But Economics of Contempt does not like this paper. No, he does not like it at all:
Sounds like the paper is going to examine the prices of the toxic assets that the Treasury is planning to buy, right?
Wrong. Instead, the authors examine investment grade corporate credit risk, using the CDX.NA.IG index. But ABS and CDOs backed by investment grade corporate bonds are not eligible for either the TALF or the PPIP. In other words, investment grade corporate bonds aren't considered "toxic assets."
The authors conclude that market prices of investment grade corporate credit risk are accurate--which isn't surprising, seeing as the CDX.NA.IG is the most liquid contract in the CDS market. Amazingly, however, the authors use this to conclude that the Treasury's plan to buy up the banks' toxic assets is misguided
This is why I'm still having trouble wrapping my brain around the notion that even a very large increase in the default rate can wipe out something like 2/3 of the value of these assets. Most of these loans will perform. And in the case of those that don't perform, while the value of the underlying collateral has fallen, it hasn't fallen to zero. They can't possibly be priced at any reasonable expected cash flow--or rather, if those expectations are reasonable, then we need to stop fannying about with the banking system, because where we're going, we won't need a banking system. We'll need canned goods and ammunition.
This is why I'm still having trouble wrapping my brain around the notion that even a very large increase in the default rate can wipe out something like 2/3 of the value of these assets.
--------
Plenty of CDOs and MBS trusts are filled with 2nd lien mortgages that will be vaporized in foreclosure sales, where the senior mortgage holder gets the house and the junior lenders get nothing. Plenty of junior tranches in trusts holding senior mortgages will get nothing due to all mortgage payments streaming to the senior tranche.
Re: "I'm still having trouble wrapping my brain around the notion that even a very large increase in the default rate can wipe out something like 2/3 of the value of these assets." Maybe this site will be helpful:
http://accruedint.blogspot.com/2009/04/leverage-doesnt-kill-investors-bad.html
Also, don't forget that the "synthetic assets" are actually credit default swaps and their value depends on the solvency of the CDO (e.g. Citi's leveraged super senior CDOs), insurer (e.g. AIG, MBIA, Ambac) or bank (e.g. UBS) that wrote the swap, so in the current environment their value can go to zero very easily.
"They can't possibly be priced at any reasonable expected cash flow--or rather, if those expectations are reasonable, then we need to stop fannying about with the banking system, because where we're going, we won't need a banking system. We'll need canned goods and ammunition."
Greatness. I have been wondering about the cash flow angle for quite a while. If these securities ever translate into real assets, surely they can generate some cash flow.
I wonder if our entire financial system is now more prone to big swings because of the tight coupling between financial institutions and the overwhelming rapid systemic response that is enabled by computers talking to each other.