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.
You can read the whole paper by Harvard’s Joshua Coval and Erik Stafford and Princeton’s Jakub Jurek below. 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 centre 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 our shareholders, giving bond holders a serious haircut–is still not on the official agenda.
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