Why bailout makes sense

What it comes down to is that distressed assets are still assets - and there will come a time when they're not so distressed. Barron's has a good analysis of why Uncle Sam might actually come out ahead in this deal.

Treasury's purchases should not only help free up credit markets but boost the prices of securities that are backed by home loans. That, in turn, is likely to arrest the relentless loop of falling home prices spawning further mortgage defaults and foreclosures that, in turn, result in further declines in residential real-estate prices.

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Bill Gross of the bond-fund behemoth Pimco is even more upbeat. He estimates that the average price of distressed mortgage debt that will pass from troubled financial institutions to Treasury will be about 65 cents on the dollar, representing about a one third loss for the seller from face amount. Financed at 3% to 4% by the sale of Treasury debt, Treasury will be in a position to earn a positive carry, or yield spread, of at least 7% to 8% on the purchases, even after taking into account severe assumptions of default rates and foreclosure recoveries.

Here's another way of looking at it: Current losses on U.S. mortgage paper - that's the difference between face value and what these things could be sold for tomorrow - is about a trillion dollars. Some of that trillion is held by hedge funds and foreign institutions, which wouldn't be eligible for the program. So let's say that the maximum amount that could be sold to Treasury is about $800 billion. If the government buys that for 65 cents on the dollar, the price is $520 billion. "Then, assuming the housing and securities markets have stabilized somewhat, the government should be able to sell the securities for something more than 65 cents, recouping its initial investment and then some," writes Barron's. That doesn't include earnings from the investment return on the mortgage paper. (Gross figures it could total $75 billion).

As the buyer of last resort under the bailout plan, Treasury hopes to reverse market psychology. Rather than prices being set by the last panicked buyer attempting to get liquid at any price, they would be dictated by the actual prospects of the mortgages underlying the securities and the cash flow they throw off. This is what Fed Chairman Ben Bernanke was implying during Congressional hearings last week when he stated that the government would seek to shift the pricing in the mortgage-securities market from fire sale to "hold-to-maturity" levels. The latter, in accounting parlance, implies pricing close to par value or a holder's original purchase price.

Not everyone agrees with this optimistic scenario, of course. Thing is, the optimistic scenario makes sense. Here's a key point from Barron's: "What augurs well for the taxpayers' recoveries under the bailout is the yawning gulf that currently exists between the current market prices for mortgage securities and any value based on rational expectations."