What are the “risky assets” worth?

Posted by Mike Sylvester - 9/30/08 @ 9:55 pm - Filed Under 2008 National Elections, National Politics

This is the 700 billion dollar question that no one has answered.

Repeatedly I have heard the Secretary of the Treasury say that no one knows what these assets are really worth since they are bundled into complicated packages. Yet, he wants to buy them with 700 billion dollars that will have to be borrowed which will increase the National Debt. The question is how much are they worth?

The two most recent batch of “toxic assets” were sold at a fire sale for 22 cents on the dollar and 27 cents on the dollar. Mark Souder said on WOWO that he talked to a local banker who felt that in general toxic assets are worth 95 cents on the dollar.

I am not sure what they are worth and the truth of the matter is that each batch of “toxic assets” would have to be individually valued and the valuation will be very difficult.

That being said there is no way these “toxic assets” are worth 95 cents on the dollar and I will show you why.

The ”700 billion dollar bailout” would spend up to 700 billion dollars to purchase the worst and most toxic debt that the mortgage holders have on their books. We would be purchasing APPROXIMATELY 5% of the mortgage related assets in the United States. Unfortunately we would also be purchasing second mortgages including unsecured credit card debt, commercial loans, and who know what else.

The banks and mortgage holders would be allowed to choose which “toxic assets” they would sell us.

Obviously they will sell us the worst and most toxic assets they have. They will sell us batches of sub-prime loans, alt-a loans, mortgages from portions of the country that have seen a 30% decrease in housing prices, mortgages that have already been foreclosed on or soon will be, etc.

In order to understand the problem lets look at a sample batch of sub-prime loans that the US Treasury could decide to purchase:

Lets say it consists of 10 sub-prime mortgages on homes located in Miami, Florida. Lets say all of these home were purchased on Dec 31st, 2006 near the peak of the real estate market for $100,000 per house. Lets assume they were purchased by the bank for cash. Assuming that the mortgages are at the market rate of interest the mortgage holders would list these assets on their books as an asset that was worth $1,000,000 in 2006. This package may have then been sold to other institutions multiple times and might have other options and derivatives placed on it. To keep this example simple I am going to assume that all were sold at the market rate of interest and that the loans were not sold and have no derivatives associated with them.

So in 2007 lets say the Miami housing market dropped by 15%. This means the houses that were put up as collateral have dropped in value to $85,000 each. Lets assume that interest rates in 2007 stayed about the same as 2006. Lets further say that in 2007 all ten home owners made all of their payments and their interest rate was 7%. This means that the mortgage holder collected approximately $70,000 in interest payments and approximately $10,000 in principal payments. The $70,000 in interest payments is booked as interest income and accounted for on the profit and loss. The $10,000 in principal payments is a return of principal to the bank and will result in the asset package being written down to $990,000. Each home owner in this package owes $99,000 in principal and their house is worth $85,000. The mortgage holder now has an asset on the books that is worth $990,000. Due to Sarbanes Oxley and mark-to-market accounting rules the mortgage holder must mark their assets to market value once per quarter. In order to mark this asset package to market you have to know what the market value of these loans are. The mortgage holders have complicated models they use to determine this value as well as the price that similar assets have sold for on the market. Recently Merrill Lynch valued a large amount of their sub prime loans at 22 cents on the dollar in a transaction and Citigroup currently has one of their large asset packages valued at 53 cents on the dollar.

So our company has to assign a value to our asset package. Clearly since the local real estate market has dropped 15% we will have to write our asset value down. Lets say that our financial specialist decides to write it down to $850,000. This means we will take an immediate loss of $140,000 on this years profit and loss statement and the asset package is now listed on our books for $850,000.

2007 Summary:

Due to this asset package we lost $70,000 on our profit and loss statement for the year.
Due to this asset package our balance sheet is $150,000 lower at the end of the year then the beginning.
Realize that all of these loans paid us this year, this hit is entirely due to mark-to-market accounting rules and the drop in the real estate market in Miami.

So in 2008 lets say that half of these mortgages go into default on Jan 1st and are foreclosed on Dec 31st. Lets say that no payments are made on these five homes. (Note many of the packages the Department of the Treasury will buy are similar to this, the mortgage holders will unload their WORST packages onto the taxpayers). Lets say the other five homes are just fine and make all of their payments on time. Lets say prevailing interest rates have stayed the same. We will soon have to manage the properties that are foreclosed on. Per the National Association of Realtors a house that is foreclosed on loses 1.5% of its value per month. The foreclosure process also costs money for the banks to foreclose on the homes via the court system. So if it costs them $10,000 per house this $50,000 will be expensed on their profit and loss. The five houses that have good loans that are paying on them will result in $35,000 of interest income for the mortgage holder and a return of principal of another $5000. Lets say that our finance expert now values the fair market value of the asset package at $50,000 for each of the foreclosed on properties and $70,000 for each of the remaining five properties. This means our asset is worth $600,000. This means we will have to write down our asset $250,000 and this loss is reflected on our profit and loss.

So at the end of 2008 here is what the bank has on their books:

The risky assets package is valued at $600,000 due to mark-to-market accounting rules. Our balance sheet position has worsened by $250,000 due to this asset package.
The package has five performing loans at the market rate of interest with 28 years of payments expected.
The package has five houses that are just foreclosed on and need to be dealt with. In this example the bank has paid the cost of foreclosure.
We have a loss of $250,000 + $50,000 - $35,000 or a total annual loss of $265,000 for the year.

Now Uncle Sam comes and and buys this package of loans. What is it worth?

That is the 700 billion dollar question.

In my mind this package of loans is certainly worth something. The fire sale price for a package of Merrill Lynch bad loans was 22 cents on the dollar. Citigroup is listing assets similar to this for 53 cents on the dollar.

There are a lot of factors that would complicate this valuation in the real world:

Interest rates. Are the loans at a fixed rate or variable?
Prevailing interest rates. If the loans are fixed rate loans then the value of the loans decreases if prevailing interest rates rise.
Geographic location and the local home market. Realize the loans could be from all over the country.
The derivatives associated with the assets.
The exact terms of the loans which could often be different.
The credit worthiness of each individual borrower.
The National economic outlook
Etc., etc., etc…

These packages would have to be valued on a case by case basis. If I was valuing them on 1/1/09 I would consider many factors including:

Miami is a down housing market that is flooded with empty houses.
50% of the sub prime loans in this package have already defaulted and it is likely that more will default.
The five performing loans have home owners who each have an average of negative $28,000 worth of equity in their house which makes them even more likely to “walk away” from their mortgage.
It will cost money to resell and maintain the five foreclosed on houses.

The free market is valuing these assets at between 22 and 27 cents per package. I agree that this is too low due to the “credit crisis”; however, the free market is often the best judge of risk and price.

If the Federal Government bought this package for 22 cents on the dollar I think the taxpayer would likely make money in the long run. If this package were purchased for 95 cents on the dollar the taxpayers would lose a lot of money on this deal.

As proposed the “bailout” package leaves the decision for the purchase price up to The Department of the Treasury. Who knows what price they will choose. They have been inconsistent concerning which companies they have bailed out and which they let fail (Bears Stearns vs Lehman Brothers).

Please realize this is a small and overly simplified example. The real packages are extremely complicated.

This simple one is difficult to value; the real ones will be nearly impossible. Note that a few days ago I thought the valuation process would be easier then I do now…

I hope this example illustrates the problem somewhat.

Mike Sylvester

Comments

4 Responses to “What are the “risky assets” worth?”

gadfly on September 30th, 2008 10:44 pm

When the government had to deal with S & L bankruptcies in the 1980s, no strategy was needed to decide which bad loans to take over. Bankruptcy meant resolve the issues under the federal deposit insurance that guaranteed deposits. It is certainly true that under the Paulson buyout, the government would have to go out and shop for bad loans. These come in all shapes and sizes, so the government would have to judge what type of loans it wants. They are illiquid, so it’s hard to know how to value them. Bad loans are weighing down the financial system precisely because private-sector experts can’t determine their worth. The government would have no better handle on the problem.

But we accountants have been sticking our nose into valuations under FAS 157’s “mark to market” rule whereby asset valuations fluctuate with today’s market (or lack thereof). The long term value of mortgage assets are being devalued thus impairing credit; this despite the fact that there is an underlying physical asset backing the mortgage.

Quite a cunundrum. I put this piece together on my blog about SEC’s loosening of MTM valuations.

http://herdgadfly.blogspot.com/2008/09/mark-to-market-rule-change.html
tim zank on October 1st, 2008 9:10 am

Is it safe to assume “voo-doo” accounting practices are a major cause of the problem? Nothing against you accountants, you’re just playing the cards you were dealt, but wouldn’t it be prudent to simplify the accounting/IRS approach?
tim zank on October 1st, 2008 5:59 pm

Hey Mike…FYI…if you have not read this already, you should. It’s a good article in Reason in r/e the causes of the meltdown & a timeline..

http://www.reason.com/news/show/129158.html
Anonymous on October 1st, 2008 7:20 pm

I wanna vote for Sylvester in 2010