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Why Banks Are Screwed--an Illustration

The FT has a great piece sorting through how much the banks' mortgage-related assets might be worth. The answer for the particular assets it looked at: not much. The highest-grade stuff came in at about 32 cents on the dollar; the mid-level stuff at about 5 cents.

As Paul Krugman points out, people who think the banks can recover without something drastic like nationalization believe the banks are fundamentally solvent, just victims of a short-term market panic. Or, as Krugman puts it, that an “'irrational despondence' [has] led to an undervaluation of these assets, and that if we can just calm things down and get cash flowing again all will be well." But if the FT piece is right, it's hard to believe those assets will ever be worth anything near what the banks say they're worth, which means the hole in their balance sheets isn't going away.

As another illustration of this, consider an example I got from Orin Kramer, a hedge fund manager and prominent Obama supporter. Kramer has a friend who recently bid on a bundle of home-equity loans the government was auctioning off (presumably after having seized a bank that owned them). The homeowners in this case weren’t subprime deadbeats but people with solid credit histories who were scrupulously making their payments. Still, the friend was the highest bidder at a measly 14 cents on the dollar—and, Kramer says, “I have another friend who claims he overbid.” (The government decided not to sell because it didn't like the price.)

This might sound like a classic "irrational despondence" issue—only 14 cents on the dollar for a bundle of perfectly upstanding loans? But there’s one big problem, as Kramer points out: None of the homes have any equity left in them. Thanks to the cratering housing market, these people's first mortgages exceed the value of their homes, which makes them good candidates to simply stop paying (both the original mortgage and the home equity loan).  

Of course, if nothing else, this example illustrates how critical the Obama administration’s housing plan is—both for homeowners and the banks. One provision helps underwater homeowners refinance, so they can at least lower their monthly payments. (You’re much more likely to walk away from your home if you have zero equity and an unaffordable mortgage, as opposed to just zero equity.) The plan could create a floor under the value of all the mortgage-backed assets, though it's unlikely to give them much of a boost.

--Noam Scheiber