Lehman

[GePap]

Originally posted by snoopy369


Ahh, that explains it then.

I am in no mood to grant any member of the Bush administration an iota of more power. I seriously doubt that the cost woul be 700 Billion, and I think Krugman is correct in his statement that this "bailout" will only "work" is the government ends up horribly overpaying for junk, which the post you posted agrees with.

[snoopy369]

His argument ( that the bailout as Paulson wants it is bad) is perfectly valid. His rationale not so much.

[GePap]

Originally posted by snoopy369
His rationale not so much.

Okay, HOW?

[snoopy369]

Because the government buying the assets at a 'reasonable price' (a price that is greater than the risk-averse price, but less than the probable return price) is beneficial to all sides. It would solve 4. and 2. (to some extent anyway), bring a likely profit to the taxpayer, and (simultaneously) avert the government incurring significant losses (either backing up failed banks, or protecting now homeless homeowners foreclosed on by banks who cannot afford to be nice).

That said, I don't support the bailout for other reasons - namely, it doesn't fix the problem in the long run, it profits people who should not be profited, and it's not the best solution. Restructuring the debt and advancing programs to forgive some mortgage debt to in-trouble borrowers is the best solution; the latter I have to give Paulson some credit for pushing, though I don't know how actually effective his particular program has been in this.

[PLATO]

Originally posted by Kidicious

1) Why do you think the bonds are worth more than their ratings say they are?

Because they are unusual in being backed by real assets with strong residual value. To use DanS's figure of no buyers at 22 cents on the dollar....if every house in an MBS was forclosed on, does anybody think the bondholder liquidates the houses at 22% of their value? The actual figure is close to 80% (as low as 60-65% in some really hard hit areas...upto 90% in others). In other words, in a worse case scenario you get 80 cents back on your dollar invested. While some MBS have experienced over 50% default ratios, the vast (and I mean VAST) majority are experiencing less than 5% default ratios.

2) Why don't people other than non-institutional investors buy them up?

Many investors make their living on buying volatile assets that appear to be undervalued. There are all manner of speculators participating in the market. The shear amount of money involved in these assets along with alternative speculative investments have created a glut of volitile assets for sale in relation to the normal amount of speculative money floating around.

Can you give me one sentence answers for both?

Nope...sorry. That's as short as I could say it.

[DanS]

Originally posted by PLATO
[q] Originally posted by Kidicious
To use DanS's figure of no buyers at 22 cents on the dollar....if every house in an MBS was forclosed on, does anybody think the bondholder liquidates the houses at 22% of their value?

As you should well know, it's not that simple. What's the leverage on the tranches that were swept under the rug at 22 cents on the dollar?

The shear amount of money involved in these assets along with alternative speculative investments have created a glut of volitile assets for sale in relation to the normal amount of speculative money floating around.

There are vast sums of money just waiting in cash. This indicates that your opinion is not correct. The people who own these assets have an absurdly high opinion about the worth of the assets.

[GePap]

Originally posted by snoopy369
Because the government buying the assets at a 'reasonable price' (a price that is greater than the risk-averse price, but less than the probable return price) is beneficial to all sides. It would solve 4. and 2. (to some extent anyway), bring a likely profit to the taxpayer, and (simultaneously) avert the government incurring significant losses (either backing up failed banks, or protecting now homeless homeowners foreclosed on by banks who cannot afford to be nice).

Wouldn't the free market be the only way to figure out a "reasonable price," and thus make the idea of the government coming in to buy these securities at this point when their value isn't set wrong? Why not wait until the market sets the reasonable price for his crap, and then have the government jump in to buy at firesale prices?

And to whom exactly would the government sell these things to afterwards? That would be the only way for the government to profit, but if no one in the private sector is willing to buy these things at their current pricing now, how the hell will the government get a higher price later, unless the government forces all the banks to lower the price of these securities extensively, thus still crashing the balance sheets of these companies and possibly making them bankrupt anyways.

[PLATO]

Originally posted by snoopy369
A more intelligent post, made by one of the colleagues of my teacher, is found here: http://faculty.chicagogsb.edu/luigi....n_is_wrong.pdf

Why Paulson is Wrong
Luigi Zingales
Robert C. Mc Cormack Professor of Entrepreneurship and Finance
University of Chicago -GSB
When a profitable company is hit by a very large liability, as was the case in 1985 when
Texaco lost a $12 billion court case against Pennzoil, the solution is not to have the
government buy its assets at inflated prices: the solution is Chapter 11. In Chapter 11,
companies with a solid underlying business generally swap debt for equity: the old equity
holders are wiped out and the old debt claims are transformed into equity claims in the
new entity which continues operating with a new capital structure. Alternatively, the
debtholders can agree to cut down the face value of debt, in exchange for some warrants.
Even before Chapter 11, these procedures were the solutions adopted to deal with the
large railroad bankruptcies at the turn of the twentieth century. So why is this wellestablished
approach not used to solve the financial sectors current problems?
The obvious answer is that we do not have time; Chapter 11 procedures are generally
long and complex, and the crisis has reached a point where time is of the essence. If left
to the negotiations of the parties involved this process will take months and we do not
have this luxury. However, we are in extraordinary times and the government has taken
and is prepared to take unprecedented measures. As if rescuing AIG and prohibiting all
short-selling of financial stocks was not enough, now Treasury Secretary Paulson
proposes a sort of Resolution Trust Corporation (RTC) that will buy out (with taxpayers’
money) the distressed assets of the financial sector. But, at what price?
If banks and financial institutions find it difficult to recapitalize (i.e., issue new equity) it
is because the private sector is uncertain about the value of the assets they have in their
portfolio and does not want to overpay. Would the government be better in valuing those
assets? No. In a negotiation between a government official and banker with a bonus at
risk, who will have more clout in determining the price? The Paulson RTC will buy toxic
assets at inflated prices thereby creating a charitable institution that provides welfare to
the rich—at the taxpayers’ expense. If this subsidy is large enough, it will succeed in
stopping the crisis. But, again, at what price? The answer: Billions of dollars in taxpayer
money and, even worse, the violation of the fundamental capitalist principle that she who
reaps the gains also bears the losses. Remember that in the Savings and Loan crisis, the
government had to bail out those institutions because the deposits were federally insured.
But in this case the government does not have do bail out the debtholders of Bear Sterns,
AIG, or any of the other financial institutions that will benefit from the Paulson RTC.
Since we do not have time for a Chapter 11 and we do not want to bail out all the
creditors, the lesser evil is to do what judges do in contentious and overextended
bankruptcy processes: to cram down a restructuring plan on creditors, where part of the
debt is forgiven in exchange for some equity or some warrants. And there is a precedent
for such a bold move. During the Great Depression, many debt contracts were indexed to
gold. So when the dollar convertibility into gold was suspended, the value of that debt
soared, threatening the survival of many institutions. The Roosevelt Administration
declared the clause invalid, de facto forcing debt forgiveness. Furthermore, the Supreme
Court maintained this decision. My colleague and current Fed Governor Randall Koszner
studied this episode and showed that not only stock prices, but bond prices as well,
soared after the Supreme Court upheld the decision. How is that possible? As corporate
finance experts have been saying for the last thirty years, there are real costs from having
too much debt and too little equity in the capital structure, and a reduction in the face
value of debt can benefit not only the equityholders, but also the debtholders.
If debt forgiveness benefits both equity and debtholders, why do debtholders not
voluntarily agree to it? First of all, there is a coordination problem. Even if each
individual debtholder benefits from a reduction in the face value of debt, she will benefit
even more if everybody else cuts the face value of their debt and she does not. Hence,
everybody waits for the other to move first, creating obvious delay. Secondly, from a
debtholder point of view, a government bail-out is better. Thus, any talk of a government
bail-out reduces the debtholders’ incentives to act, making the government bail-out more
necessary.
As during the Great Depression and in many debt restructurings, it makes sense in the
current contingency to mandate a partial debt forgiveness or a debt-for-equity swap in the
financial sector. It has the benefit of being a well-tested strategy in the private sector and
it leaves the taxpayers out of the picture. But if it is so simple, why no expert has
mentioned it?
The major players in the financial sector do not like it. It is much more appealing for the
financial industry to be bailed out at taxpayers’ expense than to bear their share of pain.
Forcing a debt-for-equity swap or a debt forgiveness would be no greater a violation of
private property rights than a massive bailout, but it faces much stronger political
opposition. The appeal of the Paulson solution is that it taxes the many and benefits the
few. Since the many (we, the taxpayers) are dispersed, we cannot put up a good fight in
Capitol Hill; while the financial industry is well represented at all the levels. It is enough
to say that for 6 of the last 13 years, the Secretary of Treasury was a Goldman Sachs
alumnus. But, as financial experts, this silence is also our responsibility. Just as it is
difficult to find a doctor willing to testify against another doctor in a malpractice suit, no
matter how egregious the case, finance experts in both political parties are too friendly to
the industry they study and work in.
The decisions that will be made this weekend matter not just to the prospects of the U.S.
economy in the year to come; they will shape the type of capitalism we will live in for the
next fifty years. Do we want to live in a system where profits are private, but losses are
socialized? Where taxpayer money is used to prop up failed firms? Or do we want to live
in a system where people are held responsible for their decisions, where imprudent
behavior is penalized and prudent behavior rewarded? For somebody like me who
believes strongly in the free market system, the most serious risk of the current situation
is that the interest of few financiers will undermine the fundamental workings of the
capitalist system. The time has come to save capitalism from the capitalists.

There are several errors in the assumptions he uses here. First, and foremost, is that there is not time for Chapter 11. There certainly is, but the Lehman bankruptcy exposed the huge problem with this. Lehman's Chapter 11 on just over $600 billion in debt triggered credit default swaps of nearly 2 trillion dollars. In some cases, credit default swaps are leveraged pretty heavily. Filing Chapter 11 is not an option unless you want to start a domino effect that will cascade around the world.

[snoopy369]

He acknowledges that there is no time for chapter 11. He's suggesting using chapter 11 methodologies (forcibly writing down debt, etc.), not using the actual court process. The domino effect is caused by investors' uncertainty, not by the actual writedown itself, right? If all the debt was written down to 80% by federal fiat, that would have a lot less of an effect on the CDS market, wouldn't it?

[PLATO]

Originally posted by DanS


As you should well know, it's not that simple. What's the leverage on the tranches that were swept under the rug at 22 cents on the dollar?



There are vast sums of money just waiting in cash. This indicates that your opinion is not correct.

This is where the problem lies in the default issues...not in the valuation of the actual MBS. While it certainly effects its trading value, it does not effect its real value.

The leverages are terrible btw, some up to 40-1.

[DanS]

Even if the bank sells a foreclosed house for 80 cents on the dollar, the equity in those tranches could be wiped out, depending on the leverage. Isn't that correct?

[PLATO]

Originally posted by DanS


There are vast sums of money just waiting in cash. This indicates that your opinion is not correct. The people who own these assets have an absurdly high opinion about the worth of the assets.

There are vast sums available. There are also downward trends continuing on a lot of this paper. The simple fact is that the speculative money is either elsewhere or waiting for a bottom. However, that being said, huge amounts of this have already been bought at pennies on the dollar. The people who own these assets do have a much higher idea of their value. If held to maturity, they would most certainly outperform their current market values.

[PLATO]

Originally posted by DanS
Even if the bank sells a foreclosed house for 80 cents on the dollar, the equity in those tranches could be wiped out, depending on the leverage. Isn't that correct?

Yes, depending on the leverage. At 40-1, 80% is a big big loser. This is partly the reason why a government bailout has become the last answer to the question.

[PLATO]

Originally posted by snoopy369
He acknowledges that there is no time for chapter 11. He's suggesting using chapter 11 methodologies (forcibly writing down debt, etc.), not using the actual court process. The domino effect is caused by investors' uncertainty, not by the actual writedown itself, right? If all the debt was written down to 80% by federal fiat, that would have a lot less of an effect on the CDS market, wouldn't it?

Well...a lot of the debt has already been written down close to that. All that did was trigger a new round of CDS buying. The rabbit hole kept getting deeper. People are taking on risk to avoid risk. It is nearly insane. It is like a bookie that has all the action going on a team that will lose for sure and trying to lay off bets all over town.

[DanS]

Originally posted by PLATO
Yes, depending on the leverage. At 40-1, 80% is a big big loser.

That's why what you have been peddling is misleading. The underlying assets could sell for 95 cents on the dollar, but the mortgage-backed security could still be worthless dog**** because of leverage.