A great deal has been written so far about the government’s proposed $700 billion purchase of mortgages. Almost all of it presents it as a huge taxpayer burden and a hard blow for the government’s finances.
I had to look through many articles before I found any discussion of how the government is actually going to purchase the mortgages. When I finally found it, I was very pleased.
The government is going to hold a “reverse auction”. They’re basically going to say “ok, who wants to sell us some 6 month delinquent stated income mortgages, and how good a price are you willing to give us?” Then the government will take offers. If one bank offers to sell at 20 cents on the dollar and the other bank requires 25 cents on the dollar, the government will first buy at 20 cents. It may never get to the 25cents bank, since the amount it will buy is finite. That gives the banks considerable incentive to sell their mortgages to the government (i.e. the taxpayer) on the cheap.
What happens then? The government sooner or later will either foreclose or restructure each loan that is in default. In order for the taxpayer to lose on this deal, the end sales price has to be even less than what the government paid.
Let’s take an example. Suppose there’s a house in Las Vegas that sold for $400k in 2006 with a 100% $400k mortgage, and is now in default. If the government pays 20 cents on the dollar for that mortgage, the government will write a check to the company holding the paper for $80,000. But the government still has a claim for $400k on the property. When the government forecloses and hands the property over to a LV agent to get it sold, the agent will put it back on the market. How many houses that were worth $400k are worth less than $80k now? The answer is hardly any. Most houses in Vegas are able to sell at prices at about 50% of their peak value. So the agent will sell the house for, say, $175k. The government gets the full $175k, and isn’t obligated to give any of it to the original lender. In this case, the taxpayer will double their money.
So whether or not this bailout costs the US taxpayer, or is even profitable, depends on two things:
1) How good the Treasury Department is at running the auction
2) How much other stuff gets thrown into the legislation by Congress
I’m not too concerned about #1. We are very fortunate to have Paulson in charge. You just don’t get to the top of Goldman Sachs without being very very intelligent. He is driving good deals for the taxpayer. The AIG bailout offer was very punishing to AIG shareholders, as was the negotiated Bear Stearns deal. I don’t think much moral hazard is being created here.
Also, the market level was set recently when Merrill Lynch sold a big set of mortgages for $.22 on the dollar. The buyer is going to make a lot of money on those mortgages, in my opinion.
I’m a little more worried about #2, but we’ll see what gets negotiated this week.
This new bailout could be incredibly profitable for the US taxpayer.