Markets at Work

In some cases, the principal on loans is already being reduced by players in the market without government assistance or encouragement. For sure, there are many scams out there claiming to reduce payments and principal, but there are some legitimate negotiations taking place. Hedge funds have bought speculative mortgages and they have approached borrowers in order to make a deal.

This recent article in Bloomberg gives an example of a hedge fund that purchased a mortgage for 60 cents on the market and renegotiated the terms of the loan. The hedge funds have worked proactively to protect their investments.

"Greenberg says she warmed to NAD’s proposal after Hussion explained that the value of the house had fallen well below the amount of the loan, and that it was in the company’s interest to head off a default by reworking mortgages like hers."

A relatively small percentage of "under water" mortgages have been renegotiated so far by the free market. The Obama administration has pledged support for changes in bankruptcy law that would allow judges to "cramdown" and force changes in the terms of mortgages. This idea raises a few questions in my mind

1. Are there in fact too few reductions of principal taking places in the market? In some cases it might be most efficient to foreclose and sell the house to another investor.
   
2. What will the long-term effects of changing bankruptcy law to allow "cramdowns" on mortgages? I suspect higher interest rates and worse terms for home buyers in the future.
3. What changes in regulation could make the market-based renegotiation of mortages more efficient?

The Bailout

The bailout measure failed the House 228-205 and the Fed has continued to provide short-term loans to banks. Most people don't understand what is meant by a bailout and what exactly is being bailed.


The Numbers - Hank Paulson, Secretary of the Treasury, is asking for $700 billion. It would start with $250 billion with the rest subject to Congressional veto. $700 billion is about 5% of the gross domestic product.

What would they spend the money on - Mortgage-backed securities and Collateralized Debt Obligations

• Mortgage Backed Securities - Cash flows paid out of principal and interest from mortgages. The buyers of these securities need to look at interest rate risk, prepayment risk, and default risk. They also need to look at the value of the underlying collateral in the event of a default in order to value these securities.
• Collateralized Debt Obligations - A special purpose entity created to buy fixed income assets(other structured securities, mortgages, bonds, loans). They are sliced up and sold to investors in tranches. The senior tranche receives payments first, followed by mezzanine, subordinate, and equity tranches. So, if the underlying asset does not pay off, investors in the equity tranche lose first.
  

Why? - Bank balance sheets are filled with mortgage backed securities and CDOs that there is not much of a market for right now. The credit markets have tightened and banks are not willing to lend money.

What does it all mean? - Estimates of the actual cost of a bailout have varied. The securities that the government buys are probably worth more than zero. Some even say that the Treasury will make a profit on this deal like in the Mexican bailout. Some have asked where the government will get the money for this scheme. It will get money from where it always does: taxing, borrowing, or printing. At least right now, it is in a good position to borrow with treasury bond rates at very low levels. The Treasury can borrow at these low rates and buy these more illiquid securities, behaving like a very large hedge fund. Albeit, a hedge fund with other motives than return on investment.


If you have any questions about this situation or if you think I should cover more in this entry, post a comment or send me an email.