Wednesday, October 8, 2008

Jeremy Siegel's take on the bailout

Wharton Business School finance professor Jeremy Siegel gives his thoughts on TARP:
It is possible that the plan can be a "win" for both taxpayers and banks. One of the central tenets of economics is that a trade often involves gains to both parties and this is no exception.

The collapse of the housing market has sharply lowered the price of real estate, so many of the mortgages and securities issued against homes are now "under water," or worth less than the value of the house. If a lender wrote a $300,000 mortgage on a house that is now worth only $150,000, the "intrinsic" or underlying value of the loan is now 50 cents on the dollar. ...

But in these stressed times, the lot for mortgage lenders is even worse. Because of the current illiquidity of the mortgage-backed security markets and the confusion of ownership rights of some of these complex securities, investors are willing to pay only 30 cents on the dollar or less for an asset with a 50 cent intrinsic value. It is in this situation where the government has an opportunity to improve the lot of the buyer and seller. The Treasury has the ability to hold these assets until the mortgage is restructured in order to realize the intrinsic value of the loan.

This does not mean a recovery of 100 cents on the dollar, but, if the government can buy the loan for 40 cents, it can still receive a good return on the investment if prices eventually rise to only 50 cents. In the meantime, the financial institution has swapped a distressed asset for a highly liquid security.

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