Monday, March 2, 2009

Reason For Excessive Discounting Of Mortgage Securities

One of the logical reasons for the apparently excessive market price discounting of mortgage securities is the market anticipated the Federal government's intervention into the mortgage contract which diminished the value of the securities. The Federal banking agencies and Congress are forcing the banks to extend mortgage life, decrease the interest rate, decrease monthly payments to a lower percentage of income, and delay foreclosure proceedings. Also, there are strong indications that banks will see the principal amounts of the mortgages lowered, either through bankruptcy judges or voluntarily. All of the above factors and others cause mortgage securities to be worth significantly less than originally anticipated based on default rates and cashflow.

As the data on the current mortgage crisis reveals itself, it is becoming increasing clear that four states were the cause of the current banking problem. California, Nevada, Arizona and Florida account for most of the subprime, no income verification, underwater, defaulting mortgages, and foreclosures. Much of it was caused by the above average and rapid house price appreciation in these states combined with lax state regulation of mortgage bankers and originators within these states.

While in all recessions there are always calls by some of our Congressional representatives to help homeowners in foreclosure, this time around we had the US Senate and the House of Representatives controlled by individuals whose states were at the forefront of the problem. Pelosi is from California and reid is from Nevada. It was also clear during the 2008 presidential campaign that a Democrat was most likely to win the White House due to Bush's and the Republican's very high unfavorably ratings and that the Democratic winner would likely accede to a Democratic Congress on helping mortgage borrowers in trouble.

The depressed market prices for mortgage securities in early 2008, which led to the Bear Stearns collapse, were lower than many anticipated by the then actual and foreseeable cashflows on the mortgage securities. Even today, the payments are better on these mortgage securities than market prices would suggest. The disconnect between expected cashflows and market prices has caused the most problems in motivating banks to take write downs and in attempting to come up with a federal government solution.

If one uses the market prices of the mortgage securities instead of their book value then one would conclude that banks that hold them have assets that are less than liabilities and are insolvent. If one would use likely cashflow projections without government intervention then these banks are solvent.

Insolvency is the trigger for government intervention of the bank. So, the insistence by the banking regulators and the Treasury to use market prices instead of cashflow projection prices has caused the deterioration in banks' equity stock market prices and insolvency. However, Krugman and others should recognize that mortgage securities prices are excessively depressed due to the involvement of the Democratically controlled Congress and White House in coercing banks' to modify mortgage loans.

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