That seems to be the argument in this paper by Harvard's Joshua Coval and Erik Stafford and Princeton's Jakub Jurek, which is being touted as evidence that Treasury is wrong to believe that the toxic assets are underpriced. 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:
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 arti…cially depressed by banks and other investors trying to unload their holdings in an illiquid market, such that they no longer refect 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.
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. To repeat: the fact that the prices for non-toxic assets are accurate does not mean that the prices for toxic assets are accurate. What's the deal with the ivory tower recently? Did everyone decide to take extra-strength stupid pills?

9 comments:

urban legend said...

"What's the deal with ivory tower recently? Did everyone decide to take extra-strength stupid pills?"

What's up with that? Are you referring to the Brad DeLong critique of the recent Chicago School pronouncements?

Anonymous said...

I think you are missing their point. They come as close as research on real world data can to demonstrating that prices on investment grade corporate CDS and CDOs failed to take systematic risk into account prior to mid-year 2007. Thus they show that these products were mispriced during the boom and only now are close to being accurately priced.

The analogy to CDS and CDOs based on other types of loans is simply too close to be ignored. If the market could eff up its pricing this badly with something as simple as investment grade corporate debt (remember this is the stuff that's rated reasonably accurately and that investors actually understand), then there's every reason to believe that CDOs on more poorly understood products were even more inaccurately priced during the boom.

No, they can not demonstrate that mortgage related CDS and CDOs are accurately priced now, but they've done a fine job of demonstrating that these products should exhibit dramatic price declines to reflect systematic risk that was ignored in the past.

In other words by demonstrating the price changes for the best understood CDOs and CDS can be explained by past pricing errors, they have shown it's stupid to attribute the price decline in any CDO or CDS to "illiquidity".

Economics of Contempt said...

urban legend: Oh no, I think DeLong has been a beacon of sanity among academics lately. I was referring to Jeff Sachs's nonsensical criticism of the Geithner plan, Tyler Cowen criticizing the Obama administration for failing to propose something they actually did propose, Martin Feldstein doing the same, Krugman offering absurdly superficial "analysis" of the bank rescue, etc.

Economics of Contempt said...

"In other words by demonstrating the price changes for the best understood CDOs and CDS can be explained by past pricing errors, they have shown it's stupid to attribute the price decline in any CDO or CDS to 'illiquidity'."

That's not even close to the issue. No one is arguing that the pre-2007 prices for mortgage-related securities were accurate. Everyone knows they were mispriced during the boom. And no one is saying that all the price declines in mortgage-related securities is due to "illiquidity."

The issue is whether mortgage-related securities are accurately priced now. They've already been dramatically re-priced -- the argument is over whether prices have fallen too far. The only way to know whether prices have fallen too far is to figure out what the true prices should be -- and that requires in-depth analysis of expected cash flows from mortgages.

Using investment grade corporate bond prices to evaluate the accuracy of prices for mortgage-related securities doesn't even pass the laugh test. For one thing, even in normal times, the IG corporate bond market is completely different from the mortgage market. That would be like evaluating yen prices by looking at crude oil futures.

Even if IG corporate bonds had anything to do with mortgage-related securities, it would still be a ridiculous comparison because one market is functioning and one market isn't. The market for CDS on investment grade corporate bonds is still liquid and functioning well. The mortgage-related securities markets (e.g., non-agency RMBS, CMBS, CDOs backed by subprime RMBS) have completely broken down. They aren't functioning at all.

The simple fact is that using prices in a well-functioning market to evaluate the accuracy of prices in a completely unrelated, completely dysfunctional market is utterly nonsensical. There's no way of getting around that.

Anonymous said...

You may not like the goal of the paper (it's academic work after all), but you've got to admit that they were clear about it:

"The main objective of this paper is to determine whether fire sales are required to explain prices currently observed in credit markets."

You are saying that the conclusion is obvious: Of course there was a huge change in fundamentals and fire sales are not required to explain huge price declines, especially in the deepest markets. As academics they did not treat this point of view as a foregone conclusion.

urban legend said...

I actually was referring to the Chicago people who say stimulus cannot work -- Ricardian equivalence, etc. -- that DeLong has been taking to task. I see your point on Sachs et al, but what's your take on these Chicago academics?

Economics of Contempt said...

urban legend: Ah, I misunderstood you. I think the Chicago academics have made utter fools of themselves. I've had no respect whatsoever for Chicago-school macroeconomists since I delved deep into the debate back in grad school in the late '80s, so I'm glad they're finally getting their comeuppance. I honestly consider them to be intellectual featherweights. I love seeing DeLong and Krugman humiliate them in public.

In grad school, the worst students in the class were always the most ardent Chicago-schoolers. (Well, the worst students were the Austrians, but the bottom half of the class was disproportionately made up of hardline Chicago-schoolers.) That tipped me off early.

Anonymous said...

The fact that D3 Itemscosts regarding tranches involving CDOs insured by purchase quality corporates are precise is very irrelevant to whether rates regarding mortgage-related stock options usually are accurate. To be able to replicate: the fact the values for non-toxic belongings tend to be precise does not always mean that the prices RS Goldintended for poisonous possessions usually are precise.

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