By Bob Ivry
Sept. 24 (Bloomberg) -- U.S. Treasury Secretary Henry Paulson's bailout plan hinges on answering the question that has vexed global markets for more than a year and sunk two securities firms: What's a bad mortgage worth?
Pay too much for hard-to-value mortgage debt held by banks and recouping taxpayers' $700 billion investment becomes less likely, Merrill Lynch & Co. analysts led by Akiva Dickstein wrote in a Sept. 22 report. Pay too little and the banks may either refuse to sell or be forced to hoard cash to make up for losses, the analysts said.
``This pricing thing is the 800-pound gorilla, the absolute core of the whole plan,'' said Bert Ely, a banking industry consultant in Alexandria, Virginia. ``If the government takes an aggressive posture, it benefits taxpayers but it means some of the banks will have serious capital problems. This has the potential of politically being very troubling.''
Paulson said an economic recovery in the U.S. depends on stabilizing home prices, which were down 18.8 percent in June from their peak two years ago, according to the S&P/Case-Shiller Home Price Index. That rebound is impossible without mortgage financing, and it's unclear how the government bailout will make credit more available, said New York-based UBS AG analyst David Goldberg.
Helps Balance Sheets
``This plan clearly helps bank balance sheets, but to what end?'' Goldberg said in an interview. ``Why do we make the assumption that it will lead to looser lending standards? It's conceivable it might be exactly the opposite. So I'm not sure this helps that much.''
To ensure bank solvency, regulators require institutions to keep a minimum amount of cash on hand based on the loans they've made, said Gary Gordon, an analyst at Portales Partners LLC in New York.
Some banks have set aside money to cover losses on mortgage assets and some haven't, Gordon said. Those that haven't will lend less because they have to keep their cash to meet loss reserves, he said.
``If banks don't have loss provisions, they'll need to shore up their capital and that might cause a contraction of credit,'' Nouriel Roubini, chairman of Roubini Global Economics and professor of economics at New York University's Stern School of Business, said in an interview. ``We're still in the process of a severe housing recession, with or without this plan.''
Proposed Bailout
The proposed bailout, being debated in Congress, comes in the wake of the Sept. 15 bankruptcy filing of New York-based Lehman Brothers Holdings Inc., the biggest U.S. underwriter of mortgage- backed securities, and the Sept. 7 nationalization of the two biggest U.S. mortgage finance companies, Washington-based Fannie Mae and Freddie Mac, based in McLean, Virginia.
Credit markets froze in August 2007 after two hedge funds run by New York-based Bear Stearns Cos., the fifth-largest U.S. securities firm, collapsed due to the deteriorating value of its mortgage-related holdings. An inability to set a price on such securities has frozen the market, said Joshua Rosner, managing director at Graham Fisher & Co. in New York.
``It's not a liquidity problem, it's a valuation problem,'' Rosner said.
After its value fell 93 percent in a week, Bear Stearns was bought by New York-based JPMorgan Chase & Co., the third-largest U.S. bank by assets, in a bailout orchestrated in March by the Federal Reserve.
The Paulson plan would focus on $6 trillion of residential mortgages not currently owned or guaranteed by Fannie Mae or Freddie Mac, and $3.4 trillion in commercial and multifamily loans and mortgage-backed securities, according to the analysts at New York-based Merrill Lynch.
The government would hold a reverse auction, Paulson said, meaning that firms holding the distressed assets would submit bids on the prices at which they were willing to sell. The Treasury might then buy the assets that are offered at the lowest prices.
Fewer Mortgages
In testimony yesterday to the Senate Banking Committee, Paulson called his troubled-asset relief program the ``single most effective thing we can do to help homeowners'' and the overall economy.
In a Sept. 11 report, the Washington-based Mortgage Bankers Association estimated that 20 percent fewer residential mortgage loans would be made this year than in 2007. Home-loan borrowing was at a 26-year low in the second quarter, according to the Federal Reserve's Sept. 18 Flow of Funds report.
The number of available mortgages will fall even further, said William Isaac, chairman of the Federal Deposit Insurance Corp. from 1981 to 1985.
``I doubt the banks that got burned in subprime mortgages will start lending anytime soon,'' Isaac said. ``I wouldn't expect a rapid comeback of the mortgage market anytime soon, especially the lower end.''
Price Comfort
In a survey of real estate executives released this month by the Chicago-based law firm DLA Piper LLP, 46 percent said they didn't expect securitized commercial property lending to return to its previous market levels until at least 2011. Sixteen percent reported that securitized lending will never again reach those levels.
``The banks haven't been able to make loans because they can't get comfortable on the price of the assets,'' said Jay Epstien, a Washington-based partner in the law firm and chairman of its U.S. real estate practice group. ``The price is the key variable. How do you pin that down? I'm sure Congress will agree that the devil is in the details in implementing this plan.''
Accounting rules require holders of mortgage debt to establish its value on an ongoing basis and post losses when it declines.
22 Cents
Merrill said in July it sold $30.6 billion of collateralized debt obligations, which included mortgages, to an affiliate of the Dallas-based investment firm Lone Star Funds for $6.7 billion, resulting in a pretax writedown of $4.4 billion. The sale valued the CDOs at about 22 cents on the dollar.
``I think the key to the Paulson program is the belief in the decoupling of the intrinsic value of the securities from market valuations,'' said Jay Brinkmann, chief economist for the Mortgage Bankers Association. ``Treasury can bid somewhere between full value and market value and the lenders would not take a big hit on the sale.''
The Treasury Department should buy the distressed mortgage- related assets at ``hold-to-maturity'' value, which assumes that the debt will be paid in full over time, rather than at discounted prices, Federal Reserve Chairman Ben S. Bernanke said at yesterday's congressional hearing.
In a conference call with analysts yesterday, Stuart Miller, chief executive officer of Miami-based Lennar Corp., the second- biggest U.S. homebuilder by revenue, said Paulson's plan wouldn't stop home-price declines.
``The current stop-gap measures to aid hard-hit financial companies will be repeatedly frustrated by falling home prices and the securities that back them,'' Miller said.
Ten percent, or $1.1 trillion, of the $11.25 trillion of U.S. mortgages are delinquent or in foreclosure, according to Guy Cecala of Bethesda, Maryland, trade newsletter Inside Mortgage Finance.
``The $700 billion theoretically would be enough to completely pay off about two-thirds of all troubled mortgages in the country,'' Cecala said.
To contact the reporter on this story: Bob Ivry in New York at bivry@bloomberg.net.
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