Thought-Experiment: Assets and Securities
wants to sidebar today into looking at the general application and implications of an Accounting Identity:
Let us assume that, since the housing bubble burst, I believe that my house has fallen in value by too much. I would understand a 20% decline, but the “market price” that the experts (realtors) tell me I can get is 40% below the price of the last “comparable sale” (a smaller house in perfect condition).
But there are ancillary factors—proximity to NYC, good public transit infrastructure, good schools, convenience to the airport and major roadways—that I believe the market is undervaluing. So I “carry” the house in Quicken at 80% of the last sale.
Since I refinanced a couple of years ago, someone out there owns the Mortgage-Backed Security that was formed from that refi. Let us pretend it is Citibank, who are carrying that security on their books at 80, even though the last similar trade in the market was 60.
I think you can see where this is going.
So along comes the U.S. Treasury to “fix” the crisis and Get Banks Lending Again. (Apparently, they can’t lend because the market values their assets as being less than their liabilities plus their equity.)
In doing so, the Treasury will supply so random number—say, 85%—of the capital required so that a Private Investor can swoop in and Save Citibank’s Securities, by buying them “closer to their real value.”
So the Private Investor says, “Yo, Big C! I see you own the MBS that covers Ken’s house. Even now, his house is worth more than he owes on it, so I want to buy that security from you.”
Big C says, “I’m carrying that security on the books at 80. And there are a few billion others just like it.”
Private Investor: “Well, the market says all those securities are worth 60.”
Big C: “I can’t sell it at that level. I would have to mark down everything else, and people would see that my liabilities exceed my assets, leaving me with negative equity. And everyone is still pretending that my equity shareholders should not be revealed to own bupkus.”
PI: “Well, I’ll tell you what. Since we can foreclose on Ken for more than the amount owed, I’m willing to pay a little more.”
Big C: “I need you to pay something close to 80, or The Truth will out.”
PI: “Well, since the U.S. taxpayer is going to support 85% of my purchase in the worst of scenarios, I can pay you–how about 76?”
Big C: “Make it 78 and you have a deal.”
PI: “All right; I’ll do that. After all, I’m only having to put up $11.70 of that.”
Big C: “And I’ll be able to pretend we’re solvent. After all, we have some Inside Investors who need loans, and the Fed wants us to loan more.”
But wait a minute: the real value of that security is supposed to be the cash flows from The Underlying Assets. In short, it’s based on my (and others) ability to pay the mortgage. So let’s look at the other side.
I carry my house in Quicken at 33% (20/60) over what the realtors tell me it is worth. So Quicken shows me that cool Net Assets thing, and I have a Net Asset Value $30,000* higher than “the market” believes.
But it’s not liquid, and I don’t run a Treasury operation, nor am I necessarily required to abide by the ALE rule. So in general I feel more solvent, but may not (or may, but let’s assume not) change my behavior because of it.
So tomorrow I have a heart attack and can’t work for a while.** And my wife needs to help me with recovery, as well as keep the kids going to school and activities, so we spend six months to a year living on savings and whatever safety net there is. And finally we realise we have to downsize our life and move to Northern Indiana where my family can help us out for a while.
So we put the house on the market, at the price the realtors said it was worth.
But—as happened last summer—there are no bidders. And when there might be a bidder, they can’t get a bank loan from The Big C.
Eventually, we realise we’re not going to move back and stop making payments on the property, which stays on the market until it is foreclosed. And then the bank that owns the mortgage sells the house short to a developer who pockets a quick few bills.***
We file for bankruptcy.
Now, in the real world, the Securitized Asset that looked so great above is now a losing proposition. But in GeithnerWorld, the asset is secured by the U.S. Treasury, and the “investor” takes no hit at all; indeed, Private Investor is made whole with…taxpayer funds!
In short: Debt that my child will have to pay.
The Geithner Plan is the ultimate in Financial Reality. Derivatives were at least based on underlying assets; if the five-year Treasury price fell, the five-year swap was worth more.**** GeithnerBuys have no relation to the “securitized” asset at all, except to add to the expenses of bankrupt taxpayers.
It is the final Decoupling of Wall Street and Main Street, so while Arlen Spector makes certain that workers can’t organize and Ellen Tauscher ensures that mortgages can only be reset to market value if it is a Vacation (or “second”) Home (despite an earlier agreement), Tim Geithner and Larry Summers—with the support of Some Economists who Should Know Better—are ensuring that any damage to the real economy is not felt in the financial sector.
Welcome to Brighton Rock. Or maybe Faust.
*Possibly not the real number.
**Knock wood, this is not real either.
***Anyone got the link on this one? Saw a piece earlier today about Citi selling a foreclosure for $131K to a developer who flipped it, doing nothing, for $249K.
****Reminder: lower price = higher yield.