As a follow up to my blog posting on September 27th titled "What Happened, The Market Implosion?", our Congress has now passed and the President has signed the bailout legislation providing $700 billion to purchased distressed mortgage backed securities. From all I have read on the subject, The US Department of the Treasury has been given great latitude in how it sets up the process to actually purchase these securities from the private sector and has been working on developing this process for some time, with support from the Federal Reserve, SEC, etc...

The key question is how to value these securities, since there is no market for them. There is a single buyer, the US taxpayer through the Treasury. There are valuation models including the Monte Carlo method and/or the Binomial Tree solution but these appear to be flawed in this particular situation.

One method I like which puts the responsibility on the organization that is looking to sell their mortgage backed securities to the Treasury is "Discounted Cash Flow" or DCF for short. It's transparent and would work as follows. The firm wishing to sell their securities to the Treasury would develop a forecast and fully document all their assumptions of the future cash flows of the security. This would be done based upon the terms of each of the underlying mortgages and would include amortization of principle (borrowers expected principle payments over the life of the mortgage), interest income based upon mortgage contract rates (including assumption of future rates for adjustable rate mortgages), borrower prepayments assumptions (generated when a borrower sells their property and pays off their mortgage early), and estimated reductions in cash flows for deferrals of borrower payments due to default and foreclosures.

Given this information, the Treasury need only decide what the taxpayer wants in return for agreeing to purchase the security and this is based the discount rate or interest rate that it will apply to the projected cash flows. The value of the security is simply the net present value of the projected future cash flows that the security will produce if held to maturity.

All of the above information can be maintained for each security in a database and used by the General Accounting Office (GAO) to provide a fully and transparent audit trail of how each security was valued including all the assumptions and what income or cash flow the security produced during the time the security was held by the Treasury and the value obtained when the security is eventually sold. The GAO can also easily calculate the return generated for the taxpayers in bailing out the markets.

In addition to transparency, the above approach might encourage private sector firms to enter into the auctioning of these distressed securities. For example, let's assume that Treasury decides it wants a return of 15% on the projected future cash flows of a specific security and bids a value based upon a 15% discount rate. Maybe Goldman Sacks or Warren Buffet would be willing to set a value on the security using a 12% or 14% discount rate. Since the lower the discount rate the higher the value to the seller, the final value would be based upon a rate of return set by the market.

I'm sure there are nuances to this idea that need to be considered, such as setting the risk factor based upon the composition of the underlying mortgages (for example how much of the portfolio are prime vs. sub-prime mortgages). However, I believe the above approach will provide the public the information we need to know to assure that the Treasury is properly investing

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