Since we are going to have another shot at the bailout bill, we might as well have a better bill. One improvement that should be made is to prohibit CDOs from carving mortgages into pieces that create different sets of creditor interests within the same mortgage, since the differing creditor interests often prevent an efficient work-out of the mortgage that might allow the homeowner to stay in the house on more sustainable terms.
As background, I am a Chief Financial Officer of a large, private, industrial corporation. We are well capitalized enough so that we will probably be beneficiaries of the certain carnage that will result if a bailout bill is not passed. As a financial professional, I am almost looking forward to the professional challenge that a period of mayhem might bring. As a human being, however, I just can't sign up for the hurt that inaction will bring to tens (yes tens!!) of millions of lives. I strongly believe that not passing the bill today was a mistake.
Given, however, that there is likely to be a rewrite, we might as well try to get a better bill. While securitization of mortgages is not, per se, the problem here, the securitization that has allowed mortgages to be split into multiple pieces with differing creditor interests serves to make it much harder to work out mortgages in ways that can be beneficial to homeowners and loss-minimizing to mortgage holders.
First some background. A typical Collaterized Debt Obligation (CDO) might have 1000 mortgages with an average mortgage of $150,000 a piece. Thus a total mortgage issue would encompass $150 million of total mortgage obligation. The mortgage pool would typically be sliced apart into three tranches, a high risk pool that might have very high returns, particularly if underlying housing values would have continued to grow, a medium risk pool that had potential yields significantly in excess of Treasury rates and a low risk pool that was supposedly ultrasafe with returns maybe 50 points above treasuries. Or at least that was the concept. The reality is, however, that almost all of the riskiest levels have been wiped out, and probably much of the medium level in most CDOs has vaporized as well. The floor level tranche mathematically retains much if not most of its value since even a fifty percent fall in housing prices still leaves an asset that is likely to yield 75% plus of its original value if held to maturity. It is the illiquidity in this grade of CDOs that the Paulsen Plan sought to re-establish.
One of the substantial causes of the illiquidity of the investment - beyond the general decline in housing values - is the difficulty in establishing the true economic worth of the underlying mortgages. A significant reason for this difficulty is that the structure of multi-tier CDOs leaves the riskier tiers without any economic value, but with the legal rights to impede a work-out process. The out of the money high risk tiers do not have economic value, but they do have extortion value which in practice serves to stop the firms servicing the mortgages from doing anything other than acting as the foreclosure agents as specified in the CDO indenture.
Prohibiting the creation of different security interests within the same mortgage would help with the workout process. A single decision making entity might be quite happy to write a mortgage down to an 80% of original value level with a low fixed rate if it meant a homeowner who kept paying. Instead we are faced with a downward spiral of foreclosures that not only further destroys the economic value of specific mortgages through a myriad of extra costs but puts further downward pressure on every other house in a neighborhood who have to compete with foreclosed homes in the event that they want, or have to sell.