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Sunday, March 22, 2009

Commenting on Drum

update: Oh wow. Drum linked to this post. A Political animal stampede. I want to stress that, while I tend to use a confident tone, I really don't know anything about finance.

kevin Drum discusses Valuing the Toxic Waste

After all, if markets can overvalue assets on the way up — and obviously they can — then they can also undervalue them on the way down. There's a pretty good chance that the toxic waste in question really is worth more than the market is currently willing to pay for it.

It is hard for markets to freeze at a price far from subjective effective hold to maturity value. It is easy for markets to flow (opposite of freeze) at such prices.
The current situation is not just that many people are willing to buy Toxic Waste at a huge discount and some owners are willing to sell it. It is also necessary that no one is willing to pay a higher price for toxic waste which happens not be available in a fire sale. Someone should be willing to buy at least a little bit of an asset at say 90% of that persons expectation of its hold to maturity present value. That would be enough to give a market price which isn't absurdly low.

In contrast back during the bubble one could sell short a huge amount of toxic waste at its huge price without affecting that price. People were willing to buy a huge amount at that price. Current owners are just not selling huge amounts of toxic waste at huge discounts (the market is frozen remember). That's the difference. It really has to be that no one wants it except at a huge discount and that really means no one not fewer people than want to sell it at a higher price (so long as they won't sell it at the huge discount because they would have to mark down the identical assets that they still own).

a lazy shorthand that a lot of us have fallen into: namely the notion that the value of mortgage-backed securities is certain to keep plummeting because home prices themselves still have another 20-30% to fall. But these securities aren't backed by the value of the homes they represent. They're backed by mortgage payments. Home prices could fall by half, but the value of the securities wouldn't drop by a dime if homeowners kept making their monthly payments. Their value only drops if default rates go up.

So what causes default rates to rise? Falling home prices are certainly a factor, since it's more tempting to mail in the keys when your loan is way underwater. Rising unemployment is an even bigger factor: if you lose your job, you're more likely to stop paying the mortgage. And the crappy lending practices at the height of the bubble produced a surplus of buyers who have always been more likely to default than average.

I comment

You understate the effect of home prices on the value of mortgage based assets for two reasons. First the value of the assets is not just based on default rates, it is also based on cents on the dollar recovered through foreclosure. That clearly falls when home prices fall. Also, if a homeowners have positive equity I'd guess that even if they have say zero income, they can fend off foreclosure by taking out a second mortgage to pay the first (even if this debt is junior it is covered by the equity in the home). So default rates are higher for under the water mortgages for a reason different from mailing in the keys.

Obviously, then, there's tremendous uncertainty about future default rates. But the market appears to be valuing most mortgage-backed securities these days at something like 30 cents on the dollar. That's crazy. When you factor in recovery rates, it assumes that over three-quarters of all homeowners will default on their loans. That might be true of the absolute worst of the toxic waste, and it's certainly true of the equity tranches of even the better stuff, but on average? No way. 30 cents on the dollar simply doesn't represent a reasonable long-term value for most of this stuff.

But everyone is scared, and when there are no buyers prices get unreasonable.

Your argument rests entirely on the figure 30% which does sound low. In fact, it seems that it would be low even if we could be absolutely sure that all mortgage debtors will never make another payment. Recovery after foreclosure should be worth more than 30% of face value on average.

You assume that the figure 30% applies to all mortgages or, at least, to all securitized mortgages. Whatever gave you that idea ? What if the figure comes from mezzanine tranches of CDOs of by liars loan only MBSs ? There are some assets which no one will buy for more than 30% of face value. They are called toxic sludge. Are they representative mortgages ? I think that's unlikely.

A key point is that there are patient, brave deep pocketed investors still out there. Warren Buffet is one and he controls enough money that there doesn't have to be another one. If the current market price is so absurdly low, why isn't he buying? If he is worried about adverse selection and counterparties with more information picking lemons to sell him and keeping the cherries, then why not offer to buy say 1% of a banks total MBS and CDO of MBS book ?

I think the fact that this isn't happening shows that the prices banks demand for their toxic sludge are higher than justified by a sober patient valuation by an agent with a huge capacity to bear risk.

To get a market price of 30 cents on the dollar it has to be that no one is willing to buy even a small amount of the asset for more. Banks would be delighted to sell a little of an asset for a high price so they could mark the rest to that high price.

The claim that everyone is scared must be literally true. Everyone. Warren Buffet has to be terrified of maybe losing a billion while probably making many billions.
How likely is that ?

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