-- You probably know how much your checking account is worth. You may well know what your company's stock is worth.
But what if you had to put a price on that '87 Dodge Omni rusting in the driveway? Your collection of Beanie Babies? How about that chipped Wedgewood you picked up at Bill's Scratch 'n Dent Shoppe?
Some things are easy to price. Others, not so much. And that's the $700 billion problem facing the U.S. Treasury: how to value vast amounts of mortgage-backed securities that no one wants to buy.
And buy them they must, the government says: Otherwise, the credit crisis will continue to worsen, threatening the entire financial system.
But figuring out how much to pay is the one of the thorniest issues the government has had to wrestle with to date. Pay too much, and the government will look like patsies of the securities industry. Pay too little, and the Treasury will drive some financial services companies out of business. And ultimately, no matter what the government pays for Wall Street's garbage securities, investors, taxpayers and politicians will argue that the price wasn't right.
Sliced and diced
Mark Batatian, president of Prudential American pricing services, has been valuing obscure securities for 40 years. If you want to know General Motors' closing price on Feb. 20, 1956, or the value of that dusty stock certificate in grandpa's closet, he could find it for you. And his company, like many others on Wall Street, can give you a good estimate of a security's worth if it hasn't traded for a long time.
He values many mortgage-backed securities all the time. "They have benchmarks for those," he says. "You have a public record on a daily basis." But what about the types the Treasury will be buying? No clue. "They are totally in the ozone," he says. "No one knows what's right."
Ironically, the overwhelming majority of mortgages aren't hard to value. Mortgages are negotiable, which means they can be bought and sold. If you have a mortgage, your note has probably been sold several times, often as part of a pool of mortgages sold to mutual funds, pension funds and insurance companies.
Those overwhelming majority of mortgage-backed securities are traded frequently, and therefore, easily valued. Unfortunately, the mortgage-backed bonds that are causing so many problems are really and truly awful. Many, for example, are filled with subprime mortgages, which are home loans made to people with poor credit histories. When the economy is in recession, these people are usually most prone to defaulting on their loans.
Other mortgage-backed securities are chock-full of creative financing options that were popular during the housing boom. Some, for example, have low initial payments that can soar after a year or two. Others are "low-doc" or "no-doc" loans, which means, essentially, that a borrower didn't have to prove capable of repayment. In the mortgage business, those became known as "liar loans."
Even subprime mortgages are reasonably easy to value. But Wall Street sliced and diced many of the mortgage-backed securities created during the housing bubble, making them much harder to value. Many had various classes of holdings. The senior class, for example, would get first claim on all payments from the pool. In return, because it had less risk, its yield would be the lowest of all the pool's classes.
Each class would be a bit lower in the pecking order. To offset the risk of losses, however, each successively lower class of security would get a higher yield. In a normal housing market, only the very lowest class would expect to get dinged by defaults.
In the greatest housing collapse since the Great Depression, however, many investors wound up getting stuck with defaults. And because Wall Street looks ahead, not behind, buyers fretted about rising defaults, and offered lower prices to anyone who wanted to sell securities backed by subprime mortgages.
Eventually, the worst happened: Just as investment banks, hedge funds and other big institutions wanted to unload their subprime mortgages, buyers disappeared. And when there are no sales, it's nearly impossible to price a security.
The Treasury, then, is left in the difficult position of naming a price for assets that no one else will buy. And that's where things get tricky. Some possible approaches:
•Fire sale. Not everyone thinks that the market for mortgage-backed securities, even subprime ones, is dead. "There is a market for these assets, but the sellers don't want to accept the price," says Alessandro Pagani, senior securitized asset strategist at Loomis Sayles. Merrill Lynch effectively sold a massive chunk of mortgage securities at the distressed price of 22 cents on the dollar. Those securities were collateralized debt obligations, which are more complex and riskier than most mortgage-backed securities, Pagani says, and most of what the Treasury will be buying should fetch higher prices, even at a fire sale.
The drawback: Banks and other institutions would have to book the sale as a loss — meaning they would probably have to raise more money as a cushion against future losses. And that's very difficult to do in the current market environment.
•Reverse auction. Unlike a regular auction, where many players put in bids for one item, a reverse auction would have only one bidder: the Treasury. Several financial companies would offer their assets to the Treasury and give an offering price. The Treasury would take the lowest bid, in theory setting the price at the lowest level that companies feel they could afford to take.
The drawback: Reverse auctions can be complicated to set up, particularly because you need to have a reasonable number of companies offering very similar securities. Given the vast array of securities that Wall Street produced in the past five years, that could be tough.
•Future payouts. Accountants are trained to measure assets' value by examining what equal or comparable securities are trading for. It's not unlike how you can figure out how much your Pez dispenser is worth by looking for completed auctions on eBay. Robert Maltbie of Singular Research estimates that a price of 30 cents on the dollar for the debt is prudent, based on recent transactions.
Lacking a market, one solution might be to measure the value using the so-called discounted cash flow approach, says Colum Chan, chief investment officer at CC Investments. Here, analysts can estimate how much cash the investments will generate each year as mortgage borrowers continue to make their payments, then adjust those cash flows based on the interest rate a buyer would demand to be paid for taking the risk.
This method, used by some stock and bond investors, would allow the government to estimate the value of the securities and perhaps pay a reasonable price, which the market is unable to pay due to excessive fear of the unknowns, he says. "If the government sells when things start calming down, taxpayers might end up winning in this one," he says.
The drawbacks: Not having an active market to indicate what the securities are worth isn't the only challenge. There's also the problem of not knowing just how high the delinquency and foreclosure rates will ultimately be on the securities, Maltbie says. The delinquency rate on mortgage loans finished the second quarter at 6.4%, and the foreclosure rate was 2.75%, according to the latest data available from the Mortgage Bankers Association. It's unclear how ugly things could get, Maltbie says. During the Depression, Maltbie says, the delinquency rate ended at 27% and the foreclosure rate at 10%.
Even if the current crisis gets as bad as the Depression, Maltbie estimates, the loans the government is taking over would ultimately be worth closer to 80 cents on the dollar. And since the government can be patient and hold the securities rather than dump them at the same time and drive down the price, there's a greater chance taxpayers will get that value back.
But the cost in the short term is unavoidable, as the government is forced to borrow more to cover the losses. Maltbie estimates that the price tag will end up being $300 a year on average per taxpayer for the next 10 years if taxpayers are left holding the bag and there is no workout or resale of the mortgages. And that's the decision that Congress — and the Treasury — is wrestling with now.
Contributing: Barbara Hagenbaugh and Sue Kirchhoff.