I'd like to know more about this:

Ian Welsh writes: (emp add)

... banks and other mortgage brokers sold mortgages to homeowners without due diligence and based on fraud, and they then sold the repackaged mortgage revenue streams to investors based on fraudulent promises about due diligence, revenue and risk.

This is also true with credit default swaps. ... Anybody could write the things, whether they had the money to back it up if large numbers of them went bad, and anyone could use any math they wanted to figure out what the likely risk and premium was.

All of this was done explicitly in ways intended to avoid regulation. Contracts were sold which stated that they could never, ever be sold on an open traded market - never be sold on something like the Chicago Board of Trade or the New York Stock Exchange. If they had been, regulators could have gotten their dirty hands on them and started to insist on some standards. But writing that into them means that they were in effect designed to make sure that they were illiquid - that there would be no large public market where large numbers of them could be sold and prices could be set in an open way.

So now the U.S. government is supposed to take on this bad paper, at valuations the banks would like, yet they were designed to be opaque from the beginning. Consider this from Calculated Risk about something that is traded: (excerpt from NYTimes article)

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.
...
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.

CR comments:

To be worth even 38 cents on the dollar, this must be a senior tranche. The lower tranches have absorbed most of the losses so far, and that is why S&P is currently valuing the bond at 87 cents on the dollar, but any higher default assumptions, and the value of this bond will plummet. I'm amazed, given that these are no money down 2nds that the loss severity is only 40 percent.

But this illustrates the problem. If the bank marks the bond to market (38 cents), they will have to take huge losses. But if the government even pays the current S&P estimated value, the bank will have to write the bond down further, and the taxpayers will probably take huge losses too. Unless a bank has been very aggressive with their write downs, buying the toxic assets doesn't help - or is a gift from taxpayers to shareholders.

And here's Paul Krugman, on bailing out the banks: (emp add)

If news reports are right, the bank rescue plan will contain two main elements: government purchases of some troubled bank assets and guarantees against losses on other assets. The guarantees would represent a big gift to bank stockholders; the purchases might not, if the price was fair — but prices would, The Financial Times reports, probably be based on “valuation models” rather than market prices, suggesting that the government would be making a big gift here, too.

But to the main point of this post. Some financial instruments were, according to Welsh, designed not to be traded. Designed to evade regulatory scrutiny. And now the U.S. is going to be purchasing this paper?


posted by Quiddity at 2/01/2009 10:17:00 PM