Why? from Russ Sears

September 20, 2008 |

FDR"Life is not fair" had always been my Mother's mantra whenever I would ask "Why?"

And that message rang true on her death of kidney cancer at 57 way before she was ready to go calmly.  She was teaching  special needs kids on a rural MO public school. She was still teaching in that small converted closet classroom the month before she died.

It also wasn't fair to see the light in my Father's eyes dim at her passing.  Before her diagnosis he was looking forward to semi-retirement working as a missionary and was learning Spanish to do this. Very quickly after her death, not only did the sparkle in his eyes dim, but in his mind also. No "Life is not fair." Many a "realist" will point out to you these bitter disappointments all individuals have as part of a full life.

But the "realist" won't stop to point out the beautiful delicate humming bird sipping nectar at the honeysuckle bush flashing his iridescent colors in the evenings setting sun.

For every bitter disappointment, there are many miraculous moments.  I can't  begin to explain "Why" I deserve any of them.  Except perhaps that I am a small piece of the over-all picture and what is so heavy an issue to me, becomes minuscule in the grand scheme of infinite time, space and life. The joy of living can't be given a concrete reason, nor guaranteed like death. What hits me hardest is within my narrow world, and what brings me joy is my inter-relationship to the infinite nature of the broader world.

However, accountants also have a mantra that everything must have a "fair value" …no matter that it references a small world, it must be "fair".

The first lesson you learn, in fixed income investing, that the books don't teach you is "it's a small world". The world of companies that actually regularly invest in MBS debt, especially the more illiquid debt, is rather limited.  Given the capital required, historically relatively small returns and specific expertise needed to wisely invest in MBS, there are not too many outfits equipped to handle them.

SOXWith Sarbanes Oxley, the auditors need a number to hang their hats on. If there is a sale, or if someone is willing to give a bid,  it matters not if the sale or bid is a desperation fire sale or the bid is an exploitation of a frozen small market for these securities… it counts as real. It matters not that it's a bid, not a real sale.  It matters not what any model might say, given even grossly conservative estimates… that your expected cash flows are much higher than this price,  you must value it at this Market Price. Though all these things may be true you can't prove it unless you are allowed to appeal to the broader world's realities. The pessimist wins, by default. But what brought the fixed income markets to a halt, was that for years the MBS market was closely tied to the "models" …if a reasonable models said it was worth $X you could always find a buyer near $X price. The pessimists now have however discredited the models, because the models gave too optimistic a price on the sub-prime …Alt A… California… Florida, etc. You can look at the data and show that unless the USA housing is sure to crash like the Depression era, there is a huge liquidity discount in many of these assets.  But the pessimist will simply say you can't prove you are right, so let's use the lower number. And your models and your cash will dry up like the dust bowls days.  Plus, it becomes a self-fulling prophecy,  as these companies value liquidity more and more, as these assets get marked down, creating less of a true market for these assets.  This lack of capital raises the cost of new mortgages as well, creating more and more foreclosures.

The Feds and SEC had pleaded in true regulators' fashion, to the accounting regulators and auditors to consider some models, give some guidelines on desperation sales and throw-away bids, to put a floor on these assets.  So the small world of investors' balance sheet can allow them to continue to invest in these asset classes.   But SOX tied the auditors and accounting regulators' hands.  They would rather under-estimate the true cash flow values by billions on thousands of assets than over estimate those values on a hand-full; the appeal to reason and the broader world must cease if at all possible.

PaulsonIt would seem to me that Paulson's actions imply that they will try to create this market, using models with reasonable estimates to create a floor for these assets.

Now I suspect that the idea is to give the taxpayers a good as deal as possible, but at the same time to bring a reasonable level of liquidity back to these markets.  Not sure how you blend these conflicting goals… but looking at the current situation they have considerable range to maneuver, as to what is a reasonable assumption to put in the models.

It remains to be seen what the consequences for this "floor" will be.  Will it attract too much capital, due to reduced risk, and perhaps bring on another bigger housing bubble?  Will there be run-away inflation throughout the USA with all this money coming in? Will it be that Paulson, with their new modeler FNM and Freddie, are too optimistic  or simply stupid, pay too much, and the taxpayers take a blood bath rather than make-out nicely?  Or will it have to be run so conservatively to protect taxpayers that it can't even work? We shall see.

And it still doesn't change the underlying confidence in the securitisation markets.  If it happened once it can happen again.  The private market for MBS long term will probably need to shrink, or continue to operate with a government supported floor.

[Secy. Paulson's Proposed Treasury Authority to Purchase Troubled Assets]

Russ Sears updates us:

Bernanke further strengthened the argument of model vs. market price in his testimony today.

But I must disagree with Mr. Mann's statement about "assuming a best case scenario". Even my primitive model analysis of several of these securities implies there is wide room between "market price" and even a reasonably severe scenario "to hold" price.


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