I just need to get this on the blog so I can come back to it and try to understand what's going on.
Here’s how it all adds up: There are about $3 trillion of non-agency mortgage-backed securities outstanding. For the sake of simplicity, let’s say that 65% are so-called AAA’s, and all are selling around where the ABX index is selling, or 35 cents on the dollar. That’s about 35% times 65%, or $682.5 billion of market value. The banks buy all of them. Over time, half of the non-agency (not guaranteed by the federal government) mortgages default, and the houses sell for 50 cents on the dollar (which is where the market seems to be clearing). With recovery costs, etc., the securities ultimately pay 75% of face. The $682.5 billion investment is worth $1.4625 triillion, or an increment of about $800 billion. That’s roughly what the banks have to write off this year.
That’s how the banks replenish their capital, provided, of course, that all the hedge funds and other prospective investors don’t get any. In fact, there’s plenty of other cheap paper out there, including $2.8 trillion of asset-backed securities and $1.3 trillion of Collateralized Debt Obligations. And if that doesn’t work, there’s the good old curve trade: with funding at 0%, banks can buy agency MBS and clip the coupons.
The trick is to keep asset prices low enough for the banks to buy it on the cheap, which sadly means bankrupting most of the hedge funds. Of course, the banks already own a ton of devalued paper, and a bit of creative accounting (of the sort proposed variously by the Group of 30, by Deutsche Bank’s Mike Mayo, and others) is required to paper over the insolvency of the system. The banks, as Goldman’s analysts said, becoe a public utility.
To get the securitized asset market moving again, first you have to find a home for all the miserably devalued securitized assets out there.