> ...These securities may pay off 85 cents on the dollar if held to
> maturity. But with mark-to-market accounting, they have to valued at
> their present market price - and whatever that is, exactly, it might be
> 20 or 30. But no one's really buying. If the gov sets a floor under the
> price, the m-t-m price will go up - and the gov could make money on the
> deal too.
>
> Not saying that this will happen, but there's a reasonable chance it
> could.
==============================
Today's Barron's cover deals with the issue. Bill Gross, among others,
thinks the bailout will benefit the Treasury. That's far from the consensus
view, even among those who support the bailout as a losing proposition to
stem the financial crisis.
Making A Mint By JONATHAN R. LAING Barron's September 29 2008
Despite the public outcry over the bailout bill, taxpayers and the Treasury are likely to come out ahead.
THERE'S NO QUESTION THAT THE BUSH ADMINISTRATION'S $700 billion bailout plan is necessary. As Warren Buffett put it last week, failure to pass the plan would trigger "a financial Pearl Harbor." Jeremy Siegel, the normally upbeat Wharton finance professor, added: "Two weeks ago was the first time in my life that I was worried about the very stability of the U.S. financial system. We were on the verge of falling into an abyss, which was only averted when news leaked out of the bailout plan."
For many, the only real issue is why taxpayers should be on the hook for the recklessness and greed of the financial-services industry. That's why Congress has insisted on some punitive measures, including caps on executive pay at firms receiving bailout money, and contingent equity stakes for Uncle Sam.
But Barron's analysis of the plan indicates that taxpayers and their proxy, the Treasury Department, will fare well in the bailout and should actually turn a profit over the years ahead. For one thing, the mortgages and mortgage securities that the government will be buying back from commercial and investment banks, credit unions, insurance companies and others aren't as toxic or wide-spread as commonly assumed. Treasury's purchases should not only help free up credit markets but boost the prices of securities that are backed by home loans. That, in turn, is likely to arrest the relentless loop of falling home prices spawning further mortgage defaults and foreclosures that, in turn, result in further declines in residential real-estate prices.
"Essentially this secondary effect would do much to lift housing out of its funk and actually improve the performance of the securities that Treasury ends up buying," says Jeffrey Gundlach, chief investment officer at major mortgage fund manager TCW. "Thus, I think that there's a good chance that the bailout plan will be a win-win for both the taxpayer and the financial system."
Bill Gross of the bond-fund behemoth Pimco is even more upbeat. He estimates that the average price of distressed mortgage debt that will pass from troubled financial institutions to Treasury will be about 65 cents on the dollar, representing about a one third loss for the seller from face amount. Financed at 3% to 4% by the sale of Treasury debt, Treasury will be in a position to earn a positive carry, or yield spread, of at least 7% to 8% on the purchases, even after taking into account severe assumptions of default rates and foreclosure recoveries.
Treasury, after all, has the lowest costs of funds around. As an unlevered investor, Treasury likewise faces none of the liquidity problems that can force a private investor to sell securities at an inauspicious time. Treasury has the ultimate luxury of time.
GROSS DISMISSES THE NOTION that the taxpayer will get snookered either in its purchases or eventual sales of its securities. Most likely, much of the management of the bailout will be outsourced to large bond specialists like Pimco and BlackRock. (Gross offered last week to work for free for the Government if other selected managers did likewise.)
"We can do a granular analysis of any mortgage security or package in 10 to 15 minutes to determine their fair value," he claims. "The prices that Treasury will get will be somewhere between par, which of course might screw the taxpayer, and a firesale price of, say, 20 cents on the dollar, which would likely bankrupt some weak institutions and defeat the purpose of the bailout."`
By most accounts, current losses on U.S. mortgage paper -- the difference between face value and current fire-sale prices -- stand at about a trillion dollars. In a sign of the distortions from panic selling, eventual losses on the underlying morgtages figure should be no greater than $250 billion. The market, irrationally, is assuming losses of four times that amount.
Of the $1 trillion presumed hole, $800 billion involve subprime and Alt-A mortgage securities, which are of slightly higher quality than subprime. The remainder of losses is accounted for by under-water prime mortgage securities and unsecuritized mortgage loans.
Since some of the $1 trillion in bad paper is held by hedge funds and foreign institutions, which won't be eligible for the program, the amount that conceivably could be sold to Treasury is about $800 billion. If the government buys that for 65 cents on the dollar, the price is $520 billion. Uncle Sam, based on Gross' projections, could then earn perhaps 7% net on that for each of two years, pocketing about $75 billion. Then, assuming the housing and securities markets have stabilized somewhat, the government should be able to sell the securities for something more than 65 cents, recouping its initial investment and then some.
Helping all this, most of the troubled mortgage-backed securities lodged in financial-institution balance sheets are senior slices of the securitizations that banks couldn't sell off because of their unexciting low-yields of 25 to 50 basis points over Libor. The good thing about these securities is that slices that are lower in the securitization structure have to absorb any losses on the underlying mortgages before the senior, triple-A tranches are touched. And most of this randier stuff was sold to hedge funds or shipped overseas to other speculative buyers. In the heyday of mortgage-backeds a couple of years ago, folks wanted the higher potential returns from the lower-ranked tranches. Trash ruled.
TCW'S GUNDLACH OFFERS an example of the hidden quality in today's mortgage securities on offer. He said he recently paid 50 cents on the dollar for a triple-A piece of a 30-year fixed subprime mortgage pool that came from the horribly performing vintage period of early 2007. Even assuming a severe acceleration in loan delinquencies, a 66% loan default rate and a skimpy 20% recovery on any foreclosures, he contends that the tranche will produce a yield of over 12% and principal pay-back of nearly 70 cents on the dollar. If only half the mortgages in the pool default, then its yield would jump to 14.2%.
Of greater moment to Gundlach, however, is what would happen if one were to lower the expected default rate to 30% and assumed that the foreclosure recovery rate rose to 40%. At those still draconian expectations, Gundlach claims that a low-cost investor like Treasury could pay 100 cents on the dollar, or par, and still get a positive return and most likely, all their principal back. That's because the bulk of the losses would be absorbed by the subordinated tranches.
In addition, what augurs well for the taxpayers' recoveries under the bailout is the yawning gulf that currently exists between the current market prices for mortgage securities and any value based on rational expectations. These days panic conditions prevail in the market. Institutional holders are dumping mortgage securities with abandon to pare their debt to capital leverage that stood as high as 30-to-one.
A negative feed-back loop has developed for the banks in their pell-mell rush to deleverage, raise capital and remain liquid. The more mortgage securities they sell, the weaker the prices get, which, in turn, forces even more security sales at ever lower prices in a futile attempt to outrun the credit tsunami.
The natural buyers of these securities, such as the bond funds, are largely missing in action or only dabbling in them. More securities with the label subprime or Alt-A attached to them are deemed too controversial to own, particularly with the constant threat of express-train credit downgrades taking their ratings many notches lower.
The primary buyers left, at least until the U.S. cavalry rides to the rescue following approval of the bailout plan, are vulture investors. They don't pay up given their high hurdle rates for any investment. What's destined to be the iconic transaction during this current period of stress was the private equity firm Lone Star's purchase from Merrill Lynch last July of nearly $31 billion of toxic mortgage-backed securities for just 22 cents on the dollar. Merrill, in its avidity to get the securities off its balance sheet, even provided seller financing of 75% of the purchase. That meant that Lone Star only had 5.5 cents on the dollar at risk.
It's just such fire sale pricing that has spawned the current liquidity panic and caused credit markets to seize up. As the buyer of last resort under the bailout plan, Treasury hopes to reverse market psychology. Rather than prices being set by the last panicked buyer attempting to get liquid at any price, they would be dictated by the actual prospects of the mortgages underlying the securities and the cash flow they throw off. This is what Fed Chairman Ben Bernanke was implying during Congressional hearings last week when he stated that the government would seek to shift the pricing in the mortgage-securities market from fire sale to "hold-to-maturity" levels. The latter, in accounting parlance, implies pricing close to par value or a holder's original purchase price.
As previously-mentioned, there's a trillion dollar negative gap between the face and marked-to-market values in U.S. mortgage securities. Active buying by the government of these securities would undoubtedly bolster the marks on other mortgage securities remaining on the banking system's books, obviating the need for Treasury to fire all $700 billion of its bullets. The rescue could be done on the cheap. Table: Sizing Up Potential Sellers
The current bailout would be anything but unprecedented for the bastion of free markets, the U.S. of A. While we worship unfettered free enterprise, occasionally the Adam Smith invisible hand goes spastic and must be restrained.
PERHAPS THE CLOSEST PARALLEL to today's proposed bailout effort was the Resolution Trust Corp., or RTC, that was created in the late 1980s to clean up the mess caused by collapse and government takeover of over 700 Savings & Loan associations. The RTC was left with some $500 billion of assets to dispose of ranging from conventional home mortgages and construction loans to raw land, half-finished real estate developments, see-through office buildings and the like.
The RTC's liquidation process took more than six years and was criticized for favoring certain buyers, political cronyism and reaping insufficient prices. But when all was said and done, the RTC was able to cut taxpayer losses on the S&L industry collapse from estimates as high as $350 billion to just $125 billion.
Granted the proposed bailout plan differs markedly from the RTC. The latter only had to liquidate, rather than also buy, assets since the government already owned the busted associations. Yet the assets that Treasury will end up with this time around will be far easier to manage than the cats and dogs RTC ended up with nearly 20 years ago. Debt portfolios consist of Cusip numbers (a number that indentifies securities) and electronic entries while the grass had to be mowed and the buildings maintained and leased out during the time that RTC was in the landlord business prior to asset sales.
RTC at its peak had 10,000 employees. Princeton economist Alan Blinder figures that the Treasury operation could function with just a tenth or so of that number. Way back in January, he'd proposed in congressional testimony that an RTC type entity might soon be needed to buy bad mortgage debt in light of deteriorating conditions in the U.S. credit market. He has a number of objections to Treasury's current proposed plan in terms of inadequate oversight and concentration of unprecedented power in the office of a political appointee. But the continued political wrangling will serve to vastly improve the bill's protections, he contends.
And all partisanship aside, the original proposal averted what he concedes could've been a terminal meltdown in the U.S. financial system. That's if it gets passed.