I estimate the average price of distressed mortgages that pass from "troubled financial institutions" to the Treasury at auction will be 65 cents on the dollar, representing a loss of one-third of the original purchase price to the seller, and a prospective yield of 10 to 15 percent to the Treasury. Financed at 3 to 4 percent via the sale of Treasury bonds, the Treasury will therefore be in a position to earn a positive carry or yield spread of at least 7 to 8 percent.
My analysis: Mr. Gross' assumptions are far too optimistic. The average distressed mortgage may have a value of 65 cents on the dollar (doubtful!), but in testimony on Capitol Hill yesterday Ben Bernanke made it clear that the Paulson Plan will make allowances to overpay for the mortgages it will buy. The intent is to keep banks' balance sheets healthy by sticking it to the taxpayer. The real purchase price may very well be closer to 80 cents on the dollar for the average bad mortgage.
Furthermore, financing at 3-4% assumes that today's rates on 10-yr Treasuries will stay that low into the forseeable future. No way! The massive amount of bonds to be issued under this plan will drive Treasury yields through the roof, at least to 8%. The net yield spread to the taxpayer will thus be no better than zero, even in a best case scenario. My back-of-the-envelope calculations may not be as sophisticated as the models Mr. Gross' research staff used to do the math for his op-ed, but they are a heck of a lot more intellectually honest.
I suspect that Mr. Gross' disingenuous offer to manage the Paulson Plan's acquisition and liquidation process free of charge is an attempt to cherry-pick those MBSs that will have an outsized effect on PIMCO's own holdings. Given PIMCO's size in the bond market, there is no way to avoid the possibility of a conflict of interest. That is precisely the problem with any version of the Paulson Plan: too many insurmountable conflicts of interest.
