Geithner’s new solution for the financial crisis…?
Jul 13, 2009
in
Private Real Estate Loans
In the beginning of this week the government proposed the Private-Public Investment Plan that would potentially unfreeze credit markets by purchasing prominent banks toxic assets, or newly named "legacy assets". It will purchase legacy loans and legacy securities, both backed by real estate assets.
When the private investors and government purchase these toxic assets, what happens next? How are these establishments going to possibly profit from them? What will drive their price up or down?
I am sure it’s as simply as supply and demand, but how do these markets work?
Thank you in advance!
Brandon
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5 comments
Paul on July 13, 2009 at 8:18 pm
Dagger is close, but not quite. The government is not providing a guarantee, but a loan that is invested.
If the asset is fairly priced at $0.50/$1, then that assumes half will default.
Let say that two are bought for $0.50 each ($1 total)
Hedge fund invest 7 cents
Treasury invests 7 cents
FDIC loans 86 cents to the group fund (at an interest rate that isn’t given yet…)
Investement "A" pays $0
Hedge fund lost 3.5 cents
Treasury lost 3.5 cents
FDIC lost 43 cents (it is a non-recourse loan, so the hedge fund does not have to pay it back)
Investement "B" pays $1
FDIC gets 43 cent loan paid back
Hedge fund gets (1 – .43)/2 = 28.25 cents
Treasury gets 28.25 cents
Hedge fund: 28.25 – 7 = 21.25 cents -> over 300% profit!!!
Treasury + FDIC = 43+29.25 – 86 – 7 = -21.25 -> 23% loss!!!
This is called financial rape. It gets worse.
Because the deal is so sweet, the hedge funds will OVERPAY on purpose:
Buy two assets (worth $.50) at $0.85 each:
FDIC loans $1.46 to the hedge fund
Hedge fund invests 12 cents + $1.46 cents
Treasury invests 12 cents
Investement "A" pays $0
Hedge fund loses 6 cents
Treasury loses 6 cents
FDIC loses 73 cents
Investement "B" pays $1
FDIC gets 73 cent loan paid back
Hedge fund gets (1 – .73)/2 = 13.5 cents
Treasury gets 13.5 cents
Hedge fund gets
13.5 – 12 = 1.5 -> 12.5% profit
Treasury + FDIC gets
(73 + 13.5) – 1.46 – 12 = -71.5 cents -> 45% loss!!!
Also, you may have been wondering, if the hedge fund got 1.5 cents, and the government lost 71.5 cents, where did the rest go? To the BANKS that created these things and sold them!!
Ron D on July 13, 2009 at 8:18 pm
the government needs to keep its hands off of companies. it ruins everything it touches. lets go back to the good, old REAGANOMICS.
Dagger_SA on July 13, 2009 at 8:18 pm
The notion works like this. Say a "toxic" asset is priced at 50 cents on the $1.00 (so a $100,000 mortgage backed obligation is now worth only $50,000).
His plan calls for investors to pay 7 cents on the dollar. The government will match another 7 cents on the dollar and will guarantee the remaining 43 cents.
What will make this instrument worth more or less is the performance of the underlying loans. If all the loans make their payments, then for a 7 cent investment, the investor makes 50 cents and the government makes 50 cents.
If only half pay, then the investor gets 25 cents + another 18 cents from the government because they guaranteed 43 cents. The government also gets 25 cents, so the government is only out 18 cents.
Supply and demand have little to do with it. Performance on the underlying debt is what will drive up the value.
But if you’ve done the math with me from above, you can see why the US gov’t is about to be bankrupt.
Jim Z on July 13, 2009 at 8:18 pm
Dagger wins! Excellent explaination. Give him the 10 Points. If his explaination does not open your eyes to how dangerous this new administration is, you should not be in this investment forum. I have worked hard for my money, and my home, and it will all be taken from us.
Michael T on July 13, 2009 at 8:18 pm
The problem is that there are many different derivatives of the mortgages on the market. There is the standard CDO that contains the mortgages and suspect that the senior tranche is a fairly solid and safe investment.
There is also the synthetic CDO which reflects the value of a standard CDO but is not comprised of mortgages but contains credit default swaps and arbitrage instruments but is unfunded in the super senior tranche. This type seems to be have a major problem currently returning less than 22 cents on the dollar.
Then there is the CDO squared security which is a derivative of the risky junior tranches in the standard CDO. This is mostly junk and probably contains very little if any value. There is also a CDO cubed security which is even more junky since it is a derivative of a CDO squared security.
The problem will be to understand and value the different CDOs. The standard CDO is the easiest to understand and value. Usually this CDO includes prime, sub-prime, and alt-a mortgages from around the country. Determining that if is evenly spread throughout the US and the percent of each type of mortgage is relatively easy. The senior tranche (about 85% of the CDO) of this type of CDO can probably be currently easily traded even without government help at 80% or more of face value. Most of the junior tranches (about 15% of the CDO) in this type of CDO is probably mostly junk and probably doesn’t have much of a value.
The Synthetic CDO is much more problematic. Since the super senior tranche (about 85% of the CDO) is unfunded since it was assumed to be risk free. This has caused major problems with the super senior tranche making it a very risky investment. Even though the junior tranches were very risky, they were fully funded so they didn’t cause the banks much of a problem.
CDO squared and CDO cubed securities are pretty much junk and probably don’t have much if any value.
The next main problem is that banks have not currently written down the CDOs the same as other banks. Although mark to market is supposed to indicate the current market value of the tranches in the CDO, one bank may still show a tranche at near face value, another at 53%, another at 22%, and another as 10%. This is because the banks may have not have tried to sell the tranches recently so may be using market value from a long time ago when the tranches were attempted to be sold. So if we assume that an investor offers 35% of face value, this will be great for the banks that previously marked them to 10% or 22% since they will write up the security which will improve their balance sheet after they are sold. However, the banks that had them marked at near face value or at 53% may think this is a bad deal since they will need to write down the security even more causing their balance sheet to deteriorate further if they sell the security.