Wednesday, April 8, 2009

An Argument Against Using Government Funds to Help Purchase Structured Credit Securities

Coval of Harvard business school and Jurek of Princeton co-wrote a paper that investigates the current prices of debt: "The Pricing of Investment Grade Credit Risk during the Financial Crisis", Joshua D. Coval, Jakub W. Jurek, and Erik Stafford, March 30, 2009.

The bottom line of the paper:

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 artificially depressed by banks and other investors trying to unload their holdings in an illiquid market, such that they no longer reflect 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 in 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.

If prices currently coming out of credit markets are actually correct, and not reflecting fire sales, this has several important implications. First, correct prices in the secondary market for these assets essentially imply that many major US banks are now legitimately insolvent. This insolvency can 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. In turn, any positive valuation assigned by shareholders to their equity claim arises solely from their anticipation of value transfer from firm debt holders or resource transfers from US taxpayers.

Second, if current market prices are fair, any taxpayer dollars allocated to supporting these markets will simply transfer wealth to the current owners of these securities. To the extent these assets reside in banks that are now insolvent, the owners are essentially the bondholders of these banks. The reason their bonds are currently trading far below par is that the assets backing up their claim are just not worth enough (nor expected to become worth enough when their bonds mature) to repay them. And so while they will be cheered by any government overpayment for the toxic assets backing up their claims, their happiness will be at the taxpayer’s expense since – to the extent that current prices are fair – they will be receiving more than fair value for their investments. Similarly, using government resources to support these markets by insuring assets against further losses amounts to providing insurance at premia that are significantly below what is fair for the risks that the US taxpayer will now bear.

Third, the market for securitized claims is not going to operate the same way it did in the past. Investors in these assets are setting prices in the secondary market that reflect both the high expected losses of the securities and the highly systematic nature of these expected losses. And while the pricing of these securities is dramatically different from the way it was a year or two ago, this is because it was wrong then, not now. Efforts to restart this market are focused on resuming the flawed pricing of the past, when there was no charge for risk and investors relied on the accuracy of ratings. Investors have learned from their mistakes and now seem to be pricing these securities in accordance with their true risks.

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