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Friday, September 26, 2008

Mortgage securities oversold by 15-25 percent

Below are some quotes which support the view that mortgage assets are currently undervalued by the market. Yes, the market is inefficient -- it overpriced the assets at the peak of the bubble (greed), and is currently underpricing them (fear). Both Buffet and ex-Merrill banker Ricciardi below think the mispricing is about 15-25 percent. That is, the "fear premium" currently demanded by the market is 15-25 percent below a conservative guess as to what the assets are really worth. This is the margin that can be used to recapitalize banks, perhaps without costing the taxpayer any money, simply by providing a rational buyer of last resort and injecting some confidence into the market. Note to traders: yes, this is obvious. Note to academic economists: this is yet another market failure -- but of an unprecedented scale and complexity.

(Actually, 15-25 percent is not bad, and just shows that credit markets are generally more rational and data driven than equities. During the Internet bubble and collapse you had mispricings of hundreds of percent, even an order of magnitude.)

Warren Buffet interview from CNBC:

Government intervention necessary to restore confidence in the market.

If I didn't think the government was going to act, I would not be doing anything this week. I might be trying to undo things this week. I am, to some extent, betting on the fact that the government will do the rational thing here and act promptly.

Mispricing is about 15-20 percent:

...all the major institutions in the world trying to deleverage. And we want them to deleverage, but they're trying to deleverage at the same time. Well, if huge institutions are trying to deleverage, you need someone in the world that's willing to leverage up. And there's no one that can leverage up except the United States government. And what they're talking about is leveraging up to the tune of 700 billion, to in effect, offset the deleveraging that's going on through all the financial institutions. And I might add, if they do it right, and I think they will do it reasonably right, they won't do it perfectly right, I think they'll make a lot of money. Because if they don't -- they shouldn't buy these debt instruments at what the institutions paid. They shouldn't buy them at what they're carrying, what the carrying value is, necessarily. They should buy them at the kind of prices that are available in the market. People who are buying these instruments in the market are expecting to make 15 to 20 percent on those instruments. If the government makes anything over its cost of borrowing, this deal will come out with a profit. And I would bet it will come out with a profit, actually.


Christopher Ricciardi, former head of Merrill's structured credit business, in an open letter to Paulson. Note his comments illustrate the role that psychology, or animal spirits (Keynes), plays in the market.

The securitization market worked exceptionally well for decades and was the financing tool of choice for large and small institutions alike. As investments, performance for securitized assets typically exceeded corporate and Treasury bond investments for decades.

Where securitization went wrong in recent years was with subprime mortgages. These securitizations performed disastrously, causing people to mistakenly question the practice of securitization itself.

Decades of historical data were ignored, with the subprime experience exclusively driving market perceptions: The entire securitization market was effectively shut down, and this explains the depth and persistence of the ongoing credit crisis.

Government purchases of illiquid mortgage assets from the system will cost taxpayers significant sums and expose them to downside risk, without addressing this fundamental issue. Billions of dollars held by all the major institutional bond managers, hedge funds and distressed funds are already available to purchase mortgage assets.

However, in the absence of a way to finance the purchase of these assets, such funds must bid at prices which represent an attractive absolute return acceptable to their investors (15% to 25% typically), resulting in typical transaction terms that have significantly impeded the sale of mortgage securities to these funds. If these funds could finance their purchases, especially under efficient financing terms, they would still require similar returns, but would be able to buy many more assets, and bid higher prices for the assets.

Our financial system needs the capital markets and the natural power of securitization to get a jumpstart from the government. I propose using the powers granted to Treasury to create “vehicles that are authorized…to purchase troubled assets and issue obligations” under currently contemplated legislation to more efficiently address the crisis and establish a program which we might call the Federal Bond Insurance Corporation (”FBIC”), as an alternative to simply having the government directly purchase assets.

Comment re: behavioral economics. The preceding housing bubble and the current crisis are very good examples of why economics is, at a fundamental level, the study of ape psychology. On the planet Vulcan, Mr. Spock and other rational, super-smart traders and investors would have cleared this market already. But we don't live on Vulcan. Anyone who wants to model the economy based on rational agents who can process infinite amounts of information without being subject to fear, bounded cognition, herd mentality, etc. is crazy.

When the conventional wisdom is that house prices never go down (people believed this just a couple years ago), you risk little of your reputation or self-image by investing in housing. When the conventional wisdom is that all mortgage backed securities are toxic, you must be extremely independent and strong willed to risk buying in, even if metrics suggest the market is oversold. This is simple psychology. Very few people can resist conventional wisdom, even when it's wrong.

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