Am I getting it? HUGE thanks for the help!

The difference here is “market prices” seem out of whack with “hold to maturity” pricing as I described above, where you value a bond based on default rate, loss severity, etc.

It is quite complicated and I don’t like the idea of a bailout etc, but I don’t think it’s the end of the world either. It could very well have long-term effects on our economy, and not for the betterment of it, but well, life is hard, not a rose garden, etc etc.

Since it’s so complicated and there seems to be so much at stake, not understanding makes it all the more frightening. So, very much appreciate the explanation.

Let’s say you have a $1B set of mortgages made to 10,000 people for $100,000 each. Let’s say they’re all 100% LTV for sake of argument and pretty low-rated paper.

Let’s say you foreclose on 50% of them, and you have a 50% loss severity (i.e. you only recover $50,000 from the sale of the house). What would you buy that tranche of loans for to break even on the underlying asset?

If you said $750M, you’re correct ($500M foreclosures, recover $250M of that). But wait, the notes bear interest too, and if you bought at $0.75 on the dollar, you’re probably getting paid double-digit interest, which is probably appropriate considering these things are essentially junk bonds now. We’re seeing these things marked down to what I think are somewhat ridiculous levels, i.e. assuming that 90% of loans will fail, etc etc.

If the gov’t buys these loans at the recent marked prices (anywhere from a nickel to $0.22 on the dollar), I actually think it’s definitely possible the gov’t won’t lose any money on the deal over time. Using the above math, $0.20 on the dollar assumes some combination of, say, 90% default rate and 70% loss severity. If that’s the “real value” of this debt, stop what you’re doing, convert all of your assets to gold, buy a gun and a shack in Montana, because that’s the end, my friend.

If it’s not the end, then as long as the gov’t doesn’t pay $0.90 on the dollar, we’ll probably do all right.

1) True….then again, from 1929 to 1930 the market dropped…30%. Still twice as much as this year so far. And it dropped another 30% the next year. I’d also mention that the Nasdaq dropped over 80% earlier this decade; I don’t recall talking about a “Great Depression” redux back then. We’re also not 1 year into this bear market, we’re 7 years into this bear market. The markets were this same level back around year-end 1998/early 1999. We’ve already had 10 years of going nowhere in nominal terms in the stock market (and of course we’re 20%+off the peak of 2000). If you “bought the market” back 10 years ago, you did nothing but lose money to inflation. Soon we’ll say the same thing about housing.

2) Interest rates will eventually rise. When I see bond yields at 54 year lows (i.e. prices are at 54 year highs), I take the other side of that trade. Anything at a multi-decade high, I take the other side of that trade. That’s as close as you’ll ever get to free money.

3) CD laddering doesn’t have to be 1 year, 2 year. It can easily be 1 month, 3 months, etc. Naturally, you have 1-3 months of pure liquid cash on hand for emergencies.

4) Short-selling can be achieved through several alternative means. Put buying, for example, is still legal, even on financials. Single stock futures also are still working.

1. CD laddering has it’s own risks. Unlike a bond-ladder with, say, US treasuries, you cannot liquidate your positions without a large penalty.
2. Short selling is a bit risky now. The government has already declared shorting of financial institutions to be “illegal”. What’s to stop the government from outlawing shorting in general? In July the government outlawed shorting of financial institutions temporarily. That caused short sellers to have to cover their positions, resulting in a 40% loss for short-sellers in the matter of a couple of weeks! It did provide a false, temporary boost to the stocks of financial companies, though, which is all the government really cares about!

1. It took three years from peak-to-trough for the market to drop 90% in the Great Depression. There were several mini bull markets along the way! We’re only one year into this bear market.

2. Interest rates may decline if we go into a recession. You have to ask yourself, which is more likely: inflation or recession (or depression). It is not a foregone conclusion that interest rates will rise (in the short to mid range). I think interest rates will eventually rise.

There’s the last bit of free advice.