By Arnold Kling
Now I just have to figure out how the “hold to maturity” price is to be determined, and how purchasing at that price minimizes losses.
Suppose that you owe $110,000 on your mortgage, due in one payment a year from now. The “hold to maturity price” is that $110,000, discounted back to the present. At an interest rate of 10 percent, the price is $100,000…..NOT!
The fair price depends on the probability that you will default. If there is a 50 percent chance that you will default, the fair price is more like $50,000.
[UPDATE: To keep the example simple, I did not talk about the mortgage lender recovering some of their loss by selling the property. Including this factor makes the example more realistic, but it also complicates the arithmetic without adding anything to the point. However, since commenters brought it up, let me add this. Historically, about half the loss is is covered by selling the real estate, although in this market my guess would be that the recovery rate is less. If you can sell the property for $50,000 in case of default, then the value of the mortgage asset is approximately $75,000.]
The probability that you will default depends on the distribution of possible paths of future home prices. Along paths of falling home prices, defaults are much more likely than along paths of stable or rising prices.
It’s hard to know how home prices will behave, but right now if I were pricing the risk (something I used to do for a living, unlike the key decision-makers in this bailout), I would include a lot of paths where prices go down. That would make the “hold-to-maturity” prices of the mortgage securities, properly calculated, pretty low in many cases.
I sure hope that Bernanke and Paulson know what business they’re getting into. Part of me thinks they don’t know. Part of me thinks they don’t even care. They’re so desperate to try to make the mess go away that they don’t think little details matter.