6 thoughts on “What about handling the bailout this way?”

1. We’re a nation of laws, sorely and dangerously ignored over the last eight years. Therefore, in addition to your fine suggestions, I would assign a prosecutorial team and bring everyone to justice that broke laws.

   I’d also go after any golden parachute recipients involved in this scandal and reclaim that money for the kitty.
   

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2. This just won’t work for a variety of reasons but lets start with the root problem.  There are assets, mainly mortgage instruments but also including more exotic derivatives, that are worth substantially less than they were bought.  Someone has to take a loss on these assets and right now the argument about the bailout is all about determining who is going to take the loss.  At the same time no one has a great idea what that assets are actually worth.  The loss on the assets might be small or it might huge and since no one knows what the probability of any outcome is everyone is paralyzed.

   Let’s focus on mortgages since they are one of the easier parts.  First we have to acknowledge that some of the people who have mortgages currently shouldn’t.  Through a bad decision on their part but possible aided in large part by a duplicitous mortgage broker, they signed up to a mortgage that they are very unlikely to have the financial means to afford.  As sad as it is, it is better off for everyone if this fact is recognized quickly and this portion of the population moves back to renting.  This might cause house prices to fall faster in the short term but once these people are out of the housing market an new stable longer term equilibrium will be set and the housing market can rebuild from this lower base.  Your plan actively opposes that new equilibrium setting in.

   The second problem and one of the biggest problems with the whole mess is that no one really owns a mortgage any more.  Let me explain.  Most of trouble comes from the development of Collateralized Debt Obligations, CDOs.  Lets use a concrete example to explain how these work. The numbers are made up and may have no relation to fact but it gets the idea across.  Also if any one works with these and I have gotten a salient detail wrong please correct me.

   Suppose that a CDO is created to fund 1000 mortgages.  The CDO issues bonds divided into different tranches and each tranche has a seniority, or order in which it is paid from the mortgage payments of 1000 homeowners.  The most senior tranche may be entitled to payments from the first 500 homeowners who pay. Not a specific 500 homeowners just the first 500 to pay in that month. Lets assume that it has a credit quality of AAA, since it receives it full monthly payment unless half the mortgages are past due, highly unlikely if the original pool was not all subprime mortgages. The next tranche would be entitled to the next 100 payments and carry only a AA credit rating since there is still an excellent chance that the CDO will pay this amount each month but not as good as the first.  So it goes until the most junior tranche, or equity tranche, which gets whatever is left over.  This tranche isn’t even rated since the payment possibilities are so bad.  The junior tranche will only pay its full monthly payment allotment if all 1000 paid their mortgage on time and that almost never happens.  For example the default rate on prime loans, the highest quality, was 0.34% in the latest MBA survey.

   Understanding the actual outcome of this structure get even harder when you allow the loans to be of different qualities.  Suppose that you start 600 prime loans, 200 Alt-A loans, and 200 sub prime loans.  The most senior trance is still easy to value since you can almost just assume the non-prime loans have no value but the outer tranches are almost entirely driven by the subprime loans.  The fact that you can prepay your mortgage only complicates things further.  Add in correlation effects for regional variability, mortgages in different parts of the country have different default rates, and general economic conditions and it is easy to see how someone could misprice the underlying bonds which caused the mess in the first place.    

   Another consequence of this structure is that the only way to “own” even one of the mortgages is to own all of bonds backing up the entire CDO, from senior AAA to equity tranches, and therefore own all of the mortgages.  This is one reason why it may take so long for an individual mortgage workout. If it wasn’t written in original documents creating the CDO, the CDO actually has to negotiate with the bond holders to modify the bonds it sold before it can actually rework an individual loan.

   So in light of this structure who would your “company” proposals be applied?  My understanding is that there are CDOs that are nothing more than a registered agent with most of the original work being done by an investment bank and the servicing being done by a specialized loan servicing company, so penalizing only the CDOs is unlikely to be a truly effective determinant.  The lack of real infrastructure in CDOs means that you can’t penalize the investment banks too much or all of the work just moves offshore.  A similar story works for the buyers of the CDOs.  How should a pension fund, which often only has advisors and trustees not employees, be penalized?

   Also it would be easy to say that junior tranche holders should face penalties; they receive the marginal payments which are supported by the government, but how about senior tranche holders?  Suppose someone at a pension fund looked at a CDO and realized that the junior tranches were absolutely worthless but the senior tranche was legitimately rated AAA.  Why should this pension fund suffer any penalties when some of the mortgages in the CDO are receiving support but even if there was no support the only tranche the pension fund owns would still be paying out?

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   1. I differ slightly in that I do believe we need to try to keep as many people in their home as we can, both because of social disruption and because we don’t need more homes hitting the market.

      Great explaination of the asset backed however and what this plan is failing to address.

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      1. Can one (or both) of you write a diary about  what you think of the present proposal and what you think we should do? I would be very happy to front page what you write.

         thanks – dave

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   2. Very well explained – oh well, I thought it was worth mentioning it in case it would work.

      I’d like to see some way we could do this bottom up instead of top down – so that the emphasis is on people not being screwed. I’m fine with the financial institutes taking it in the shorts for their bad bets as long as it doesn’t trash the economy.

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