How to Buy Notes – Thoughts on the Bailout…

A few weeks back, I wrote an Open Letter to Congress that my friend Paul Jackson at HousingWire kindly posted to his news subscribers.

It’s even more important in my opinion NOW than it was several weeks ago, because Treasury’s been sidetracked onto a cul-de-sac by both Congress and by European leaders, in my opinion.

Paulson’s original TARP plan was intended to infuse capital into banks by buying assets, not by merely taking senior equity positions.

That plan was sound because it addressed the core problem: banks are holding mortgages whose value is either:

a) very low now (what I will call Impairment Risk)

OR

b) at a value that will continue to drop over time (what I will call Asset Deterioration Risk).

Let’s look at each of these two risks one at a time:

(a) Impairment Risk (assets on a bank’s balance sheet are “very low” now). Very simply, the inherent “risk” of holding impaired or low-value assets (e.g. non-performing loans) on your balance sheet – is that you may not know exactly what the value of that impaired asset because you haven’t tried to sell it on the secondary market to firms like mine.
So now, what does a cash infusion do to your ability to price those assets and what’s called “mark them to market”? Absolutely nothing is the answer.

(b) Asset Deterioration Risk (assets on a bank’s balance sheet will/may continue to drop in value). This risk is the biggest of all in my opinion, and is at the core of the current financial crisis. Understand this - and address this – and we’ll pull a u-turn on our little cul-de-sac and get back onto the superhighway of financial soundness.

Let me give you an example of (b) above. You’re the Chief Financial Officer of Bank I-Hold-Mortgage-Debt. Let’s take a perfectly performing $100,000 mortgage on our books at $100,000.

Borrower has been current for 24 months, they have just hit their cap of 115% (this is one of those lovely but toxic Option ARM’s originated by, say, World Savings, in 2006 – if you’re not familiar with Option ARM’s and how they work, click here for a simple explanation, then come back here to get the rest of this little story).

Question: how much do you value this mortgage at on your books?

Well, the value of the mortgage is actually pretty easy: it’s $100,000. So you book it as an asset with a value of $100,000. But now it’s this pesky little category on your balance sheet called “Loan Loss Reserve” that you’re confused about.

If you don’t know whether someone’s going to be able to make their mortgage payments in 3 months or 12 months or 24 months, then the value of that mortgage today could either be: (i) 100% of principal balance because the loan is perfectly performing and you’re planning on just holding onto it as a performing loan, (ii) 70% of principal balance because you’d want to sell that loan as a performing loan, (iii) 45% of principal balance because you actually think this Option ARM is already non-performing even though the borrower has made every single “teaser” payment.

Let me explain the third option I just mentioned, about treating this as a non-performing loan.

This is crucial to understanding what’s going on with financial institutions today: we are seeing entire portfolios of Option ARM loans ($20M and larger pools) being marketed by the Seller as “performing” loans, EVEN THOUGH the initial Minimum Payment period has expired or the Loan Recast limit on the loan’s principal balance has been reached.

What does this mean?

It means that financial institutions are holding these Option ARMs on their books as performing loans at probably a value of $100,000 in my example above.

But the Borrower is still paying some ridiculously small introductory rate of maybe 1.5% – so that’s $125/month on that $100,000 loan, rather than the loan’s regularly amortizing rate of, say, 7%, which translates to a monthly payment of $583/month.

So let’s get back to Treasury and to TARP, and both Impairment and Asset Deterioration risk.

If Banks get an infusion of capital, they may be more willing to mark down some of their assets to what they anticipate current value to be. That’s a very good thing: it addresses the Impairment risk.

But the fundamental problem in the markets today is that we are still seeing Asset Deterioration happening as loans fall into non-performing status.

What did TARP initially propose?

Paulson wanted to go to the markets and buy a whole chunk of these mortgages, and then try to “fix” them in some way once they were being managed by the government.

I’m confident that will stll happen.

It’s just that we got sidetracked with a nice little gimme of several hundred billion dollars that some banks close to Paulson were able to nab before TARP ever got going.

So with all that said, some of the original points that I’d raised back when Congress was debating what TARP should look like, are still valid today, and I wanted to share them with you here.

Let me know your thoughts as a comment below- I welcome debate and your opinion on this.

Understanding, and drilling down into this question of what to do to get out of this mess is something we owe it to ourselves as investors in this space to both understand and to educate others about.

Be your success.

Dean

PS: We are gearing up for a series of 8 how-to-buy-notes webinars where I will take you by the hand and walk you through how to get YOUR note buying business kick-started. No kidding.

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More on that later, but for now: it will start on Wed., 11/5, as part of the Private Access Club – and you can test-drive it for 30-Days for F.ree. Not much risk there…

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