[lbo-talk] NYT: Plan's Basic Mystery - What's All This Stuff Worth?

Michael Pollak mpollak at panix.com
Wed Sep 24 23:11:48 PDT 2008


[Very nice illustrative walk through some sample numbers, followed by a very clear explanation of just how bad we're going to get fucked. My favorite joke is Summer's idea of a compromise between the interests of taxpayers and the interests of banks.]

http://www.nytimes.com/2008/09/25/business/25value.html

The New York Times

September 25, 2008

Plans Basic Mystery: Whats All This Stuff Worth?

By VIKAS BAJAJ

What would you pay, sight unseen, for a house that nobody wants, on a

hard-luck street where no houses are selling?

That question is easy compared to the one confronting the Treasury

Department as Washington works toward a vast bailout of financial

institutions. Treasury Secretary Henry M. Paulson Jr. is proposing to

spend up to $700 billion to buy troubled investments that even Wall

Street is struggling to put a price on.

A big concern in Washington -- and among many ordinary Americans -- is

that the difficulty in valuing these assets could result in the

government's buying them for more than they will ever be worth, a step

that would benefit financial institutions at taxpayers' expense.

Anyone who has tried to buy or sell a house when the market is falling,

as it is now, knows how difficult it can be to agree on a price. But

valuing the securities that the Treasury aims to buy will be far more

difficult. Each one of these investments is tied to thousands of

individual mortgages, and many of those loans are going bad as the

housing market worsens.

"The reality is that we are not going to know what the right price is

for years," said Andrew Feltus, a bond portfolio manager at Pioneer

Investments, a mutual fund firm based in Boston. "It might be 20 cents

on the dollar or 60 cents on the dollar, but we won't know for years."

While prices of most stocks are no mystery -- they flicker across PCs

and televisions all day -- the troubled investments are not traded on

any exchange. The market for them is opaque: traders do business over

the telephone, and days can go by without a single trade.

Not only that, many of these instruments are extremely complex.

Consider the Bear Stearns Alt-A Trust 2006-7, a $1.3 billion drop in

the sea of risky loans. Here's how it worked:

As the credit bubble grew in 2006, Bear Stearns, then one of the

leading mortgage traders on Wall Street, bought 2,871 mortgages from

lenders like the Countrywide Financial Corporation.

The mortgages, with an average size of about $450,000, were Alt-A loans

-- the kind often referred to as liar loans, because lenders made them

without the usual documentation to verify borrowers' incomes or

savings. Nearly 60 percent of the loans were made in California,

Florida and Arizona, where home prices rose -- and subsequently fell --

faster than almost anywhere else in the country.

Bear Stearns bundled the loans into 37 different kinds of bonds, ranked

by varying levels of risk, for sale to investment banks, hedge funds

and insurance companies.

If any of the mortgages went bad -- and, it turned out, many did -- the

bonds at the bottom of the pecking order would suffer losses first,

followed by the next lowest, and so on up the chain. By one measure,

the Bear Stearns Alt-A Trust 2006-7 has performed well: It has suffered

losses of about 1.6 percent. Of those loans, 778 have been paid off or

moved through the foreclosure process.

But by many other measures, it's a toxic portfolio. Of the 2,093 loans

that remain, 23 percent are delinquent or in foreclosure, according to

Bloomberg News data. Initially rated triple-A, the most senior of the

securities were downgraded to near junk bond status last week. Valuing

mortgage bonds, even the safest variety, requires guesstimates: How

many homeowners will fall behind on their mortgages? If the bank

forecloses, what will the homes sell for? Investments like the Bear

Stearns securities are almost certain to lose value as long as home

prices keep falling.

"Under the current circumstances it's likely that you are going to take

a loss on these loans," said Chandrajit Bhattacharya, a mortgage

strategist at Credit Suisse, the investment bank.

The Bear Stearns bonds are just one example of the kind of assets the

government could buy, and they are by no means the most complicated of

the lot. Wall Street took bonds like those of Bear Stearns and bundled

and rebundled them into even trickier investments known as

collateralized debt obligations, or C.D.O.'s

"No two pieces of paper are the same," said Mr. Feltus of Pioneer

Investments.

On Wall Street, many of these C.D.O.'s have been selling for pennies on

the dollar, if they are selling at all. In July, Merrill Lynch,

struggling to bolster its finances, sold $31 billion of tricky

mortgage-linked investments for 22 cents on the dollar. Last November,

Citadel, a large hedge fund in Chicago, bought $3 billion of mortgage

securities and other investments for 27 cents on the dollar.

But Citigroup, the financial giant, values similar investments on its

books at 61 cents on the dollar. Citigroup says its C.D.O.'s are

relatively high quality because they were created before lending

standards weakened in 2006.

A big challenge for Treasury officials will be deciding whether to buy

the troubled investments near the values at which the banks hold them

on their books. That would help minimize losses for financial

institutions. Driving a hard bargain, however, would protect taxpayers.

"Many are tempted by a strategy of trying to do both things at once,"

said Lawrence H. Summers, a former Treasury secretary in the Clinton

administration. As a hypothetical example, Mr. Summers suggested that

an institution could have securities on its books at $60, but the

current market price might only be $30. In that case, the government

might be tempted to come in at about $55.

Many financial institutions are so weak that they must sell their

troubled assets at prices near the value on their books, Carlos Mendez,

a senior managing director at ICP Capital, an investment firm that

specializes in credit markets. Anything less would eat into their

capital.

"Depending on your perspective on the economy, foreclosure rates and

home prices, the market may eventually reflect that price. But most

buyers are not willing to make that bet right now," he said. "And

that's why we have these low prices."

Ben S. Bernanke, the chairman of the Federal Reserve, told Congress on

Tuesday that the government should avoid paying a fire-sale price, and

pay what he called the "hold-to-maturity price," or the price that

investors would bid if they expected to keep the bond till it was paid

off.

The government would buy the troubled investments with the intention of

eventually selling them back to the market when prices recover.

The Treasury has suggested it might conduct reverse auctions to

determine the price for securities that are not trading in the market.

Unlike in a traditional auction in which would-be buyers submit bids to

the seller, in a reverse auction the buyer solicits bids from would-be

sellers. Often, the buyer agrees to pay the second-highest bid

submitted to encourage sellers to compete by lowering their bids for

all the assets submitted. The buyer often also sets a reserve price and

refuses to pay any more than that price.

But Mr. Paulson told Congress on Tuesday that the government would use

many other means in addition to auctions, suggesting that it would

exercise wide discretion over the final prices to be paid.

Financial institutions will have an incentive to sell their worst

assets to the government, a risk that the Treasury will have to guard

against, said Robert G. Hansen, senior associate dean at the Tuck

School of Business at Dartmouth College.

"I am worried that the people who are going to offer the securities to

the government will be the ones that have the absolute worst toxic

waste," Professor Hansen said.

<end excerpt>

And of course bad as their stated intention is to pay 2 or 3 times what the market currently thinks they are worth, this adds a whole 'nother level of extreme asymetric information. The article just explained how super hard it is to value these things and how individual they are. And who's going have a closer guess, the people who created them and have been working on the problem for years, or an outsider whose buying?

Not to mention the possibilities for silent collusion when all the sellers have the same interest in keep the price high -- and the buyer says he does too!

Oooooog.

Michael



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