Let the Current Bailout Die

This piece was published on The Aleph Blog and is being reprinted with permission for RealMoney subscribers.

I'll start with two stories, to illustrate my position on the bailout. Recently I did some consulting for a financial institution that held the single-A tranches of several trust-preferred collateral debt obligations that had commercial mortgage-backed securities, REIT debt and a lot of junior debt from bank, mortgage and housing-related names. They wanted to know where I would market the bonds at year-end 2007. I created a really complex simulation model with regime-switching for credit migration, to simulate how creditworthy the underlying bonds would be.

These bonds were on the cusp; the value of the bonds would vary a lot depending on the assumptions used. The bonds below the single-As in the securitization were all likely to eventually default. All they are worth is the value of interest they will get paid before the securitization shuts them off, plus the warrant value if things improved dramatically. The bonds above the single-As were very likely money good. Losses to the AA and AAA bonds were a remote possibility.

After estimating likely cash flow streams, I tried to estimate where a single-B bond would trade in that environment; that is, if it would trade. I estimated that it would need a 20% annualized return, leading to a dollar price around $35 on a par of $100. The bank pushed back in two ways, suggesting that my discount rate was too high, suggesting that I use 10% (price $65), and they trotted out another analysis from one of the subsidiaries of the rating agencies that was incredibly lightweight, suggesting a price of $85.