Tuesday, September 23, 2008

The time to buy is when there is blood in the streets

As I mentioned in my previous post on the mortgage bailout, it seems clear that Bernanke and Paulson both think that mortgage backed securities are undervalued at current market prices (my scenario (1) in the previous post). Bernanke refers to the difference between "hold to maturity" and "fire sale" prices in his congressional testimony.

Many commentators are trying to wrap their heads around this difference. To understand, it helps to have seen the collapse of a financial bubble firsthand. If you haven't (as I suspect is the case with most academic economists), you are likely to cling to the idea that the market price of an asset is a good forecast of its actual value. However, this is completely wrong in the wake of a collapse. (And, certainly, the predictive power of the market price cannot hold at all times -- it is likely to be most wrong at the peak and in the aftermath of a bubble.)

The following false conundrum has been stated recently by numerous analysts, including Paul Krugman: "if Treasury wants to recapitalize banks it has to overpay for toxic assets, to the detriment of taxpayers; if it wants to pay fair prices for the assets then banks won't benefit." There is no conundrum if markets, at this instant in time, are systematically underpricing mortgage assets.

When the Internet bubble burst in the early years of this century, investors were so gun shy and under so much pressure that they would not pay even rationally justifiable prices for stakes in technology companies. Smart investors who were willing to put capital at risk bought assets at fire sale prices and made huge profits. This is nothing more than fear and herd mentality at work. If herd thinking can lead to overpricing of assets, why not underpricing immediately following a collapse?

Markets overshoot on both the up- and the down-side!

These points are obvious to any trader... it's the academics with equilibrium intuitions who are struggling to understand! Note as I mentioned in the earlier post, the "hold to maturity value" can only be modeled using probability distributions for defaults, price movements, interest rates, etc. But I've been told many times by people in the industry that current market prices imply massive default rates which are unrealistically high.

WSJ has the best summary.

Related discussion: Paul Krugman , more Krugman , Economist's View , Brad Setser.

WSJ: ...Uncertainty in housing markets and the economy are forcing financial institutions to mark mortgage securities at fire-sale prices, rather than their value if held to maturity, effectively creating a vicious circle of more write-downs that further depress asset values, Mr. Bernanke explained.

Mr. Bernanke said the Treasury plan should have taxpayers buy the assets and hold them at close to their maturity value. Removing the assets, he said, would bring liquidity back to markets, unfreeze credit markets, reduce uncertainty and allow banks to attract private capital.

...In subsequent questioning, Mr. Bernanke distinguished between, on the one hand, “fire sale prices,” the ones that prevail “when you sell into an illiquid market” and, on the other, the prices that holders think the assets are really worth, sometimes described as “fundamental” values or “hold-to-maturity” value.

“The holders have a view of what they think it’s worth. It’s hard for outsiders to know,” Mr. Bernanke said. The point of an auction is to reveal those prices. “If you have an appropriate auction mechanism… what you’ll do is restart this market,” he added.

Paulson, while seeking maximum flexibility, said the Treasury is considering doing auctions one asset class at a time. He said the aim to bring “bright people” to work on the challenge of designing market mechanisms.

Update: Krugman admits he agrees with me on this point, although he still doesn't like the plan:

Krugman NYT blog: ...Just to be fair, it’s possible, maybe even probable, that mortgage-related paper is being sold too cheaply.

I don't really like the plan either, but at least the earlier argument based on the pricing conundrum is now understood to be sloppy. I just read that Paulson will cave on the populist CEO compensation limit. As usual, bounded rationality (limited brainpower) is at work here. The taxpayers would be benifited much more by Treasury taking an equity stake or warrants in banks that are being bailed out. They should have made Paulson cave on that -- the compensation issue is just symbolic.


Anonymous said...

I think the assumption made in the academic posts you pointed to is that previous write downs haven't absorbed most of the losses. Looking at the price to rent ratio (yes a simplistic metric) I'd have to agree with that assumption.

I guess where I don't follow what you are saying is that, you assume that there exists a model (and available to the Treasury) right now, that can give a more accurate predictions of true price. I'm not sure there is any such mythical model.

What would you use to asses ground truth here? I'm interested in this more as an academic exercise. I'm too poor to be exposed to the markets and grad school will keep me out of the job markets for a few more years :)

Anonymous said...

Any ideas how a small retain investor can profit from these supposedly underpriced assets?

Anonymous said...

Greg Mankiw's take

In other words, the premise appears to be that the market is irrationally pessimistic. That might be so. Nonetheless, one has to be at least a bit skeptical about the idea that government policymakers gambling with other people's money are better at judging the value of complex financial instruments than are private investors gambling with their own.

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