Thursday, September 25, 2008

Bush Makes the Case

President Bush did in tonight's prime-time address to the nation what Henry Paulson and Ben Bernanke have not been able to do as effectively this week in front of Congress.

Bush spoke in clear, simple language and described very well the genesis and development of the mortgage problem and the solution proposed to solve it. This is rendered so simply and directly that even nearly all of Congress could understand it:

Second, as markets have lost confidence in mortgage-backed securities, their prices have dropped sharply. Yet the value of many of these assets will likely be higher than their current price, because the vast majority of Americans will ultimately pay off their mortgages. The government is the one institution with the patience and resources to buy these assets at their current low prices and hold them until markets return to normal. And when that happens, money will flow back to the Treasury as these assets are sold. And we expect that much, if not all, of the tax dollars we invest will be paid back.

Henry Paulson as brilliant as he certainly is [if there are three certain things in life, it's death, taxes and you don't get to be chairman and CEO of Goldman Sachs by being a dummy] speaks Wall Street and 'market mechanisms' and 'reverse auctions' which frankly are gobbledygook to most of America. Hopefully enough of America paid attention tonight.

Let me give a dollars and cents example.

John Thain at Merrill Lynch recently sold off some risky loans at 22 cents on the dollar. This means if Merrill paid one billion dollars for this basket of loans it only got 220 million dollars back. A lot of this toxic stuff is still sitting in the financial system, in the investment banks as well as pension funds and insurance companies. THE MARKET'S UNCERTAINTY ABOUT HOW MUCH A FIRM HAS AND HOW MUCH IT HAS BEEN MARKED DOWN has directly caused the failure of Lehman Brothers and nearly the failure of Freddie and Fannie and AIG.

What Paulson proposes to do is have Congress approve a fund up to 700 billion dollars that creates a market for these securities that haven't existed for the better part of a year.

22 cents on the dollar simply speaking assumes that only 78 percent of these mortgages would default. Since many of these loans particularly those made in 2006 and 2007 were made to marginal customers it is probable that there will be significant defaults. BUT NOT 78%. If the US Treasury examined a bucket such as this and shows the market a 45 cent bid for these securities it would be likely that many institutions will sell to the Treasury as many could actually book a profit if they had already marked these securities lower. A profit only in the sense that they had written down 78 cents of loss but would gain back 23 cents of that loss by selling to the Treasury. Even if this bucket of loans was particularly toxic even a default rate of 40% would mean a 15 cent profit for the Treasury and the taxpayer.

What it also does is allow the banks to clean house and with the books clean can start to lend again. Just as important with the uncertainty removed firms won't be subject to panic liquidation which claimed Lehman Brothers and threatened AIG as well as the venerable investment bank Morgan Stanley.

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