THE LAW OFFICE: Vultures in the American skies

| 10/11/2008 12:00:00 AM | GARY LACHMAN


Everybody with a brain inside and outside the Washington Beltway is wondering just how the Bush Administration arrived at the magic number of $700 billion as the potential cost of a bailout of the financial institutions' mortgage crisis facing the nation. Economic angst, politics, and a need for definitive action combined last week to result in the enactment of legislation that set an example for the rest of the world. But will it work? Will the U.S. government be paying a fair price or will this just be another rather large footnote in the history of bureaucrats being hoodwinked into providing a windfall for savvy private investors and corporations.

While the strength of the dollar rose against the Lira, the Euro, and other currencies, the stock markets have been plunging. As hard as it may be to sell a single home in a rapidly decaying market, imagine the challenge of selling undifferentiated interests in the form of debt securities in tens of thousands of pooled mortgage loans. Some are barely breathing and others have started putrefying, secured by houses that have been empty for months with fixtures, appliances, wiring, even landscaping stripped away by thieves.

Are those loans really worth 50 cents on the dollar, 10 cents, or actually more of a liability than an asset? The correct value may not be known for years.Although prices of publicly traded corporate shares are easily viewed over a variety of media, these debt securities are more esoteric and exist in an opaque market. Many trades are accomplished verbally, and are represented by a confusing array of formats. Some were conventional Freddie Mac and Fannie Mae loans but with absurdly high debt to equity ratios (some even virtually at 100 percent) and others are what are known as “no doc” loans or “liar's loans” because they are made without independently verified financial statements and earnings receipts from the borrowers. A large majority of those loans were made in markets like Florida and California where prices rose and fell as fast as the Fire and Ice Rollercoaster at Florida's Universal Studios theme park.These loans were packaged into different tranches according to risk, anticipated term, priority of call, and other factors. In other words, the debt instruments that were created by the investment bankers and securities lawyers were literally, as well as figuratively, all over the map. These collateralized debt obligations, or C.D.O.'s as they are known, were often repackaged into other stultifying securities that became more dangerous than the original “risky business.”These C.D.O.'s are now selling for pennies on the dollar; witness the sales by Merrill Lynch, Washington Mutual, Lehman Bros., Wachovia, and others over recent days.

The task faced by the Treasury Department is putting a value on the securities and loans that they will buy with their newly allocated treasure chest. Will the Treasury buy at book value or market value, or somewhere in between? Two weeks ago, Ben S. Bernanke, the chairman of the U.S. Federal Reserve, told Congress that the government should avoid paying fire-sale prices, and instead pay what he called the “hold-to-maturity price.” That is the price that investors would bid if they expected to keep the bond until it was paid off. The U.S. government intends to buy the troubled investments with the intention of eventually selling them back to the market when prices recover.

The Treasury has indicated that it is considering holding “reverse auctions” to determine the price for securities that are not trading in the market. In a reverse auction, buyers submit bids from sellers and set their own reserve price. However, the weakness of this strategy is that in this case, it would be patently artificial.“Depending on your perspective on the economy, foreclosure rates and home prices, the market may eventually reflect that price. But most buyers are not willing to make that bet right now,” Bernanke said. “And that's why we have these low prices.” The bottom line is that currently there is no accurate measure of the value of these securities. The Treasury department will hopefully beware of what American professor Robert G. Hansen, senior associate dean at the Tuck School of Business at Dartmouth College, has referred to as “the absolute worst toxic waste” of the debt securities it purchases. But if they are smart, they will turn the proverbial sow's ear into a silk purse that could be filled with gold. Employing a technique using the lowest common denominator to grade the quality of the offered portfolios, American taxpayers can only hope that the government will buy low and in the not too distant future, sell high.Indeed, buyers will come like sharks to blood and vultures to carrion. David M. Rubenstein, a Co-Founder and Managing Director of the Carlyle Group, one of the world's largest private equity firms said he and other private equity players would be among the biggest buyers of the distressed mortgage and real estate-related assets set to be acquired by the U.S. governments' $700bn financial rescue plan.

Rubenstein and others see international investors including so-called Sovereign Wealth Funds also participating in the hunt for bargains in the U.S. directly from distressed institutions as well as standing in line if and when the U.S. Treasury's “For Sale” window opens. A highly placed attorney at the U.S. Treasury Department told me last weekend that the government does not intend to sell purchased debt securities anytime soon. “We want to see some of the volatility dissipate from the market before we go to market,” she said. Who knows, maybe the big players from Turkey will be shopping in this grandest of all Grand Bazaars. After all, the Turks have plenty of experience with financial crises. Those hard-learned lessons might serve the American banking regulators well over the coming months. By Gary Lachman © 2008 



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