Orlando Mortgage Blog

The events of the past few days have been especially troubling for institutional and individual investors alike.  As recently as one week ago, Secretary Paulson proposed a rescue plan aimed at creating a Federal Agency to purchase problematic mortgage debt from struggling financial institutions.  The cost of said plan was a whopping $700B.  As Wall Street digested the news, investors rejoiced, allowing markets to recover from losses sustained earlier in the week.  Yet we weren't out of the woods.  $700B at the expense of the taxpayer was highly unpopular on Main Street and difficult for those in the House and Senate to back especially for those facing re-election.  As markets began to realize that the bill would fail to pass the House of Representatives, markets sold off to correct for the gains that were built in a week earlier reflecting the prospect of the bail out becoming a reality.  So where does this leave us today? 

Optimistically, no worse off than we were two weeks ago.  Sadly, we are in the same position as we were then, badly in need of something to reassure and to restore order to the credit markets.  Individually, financial institutions that have taken on excessive risk must be allowed to fail, but when that failure becomes widespread and systemic, intervention is a necessary evil.  Business and individuals rely on access to credit to function.  Our business community is accustomed to ordering and receiving materials and/or merchandise on short or longer term credit arrangements.  Few organizations ever send advance payment for these goods.  Even for individuals, access to credit has become a normal part of our lives.  When is the last time you financed a major purchase by writing a check for payment in full or by paying with actual cash?  Most will answer, never. But is a solution worth the price of $700B to the US taxpayer?  Shockingly, I will answer yes.  Even at that cost. 

The credit crisis that we face today is a confluence of fear, accounting rules and yes, actual bad debt.  But is all of the debt on the balance sheets of financial institutions worthless?  The answer is quite simply no.  Most of us continue to pay our mortgages each and every month.  The default rate on Prime US mortgages was a meager 2%[1] in August.  So if some of the mortgage debt are viable paying investments, why the issue? 

Therein lies the accounting part of the equation.  In November of 2007, legislation was passed that required all financial institutions to use mark to market accounting.  At its root, this was a great idea to enhance transparency to investors.  However, it has become a big part of the problem (unfortunately undoing this today is unlikely to cure what ails us).  In mark to market accounting, assets are only worth what someone is willing to pay for them.  In a market gripped by fear, where institutions struggle to differentiate good assets from bad, investors have shunned all mortgage debt.  This has pressured prices on even viable mortgage debt in good standing.  This can be seen in no better example than in GNMAs.  GNMAs, unlike their cousins Fannie and Freddie are actual government obligations.  Yet yield spreads have moved out to historical levels, reflecting an overall level of risk aversion as it pertains to all mortgages.  In mark to market accounting, good debt, along with the bad is being priced at a fraction of its intrinsic value (the present value of future cash flows).  This in turn is causing the value of assets on bank balance sheets to fall below required capitalization levels which results in failures.   If assets were to be deposited to a Federal Agency via a bailout, similar to what was proposed in the Paulson Plan, it is doubtful that the actual cost of the long term would come anywhere close to $700B.  As mortgages are bought at a fraction of face value, the yield received by the bailout agency will be higher than stated face value (a 5% face value mortgage bought for $50 on the $1 becomes a $10% yield to the investor).  This will be financed with 3.5%-4% treasury debt.  The difference will be a positive carry or rate of return to the taxpayer.  Now, I am not bold enough to predict that the taxpayer will earn a positive return on their investment in total (defaults need to be considered), however is it unreasonable to assume that viable mortgages continuing to make interest and principal payments will somewhat offset the total $700B if and when it is approved?

As always, thank you for your trust and confidence.