Rortybomb quotes Megan McArdle:
This is why I’m still having trouble wrapping my brain around the notion that even a very large increase in the default rate can wipe out something like 2/3 of the value of these assets. 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.
And asks:
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’m not interviewing for a risk manager gig – I limit my Greek to Aegean vacations and my math to trying to work out a tip without counting out loud – but here is my answer. I won’t even get into how a 50% decline from peak housing prices compresses a whole mortgage 37.5%, so double that level of loss in a tranche of securitized product is hardly surprising on its face.
I would suggest that toxic assets are actually overpriced.
Right now, their price reflects three things:
- (a) The underlying value of the asset, which is probably itself overvalued because people are loathe to recognize losses and in this case, recognizing a loss would mean recognizing that the entire premise behind the acquisition was flawed. Like earthquake insurance.
- (b) The value of the Baghdad Tim Put. If you just hang on long enough, Baghdad Tim is going to come up with an even sweeter deal. So you would need to be paid what you consider an irrationally high price to part with an asset, since you know there’s a sucker waiting in DC if you can’t find one on your own.
- (c) The limit of liability. You can only lose your equity once before you lose your license and go out of business. Losing your equity 1x, 3x, 5x is all the same – game over. So if you hold nothing but underwater Inland Empire mortgages, there is no point entertaining bids below 90 cents – 87 cents or 17 cents, they’re taking the art of the walls. You might as well offer at 95 cents and hold tight.
Given a+b+c, I would take the over…
Awesome post – thanks for adding some light!