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Forgive a portion of the underlying debt

It's not too late to enact a better plan than the one the Treasury has put on the table. Peter Lee looks at alternative strategies that might prove sharper than Paulson's bailout plan.

Fix the underlyings

Tim Bond, head of global asset allocation at Barclays Capital, pointed out in a research note on September 25 the size of the gap between present market prices for often synthetic securities derived from mortgage indices and derivative instruments and the underlying value in actual mortgages to real homeowners. “The ABX 07-2 CDS index currently implies a 45% total loss in the underlying mortgages. If we assume a recovery rate somewhere around 50%, the price is therefore suggesting that around 90% of the mortgages will default.” In the real world, he points out: “Total sub-prime foreclosures are currently running at 11.8%, with seriously delinquent loans at 17.9%, according to the MBA.”

The problems of US banks stem from the collapse in values of homes, an asset class, like all others, hugely dependent on the availability of finance for buyers. Declines in the value of mortgage loans have been further amplified through vast holdings of securities and synthetic instruments that reference them as underlyings.

So it’s worth considering how much it might cost to fix the underlyings. The Federal Reserve suggests that total US household mortgage debt reached $10.126 trillion in June 2008, although this excludes home equity loans.

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