Wednesday, October 8, 2008


I have talked with many people about last week’s bailout; they are all angry. Some that I have talked with were complete strangers who started in ranting and raving at the newsstand and several at my neighborhood library. In my unscientific poll it is unanimous: everyone regards the bailout plan as a payoff to politically connected cronies who caused the defaults. Many recognize there are better alternative plans.

For the federal government to buy the current defaulted mortgage backed securities has enormous potential for abuse. Salomon brothers got the idea to bundle home mortgages together and re-sell them as bonds back in the 1980’s. They call these bonds various things like collateralized debt obligations or mortgage backed securities, but they are not the same as bonds at all.

For example, if I buy a $10,000 municipal bond at 5 percent for a term of 10 years, I get $250 every six months and after 10 years I get my $10,000 back. If I need money before the 10 year term is up I can sell my bond. If the interest rate is up I will have to accept less than $10,000 because potential buyers know they can earn 6 percent instead of 5.

To sell my bond I will have to discount the price so that $250 twice a year will earn a 6 percent yield. If I sell after 5 years with a 6 percent interest rate, then $250 twice a year and a $10,000 final payout will sell at $9,573.* A home mortgage all by itself is like a bond because it has known payment and maturity dates, which make it possible to determine the yield at any time. Mortgage backed securities are many mortgages all bundled together as a lump sum and then divided into smaller but different parts to be resold to investors.

Trouble is the underlying mortgage holders can prepay at anytime and for investors who have mortgage backed securities that contain many mortgages there is no way to know when prepayments will come. Mortgage backed securities were marketed by selling them at a discount over the total of their final payout. It is just that the date of the final payout could not be specified. Without a known maturity date or a known number of payments a yield cannot be determined, but only guessed at as a gamble.

Any transaction of these securities will be a negotiation between sellers who do not know for sure what they are selling and a government that does not know for sure what it is buying. It is a situation ripe for cronyism and abuse.

Congress has the authority to ban the use of securities without a known yield, instead they did nothing but decide to buy them. It looks like a bad deal for savers and taxpayers.

*[Computations are Excel functions YIELD("1/1/2004","1/1/2009",0.05,95.735,100,2,1) also FV(0.06/2,10,250,-9573.5,0)]

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