The numbers work...

Mike Plaiss posted a comment to the earlier post A safe haven for capital. I think it's worth posting on its own...

Well, I do know enough to know if the numbers work, and they do. Let's take an example of something a little less exotic than a sub-prime CDO. Imagine just a large pool of mortgages (not insured by Fannie or Freddie) that is currently suffering from a relatively high level of delinquencies -- say, 10% of the pool is 90 or more days past due on their monthly payment. Now let's say that fully one half of the mortgages in the pool will eventually default -- a number that far exceeds what just about anyone is predicting. That means half your money is good. But what about the other half? Well, eventually the house will be sold, likely at auction, and the proceeds of that sale go to...the holder of the mortgage. If the loss that is taken on the mortgages that do default is 50% (again higher than anyone is predicting and higher than we are presently seeing), then the mortgage holder has lost 50% of 50% or 25%. Thus, at the end of the day, the mortgage holder will get back 75 cents on the dollar.

I can tell you from personal experience that the mortgage described above may well be trading right now at 50 or 60 cents on the dollar, and if the government were to offer a bank 75 to 80 cents on the dollar for the mortgage pool, the bank would likely jump all over it with both feet.

But wait, the numbers get better. Remember that there is a monthly interest payment that the mortgage holder collects, so if I get 75 cents of the principal back, plus interest, then the thing has to ultimately be worth, if held to maturity, something north of 75. And this is all assuming truly depression era levels of default and loss severity.

So if all of that is true, and it's that simple, why are the bonds trading at 50 or 60 cents in the first place? Why aren't there buyers at 75. There is a very good answer to that question, but I'm afraid it's at least as long as everything I've written so far.

The point is that Mr. Kessler's numbers are correct. If done right (and the likes of Bill Gross have stepped up to say they'll help to see that it is done right) the Paulson plan will not cost taxpayers money, and could in fact add to the treasury over the next several years. This all doesn't mean that I'm thrilled with the plan. But I do believe it is the least bad option out there, and the cost, at least in dollar terms, will almost certainly be negligible.

"There is a very good answer to that question..." Well, send it on Mike, and I'll post it! I bet I could answer it, but not clearly.

I think we need to bail-out pronto, and I think the arguments of "Why should the taxpayers bail out Wall Street?" are silly. As if Wall Street is something separate from the rest of us, not joined at the hip with everybody's pocketbook. (Bad metaphor but you know what I mean.)

And my main objection to the plan(s) is that no one seems to be shaping them to shape the financial sector to create a better future. No one seems to be planning with an underlying philosophy. I hope I'm wrong. But the main thing is just to pass some hocus-pocus to preserve confidence in our markets. If we do, the basic robust good health of the patient will ensure recovery...

Posted by John Weidner at September 25, 2008 11:04 AM