I estimate the average price of distressed mortgages that pass from "troubled financial institutions" to the Treasury at auction will be 65 cents on the dollar, representing a loss of one-third of the original purchase price to the seller, and a prospective yield of 10 to 15 percent to the Treasury. Financed at 3 to 4 percent via the sale of Treasury bonds, the Treasury will therefore be in a position to earn a positive carry or yield spread of at least 7 to 8 percent.
This doesn't take into account the proposals for the government to take equity stakes in the institutions that participate in these auctions, but as Wharton Prof. Jeremy Siegel noted earlier today on CNBC, if the government takes equity stakes in participating companies, it may be willing to offer higher prices that it would offer otherwise for the troubled assets.
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You know bondholders are going to get whacked when Bill Gross has to pull out his stops in the mainstream media to spend time arguing in favour of the bill.
The key thing conveniently ignored by Bill Gross is RISK. The carry he talks about does not account for potential losses. He simply says in the article that he expects mortgages to improve, which seems more optimistic than even the most bullish housing bull on the Street.
Since everyone will try to unload their worst mortgages while holding onto the best, defaults are a real threat to the government. A 10% yield isn't going to compensate for that.
If the government does not want this to be a free handout to the shareholders, bondholders, and executives who made the mistakes in the first place, then it has to take an equity stake (perhaps a contingent stake based on the long-term performance of the purchased bonds.) Otherwise, it's nothing more than free money for toxic mortgages that the fake free-market supporters at places like WSJ crowd seems to clamour for.
Whether or not a Paulson-type of deal would be a handout depends on what the government would pay for the assets. Paulson was a little vague about this yesterday. My idea would have been to buy only mortgages themselves, because these would be a lot easier to value than mortgage-backed securities or more complex securities derived from mortgages. If the government bought these assets at steep enough discounts, then the companies selling them would take losses on them and the government would stand to make a healthy profit on them down the road.
Recapitalizing financial companies by having the government take preferred equity stakes in them is another idea that has been proposed (e.g., by Martin Wolf), but I'm not sure if it is feasible to try to combine that approach with a Paulson-type deal. The government would probably only get assets directly from the most desperate companies in that case, and the other companies would still benefit from a liquid market in these securities.
I was assuming that the government is going to pay higher than mark-to-market prices (these are depressed right now.) If it pays market prices then the ownership stake is not needed. It's only needed if you purposely pay higher than market prices (this is the Paulson proposal where it says to pay "hold to maturity" prices and not market prices.)
If the government pays market prices, I don't think this plan will work. Why would anyone sell the assets at, what many, including me, argue, are depressed prices and realize a loss? The only exception is if they thought the assets were going to deteriorate even further.
"this is the Paulson proposal where it says to pay "hold to maturity" prices and not market prices."
He was a little vague about that. My sense, from listening to his testimony as well as Bernanke's, was that the price would be closer to the "fire sale" price than "the hold to maturity price", but it's not clear at this point. I agree that if the government is going to deliberately overpay for these assets, it would be better off infusing capital into the financial companies directly and getting an equity stake for it.
"Why would anyone sell the assets at, what many, including me, argue, are depressed prices and realize a loss?"
Well, two reasons come to mind. One is that mark-to-market accounting might have made them realize a loss on the assets anyway, and the second is if they need the cash.
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