Congress is being asked to provide $700 billion by allowing the Treasury Department to sell debt and using the proceeds to purchase illiquid mortgage debt. This is similar to what the Federal Reserve does every day with two exceptions: 1) normally the Fed makes, in essence, short-term loans to members to give them liquidity and reserves. The present situation is not a loan but an outright purchase of assets; and 2) the extraordinary events of the past few months have depleted the reserves the Fed can use to perform market operations.
What I find most disconcerting about the present discussion is that this $700 billion is viewed as if it is going to be spent and gone.
This $700 billion should in no way be looked upon as gone. Treasury should do this in a manner so that the net cost to the taxpayers is either zero or this is in fact profitable to Treasury. How? We are addressing illiquid mortgage debt, and illiquid residential mortgage debt can be viewed as falling into three categories: jumbo A paper, Alt-A and subprime.
Take a plan like this:
- Use $300 billion to buy A paper jumbo MBS at a discount of 20 percent.
- Use $200 billion to buy Alt-A debt at a discount of 35 percent.
- Use $200 billion to buy subprime debt at a discount of 65 percent.
I am in no way suggesting that these are the correct or best numbers — regard this only as a framework.
There are vital details about the pools of mortgages such as different discounts applying to different note rates for A-paper and rules about how many mortgage rates the Alt-A and subprime can have, which must be worked out.
Treasury would then have $1.25 trillion worth of mortgages and be collecting the interest at the weighted average note rate and paying something like 2.5 percent (0.25 percent above the current 2 year Treasury) for this.
In short, Treasury should make the sellers take the losses. The losses should not be carried by the taxpayers.
As an extreme, let us assume that not a single dollar is paid on any of this $1.25 trillion in mortgages and every one of them is foreclosed, held for a couple of years and sold. If the land were sold for 28 percent of the value of the mortgages, the loss would be half of the $700 billion. An additional $62 billion would have been spent on interest.
A more realistic worst case might be something like this: Assume that 60 percent of the $1.25 trillion is foreclosed on and that those foreclosures produce sales worth 27 percent of the loan amount. Treasury still breaks even.
The salient facts are these: Treasury is purchasing illiquid assets at a low price. These assets are secured by real estate. This Treasury debt is unlike any other Treasury debt because it will purchase assets that produce a monthly cash-flow profit.
There are some important accounting details that will impact the effect of these purchases on liquidity. The greatest effect is on paper that has already been written down on the books of the sellers.
If the weighted average note rate on the $1.25 trillion portfolio is 6.5 percent, Treasury would be receiving $81.1 billion a year in interest if the entire portfolio performed. It would be spending $21 billion on interest (3 percent of $700 billion). Clearly this is a moneymaker for Treasury. The positive carry on this is so large that Treasury can sell this debt back to the market at a time and in a manner to benefit both its own coffers and the economy.
The liquidity provided by this process will have a positive effect on real estate values further enhancing the value of these mortgages and further strengthening the banking system as well as the entire economy. The most likely outcome is that Treasury will sell all of these mortgage-backed securities back into the market at a profit in a period of between two to five years.
The debate is framed incorrectly. Treasury (the taxpayers) is going to make a handsome profit and the folks who hold this mortgage debt are going to take a loss. This is not to imply that there will be no benefit to financial institutions. This will take off their books illiquid debt and allow them to regain the function that they have in our economy: making loans to drive the economy forward.
One more important point: This $700 billion in liquidity will not solve the problem by itself. It is necessary that other players in the secondary market start buying again. That is not going to happen anytime soon if Congress fails to produce. It is the illiquidity of mortgage debt that is the root of the present credit crisis. To the extent that Congress mitigates the Treasury proposal by having other debt covered by this bill it will be choosing to water down the solution — and the probability of success — while increasing the risk to the taxpayers.
The flak about CEO salaries is something I could not care less about.
That does, however, bring up another issue that is for discussion at another time. Namely, business has chosen shortsighted methods of compensating executives for producing seeming profits in a given year despite the fact that those executives did not have the long-term viability of their corporation as a priority.
In summary: Done correctly, Treasury will net a profit and the benefit to the banking system and the economy in general will be massive.
Dick Lepre is a loan agent for Residential Pacific Mortgage in San Francisco, Calif. Since June 1995 he has produced RateWatch, a weekly newsletter for borrowers and real estate professionals. He has written extensively about macroeconomics, mortgages and real estate.
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