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…