Tuesday, March 3, 2009

Government Actions Depressed Toxic Asset Prices

Robert C Merton of Harvard at an October 2008 panel discussion at that university about the financial crisis said that modification to mortgage terms that increased consumer rights, such as giving bankruptcy judges greater power to modify mortgage terms, would increase the consumer's cost of a mortgage through a higher mortgage interest rate. A market's perception that a higher interest rate is required on an existing investment due to an after the fact modification of existing mortgage investment terms that increase the investor's risk of loss or delay of payments would cause existing mortgage securities to trade at a discount.

With Pelosi and Reid representing the two of the four states with the highest US foreclosure rates and with President Obama's populist stance against big business and banks, the markets, which are forward looking, excessively discounted the mortgage securities prices in 2008 in expectation of government interference with existing mortgage security contracts.

Congress, the President and the bank regulators have repeatedly pressured, cajoled, coerced and threatened the banks and investors to delay foreclosures, lower existing interest rates and payments, and decrease outstanding mortgage principal amounts. In addition, efforts are under way to increase a judge's power and discretion to modify the terms of a mortgage, including mortgage principal reduction to aid borrowers. Moreover, the current administration's programs and stance reward defaulting borrowers through lower mortgage payments and increase the likelihood of default to benefit from the program. Additionally, the administration repeatedly states that it expects underwater homeowners to walk away from their mortgage obligations, a fact not supported by studies of other times of underwater mortgages in periods of economic downturns in Boston and in Texas. The President's actions and plans have increased the number of homeowners likely to default on their mortgages beyond that expected by our current economic downturn through economic rewards and tolerance of default.

The decline in the prices of mortgage related securities, the toxic assets, to a significant discount below book value is only partially due to an increase in all homeowner foreclosure rates from about the normal 1 percent rate to an almost 2 percent rate and to the lowering of home prices. Part of the discount is also attributable to the government's tolerance of default and willingness to interfere after the fact in existing mortgage loan terms, which lowers the return to investors and increases their risk of loss and delayed payments. Cashflow projections of the toxic assets show that they have a value higher than their market prices and support the contention that a significant part of the price discount is due to factors other than default rates.

The President, his administration and the Democratic controlled Congress are responsible for part of the discount in prices of the toxic assets. The deep discount is contributing to bank capital insufficiency and insolvency problems and contributed to the collapse of Bear Stearns.

There is nothing stupid about the administration's plan to recognize that market prices of toxic assets are below market prices attributable to economic conditions. The administration wants to compensate the banks for the shortfall caused by government interference in the mortgage markets and subsidize part of the discount below book value through government action to purchase the assets at an above market price.

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