First, I would like to make a clarification in my last blog article (The Acceleration Though the Turn Will Make All the Difference), in that I should have added an “S” to the word Fed (Feds) – relating to both the Treasury and the Federal Reserve.

The President recently signed HR 1424, “Emergency Economic Stability act of 2008”, creating a new office by the government titled, The Office of Financial Stability (OFS). OFS, attached to the hip of the Treasury and the Federal Reserve, will now oversee the Troubled Asset Relief Program, (T.A.R.P.). There are more than a few people that believe the name of the initiative should have been something more like the Captured Rancid Asset Program, (C.R.A.P.). Much of this sentiment is due to a misunderstanding of these assets, how they are valued and what the process will be for managing the $700 billion allocated thus far. Yes, a lot of these assets can be defined as crap, but I, for one, am very happy that the T.A.R.P. initiative has been approved (for the sake of the US and global economy) and now all that we need to do is successfully activate the mechanism – however, this is much easier said than done, of course.

Everyone seems to be a little confused about how the government will ultimately buy these troubled assets at a price that doesn’t “break the bank”. They actually buy them to ensure that the T.A.R.P. initiative is a successful program and ultimately frees-up the frozen credit markets. At the same time they pay a price that will allow the government to sell the assets for a profit at some point in the future. The issue itself is, in fact, price – Mark-To-Market – and that is at the very heart of the matter. The Genesis of the price is the actual piece of real estate, or collateral, that the Mortgage Note is attached to. The Mortgage Backed Security (MBS-Bond), for a lot of people, looks a lot more like a Magically Backed Security with all the media hype and the recent government intervention. However, this isn’t exactly the case and I would like to spend some time on the subject.

Think of it this way. If a Mortgage Note had zero value, that would mean the real estate it was collateralized by had zero value as well. If the government forecloses on a mortgage, then they will then have an opportunity to fix up the property and sell it to the public for a specified price. Whatever the property sells for is what the market price is. So, getting down to the brass-tax, there is a real value tied to each and every Mortgage Note that will be purchased and managed by the OFS.

Now, let’s take this up the chain a bit and start to reflect on the actual value of the Mortgage Note itself. Even beyond the real estate value that is backing the Note, each loan itself is an asset of sorts and has a value based on what the market is willing to pay for it based on the type, performance history, and available liquidity for it in the secondary market to transfer such loan assets around the financial system. As we are clearly aware, the liquidity that allowed for these type of loans to transfer around the globe pretty much dried up – and, in turn, they became stuck on the bank’s books – clogging the kitchen sink so that nothing could flow at all. Now the government is artificially “making the market” and ultimately providing the financial system with new liquidity to allow banks to sell the paper down the line. This does not only start to unclog the drain, it also allows for the market, and the bank, to set the new price, due to the fact that one of the missing components in valuing the asset has now been provided – and that is the liquidity to allow the loan to move into the secondary market – and that artificial market is now the OFS.

The Mortgage Note has a minimum value regardless – there is no question about that. Now, if you have a Mortgage Note that is held up on a bank’s books with a principle balance of $100,000, the home is worth $100,000, it is performing (meaning all payments are being made on-time), and there is no way for the bank to sell the loan into the secondary market – the bank then decides if it will simply keep the loan at an unknown value (due to there not being a secondary market and an unknown real estate factor due to a possible declining real estate market in the area). This, however, is problematic to the bank for a number of reasons. The two most difficult challenges are; first, Mark-To-Market calculations imposed by GAAP accounting regulations (General Accepted Accounting Principles) and the reports that ultimately need to follow to the regulators, etc. and second, the bank cannot tie up the cash and desperately needs it to lend to its customers; freeing up much needed liquidity for the commercial paper market, student loans, car loans, credit cards – you name it. The action taken by the government has literally created an ability for the banks to set the price, and have an outlet to sell the paper to ultimately free up cash. If the government did not create this artificial market, the banks that would be forced to sell the paper at any cost to free up liquidity and would ultimately be forced to sell the paper well under its actual real value. We’ve all been hearing the statements flying around about 65 cents on the dollar. This basically means that, based on the scenario above, the bank would be forced to sell the $100,000 Mortgage Note to someone, or some entity, for $65,000 – or much less depending on the bid. However, even in this scenario, the Mortgage Note, or the Mortgage Backed Security Bond (MBS) still has value – and finding the value has been the essential problem as of late.

Now that the government has made a commitment to create a market for the banks to sell the paper to – what will happen next? I think there is something very interesting and unpredicted in the near future that could stall the process a bit and not allow money to flow as fast as I, and everyone involved, would like. Think about this for just a minute – if the bank now can effectively mark the value – what happens if the value is high enough for the bank to balance its books, raise capital, and ultimately hold onto the Mortgage Note without selling it to the OFS for a loss? I don’t have the answer to that question – and, in fact, I’m still trying to figure out if that is a good thing or a bad thing.

On the good side, I would imagine that it makes it possible to double the effectiveness of the $700 billion pile of funds that the OFS will use to free up the markets. Or, it could cause a delay in the freeing up of liquidity due to banks not being able to give up that newly captured value on the books. You could argue that it is a good problem to have. I would guess that the media is going to flip from statements such as, “banks are in trouble due to not being able to value certain loans on their books”, to, “banks are troubled now that they can, in fact, value certain loans on their books”. I hope this does not slow the process of getting money flowing around the world to stabilize the economy and get all businesses in a stronger position to financially manage their going concerns with much needed bank lending support. If it does slow the process it may only be temporary – but, again, I hope that the delay doesn’t make us all a day late and a dollar short. Small businesses are being strangled by this whole mess and can’t wait much longer for a breath.

At the end of the day, mortgages do have value and a MBS is not necessarily a Magically Backed Security. I predict that the next set of challenges in this whole mess will be that these loans in question will now actually have marked value and then the tough decisions and bidding wars will begin to take root. No one really knows how long it will take for this to stabilize and what new challenges will arise – but I assure you there will be new and unforeseen potholes in the road ahead simply due to the fact that we have not exactly been here before and there is no effective way to deploy foresight in an artificial market. It is essential, however, that the government gets this right – which I believe they can. But for this market to ever be real again, the OFS needs to get in, help set the price, buy a bunch of these loans, clean them up and sell them back into the market – then GET OUT. The faster this can happen, the more stable the “real market” will become. The public and the business world need to be able to feel that it is on solid ground when relating to value. That is just not going to happen as long as an artificial secondary market is in place. However, as soon as the OFS steps out and all Mortgage Notes are being sold in the public market – at that time I think we will be headed down the right path.