The mortgage backed securities they plan to buy are NOT "worthless junk"

[HamdenRice]

I have serious concerns about the current structure and wording of the bailout, but as my recent posts suggest, overall I'm in favor of it.

We, as the public have to be informed about what's happening and unfortunately, there is a lot of misunderstanding about the situation.

As a point of information, I would just like to make sure everyone understands that the mortgage backed securities (mbs) that the Treasury proposes buying is not all "junk," "toilet paper," "worthless" or "toxic."

I posted this explanation of it's value in another thread and have been asked to make it a separate post so that more people can understand just what may be proposed and what the Democrats need to insist for the plan to work and be fair.

To summarize in advance though, this is a strange transaction for a "bailout" because it is possible for the Treasury to get value for its money -- assuming that the federal government also puts a serious effort into helping homeowners who are paying the underlying mortgages.

So, copied and pasted, here is a guide to what mbs may be worth. Thanks to junkdrawer for asking, and acibiades_mystery for adding his insight:


<On what MBS are worth>

You have asked a very good question and I hope lots of DUers pay attention to the answer, because it is key to understanding the crisis.

Ironically, as you point out, not that many homeowners are actually in default. So the question is: why are a relatively few defaults causing such massive collapse of the mortgage backed security (mbs) market?

The short answer: just a few bad mortgages can destroy an entire pool of mbs. That's why so many people are blaming securitization: it multiplied the problem many fold.

It's because the good has been packaged with the bad. Let's use a simple model and say a particular mbs is backed by 100 mortgages -- each is for $100,000, and each one is paying 5% interest ($5,000 each). That "series" of mbs would have a face value of $10,000,000 and pay $500,000 per year.

The contractual requirements are very severe and say that the mbs is only performing if exactly $500,000 is paid out annually.

Now let's say that 5 out of 100 homeowners go into foreclosure. The mbs now collects $25,000 less. The total interest it can distribute to the holders is now $475,000.

In the debt world, that means the bond is in default. As debt it is worthless. It would be different in the stock world, where investment incomes (dividends) are expected to vary. In the debt/bond/mbs world, if the security doesn't pay exactly what it's supposed to it can't be valued, and no other bank or investor will buy it.

This is why it's so frustrating to hear DUers screaming that mbs are worthless, junk, toilet paper, etc.

They don't realize that this stuff still has value and that the bailout is about separating the good from the bad so it can be valued and sold again.

There is a difference between something that can't be valued and something that has no value.

<Note: This model above intentionally simplifies the situation. All mbs was over-collaterlized, which means they had more mortgages than they thought they needed on the assumption that some small percentage would indeed go into foreclosure. They did not anticipate the severity of the level of foreclosures.>

<More why the "bailout costs so much up front>

In my model, $500,000 worth of foreclosures made $10,000,000 worth of mbs "worthless" <as debt, but not worthless in a bailout>.

But if the feds want to undo the mbs and separate the good from the bad, they still have to buy the entire mbs series. In my model, your upfront cost would be $10,000,000 - $500,000 = $9,500,000 .

So $500,000 worth of foreclosures requires the govt to spend $9,500,000 up front. If they bargain the holders down to, say $8,000,000 then their upfront costs are only $8 million. According to news sources, they plan to drive very hard bargains with the financial institutions which are desperate to sell. That's why they say they will buy at a "steep discount."

Now, if they get rid of the $500,000 foreclosures from the series, they can turn around and sell the new series of mbs for $9,500,000. This will be with a fed seal of approval.

The feds make $1,500,000 on the deal.

[HamdenRice]

1. shameless self kick nt

[AngryAmish]

2. Give up on explaining this around here

Nobody gets it. I tried yesterday and was accused of acting superior to people.

I think this deal, as I currently envision it, is dangerous. There will be graft and theft in this new RTC-style entity that makes the Tammany Hall era NY City Hall and the Big Dig look like small change. There has to be oversight.

But on your issue of the gov't making money - it is possible.

[HamdenRice]

3. I heard one commentator put it clearly: If it's Obama, the fed makes money

If it's McCain with Treasury Secretary Phil Gramm, it's the biggest giveaway scam to the banking system in history.

But right now so many DUers are angry and scared that they don't wanna know the facts.

[eowyn_of_rohan]

63. I think most of us do want to know the facts

but we are experiencing info overload. I appreciate your effort to straighten all this out for us, and I hang in there with you to a point but this is not exactly a 101 level course - at least not to me - and I am having trouble following all of this. But please don't stop what you are doing because it really is appreciated by many.

[depakid]

4. Seems to me it also makes sense to add in foreclose relief

The more people keep their houses, even if they are paying on more favorable terms, the securities based on their mortgages will stop hemorrhaging what value they have.

[HamdenRice]

19. Exactly -- and that's why the feds could make money

They can use their market power to fix the problem from the top and the bottom, thereby ensuring a tidy profit to the Treasury.

[bemildred]

5. Well, something clearly IS "worthless junk", else why are all these formerly "very wealthy"

banks suddenly bankrupt?

[HamdenRice]

6. Because they were leveraged

Let's go back to the numbers in my example. Let's say you're Lehman, and you have a $10 million mbs in your inventory. You decide to do some other transaction, maybe a speculative purchase of shares or a short sale or something funky with a derivative.

Let's say it's a stock purchase in a small company whose shares can't be sold quickly. You pledge your mbs for $9 million cash loan from Bank of America. Even if your stock purchase is going successfully, once you acknowledge that your mbs is (a) only performing to the tune of $9.5 million and (b) can't be sold, it's as though it has no value.

Bank of America demands $9 million by 5:00 pm. You can't sell the mbs, you can't pledge it to another bank, no one will lend because they are scared and equally illiquid. Nothing. No liquidity.

So ironically, even though your stock speculation went well, and even though the mbs is mostly performing, you are now insolvent.

Game over.

Note that this is a liquidity crisis. The underlying business is good, but it was destroyed because it became illiquid.

This is what the bailout is trying to prevent -- letting those institutions bring in that unmarketable mbs debt, get paid what it's worth in cash or t-bills (hopefully a bit less) and meet their obligations.

[bemildred]

22. Any security is worth what it can be sold for. This is elementary.

If it cannot be sold because there are no buyers, it is worthless. The "liquidity problem" is precisely the absence of willing buyers, and that is precisely "worthless". The bailout creates a fake buyer, the government, so that the owners of the worthless securities can pretend they have a value long enough to dump them, on the government, that is: us.

In the case of MBS, there are also the court cases that introduce other problems.

Edit: changed "A" to "The", bolded. There is a sense is which "providing liquidity" means providing means to bring willing sellers and willing buyers together, but that is not what is going on here.

[Romulox]

53. This entire thread is based on the OPs idiosyncratic definition of "value"

The value of an asset is whatever the market will bear. If there is no willing buyer for an asset, then by definition, it is without value.

[bemildred]

54. The problem is that he is treating the "expected value" of a bet as though it were a real value.

Just because you make 1000 bets on a spin of the roulette wheel, instead of one, you don't create some real expectation of profit. The entire real estate price bubble is based on the "expectation" that prices will always go up, or at least not go down much, and that people will always be able to "service their debts". Yet simple observation of history shows that that is false. And the whole MBS pyramid scheme is based on that assumption.

[Romulox]

60. The problem with that is that the RISK IS BUILT INTO THE PRICE! (That price being ZERO.)

He gave a long-winded recitation of the concept of "discounting" on another thread. What he fails to understand is that the market has discounted this debt to zero.

[bemildred]

64. That works for me.

Much too simple, but yeah.
:hi:

[Nickster]

7. Thank you for your very well thought out post. It helps me to understand this mess much better

through all the noise. My biggest fear is that this mis-administration is trying to ram this down. I'd feel much better if a President Obama was leading this, then I'd feel like we might actually make our money back. With this current group of misfits, I'm not sure they could supervise making ice cubes successfully, let alone create something this important without it failing horribly.

[mrsteve]

8. Agree but with *major* caveat

First, Hamden, I definitely appreciate the insights you have provided on the current Wall Street liquidity crises. I also appreciate the evenhandedness you've displayed as you've presented your views.

As early as 2006 I remember economic pundits rumbling about valuations on mortgage backed securities, and the fact that the balance sheets of many Wall Street firms were becoming increasingly dubious because these securities could not be properly valued. So based on my readings and your explanation above, it's clear that the root cause of this whole problem is the valuation of these mortgage backed securities, and the legal rules about bond valuation and defaults.

Unfortunately, either I'm over cynical or outright paranoid and see a major hole. The sentence "According to news sources, they plan to drive very hard bargains with the financial institutions which are desperate to sell. That's why they say they will buy at a "steep discount""

And here's my fear.

You seem to be hopeful that prudence and good faith will compel the Feds to push for steep discounts. But what is to keep Paulson instead to offer only small discounts, or even premiums? Nothing in the current legislation. And after 7 years of Bushenomics and crony capitalism, I fear that Mr Hank "Goldman Sachs" Paulson might not be quite so willing to take the shirts off the backs of his old friends and associates.

And at the same time, the Fed is now getting pressure from overseas to bail out foreign investments along with Wall Street. Paulson has strong ties to China - what if political pressure forces him to also rate up mortgage paper held by China to keep their government happy, similar to the apology issues over the spy plane "incursion" of 2001?

[Nickster]

10. Exactly. I couldn't word it so well, but I have essentially the same fears. How can we trust them to

do any of this in OUR best interests? They've been all about fleecing the taxpayer for the last 8 years, why would they find religion now?

[HamdenRice]

12. I completely agree with you -- that's the key question, valuation

I heard a commentator on NPR the other day say that if the Treasury Secretary doing the buying is an Obama Secy, they the Treasury may well make a killing. If it's Secy Gramm, it's going to be a huge corporate give away and boondogle.

Congress has to put the valuation method and requirement for discount in the legislation and we have to elect Obama in November.

As for China, here's where I put my tin foil hat on and this is pure speculation: I think the Chinese and European central banks are calling the shots. Do this or we dump dollars. So I don't think they had a choice but to open it up.

Ten years of China's national savings are tied up in this stuff and our t-bills, and they will not be happy getting stiffed on it.

That said, if the feds make money on each purchase-unbudle-rebundle-sale, the why not? More profits for that down payment on universal health care.

This isn't really a bailout, and it is terrible PR for Paulson, Bernanke et all to be called that in the first place. The way I see it, is that the feds propose to be the "market maker" -- just like the so called "specialist traders" on the NY Stock Exchange who have to make a market in particular stocks. And "specialists traders" always make money.

[mrsteve]

26. From your lips to God's Ear...

Agreed - the optimal solution is somewhat tougher legislation (defined valuations processes, punitive measures for executives, revised oversight provisions) wielded by a Democratic Whitehouse.

And without profits from the plan, most of Obama's first term legislative agenda (Health Care, etc) could be derailed.

Unfortunately that pushes the Republicans even harder to win (or steal) this election. Either they and their Wall Street boys walk away almost whole under a reasonable plan (poor babies) or under a boondoggle plan administered by Republicans they pillage the treasury once again.

Unrelated but relevant - As as for the executives who are unwilling to accept 100's of billions in aid because they might have to take a haircut or face a clawback on their incomes and bonuses - a few shareholder suit threats will cure that right quick.

Dealing China and the Europeans will be very tricky, as you and I agree. But if the ratio of good to bad mortgages in the bundles is high enough, won't they just lose a few percentage points of return instead of any part of their principle? And couldn't this just be presented as just a slight drop in the value of the investments versus a complete washout if the plan is not accepted by the foreign investors?

[HamdenRice]

28. Yes, everyone will take a hit

It won't be evenly distributed. I think what really will piss the foreign banks off is that the subprime was marketed as being as safe as the regular mbs. Some mbs market making will shave a few points of return off particular mbs, some will get nearly wiped out.

Overall, though taking a haircut is better than having hundreds of billions in unmarketable securities.

[amandabeech]

62. You are right about the Chinese. However, it looks to me from bits and pieces

here and there, that the Chinese don't understand risk and reward when it comes to them.

They expect to get all the rewards and they expect the other party to the transaction to take all the risk.

Apparently the Brazilians and others are rather disenchanted.

The Euros can kick and scream, but they know that they fell for their own irrational exuberance. It's just that they can't admit it to their taxpayers.

I'm not sure that the Chinese get it in the same way.

[AngryAmish]

25. You have articulated the exact problem.

Not just Paulson but anyone involved in this.

There will be epic scale graft. Epic.

[barbtries]

31. thank you

i think i'm resigned to the need to do something, but that shit that was being passed around over the weekend: NO! NOT paulson, not bush, not gramm. these people canNOT be trusted and if the paper is worth something then we should be able to forestall the next great depression at least long enough to get SOMEBODY working on this who has a conscience.

these phrases about absolute power to henry paulson. no. no. no.

[KoKo]

38. Not only ties to China but check this out about what he could be covering up...from McClatchy news..

Can you trust a Wall Street veteran with a Wall Street bailout?


In late July, Paulson tapped Ken Wilson, one of Goldman's most senior executives, to join him as an adviser on what to about problems in the U.S. and global banking sector.

Paulson's former assistant secretary, Robert Steel, left in July to become head of Wachovia, the Charlotte-based bank that has hundreds of millions of troubled mortgage loans on its books.

The administration's draft law also would preclude court review of steps Paulson might take, something Joshua Rosner, managing director of economic researcher Graham Fisher & Co. in New York, said could be used to mask previous illegal activity.

"The Treasury's ability to, without oversight, determine (that) a financial institution (is) an agent of the government seems like it could be used to serve several purposes, including limiting the potential liabilities of an institution or its executives," he wrote in a note to investors late Sunday.

http://www.mcclatchydc.com/227/story/52856.html

[fla nocount]

9. I might agree if there was a healthy job market a growing ecomony.

That's not the case, some people can't pay their mortgages today. Tomorrow there will be more who can't pay. You also assume that real property has real value and it doesn't. It has subjective value, it's worth whatever you can get for it and not a penny more.

[Neshanic]

11. They ARE worthless junk. What do you think the 700 B is for? Coffee service?

How many tranches of shit were sold with this? Does anyone know? Hell, there are people who can't even get the info on who OWNS their house.

No firm is going to come clean. They still have not. Hence the bailout behind door number three.

Has any firm come clean on their assets in their garbage come clean? NO. That's why their pals are in such a hurry to save them, so they don't have to mark to market their shit assets that are worthless.

[HamdenRice]

14. To understand the mbs, you don't need to understand the firm selling it

The information about what's in the mbs was filed with the SEC. In order to sell mbs, the investment bank creating it had to file a Prospectus and Registration Statement with the SEC. A vast amount of info about what is in each series of mbs is already on file with the federal government.

You can read about how the feds will access that information here:

http://www.democraticunderground.com/discuss/duboard.php?az=show_topic&forum=114&topic_id=43574

That said the firms need to come clean with information for other reasons, but it's not needed to understand the value of the mbs.

[Neshanic]

21. dupe post

[Neshanic]

23. That said the firms need to come clean with information for other reasons

And what would those reasons be?

More than 700 billion is my guess.

[UndertheOcean]

13. Ok, I have a layman question for you

Why can't the private institutions themselves separate the Good from the Bad as you put it .

[HamdenRice]

17. Liquidity and timing

This was discussed here around post 14 and down:

http://www.democraticunderground.com/discuss/duboard.php?az=view_all&address=389x4044397#4044664

Basically, when a mbs series is sold, it isn't sold all to one investor. Like stock, many investors, mostly financial institutions, take a piece of each series.

To unbundle them, first someone has to buy all the mbs that was issued in a particular series. Only when you've got them all in one place can you undo the trust, take out the mortgages, separate the good from the bad, and rebundle.

Under current conditions, no financial institution has enough cash to offer to repurchase an entire series.

Funny, though, the banks suggested something like that a year or so ago when it was possible, but they dithered. Now it's too late.

In the meantime, we keep reaching these almost complete meltdown moments and if we ever go over the edge, it will be just too late.

[TroglodyteScholar]

70. Unbundle, separate good from bad, rebundle?

Okay, so say this all goes down and all the "good" and "bad" get rebundled. What's to stop this from happening again? You said yourself that the problem is that a small amount of bad debt ruins a whole mbs (or the liquidity thereof). If it's rebundled according to what is currently considered "good," what assurance is there than some part of that new "good" bundle won't go "bad" at some point in the future, causing the exact same problem?

Not trying to do a gotcha, just trying to understand what's going on. Thanks....

[CharmCity]

15. Right! Pleased to see this.

Much of what is going on is the inability to sell to the secondary market: investors who buy bundled mortgages. There came a point when investors -- many of them overseas, by the way -- refused to buy the bundled mortgages. Even if most of the mortgages were perfectly fine, those "bad apples" in the bundles made them sub-par investments.

It's critical that there be a secondary market -- it helps provide cash that allows for credit elsewhere. That credit is used for many things, including covering payrolls.

So... plucking out the "bad apples" is a very good idea. And you're on the money -- houses are not the same as stocks. They truly exist and are actual assets. The can be resold or refinanced. Treasury can in fact recoup a portion of this money (how much, hard to say, or course).

[On the Road]

16. I've Been Arguing with a Lot of People the Last Week

over this. I suspect the net of the whole thing is going to be less than $200B. That is a small price for avoiding the consequences of an Argentina-like meltdown.

Glad the Democrats are trying to get a better argeement, but I hope a deal goes through.

[HamdenRice]

18. The feds actually made money on Chrysler and the Mexican peso bailout

I say go for not just small net cost, but a big profit to the feds.

Clinton made $500 million on the peso crisis bailout for the US Treasury.

[On the Road]

24. I Had Not Heard That About the Mexican Intervention

Unless it's a scandal, these things tend to disappear from view.

I think that enough politicians are alarmed that some kind of deal is going to get done. Democrats would be wise to force some changes. I just hope that the mau-mauing is not going to turn the tide against some kind of plan.

[Junkdrawer]

20. Bait and Switch...Paulson really wants to bail out Bad Consumer Debt...

http://www.democraticunderground.com/discuss/duboard.php?az=show_mesg&forum=389&topic_id=4059003&mesg_id=4059003

[AlinPA]

27. My problem is one of trust. I am having trouble trusting Paulsen/Bush admin after

the lies for almost 8 years. Iraq was the beginning. Are we getting the wool pulled over our eyes again?

[nichomachus]

30. Bingo

The OP explains very well how it all works on paper. However, we're talking about a gang that would steal the air from the room, if they could figure out how to do it and how to monetize it.

They have stolen billions -- nay, trillions -- in the US and Iraq. I have seen nothing from them that assures me that they will work for the betterment of the people and the taxpayers of the US. They will line their pockets and the pockets of their friends.

[HamdenRice]

34. Agreed, but I hope that

Bush has had a Serpico moment:

http://www.democraticunderground.com/discuss/duboard.php?az=view_all&address=389x4049626#4049657

I honestly don't thing that the Bush looting gang has been allowed near this one.

[AlinPA]

58. So it is down to Paulson , Cox and Bush**'s financial advisors. Not a lot of trust there either.

[amandabeech]

68. Maybe not, but I don't agree with your linked post in which you call the infamous Sec. 8

a "drafting error."

IMHO, and I'm an attorney for what it's worth, Sec. 8 is a blatant attempt to force a review of the ancient precedent of Marbury v. Madison from the days of our founders. There's a lot out there on the precedent's history, so I'll leave you to your favorite info site or publication for the interesting details.

In short, Marbury set up the precedent of judicial review of executive decisions for agreement with the Constitution. Pukes hate it because it means that the Supreme Court, not the Unitary Executive is the final arbiter of what laws and actions are Constitutional and which ones aren't.

If McCain should win, by hook, crook or actual vote, he will appoint "conservative" Supreme Court justices who will abandon stare decisis, which means deciding all cases on the basis of principles already enunciated, in the case of Marbury.

If a Roberts/Alito/McCain court rules that Marbury was incorrectly decided, this blatant power grab will stand, and there will be no ultimate judicial oversight of the mess should things, in McCain's hands, inevitably get totally out of hand. Nor will there be any judicial review of any other hideous McCain acts. Or any other President's until we can get some reasonable Justices on the Court after all the current conservative idiots depart this world. I don't expect to live that long myself.

So I beg to differ. This is dangerous.

Any other attorneys here have an opinion? Am I remembering Con Law correctly after so many years?

[Kaleko]

29. Like a breath of fresh air -

an actually knowledgeable poster offering reasonable points to discuss. Thank you, Hamden. You're a rarity around here at the moment. And I fully understand why people want to freak out first before thinking things through.

Recommended.

[HamdenRice]

32. Thanks -- given the beating I take sometimes for trying to explain

to the "let it collapse" contingent, you have no idea what encouragement means.

[Beam Me Up]

45. Ok, then, more encouragement!

I'm not one to say "let it collapse" but I'm certainly one who doesn't grasp financial matters. Have no head for it. However, your recent posts have really helped me comprehend what is going on. Very informative -- and the responses to questions and concerns as well within the threads. Thank you VERY much for taking the time to do this. Like others, I'm very concerned (given recent history of these crooks) but your words are helping me both comprehend the problem and think things through.


:thumbsup: :hi:

[sandnsea]

33. Please clarify this part

Others are saying it's in Section 8.

"Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency."

I also have a concern about the government owning all the property and wonder if they're going to "outsource" our land the way they did our jobs. Since they can save foreign banking institutions too, which I don't like either.

[HamdenRice]

36. It certainly needs to be redrafted

but my impression was that it was intended to prevent banks from suing over the valuation of the mbs that Treasury proposed to buy:

http://www.democraticunderground.com/discuss/duboard.php?az=show_mesg&forum=389&topic_id=4049626&mesg_id=4049626

[sandnsea]

37. Suing. Oh lord.

I never thought about that. My stomach is churning again. We're fucked for a good long while, even with this bail out, aren't we?

They pushed this "economy". It is absolutely outrageous that they are blaming working people who were just trying to do what their parents had done.

[eowyn_of_rohan]

66. hmmm... My impression of Section 8 is that it's a straw man.

[eowyn_of_rohan]

67. hmmm... My impression of Section 8 is that it is a STRAW MAN

[Jacobin]

35. Can I give you a bit of anecdotal evidence?

I do bankruptcy work. For the past 3 to 4 years, I've had clients come in and when we go over their budget, their take home pay is 9 times out of ten times enough to pay for living expenses (food, insurance, utilities, etc)and maybe a car note. There is usually not enough for a mortgage payment. Oddly, 5 times out of 10, these people own a home and usually it has 2 to 3 mortgages, usually adjustable rate mortgages which have re-set to higher amounts.

They are usually 2 to 6 payments behind and come in because of a foreclosure sale that's pending.

In a Chapter 13, they could keep the house and make up the past due payments and stop the foreclosure, but they have to demonstrate through their budget that they have the means to do so. Most try for a few months, and then give up and surrender the home, because they simply don't have the income to service the debt. In bankruptcy, you can't write down the value of a residential mortgage, you can only catch up past due payments

What I'm trying to say is that the number of defaults of mortgages and those that are likely to default when the adjustable rates re-set is WAAAAY understated by the lenders, who are simply trying to survive by lying about their financial condition.

In addition, second and third mortgages get wiped out in a foreclosure sale by the first mortgage, so they really are 'junk' and of extremely dubious value.

The 'shorts' have flushed out the fact that the mortgage default crises is far worse than the lenders who have been cooking the books.

I would venture that the bail out will need to be double or triple what Paulson is asking for in his first installment.

What was lent to people who in no way could afford it would stagger you if you saw it day after day. There are millions of mortgage loans that are going to default. Millions.

[HamdenRice]

39. That's extremely dire news -- but I'm not sure it affects the size of the bailout

As I understand it, and as one NPR commentator usefully put it, this is to solve the liquidity crisis, not to solve the solvency crisis. It's to make the good stuff marketable, not to make investors whole on the bad stuff.

This all depends on who the Treasury Secretary is and what his valuation method is. So if a mbs series is all shit second mortgages it gets priced appropriately with all foreclosed mortgages in it having zero value, and thereby costing the treasury nothing.

The idea is not to pay investors for defaulted mortgages; it's to get the good mortgages out of the pools with the bad ones, and make them marketable again.

At least that's what I hope the Dems ensure this plan is all about.

[KoKo]

41. Thank you....your insight from your experience with this shows the problem is much worse than Hamden

thinks it is. Although, he might not be aware of how severe the situation is and is trying to explain how it would work...if there weren't so many mortgages that have 2nd and 3rd mortgages on their homes.

[HamdenRice]

46. See post 39. They are trying to solve the liquidity crisis, not the solvency crisis

and if I understand it, if the mbs are properly valued, the fact that there is a greater scale of defaults does not increase the cost of the bailout.

[KoKo]

49. Actually it's the Derivatives owners they are trying to bail out...check out this:

http://www.democraticunderground.com/discuss/duboard.php?az=show_mesg&forum=103&topic_id=386477&mesg_id=386477


HAT TIP to: Tansy Gold, who added her own emphasis to the snip below



http://www.webofdebt.com/articles/its_the_derivatives.p...

Until recently, most people had never even heard of derivatives; but in terms of money traded, these investments represent the biggest financial market in the world. Derivatives are financial instruments that have no intrinsic value but derive their value from something else. Basically, they are just bets. You can “hedge your bet” that something you own will go up by placing a side bet that it will go down. “Hedge funds” hedge bets in the derivatives market. Bets can be placed on anything, from the price of tea in China to the movements of specific markets.

“The point everyone misses,” wrote economist Robert Chapman a decade ago, “is that buying derivatives is not investing. It is gambling, insurance and high stakes bookmaking. Derivatives create nothing.”1 They not only create nothing, but they serve to enrich non-producers at the expense of the people who do create real goods and services. In congressional hearings in the early 1990s, derivatives trading was challenged as being an illegal form of gambling. But the practice was legitimized by Fed Chairman Alan Greenspan, who not only lent legal and regulatory support to the trade but actively promoted derivatives as a way to improve “risk management.” Partly, this was to boost the flagging profits of the banks; and at the larger banks and dealers, it worked. But the cost was an increase in risk to the financial system as a whole.2

Since then, derivative trades have grown exponentially, until now they are larger than the entire global economy. The Bank for International Settlements recently reported that total derivatives trades exceeded one quadrillion dollars – that’s 1,000 trillion dollars.3 How is that figure even possible? The gross domestic product of all the countries in the world is only about 60 trillion dollars. The answer is that gamblers can bet as much as they want. They can bet money they don’t have, and that is where the huge increase in risk comes in.

Credit default swaps (CDS) are the most widely traded form of credit derivative. CDS are bets between two parties on whether or not a company will default on its bonds. In a typical default swap, the “protection buyer” gets a large payoff from the “protection seller” if the company defaults within a certain period of time, while the “protection seller” collects periodic payments from the “protection buyer” for assuming the risk of default. CDS thus resemble insurance policies, but there is no requirement to actually hold any asset or suffer any loss, so CDS are widely used just to increase profits by gambling on market changes. In one blogger’s example, a hedge fund could sit back and collect $320,000 a year in premiums just for selling “protection” on a risky BBB junk bond. The premiums are “free” money – free until the bond actually goes into default, when the hedge fund could be on the hook for $100 million in claims.

And there’s the catch: what if the hedge fund doesn’t have the $100 million? The fund’s corporate shell or limited partnership is put into bankruptcy; but both parties are claiming the derivative as an asset on their books, which they now have to write down. Players who have “hedged their bets” by betting both ways cannot collect on their winning bets; and that means they cannot afford to pay their losing bets, causing other players to also default on their bets.

The dominos go down in a cascade of cross-defaults that infects the whole banking industry and jeopardizes the global pyramid scheme. The potential for this sort of nuclear reaction was what prompted billionaire investor Warren Buffett to call derivatives “weapons of financial mass destruction.” It is also why the banking system cannot let a major derivatives player go down, and it is the banking system that calls the shots. The Federal Reserve is literally owned by a conglomerate of banks; and Hank Paulson, who heads the U.S. Treasury, entered that position through the revolving door of investment bank Goldman Sachs, where he was formerly

[bemildred]

55. Yeah, that's exactly right.

What's amazing it that they seem to have drunk their own KoolAid to the extent of screwing themselves out of a sweet deal. These guys were Masters of the Universe, Big Swinging Dicks, all they had to do was not push their luck.

[sandnsea]

43. They're trying to change the write down part

They may have with the HOPE program. It might be nice if you could find out and post about it. I had read that writing down mortgages 10-15% was something that was being done. Maybe they haven't allowed bankruptcy judges to do that yet.

I also read that the previous HOPE plan would disqualify anybody who had missed credit card payments. So any normal person who had put off another payment to make the mortgage, didn't qualify. Then they reported how stumped they were that people were making credit card payments and not mortgage payments. Well, that's how they set up the mortgage assistance. :crazy:

I know it's very complicated, I've been trying to help someone to figure out what to do.

[LonelyLRLiberal]

40. I heard a guy on NPR this morning saying that it will be difficult to put a value on the assets.

Each mbs could have a different value, according to him. He anticipates a big argument over price when it comes time for the government to buy the porfolios. He advocated taking an ownership interest in the financial institutions instead.

[JVS]

42. If they had value, you'd think they'd be able to sell them to someone other than the government

[HamdenRice]

73. Many would be buyers are legally forbidden from buying

For many purposes, banks and insurance companies are required to purchase "investment grade" securities. Once an mbs issue has defaulted or even been downgraded, most of the market dries up and they are unsaleable even though they have value.

[Junkdrawer]

44. Any and all sales of reconstituted junk will be used to buy irretrievable junk

There will be no profit. Count on it.

[galileoreloaded]

47. Sorry Hamden, but the analysis is flawed, and missing a key point...

This has NOTHING to do with the MBS or the securities themselves. This has to do with recapitalizing the banks. Overcapitalizing, really. The securities are the conduit to recapitalize the private lending infrastructure, and a way to shove this down the throat of an unsuspecting public with the promise of future asset re-capitalization of the debt to cover costs. This really looks nothing like RTC, as those values were recognized after the institutions failed and used as a baseline for future allowable writedowns.

There is no market for these tranches, as they were so deftly sliced and diced by the Black Box Boys to avoid discovery, that many stories exist of homeowner under FCRA attempting to validate debt, only to find the servicer was unable to find the actual security holder. If there was a market, the big boys would have TEAMS of guys like me pouring through the "piles" as they were to asses value, and making plays. Actually, this was tried by many including Lone Star to name one, and they are buried in shit right now. When there are seconds and Heloc's involved, it gets really nasty, as often the same collateral is used to secure different debts to different owners. Wanna call your buddy at JPM and tell him his 80K second just got crushed to a weak second position in a foreclosure, or vise versa??? Odds are the guy doesn't even know he HAD a second, as Ditech just sent him a check every month against a bundle of loan numbers on a spreadsheet.

Nobody wants this shit. Nobody even knows how Alt-A and O-ARMS will affect mark to market and future valuation, much less a self reinforcing negative consumer cycle and shifting consumer demographics. There will be DECADES of discovery, and in the meantime banks bleed and commercial paper crashes.

This is a method to overcapitalize banks and get them lending again. Problem is, once bitten, twice shy, so best estimates are that only the top 10% of borrowers will be able to borrow at all. Hmm. Sounds alot a third world country huh.

Quick breakdown of how this will REALLY work. Gonna call the bailout 1,000 billion instead of 700 for ease of instruction.

UST pulls 1,000 B onto the books. At 100% of original note, I guarantee. If not at 100% then the selling bank runs up to the window and borrows the difference in valuation on a 86 day TAF, which I promise will roll over in perpetuity. Fed doesn't want to pollute it's books like this anymore, as they can't continue lending without recapitalizing through the Treasury, and are quickly losing credibility on the world stage. We will pay 100% original note. Only way this works.

Half the tranches are ok, say 65% value to original note, and can be sold, but only after a, say, 50 million dollar "agreement" to GS or MS or JPM to assess.

Other half stink, bad. With continuing deterioration in the RE market, these have 10-15% real value.

Feds need to MOVE paper in and out, as the proposal is to have 1000 Billion AT ANY GIVEN TIME, not total.

Split the difference between the two tranches, to get the good stuff out the door, first half gets sold, and makes a market at 30% so the whole thing gets marked to 30%. The bad crap gets a bump, and "earns" 15% (30%MTM-15% actual value) and comes on as an deliverable asset, or "inventory".

Here is the awesome part. Given the parameters listed above, and the deal they want, the fed just spent 1000 billion, sold off 150 billion, and holds 150 Billion on the books. And again, because of the way it's written, pull another 850 billion back in and start all over. They do this right, and they can hook us for TRILLIONS. And when they are done have 500-600 billion in "performing" assets for make benefit glorious nation of America.

How do we know they will do this??? They have already done it. That's why oil went nuts, that's why the Dow tanked, and that is why we will see double digit MONTHLY inflation, real soon.

They chose Hyperinflation, but with first use of the money and it's buying power. World markets know this, and I think if we search our instincts, we know this as well.

End result, same same.

[amandabeech]

71. Okay. How about credit default swaps and other more exotic instruments.

Are we taking these &*()*&%$#$ things, too? The original Treasury proposal seems to allow Paulson and his successors to purchase SIVs involving kitchen sink sales.

If so, how in the world are these things valued and sold?

[galileoreloaded]

74. The idea is to hit the "go back button" and reverse the credit event by contractually...

making everyone whole. No default because of new funds, no CDS "credit event" trigger. Like Superman spinning the world in reverse.

[amandabeech]

75. So the CDSs will not be part of the bailout? n/t

[galileoreloaded]

79. no Credit trigger, no swap clearance. Depends on individual ...

terms of course, but the trigger won't hit if a Goldman sold the security to say JPMorgan in a functioning market. Have to have a default before you can get paid for a default. This is another reason gov't has to pay 100% of the original note. Valuations fall below preset levels, trigger. Counterparty default, trigger.

[amandabeech]

80. This is going to be bigger than the Okeefenokee,

and just as slimy and opaque.

I'm glad that there's still a farm in my family to which I might retire if we hit 20% unemployment.

You know, raise a few chickens, work a huge garden, get a local to cut some firewood from the wood lot for the stove and rent out the tillable acreage, pasture and outbuildings. Could be worse.

[galileoreloaded]

81. hmmm. Upon review...

looks like the recent (today) downgrade of WAMU by Moody's will probably trigger swaps. We are fuct.

[amandabeech]

83. Ouch.

I missed that.

In other words, no one can predict just how difficult and expensive unwinding this mess will be.

[HamdenRice]

85. No. The legislation applies only to mortgage backed securities nt

[PA Democrat]

84. Good post which deserves a thread of its own.

The problem is that the entire fiasco is so complex and everyone is looking for a quick, simple fix when there is none. It's a matter of trying to assess which option is going to be the least lethal.

[bertman]

48. Okay, I get what you're saying, HamdenRice. Thank you for explaining that.

I guess I'm still trying to figure out how the corporatists have set this up so they get ALL THE MONEY and ALL THE POWER while we pay the bills, as usual.

I know that's what's happening here, but I'm too ignorant to figure out how it's being done.

Oh wait, here's a hypothesis: Bail out the poor rich guys who are holding the mbs's. Voila, we've nationalized a huge percentage of the mortgages in America. Declare martial law, adjourn Congress indefinitely, nationalize the Guard, BlackWater, the state and local police under DHS, change the name to U.S.A., Inc.

Sorry, my cynicism is showing.

[avaistheone1]

50. This bailout sucks. And there is worse one coming - the derivative bubble.

Hang on to your ankles.


I am agsinst this and any other bailout. Wall Street doesn't give away valuable assets. They never have and never will.

[Romulox]

51. Completely illogical. No buyer, no market = NO VALUE. nt

[avaistheone1]

56. Precisely. The next piece of trash they will try to pawn off us is the derivative bubble costing

$45 to $100 trillion.

Can you say sucker?

[HamdenRice]

72. Absolutely wrong

First of all, the bulk of mbs were designed to be "investment grade" so that commercial banks and insurance companies could buy them for particular asset uses. Once they default, they are not "investment grade" and most of the market for them goes away even if they are still valuable.

Last week there wasn't even a market for interbank loans, even though they have value.

You seem not to grasp what a "liquidity crisis" actually is.

[LSK]

52. K&R

Why does this only have 10 recs?

[TexasObserver]

57. You seem well intentioned, but terribly naive or uninformed.

The whole point is move the JUNK out of the failing companies, like removing cancerous tissue.

If you think there's going to be ANY profit to be made from the failed loans, you must not have been around as a business player in the late 1980s and early 1990s.

I don't know where you're getting your talking points, but it sounds like you're getting them from the RNC. The JUNK is going to be bought, so it doesn't bring down the companies that can exist without it. You need to stop pretending you know what you're talking about when it comes to finance and bailouts.

[Recursion]

59. Why should we sell them back?

If they're actually worth something, buy them now for pennies on the dollar and keep them in public hands.

[galileoreloaded]

61. Except the banks need 100% of original note to remain solvent. N/T

[avaistheone1]

69. Too bad. Let's build our own financial system without these vipers.

[XRubicon]

65. So why do they need a bail out?

http://www.webofdebt.com/articles/its_the_derivatives.php

[alittlelark]

76. Are you and TwixVoy roomies?

........just askin'.

[struggle4progress]

77. They're not junk! They're not junk! It's just that nobody sane wants to own them!

[endthewar]

78. Excellent summary!

:patriot:

[lostnfound]

82. Whatever isn't worthless will be sold off at junk prices to 'debt vultures' per GOP-con playbook

Hence the taxpayers / "feds" will be screwed twice..

They've done this before, with third world debt. They've figured out how to make a ton of money coming and going.

[LSK]

86. kick