Wednesday, October 1, 2008


We’ve been hearing a lot about how these mortgage-backed securities are becoming nearly worthless. You might ask yourself why this could be. If these securities are being sold for 20 cents on the dollar, does that mean that 80% of people are being foreclosed on?

No, it doesn’t. But it brings up an interesting point that I think we should be talking about. And that is the concept of value. Part of the problem is that firms are unable to value these securities properly, which is a problem, because you can’t trade securities if you don’t know what they’re worth.

But whatever they’re worth, we know they are worth a lot less to the mortgage holder than they are to the homeowner.

Why is this? Well, if a bank forecloses on a home, they don’t have any use for it. It doesn’t generate income for them. The are not in the business of renting houses, or investing in real estate, or really even very good at selling them. Other people do these things, but not banks.

As an analogy, pretend your friend, the neuro-surgeon, wanted to buy a set of neuro-surgical scalpels. These scalpels cost $10,000. For some reason he needs to borrow money from you to buy them. You agree to lend it, but require him to sign a document saying that if he doesn’t pay you back on time, you get the scalpels.

Sure enough, he nicks someone’s medulla-oblongata, incurs a lawsuit and a judgement, and has to declare bankruptcy. You get the scalpels. But, like a bank with a house in suburbia, they don’t do you much good. You’re not a surgeon. You could use them for cutting cheese, but that’s a pretty expensive cheese knife. So you decide to sell them.

But when you do, you quickly realize that the potential market for this set of scalpels is pretty small. There just aren’t that many neuro-surgeons out there. And most of them already have knives. Of course, eventually you’ll find someone that will pay close to $10,000, but it could take years. Since you need the cash now, you end up selling them for $3500.

How much were they worth to you? $3500.

But how much were they worth to your friend? $10,000.

And the thing is, this is real value. When you took possession of them, they immediately lost $6500 in real value. Why? Because, as they say, value is in the eye of the beholder.

Why do I think this is important? Because if we could find a way to keep people in these home that are being foreclosed on, we would be maintaining a lot of their actual values, instead of handing them over to banks that have no use for them. This bailout proposal actually takes our tax money, and uses it to buy mortgages from banks who are kicking people out of homes which, in most cases, have far more value to them than to the banks!

If we’re going to bail out anyone, why don’t we bail out the homeowners?

I can hear the objections now:

“It’ll take too long to work out!” How, exactly, is taking the time to do something right worse than do the wrong thing right now?

“It’ll set a terrible precedent!” Of course it will. Do we want people to think that the government will bail them out if they do stupid things? Of course not. But is this a worse moral hazard than allowing multi-billion dollar financial companies think that the government is going to bail them out? I don’t think so.

I don’t know how you would administer something like this. Maybe the government could require people with foreclosures to go through a pseudo bankruptcy proceeding where they would have their debt restructured, but would be allowed to stay in the house if they kept paying the restructured amount. There is a very interesting discussion of this whole issue here.

The point is that you maximize the value of the underlying asset (the home) when you leave it in the hands of the person who values it most. In almost every case, this is the homeowner.

I’d love Secretary Paulson to explain how buying $700 billion of homes from banks at 60 cents on the dollar from banks that value them at 20 cents at the dollar, and charging it all to taxpayers who are being kicked out of homes they may well value at 80 cents on the dollar makes any sense at all.

The only possible explanation is that the world as we know it will end if we don’t get this done tomorrow. Bush might refer to this as a “Market of Mass Destruction.” I’m going to need some better documentation this time.

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