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Wednesday, September 24, 2008

Creative Destruction Of Debt

I watched Bush's speech tonight. No text I can find to link to yet. It was a bad speech because it contradicted what both Paulson and Bernanke have been saying. The problem is that they are not telling the truth (Bush doesn't know that) about what they intend to do, and the average American is not so dumb as they think, and realizes that their overt statements about the plan don't make sense. Thus no support.

However, I think the real plan is what follows, and it can work provided we take equity in exchange for buying the assets. I like the Dodd plan in which the equity is gained if the assets are sold at a loss to Treasury.

Buy the debt tranches at current balance sheet values, most of which have been marked down at least 80%. Company gets money, treasury gets rights. Here's the kicker - securitizations have been sold mostly in tranches, so you have to get all extant tranches that have any value. Basically, you are going to aggregate the payment rights (securitized debts) back so that you end up pooling all the rights to payment of the underlying pool of loans. Now you effectively own the entire pool.

So, buy say at 80%. Now the taxpayer owns all or effectively all of the payment rights stemming from one pool, instead of a bunch of different institutions owning payment rights from one pool stemming from different tranches. Then deal with the underlying pool. It takes a lot of money to aggregate like this, but once you do you can do things with the underlying pool that you can't do otherwise. Now one player can give permission to violate the contractual provisions involved in the securitization, which, for example, may say that only a certain percent of the principal can be written down and so forth.

The moment you aggregate all the tranches on the pool, the collective value does go up. That is because when you calculate the value of the individual tranches, you have to figure various possibilities on payment streams to each tranche depending on your expectation for the entire pool. However, the entire pool will pay out only one way, so if one tranche is discounted by a certain set of circumstances, another tranche would in practice be upgraded. Obviously, when you are buying just one tranche, you can't assume that the possibility favorable to your tranche will happen, so you discount your individual tranche.

This mostly affects deeply tranched securitizations, and most of the Alt-A and subprime MBS are deeply tranched. If anyone doesn't understand this, I can explain further. It's a technical issue having to do with certain securitizations. The deeply tranched structure is supposed to support the value of the top tranches, but if there are significantly heavier than anticipated losses, the market value on the individual tranches, and thus the market value of all the individual tranches summed, will be below the expected aggregate return on all of the tranches over the pool lifetime. Thus if you have them all, your market value is higher than if they are owned by different parties.

When you have the rights of payment from the entire pool, you can add 4-5% on the value of the total tranches compared to buying them separately. .

Now you have acquired all the significant tranches at 80%, so you can instruct servicers to simply write down debt or write down interest payments. Say you have a bunch of loans with high DTIs - you can have the servicer adjust payments on the loans by writing down say 15-20% of principal or dropping interest rates to 4-5%. One rough sample:
Categories Principal Interest Periodic Rate Payment
Original $300,000.00 6.50% 0.54% -$1,896.20
Adjust Principal 80% $240,000.00 6.50% 0.54% -$1,516.96
Adjust Interest 70% $300,000.00 4.55% 0.38% -$1,528.98

Alright, so now you have some easy way out for the servicers. You authorize them to do such adjustments without letting the people go deeply into default as long as the borrowers are willing to provide income and asset information to qualify them for the new payment and as long as the borrowers are over their realistic DTIs with the old payment. Writing down the principal is a much better stability option, but it is hard to authorize under the terms of the current master servicing agreements unless the borrower has demonstrated that the borrower will default. If you own all the tranches, you can modify the master servicing agreement at will.

What you would get out of this are several benefits. First, if done well, after a year or two you should have improved the fundamental character of the pool. Second, you would have prevented quite a few foreclosures, and thus have avoided driving down the market value of the homes. Third, your borrowers are gaining some disposable income. If done widely, this could have a very good economic effect. The most important factors are cutting borrowers' debt payments to a more reasonable level and stopping foreclosures.

For the CC and auto securitizations, you can do the same. This actually would work; it would stimulate the economy directly, it would control rates of loss on housing, although housing will still go back to rational values supported by loan underwriting sufficient to verify that the borrower is expected to be able to pay the loan, and it would over time not result in huge losses on the Treasury deals.

If I were sure that this was the Paulson/Bernanke plan, I'd be for it (with the addition of the equity options to indemnify Treasury in the case of really bad debt).

Argument in favor of the proposition that it is the plan: 1) Up till now I have been able to closely predict the actions of the Bernanke Fed based on the strategy which I believe they are following. 2) Bernanke has written papers about the mechanism of deflation that make me think he would understand this. 3) Bernanke is strongly supporting the idea that this debt should be bought by the Fed. 4) We actually do know how to keep the loans from defaulting in such high numbers. Baird of the FDIC has been tramping the country pushing this idea for quite some time. However, in practice, it is not legally possible to execute the strategy when ownership of the payment rights on these pools is so diffused.

So I am tentatively favoring the plan, but I still want the equity options and oversight to make sure they are executed when necessary. I don't trust Paulson at all; this is a good theoretical plan that might in practice degenerate into a total FUBAR. Everyone will have more incentive to cooperate if the firms participating now realize that collective failure of the plan will cost them money later.

Hmmm. I think it needs one additional element: the government is going to need some financial-system equivalent of eminent domain to prevent a small number of holdout senior tranche investors in a pool from scotching the buyout. Given that, and a very large amount of staff, I can see that it could work. (Note to gov't: staff plan with as many people like Tanta as you can find!)
Bush's text here. Some interesting quotes here.
Glad to see you are seeing a possible way this can work, MOM.

It is an investment that, over the long haul, should break even or make a bit of money for the taxpayers. Even if it ended up losing 10% overall, that is far preferable to a financial meltdown.

I will sleep better tonight.
The de-complexifying of mortgage based securities and then doing a work out on the underlying polls could solve/mitigate the problem, but:

1) the worked out mortgages would have to be fixed term, fixed interest rate with monthly payments not to exceed 30% of borrowers income (i.e., system-wide cram down);

2) shut down the CDO/CMO/IO/PO creation engine (hint: SEC becomes too busy to review and approve prospectuses for securities more complex than a simple REMIC, a simple note/bond, or common/preferred stock)

3) treat all swaps and derivatives not traded on an exchange as illegal gambling (make this effective for ALL current and future positions)
This is all very complex but I am gla d that you think this plan might have a chance.

I agree that their needs to be some major accountability here.
John - I think when you're sitting on a pool of 700 billion, you have bargaining power.

Carl, thanks for the links. Jimmy, it can work.

Anon - it will be all right as long as new credit is granted on realistic terms, because pulling the really bad tranches out of CDOs is going to provide capital for buying better quality stuff to swap in.

Viola - it's all in the execution, and of course we are all feeling some trepidation about that. That's why I'd like to see some oversight.
A very interesting analysis. Thoughts/questions:

1)I'm also concerned about the "holdout" issue...in acquisitions of large strips of physical property, holdouts have (absent eminent domain) considerable bargaining ability.
2)If the assets are bought at current book value, then does this really do anything for bank capital and for the expansion of lending capacity?
3)How on earth would the government *quickly* put in place the systems & procedures to manage kazillions of individual mortgages in the pools? Even if the mortgages continued with the current servicers, various kinds of aggregation systems would be needed.
Assuming it works, it sounds like we need to re-think the way these obligations are split up. At the very least, we need real-time accounting for every last bit of the loan contract, but it sounds like we also need to reduce the depth of the chain somehow, or at least keep someone in the driver seat.
Andy here,

I'm sure as hell no economist, but I was wondering if a plan like this, or "somewhat" similar to this would help liquidity of the banks and encourage and depend on people using the banks:

Taxpayers can waive their social security tax every year when they open a retirement account at banks that offer this tax immunity. It would give sense of security about a citizen's well-earned dollars closer to their wallet then in the failing social security program.

Just an idea that came to me, I have no detailed specifics on the amount that would need to be in the retirement account and the amount needed to be maintained to ensure a waiver form, but I still think the plan has some merit.

Anybody's thoughts?
David - the government doesn't have to manage the mortgages. They already have servicers. The change here comes fromt the ability of the Treasury, as an owner, to authorize different servicing parameters.

A bank which is managing its own portfolio of loans can and does implement strategies similar to those I am suggesting here. However, the deeply tranched "innovative" mortgage securitizations have such split ownership that until now, this has not been possible.

As for the possibility of tranche holdouts, the Treasury could simply say to them "Very well, but then we will buy none of your holdings." It will have to be a bit thuggish to work.

My concern here is that if this is the plan, the population is not being advised of it.

A couple of problems with your analysis, which btw is impressive:

-There's a big political problem with offering debt forgiveness only for randomly-selected homeowners (those that belong to whole pools purchased by the government). There is no equity in that plan, and many will resist it, on both sides of the isle.

-Forgiveness works as long as hom prices are overshooting to the downside. If home prices are still too high relative to incomes and rents, then debt forgiveness will not result in asset prices that clear the real estate market. This is essentially what happened in Japan. Markets that don't clear stagnate, and they result in slow credit growth.

Bottom line: there can be no solution to the credit crisis that does not make home rices affordable based on conforming loans.

Likewise, there is no economic stimulus that will work as long as Americans are saving based on asset appreciation. Only when they save based on income will the process be complete.
I have not heard the bailout plan explained so well as you have done. You have won me over to the side of the ones in favor of the plan. What worried me about the plan before was the fact that there may be large payouts to the CEOs again and I have been wary of this for a long time. Why would they be given bonuses if the economy is bad and so many are suffering? Now they're saying it's because the business will not be able to attract good skillful managers if they're not paid the exorbitant amount they are being paid now. I say let's accept their challenge and see if we can't get someone to work harder at 10% less than these people are making now.

Evelyn Guzman
http://www.debtchallenges.com (If you want to visit, just click but if it doesn’t work, copy and paste it onto your browser.)
"I like the Dodd plan in which the equity is gained if the assets are sold at a loss to Treasury"...

Well that pretty much put maxedoutmama on the same bench with the libtards...

douche Dodd is one of the major clowns causing this debacle and this so called plan is just another earmark project for the party of the Seditious & Sleazy that foisted off this housing crisis onto the taxpayer...

The Diversity Recession, or How Affirmative Action Helped Cause the Housing Crisis

Was this where mortgages went off-track, as Professor Perry has suggested? And if so, wouldn't it be relatively easy to avoid a repeat?
Here's a rather upbeat analysis of the Paulson plan. Sounds good. Could it be true?
Check it out at:
Carl & Juandos - no. Fannie & Freddie did not cause this. There has been some pressure on the GSEs to extend credit in ways and in amounts that are highly questionable, but the causation of the bubble actually rested almost solely in private firms.

Fannie & Freddie loosened up when they were losing so much market share that it became a huge risk to them. Their problems appear to be a result of the credit bubble rather than the cause. I will address this in more detail later.

Jimmie J - it is overoptimistic.
since in California and Florida housing prices have a long way to go downward, this looks like a hole in the pocket for taxpayers. In addition to the smaller number of potential buyers (loan qualified on higher standards), salaries are not going to support current prices by about 30%. How do servicers "help" mortgage holders who simply walked away when it became evident that they wouldn't make money on their non-investment? there are a lot of toxic loans out there that are not evident to the mortgage holders - check with any Florida mortgage broker (any one not in jail, that is)
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