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I would agree with you if the only problem was the loans banks were holding on their balance sheets (intended to be held to maturity) and not securities made up of pools of mortgages which are purchased by banks as investments (not necessarily, in fact rarely, to hold until maturity).

Also let's be careful when throwing around terms like performing assets and subprime assets. There are plenty of non-subprime mortgages now listed in the non-performing asset category.

Valuing them based on cash flows and default rates does make sense, but now the question becomes what cash flows and default rates are we using? As you have pointed out repeatedly, many homeowners (non-subprime) are facing situations where their homes are worth less than their mortgage and are economically rational in just walking away.

This throws off your historical assumptions of default rates. So are we to presume that banks are going to use conservative numbers and pick something appropriately above historical rates? If you answered yes, I have somes shares in this company called Lehman Brothers to sell you.

Housing prices were artifically inflated by prolonged periods of low interest rates. According to rents, we still have a ways to go before houses are correctly priced. How many prime borrowers will feel the need to walk away from their mortgages before we reach equilibrium (and remember, odds are we will overshoot on the downside)?



Just as a side note for those interested:

The problem we are facing isn't as simple as it should be. With the enormous bulge in loan securitization, most of the mortgages that big banks wrote were then securitized (thrown into pools of mortgages and sliced up into various levels of risk and repackaged and sold to investors). Works wonderfully and lowers borrowing costs as long as above average defaults don't occur.

The reason the gov't can't just go in and rewrite loans on the vast number of foreclosures (one of the plans originally floated that I wholeheartedly disagree with) is that they aren't held by the bank that originally wrote the loan and have been pooled and sliced up so that any re-writing is essentially impossible. Even if you could find all the parties that now own part of this loan, they would all have to agree to take the haircut required to re-write the loan.
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