The Toxic Asset Plan & Donkey Math

Details on the plan to create a private/public partnership to buy up toxic mortgage backed securities were just announced. The stock market reacted positively at first, as it looked like the first market based solution proposed by the Obama administration. I think the facts are starting to sink in now. The math of the plan does not work at all. Its kind of like Donkey math at the poker table. They go through the motions and think they got it all figured out, but the math is still wrong. The Toxic Asset plan simply bails out investors who have not even invested in anything yet. Is there anything we can’t throw our taxpayer money at?

Think about what a mortgage backed security is. It is 1000 or so Mortgages packaged together. So it is like a bond in that you collect the monthly cash flows from the payments on all of the mortgages. If a payer defaults, they foreclose the house and sell it on the open market, and you get an immediate cash flow. Let just assume for a second that all of the 1000 mortgages were 30 year of some type, and all originated around the same day. So a mortgage backed security is like a monthly cash flow for the next 30 years that is somewhat uncertain. To value a security like this, you just discount the cash flows of the future to their present day value. Since we are not sure about the future cash flows, valuation gets tricky.

So let’s assume that banks have these mortgage backed securities on their books with a face value of $100, but have marked them down already to $80 based on the existing reductions in cash flows due to booked foreclosures and late payments. The cash flows could further deteriorate or stabilize from here. Let’s assume that the current open market rate for these securities is $30. So the banks have a choice currently of keeping them on their books, and taking the 30 years of uncertain cash flows (currently valued at $80), or they can take $30 now, and take an immediate loss of $50. You can start to understand why they are not selling them.

So we get an investor to put up 6% of their own money, Treasury matches that, and we loan the rest without a requirement of repayment. So let’s say that the partnership buys a bunch of these securities at $50. On the surface that seems a bit better because the bank now has a market to offload these things at 50 cents on the dollar, but the problem is the math. The only way the investor makes money on this deal is if they are worth more than 50 cents on the dollar. If they are worth more than that, it was a bad deal for the bank, and they should have held on and not sold. If it turns out that it was a good deal for the banks, and the securities were only worth $30 the investor would lose money in theory, but the government takes the bulk of the loss here. All this ultimately does is subsidize investors buying these toxic assets up. It can’t help the banks in anyway unless the investor overpays for the securities. If that happens the U.S. Government takes the bulk of the loss and would have been better off just giving the banks the cash value of the subsidy. Anything the banks gain from this arrangement is paid for 94% by the Government and only 6% by the investor. Anything the banks lose from this goes 50/50 to the Government and Investor. If you take the investor out of the picture, you have a zero sum game that can’t help the banks in anyway. Throw in the investor, and some of the money that could have helped the banks will just bleed off to them. Donkey math at its finest