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Merrill Toxic Asset Sale May Present Model


As we just heard, Treasury Secretary Geithner announced plans to use both public and private money to buy up those so-called toxic assets. Those are the assets mired in bad mortgage securities. The idea is to take those debts off the hands of the banks that are holding them. So, how might that work? And could this public-private partnership actually stand to make some money? We're going to put those questions to Simon Johnson. He is a professor at MIT, and a former chief economist at the International Monetary Fund. Welcome, Professor Johnson.

Professor SIMON JOHNSON (MIT; Former Chief Economist, International Monetary Fund): Thanks for inviting me.

BLOCK: I want to talk to you about one key component of these toxic assets, and those are what are known as collateralized debt obligations, or CDOs. Why don't you explain for us just what those are?

Prof. JOHNSON: Well there's a variety of troubled assets out there. It's all kinds of loans that have gone bad, and the various structures, or debts, built on top of those loans. But, in the essence, it's mortgages that people have defaulted on because the house prices have fallen and they walked away. And, of course, now we have businesses defaulting on commercial real estate, mortgages and on other loans. So it's spreading throughout the economy.

BLOCK: And the CDOs might be a, sort of a conglomeration of a bunch of different bad mortgages as I understand this, right? I'm trying to figure out how someone would get a fair value of what this might be worth.

Prof. JOHNSON: Well the CDOs are one of the more complicated versions, and they are difficult to value. However, people who are in this market do say that you can sell things, you can get prices, and you can at least figure out, roughly, what these securities are worth. So, I would say the inability to value these securities has been greatly exaggerated.

BLOCK: There is one buyer out there who has been running some kind of experiment with this, and why don't we talk about that example. This is Lone Star Funds. What can you - explain to us what they have been doing over the past year.

Prof. JOHNSON: Well, we don't know all the details of these transactions. But, what we do know - and there's a particular prominent transaction that they did with Merrill Lynch - is they bought these toxic assets at a fairly substantial discount with - this is very important, and, I think, a model for Mr. Geithner - they got a big loan from Merrill Lynch. So, roughly speaking, they put 25 percent down, and they got financing for 75 percent. It's like if you buy a car at $10,000, you only put $2,500 down; you get a loan for $7,500.

Key point here is, they're able to walk away from it. So, if they decide that the value of these securities has gone down further, they are only out of pocket the $2,500. So, it's called nonrecourse loan, and it's quite a good deal for Lone Star in the sense that they get all the upside if this toxic asset turns out to be more valuable than what they paid. And if it goes down in value, there's a limit on what their losses are.

BLOCK: And who is assuming the risks then, if it wasn't Lone Star?

Prof. JOHNSON: Well, Merrill Lynch is still holding some of the risk. And we don't know the exact structure of who received what interest payment, so it's hard to value exactly. But, if you took the same scheme to Mr. Geithner's proposal, it would basically be that the taxpayer will be financing private investors coming in, buying these assets from banks. And it would be the taxpayer who is holding a lot of the residual risk.

BLOCK: If you assume that a private-sector company - maybe a hedge fund - has bought some of these toxic assets, how do they then turn around and sell them at a profit?

Prof. JOHNSON: Well, that's a great question. One thing they might do, of course, is hold them to maturity. So, these are - underlying them is mortgages. And the mortgages are either going to be paid off by people early, or they'll service the mortgage throughout the whole duration - a 30-year mortgage will be paid off over 30 years, for example. So you could hold on to these things and you can get the cash flow, the interest and the principal payments, that come from them. And you may be happy with that.

Of course, it's also possible that the macro-economy turns around if the fiscal stimulus is effective, if the other measures put in place to support the housing market are successful - then that, by itself, may reduce default rates, moving forward. And these securities reflect expectations of future defaults. So, it's possible you buy them one day and flip them a week later, and make some good money.

BLOCK: Not a lot of detail from Secretary Geithner today about how this partnership would work, but would you assume that he's looking at that example of Lone Star and Merrill, and using that as a model for what he wants to happen here?

Prof. JOHNSON: Yes, it is very much the conversation piece for people who are trying to design this kind of transaction. And I think it's a benchmark for all the discussions.

BLOCK: Well, Professor Johnson, thanks for sorting through this with us.

Prof. JOHNSON: You're very welcome.

BLOCK: Simon Johnson is a professor at the Sloan School of Management at MIT. Transcript provided by NPR, Copyright NPR.

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