What Are We About to Buy for $1 Trillion?

On Sept. 18, Treasury Secretary Henry Paulson announced that he would seek approval from Congress to create a new government entity to buy assets from U.S. financial firms, to relieve those companies of their debt and prevent a collapse of the Western world's financial system. Paulson repeatedly referred to the new entity as the "Troubled Asset Relief Program," or TARP.

A skeletal planleaked by the Treasury specified $700 billion, but that's not a total number, only a limit for any one time. The consensus: at least a trillion.

News reports talk about buying bad mortgage debt, but the plan is broader than that and may encompass all kinds of so-called "Level 3 Assets." What are they? On filings with the Securities and Exchange Commission, in quarterly and annual reports, the volume of "Level 3 Assets" had been ballooning for more than a year. According to the companies holding them, "Level 3" means "hard to value." According to people who do not hold them, "Level 3" means "toxic waste."

So who is right(er)? To figure that out it helps to understand what actual assets are deemed "Level 3" and why. Here's the list:

%u2022 Mortgage-backed securities (these can be high-interest residential mortgages or AAA-grade commercial mortgages, or anything in between);

%u2022 other asset-backed securities (business debt backed by inventory, for example, or by accounts receivable);

%u2022 credit derivatives (credit default swaps, options, currency futures, and various contracts based on these and other things--very tricky);

%u2022 real estate (buildings and land--or the actual mortgages on same);

%u2022 private equity stakes (venture capitalists routinely invest millions for periods of three to seven years in companies that do not trade on stock exchanges; some go bankrupt, others grow wildly and profit investors handsomely--hard to know which is which until the dealing's done); and

%u2022 certain customized corporate debt instruments (these are loans and similar deals not backed by collateral that the company holds; they don't trade on any market, hence they're hard to value).

Now that we know what they are (sort of), understanding why they are "hard to value" becomes easier, though it's still a bit of a guessing game. Real estate directly held, for instance, may not be traded on the market like stocks, but its value can be inferred by how similar property is doing. Private equity stakes are a bit harder to price but can be valued over time with a little spadework. These (and other) items are Level 3 because of specific accounting rules, and the thing to know is that they're not really the problem.

That leaves mortgage-backed securities (MBS) and credit derivatives. These are the things that caused the blowup, because they used to trade freely and used to be marked to market, or marked to someone's best guess (or model) about what the market would pay.

These instruments became "hard to value" only when they lost value. Take the MBS market, for example.

A mortgage-backed security is more (or less) than just a bundle of mortgages piled into a bond. To make an MBS, financial engineers first bundle up lots of mortgage notes paying similar interest rates, but they then subdivide them and sell off bits--called "tranches"--according to who wants to get the most interest (and take the most risk of default). (There's way more to this, details courtesy of Tanta @ Calculated Risk here, here, and here.)

So the safest tranche--the person who gets paid first--might be only getting, say, 4 percent interest. The riskiest tranche gets maybe 8 percent, but the owner of that gets paid last. As soon as more people than expected start defaulting on their home mortgages, Mr. Risky Tranche starts losing money, while Mr. Safe Tranche is still safe, or relatively so.

The problem comes in because the holders of these tranches used them as collateral to borrow even more money (and buy more MBS). If the credit rating of a tranche falls, the holder of that tranche has to come up with more actual money; otherwise the lender will demand repayment immediately. In this way, even tranches made up of loans that are still paying on time have contributed to the financial meltdown.

These downgrades started happening more than 18 months ago, and their values fell in tandem because lenders in the market knew they were all similar. As confidence in the value of the mortgage-backed bonds withered, the holders of those bonds took write-downs on their value and had to raise more capital--more real money--to stay solvent.

Meanwhile, some investors wanted to buy these bonds. But like a "We Buy Houses for CA$H" bottom-feeder who offers you $100,000 less than you're asking for your house, the vulture investors were offering in the neighborhood of 25 percent of the face value of these mortgage-backed bonds.

Now the bond-holders were in a fix. If they "marked" their bonds "to market," they'd have to write down huge losses--twice what they already had recognized--and raise hundreds of billions in new capital. The companies did not believe the bonds were worth so little, so they started moving these bonds into their Level 3 pile, valued them at, say, 75 percent of face value, and tried to wait out the vultures.

More vultures came.

To get an idea about the volume of this shift, consider the case of Merrill Lynch. In May, Merrill announced in a filing that it had increased its Level 3 assets by 70 percent over the previous quarter, from $48 billion at the end of December 2007 to more than $82 billion at the end of March. The firm cited "uncertainty resulting from a drastic decline in market activity for certain credit products."

Goldman Sachs upped its Level 3 notes to $96 billion at about the same time.

Here are some charts of the level 3 "assets" held by major players, as of last quarter. Little should have changed by now, but, of course, Fannie Mae and Freddie Mac were effectively nationalized, as was A.I.G., so that debt has shifted somewhat onto taxpayers' balance sheets. Then and Lehman went bankrupt and Bank of America bought Merrill last week in a distress sale.

The total there (which is incomplete) is about $800 billion, not including Fannie and Freddie and A.I.G., which are already under the TARP. Note that CitiGroup leads all comers with about $160 billion. But they're so big, no one seems to notice. As a percent of equity or as a percent of total assets, CitiGroup's L3 holdings exceed (effectively bankrupt) A.I.G.'s.

Now, some of these tranches, even those backed by subprime mortgages, are still going to pay off. As of July, subprime defaults were only about 14 percent. The tricky part in evaluating this whole steaming pile is figuring out which "assets" are backed by actual assets and which are derivatives--shadows of assets, essentially used losing lottery tickets. It appears that a lot of L3 paper is of the latter variety.

To see why, look at the percent-of-equity charts. Those are not misprints: Citi's L3 is about 200 percent of equity, and equity means, basically, "actual money."

All this means is that every player in the financial world borrowed many times their actual value in order to "invest" in stuff like your home mortgage, or bet on your ability to repay it. But with mighty leverage comes mighty risk, and now that mortgages are being repaid at much lower rates than those assumed by the financial engineers who devised all the complicated debt structures now classified as L3, nobody--except We the Taxpayers, apparently--has the cash on hand to settle up all these contracts.

What? You say you don't have the $4,000 on hand to toss under the TARP?

No problemo! The government will just borrow it for you. If you don't pay it back, your kids will.