A better way to price toxic waste - and it costs only $70 million

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Last weekend I wrote about six flaws in the $1 trillion toxic waste cleanup plan. Yesterday, I added a seventh flaw -- hedge funds and private equity firms are worried that if they participate in the program, political pressure will strip them of their profits.

And now, a bigger problem has reared its ugly head -- investors are becoming less eager to buy the U.S. debt needed to finance all these bailout programs. This puts on even more pressure to come up with a plan that works.

So what to do? Pay $70 million to get hard data on the value of toxic waste rather than putting hundreds of billions at risk to play a game that might get the toxic waste off banks' books. To explain why this $70 million plan to get data will work, let's examine one of the biggest problems with the $1 trillion toxic waste removal plan -- there is no agreement on how to price it.

Banks have booked their troubled assets at 60 cents on the dollar but investors are only willing to pay five cents. Pay less than 60 cents and banks take a loss and need to raise more capital; pay more than 60 and taxpayers and investors lose.

To explain this pricing problem, it's important to recognize that mortgage-backed securities (MBSs) are backed by individual mortgages, say, 4,000 of them in a typical bundle. The reason that nobody knows what such toxic waste is worth is that there is no information available in one place about the likely future cash flows of each of those 4,000 mortgages. If 15 percent of those mortgages, or 600, are in default and the other 3,400 are likely to keep paying the mortgages, then it becomes possible to put a specific value on that MBS.

But that information does not exist, so the U.S. wants to finance an auction process that is designed to set a price on the toxic waste. But rather than put hundreds of billions of taxpayer money at risk, I think the government would be better off hiring people to examine each individual mortgage and draw a conclusion about the value of the MBSs based on hard data.

How much would it cost to hire such data crunchers? A colleague ran some numbers and concluded it would be much less expensive to get this information than to simply take a loss due to the lack of data. He estimates that it would cost $28,000 to price 4,000 mortgages in the example I used above.

He based this on the assumption that an analyst who is paid $40 per hour could estimate the cash flows of six mortgages per hour -- yielding a cost per mortgage of about $7. With the expected loss on a single mortgage at 40 percent, a $300,000 mortgage would generate a loss of $120,000. So the value of the information would be far lower than the benefits from getting the information.

If there are 10 million mortgages buried inside all that toxic waste, the total cost of putting a hard value on those mortgages would be a relatively paltry $70 million. Getting this hard data on the value of the toxic waste would not solve the problem. It would merely make it easier to price it accurately. And those prices would take much of the uncertainty out of the price setting process. As I posted, the FDIC could then buy the defaulted mortgages out of the MBSs and restructure them.

And then the toxic waste could trade on the open market since the defaulted mortgages would have been stripped out of them. With the cost of financing all these bailouts going up, we need to find smarter ways to solve the problem with less taxpayer money.

I think my $70 million data plan would get things headed in the right direction.

Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College. His eighth book is You Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing.

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