that is what they are doing.

But....is Yglesias really a good writer? Is Ezra Klein even really a wonk, even in his stated field, health care? ISTM in the blogosphere, unlike in traditional media, there is a cult of personality aspect. I don't mind when that is contained in the blogs, but it shouldn't bleed into real news outlets. Whatever they are anymore.

[glasater]

Krauthammer, for example, is a psychiatrist

He's also an attorney:-)

[Verner]

I've been watching Paulson Bernanke and Cox before the Banking Committee on Bloomberg.

Wish you all could watch it. But some things seem clear.

1) Cox mentioned that they are going to investigate market manipulation, and suspect it.

2) B anmd P both say that the housing market is the root cause of all of this. Unless that is resplved, nothing will work.

3) All complained of antequated regulatory practices that left the tax payers virtually unprotected.

4) Much lending backed up by FMFM was regulated at a state level, and that's how they got away with all the fraud loans. They want a new federal standard to oversee mortgage origination.

Much more. The reverse auction was explained. Paulson said that it would be pointless to inject capital alone until the housing problem is resolved, and lot's of other good stuff.

And Chris Dodd kept harping on forclosures...

Paulson replied, in good times, we have forclosures. By making credit more available, we will enable those who can afford it to resist forclosure.

Dodd is such a tool.

Bernanke said that in the long run, the taxpayers should not lose any money, and will eventually regain the 700 billion.

Really would like to read a transcript of Cox's remarks. They seem to be on someone's scent, and are getting ready to go after them. Noticed Dodd didn't ask too many questions--or let him talk much.

Think McCain is dead wrong. Cox seems like a pretty good guy.

[Charlie (Colorado)]

Why not combine the two? Have the Treasury buy these distressed securities AND receive some form of immediate equity stake in the firm coming to the feds for a bailout?

because the underlying problem comes from the Government owning too much of the mortgage securities business as it is; worse, they lied about it by setting up Fannie and Freddie.

[GMax]

The rescue here is for mainstreet. For Joesixpack to keep his job and his employer has access to a renewed and even expanded line of credit for his widget business. If the credit market freezes that all is in jeopardy. What were the unemployment rates in the 30s? Will make Michigan currently look like a paradise.

The part of the Q & A with the Senators was informative. They made the point above and kept saying that they are looking for broad based institution participation and kept distinguishing from the insolvency of Lehman and Bearn Sterns and even AIG.

There was even a discussion about the different valuation amounts, fire sale today price versus a hold to maturity price. Clearly both Bernanke and Paulson believe the written down fair values are low and difficult to get hurt on if you do the due diligence on the front end.

I wish that I could now express more confidence in the Senate Democrats doing the right thing, but I doubt that currently.

[Charlie (Colorado)]

But....is Yglesias really a good writer?

he gets paid more for it than I do, and I'm supposed to be a pretty good writer.

[Charlie (Colorado)]

Wish you all could watch it.

I'm listening on CNBC, and Fox Business has it too.

[Rick Ballard]

Charlie,

I wouldn't want readers to think that the Stinky Stuff tranches have a value in excess of 90% because they certainly don't. I would also note for readers who have never looked at one of these MBS deals that each tranche (piece) carries its own CUSIP (that's a number which identifies the security as being a "separate entity"). A MBS may well have a 'total value' in excess of 90% but the Stinky Stuff tranches are what Benny and Darth are buying.

The proper (IMO) place to take a Treasury profit on this deal is at the reverse auction level. The Fed data on weak loans is sufficient to set prices which will amount to amputation to get rid of gangrene. The doc's fee should be set before the amputation begins.

[Charlie (Colorado)]

Yeah, I can't disagree with any of that. I wasn't aware (I just printed the statements, haven't read them yet) that Treas was only buying the flaky tranches; I thought the structure of the securities was such that they had to buy the whole thing. Of course, this is the government, they have more flexibility.

But your point about the reverse auction is also just right; I'm glad they settled on that approach, because it means they liquidate the Government's holdings expeditiously.

[Barney Frank]

I wouldn't want readers to think that the Stinky Stuff tranches have a value in excess of 90% because they certainly don't.

Rick or Charlie,

I understand how you got to the 90%+ average valuation by calculating the number of delinquent and foreclosed mortgages involved. But most of these instruments were taken out at the peak and presumably face value is based on those peak prices, so how does the 10-20% drop in real estate prices factor into the 90%? Or did you factor it in and I just missed it?

[Barney Frank]

And I do understand that, held until maturity, the underlying mortgages do pay off at face value as do the MBSs. Just seems like there has to be some considerable effect on these MBSs when the asset they are ultimately founded on declines 20%.

[GMax]

Here is the short 8-K from Sovereign Bank about their CDO sale.

On September 19, 2008, Sovereign Bancorp, Inc. (NYSE: SOV), parent company of Sovereign Bank, reported that it has taken a major step to reduce risk in its investment portfolio by selling its entire portfolio of collateralized debt obligations (CDOs).

The CDO portfolio has experienced significant volatility over the past year as a result of conditions in the credit markets. Sovereign decided to eliminate the risk of future volatility in its capital levels.

The CDOs were carried at fair value on Sovereign’s balance sheet on June 30, 2008 and the unrealized loss for the CDOs of $254 million, net of taxes, was recorded in other comprehensive income within stockholders’ equity and as a result fully reflected in tangible capital levels on that date. As a result of the CDO sale, Sovereign’s tangible capital levels were reduced by an additional $136 million. The unrealized loss at June 30, 2008 plus the additional loss, net of tax, from the sale will be reflected in our statement of operations for the quarter ending September 30, 2008. On a pro-forma basis at June 30, 2008, this sale would have reduced our tangible capital levels by 17 basis points.

Sovereign continues to be proactive in reducing risk on its balance sheet. When Sovereign raised $1.9 billion in new regulatory capital in May, a number of factors were taken into consideration including a possible decline in its investments. Sovereign is well capitalized and has adequate cushion according to all regulatory standards.

I have not determined the buyer as yet, but the reported price was $.35 per face. I am certain before I even check that the buyer will be a hedge hog, vulture type so the write down to $.35 was two thirds accomplished on the books of Sovereign by 6/30 according to this.

I think that means that Sovereign was carrying this CDOs at about $.56 cents in June with likely some planned writedowns over the subsequent two quarters to get to a number the CPAs would attest to at year end.

If these things are at about $.50 elsewhere, and vultures like em just fine at $.35, the Treasury can buy them in place in the middle and make a fine mark for you and I.

[Gabriel Sutherland]

Page 107, paragraph 4, from the paperback version of "Liar's Poker".

Ranieri & Co. intended to transform the "whole loans" into bonds as soon as possible by taking them for stamping to the U.S. Government. Then they could sell bonds to Salomon's institutional investors as, in effect, U.S. government bonds. For that purpose, partly as the result of Ranieri's persistent lobbying, two new facilities had sprung up in the federal government alongside Ginnie Mae. They guaranteed the mortgages that did not qualify for the Ginnie Mae stamp. The Federal Home Loan Mortgage Corporation(called Freddie Mac) and the Federal National Mortgage Association(called Fannie Mae) between them, by giving their guarantees, were able to transform most home mortgages into government backed bonds. The thrifts paid a fee to have their mortgages guaranteed. The shakier the loans, the larger the fee a thrift had to pay to get its mortgages stamped by one of the agencies. Once they were stamped, however, nobody cared about the quality of the loans. Defaulting homeowners became the government's problem. The principle underlying the programs was that these agencies could better assess and charge for credit quality than individual investors.

One of the people Hank Paulson called last October as part of his "house meetings" to find a way out of the Freddie and Fannie mess was Lewis Ranieri.

From the 8/30/2008 edition of the Wall Street Journal.

>Treasury officials gathered around a speakerphone as Mr. Ranieri told them the mortgage situation was "a bit more troubling" than most people realized, says a person familiar with the call.

If I told you I could make real estate prices go up with some minor congressional procedural moves, would you have believed me in 1981?

Enron collapsed because it too was trying to make a market out of something it thought was necessary, but they did the same thing Fannie and Freddie were doing. They were cooking their books to MAINTAIN THEIR CREDIT LINES.

[GMax]

Sorry missed a tag, last three para. above are me, not the 8 -K.

[Verner]

The discussion with Liddy Dole over CDSs was absolutely JAW DROPPING.

65 trillion dollar market, and nobody knows exactly what it is. And, it has little if any transparancy, and virtually no regulation.

Although all agree that i serves a VITAL market function.

Holy Smoke. That's like something out of the twilight zone.

[Rick Ballard]

Barney,

The value of a mortgage is determined as much (actually, much more) by probability of repayment as it is by the value of the underlying property. The LTV on the Stinky Stuff is 83%. The Stinky Stuff only amounts to 4.5% (count, not value) of the total housing market. I was using a 50% residual valuation of the 83% (so 40-42% of the appraisal) to come to a 90%+ overall valuation of the whole MBS.

I cheerfully acknowledge that there might be some bomb hidden deep within this mess but shelter is one of those 'need rather than want' items and every foreclosure creates a renter.

[Barney Frank]

The discussion with Liddy Dole over CDSs was absolutely JAW DROPPING.

65 trillion dollar market, and nobody knows exactly what it is. And, it has little if any transparancy, and virtually no regulation.

Although all agree that i serves a VITAL market function.

Gmax or other sharp poster,

CDSs seem like they are a bit of a problem.
Don't they encourage irresponsible lending and double the leverage problem when the credit begins defaulting, especialy on assets which rise and fall in value like real estate as opposed to, say credit card balances?

Were mortgages hedged against default prior to CDSs? Or did the hedge simply consist of due diligence, substantial down payments and higher interest rates?

[GMax]

I dont think CDS are anywhere near the issue that you think. I will admit to it being fairly new "innovation" and not my own direct experience. The 65 trillion I am sure is the notional amount, and as such I would relax, as that never ever comes into play WELL unless the democrats botch the bailout and every damn think melts right in front of us.

[Charlie (Colorado)]

And I do understand that, held until maturity, the underlying mortgages do pay off at face value as do the MBSs. Just seems like there has to be some considerable effect on these MBSs when the asset they are ultimately founded on declines 20%.

The value of the mortgage is not the same as the value of the underlying asset: just like you get to keep the gains if you get more at sale than the remaining value of the mortgage, you're on the hook for the loss if you don't get as much on the sale. In a recourse state, the bank can collect that difference, in court if necessary, with your final defense being bankruptcy.

There's certainly risk that one way or another these wouldn't pay off 90+ percent; that's why Rick and I expect these things to sell for less. On the other hand, I got to 90 percent pretty conservatively, since I'm using all the defaults --- which would be not just foreclosures but also people who are simply a payment or two behind. Rick's approach was completely different and more details and he got effectively the same number. This gives me some confidence in the number.

[narciso]

65 trillion dollars, 5 times our annual GDP, yeah you could call it a problem; the financial version of MAD. There's no backstop large enough for that kind of exposure.

Yes, we know Matthew went to Dalton & Harvard, but his post evince a frightening
lack of knowledge about history, economics,
physics, animal husbandry, what have you. Much like his preferred presidential candidate; except Barry had the excuse of going to school; back when much of Reagan's policies had not succeeded fully yet.

[GMax]

You can have the loan not be fully collateralized and never have an issue. Borrower will not want to lose abode and besmirch credit rating so unless the collateral is in a nonrecourse state ( I think CathyF explained this to you before ) the collateral value is only that significant after a foreclosure. This is another way of saying what Rick said above.

[Charlie (Colorado)]

Barney, I think GMax gave you a good bit of the answer.

Were mortgages hedged against default prior to CDSs? Or did the hedge simply consist of due diligence, substantial down payments and higher interest rates?

The one thing I'd say here is that I'm sure mortgages were hedged before. People used to have to buy mortgage insurance until they had 20 percent equity or more. I don't know this is still true just because I haven't bought a house in a long time, but I'd think so, which would be another reason to think the underlying value is reasonably high.

The thing is, these CDSs weren't hedging mortgages, they were insuring mortgage backed securities, which I think were an innovation.

[GMax]

Here is a little more from Wiki but I am pretty certain this part is right, its entity insurance for the most part.

CDS confirmations also specify the credit events that will give rise to payment obligations by the protection seller and delivery obligations by the protection buyer. Typical credit events include bankruptcy with respect to the reference entity and failure to pay with respect to its direct or guaranteed bond or loan debt

Since most MBS that have investment grade ratings are overcollateralized to begin with, then this credit enhancement is standing behind a huge erosion is willing to pay on the mortgage, even further erosion of the excess collateral and then an unwillingness or structual inability to pay on the insurer's part due to a defined term like BK.

[Verner]

Yes, but this market (CDS) has gone form 165 billion to the monster we see today in just 10 years. That is in direct corelation to the Sub prime market, and the steps FMFM made to make unbacked loans for "affordable" housing, and all the loosy goosey credit that followed.

And they had to have some way to hedge all that junky stuff.

Like Paulson, Bernanke keep saying--it's the housing market stupid.

Boy, do I feel screwed. And mad. I don't know how Chris Dodd showed his frog like fgace at that hearing.

[Charlie (Colorado)]

Okay, Paulson (I think) just pushed back hard on the Dodd equity scheme.

[Podunk]

In response to the CDS being huge, opaque, and vitally necessary, there was a statistic today in the NYT David Brooks column noting that in 2001 there were only 900 billion in the CDS market. 7 years later, we have 45 trillion, and a crisis. Seems like we did pretty well through the 90's without them, and have a big problem now with them, so I'm pretty skeptical of the vitally necessary aspect of credit default swaps.

In an ideal world, banks will have learned their lesson and won't rely on them anymore. In the real world, I'm inclined to get rid of them altogether.

[Charlie (Colorado)]

Boy, do I feel screwed. And mad.

Take deep breaths. Everyone had good intentions, it just didn't work.

[Charlie (Colorado)]

In an ideal world, banks will have learned their lesson and won't rely on them anymore. In the real world, I'm inclined to get rid of them altogether.

Maybe so, but as Cthyf and I (and others, I can't recall) were pointing out is that there's always some really smart guy to find a new way around the rules. Sometimes that has unexpected side effects, but then the only other ansswer would be to completely regulate the invention of new products, and that would have side effects as well.

[Charlie (Colorado)]

Listening to Dodd, I reiterate my prediction that the result is going to look a lot like the original proposal, with no big dilutions and reverse auctions to clear the assets.

[GMax]

Obama's whole talking point on this is Gramm Leach Biley bill which deregulated financial institutions on Clinton's watch. Obama's advisor is having none of that per the WAPO:

In an interview on Friday, Rubin said the law, named after its now-retired congressional sponsors — Phil Gramm (Tex.), a top McCain economic adviser; Jim Leach (Iowa), who heads Republicans for Obama; and Thomas J. Bliley Jr. (Va.) — “had no impact, zero,” on the current crisis.

[Podunk]

Speaking of NYT editorials today (yes, I know, but it was free), there was also a pretty good article outlining four possibilities of what this bailout could look like, ranging from a Krugman-like equity injection to a Paulson-like overpaying for the assets to indirectly inject capitol.

As for the overpaying and getting equity for losses, I'm not sure it's such a bad deal for a bank. If they get the government to overpay but not realize the loss for 5 years, it's a 5 year loan at less than 5%. If they get 10 years out of it, it's less than 2.5%. Of course, it's in shares at todays prices, and any banking executive is going to assume his shares will be worth much more in 5-10 years. If he didn't, he'd be bailing for some other company that was going to show growth, so he could get his millions in bonuses.

The big problem for the banks is there's only downside risk, no upside benefit. While I have a hard time feeling a lot of sympathy for the poor souls, it does make me see why they're fighting it so hard.

So my question is, how does one build in an incentive to the banks to sell at a fair price if you don't do the equity compensation for losses? The only thing I could come up with is if they don't want to miss out on some of the 700 billion.

[Verner]

Podunk,

Someone brought the examples of Cryslar and the S&L bailout.

In both cases, there was no infusion of equity--the feds just took over bad debt as they are proposing to do now. And in both cases, the tax payer came out ahead.

Bernanke keeps emphasizing that these assets are not worth zero.

If we inject equty, that means we own shares in the banks--but the ones having a say in what "we" do with those shares are Chris Dodd and Barney Frank.

No, Merci.

Can you imagine what they would do with that kind of power? It could make the FMFM debacle look tame.

At heart, I think that both Dodd and Frank are socialists. They would be quite happy to nationalize everything. So why let them get their noses in the tent?

[Verner]

In an interview on Friday, Rubin said the law, named after its now-retired congressional sponsors — Phil Gramm (Tex.), a top McCain economic adviser; Jim Leach (Iowa), who heads Republicans for Obama; and Thomas J. Bliley Jr. (Va.) — “had no impact, zero,” on the current crisis.

Well, you know Rubin was a big Hillary supporter in the primaries.

You think that maybe some top level democrats are waking up to the fact that their candidate is a radical leftist with a red diaper baby as his campaign manager, and controlled by an insane billionaire who wants to rule the world?

Not to mention, he's as dumb as a pile of rocks on what its going to take to get this mess straigntened out?

[Gabriel Sutherland]

The major league problem today makes the S&L crisis look like T-ball.

[GMax]

I would much prefer a steeper mark on the assets purchased than the government directly holding equity in so many US corporations. You want the US to look like Mexico and Pemex? Democrats and their labor buddies can run wild just like Pemex. How does that sound?

[Charlie (Colorado)]

Okay, I'm sorry, but if Schumer was smart enough to find his ass with both hands, he's have them covering his mouth.

[Tom Maguire]

From Steve Sturm:

Why not combine the two? Have the Treasury buy these distressed securities AND receive some form of immediate equity stake in the firm coming to the feds for a bailout?

This avoids the problems TM has outlined while still giving the taxpayers a way of benefiting from their 'generosity'.

I don't have a religious objection to this. However, if the seller is obliged to toss in a free warrant, that pretty much obliges Treasury to "overpay" for the asset - what fool would give away warrants if the asset was fairly valued?

Which means that requiring "free" warrants assures that Treasury will overpay.

Conversely, suppose Treasury is given an opportunity to buy warrants separately. If the firm's share price declines and the warrants become worthless, did Treasury "overpay"? (Obviously, ex post they did, but ex ante?).

I wonder what the law would look like that obliged securities firms to sell a 25% stake to the government. Maybe not a big deal - I read somewhere that the government took warrants during the Chrysler bail-out.

Bonus Bizarre Example - for anyone not fully fed up with the Dodd proposal - imagine that I am the seller. My "troubled" asset is a conventional 30 year Treasury bond trading at par.

Treasury could easily lose money on this if rates are higher a year later. On the other hand, if they pay exactly par for it (the current price), I am giving them a great deal, since they get price protection during their holding period.

Hence, the "fair" price for the "troubled" asset is actually some premium to the fair, known, visible market price. Let's posit they pay 101 for the bond plus the price protection.

That means that Treasury's option is "in the money" on Day One - if they re-sell the Treasury for 100, they have an immediate loss of $1 for which they receive equity compensation.

However, options have time value, so they would be silly to exercise theirs. They can hold the T-bond and keep all of the appreciation (if any); if it goes down, they can ride it down as long as they want and then stick me with the loss.

So under Dodd, again a rational seller will only sell *above* the fair price.

And this is an improvement?

[Neo]

I wonder how many parts of the government can take equity positions for losses ?

Can locals claim an equity position in the homes of homeowners if property values drop and taxes go down ?

Maybe all of them can take an equity position after a natural disaster destroys homes and takes a hit on the tax rolls as losses.

[Charlie (Colorado)]

At heart, I think that both Dodd and Frank are socialists. They would be quite happy to nationalize everything. So why let them get their noses in the tent?

+1

[sbw]

I scanned this too fast, and have to go. I'll re-read again later.

Can someone answer me this: Isn't an MBS tranche a nebulous mixture of mortgages? Or were some tranches set up as Stinky Stuff tranches?

If one is as ambiguous as another, then it would seem hard to separate out the Stinky Stuff and the overall value of the Potentially Stinky Stuff tranches would be as high as any other tranche.

Of course that made sense. Right?

[Charlie (Colorado)]

SBW, Rick said there are recognizably smellier tranches, and those are what the Treasury wants to buy up.

I presume part of the process of setting up the auction will be gaining some transparency on the actual composition of each tranche so the buyers can exercise due diligence appropriately.

[glasater]

The 65 trillion figure brought a Trip Down Memory Lane with Cathyf .

We were going through this stuff 'way back in June. Seems like decades to me:-)

[sylvia]

I haven't had time to study in depth the proposals yet. But one thing I know is that these brokerage firms are pretty much legalized mafia extortion firms.

I remember when we had the dotcom crash, and I looked at my dad's stocks that were sinking every month after he complained about it. I told him he needed to do something about it, but he said his adviser at Meryll Lynch told him to hold on to the stocks, and of course he trusted him and he was the expert. So we made an appointment with his advisor, and I spoke to him and said, I am no expert, but it seemed if the stocks were crashing, it was time to sell. He said no, no, it's just temporary. Of course the stocks never came back to where they were. Then we heard years later that Meryl Lynch was involved in some scandal.

The point is, these low level advisors don't know the first thing about finances and don't care about your money. They follow the directive from corporate, and corporate issues the directives to prop up their favorites and earn their own money to buy their vacation homes in Santa Fe.

As a resut, milions of people buy en masse, like a herd of sheep, hence resulting in huge artificial swings, with the periodic stock and banking scandals that we have today. The moral of the story is, don't listen to the experts - do it yourself.

[Extraneus]

Here's an interactive map showing some subprime mortgage statistics from 2004-2006. The page contains a link to a somewhat prescient accompanying WSJ article, the authors of which claim to have reviewed the data from 130 million loans over the prior decade and conclude that the "high-rate" loans were distributed over a much large demographic than just low-income urban homebuyers. No supporting data was included on that last piece (that I could see).

[sylvia]

Yes my hunch is is that it is not the low-income loans that are causing the problem. I think that is another myth Wall Street is propagating to save face. There couldn't be enough low income people out there to cause a problem this big, and I don't know what low income people they are talking about, but the ones I know pretty much don't own their own homes, even still, it's the rare one who does.

No, the problem is the price of housing is too high. It's been too high for at least the last five years. It was a pyramid scheme destined to crash. I knew that about five years ago which is why I didn't buy any property since then. Lots of other people didn't get that, including the experts on TV until recently, and they thought the prices would climb forever.

The Feds should have raised the mortgage interest rates steadily higher starting about 5 years ago, maybe up to 10%. That would have discouraged the price inflation.

[Rick Ballard]

SBW,

I do not warrant and cannot guarantee etc* that all MBS are structured like this one but I suggest that you read through it for a few minutes to get an idea of what the Stinky Stuff tranches look like (they might start at M-1, they certainly start by B-1). Each tranche contains X mortgages and each of the mortgages is tied to its tranche, which has that all important CUSIP #. The Fed is certainly capable of evaluating each type of tranche and establishing whether the haircut should be a buzz or a razor. It's complicated but it's not hard.

*This comment is covered by CDS AB34789 issued by Fred's Insurance & Pawn which has assumed all liability therefore.

[sylvia]

That was an interesting WSJ graphic. It blames the problem on high interest loans. I thought the interest rates were too low in the last five years. However, after thinking about it, I still think the problem was still the interest rates were too low.

This graphic calls high interest loans loans that are 3 percentage points higher than the standard mortgage. Because the standard was so low, the high rate was not that high, comparatively. Because the standard rates were so low, there was a lot of movement in the regular market. Because of that, the investors didn't think three percentage points extra was so much more to pay if they thought they had a guaranteed payoff in the end.

When the main mortage market prices skyrocketed as a result of these low rates, it cooled, and then investors couldn't unload their goods. It's not that their investor rates were so high that was the problem, it's that they couldn't sell their goods to the general public.

[sylvia]

And by the way it's not just actual real estate investors I'm talking about, this includes regular people who paid high rates for their own homes thinking that it was a cash machine for them.

[Extraneus]

Here' a blog post (from nakedcapitalism.com) which was critical of the WSJ article, but not with regards to that aspect of it. The idea behind focusing on "high-rate" loans was that these were basically the subprime loans, as long as the low-introductory-rate loans were reported as high-rate loans, which didn't start happening until 2004.

[Charlie (Colorado)]

I remember when we had the dotcom crash, and I looked at my dad's stocks that were sinking every month after he complained about it.

Always remember, don't look at the broker's yacht: look at the yachts of his clients.

[Rick Ballard]

bgates,

Did you know that Troll Blocker 3 works on the terminally stuck on stupid just like it does on trolls?

Thanks again.

[Tom Maguire]

File this under "Games People Play" - a friend of mine is now at a hedge fund, having previously been involved in creating MBS at an investment bank.

He feels pretty confident in his ability to value this sludge, so this is what he does - he calls firms with paper he thinks it worth $0.45 and bids $0.15. Most guys he calls laugh and hang up, but at some of the firms the accountants come along with the goal of valuing this illiquid paper.

"What is your last bid on this?" they ask.

"Well, there are no serious bidders, this paper is illiquid" says the not-laughing-now trader.

"OK, what were the non-serious bids?" insist the accountants.

And sometimes the accountants end up insisting that the paper be marked down to $0.15. Not every time, but often enough. Then, when my friend calls back a week later, the trader is a lot more receptive - he has already booked the loss, so selling the paper and moving on doesn't seem so dreadful.

Works often enough to make a bit of money, assuming he can hold this and realize the value over time. And it certainly gives one pause in assuming that "the market price" has Biblical, oracular significance.

[Charlie (Colorado)]

I thought the interest rates were too low in the last five years. However, after thinking about it, I still think the problem was still the interest rates were too low.

Well, possibly, although remember the interest rates were low to deal with the financial impact of four airplanes and associated losses.

But in this context, they're talking about "high interest rates" by comparison, which should in theory correspond to the higher risk loans.

Except for Chris Dodd and some of the other Countrywide VIPs.

[Charlie (Colorado)]

Works often enough to make a bit of money, assuming he can hold this and realize the value over time. And it certainly gives one pause in assuming that "the market price" has Biblical, oracular significance.

And it's not even an insider trade; he's just wargaming the "mark to market" rule.

Tom, I think you've just succeeded in convincing me that M2M has to be rethought.

[Charlie (Colorado)]

Come to think of it...

Works often enough to make a bit of money, assuming he can hold this and realize the value over time.

... this should work even better if Paulson gets his way.

[JM Hanes]

"But....is Yglesias really a good writer?"

Hat vs. cattle.

[steve sturm]

TM:

By definition, the feds will 'overpay' for these assets, as (1) the price paid by the feds will be higher than the price the selling firm could get from a third party, and (2) the selling firm can hold any assets they feel isn't commanding a high enough price from the feds.

Having said that, I don't believe taking an equity stake in the seller would necessarily lead to the feds overpaying, as firms participating will do so only because they have no other alternative; for these firms, their choice is between giving up equity in return for bailout funds or to refuse and run the very real risk of being forced into insolvency.

And having said all that, I think the mistake is to structure the bailout as an asset sale, I would rather structure it as a loan that needs to (eventually) be repaid. The participating firm gets cash they can use to satisfy their current needs (replacing short term debt with long term variable repayment debt, pretty much a no-brainer on anyone's part). There is no fixed repayment schedule so the firm isn't hobbled, but it has to repay the money out of its future profits, the only limit being that they have to repay the money before they can restore executive compensation, start paying dividends or issue new equity (new equity can be used to repay these loans).

[Charlie (Colorado)]

Steve, I don't think that addresses the underlying issue: that the value of the securities has a wide variance. If you get a loan against them, you'd still never know what the securities would book at, and you'd still have to mark-to-market with every sneeze sniffle and cough in the market for the things.

If something forced you to mark the securities down below the price assumed in the loan, all you're doing is setting yourself up with a new liability.

[GMax]

That loan idea wont work. you still have the liability hanging around and why would anyone believe that the govt is going to better at collecting on these assets than the current holder?

[Charlie (Colorado)]

Okay, Rich Lowry just posted something at the Corner. I sent him a letter, but I'll c&p it here:

We've been digging at it over at Just One Minute (the proprietor is some kind of investor, and several of us are hard-core quants who have been or are currently doing Wall Street) and there are actually some good answers:

1) Bernanke made a distinction between the fire-sale price and the hold-to-maturity price and seemed to suggest the government would be paying the hold-to-maturity price. But how would it establish that in a fire-sale environment? Sen. Bennett tried to drill down on this and I'm not sure I ever heard a good answer.

I suspect it's because he wants more time to look at the things. We've made several different back-of-envelope estimates and we keep coming up with the idea that the whole mass is worth about 90 cents on the dollar. The securities themselves are currently way undervalued, say 15 cents on the dollar. The price Bernanke wants to pay, since it's his intention to neither gain nor lose money (we assume) is the discounted price that would pay an appropriate risk adjusted rate of return to the eventual buyer, which would be the hold to maturity price. The number that seems to keep coming up is about 65 cents on the dollar on average, but since he would have the chance to look at the underlying mortgages and evaluate each security individually, thereby making them transparent again. His goal would be to manage as well as he can with it, and then probably discount a bit more for protection.

2) It became clear a couple of times that even Paulson doesn't know how this thing is going to work exactly. Essentially, he wants maximum authority and flexibility and then he'll get a bunch of smart people in a room and try to figure it out.

Would you want to give the details to Dodd and Schumer? That just gives them a chance to try to get their hands in the pot.

3) Sen. Schumer's idea of doing it in stages seems to make sense. Why not make some notional commitment of up to $700 billion, but dole it out in monthly tranches and see if the thing is actually working before going all in?

And Bernanke says he wants to put it out in tranches. But if he doesn't have what he thinks he needs as full authority, it means he has to go back to Dodd and Schumer, hat in hand, every few months. That gives them many chances to screw it up, and doesn't fulfill the basic goal, which is to reassure the market that Daddy can straighten things out.

[Rick Ballard]

GMax,

It sure wouldn't take long to come up with a lower bound on the value of the property as a rental, using HUD Fair Market Rents and a Darth chosen cap rate. The model would be clean, easy to understand and would assure the taxpayer that they hadn't overpaid. All it takes is Zipcode, number of bedrooms and perhaps a sliding scale for loan amount. It would take the 'mystery' right out of the process.

[Charlie (Colorado)]

here's a question for you all: how long before the New York Times says the problem is the Bush Administration's repeal of Glass-Steagal?

[sylvia]

Ya'll should read Edith Wharton's House of Mirth for some inspiration, written in, I think, 1908. I read some Wharton books before, but just finished reading that one, very stark in it's description of New York wealth and Wall Street. If you skip past the love stuff, you can see that they were dealing with a lot of the same themes back then. And then the Great Depression happened...

[steve sturm]

Charlie: I don't see the problem you raise. I would combine the two elements of a buyout and loan. The firm would remove the hard to value assets from its balance sheet, removing the need or issues associated with mark to market (especially the risk of further declines in its value), and getting real cash to pay its real obligations.

Gmax: I don't know if the government will be any better able to collect than the current asset holder, but that is the price the firm has to pay in return for getting cash for junk. Firms that think they're being asked to pay too high a price always have the option of simply saying No.

I know you geniuses (said affectionately) make it all complicated, but it's not: a firm gets the opportunity to take hard-to-value, hard-to-move assets off its balance sheet in return for some cash and a promise to let the taxpayer share in the firm's future.

[GMax]

What I have not reconciled from anything in the testimony nor anyone else, is this. Since the traunches were sold off to different buyers with different needs, I dont see it being easy or even practical in most cases to put humpty dumpty back together again by buying all traunches of a pool. So if its unrated residuals that must wait until the rated superior pieces are paid off, there is little that can be done by the Fed except wait like the current holders.

Maybe there is more true cashflowing today pieces than I am supposing, but you cant tell it from anything I can find. And the ML and Sovereign Bank pricing aint near $.65
so until I know differently, I think it more uncertainty and lower prices than some are currently assuming.

[Charlie (Colorado)]

Steve, the problem is to make it, as Einstein said, "as simple as possible but no simpler." In this case, though, you've got a simple error.

You say "The firm would remove the hard to value assets from its balance sheet,...."

See, when you give someone money, and they take the asset off their balance sheet --- presumably giving you the asset --- that's called a "sale".

[tp]

Why not have Treasury swap a special issue sinking fund bond at a rate of 300 basis points over the rate on the mortgage pools with the right to put the mortgage pools back to the selling banks based on the stated amortization schedules on the mortgage pools at face. The banks could use cash (from earnings or the special issue treasury bonds to fulfill the obligation to accept the put. The Treasury could actually allow the banks to carry the special issue Treasuries as equity. Theoretically, this would give banks 30 years to work through the problems and the Treasury a nice profit on its money.

[Sara (Pal2Pal)]

At the risk of being permanently banned from JOM, I am going to admit that I'm bored to tears with this subject. I know there is a "crisis," but I don't care. I don't care, not because I don't realize the consequences and ramifications, but because there isn't a damn thing I can do to change whatever is going to happen anyway. All the talk in the world isn't going to change the greed and stupidity rampant in Congress or the lack of reality on Wall Street. I prefer to spend my time on things I can actually control and can have some influence on outcome. This "crisis" is not one of those things. I'm with Newt Gingrich.

[GMax]

Steve

Seriously your genius idea, gives them potentially a larger liability than before. See the 125% provision. Its one thing to swallow hard, take the cash and either shrink by running off non core deposits, or thinking you will be able to raise more capital with the sludge removed.

But with this contingent warrant nonsense, you probably say no thanks, I will continue to muddle along.

[bgates]

a friend of mine is now at a hedge fund, having previously been involved in creating MBS at an investment bank.
I'm going to guess that his wife was one of the people horrified at the presumptuousness of some rube from the sticks who thought she could regulate the business of the nation nearly as well as the Wise Men like Dodd, Biden, Raines, etc.

[steve sturm]

charlie: thanks for the accounting primer, but I already knew that. yes, the firm books it as a sale, removing issues associated with future valuations of the asset. They also have a contingent (non-booked) liability of the difference between the sale price and the price the government eventually recovers. Yes, this hidden liability is a drag on the stock price (both because it will be repaid someday and because dividends are halted until it is), but not on current operations. The firm's trading partners don't have to worry about the firm having the capital to make good on its obligations. The firm can continue making money in whatever other operations it has (in the case of Merrill, brokerage commissions). And to be fair, if the government makes a profit on the disposition of the asset, the firm gets the profit (less a cut for the taxpayers).

[glasater]

From Hot Air:

And James Pethokoukis regarding Newt's Plan.

He said the Paulson Plan would be a "dead loser" on Election Day that will "break against anyone who votes for it." It will hurt even worse with the 2010 election once Americans see what a drag it is on the economy when implemented.

This will be a loser on election day no matter who wins.

It's just that I like McCain's stable of ponies versus Zero's.

[GMax]

"We are angry that the SEC, the Fed, and Treasury did not warn us earlier. Still, we are extremely aware of the danger of not supporting the $700 billion bail out package, and in huge numbers, we will back the plan," one House Republican member who attended the meeting told ABC News.

Looks like the House Republicans wont be the problem. That leaves Senate Republicans and every Democrat as potential problems. Somehow, I expect some idiot to cause this to not pass, and massive dislocations. I hope I am wrong.

[Charlie (Colorado)]

And the ML and Sovereign Bank pricing aint near $.65 so until I know differently, I think it more uncertainty and lower prices than some are currently assuming.

Well, you're on to something there, and that's just why Bernanke and Paulson are needed to step in. You're absolutely right: if you look at any one of these things --- whether individual tranches or whole MBSs --- they're very hard to value, and your value has a wide variance (which is exactly the same thing as saying the value has great risk.) So you have to value the individual item at a risk-adjusted price, which will be very low.

But as we discussed before, if you buy up more or less the whole thing and make it one portfolio, the variance will narrow. I could explain it better with a picture, but basically it's going to be a more or less normal distribution, a "bell curve" sskewed to the high end and trailing off to the low end. The total area under the curve, the "mass function", is the total value of all the securities, the x axis is the probability that the "right price" is at a particular price, and the height is what that price is.

To Bernanke and Paulson, the whole market has a curve that's high and narrow. To anyone holding only a small (comparatively) portfolio, the curve is low and wide: the variance is greater, or in other words they don't have as much confidence in the price. Still, the total area has to add up to the value; the uncertainty forces the "best guess" at the price to be lower.

To reduce the variance, you need a really really big portfolio --- which is what that $700 billion is for.

(Cathyf, where are you? What's the right distribution going to look like? I'm sure it's going to look a lot like a kurtotic Gaussian. Use Black-Sholes?)

[steve sturm]

Gmax: setting aside the advantages / disadvantages the government has relative to the firm in getting value for these assets, why wouldn't the firm take the cash now? If they don't, and if the assets are (still) overvalued, they'd have to take the hit to earnings, capital and liquidity. If they sell the assets to the feds, any further loss is in effect deferred indefinitely. If I were running the firm, I'd gladly take a contingent obligation with a pay-it-back-when-you-can due date over a more immediate write down. Conversely, if the assets are fairly valued or undervalued, there is no repayment and the firm only has to suffer a relative small dilution of its equity due to the stake given the taxpayers.

[GMax]

(non-booked) liability

Really? I think you dont have a sale. I am only a CPA by training, but when the full risks and rewards of ownership dont transfer, it aint a sale. Lipstick on a pig to bring back a more mirthful time.

[Charlie (Colorado)]

Steve, then I think you're running into the "duck rule": it looks like a duck and it walks like a duck --- it's a damn duck. Paulson's scheme clears the books, sets them up for the reverse auction, and doesn't require six pages of footnotes to explain it in the Annual report.

[steve sturm]

A CPA who hasn't handled a sale with a contingent payment provision?

[GMax]

Charlie

The pieces have been scattered all over the globe. Some AAA holder wont want to sell, they like what they got. I dont think it feasible to put Humpty back together again.

[Charlie (Colorado)]

"... they're very hard to value, and your value has a wide variance (which is exactly the same thing as saying the value has great risk.)"

Actually, those are all three ways of saying the same thing, come to think of it.

[GMax]

Steve why dont you share your own expertise with us and we can see if you have any reason to be making fun of mine. Thanks.

[Charlie (Colorado)]

hey folks, I'm going to try to write 1500 words explaining all this to the interested lay person. Could I get some volunteers to review it this evening?

[steve sturm]

The problem I have (and I guess a whole lot of other people, Democrats and Republicans alike) with Paulson's proposal is that it takes the firm's problem assets and makes it our problem, and irretrievably so. As a taxpayer, I am willing to help out, but I don't want to assume ownership of the problem.

[GMax]

Steve

Perhaps since you know the sale rules so much better than me, you might share your thoughts on FAS # 5 ? Pay particular attention to how to recognize a sale when you have not for sure earned any revenue and may actual have to pay out more than you got. Thanks.

[Charlie (Colorado)]

The pieces have been scattered all over the globe. Some AAA holder wont want to sell, they like what they got. I dont think it feasible to put Humpty back together again.

Doesn't matter. ANY subset of the outstanding stuff, gathered into a single portfolio, will have a smaller variance than the individual items.

For that matter, the powers that B&P are asking for are sufficient that they can say "if you want to play, you have to sell all your portfolio to us." Some people will look at their portfolio and say "no thanks" and that's fine --- they probably will actually make out like bandits. The ones that are risking insolvency on paper will sell, and that's fine oo.

[steve sturm]

My experience includes being a principal in numerous transactions with contingent and/or deferred payment components.

It's been fun, but I've got carpool duties, got to go now.

[Charlie (Colorado)]

Hey, speaking of, GMax, how could one change FAS 157 to be simple and still not vulnerable to this kind of panic?

[Charlie (Colorado)]

It's been fun, but I've got carpool duties, got to go now.

besides, my mother's calling me.

[Rocco]

Call me a skeptic, but I don't see the government selling all this property at a fair market value. I see the government giving it away in a massive social program.

[GMax]

Charlie

Dont punch out mind numbingly complex securities and dont trash your credibility by stirring lots of liar loans into the mix, I guess.

Fas 157 aint the problem, its the opaque nature of the instruments.

[GMax]

deferred payments are not the issue here so nice try. FAS # 5 prohibits booking a sale when what you have is a loan that could convert in the future to a sale based on unknown and unknowable events.

FASB Statement of Financial Accounting Concepts No. 5, revenue is recognized when a transaction occurs and 1) the revenue is realized or realizable and 2) the revenue is earned.

revenue not earned, no sale.

Nothing accomplished. And still lots of gridlock and panic. Nice fix.

[Charlie (Colorado)]

Call me a skeptic,...

okay, you're a skeptic.

... but I don't see the government selling all this property at a fair market value. I see the government giving it away in a massive social program.

Why? that's not what they did with the RTC. The reverse auction plan would seem to argue they're going to get all the market will bear.

[Charlie (Colorado)]

Well, as I say, I'm not convinced one way or t'other about mark-to-market, but Tom's friend's example seems to argue that in an illiquid market, the current implementation of 157 seems vulnerable to being gamed.

[Charlie (Colorado)]

Steve's scheme could work as long as the enabling legislation allows Bernanke to impose changes on GAAP at the same time.

(insert screaming in terror here.)

[Charlie (Colorado)]

"...in an illiquid market, the current implementation of 157 seems vulnerable to being gamed."

Of course, if these things were transparent, they might not be illiquid, either.

[GMax]

Well if there is no market, then what is correct is probably zero. Its harsh, but it should make lenders a little more circumspect. I can tell you historical cost is the last refuse of scoundrels. I never want to see that return, we would be talking about a 2 trillion problem with that only it would be a year or more from now.

M2M is an early warning system. If cashflow is known, this securites would have easy values and buyers would exist. Its the multiple traunches, overcollaterilizations in the early traunches and prepayment and default assumptions that have changed that make this mess an especially vexing one.