WHY DO BANKS GET HOLD-TO-MATURITY PRICING FROM TREASURY, BUT NOT MORTGAGE HOLDERS?
It just strikes one as a grim juxtaposition that those who ran around insisting that we wouldn't bail out borrowers who went beyond their means are now ready to give "theoretical pricing" to lenders, which is what hold-to-maturity amounts to.
Sure, it's easier to run an auction among highly paid professionals, but did it occur to anyone that you might achieve that same ends by giving new terms to borrowers to keep them in the houses for a while longer, yet? Is that too ... messy?
MAKING GOOD, DOING GOOD
If someone came up with a scheme to "make good" on even 50% of the sub-prime loans going into default, that would reflate Wall Street, immediately.
What is the risk to the Treasury?
Well, I don't recall the exact figures, but total sub-prime lending was in the range of $700-$1,500 billiion.
Suppose the Treasury "absorbs" a 20% housing price decline, today. That would put them at risk for $140-$300 billion (assuming they took on the whole price-decline risk, not 95% of it, say). If they took an equity stake in a refinancing alongside the homeowner, they might get some fraction of that back over time, say $40 billion, for a net of $100-$260 billion. If it is true that 50% of the borrower credits for sub-prime are good enough for a conventional rate mortgage, that would even further limit their exposure under such a scheme.
For the subprime debt that the Treasury steps in on, they pay out to lenders at some rate (less a small fee), probably the rate at which the Treasury can get financing...
If the Treasury really wants to get exciting, they can give a direct cash infusion to the banking system, right to the places that are suffering the most. To do so, they can choose to pay off some of the foreclosed loans in full (or at some discount), rather than assume payments at a "government guaranteed rate", i.e. pre-pay the loans at 90% of face, say.
With some luck and foresight, the Federal Agencies will be able to package and sell the restructured loans that the government passes out as part of mitigating the impact of foreclosures. In other words, done right, the mess of restructured loans doesn't have to stay with the Fed/Treasury forever, because the borrower terms were so bleeding favorable there is no way to repacakge them for sale at market prices.
FIXING THE DERIVATIVE PROBLEM BY MITIGATING THE UNDERLYING ASSET DISTRESS
CDOs will continue to be risky assets, but they will have a theoretical floor value, because the government is backing up the foreclosure risk and providing a known, "workout" rate of interest to the lenders. There is no costly and lengthy bankruptcy process, either, for the private sector lenders, just the haircut(s) they take.
Will such a guarantee be enough, or will looming CDO/CMO write-downs still be crippling to "the system"? That depends on where the CDOs are marked now and what the new, government-backed valuations look like in comparison. If there is still not enough capital at the "banks", that would be the time for the Fed to lend its balance sheet. (Yes, it would be on both sides of the transaction, but we'd be monetizing less, hopefully, or some total amount that can be completely determined by the authorities, not by the beggars at the feast).
As for the CDS, taking out some of the foreclosure and interest-rate risk on the underlying securities will greatly improve spreads (they could be cut in half overnight, right?). This could cause a great mark-to-market boost. That itself may help some of the most troubled (reckless) institutions.
This "plan" has many advantages:
- The authorities deal only with one type of security, sub-prime and alt-A mortgages (let the rest follow suit, plugging holes if necessary for individual institutions). It deals with a reasonably well known legal process, foreclosure and real-estate law in general.
- Many people may get to stay in the their homes and the "welfare" goes to the borrowers, rather than the lenders on Wall Street (or at least in a more equitable proportion).
- The government is on the hook for the value of home-price declines that may affect the subprime segment of the market, only, and that could be $300 billion, less whatever they can collect from
- any long-term equity stake they take with the homeowner;
- "savings" from any realized home-price declines not as bad as the 20% overall decline guesstimate or any haircut they pass on to the lender;
- the haircut that banks/lenders are willing to take to get pre-paid by the Treasury (i.e., cash now) in order to rebuild their cash reserves;
- and any spread the Treassury picks up between the rate they 'guarantee' to the original lenders of sub-prime and what they get from restructured sub-prime loans that keep people in their homes, for a while longer.
Q.E.D.
