It is possible that the plan can be a "win" for both taxpayers and banks. One of the central tenets of economics is that a trade often involves gains to both parties and this is no exception.
The collapse of the housing market has sharply lowered the price of real estate, so many of the mortgages and securities issued against homes are now "under water," or worth less than the value of the house. If a lender wrote a $300,000 mortgage on a house that is now worth only $150,000, the "intrinsic" or underlying value of the loan is now 50 cents on the dollar. ...
But in these stressed times, the lot for mortgage lenders is even worse. Because of the current illiquidity of the mortgage-backed security markets and the confusion of ownership rights of some of these complex securities, investors are willing to pay only 30 cents on the dollar or less for an asset with a 50 cent intrinsic value. It is in this situation where the government has an opportunity to improve the lot of the buyer and seller. The Treasury has the ability to hold these assets until the mortgage is restructured in order to realize the intrinsic value of the loan.
This does not mean a recovery of 100 cents on the dollar, but, if the government can buy the loan for 40 cents, it can still receive a good return on the investment if prices eventually rise to only 50 cents. In the meantime, the financial institution has swapped a distressed asset for a highly liquid security.
Wednesday, October 08, 2008
Jeremy Siegel's take on the bailout
Wharton Business School finance professor Jeremy Siegel gives his thoughts on TARP:
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"If a lender wrote a $300,000 mortgage on a house that is now worth only $150,000, the "intrinsic" or underlying value of the loan is now 50 cents on the dollar. ..."
ReplyDeleteJust a slight, but very important, technical correction. The intrinsic value of the loan isn't "now" 50 cents, it was "always" 50 cents. Home prices ran way beyond intrinsic values and loans followed suit. That prices are now reverting back to intrinsic values just exposes the fact that loans were made for twice intrinsic values. I.E., the underlying value was never truly there.
Good point, John.
ReplyDeleteIf a house is only worth what somebody will pay for it, and if these loans are operating on the same principle... how can someone say that 30 cents on the dollar is not the intrinsic value? And somehow 50 cents arbitrarily is?
ReplyDeleteInfinity8Ball said...
ReplyDelete"If a house is only worth what somebody will pay for it, and if these loans are operating on the same principle... how can someone say that 30 cents on the dollar is not the intrinsic value? And somehow 50 cents arbitrarily is?"
You are confusing intrinsic value with market value. In the short run, a bond is worth its market value—the price someone else will pay for it. In the long run, a bond is worth its intrinsic value—the sum of all future interest payments discounted to present value.
You can think of intrinsic value like this: If you were to buy a bond and hold it until maturity, would it have been a good investment? If the answer is yes, then you bought it at or below its intrinsic value. If the answer is no, then you bought it above its intrinsic value. You can't conclusively know a bond's intrinsic value when you buy it, but you can estimate it.
The same principle applies to stock and real estate investments as well, except they don't have a set maturity date. However, every investment has an end to its useful life.
I live in zip code 22310 and the median household income is around $95,000 whereas the median home price is around $320,000. That is close to the historic price to rent average of 3. 3 years ago the ratio was around 5 and 1/2. The P/E ratio for the stock market is around 12.5; it peaked around 45 around March 2000. These are two metrics that I wish the experts like Siegel would discuss. It shows that the market has significantly corrected to a fair value.
ReplyDeleteJohn Fontain said:
ReplyDelete"Just a slight, but very important, technical correction. The intrinsic value of the loan isn't "now" 50 cents, it was "always" 50 cents."
A slight, but very important technical correction to your technical correction:
When the loan was made, 100 cents was paid out by the person making the loan ... not the 50 cents that the asset securing the loan is worth under this scenario. Hence its intrinsice value was at least at the time the 100 cents was turned over, worth 100 cents.
i.e., You can't used hindsight to claim what something should have been worth. This can easily be illustrated by the fact that the vast majority of loans out there are still being paid off ... and are still worth the original 100 cents that was loaned out.
Good points Lance and anon 7:57.
ReplyDeleteBy the way, zip 22310 is about 3 miles from 22311, where BRAC is dropping 6,400 jobs (double or triple that for the companies that will flock to the area.)
This will add about a billion dollars a year in salaries to this area.
22310 is about 6 miles outbound to the rest of the BRAC jobs.
Even if you don't work BRAC, eager buyers will bid up 22310.
What's a hoot is how folks out in the boonies have written about the future traffic congestion at Seminary and 395.
It's not a problem when you can WALK from Fairlington, Parkington, Parkfairfax, etc to BRAC.
For Lance and anyone in the central city, 22311's billion dollars/year of new jobs is 10 minutes outbound on I395 DURING rush hour.
Lance - I'll try to explain the notion of intrinsic value in a way that should help you understand my point.
ReplyDeleteThink of intrinsic as "from within" and of extrinsic as "from the outside."
The intrinsic value of a house is not the price applied to it by the market at any given time - that is the extrinsic value (more properly referred to as extrinsic price, which usually derived from the comparable sales approach to valuation).
The intrinsic value of a house is the capitalized value of future rents that the property could produce (i.e., the value that comes from within the property, usually derived from the income approach to valuation).
Thus, in the case of a house whose price has fallen by 50% back to its intrinsic value, the loan was originally made for an amount equal to:
-one times the extrinsic price and
-two times the intrinsic value of the underlying property.
That is my point - extrinsic price has fallen, but intrinsic value has not changed.
thanks, John. you put it in very understandable terms.
ReplyDeleteas someone who grew up in 22310, i'd like to go on record saying it rules. the big positives being Edison high school's vo-tech program, an abundance of pools, and Chipotle.