The news du jour is a quickening of interest in an idea originally mooted by the FDIC’s Sheila Bair, now adopted by U.S. Treasury Secretary Henry Paulson, that would freeze resets wholesale for certain classes of struggling mortgages. The Victorians among us, cluck and tutt at, yes, the moral hazard and perverse incentives implied by this sort of plan. Fortunately, no one ever listens to us.

Elizabeth Warren offers up a combination of pragmatic and Victorian concerns, among which are that “lawsuits will fly thick and fast, enriching the lawyers and tangling up the homeowners.” Felix Salmon argues not, but he’s mistaken, and he himself explained why. Besides teasing Felix, understanding this issue sheds light on why this plan could be an important tool in resolving the current credit crunch. Big hint: It ain’t (primarily) about helping homeowners.

Here’s Felix, today:

Most loan modifications actually increase the total amount of money that the investors stand to receive. In this case, it’s conceivable that… bondholders might get a bit less money than they would otherwise. But that’s a really hard calculation to make, and unless you can make that calculation with some certainty, it’s going to be very hard for you to show damages. Let’s assume that an investor in an RMBS tranche can compellingly show losses of say 5 cents on the dollar as a result of the Paulson plan. (We’re talking about the difference, remember, between the present value of what that investor will now receive and the present value of what that investor would receive were the plan not in place.) Given the size of individual RMBS tranches, and the number of investors they were sold to, that investor probably has no more than about $20 million invested in the tranche. Which means that he’d be suing for $1 million. Not worth it… What if he put a class action together, and got all the owners of that tranche to sue? Well, maybe the tranche was $50 million in total. We’re still only talking $2.5 million in damages here.

Now, here’s Felix with the answer, on Friday:

In reality, it’s almost certain that some bondholders would benefit from this scheme, while others would lose out.

Suppose it is true that, on-average, cashflows to the whole class of affected securities changes very little under the workout, that the savings to investors from avoiding defaults roughly balances the cost of the reduced income stream. Consider what this workout does to the certainty of cashflows for any particular MBS pool. Prior to the workout, under a low-default scenario cashflows are very high, while under a high default scenario they are very low. In the “good case”, the senior tranches get paid, but so do the tranches a few levels down. In the bad case, the junior tranches lose everything, and the senior tranches lose some fraction of their value. For valuation purposes, the marginal junior tranches now resemble at-the-money call options, valuable when outcomes are volatile, worthless when they are certain.

And what would the Bair/Paulson plan do? It would increase the certainty of the cash flows, to a level where, on average, senior tranches would be made whole, but marginal tranches would lose out. In other words, even if the effect on total cashflows in the aggregate is very small, the Paulson plan would wipe out the option value of tranches at the margin. Holders of these tranches won’t take a 5% haircut, but a 100% haircut off the tranch’s current value. You betcha they’ll sue if they have any hope of relief. [*]

On the other hand, holders of senior debt will be made whole with much greater certainty. The proposal effectively represents a transfer of wealth from junior to senior trancheholders. Which gets us to its clever systemic implications.

The current credit crunch stems not from the absolute scale of writedowns, but from the distribution of the losses. Highly leveraged entities with very little capacity to bear risk, who thought they were holding “supersenior” (but yield enhanced!) securities, are facing catastrophic unexpected losses. If those losses could be shifted to investors with a greater capacity to bear risk, the systemic implications would diminish towards the absolute scale of the losses, that is, towards insignificance.

Less senior trancheholders are being asked to take a hit, because they can, to save other investors who can’t afford their losses. From each according to his ability, to each according to his need. You’ve gotta love capitalism.

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[*] To understand this better, recall that the total world of securitized mortgages is divided into distinct pools, each of which (simplifying some) backs a security, which is then subdivided into tranches. Without the Bair/Paulson plan, some of these pools would do well enough to pay the senior tranches and a few junior tranches, while other pools would do poorly, wiping out the junior tranches and forcing the senior tranches to take a haircut. Under the proposal, all of our stylized-just-at-the-margin junior tranches get wiped out, while all the senior tranches are made whole. Prior to the payment streams actually developing, we can’t know which pools would pay-off junior tranches and which wouldn’t, so all these tranches currently have some value, like a lottery ticket. That value would be wiped out under the plan. Note that some junior-tranche investors may have done due-diligence on the quality of credits in the underlying pool (or relied exclusively upon unusually high-quality packagers), and these investors might expect with high probability that the “good scenario” would unfold. Under the Bair/Paulson scheme, these investors would be wiped out anyway, and therefore penalized for their efforts (due diligence is expensive), unless you believe that it’s possible (and equitable) for those executing the plan to separate those who can and can’t afford a reset with very high precision.

This entry was posted on Monday, December 3rd, 2007 at 2:54 pm PST.
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