Most of the consternation I’m still hearing about Geithner’s Plan revolves around the concern that the toxic assets are either worthless or are worth substantially less than whatever price they will be auctioned off for. You will read Krugman, for example, saying that Geithner is behaving as if there was no housing bubble. First of all, no one is talking about selling or buying these assets at their original value. They might be valued currently at .30/dollar. In the case of the First National Bank of Nevada, they sold off their toxic mortgages to PennyMac at .38/dollar. Under auction conditions, the toxic assets will hopefully sell for something closer to .70 or .80/dollar. Why the difference? Well, in part it has to do with this provision of Geithner’s Plan:
# Funding Purchase of Legacy Securities: Through this new program, non-recourse loans will be made available to investors to fund purchases of legacy securitization assets. Eligible assets are expected to include certain non-agency residential mortgage backed securities (RMBS) that were originally rated AAA and outstanding commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS) that are rated AAA.
We all know that the AAA rating wasn’t worth a damn. But the plan envisions restricting the program to AAA junk, which means that the worst junk is not in play. For that reason alone, we should expect the price to be higher than the .38/dollar PennyMac paid for First Bank of Nevada’s shitpile.
Now, I want you to consider the case of John Paulson. He is a member of a consortium that just bought up IndyMac. He got the money to invest in IndyMac by essentially shorting the housing bubble by buying up credit-default swaps on the BBB-rated shitpile. Here is how is described his strategy:
[Paulson] insists that his fruitful subprime trade, far from being stunningly clever, was a no-brainer for anyone who bothered to analyse the complex securities’ underlying collateral. “It was obvious that a lot of the stuff…was practically worthless at the time of issuance,” he says. He finds it “perplexing” that the banks holding the higher-rated tranches could not see this danger, and that so few others were prepared to believe that Wall Street’s finest could have miscalculated so badly.
Another motivating factor for Mr Paulson was the alluring asymmetry of shorting credit. The most you can lose is the spread over some benchmark rate. Yet if the bond defaults, the gains can be mouth-watering. He targeted BBB-rated tranches, the lowest in subprime securities. With credit spreads so low because of a liquidity glut, his possible upside as a buyer of protection using credit-default swaps (CDSs) was as much as hundred times the potential downside. One $22m trade is said to have netted him $1 billion when Lehman Brothers went bust.
Love him or hate him, this Paulson guy is one savvy investor. So, what does he think about the AAA-rated junk right now?
Just as markets used to hang on Mr Soros’s every move, they are now keen followers of Mr Paulson. He does not see the economy reaching bottom this year and is still a net short-seller of financial firms. More encouragingly, he has started buying up bombed-out mortgage securities. The number-crunching that told him subprime-linked paper was overvalued now suggests that some previously AAA-rated tranches are a bargain. He talks of distressed debt—mortgages, leveraged loans and the debt of bankrupt firms—as a $10 trillion opportunity.
So, you have Krugman and a lot of liberal bloggers on one side saying that all this AAA-rated junk is near worthless and that we are about to make a huge mistake in overpaying for it, and then you have the guy that got rich off shorting BBB-rated shitpile saying that the AAA-rated stuff is a $10 trillion opportunity.
It’s just something to think about. That’s all.
