There Is No Way They Understand This

Bloomberg News summarizes Dodd's alternative plan; the text is at The Politico (and a hat tip to blogger P Krugman, who writes: "Very preliminary, no details — but this sounds like a big step in the right direction."  Wait until he sees the fine print (although he will still back it, as explained below) - what Bloomberg characterizes as an equity stake is really a random loss recapture provision that dilutes the equity stake of current shareholders and will probably scare off prospective new equity investors; it does not represent new capital at all.

A baffler is here, from Bloomberg:

Sept. 22 (Bloomberg) -- Senate Banking Committee Chairman Chris Dodd offered an alternative today to the Bush administration's financial rescue plan aimed at giving the U.S. Treasury an equity stake when it helps companies burdened by debt.    

...

Equity Stake    

The legislation requires Treasury to take an equity stake equal to the purchase price of the assets being bought. If the company isn't publicly traded, the government would take senior debt instead, placing it in the front of the line of debt holders for repayment in the event of a bankruptcy.

Among my many questions [and see UPDATE - the Bloomberg summary oversimplifies the equity stake]:

1. IF the problem is an absence of capital in the financial services industry, how does issuing *senior* debt to the US Government solve that, and why is that a plausible alternative to equity?  Surely the US ought to be taking subordinated debt.  Answer - the point of this provision is to protect taxpayers in the event of a future loss, not to add capital to the system and enhance stability.  Let's note that the future loss requires a decision by Treasury to sell and realize a loss.  Let's also note that, since asset prices move as market conditions change, these losses may not reflect an "overpayment" by Treasury at the time of purchase - even a price that is free, fair, transparent and "correct" at the time can be overtaken by subsequent events. 

The text of the bill is this:

(ii) DEBT INSTRUMENTS.—In the event that the equity of the financial institution from which such troubled assets were purchased is not publicly traded on a national securities exchange, the Secretary shall acquire a senior contingent debt instrument in lieu of contingent shares, which shall automatically vest to the Secretary on behalf of the United States Treasury in an amount equal to 125 per cent of the dollar amount of the difference between the amount the Secretary paid for the troubled assets and the disposition price of such assets. The Secretary may demand payment of such contingent debt instrument under such terms and conditions as determined appropriate by the Secretary.

Well.  First, clearly a mechanism would be needed to track funding costs and cash receipts of instruments that were held for a while and then re-sold.

By my simple reckoning, suppose the Treasury buys an asset for $10 million dollars, tracks the funding costs and cash flows correctly, and then sells the asset for a net price of $10 million dollars.  Does this mean the senior debt vests at the difference between $10 million and $10 million, namely zero?  Well, yes.  In which case, what was the senior liability prior to sale and how were other investors supposed to evaluate it?  And I'm afraid to ask what the interest rate was on this senior debt.  This mechanism is not intended to put capital into non-traded firms *or* provide reassurance to investors - the goal is to protect the taxpayer.

So here is a new example - suppose instead of a final sale price of $10 million the asset is flipped for $8 million.  The difference is $2 million; 125% of that is $2.5 million.

So for costing the government $2 million the private firm now has a senior debt obligation equal to $2.5 million.  I see how that helped the government, but how did this help the firm or reassure investors? 

If the firm is exposed to losses on the assets it has "sold" during their remaining life, in what sense have they sold it?

OK, in some fantasy I suppose someone could argue that the firm's payment of $2.5 million represents their loss plus some share of the interest ostensibly due on the senior debt.  But I smell "half-baked" even at my great distance from Washington.

For the conventional equity my question is different - why do we think the financial sector needs $700 billion in new capital as well as an opportunity to shed $700 billion in troubled assets?  Or, if Paulson is limited to writing $700 billion in checks, why do we think that a mix of $350 of new capital and $350 of asset purchases is the right answer?  [See UPDATE; I made the mistake of relying on the Bloomberg summary instead of reading the bill.  Apparently, this "equity stake" vests at 125% of any losses on the asset in a manner similar to the senior debt described above, which is hardly equity as we normally think of it.  Instead, *if* Treasury chooses to recognize a loss on an asset, current equity holders are diluted by the issuance of new shares intended to compensate Treasury].

The general rule from the bill is this:

(1) IN GENERAL.—The Secretary may not purchase, or make any commitment to purchase, any troubled asset unless the Secretary receives contingent shares in the financial institution from which such assets are to be purchased equal in value to the purchase price of the assets to be purchased.

The UPDATE continues this train of thought but my key insight is this - a firm which sells assets to the government will experience equity dilution at a future date *if* the government sells the assets at a loss; if the government chooses to buy and hold or can sell at a profit, the firm is in the clear.   So how will a firm in that situation attract new equity investors?  The prospect of possibly dramatic dilution based on a Treasury decision to sell or hold a complicated, troubled asset based on prevailing market conditions (which may move against the asset even if the original price was fair) will probably deter many people.

This next bit is just goofy:

(B) MULTIPLE CLASS OF SHARES.—If the financial institution from which troubled assets are to be purchased has more than 1 class of shares, the contingent shares to be received by the Secretary shall be that class of shares with the highest trading price during the 14 business days prior to the date of the purchase of such assets.

So if one set of preferred shares were issued at 100 and are trading at 105 and another preferred class was issued at 50 and is trading at 40, the Treasury will be obliged to buy the shares trading at 105.  Why?  Because 105 is a bigger number?  Surely they want the government to purchase the class trading at the greatest discount from par (or the greatest premium to par, or something more logical than simply buying the class with the highest absolute dollar price).

This is being drafted by tired and confused lawyers who don't understand finance, and we are going to pass it this week?

DEVELOPING...

MORE:  Per the WSJ, there will be equity kickers in some fashion:

WASHINGTON -- The Bush administration has conceded several changes to its rescue plan for the troubled banking industry, including agreeing to compensation limits for bank chief executives taking part in the plan and the need for more help for homeowners facing foreclosure, a leading House Democrat said Monday.

Chairman of the House Financial Services Committee Rep. Barney Frank said the Treasury also agreed to Democrats' idea that the federal government should receive warrants to take an equity stake in financial firms in exchange for the government purchasing toxic assets from them.

That is a difference in reporting, but the story does not explain whether the Dodd bill has been revised. 

UPDATE:  I should have read on!  Here is the bill describing the vesting of the equity investment:

(3) VESTING OF SHARES.—If, after the purchase of troubled assets from a financial institution, the amount the Secretary receives in disposing of such assets is less than the amount that the Secretary paid for such assets, the contingent shares received by the Secretary under paragraph (1) shall automatically vest to the Secretary on behalf of the United States Treasury in an amount equal to— (A) 125 percent of the dollar amount of the difference between the amount that the Secretary paid for the troubled assets and the disposition price of such assets; divided by (B) the amount of the average share price of the financial institution from which such assets were purchased during the 14 business days prior to the date of such purchase.

[Note - "14 days" is simply evidence of fatigue and haste; it should be 10 business days or 14 calendar days].

Let's work through a new example. 

1.  "Troubled" sells $50 billion of dubious assets to the Treasury.

2.  At some later date the assets are sold for $40 billion; I have no idea whether the $40 billion figure tracks cash receipts and funding costs but it ought to.

3.  The Treasury loss of $10 billion results in a contingent claim for $12.5 billion.  To satisfy this claim "Troubled" does not write a check or simply say "Sorry".  Instead, they issue new shares to the Treasury.  How many?  Well, let's assume that the average share price for the two weeks prior to the Treasury purchase was $10/share.  In that case, "Troubled" needs to issue 1.25 billion new shares at $10 each, to the Treasury, thereby satisfying their $12.5 billion obligation.

And what are those shares worth when the Treasury gets them?  That depends on the prevailing share price.  If "Troubled" is on the brink of bankruptcy, they are essentially worthless; if "Troubled" stock has soared, they could be worth quite a bit.

At first blush this approach does nothing to address Krugman's assertion that the Treasury must inject new capital into the system.  On day one, "Troubled" had $50 billion in bad assets.  On day two, they had a check from the Treasury for $50 billion, which presumably was used to retire short term debt.  And on Day Three "Troubled" showed $50 billion less in bad assets, $50 billion less in short term debt, and 1.25 billion new shares outstanding.  The upshot - current holders were diluted in exchange for an opportunity to sell their bad assets at a negotiated price with Treasury.  When did new capital come into the system?  Not ever.  However, the asset-to-capital ratio was reduced by the asset sale, as I argued here, so the capitalization of the industry was impoved even without more capital.

Now, one might argue that this equity make-whole provision gives a firm an incentive to be sure it is not overpaid for the assets it sells - assets sold at a premium are more likely to result in equity dilution down the road. 

However, economic conditions change and markets change with them - even if the original selling price of $50 billion was absolutely and inarguably fair, subsequent changes might knock the value of those assets down to $40 billion.  In that scenario, the seller is still penalized through a forced sale of equity.  Why do we want to do that?  Yes, it protects the taxpayer but does that add to stability of make the raising of new capital easier?

Or if the Treasury chooses to simply play a buy and hold strategy with a particular bum asset, that particular seller will never be penalized since the asset will never be sold.  Does that make sense?  From a different perspective, it actually might make profit-maximizing sense for the Treasury to sell the worst-performing assets in order to scoop up equity stakes in the sellers.  Whether Treasury would act on that incentive and whether that contributes to financial stability I can't guess.

Well, let's acknowledge that the goal is not to inject new capital or increase stability but simply to recoup losses for assets for which the Treasury "overpaid" (regardless of whether the initial price was fair).  The shares the Treasury receives will be worth something even in near-bankruptcy, but the direct connection to the "loss" will be slight - if, for example, the seller's shares have doubled, Treasury gets a windfall on bum assets on which it realized a loss, regardless of the fairness of the original purchase price.  If the firm is near bankruptcy then Treasury gets virtually no compensation for its "overpayment".

Krugman asserted that direct equity investment by the government made more sense as a way to stabilize the system and deter gamesmanship and bad behavior.  I argued that his objections ignored the fact that selling assets is another way to improve capital ratios.  But although I assume he will support this Dodd proposal, I can't wait to see how he contorts himself to square it with his previous call for direct equity investment to stabilize the system. 

Dodd is calling, in effect, for random equity issuance with no underlying cash in order to dilute some owners if the Treasury chooses to sell assets at a loss, regardless of why or when that loss may have occurred.  This does not bring new government equity into the system but may create enough uncertainty to deter private investors from joining in.  That is stabilizing?  How in the world will any of these firms attract new capital investors (if that is what is needed) with that random cloud over their heads?  How will a prospective new investor in a firm evaluate the joint probability that (a) the assets sold by the firm a few years ago have depreciated and (b) the Treasury will actually sell them rather than ride it out?

Krugman will support this because it looks punitive and onerous to Wall Street.  But this is daft.

Comments

[MarkO]

"This is being drafted by tired and confused lawyers who don't understand finance, . . .."

I can only hope the billing rate is high, as it should be. It's damn hard to do something you know nothing about.

[Charlie (Colorado)]

Dodd's billing rate must be astounding.

[Sasha Baron Cohen]

The 32-word shot heard 'round the world.....

"Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency."

In short, the so-called "mother of all bailouts," which will transfer $700 billion taxpayer dollars to purchase the distressed assets of several failed financial institutions, will be conducted in a manner unchallengeable by courts and ungovernable by the People's duly sworn representatives.

[Barry]

Hmm, sounds like I might as well write the plan.

[MarkO]

Dodd couldn't draft a stock car.

[Barry]

test

[Thomas Collins]

TM, totally relax about the statutory language being murky. We lawyers in the financial markets sector of law practice are used to dealing with murky statutes. That part will all work out. It's getting the big picture structure of the bailout (or, as I like to call it, the Government Facilitated Restructuring Resolution) correct that's key.

And maybe we are all a little overwrought about this. We are in a lot better shape than when Alexander Hamilton successfully sold his plan for the Feds to take on the Revolutionary War debt of the States.

[bgates]

ungovernable by the People's duly sworn representatives.
If the People's duly sworn (and not unduly sworn at) representatives agree to the plan, yes.

[Daddy]

Remember how Socrates was considered the wisest man in the world because he was the only one who realized how little he knew?

Well I for one wish our Solon's knew a whole lot less.

[MayBee]

Has Barack Obama reclaimed the Senate Banking Committee yet? What's he waiting for?

[Podunk]

I seems like they're trying to trend somewhere toward the "government gets equity for losses" idea that's been floating around CalculatedRisk for a while. But the Bloomberg summary doesn't really cover how the shares are contingent. Here's some text from the bill:

(3) VESTING OF SHARES.—If, after the purchase of troubled assets from a financial institution, the amount the Secretary receives in disposing of such assets is less than the amount that the Secretary paid for such assets, the contingent shares received by the Secretary under paragraph (1) shall automatically vest to the Secretary on behalf of the United States Treasury in an amount equal to—
(A) 125 percent of the dollar amount of
the difference between the amount that the Secretary paid for the troubled assets and the disposition price of such assets; divided by
(B) the amount of the average share price
of the financial institution from which such assets were purchased during the 14 business days prior to the date of such purchase.
(4) DEFINITION.—As used in this subsection,
the term ‘‘contingent share’’ means any equity security traded on a national securities exchange.

--

So the treasury isn't automatically buying in, they're just saying that if we (the taxpayers) buy it at too high a price, we'll be protected on the back-end by this provision.

As TM said, this doesn't actually reduce their risk. They're still on the hook for the losses, at 125%/share price. Well, now that I think about it, I guess it does reduce some risk, in that it sets the price (in stock) of the sale of these assets. For instance, if bank A has a debt that it knows is worth absolutely nothing, but sells it to the treasury for $1 billion, then they'll have to give up $1.25 billion worth of stock (at todays prices, not the drastically reduced price after the deal) at some point in the future.

Wait, that sounds a lot like what AIG ended up with, selling 80% of the company for $85 billion. I'm sure the shareholders of all these other companies will be thrilled by this prospect, but it at least ensures that the new creditor (us, the taxpayers) won't demand cash that can't be obtained and force a bankruptcy.

So while I'm not sure what's up with the whole debt instruments thing, I think the stock version has been given a bit of a bad summary from Bloomberg. Whether it's a good idea, I'm not ready to pass judgment just yet. Just wanted to clear up a misconception.

[Pofarmer]

This is gonna turn into a clusterfuck of epic proportions.

[Blue Texan]

"We cannot have taxpayers footing the bill for bloated golden parachutes like we see in the Lehman Bros. bankruptcy, where the top executives are asking for $2.5 billion in bonuses after they ran the company into the ground."

No, we cannot. Except of course when those top executives work for John McSame.

Earlier in the day McCain was asked if Carly Fiorina, one of McCain's top economic advisors, is an example of the problem. Fiorina was fired as CEO of Hewlett-Packard in 2005 but left with an estimated $45-million severance package while some 20,000 employees were laid off.

"I don't think so," McCain said on NBC's Today. "I think she did a good job as CEO in many respects."

[bio mom]

I read that Pelosi is trying to stick her "no-drill" drilling bill onto the bailout bill!! What the heck are they doing?? Do they think this is all some kind of political joke? On the Sunday News Shows Schumer was promising they would not "decorate" that bill. It was too important. But now it is politics as usual??

[JM Hanes]

MayBee:

"Has Barack Obama reclaimed the Senate Banking Committee yet? What's he waiting for?"

It's really quite stunning that Obama has not bothered to convene his Banking Committee even once, isn't it?

[Verner]

Why in the hell would I want Soviet banking? Because that's exactly what he's proposing. I think Fannie Mae and Freddie Mac were quite close enough thank you, and look where they got us.

Why in the hell would I want to put so much control of the economic power of this nation to a socialist like Chris Dodd who started his political career chanting Ho Ho Ho Chi Mihn?

Why in the hell would I want to give any more power to Dodd and Frank, the two assholes who got us into this mess in the first place.

I read Newt's piece at NRO. Partner this so called emergency plan with a comprehensive energy bill, that will keep 500 billion a year in the country, and slash capital gains to ZERO--and then we'll talk.

I'll only add, make sure that the government Never ever ever ever again secures another worthless suprime loan. Ever.

[clarice]

JMH I posted something you might find of interest on the Stray Thoughts thread.

[Patrick R. Sullivan]

If Dodd is trying to get something like the Swedes did when they had the same problem in the 90s, fine:

Sweden didn't just bail out its financial institutions by having the government take over the bad debts. It also clawed its way back by pugnaciously extracting pounds of flesh from bank shareholders before the state started writing checks. That strategy kept banks on the hook while returning profits to taxpayers from the sale of distressed assets by granting warrants that turned the government into an owner. Even the chairman of Sweden's largest bank got a stern answer to the question of whether the state would really nationalize his bank: yes, we will.

[...]Sweden formed a new agency to supervise institutions that needed recapitalization, and another that sold off the assets, mainly real estate, that the banks held as collateral.

Sweden told its banks to write down their losses promptly before coming to the state for recapitalization. In a similar situation later in the decade, Japan made the mistake of dragging the process out, officials in Sweden and elsewhere note, delaying a solution for years.

Then came the imperative to bleed shareholders first.

[Sweden's finance minister Bo] Lundgren recalls a conversation with Peter Wallenberg, at the time chairman of SEB, Sweden's largest bank. Wallenberg, the scion of the country's most famous family and steward of large chunks of its economy, heard from the finance minister that there would be no sacred cows.

The Wallenbergs turned around and arranged a private recapitalization, obviating the need for a bailout at all. SEB turned a profit the following year, 1993.

"For every krona we put into the bank, we wanted the same influence," Lundgren said. "That ensured that we did not have to go into certain banks at all."

By the end of the crisis, the Swedish government had seized vast swathes of the banking sector, and the agency had mostly fulfilled its hard-nosed mandate to drain share capital before injecting cash. When markets stabilized, the Swedish state then reaped the benefits by taking the banks public again.

[Roux]

Maybe I've got it wrong but aren't these individual mortgages "bundled"?

[bgates]

Hooray, the government is adding mortgage aid to their plan!
The proposal that Dodd sent to Treasury Secretary Henry Paulson would let judges modify the mortgages of homeowners in bankruptcy to allow them to keep their homes.

It also would require that the government come up with "a systematic approach for preventing foreclosure" on the mortgages it acquires as part of the bailout.

Not only will I be able to keep renting until I'm 40, I'll be allowed to subsidize the mortgages of the irresponsible morons whose fraud started this whole mess! And keep Chris Dodd in office!

[Rick Ballard]

"Maybe I've got it wrong but aren't these individual mortgages "bundled"?"

First you bundle 'em, then you put 'em in a blender for a week, then you freeze 'em and run 'em through a chipper, then you run 'em through a food processor and meat grinder then you bake 'em for a month at 850.

Then you serve 'em by the slice (after blindfolding the customer).

How many pieces would you like?

Could Paulson jump start the M2M revision that will occur 20 minutes after the first reverse auction by making some sort of valuation announcement on FNs teeny tiny pool of MBS? That would clear up some of the uncertainty that seems to be clogging the markets.

[RichatUF]

Pofarmer-

This is gonna turn into a clusterfuck of epic proportions.

Yep. I really thought that the Dem's would have waited til Wednesday though. Wonder if they plan on walking this thing over the cliff tomorrow as a gift for Ahmadinejad while he gloats and makes his dawa.

[clarice]

bgates--I'm laying by a large supply of sharpened pikes and invite you all to koin me on a march to the Capitol.

[clarice]

**Join me***

[Thomas Collins]

Bggates, we should be so lucky if all that is added to this bill is mortgage aid relief. I half expect the Reid-Pelosi-Obama Axis of Corruption to add special grants to foundations run by community organizers

[Extraneus]

Sharpened pikes? I think I'd like to join, Clarice.

[Charlie (Colorado)]

I'm laying 8 to 5 that what comes out will be recognizably what they started with. In particular, I'm reasonably sure Bernanke and Paulson are at least as smart about this stuff as the rest of us, and so recognize that anything which makes the asset valuation of mortgages more uncertain will make things worse, not better.

[bgates]

I'm laying by a large supply of sharpened pikes and invite you all
At last, community organizing I can believe in!

[clarice]

I hope you are right, chaco, but I wouldn't bet on anything..Maybe when they start foreclosing on Dodd's home and attaching liens on chez casa de Pelosi.

[Rick Ballard]

Extraneous,

You asked about details re mortgages on another thread. Here's a Morgan Stanley 'deal' to thumb through - if you scroll way down you'll find info on individual defaults and prepays with amount, state, LTV and interest rate.

If you have any questions, be sure and ask Charlie and GMax.

[Jim Rhoads aka Vnjagvet]

First you bundle 'em, then you put 'em in a blender for a week, then you freeze 'em and run 'em through a chipper, then you run 'em through a food processor and meat grinder then you bake 'em for a month at 850.

Then you serve 'em by the slice (after blindfolding the customer).

How many pieces would you like?

At the end, though, there are notes and mortgages securing them with deeds to individual properties. There are individual obligors and insurers and guarantors on each transaction. It will keep little drones busy 24/7 just to figure out what is really there. In pretty quick time, someone will figure out how to make a new buck on the mess. In many instances, if the past is any indication, it will be many of the same folks that got us into the mess in the first place.

Remember, one of the most successful stock manipulators in the 1920's became the first Chairman of the SEC after it was formed during the depression to protect investors and recreate the market for corporate stock.

You may remember his name. Joseph P. Kennedy. His youngest son still sits in the Senate. Unlike his dad, he is a liberal.

[clarice]

(A little sherbet here to cleanse the palate.)
Taranto has fun with last week's WaPo who effed up story:
"So the Washington Post is saying you can't believe McCain's ad because it is based on reporting in . . . the Washington Post. The Washington Post is not a reliable source of information, according to the Washington Post.

But if the Washington Post is not a reliable source of information, how can we believe the Washington Post when it says it's not a reliable source of information? But if we don't believe the Washington Post when it says it's not a reliable source of information, then we must believe the Washington Post is a reliable source of information, in which case how can we believe the Washington Post is not a reliable source of information. But if . . .

You get the picture. Clearly this is part of a sinister plot by the Obama-coddling mainstream media to induce madness in all Americans who have the capacity for logical thought, rendering them unable to vote and ensuring the election is decided by Obama backers who act totally on emotion.

Then again, it may not work. After all, "Star Trek" was only a TV show.
"

[Extraneus]

Thanks, Rick. Those pre-payment detail tables are all defaults?

[Tom Maguire]

Wait, that sounds a lot like what AIG ended up with, selling 80% of the company for $85 billion. I'm sure the shareholders of all these other companies will be thrilled by this prospect, but it at least ensures that the new creditor (us, the taxpayers) won't demand cash that can't be obtained and force a bankruptcy.

Thanks, I had a chance (finally) to read on and see the vesting bit, so the post has been substantially updated.

Still a daft, non-stabilizing idea.

As to forcing a bankruptcy, well... I'll repeat the example from the post:

Let's work through a new example.

1. "Troubled" sells $50 billion in dubious assets to the Treasury.

2. At some later date the assets are sold for $40 billion; I have no idea whether the $40 billion figure tracks cash receipts and funding costs but it ought to.

3. The Treasury loss of $10 billion results in a contingent claim for $12.5 billion. To satisfy this claim "Troubled" does not write a check or simply say "Sorry". Instead, they issue new shares to the Treasury. How many? Well, let's assume that the average share price prior to the Treasury purchase was $10/share. In that case, "Troubled" needs to issue 1.25 billion new shares at $10 each, to the Treasury, thereby satisfying their $12.5 billion obligation.

And what are those shares worth when the Treasury gets them? That depends on the prevailing share price. If "Troubled" is on the brink of bankruptcy, they are essentially worthless; if "Troubled" stock has soared, they could be worth quite a bit.

At first blush this approach does nothing to address Krugman's assertion that the Treasury must inject new capital into the system. On day one, "Troubled" had $50 billion in bad assets. On day two, they had a check from the Treasury for $50 billion, which presumably was used to retire short term debt. And on Day Three "Troubled" showed $50 billion less in bad assets, $50 billion less in short term debt, and 1.25 billion new shares outstanding. The upshot - current holders were diluted in exchange for an opportunity to sell their bad assets at a negotiated price with Treasury. When did new capital come into the system? Not ever.

SO, no new capital and random dilution depending on asset performance and a Treasury decision to hold rather than sell.

[Pofarmer]

Ok. Somebody correct me if I'm wrong. But. If the taxpayer buys out this bad debt, then subsidizes the mortgage holder, aren't the taxpayers paying for the same thing twice?

[Rick Ballard]

Extraneous,

No, the tables at the very bottom are prepays. The starting pool (for the period) was 11,152 loans, 246 prepaid and 391 were in foreclosure, REO or BK. An additional 906 were delinquent. That was a YE 2006 report and was the last one required to be filed with the SEC for that deal.

It's just an illustration of the complexity of a typical MBS - 11,152 loans with a face values of $2.16 billion divided into 15 tranches, each paying a slightly different interest rate depending upon the presumed quality of the tranche.

Fun stuff.

[Rick Ballard]

Extraneous,

Sorry. I missed the import of your question. A prepaid loan is one that is paid off in full prior to its term. These pools do not have a 30 year life because people refi, sell, default (I'd add 'and so on' but I can't think of anything else the do). GMax mentioned that the average life (duration) of these things is 9 years. That's a variable that is very dependent upon the movement and direction of interest rates wrt the refi portion but I don't doubt that it's an excellent rule of thumb.

What seems to be missing in the discussion is the fact that the "worst" wrt foreclosures due to fraud and stupidity (or unbridled optimism) is behind us. The crest of the reset wave passed in August and the foreclosure rate will fall from this point forward unless the unemployment rate skyrockets.

[bgates]

The crest of the reset wave passed in August and the foreclosure rate will fall from this point forward
How can we know that, Rick?

[GMax]

Actually the duration changes, daily. I have no idea what the duration of these 2006 mortgages would be. If interest rates rise the duration tends to get a bit longer and vice versa. Makes sense, if rates fall folks are looking to refinance, when they rise they like to hang on to their below market rate and may even forgo a move in some cases because the rate is so good.

Its substantially less than 30 years even if that it the stated maturity on every damn loan in the portfolio. Almost no one stays in the same mortgage on the same house for 30 years.

I have seen mortgage portfolios of 9% face rates in a 7$ market have durations around 5 years. They litterally were paying off while you watched.

[JM Hanes]

You know what? There's no way I understand this either -- any of it. As your average, reasonably intelligent, voter, who never borrowed her way into bankruptcy and who may glance at the front page of the Wall St. Journal when she's stuck in an airport, perhaps y'all might be interested in hearing what things look like from outside the loop.

I see a vast incestuous partnership between government and financial marketeers, building a gigantic house of cards atop the U.S. economy, all playing poker with money other people made. I see whole industries devoted to cultivating and selling debt at every conceivable level, from the top all the way down to the guy at Sears who shows you how to borrow more money on your house so you can pay three times as much for those replacement windows than they're worth -- and thoughtfully providing the paperwork that will allow every Tom, Dick and Harry to take a cut of the markup as it travels through what is loosely called a capitalist system.

I don't have much sympathy for folks who take on too much debt, but it's more than ironic when the very people who are so willing to share in the profits that debt generates self-righteously assert that the irresponsible suckers at the bottom of the scheme, who make it all possible, have only themselves to blame for the consequences -- but heaven forfend the house of cards collapsing!

The average voter thinks it's the Feds & Wall St. who have only themselves to blame, but not to worry! There are plenty of tax-paying suckers to foot the bill which keeps the Feds and Financiers in business, because, of course, you know whose economy they'll wreck on the way down, don't you? Silly me, I thought I was already doing my part to keep them afloat when I paid those ginormous finance charges on my overdue credit card bills.

[JM Hanes]

Clarice: I'll check it out.

[Angellight]

"In 2007, Wall Street's five biggest firms-- Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley - paid a record $39 billion in bonuses to themselves." ABC's Political Punch -- I say no Bail Out!
AND
Sen. John McCain’s campaign manager, Rick Davis, was paid more than $30,000 a month for five years as president of an advocacy group set up by the mortgage giants Fannie Mae and Freddie Mac to defend them against stricter regulations!
http://www.nytimes.com/2008/09/22/us/politics/22mccain.html?ref=politics

More McCain Hypocrisy! - And for those who think we will not have another Bush/Cheney Whitehouse if McCain gets elected, please be advised that McCain has 10 former Bush strategists and operatives working and advising him now. They are: Steve Schmitt, Tucker Eskew, Tracey Schmitt, Nicole Wallace, Mark Wallace, Stephen E. Biegun, W. Taylor Griffin, Matthew Scully, Greg Jenkins and Matt McDonald, which spells McCain-Bush all over again!

McCain who has been Chairman of the Commerce Committee for years says he knows very little about the economy, the one truth he has been honest about, because it has always been about Corporations first, only and last! It is our turn now and no more corporate bail outs who are in fear of losing their luxurious way of life on the back of the American people.

[Pofarmer]

GMax

I wonder what the duration on these notes would be compared to the 1990. I know an awful lot of people who had borrowed back up to 100% or darn close with home equity loans. I know some others that were zero down and 30 year and no dang way that they are making extra payments. Maybe the refi's would average them out, but I just don't seeing these loans being of as short a duration as 20 years ago.

[Pofarmer]

Yep, the Homeownership alliance was pretty controversial at the time.

Based in Washington, D.C., the Homeownership Alliance is a coalition whose members include Consumer Federation of America, The Council of Insurance Agents & Brokers, The Enterprise Foundation, Fannie Mae, Freddie Mac, Habitat for Humanity International, Independent Community Bankers of America, Independent Insurance Agents of America, Local Initiatives Support Corporation, National Association of Hispanic Real Estate Professionals, National Association of Home Builders, National Association of Real Estate Brokers, the World Floor Covering Association, National Bankers Association, National Council of La Raza, and National Urban League.

The National Association of Realtors®, “The Voice for Real Estate,” is America’s largest trade association, representing more than 800,000 members involved in all aspects of the residential and commercial real estate industries.

[PeterUK]

"McCain who has been Chairman of the Commerce Committee for years says he knows very little about the economy,"

Presidents don't need to know about the economy,they need to be able to delegate and take advice.
But what happened to Congressional Oversight,what are the Lawmakers doing?

[The Duke of PUKE]

"what are the Lawmakers doing?"

Concern yourself more with MP.......

[Rick Ballard]

bgates,

The NY Fed is providing very detailed sub-prime information. The interactive mapping feature is good if you don't like poring over Excel spreadsheets (although I really don't understand the utter depravity involved in not enjoying combing a spreadsheet). The ARM reset level is forecast to be down everywhere but Utah and the Alt-A reset level is down or unchanged for all the problem states.

[JM Hanes]

Gateway Pundit has today's Gaffetastic EconObama video.

[GMax]

You know I went to see if I could find any readily available calculations and I did find one quick that said that in Feb 1997 that a FHlMC 7.5% security had a duration of 4.4 years and a price of 99.75.

That does not go all the way back to 1990 but its still back quite a bit and duration is quite low and the price being about par means that the market rate was only slightly higher than the face of the security.

Mortgages pay off, by sales and refinancings and terminate by foreclosures. You dont get long lifes in Mortgages in the US, despite the face terms.

[Baffled Bean Counter]

James Howard Kuntsler

"Any way you paint this grotesque panorama, it looks like a very new chapter of history for life in the USA. Basically, we are a much poorer nation than we were even a couple of years ago, and we have a much-reduced ability to project our will around the world, or even among our own floundering sectors and regions. Most troubling to me is the question of legitimacy that now hangs over the proscenium like a guillotine blade. Factoring in the old saw that history doesn't repeat but it rhymes, I think the situation emerging is rather like the crisis of legitimacy that preceded the Civil War. Then, in the 1850s, the nation's two symbiotic political parties, Whig and Democrat, entered a zone of fatal discredit. The White House had been occupied by a sequence of empty cravats named Fillmore, Pierce, and Buchanan, and so much pent-up mistrust roiled the centers of power that the nation entered a convulsion.
At issue then was the great festering unresolved polity of slavery. The Whig party, in its oafish, craven fecklessness, disappeared so quickly from the scene that an embarrassed God Almighty seemed to have hooked it off-stage in a nanosecond. Into the vacuum stepped an awkward lawyer from Illinois -- widely mocked by the coarser elements of what was then called the press as a figure resembling an ape in a stovepipe hat. He accomplished one crucial thing in the process of his emergence: he deployed a potent rhetoric that captured the essence of the crisis and clarified it for all to understand what was at stake -- and then the convulsion commenced in earnest.
The Republican Party amounts to today's Whigs. Their candidate for president, John McCain, is trying to run away from his own party -- as one might shrink away from a colony of importuning lepers. I am actually not kidding when I label the Republicans "the party that wrecked America," because I believe that is truly how the popular strain of history will regard them when (maybe if) the wreckage of their ministrations ever clears."

http://jameshowardkunstler.typepad.com/clusterfuck_nation/

[Charlie (Colorado)]

Well, Angellights comment is copied verbatim at least at Daily Kos, Yglesias, and two or three other blogs. A special martin no prize to the person who finds the original source.

[Rhetoric Cop]

"comment is copied verbatim'

Invalidation found 'invalid'

[Patrick R. Sullivan]

McCain who has been Chairman of the Commerce Committee for years says he knows very little about the economy...

But Obama worked as a copy editor at a business newsletter for a year after college, so he does?

[Verner]

The average voter thinks it's the Feds & Wall St. who have only themselves to blame, but not to worry! There are plenty of tax-paying suckers to foot the bill which keeps the Feds and Financiers in business, because, of course, you know whose economy they'll wreck on the way down, don't you? Silly me, I thought I was already doing my part to keep them afloat when I paid those ginormous finance charges on my overdue credit card bills.

JM, Can relate. I'm mad as hell too. I posted that great bloomberg article with the fabulous line "socializing risk while privatizing profit" Sums it up for me.

But the fact is, we are now in this mess. And who do we want pulling us out? McCain/Palin or Obama/Biden. I think the choice is pretty clear.

[Cecil Turner]

The Republican Party amounts to today's Whigs.

Or, alternately, it amounts to today's Republicans. McCain might not be Lincoln, but Obama . . .? Puh-leeze.

[Sue]

Did McCain really say he didn't know much about the economy? I think he said he knew more about foreign policy and should know more about economics. I would like to see the exact quote. I think I'll go find it. I can't imagine why McCain hasn't fought back on that if he indeed said what I thought he said.

[Verner]

And something I want Bush to do. He only has three months left, and nothing to lose.

I want him to get on National TV and give a ten minute address to the Nation.

I want him to tell the public EXACTLY how we got into this mess in terms that they can understand. I want him to explain that he warned congress 17 times, but that they simply would not listen.

I want him to name names. It's only fair after all the nasty insults Pelosi has hurled his way.

Then I want him to explain why these measures are necessary.

I also want him to condemn the democrats for trying to tack that worthless bit of trash called an energy bill on to emergency relief.

Follow it up by calling for an energy bill that would keep 500 billion circulating in the US economy--and make it a national security issue.

Then propose, that in this time of crisis, Capital gains should be cut to zero-as a sort of response to the democrat's "forclosure relief." Capital gains hurts honest hard working Americans who have seen their savings suffer. Explain that THEY are the ones who deserve a break, not the people who don't pay their housenotes.

If he did all of that, McCain would be ten points ahead in the polls within a week.

BECAUSE IT IS ALL TRUE.

So sad that it will never happen.

[Sue]

“The issue of economics is not something I’ve understood as well as I should,” he said. But, “I’ve got Greenspan’s book,” he assured the audience.

The Greenspan book should be lost by now, I hope. And was clearly a joke. That has morphed into the quote that I can never find. I see it everywhere on the web, quoted as "didn't know much about the economy", but the two quotes mean something different.

[Pofarmer]

Thanks GMax.

So, what's the term on a typical MBS? How in the world do you value something where it's makeup would be constantly changing?

[Extraneus]

"McCain who has been Chairman of the Commerce Committee for years says he knows very little about the economy,"

Presidents don't need to know about the economy,they need to be able to delegate and take advice.

Yes, Sue, McCain did say something along the lines of "I should know more about economics," as opposed to "I don't understand economics."

Does the original commenter think he/she, or Obama, knows more about economics or the economy than McCain does?

Obama has taken to producing patent lies in his commercials. Many on their side see no problem lying for they claim is the greater good. The left has sunken into a morass, allowing themselves to be purposefully dishonest, essentially admitting to their own immorality and rationalizing it with vapid platitudes they can't possibly even believe themselves.

[Sue]

http://minx.cc/?post=273984>Statement of Ethan Winner. Yeah, he did it, but he did it on his on. Obama wasn't involved. Concerned citizen. Yada yada yada.

[Pofarmer]

Obama has taken to producing patent lies in his commercials.

The latest one I caught in the NFL football player ad, was "The Bush administration has watched as China has defaulted(may not be exact word) on it's trade deals with the U.S.".

Has this ever happened?

[boris]

Many on their side see no problem lying ...

You can stop right there.

[Balls to the Wall Democrat]

"McCain might not be Lincoln, but Obama . . .? Puh-leeze."

Obama is the logical concomitant you inferred, correctly.

The conscious mind lies, the sub-conscious cannot.

[Pofarmer]

Two things come to mind.

#1, if mortgages payoff, or are refinanced early, how many properties are presented on more than one MBS or CDO?

#2 These jokers did EXACTLY what precipitated the farm crisis of the 80's, the borrowed on net worth instead of cash flows. Unfortunately, the Ag sector wasn't important enough to bail out.

[Rick Ballard]

Pofarmer,

Why would the value of the income stream from a particular tranche of an MBS issued by Stinky Stuff Inc. be harder to calculate than the income stream from a quarter section planted to corn? It's pretty much projections and assumptions based upon historical data.

Introducing no doc 100%ers during a rising bubble doesn't have a historical background (it will soon) but I still look at those mortgages and wonder how average valuation could drop below 40-50%. That Fed data shows ARMS and Alt-A mortgages on only 4.47% of housing units. That's the puzzler to me. The percentage is just too small for all this fuss.

[Barney Frank]

So, what's the term on a typical MBS?

It was either Paulson or someone on Kudlow commenting on Paulson last Friday that mortgages as a group are averaging 5-7 years and MBSs are at five.

[Pofarmer]

Maybe I just don't understand enough about how these MBS's are structured(fancy that)

Do MBS's pay a fixed percentage or do they vary depending on the payments coming into the various tranche's?

I guess what I'm getting at, is I just don't see how the problem got this bad without SOMETHING being multiplied somewhere. Either some of these instruments don't have the underlying income stream, IE, the loans got refi'ed and tied into another MBS, and all the bad loans basically got shoved into a corner in the back somewhere. What makes me think of this is the huge boom in refi's back in the early 2000-2004 or so timeframe. I can't beleive that this is just a straight up problem, otherwise, like you say, these things would be way too easy to value.

[Pofarmer]

That's the puzzler to me. The percentage is just too small for all this fuss.< /i>

Me too.

Thanks Barney.

I wonder, if mortgages are averaging 5-7, how many have been rolled over twice in that 5?

[Bear Stearns CEO]

"It's pretty much projections and assumptions based upon historical data."

What are the POWERBALL numbers for the next play?

Can you predict earthquakes too?

Share that..................

[Sue]

Off.

[Rick Ballard]

Hey, a whole new level of stupid has arrived.

[Thomas Collins]

Rick Ballard stated that:

Introducing no doc 100%ers during a rising bubble doesn't have a historical background (it will soon) but I still look at those mortgages and wonder how average valuation could drop below 40-50%. That Fed data shows ARMS and Alt-A mortgages on only 4.47% of housing units. That's the puzzler to me. The percentage is just too small for all this fuss.

I hope RB is right. I am concerned that folks are leveraged enough so that, even with modest economic growth, we have not seen the apex of the nonperforming asset problem (even taking into account the pooled nature of these assets). With a recession, I am concerned that the House of Cards will topple.

Of course, I realize that referring to the current financial markets as a House of Cards assumes the answer. And perhaps I am wrong about consumer debt as a percentage of household cash flow being a problem. But Paulson's hard stance against repealing M2M is not based on ignorance (in Paulson's case it is not based on ignorance, that is; in my case, it might well be). I still wonder whether Paulson's stance is based on the view that M2M provides discipline that other valuation methods won't (although RB's incredulity at 40%-50% valuation markdowns is understandable).

[Rick Ballard]

Pofarmer,

When people refi they go into a new pool. That's really what all the fun and games are about - fees on writing "new" mortgages and packaging "new" pools into "new" MBS.

[Pofarmer]

So what happens to the old MBS that that mortgage was in? Is it recalculated in the middle of it's life?

[JM Hanes]

Verner:

"But the fact is, we are now in this mess. And who do we want pulling us out? McCain/Palin or Obama/Biden. I think the choice is pretty clear."

No question about the mess, but I don't think the choice is all that clear to most of the rest of the voters out there. Discussions a la JOM, for instance, might as well be in a foreign language. If Bush, per your suggestion, or someone else whose voice can actually be heard above fray, doesn't step up to bat, voters will basically be tossing an emotional coin.

[Rick Ballard]

Thomas Collins,

If you look at the data at that Fed site I referenced above and use averages (dangerous, I know), the average payment on ARMS is $1,405 (P & I only) while Alt-A payments would be $1,450. Using a "traditional 25% of gross income devoted to shelter" formula the "safe" annual income levels would be $68K and $70K. Average family (not household) income is currently $73K. 10% of the ARMS and 5.6% of the ALT-A are in foreclosure. That means that 8.5% of the total Stinky Stuff (440,000 loans out of 5,179,000) are really on the rocks. There are more than 115,000,000 units that are not in foreclosure. Those aren't annual numbers but multiply the 440 x 12 (exaggerated) and the total annual rate is 4.5%, which still doesn't come close to "crisis" in my mind. If you look at it as a vacancy rate, you would say it's rather low.

[ml]

Obama and the dems are pushing a stimulus package as part of the bailout, just adding more cost. Perhaps McCain should propose that congress suspend all earmarks for the next few years until this mess is cleaned up. Let congress share the pain along with the public.

[Charlie (Colorado)]

I guess what I'm getting at, is I just don't see how the problem got this bad without SOMETHING being multiplied somewhere. Either some of these instruments don't have the underlying income stream, IE, the loans got refi'ed and tied into another MBS, and all the bad loans basically got shoved into a corner in the back somewhere.

I think you've hit the nail on the head. Underneath all these things are real mortgages, on real houses. On most of those real mortgages, someone, somewhere is receiving real checks for real mortgage payments. Like, 90 out of 100 of them. On something like 6 out of 100 of them, the checks are behind but not in foreclosure; there's a real family in a real house that isn't keeping up but is also is at least managing to cope to some extent; those people may very well make some kind of arrangements with the banks (and, by the way, there were somethign like 3 out of 100 doing that even in the good years.)

Then there are 4 of 100 that are in foreclosure. All those have attached to them a home with some residual value.

HOWEVER, let's say one of these bundles is entirely on homes in a state with a no-recourse law, or one with a homestead exemption like Florida, and where the home values are significantly underwater. Then the mortgagee can walk away, and the mortgager can only recover as much as they can actually sell the house for, in a bad market, and minus their costs.

Now the real black magic starts. People start to worry about these mortgages, and they can't readily tell if the MBS they owned is backed by good or bad mortgages. So, rather than worry, they sell as a cheap price, say 60 cents on the dollar, which costs them money but reduces the exposure.

Then, with "mark to market", everyone else has to mark their assets to 60 cents on the dollar!

They say "Jesus H CHRIST!" and try to sell too. This drives the price down again!.

Repeat several times, and you have people who own an asset that should theoretically value at, say, 98 cents on the dollar face value, and they can't move them for 25. And the rating agencies see the panic and say "Holy CRAP!" and reduce the ratings... which makes everyone look bad.

And where does this get you? To last Wednesday.

[Pofarmer]

The thing is, suspending earmarks doesn't cause any pain to congress, it goes right back to the districts not getting the funds, some of which are worthwhile.

[Charlie (Colorado)]

By the way, I think as a member of the VRWC I'm supposed to be OUTRAGED, but this sketch about Palin and Alaska vs the New York Times is actually very funny and completely at the expense of the Times.

[Charlie (Colorado)]

10% of the ARMS and 5.6% of the ALT-A are in foreclosure. That means that 8.5% of the total Stinky Stuff (440,000 loans out of 5,179,000) are really on the rocks.

It's generally a really good sign when two different back-of-envelope estimates come out within a few percent. RB and I just came up with agreement within one percent, I believe.

[Thomas Collins]

Tough to argue with your figures, RB. In addition, the second quarter '08 financial obligations as a percentage of disposable personal income number doesn't seem out of whack if we simply look at the last three or four years. It is up, however, if we look over the last couple of decades (LUN).

By the way, RB, do you think I am reading too much into Paulson's stand against suspending mark to market as indicating that he thinks some kind of instrument of discipline, however blunt that instrument might be, needs to be imposed now?

[Rick Ballard]

TC,

I believe that Paulson is saying that the day after* the first reverse auction, there will be an honest to goodness "market" (as opposed to the Third Level of Hell) and that M2M will be functional.

*"day after" is to be interpreted as "shortly".

IMO, the DSR is 1.5% higher than Nirvana would dictate but we're headed in the right direction.

[Tom Maguire]

Ok, folks. As predicted Krugman has a new post out endorsing the Dodd plan and I have a new post explainging (again) why the Dodd plan is nothing like direct equity investment, warrants, or anything else.

This would be a lovely time for the JOM brain trust to walk me back if I am misreading/misconstruing that statute. I am highly confident that I am getting it right (and that Krugman is wrong) but on my personal Smugometer I am not all the way up to Totally Insufferable yet, so some reassurance would be welcome.

[Cecil Turner]

Go long insufferable.

But I think the technical argument may be irrelevant. The political argument is where the action is, and Krugman (correctly) assumes the average Joe won't be able to unravel it.

Bottom line: by bundling a bunch of feel-good stupidity with the bailout, the Dems manage to make it less effective whilst simultaneously blaming the underlying problem on someone else (the "party in power"). With the MSM braying at full throat, I suspect it might work. Polls suggest it is so far.

[Greg Q]

You all are missing the real threat of the Dodd plan: The government's ability to practice extortion on any institution it's bought "bad assets" from.

How does the government decide when it's going to sell the "bad assets"? To whom? For how much? You think the MSM will report on the Obama Administration selling assets at low prices to Obama supporters, and then collecting the equity from the institution they just screwed over?

This is a bad plan.

[kim]

So, with the government stabilizing the market, these instruments can be valued, reducing the need for an institution to place itself in a position from whence it can be extorted. Between the Devil and the Deep Blue Sea. You thought this was largesse?
================================

[sophy]

I do not know how to use the knight online gold ; my friend tells me how to use.