Risk Management

From Megan McArdle:

A new paper out of Harvard and Princeton arguing that toxic assets actually aren’t underpriced has garnered a lot of attention. As well it might: if toxic assets aren’t underpriced, we’re all in big, big, BIG trouble…

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.

1) If I was interviewing risk managers these days, my first question would be: What’s your estimate that the legacy assets are currently, in their low bids, overpriced? Why?

I’d be looking, after 30 seconds of thought, for an answer at the 1%-5% range on the p-value. The argument I’d like to hear is that the kind of Limts To Arbitrage/market failure approach that people use when saying the assets are underpriced cuts both ways – poor liquidity, non-standardizable contracts, poor resale design, asymmetric information and potential insolvency of their owners preventing price discovery could all be preventing the price of these things from being bid down, not just up, in the current market. I’d be open to other answers of course.

2) One of the reasons risk management is frustrating is because this exchange occurs all the time:

Risk Manager: So if we do that, the tail risk in the 1% region expands exponentially.
Other Dude: I know. And if we end up there, it’s going to be Mad Max. We are all screwed. There won’t even be a company left.
Risk Manager: Exactly. So if we gamma-hedge dynamically we can shift…
Other Dude: What? Let’s go ahead. If the worst case happens, we are screwed anyway.
Risk Manager: Hmmm.

The other issue is that the exchange above generalizes to a prisoner’s dilemma incredible fast. “Well, the desk down the hall is doing this, and if the worst case scenario happens, we don’t get bonus points when our business goes bankrupt. And if it works and we didn’t do it, second place is no bonus. Third place is you’re Fired.” Replace “desk down the hall” with “bank across the street”, or “shady mortgage lender across the neighborhood”, and I think you get a lot of what went wrong the past 8 years. I’ve mentioned this before, and the more information we learn the more I think it is accurate. We shouldn’t expect markets to be able to regulate themselves in these cases…

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2 Responses to Risk Management

  1. Taunter says:

    I would suggest that toxic assets are actually overpriced.

    Right now, their price reflects three things:
    (a) The underlying value of the asset, which is probably itself overvalued because people are loathe to recognize losses and in this case, recognizing a loss would mean recognizing that the entire premise behind the acquisition was flawed. Like earthquake insurance.
    (b) The value of the Baghdad Tim Put. If you just hang on long enough, Baghdad Tim is going to come up with an even sweeter deal. So you would need to be paid what you consider an irrationally high price to part with an asset, since you know there’s a sucker waiting in DC if you can’t find one on your own.
    (c) The limit of liability. You can only lose your equity once before you lose your license and go out of business. Losing your equity 1x, 3x, 5x is all the same – game over. So if you hold nothing but underwater Inland Empire mortgages, there is no point entertaining bids below 90 cents – 87 cents or 17 cents, they’re taking the art of the walls. You might as well offer at 95 cents and hold tight.

    Given a+b+c, I would take the over…

  2. Pingback: Toxic Asset Pricing « Taunter Media

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