How Much for Those Lender Assets in the Window?

Long ago there was a song which asked the magic question, how much for that doggie in the window?

At first it might seem that such a question has little to do with the current mortgage crisis, but actually it’s at the center of the recent legislation that authorizes the Treasury Department to pay out $700 billion in taxpayer money for financial paper of questionable value.

This is a huge issue because at the end of 2007 the United States had residential mortgages worth $10.5 trillion. If most of this debt is good then perhaps $700 billion will be sufficient to re-start the market, especially if Uncle Sam can get some discounts.

So just how much is this paper worth? Should the government pay $1 for a mortgage-backed security with a $1 face value? If it should pay less, how much less?

The way we usually figure value is that we look at the price others are willing to pay for the same or similar items. As it happens we have a current and relevant set of valuations with which to work.
The Merrill Portfolio
On July 28 Merrill Lynch sold “super senior ABS CDOs” with a face value of $30.6 billion to an affiliate of Lone Star Funds for $6.7 billion. CDOs, or “collateralized debt obligations” are complex securities that can be backed by various forms of assets, including mortgages.

You could look at the Merrill sale and say, Aha! If I can buy mortgage paper worth $30.6 billion for just $6.7 billion then I’m only paying 22 cents on the dollar.

However, the arrangement between Merrill Lynch and Lone Star is not quite so straight-foward.

“Merrill Lynch will provide financing to the purchaser for approximately 75 percent of the purchase price,” said the company. “The recourse on this loan will be limited to the assets of the purchaser. The purchaser will not own any assets other than those sold pursuant to this transaction. The transaction is expected to close within 60 days.”
As I read the Merrill Lynch announcement, a corporate subsidiary was set up by Lone Star to hold one asset, those “super senior ABS CDOs.” To pay for the asset, Lone Star put up $1.68 billion and borrowed about $5 billion from Merrill Lynch. If Lone Star defaults, Merrill Lynch gets back its super senior ABS CDOs.

Given such financing it’s not clear that Lone Star “paid” 22 cents on the dollar for Merrill Lynch’s CDOs. The friendly loan surely has some value and that value should represent a further discount against the purchase price.

In September Merrill was bought by the Bank of America for $29 a share. That’s a 70 percent premium over the stock’s pre-acquisition value — but far from the one-year high of $77.89.

The WAMU Deal
In September, JP Morgan Chase paid $1.9 billion for the “deposits, assets and certain liabilities of Washington Mutuals banking operations.” In other words, not all of WAMU’s liabilities.

“In conjunction with this acquisition,” said JPMorgan Chase, it would be “marking down the acquired loan portfolio by approximately $31 billion, which primarily represents our estimate of remaining credit losses related to the impaired loans.”
In its investor presentation regarding the transaction, JPMorgan Chase divided the WAMU mortgage portfolio into four parts and detailed its expected losses:

  • $50.3 billion in option ARMs. Expected loss ratio: 20 percent ($10.346 billion)
  • $51.1 billion in prime mortgages. Expected loss ratio: 5 percent ($2.183 billion)
  • $59.5 billion in home equity loans and lines of credit. Expected loss ratio: 23 percent ($11.739 billion)
  • $15.1 billion in subprime loans. Expected loss ratio: 40 percent ($6.438 billion)
  • Total portfolio: $176 billion. Expected remaining losses: 19 percent ($30.706 billion)

“The JPMorgan Chase valuations are must reading for any buyer of mortgage-backed securities,” says Jim Saccacio, Chairman and CEO at, the country’s largest source of foreclosure listings and data. “What they show is that investors today, including Uncle Sam, should be able to value mortgage paper with some clarity.”
The catch, said Saccacio, is that loan portfolios likely differ so much that generalizations may not work.

“Every would-be buyer of mortgage-related securities will have to review portfolios with enormous care. It won’t be good enough to just apply the JPMorgan Chase percentages or the percentages from the Merrill Lynch deal. One can see investors looking at delinquency and foreclosure rates, loan age and also geographic concentrations, down payment data, equity, income, credit ratings, sale terms and other factors. A lot of loan servicers, accountants and attorneys are going to be working nights and weekends to get the work done.”
As an example, the surprise in the WAMU deal was not the high default rates for subprime or option ARMs, rather it was the huge losses associated with home equity lending.

For months lenders have been cutting off access to home equity lines of credit (HELOCs) and reducing available credit levels. Combine WAMU’s high loss percentage (23 percent) and the enormous amounts outstanding and suddenly there’s a new problem to consider: Could it be that borrowers who now appear to have good credit have been living off their credit lines? If that’s the case then bigger problems loom ahead.

Hopefully the WAMU portfolio is not typical, otherwise Uncle Sam may need a lot more than $700 billion to refashion the marketplace. At the same time, the Merrill discount may be too steep for owners without a pressing need to sell their mortgage paper.
Peter G. Miller is the author of the Common-Sense Mortgage and is syndicated in more than 100 newspapers.

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