New Bailout: What Are The Fed's Assumptions?

In announcing its plans to lend up to $200 billion to holders of AAA-rated ABS, the Fed offered the following explanation for its actions:

New issuance of ABS declined precipitously in September and came to a halt in October. At the same time, interest rate spreads on AAA-rated tranches of ABS soared to levels well outside the range of historical experience, reflecting unusually high risk premiums.  The ABS markets historically have funded a substantial share of consumer credit and SBA-guaranteed small business loans.

The implicit argument is that these interest rate spreads, which are “well outside the range of historical experience”, are mispriced, so the Fed needs to intervene. But what good is the “range of historical experience”, when historical experience has been obliterated? Citgroup (C) used the range of historical experience to model their risk, but that historical experience never included a prolonged housing downturn, as this weekend’s NYT profile confirmed.

It’s amazing, actually. Nobody out there — whether it’s the government or private banks — is willing to believe the prices that are being paid for debt-related securites. Everyone, it seems, believes they’re an aberration (which is why people argue for a suspension of mark-to-market accounting). And yet with everyone in this state of disbelief, the actual market hasn’t changed.

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