Wednesday, September 24, 2008

Confused, and nowhere to go... (updated)

OK, exactly where's a blogger to go to get a real understanding of what is happening with the U.S. financial meltdown and with what some are calling "the mother of all bailouts" (MOAB)? This blogger has perused what must be a couple of hundred articles in newspapers, financial magazines, and on the web; and just as he found it impossible to get a "correct' answer re why oil prices rose so far earlier in the year (supply and demand, speculators, value of the greenback, peak oil) it has been an exercise in frustration. Dueling economists, arguments re 'Wall Street' vs. 'Main Street; 'we have to intervene' vs. 'let them crash and burn', etc. Even getting solid numbers is not easy e.g. some figures are for mortgage delinquency and others for mortgage foreclosures (NOT the same thing).

So, this blogger's questions are:

1. Exactly how much "toxic waste" is out there? And exactly what are they talking about when they say "toxic waste"?

Simplifying greatly, financial institutions loan money to people to buy homes i.e. mortgages. These days they don't hold on to the mortgages forever, but sell them. These are pooled, packaged, and sold as securities, thus the name 'mortgage backed securities.' See the diagram above (source: Wikipedia). Mortgages can also be bundled into Collateralized Debt Obligations, or CDOs. These are split into three or more 'tranches', each with a different maturity, interest rate, and level of risk (which allows the seller to sell packages sell to different investors with different degrees of risk preference (for an explanation of CDOs see here). Not content with this , all sorts of other derivative, exotic, financial instruments were devised and built on top of these... Mortgages can also be further divided into 'prime', 'near-prime (Alt-A), and 'subprime', with the creditworthiness of the borrower decreasing as we move from prime to subprime. For the remainder of this entry let's assume that "toxic waste" refers to near- and sub-prime MBS/CDOs, and not to the more exoteric derivatives thereof... (however, this blogger has not seen Bernanke or Paulson define exactly what is "in scope" for the MOAB!)

The entire U.S. housing mortgage market stands at approximately USD thirteen trillion, while Fannie and Freddy have approximately USD 6 trillion of this. This blogger is assuming that since Freddie/Fannie have already been taken over by the government, Messrs. Bernanke and Paulson are not including them in their plan... That leaves USD 7 trillion. Assuming the split is 70% prime and 30% near- and sub-prime (the closest this blogger could find..), then we are talking about USD 4.9 trillion of prime and USD 2.1 trillion of near- and sub-prime. OK, right now delinquencies are running at 25% of near- and sub-prime and 2.5% of prime. Earlier we assumed that "toxic waste" did not include prime, so let us exclude that (the financial institutions need to manage some things themselves, and surely shouldn't be bailed out for every non-performing loan!) Scenario: 50% of subprime is "toxic" i.e. USD 1.05 trillion. Assuming that the MOAB pays 50 cents on the dollar, the "toxic waste" should be able to be purchased for the mere bagatelle of USD 525 billion. So, perhaps the USD 700 billion is "rounding up" plus swag, or else Messrs Bernanke and Paulson want to define "toxic waste" more broadly. Instead of speechifying and posturing it would have been nice if the Senate Banking Committee members had asked Messrs. Bernanke and Paulson to explain in plain English terms what exactly is the "toxic waste" they are proposing to buy up. And if the Senators were too shy to say that "in plain English" was for their own benefit (actually, we know they all consider themselves veritable Einsteins who don't need any explanations), then they at least could have requested it for the benefit of the viewing audience.

2. When this blogger bought his house (at the height of the bubble!) he was assessed PMI, private mortgage insurance, because he only put down slightly less than 20% of the value of the home. This is insurance that protects the lender - if the borrower defaults and the lender is not able to recover its costs after foreclosure and sale of the mortgaged property then the insurance kicks in. OK, since the vast majority of near- and sub-prime loans probably have a loan-to-value ratio appreciably above 80% they would all require PMI. So, how come this blogger has not heard word one re PMI. Looks like the banks should be covered and that it would be the insurers that are screaming about "toxic waste"! However, they don't seem to figure into any of the articles and news - are Messrs. Bernanke and Paulson bailing out the banks or the insurers?

Hard to say what is actually happening, this crisis is generating more heat than light!

Disclaimer: This blogger is no economist or expert. Perhaps the answers to both these questions are easy and somewhere out there.. Any pointers would be welcome!

Updated 09/25: Actually, of the $1.05 trillion in non Fannie/Freddie toxic waste the banks have already written off USD 500 billion so far this year, so (unless it has already been subtracted off the overall mortgage stock number) that would leave only USD 550 billion. Paying 50 cents on the dollar that would only cost the MOAB USD 275 billion and not USD 700 billion! More confusion, the numbers just don't seem to add up - which makes it even more important that there be clarity around this!

Second update 09/25: From a Forbes article: "In fact, some of the most basic details, including the $700 billion figure Treasury would use to buy up bad debt, are fuzzy."It's not based on any particular data point," a Treasury spokeswoman told Tuesday. "We just wanted to choose a really large number."

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