it would leave homeowners obligors on “contingent payment debt instruments” and lenders on the other side (obligees).

of course the “lenders” are not the banks, as the loans have been securitized away, so we should probably use the term “holders”

so FORGETTING the interesting and non trivial question whether the holders have a recognition event in the form of debt instrument substitution (they probably do)…

you have a situation where the obligors (homeowners) are BY THE CODE (that is, its part of the internal revenue code of 1986 and regs and can’t be hand-waved away) “issuers” of those instruments

or some transformer intermediary is an “issuer”

which means the interest deductions are NOT equal to the amounts actually PAID in cash, but have to incorporate a formulaic value representing the accreting expected contingent payoff.

which ALSO means whoever is the holder of those notes is picking up income without cash.

think that through. you take a contingent payment debt instrument from someone and they pay you a coupon rate in cash but YOU recognize income equal to that PLUS an additional amount even though that additional amount is not paid in cash currently, but only (if ever) at the end (where it’s all reconciled).

and who gets to take the “phantom income” hit if there are securitized tranches?

not all of those tranches are held by tax-indifferent entities; aunt tilly has maybe some CMOS that would be affected and boy won’t she be happy to be paying tax on income she doesn’t get in cash.

mathematically, what would probably happen would be that the taxable income would remain the same but the cash income would drop about 30% (a guess) so instead of taking in $100 and paying out $38 (federal and state, on average), you’re now taking in $70 and paying out the same $38, so your after tax income has dropped from $62 to $32…

oh boy this is going to go over well with the aarp isnt it…

AND…

(this just gets better)

this assumes the transaction is aggregated (which it should be), that is warrant shmarrant its fixed principal debt being exchanged for a contingent payment debt instrument.

if however the transaction is disaggregated and considered as the exchange of a debt instrument for a different debt instrument plus a warrant…

thats a taxable event

and

even if by MAGIC there’s no income or loss recognition on the exchange…

the basis has to be allocated between the warrant and the new loan…

because as warren buffett said, “i dont care how hard it is to value an option, i know the right value is not $0″

so don’t let’s pretend that the value of that warrant is $0

now all this could be fixed by new tax legislation making special rules…

these would be rules that say, basically, “in all events but bail-out-the-reckless-homeowners, standard treatment applies, but in the case of bailing out these folks, then we’re all going to look the other way and bastardize tax law and by legislative fiat just say this and that and hope no one throws up”

meaning the non-owners will wind up paying the tab…

this is a massive wealth transfer to support artificial price / earnings multiples of homes

(ooh, and just imagine how FASB and the other bodies will be thrilled to allow holders to value the warrants at one number for financial purposes at the same time our new tax law values them at zero to avoid a political inconvenience)

i dont care how boring or conceptually hard this stuff is, its reality

you get the system you deserve

remember what franklin said when asked what kind of government they had produced: “a republic, sir, if you can keep it”

i want to fwow up

as to the uk chap, the inherent value of a BBB bond insured by a BBB insurer itself indemnified by another BBB insurer is undoubtedly AAA equivalent; but the US is full of lazy morons (probably safer in the long run than eager morons, but we have those too) who dont do their own work and rely on others for a stupid simple reduction of dimensionality to a single rating; lots of them are in state legislatures or on pension boards or consultants thereto who cant vary from the accepted line and write into their documents that there has to be a rating of at least the top two or three from an nsro; also federal law often requires an nsro rating on many securities as well.

“If muni bonds got the ratings they deserve, we wouldn’t need to bail out the bond insurers. We wouldn’t need bond insurers at all.”

Buffet obviously thinks that the muni business is a ‘good’ business. This seems equivalent to saying that the risk of the muni business is generally overestimated and the corresponding capital requirements are generally overstated.

The AAA rating is based on the expectation that the monoline can meet its liabilities, in this case insured muni bonds. The rating logic is causality based (monoline risk as a function of muni risk), not correlation based.

NEW YORK (CNNMoney.com) — A plan that would help troubled mortgage borrowers today – and might make lenders whole later on – was unveiled Wednesday in Washington.

The Office of Thrift Supervision (OTS) is urging the federal savings and loans lenders under its authority to refinance loans by reducing mortgage balances to the current market values of the homes. Thanks to falling home prices, many homeowners are now stuck with mortgages that are actually worth more than the houses themselves.

But instead of having lenders forgive the difference between the old mortgage and a house’s current resale value, called a short sale, the OTS advises that lenders issue a warrant or “negative amortization certificate” for the difference. If a home regains its market value and is then sold, lenders have first claims to the profits.

“If a house has a $100,000 mortgage originally,” said Bill Ruberry, a press spokesman for the agency, “and the fair market value is $80,000, there’s $20,000 in negative equity. The lender could refinance for $80,000 and a warrant [for the $20,000 in lost value].”

If the house later sold for $100,000, the lender would collect the $80,000 mortgage balance plus the $20,000. If the sale realized more than $100,000, the certificate holder might even get interest on top of the $20,000. Any profit beyond that would go to the borrower. The warrants could be publicly traded.
Home prices still falling

The hope is that this plan will help prevent foreclosures while minimizing the hit that lenders will take, all without putting any burden on the taxpayers.

All borrowers are likely to be eligible, according to Jaret Seiberg of the Stanford Group, a policy research company, but the proposal appears to be aimed at those with subprime ARMs, negative amortization mortgages and interest-only mortgage borrowers. They’re the ones most likely to have negative equity.

The savings and loan industry, which held 31% of mortgage loans last year, saw record losses of $5.24 billion for the fourth quarter of 2007, according to the OTS.
Can’t pay? Just walk away

Few details about the plan have been settled, but it would not involve any legislation, nor would it be mandated in any way. Adoption would be on a voluntary basis by the hundreds of thrift institutions in the United States, like Washington Mutual (WASH) and IndyMac Bancorp (IMB).

Indeed, banks may not want to take this approach in markets where prices have fallen so steeply that it is unlikely they’ll recover any money.

The plan’s biggest attraction for lenders, according to Seiberg, is that rather than spending $50,000 to foreclose on a home or to write-off the negative amortization in a short-sale, they get a certificate that permits them to share in the up-side, if and when housing markets recover.

“The plan still needs to be discussed, but it has some attractions,” said Ruberry. “We’re putting it out there and urging our institutions to give it a look.” To top of page

Is there something wrong with my thinking? (I am from the UK, so I might be missing some knowledge of how the system works).

Thanks for any enlightenment you can provide.

or did i misunderstand something?

(if i didnt it just sounds like most things we have seen the last few years, the AAA ratings for structured issues, the insurance given by the monolines..etc)