Tuesday, February 24, 2009

Why deflation is so terrible...

Eric has a good illustration of how deflation can be a big problem:

I am a bank. So, I have a loan, an ABS [asset backed security] on a home [worth] 300K at 4%;
it's a performer, made to a borrower paying back at full value.  is it toxic?

Well the value of the home is now 230K, but the borrower is still paying it back at 3%.
so that is $1432 coming in every month.

But... at best it has to be written down to .76 on the dollar.
Now it still is $1432 coming in every month..

but the thesis is, I need to get rid of it.... "Get the Toxic Asset off my books", ie Mark to market....

If I take 230K... the value of the bond, which pays 230K at 3% over 30 years.
Right now I can buy Corporate debt AA at 6.86% over 20 years

Which means that the Market rate for my Money the 230K is Twice what it is in my ABS, and the credit risk is much less.

so if the Market rate for my money is twice that of what I'm getting. Then my ABS at .76 cents on the dollar... Is solidly 10-20% below .76 So now the Fair value is .60cents on the dollar.

So if I sell it, I get...$180,000, but it is returning $1400 per month over 30 years. That is $515520 Yield to maturity.

I'm taking 30% of it's yield to maturity value.... Why would I do that??? to make the market happy.

this is very simple look. and there are Tranches, and some mortgages that are not performing, and some ABS that are not at full yield, and will probably only return half of the money. There are some Very bad assets...

but the real problem is that the Value of money has come up, and that instead of bonds at 3% yield, we now have better quality borrowers who will now borrow money at 6-9%. That is where this "Mark to market" thing isn't working.

It's one thing to let the vultures feed, and it's another to Kill someone to Let them feed.

My response:
Excellent illustration. One of the assumptions is that the mortgage holder will continue to pay the $1432 per month and thus the ABS is "secure."

The problem is that assumption may be faulty. The only way the guy can make the $1432 per month is if he remains employed, and his wife also remains employed full-time and her employer is cutting her hours and his employer is laying people off.

Furthermore, this is a non-recourse loan so if the mortgage holder defaults he does not need to file bankruptcy (unlike other loans)... little moral hazard. And he doesn't have any equity in the house anyway, so he'll just walk away.

Sure he needs a place to live, but heck there are tons of houses on the market and someone will surely rent him one for $800 per month after he forecloses.  Then asset prices like houses fall further in a vicious cycle.

So the "S" in the ABS illustration is not very "secure." The $1432 and $515,512 is a big, 
big assumption.

That is exactly why deflation is worse in some ways than inflation, and it shows why the president's three pronged plan to bolster the banks AND stimulate the economy to save jobs AND immediately help homeowners to prevent foreclosures is important.  If any one of those three legs of the stool fails, the whole stool falls. And once foreclosures start, the pace will quicken and be relentless.

Does it suck?  Sure it does, but that's life.   The Rick Santelli's of the world think that we can all live in isolation of the other actors in the economic system and that is a lethal assumption that could damage the system even more than it is already damaged.

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