Questions about the ‘Economy Bailout’

President Bush just gave his speech on the ‘economy bailout’.  From his description, it sounds like the federal government will buy up the mortgage backed securities – up to $700B worth of them.  This amount was calculated by taking 5% of the total amount of mortgages nationwide – assuming that the nominal default rate is 5%.

I have some questions – to be fair, his speech was only 12 minutes long and the subject is complicated.

Let me setup an example for use in our discussion.  Let’s say that Fred bought a house a few years ago and financed it with an 80-10-10 program through Countrywide.  Suppose the house sold for $500K, so the mortgages were $400K, $50k, and $50K.  After 2 months, Countrywide sells the second position note to GMAC and the third position note to SunTrust.  Each of these companies assembles packages of 1000 notes each and sells them to the market. 

Let’s further speculate that Mary’s retirement fund bought partial ownership of each of these mortgage backed security packages for a $1 million investment.

Fast forward a bit and Fred loses his job and stops paying on all three of his mortgages.  A few months later and we have reached today.

Nobody is trading mortgaged backed securities anymore and supposedly Mary’s retirement fund has lost $1 million in value.  The still own the packages, but they don’t have any sale value – although they should still have payment income.

Let’s say that Fred’s house is now worth $350K because the market has turned bad in his area.  If the first note forecloses, the starting bid at the auction will be what is owed to the lender (a bit over $400K because of fees and arrears owed).  If there are no bids, title will transfer to the first note holder and the second and third position notes will be wiped out.

If Fred tries to sell his house and gets an offer for $350K, then the lenders will need to agree to accept less than they are owed – this is known as a short sale.  Often, the first will want the majority of the money and the second and third note holders will agree to accept nominal amounts (better than being wiped out at auction).

So, here are my questions:

• When the packages were assembled, my understanding is that a variety of notes were included – different positions, different qualifications (credit score requirements, loan to value ratios, etc.).  If so, then why has the value of the package gone to zero?  Isn’t there still a cash flow (payments) from the performing notes in the package?
• Is the government going to buy entire packages or instead extract the ‘toxic’ defaulted notes out of the packages?
• Bush indicated that the government is one of the only entities with enough patience to hold these securities until the time when they will again have value.  Does that mean that they are going to foreclose and hold the houses?  Does that mean that in the case of junior position notes that they will prevent the sale / foreclosure of the property?  Will they participate in short sales and take nominal amounts for junior notes when the offer requires it?  If they prevent the foreclosure, do the ‘owners’ get to continue living there for free?  Do you think that would be popular?
• Anybody who has been involved in short sales can tell you that part of the problem is the long delays by the lenders.  It is not uncommon that Fred’s offer would take 4-6 months for the lenders to approve.  This limits the ability to sell the property since a lot of buyers do not have the patience to wait that long.  Streamlining these processes would increase the pool of potential buyers, increasing demand and therefore increasing the potential sale price of all of these properties.  Will the federal government process short sale requests quicker?  How about loan modifications requests?

Anybody else have questions you want to add?