Monday, February 9, 2009

From AAA To Zero

The government is preparing yet another bank rescue plan, this time hoping that private investors will be willing to buy "toxic" assets at a greatly reduced price. The government would provide a put option to the buyers, i.e. a guaranteed floor price.

Here, then, is my suggestion for the floor price: zero.

I know this won't promote the sale of a whole lot of radioactive CDO's, CPDO's, etc, and thus won't lead to a clean-up of bank balance sheets. But zero is, in fact, a very realistic price - at least for a great deal of those so-called assets. Why?

  • The cascade structure means that most of the tranches (i.e. all except the super-senior) are worth zero once the underying assets (mortgages) default at a rate beyond a certain benchmark. This benchmark, based on highly optimistic historic assumptions, was overtaken a long time ago.
  • The fees involved in structuring such products "sucked away" a large portion of the stated face value and probably the entire residual value. Consider the whole cycle involving the purchase of a newly-built home: the builder's profit, the realtor's/saleman's commission, closing costs, the mortgage originator's commissions, the loan packager's fees, the investment banker's fees, the broker's commissions. Add it all up and it easily comes to 20-25%.
  • Home prices have plunged fast and furious, wiping out the security deposit of the original borrower - if there was a deposit in the first place. Look at this example from Florida:
Put everything together and you come up with this disturbing conclusion: even the super-senior tranches are highly suspect of being worth exactly nothing. In fact, given local ordinances on property upkeep, back real estate taxes, etc., there is a good possibility that whoever gets title to homes after prolonged foreclosure proceedings may end up owing more money than the property is worth.

In such cases even zero is too much to pay for "toxic assets" and that's why the government should provide no better floor price than that.


  1. So, if I follow you correctly, even buying at $0, you could end up OWING money ?
    That means that you are actually buying a loss, right ?
    If this is right, then it kind of shows just how ABSTRACT the whole money shebang has become doesn't it ?
    It also seems to show that with words and figures you can make black look white, and white black.
    Is this analysis correct ?
    Thanks for contributing to my education.
    It looks like there are too many (higly specialized, highly interested) middlemen in these operations.
    Pare it down, she says...

  2. Thank you so much for your very educational posts. I have had to stop reading the libertarians and the gold bugs - except for the really funny ones. I especially liked the history lessons about debt in the Roman Empire. You are teaching me and (I hope) my kids. What you are doing is obviously important to a lot of people. Keep it up. I missed your writings during your absence.
    I have always thought that they would try to suspend "mark to market" accounting in order to get rid of the toxic stuff. Here they go! (I am a commercial real estate appraiser, so I know what it would mean to toss out the notion of "fair market value."

  3. You're absolutely right. We are going to have to completely restructure the debt that got us into this mess in the first place. Without doing that, debtors will simply be unable to service their debt, especially with the strong dollar and declining asset prices.

  4. On a chatty note, i just read through the publisher's weekly summary of Niall Ferguson's book, the Ascent of Money.
    I never managed to finish Empire.
    I found Ferguson to be an apologist for American culture and militarism.
    I say : if the U.S. is so wonderful, then why apologize for her ? And if she isn't, well then we need real critics and not apologists, don't we ?
    His new book sounds rather superficial, which doesn't surprise me. I prefer J.K. Galbraith...
    No Pirates of the Caribbean masquerading as economic theory for me, thanks.

  5. Spin is Spin and he is totaly correct to the level of this malinvestment to find and try the basis of value on events still sinking and tax is theft on these units also. I am still reading Alfred Marshall who was Keynes guiding Light. As many learn or not, what the message really spells out is just because you did not see it does not mean it is not there. If you get time read Howard Zinn to the fact of matter's and leave politic aside foremost in that and think for yourself. The danger is not understanding what Mises, Hayek and Keynes said about what the citizen needs to do for himself. As pounded time after time by the host here is that Government as such cannot fix this
    malinvestment. Years, not months to go caused by who? Avarice and the Statist will stop at nothing now.
    ---In the market economy the worker sells his services as other people sell their commodities. The employer is not the employee’s lord. He is simply the buyer of services which he must purchase at their market price. The hired man does not owe the employer gratitude; he owes him a definite quantity of work of a definite kind and quality.
    In a society based on free contract, men come together as free and independent parties to an agreement which is of mutual advantage. He is the simple, honest laborer, ready to earn his living by productive work. We pass him by because he is independent, self-supporting, and asks no favors. He does not appeal to the emotions or excite the sentiments. He only wants to make a contract and fulfill it, with respect on both sides and favor on neither side. He must get his living out of the capital of the country. The larger the capital is the better living he can get. Every particle of capital which is wasted on the vicious, the idle, and the shiftless is so much taken from the capital available to reward the independent and productive laborer. But we stand with
    our backs to the independent and productive laborer all the time. We do not remember him because he makes no clamor or appeal to you whether he is not the man who
    ought to be remembered first of all, and whether, on any sound social theory............

  6. You forgot to include the other part - government would guarantee the investments.

  7. First of all the potential Buyers will be buying at ridiculously high prices like $0.65 to the dollar, so the banks have little to no further write down. Then the Government will guarantee a floor at another ridiculously high price of $0.50 to the dollar so the investors potential loss is Capped at $0.15 to the dollar.

    And if you are correct that Zero is the true value then the Tax Payer takes the lagest loss at $0.50 cents!

    Just great the Tax Payer gets F--ked Again! But the government knows we are use to it buy now. Remember we got short changed on the first $350 Billion the put out getting us $0.66 cents for every dollar we invested.

    WOW! Now that is change we can believe in! Way to go Obama!



    Yes there is a notable difference between the two men, but change I don't think so, other then politics flavored by Democrats rather then Republicans and that has never produced a big change in America and it hasn't changed anything again.

    I'm sorry to say it because I was hoping for so much more, but if you look at his cabinet and the same old stimulus of pork spending that will do nothing. You know we are in big trouble because OBAMA is a fake! He will change nothing!

  9. WAIT!!

    We've got it all wrong! The church is selling indulgences again... So, F the bailout, the government needs to work out a deal with the pope instead. And imagine the deal uncle Sam could get buying indulgences in bulk!

    Hell. Uncle Sam could even persuade GM to attach some scrap SUV (sharpened of course) to the upper right corner of the indulgence with well crafted instructions on how to use said sharpened SUV scrap (printed in china of course).

    And... Wham-o. Economic crisis solved!!

    We could even arrange an after party in heaven! (unless the church was printing toxic paper... but, lets not think about the un-likelyhood of that. I mean, it the CHURCH fer crizzakes. They're obviously looking out for humanity's best interests!)

  10. There were lots of people who hailed Obama almost like Jesus reborn. I, however, was not one of them; in fact, I found the whole matter quite hilarious. No doubt Obama can speak, but that alone is not enough to do a 180, after all, he's THE president, not a popstar.

    Part of me wishes him the best of luck, another, somehow, is a bit nastier and would prefer a (limited) rude awakening for the silly legions of his worshippers.

  11. Hmm, check this out,%5Egspc,QQQQ,SPY,DIA,TLT,UDN

  12. Wow, Cottonbloggin, I am really impressed, I think that you have just become my idol.
    (I didn't really understand what you said, but it sounded good, at least the vocabulary was a hell of a lot more interesting than the dry economic rot...)
    So, you notice by now, words ARE EVERYTHING.
    The words change, the underlying phenomena remain the same...
    I wish Barack Obama would realize that we are facing a crisis in civilization.
    But...the man who disavowed Reverend Wright, could he really recognize that we are facing a crisis in civilization, and could he really have the integrity and the courage to do something about it ?

  13. "They're obviously looking out for humanity's best interests!"

    Love it, Cotton :)

    So all this revolution talk has me agitated. So what would be a political/philosophical party that would best capture my desires. I've decided on the Thermodynamically Sustainability and Behavioral Consequences party (sexy name, yes?).

    The TS part of the TSBC party is going to mean a lot less cows and Dora The Explora backpacks on the planet. The BC part of the TSBC party is going to piss even more people off as drunk drivers start getting executed (painless lethal injection; this isn't about revenge).

    Not sure if we would technically be the USA anymore even though I don't see why the TSBC and US constitution couldn't mesh.

    One problem with still being the USA would be the debt. China would be furious that they wouldn't be paid back on all those treasury notes and many people who paid into SSA would complain about broken promises. But in a way it would be a tough love lesson to humanity that you should never believe absurd promises for future behavior. And there would never be Central Banks or morally hazardous social programs ever again.

    I glanced at Mish's site earlier. Items of note: 1) BofA will be getting a bailout for more than the company could actually be purchased for, and 2) CA is planning early release of prisoners to save money. Its new like this that makes me want to go start printing TSBC t-shirts and bumper stickers.

  14. Jim T et al:

    Let's wait and see if Obama gets us into a multi-trillion dollar fiasco like Bush (you know a war the result which aligns Shiites in Iran with Iraq). How is that investment workin' for ya?

    Or how bout the strict ideology that says no oversight, no regulations is the best policy, while Hank Paulson and the boys create 60 trillion dollars of "financial weapons of mass destruction" (Warren Buffet)?

    I agree that economics is not Obama's strong suit but please don't compare him to the last Fool--it ain't even close.

  15. Good stuff here:

    Nassim Taleb and Roubini preach A Hell-esque economic reality to cnbc

  16. Of course, if the bailout doesn't get us, we always have bird flu to worry about.

    It is good to know there are companies like Panasonic that watch out for their employees and make decisions based on welfare instead of economics.

  17. Actually, Homo Sarcasticus, I understand your apprehension.
    I myself had (have) slight misgivings about Obama's election particularly after listening to the eggheads in Europe talk about THEIR plans for the bailout.
    It strikes me that Obama's election just might be a case of needlessly prolonging a system which is a total failure, under the illusion that we will somehow manage to make it work, and that Mr Intelligent, Likeable, Earnest, and Honest Obama is going to pull a miracle.
    I don't like the idea of prolonging the inevitable demise of market capitalism. (I said MARKET capitalism, careful...)

  18. i've been saying exactly what your post says for nearly 2 years--your saying it makes it official.