Last week U.S Secretary of the Treasury Henry Paulson extended the biggest lifeline to the financial markets of all time - and perhaps made the biggest gamble with U.S. taxpayer money - when he announced a plan to purchase approximately $700 billion in troubled assets from U.S. financial institutions.

While the ABS market reacted positively to the news, the plan's impact will be determined by the pricing of illiquid assets, something the credit markets have been grappling with for more than a year now.

On initial news of a proposal on Friday, Sept 19, market participants expected that prices in the non-agency MBS market would start to rebound, as a government intervention could take some of the supply overload off the market.

When the initial announcement was made, the 'AAA' ABX rallied about two to three points, though still ended down approximately a point on the week, according to data from Merrill Lynch. CMBX super-senior 'AAAs' were about 35 basis points tighter on the week, and junior 'AAA' classes, or 'AJ' classes, were about 140 basis points tighter.

Presently, there is approximately $11 trillion in residential non-business home mortgages outstanding in the U.S. Of those, about $5 trillion are either guaranteed by Ginnie Mae, Fannie Mae or Freddie Mac, or are already owned as loans by the GSEs, according to data cited on a Merrill Lynch conference call held last week. This leaves around $6 trillion in non-agency MBS, and about 40% of those are securitized. The rest are in whole-loan form.

On the commercial side, there are approximately $3 trillion notional of commercial and multi-family mortgages and about 22% of those are securitized, Merrill said. This means, in total, there is between $9 trillion and $10 trillion in non-agency residential and commercial mortgages. The scope of the government's plan will translate into around $1 trillion in the face value of these mortgages if they are bought at distressed prices, Merrill Lynch said. This equals about 10% of outstanding non-agency residential and commercial mortgages.

Over the past year, investors have been reluctant to purchase securities like subprime or option ARMs given the risk of further deterioration in the housing market and the rising unemployment rate. "The market depends on confidence and the sense that this collateral is not all of a sudden going to be worth a fraction of what it used to be," said Glenn Boyd, director and head of U.S. securitization research at Barclays Capital. "If I buy an option ARM, the chance that it drops 20 points in a week is now a lot smaller."

Furthermore, previously frozen sectors could potentially become relatively robust two-way markets if Treasury asset managers selectively resell securities into stronger hands, such as distressed debt funds under pressure to act before markets recover, according to a recent report from Barclays.

Pay to Play

But market participants do not expect the Treasury to buy back troubled loans or securities at par, and it is this uncertainty about valuation that will challenge the effectiveness of the TARP program.

"It simply boils down to what price they are willing to pay," said Mark Adelson, chief credit officer at Standard & Poor's. He noted that it is the different valuations of these assets that have caused them to be illiquid. "The ones who are bidding want to have the upside on their side of the trade so they want to bid using conservative or adverse assumptions about the amount of losses that will come in. And the sellers on the trade want the upside for themselves. They don't want to sell it at a low price and give all the upside to the buyer."

As the plan was being outlined last week, it was unclear what bidding strategy for purchasing distressed assets would be employed by the yet-to-be hired asset management firms that would run the Treasury program.

In his opening comments before the Senate Banking Committee last week, Federal Reserve Chairman Ben Bernanke assured the market that asset values would not be driven down too low in the purchase process.

"Banks will have a basis for valuing those assets and will not have to use fire sale prices," he said. "Their capital will not be unreasonably marked down."

But there is still market concern that if the government bids on bonds at a lower price in order to keep the upside for the Treasury, it would mean a loss to a participating financial institution, and that may dissuade a given institution from taking part in the program. This, in turn, would reduce the breadth of the plan's impact. However, if the Treasury bids at a high price for the bonds, the taxpayer will be left in a more speculative position.

Furthermore, different institutions will likely have very different cost bases in these securities, Merrill Lynch said. Financial institutions that have purchased securities more recently may be able to sell to the government at a profit, whereas those who purchased years ago at par might have to take a significant write-down. As a result, these institutions may not be willing to participate in the plan if prices are too low, since participation would have a significant negative impact on their balance sheets. The bank also noted that some holders of non-agency MBS and loans have likely marked their positions more than others, and may be more likely to be able to participate in a Treasury program.

The Devil's in the Details

The idea, in theory, is the same as the Resolution Trust Corp, (RTC) set up in the late 1980s to buy mortgage securities from struggling savings and loan institutions, but the types of the troubled assets in question differ dramatically. In the original RTC program, the assets, purchased were primarily owned by U.S. financial institutions. They were basically all the same types of assets and they weren't reconstituted into several structured products for each underlying asset. However, in the new program, the types of assets are much more diverse and globally widespread.

Also adding complexity to the program is the way assets will be purchased, which could put pressure on price discovery. One of the ideas mentioned in the initial release of the plan was buying troubled assets through a reverse auction.

However, reverse auctions are associated with a lot of downward pressure on the underlying assets being bid out, which could result in a self-reinforcing process for the market, said Brian Yelvington, senior macro strategist at CreditSights. "If you have banks come in and offer to sell assets, then the winning bank is going to be the lowest offer or some combination of the lowest offers. The question that remains is: Are the banks that didn't get those assets off their books required to write down those assets?" he said, which could cause a deeper depression. This is because now such securities have a clearing price and are no longer considered 'level three' hard-to-value assets.

However, the contrary could also be true if a reverse auction resulted in prices higher than those previously marked, allowing financial institutions to actually write up asset values. "It is not clear how this mechanism is going to work and how the accounting value is going to work," Yelvington said.

There is also the question of how assets will be chosen, since many of the structured products in question are custom in design. This will make it difficult to decide which products would be most helpfully taken off bank balance sheets first, market participants agreed.

Barrier to Entry

Obstacles will remain despite promises of liquidity. New MBS issuance might take longer to come back, even under the Treasury plan, given its dependence on the fundamental economic outlook. While the Treasury proposal should improve liquidity and make institutions more comfortable extending credit, "as long as people are concerned that housing is going to continue deteriorating, it will be difficult to get investors to pay par for newly issued securities," Barclays' Boyd said.

The plan has faced challenges from the start; many of the details had not been fleshed out in Congress as of press time. Questions include a proposal to include a bankruptcy "cram down," or the ability to allow judges to reduce the balance owed on a mortgage and to rewrite the terms of mortgages.

A consortium of trade associations sent a letter to Congress, urging it to drop the proposal on the basis that not only would these mortgage writedowns increase the cost of credit and reduce its availability for consumers, it would only fuel the credit crunch by making MBS harder to value and sell, the group said.

Instead, allowing the Treasury "flexibility" to make loan modifications could still keep homeowners in their homes, reducing REO inventories. According to a Barclays model, in the hardest hit regions of the U.S., like California, Florida and Arizona, REO overhangs are a dominant driving force on depressed home prices.

Industry organizations that signed the petition to Congress include the American Bankers Association, the Mortgage Bankers Association, the American Securitization Forum, the Securities Industry and Financial Markets Association, The Financial Services Roundtable, the Housing Policy Council, the U.S. Chamber of Commerce, the American Financial Services Association, the Consumer Bankers Association, the Independent Community Bankers of America, the Manufactured Housing Institute and the National Association of Home Builders.

As of press time, only a general agreement proposal had been reached. Speculation was that cram-downs would not be implemented in the bill but there could be limits on pay packages for executives participating in the plan and a potential for funding to be given in increments.

(c) 2008 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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