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TARP-pay Diem!

February 2, 2009

The New York Times finally caught on today, publishing this pretty good story about the perils of bailing out Level 3 assets held by profligate banks.

To recap our saga: Back in September, Treasury Secretary Henry Paulson rolled out the Troubled Assets Relief Program, fondly known as TARP, and told congress that the $700 billion he demanded for the program would be used to buy “hard to value” assets held by banks. That prompted people familiar with bank processes to explain to people like me that “hard to value” meant Level 3, which is “financial pig shit.”

Further inquiries revealed that banks had been piling up these bad debts and calling them “assets” for more than a year, just waiting for Uncle Sam to rush in with a bail bucket.

Paulson started spending the money otherwise–buying up “preferred stock” and other allegedly less toxic stuff, and then took credit for the total lack of financial Armageddon that has happened since.

Meanwhile came the pained whimpers of bond holders, hedge funds, and others demanding payment for their correct bets on the direction of various mortgage-backed securities. Seemed their counterparties–AIG especially–couldn’t pay. So, in several steps, the taxpayers pumped about $150 billion into AIG, while AIG stopped paying the man who wrecked it–Joe Cassano–his $1 million per month severance pay.

A total of $2.5 trillion got shoveled into other banks and financial companies. They spent more than $18 billion of it of it on executive bonuses, reasoning that such big brains as theirs must be compensated appropriately, lest they debark to some less socially valuable pursuit, such as nuclear physics.

Now comes President Obama and Timothy Geithner, one of Paulson’s protégés. Geithner is going back to his predecessor’s original TARP plan, which means buying up the toxic bonds that the banks say they can’t easily value.

So the Times rightly asks, well, how can they be valued? The paper illustrates with a single mortgage-backed bond:

The financial institution that owns the bond calculates the value at 97 cents on the dollar, or a mere 3 percent loss. But S.& P. estimates it is worth 87 cents, based on the current loan-default rate, and could be worth 53 cents under a bleaker situation that contemplates a doubling of defaults. But even that might be optimistic, because the bond traded recently for just 38 cents on the dollar, reflecting the even gloomier outlook of investors.

So confusing, yes? Who could possibly be right?

And yet, always before it was the bond market–the 38 cents guys–who were presumed to have the true value. They are, by definition, the actual market value.

To understand where they’re coming from, it helps to know something about the bond under analysis. The Times gives us that:

The bond is backed by 9,000 second mortgages used by borrowers who put down little or no money to buy homes. Nearly a quarter of the loans are delinquent, and losses on defaulted mortgages are averaging 40 percent. The security once had a top rating, triple-A.

Hmmm. 9,000 piggy-back loans with a 25 percent delinquency rate? The only way for this bond to be worth more than 50 cents is if it is an upper-level tranche. That is, though the Times story does not say this, the bond under study must be protected by lower-level bonds made from the same mortgages. The holders of those lower tranches were promised higher returns for taking higher risks of default–so the first defaults would have already wiped those investors out, leaving these bondholders still afloat.

Even still, does anyone still think there is a significant percentage of no-money-down home-owners who are not underwater? Realistically, about 8,900 of these 9,000 mortgages are in technical default, because the underlying asset–the house–is no longer worth as much as the loan. That 75 percent of them are still paying is a testament to their honesty and good faith. But since a typical foreclosure recovers about 60 percent of the loan value, and these loans are all in line behind the first mortgages, the chances of any recovery in foreclosure is virtually nil. The Times doesn’t consider this.

It does, however, make this obvious point:

Big banks and other owners of mortgage investments have argued that the low market prices reflect fire sales. Many have classified such securities as level-three assets, for which accounting rules allow them to determine values using computer models rather than the marketplace. . . .
But critics . . . say that the banks’ accounting for these assets cannot be trusted because they have an incentive to use optimistic assumptions.

Well. You suppose?

The Times gets the main point right: What’s being contemplated by the Obama Administration is that taxpayers will pay the banks’–or, at worst, S&P’s–price for these “toxic assets.” We’ll take the loss so that bondholders–some of which are municipal pensions and others of which are rich playboys–don’t have to. We’ll take the loss so the bankers themselves can continue to pay themselves commensurately to their intelligence.

But it’s probably worse than the Times yet imagines: The Times‘ example is a real bond–an honest-to-Hayek “mortgage-backed security” based on mortgages on actual McMansions. We’ve seen how these can be worthless even though the houses exist. But the Times has yet to explain the wonders of synthetic mortgage-backed securities. These are derivatives-based on the value of the real MBS, but untethered to any actual houses–and there’s a lot of this stuff parked at Level 3 on banks’ balance sheets.

The story of why American taxpayers should or might fork over full face value for that stuff, which has the intrinsic value of a scratched lottery ticket, awaits the next striking realization of the Times.

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