Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

Paulson's Plan Really a Bailout?


Contract law, the foundation of capitalism and democracy, was dealt a heavy blow yesterday.

The details are sketchy, but let's try to understand the plan Mr. Paulson has put together to help out homeowners.

First of all this doesn't really help many homeowners. Those in delinquency currently do not qualify for help. See ya! The plan only offers hope to those not currently in delinquency who in the near future face the prospect of higher interest rates and can show they will have problems making those payments. I don't know how many people that is (no one does yet).

Whatever it is, it is a drop in the bucket relative to the real problem: the incredibly high level of debt in the global economy is clearly unmanageable (that is why extraordinary steps are being taken to quell the problems caused by it) and that new borrowing has stalled completely. That will clearly hurt consumption going forward and all those rosy earnings estimates will come down.

I think what happens in the current plan is the FHA or municipality that is helping an individual work through their mortgage notifies a central information committee. That committee will amalgamate all such situations, find the CDOs affected, contact the owners of those securities, and negotiate new terms for payment. They will need a super-computer to figure all this out and it will be a mess. Frankly, I don't know how they are going to do it.

The biggest ramification is this. Those investors will have to decide whether or not to accept the new terms. If they accept lower interest payments because it is better than default, the value (price) of the CDO will go down to reflect the new present value of the payments. This is a big fact that I think everyone is missing: the price of CDOs will be marked down from current levels. Banks' desire to lend will go down as a result of this. As an illustration, the spread between libor and ECB funding rate (equivalent fed funds) rose again last night and is at a record 89 basis points.

A nuance of the above is that senior trauches of CDO now have a higher certainty of pay-outs while the junior trauches now may be worthless. These junior trauches will sue like crazy as this thing unfolds.

What will happen is that banks/other investors who own these will then take another write-down but then declare this is the end. This will not be true. A huge percent of all re-negotiated mortgages eventually still default. It just buys a little time for a few more interest payments. The bottom line is these folks bought houses they couldn't afford when paying market interest rates. This is really a plan to help banks take one more write-down and declare all is well and then hope for some magic turnaround. But there won't be a turnaround.

And now we see why the plan doesn't help the homeowner who is already in default: the CDOs affected by the default cannot be written up. The real purpose of the plan is to try to slow the deterioration in collateral values.

So far Mr. Paulson is trying to make this look like a "voluntary" plan by lenders. We all know there is lots and lots of pressure being exerted by government to get them to volunteer. But I have a feeling Mr. Paulson's plan does not end here. There is also talk of getting Congress to pass legislation to let states and municipalities issue tax-exempt debt to refinance loans for those who cannot keep their homes. This would be nothing more than a government led bailout of banks and large investors at the expense of taxpayers.

As I pointed out yesterday, central banks are desperate to keep collateral values high to keep liquidity in the system. That liquidity is currently being sucked up by banks because their collateral value was dropping precipitously.

The final and most important ramification of this plan is the future effect on CDO investors, which is a very large percent of the global liquidity pool. If they believe their contracts can be forcefully re-negotiated they will demand better terms (higher rates and wider spreads) the next time they consider such an investment. So long term liquidity will be decreased substantially.

Contract law, the foundation of capitalism and democracy, was dealt a heavy blow yesterday.

Risk is high.
< Previous
  • 1
Next >
No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Featured Videos