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I’ve stayed away from the mortgage mess for the most part. I wanted to specifically share this article however because it is written by Bill Gross, who is generally recognized as the top bond guru in the world. Understand this one thing before you read the article: Bill Gross understands bonds.

The little that I’ve read so far on the bailout talks about the gross dollars involved in the bailout but doesn’t discuss what the net cost will be to taxpayers in the end. The net cost is an important factor that we need to know.

And so, instead of mild medication and rest, it became apparent that quadruple bypass surgery is necessary. The extreme measures are extended government guarantees and the formation of an RTC-like holding company housed within the Treasury. Critics call this a bailout of Wall Street; in fact, it is anything but. I estimate the average price of distressed mortgages that pass from “troubled financial institutions” to the Treasury at auction will be 65 cents on the dollar, representing a loss of one-third of the original purchase price to the seller, and a prospective yield of 10 to 15 percent to the Treasury. Financed at 3 to 4 percent via the sale of Treasury bonds, the Treasury will therefore be in a position to earn a positive carry or yield spread of at least 7 to 8 percent. Calls for appropriate oversight of this auction process are more than justified. There are disinterested firms, some not even based on Wall Street, with the expertise to evaluate these complicated pools of mortgages and other assets to assure taxpayers that their money is being wisely invested. My estimate of double-digit returns assumes lengthy ownership of the assets and is in turn dependent on the level of home foreclosures, but this program is, in fact, directed to prevent just that.


For simplicity’s sake, let’s examine a $100 million mortgage backed security. The Treasury would buy a mortgage backed security from a distressed bank with a face value of $100 million. Gross is asserting that on average, the Treasury will pay the bank $65 million for that security.

The bank has just lost $35 million, or 1/3 of its investment. The government now owns $100 million in mortgages that it paid only $65 million dollars for. These mortgages pay nominal interest at a rate of 6%. Because of the discount that the government paid to buy the security however, the government’s real rate of return is 10-15%.

If the government borrows money at 4% and earns 12% on the securities it purchases, it has a return of 8% if all of the mortgages were eventually paid in full. All of these mortgages will not be paid in full of course. How many of them will? That the $700 billion question.

If $50 million of the $100 million in mortgages is ultimately repaid then the government loses $15 million minus whatever interest it has earned while holding the securities. If $70 million of those mortgages is ultimately repaid then the government has $5 million capital gains plus interest.

Here’s the big picture: with $700 billion, the Treasury will buy securities with a face value of $1 trillion. Those $1 trillion worth of securities might ultimately be worth $400 billion. They might ultimately be worth $600 billion. Or $800 billion. Only with time will we find out.

One More Note: The Democrats are working foreclosure relief into the bill. This is obviously good, but it doesn’t necessarily need to be done right now. Once the Treasury buys these securities, the government owns them. The government can do whatever it wants with them. The government will be able to give foreclosure relief simply by not forcing foreclosures on the mortgages that they own.