Liquidity is in the Eye of the Holder

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Liquidity is in the Eye of the Holder
We are being told loudly and repeatedly that the gargantuan mortgage
bail-out package is necessary because illiquid mortgage-backed
securities are clogging our financial arteries, threatening the
economic equivalent of cardiac arrest. The idea of the plan is to
transfer these supposedly valuable, but currently unmarketable, assets
to the government so that private institutions can freely lend once
more. The monumental flaw in this argument is that the mortgage backed
securities are in fact highly liquid, just not at the prices the owners
would like to receive.

Mortgage bonds are just like houses. They
won't sell if the owners stubbornly refuse to drop the price. However,
they can find buyers if they acknowledge reality, and lower their
expectations accordingly.

The government tells us that if these
assets are held to maturity their full value will eventually be
realized, and that it is only because of a lack of current liquidity
that their value is not reflected in the market. However, as many
private transactions have shown us in recent months, these assets will
find buyers at the right price. These are not overly exotic assets but
relatively straight forward mortgage obligations. The inability to find
buyers is not a function of liquidity but simply of price. The
government is seeking to "create liquidity" by overpaying.

The
government's assumptions about the "held to maturity" value of these
mortgages completely understate the likelihood of widespread default.
Some of the "illiquid" assets represent tranches of mortgage-backed
securities that will be completely wiped out. Even the higher quality
tranches will suffer severe losses due to mortgages that will
inevitably go bad.

For example, take a $500,000 adjustable rate
mortgage on a condo in Las Vegas that has a current value of only
$250,000. To assume that this asset can be safely held to maturity is
absurd, when in all likelihood the borrower will default shortly after
the rate re-sets, even if the borrower has not yet shown signs of
distress. Of course such a mortgage would be completely illiquid if one
tried to sell it anywhere near par, but would be extremely liquid if
priced to reflect a more realistic value; say 35 cents on the dollar.
But if the government pays prices that fairly factors in likely
defaults, it will bankrupt the very institutions it is trying to bail
out.

Another factor that has not yet been considered is that
that the government has already indicated that it will try to avoid
foreclosures by reducing the principal and interest rates on the loans
it acquires to levels current homeowners can afford. This will
immediately eliminate the delusion of the government recouping its
"investment" as even if held to maturity the mortgages will never be
worth anything close to what the government pays.

Also missing
in the discussion is the concept of the time value of money. Even if a
substantial percentage of the $700 billion is eventually recovered, it
will still represent a huge loss for taxpayers who theoretically have
to come up with the cash today to buy the mortgages. Further, the
inflationary nature of the bailout ensures a substantial rise in long
term interest rates. This will further suppress the present values of
the low coupon mortgages the government will be restructuring.

The
moral hazard implicit in the government's willingness to re-write
troubled mortgages ensures that the plan will spark a wave of new
delinquencies by borrowers looking to cash in on the windfall. Since
troubled loans will no longer be foreclosed by lenders but instead sold
to the government, the rational choice for many homeowners will be to
stop making their mortgage payments and wait for a better deal from the
government. This reality will eventually push the cost of this bailout
well above $2 trillion.

In addition to the government bailout,
distressed lenders are looking to the suspension of "mark to market"
accounting rules as a means of salvation. These rules require
institutions to value their mortgage assets according to the most
recently traded price. However, suspending these rules will not make
the losses go away. Rather it will simply allow lenders to pretend that
the losses do not exist.

Armed with such fantasies, banks could
pretend that their mortgage assets had more value, and that their
balance sheets were well capitalized. They would not need to raise more
capital in order to fund new loans. But, just as a person with no
sensitivity to pain runs the risk of catastrophic injury, such a move
would encourage financial institutions to take greater risks which, in
the end, will produce more bankruptcies and greater losses.

In
fact, the Senate version of the bailout bill, which authorizes a
suspension of mark- to-market, also increases the dollar limit on FDIC
insured deposits from $100,000 to $250,000 (with no extra money
budgeted to fund the increased taxpayer liability). Only in Washington
would a bill pass which simultaneous makes banks more likely to fail
while increasing taxpayer exposure when they do!

For a more in
depth analysis of our financial problems and the inherent dangers they
pose for the U.S. economy and U.S. dollar denominated investments, read
my new book "Crash Proof: How to Profit from the Coming Economic
Collapse."