Insolvent Banks and Imaginary Firesale?

by Chris Sturr | April 07, 2009

An interesting article on an interesting academic paper, and at least one blog post expressing reservations about the paper’s conclusions. First, the article (I like “crap assets” as an alternative to “toxic assets”: far preferable to the ridiculous “legacy assets”):

Geithner Wrong, Crap Assets Correctly Priced, Say Harvard And Princeton Profs

John Carney | The Business Insider | Apr. 6, 2009

The government’s official view that toxic assets are incorrectly priced due to illiquidity “fire sales” is wrong, a new study by Harvard and Princeton finance professors suggests.

… The striking conclusion is that the low prices of toxic assets actually reflect the fundamentals, rather than being driven by an illiquidity discount.

“The analysis of this paper suggests that recent credit market prices are actually highly consistent with fundamentals. A structural framework confirms that bonds and credit derivatives should have experienced a significant repricing in 2008 as the economic outlook darkened and volatility increased. The analysis also confirms that severe mispricing existed in the structured credit tranches prior to the crisis and that a large part of the dramatic rise in spreads has been the elimination of this mispricing.”

This contrasts sharply with the analysis that underlies most of the financial rescue programs launched by the Federal Reserve and the Treasury Department. The white paper released to support the Private-Public Investment Partnerships, the program that seeks to encourage private firms to buy toxic assets with government subsidized loans, took the opposite point of view.

“Troubled real estate-related assets comprised of legacy loans and securities, are at the center of the problems currently impacting the U.S. financial system…The resulting need to reduce risk triggered a wide-scale deleveraging in these markets and led to fire sales,” the Treasury and the Fed claimed.

Many prominent economists–including such diverse types as Anna Schwartz and Paul Krugman–have taken with this official view, saying the government was mistaking a solvency crisis for a liquidity crisis. This latest paper effectively demolishes the “fire sale” view. It draws three important conclusions.

* Many banks are now insolvent. “…many major US banks are now legitimately insolvent. This insolvency can no longer be viewed as an artifact of bank assets being marked to artificially depressed prices coming out of an illiquid market. It means that bank assets are being fairly priced at valuations that sum to less than bank liabilities.”

* Supporting markets in toxic assets has no purpose other than transfering money from taxpayers to banks. “…any taxpayer dollars allocated to supporting these markets will simply transfer wealth to the current owners of these securities.”

* We’re making it worse. “…policies that attempt to prevent a widespread mark-down in the value of credit-sensitive assets are likely to only delay—and perhaps even worsen—the day of reckoning.”

In short, the government cannot save the banks by improving liquidity or changing mark to market rules because the problem isn’t illiquidity or accounting. The problem is that highly leveraged financial firms own assets that are worth far less than they thought they would be, and the firms are insolvent as a result. This is why the latest bailout plans secretly give huge subsidies to banks–because the only way to keep the insolvent zombies afloat is to transfer billions of dollars to banks, bank stockholders, and bank creditors. The alternative–allowing the insolvent banks to fail, seizing the assets, wiping out shareholders, giving bond holders a serious haircut–is still not on the official agenda.

Next, the interesting paragraphs from the academic paper (which appears to be online only in pdf form–I had to do some reformatting/retyping; this might be the first place where a good chunk of it appears in searchable html form, though I could be wrong):

Policymakers are rapidly moving towards using TARP money to purchase toxic assets—primarily tranches of collateralized debt obligations (CDOs)—from banks, with the aim of supporting secondary markets and increasing bank lending. The key premise of current policies is that the prices for these assets have become artificially depressed by banks and other investors trying to unload their holdings in an illiquid market, such that they no longer reflect their true hold-to-maturity value. By purchasing or insuring a large quantity of bank assets, the government can restore liquidity to credit markets and solvency to the banking sector.

The analysis of this paper suggests that recent credit market prices are actually highly consistent with fundamentals. A structural framework confirms that bonds and credit derivatives should have experienced a significant repricing in 2008 as the economic outlook darkened and volatility increased. The analysis also confirms that severe mispricing existed in the structured credit tranches prior to the crisis and that a large part of the dramatic rise in spreads has been the elimination of this mispricing.

If prices currently coming out of credit markets are actually correct, and not reflecting fire sales, this has several important implications. First, correct prices in the secondary market for these assets essentially imply that many major US banks are now legitimately insolvent. This insolvency can no longer be viewed as an artifact of bank assets being marked to artificially depressed prices coming out of an illiquid market. It means that bank assets are being fairly priced at valuations that sum to less than bank liabilities. In turn, any positive valuation assigned by shareholders to their equity claim arises solely from their anticipation of value transfer from firm debtholders or resource transfers from US taxpayers.

Second, if current market prices are fair, any taxpayer dollars allocated to supporting these markets will simply transfer wealth to the current owners of these securities. To the extent that these assets reside in banks that are now insolvent, the owners are essentially the bondholders of these banks. The reason their bonds are currently trading far below par is that the assets backing up their claim are just not worth enough (nor expected to become worth enough when their bonds mature) to repay them. And so while they will be cheered by any government overpayment for the toxic assets backing up their claims, their happiness will be at the taxpayers’ expense since—to the extent that current prices are fair—they will be receiving more than fair value for their investments. Similarly, using government resources to support these markets by insuring assets against further losses amounts to providing insurance at premia that are significantly below what is fair for the risks that the US taxpayer will now bear.

Third, the market for securitized claims is not going to operate the same way it did in the past. Investors in these assets are setting prices in the secondary market that reflect both the high expected losses of the securities and the highly systematic nature of these expected losses. And while the pricing of these securities is dramatically different from the way it was a year or two ago, this is because it was wrong then, not now. Efforts to restart this market are focused on resuming the flawed pricing of the past, when there was no charge for risk and investors relied on the accuracy of ratings. Investors have learned from their mistakes and now seem t
o be pricing these securities in accordance with their true risks.

Read the full paper.

Finally, a sharply dissenting view from the blog Economics of Contempt; his point is that the paper’s analysis is not of mortgage-backed securities, yet it claims to draw conclusions about them:

The introduction states:
On March 23, 2009, the Treasury announced that the TALF plan will commit up to $1 trillion to purchase legacy structured credit products. The government’s view is that a disappearance of liquidity has caused credit market prices to no longer reflect fundamentals. … The main objective of this paper is to determine whether …fire sales are required to explain prices currently observed in credit markets.

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 …

Are they serious? The Treasury is arguing that the prices for mortgage-related securities are artificially depressed because of illiquidity and fire sales. No one is arguing that investment grade corporates are underpriced due to illiquidity and fire sales. That’s why ABS and CDOs backed by investment grade corporates aren’t eligible for the TALF or the PPIP. The fact that prices for tranches of CDOs backed by investment grade corporates are accurate is completely irrelevant to whether prices for mortgage-related securities are accurate.

Read the full blog post (though I’ve given you most of it).

The criticism seems sound, but what’s interesting is the very suggestion that the “firesale” scenario is imaginary. If they are right (even if the blogger is right that their evidence doesn’t support their conclusion), then the bailout represents a huge transfer of wealth from ordinary folks (I hate the term “taxpayers”) to shareholders and bondholders. If anyone has a better grip on this than I do, please leave enlightening comments.

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