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Confessions of a Money Manager: Paulson's 'bottom' key to solving financial crisis

Ray Unger  —  9/26/2008 12:51 pm

Henry Paulson's "bottom" is the key to solving the nation's financial crisis.

No, Paulson's bottom is not a place like Washington, D.C.'s Foggy Bottom, nor is it a curvy bottom featured in Fruit of the Loom underwear commercials. Paulson's bottom refers to Treasury Secretary Paulson's effort to find a bottom to the horrendous slide in real estate values, and it's the key to ending the malaise that's infected the financial markets both here and abroad.

The crux of the $700 billion "bailout" -- the term "bailout" does a disservice to this proposal, but it's the word the media seems fixated on -- is to give the U.S. Treasury the financial resources to be the buyer of last resort for real estate mortgages that are now considered too toxic for private firms to own.

There are a couple of things that are often misunderstood about the plan.

First, the $700 billion number is the upper limit Paulson is seeking. He may need less, but he can't exceed that limit. Second, the money would be used to buy mortgages from banks and other financial institutions. It wouldn't be used to shore up balance sheets. The idea is that buying the questionable mortgages would help these private companies get needed capital so that they can resume making loans and the economy can begin to function normally again.

But before we go any further, it's important to understand these questionable mortgages.

Suppose you bought a home in Maple Bluff for $500,000 but you had little money for a down payment. No problem. Your lender originated a mortgage for the entire $500,000. After all, what could go wrong? If you default, the next buyer will probably pay more. Housing values, you see, never fall, right?

With that mentality, the lending institutions went crazy making such loans. Why? Because Wall Street firms like Merrill Lynch, Bear Stearns, and Lehman Brothers were buying such mortgages like they were manna from heaven.

Mortgages like yours for $500,000 were regularly assembled with other mortgages and sold like a crate of apples -- one crate, one price -- with a whole bunch of apples (mortgages) inside. Just buy the crate and collect the money (monthly interest and principal payments). How sweet it is. And if an occasional apple goes rotten (foreclosed mortgage) just pluck it out, and roll in a replacement. After all, those few foreclosed mortgages can either be written off against the profits and-or re-financed into a new mortgage because as we all know -- REAL ESTATE VALUES NEVER GO DOWN!

Suddenly, a big OOPS. You lose your job and can't make your payments, or you bought the house for a quick profit and discover you're looking at a loss, or your monthly payment suddenly jumps higher because the sweetheart interest rate that attracted you to the mortgage elapsed. Adding insult to injury, everyone in your neighborhood decides to sell at the same time you must sell. So you lower your asking price to $300,000, but still no buyers. Major oops for all concerned.

Now this example, with a few variations, pretty much sums up what's been happening all over the country, particularly in California, Arizona, Nevada, and Florida.

Unfortunately, that's just the tip of the mortgage iceberg. Those crates of mortgages (officially known as Collateralized Mortgage Obligations or CMOs) were bought and sold so many times by so many banks and Wall Street firms that it's hard to know which mortgages are in default or about to go into default. This all started in August 2007. Since then the owners and traders of these CMOs have been marking them down to what they think are accurate values, but because real estate values have continued to fall, there doesn't seem to be any end in sight. As a result, no one wants to hold these mortgages and the market for them has virtually dried up. Some of these CMO packages have been sold for as little as 15 cents on the dollar.

So in steps Paulson -- who was the CEO of Goldman Sachs before he was appointed Treasury secretary, and Goldman was one of the few Wall Street firms that avoided this mortgage mania -- with a proposal to use up to $700 billion to buy these mortgages from the same banks and Wall Street firms that originated them. Is he crazy? I don't think so.

You see, most of those mortgages will turn out to be OK if they're held to maturity, or if the underlying real estate collateral can be gleaned when the mortgage defaults. But we need sort of a time out to catch our collective breath and let the real estate market stabilize. That can't happen if everyone is trying to sell at the same time. Paulson hopes this time out will help the real estate market find a bottom. That means taking these mortgages off the market and in a patient, orderly manner, sell them. The risk, then, is what Paulson pays for these mortgages.

Let's go back to our original example. You bought a home for $500,000 but can't seem to sell it for $300,000. If Paulson buys that mortgage for $500,000, then we taxpayers will probably take a hit. If Paulson buys it for $300,000, and it eventually sells for $300,000, the taxpayers may not take a loss. Nonetheless, $300,000 of taxpayer money will be needed to take this mortgage off the market (temporarily) and help the selling institution with $300,000 of fresh capital.

Paulson's strategy is actually quite simple: take the toxic mortgages off the market by acquiring them at the right price, hold them off the market so that real estate values can find a bottom, and then gradually sell them back into the market. That's why Paulson's bottom is the key to solving this credit crisis.

Ray Unger is chairman of Forward Investment Advisors in Madison. He can be reached at 833-9400; e-mail: runger@forwardinvestmentadvisors.com

Ray Unger  —  9/26/2008 12:51 pm