Mortgage Backed Securities Bailout

David Stout in the NYTimes today, "Paulson Explains Need for Plan to Buy Mortgages"

Paulson reasoning that this needs to be done, and is far more than a rescue of Wall Street, but is needed to protect ordinary people:

“Their retirement savings, their home values, their ability to borrow for college” and their chance to find and keep good jobs depend on it, he said.

The plan seems to be for Fannie and Freddie to purchase toxic Mortgage Backed Securities, and thus create a market where there really isn't one.

This may actually be a brilliant plan for intervention. It helps address one of the underlying problems of the credit market turbulence--large institutions were unable to liquidate their holdings--at all (partly because there is really no way to accurately value the paper). In steps the government (through Fannie and Freddie), and suddenly there is a market for this paper, and the institutions can liquidate their positions--instant liquidity!!! This is great, as credit has tightened, and everyone needs cash to operate.

Where the rubber hits the road is the valuation of these assets. This is also where it will be determined if this is a bail out of irresponsible firms or a measure to protect macro-stability. If the government pays too high a price, it will in effect be providing free insurance to the firms who made the bad bets in first place. This issue is extremely problematic because one of the reasons there is no private market for this paper is there have been few people willing or able to value the paper. So, if no one in the private market has been able to, how will the government undertake this task????

The upshot: It's a great idea for the government to buy this paper, but what is the appropriate discount???

UPDATE Freddie/Fannie CDS

Follow up article by Ms. van Duyn at the FT.

CDS triggered by US action on Fannie, Freddie

Aline van Duyn at the FT has a piece of reporting on the effect of US intervention at Fannie and Freddie.

Apparently the act of being placed in "conservatorship" is equivalent to bankruptcy, and triggers many of these "insurance" contracts. The International Swaps and Derivatives Association (ISDA) is working on a protocol to address the situation.

This protocol will likely allow adherents to amend the documentation of their contracts, most likely (if past practice rules) to take advantage of some auction pricing mechanism.

Depending on the specific documentation (I haven't seen any) there could also be disputes over whether the "conservatorship" was actually a triggering event. Whether something actually constitutes a triggering event can be a notoriously tricky question.