Yves Smith on Credit Risk Study

Yves Smith writes approvingly of the study on credit risk during the financial crisis that I linked to yesterday and makes a couple of points that are probably familiar to everyone following the financial crisis but are worth repeating--repeatedly--because Geithner and co. and their supporters seem to be getting everything so wrong.

1) Prior to the financial crisis, there was a "gross underpricing of risk"; 2) The plummeting value of assets represents a "return to rationality," so what we're seeing is NOT, as Geithner and co. argue, an irrational flee from risk or a fire sale.

In sum, as I wrote yesterday: toxic assets, toxic after all.

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    Are more people listening? (5.00 / 1) (#1)
    by Militarytracy on Tue Apr 07, 2009 at 08:02:00 PM EST
    I haven't watched TV today at all.  My daughter phoned from N.Y. wanting me to explain things to her more clearly.  She's 19 :)  She said that she had been watching a news program and people were  shown very upset about the Geithner plan.  I did my best.  Sure it was lacking soooo much because risklessness was everywhere, I told her that I don't know how bad it really is because some of it is being hidden and there's stuff out there that we just don't know about.  I did tell her though that I hope we get the rules reestablished and an economy reestablished that she and her brother can live in again.  Then she told me she just watched Sicko too and wanted to know if Obama was for Universal healthcare.  It's probably a good thing that Vonage doesn't charge for long distance calls in the United States.

    [pounds head on desk] (5.00 / 1) (#5)
    by lambert on Tue Apr 07, 2009 at 08:39:15 PM EST
    Well, at least she's asking. Good for you, keeping the lines of communication open.

    I probably shouldn't type this (none / 0) (#22)
    by Militarytracy on Wed Apr 08, 2009 at 07:27:04 AM EST
    But deceptions are sinking all of us soooooo guess what was on her myspace that I noticed the last time I was there awhile back?  A small black and white of Obama and it said "my hero" under it......but she didn't even understand his policies :) She's only nineteen though and having a family always asking political questions about everything got on her last nerve trying to grow up around here.  She'd get so mad and stomp out telling us there were some other things in the world, and there are. I'm fine with him being her hero....and when he's failing to be her hero I hope she got something from me and she lets him know.

    I know, I know (none / 0) (#33)
    by lambert on Wed Apr 08, 2009 at 05:32:51 PM EST
    Why do marketers target parents through kids? the kids are more vulnerable.

    You should check into Skype (none / 0) (#11)
    by Amiss on Wed Apr 08, 2009 at 01:26:44 AM EST
    I'm probably going to have to figure that out (none / 0) (#16)
    by Militarytracy on Wed Apr 08, 2009 at 07:13:06 AM EST
    She has asked about it lately, last week I believe.  Said we needed to do some Skype.  Great, another techie thing that I get to flunk at long before I get some passing grades.  I know that a lot families doing a deployment have been able it use too. I've "heard" of it but I really don't understand what it is outside of "better than phones".

    God I can't type....I've had no coffee yet :) (none / 0) (#17)
    by Militarytracy on Wed Apr 08, 2009 at 07:15:20 AM EST
    Where (none / 0) (#13)
    by Ga6thDem on Wed Apr 08, 2009 at 06:35:47 AM EST
    in NY is she?

    Northport (none / 0) (#15)
    by Militarytracy on Wed Apr 08, 2009 at 07:08:18 AM EST
    With the Coasties.  She's said it is bizarrely wealthy but also depressing.  Nothing for poor people to do there.  She loves all the beautiful boats though.

    UHC (none / 0) (#24)
    by BigElephant on Wed Apr 08, 2009 at 07:36:53 AM EST
    Did you let her know that no major politician in the US is for real universal health care?  Supporting a real single-payer system would be like saying your an atheist in today's political world.  And until we have a single-payer system, there will be a significant (millions) of people who will not have health care.

    The Dems (Obama and Clinton) both campaigned on false promises, although I think that Obama's false promise was better than Hillary's.  In any case it's like asking if Kool-Aid or bubble gum will cure cancer -- neither will, but one may still be preferable for just taste alone.

    BTW, let her know that Michael Moore is sensationalist (although not nearly as bad as Anne Coulter).  He's good to get her interested, but I'd advise her to read some good journals in the field like "Health Affairs"


    I'm not telling her any of this stuff (none / 0) (#26)
    by Militarytracy on Wed Apr 08, 2009 at 08:35:42 AM EST
    Like she would listen to a ranting jaded lecture like that anyhow.  Ever had a teenager?  I'm jaded but not through anyone's lecture, only through getting the spiritual tar beaten out of me trying to live beyond what my optimism could hold out for.

    Nope... (none / 0) (#31)
    by BigElephant on Wed Apr 08, 2009 at 10:13:26 AM EST
    Never had a teenager.  But I'd hope that anyone would listen to reason, regardless of their age (well toddlers and younger I'd make exceptions for).

    Yes because we all know that (5.00 / 2) (#2)
    by inclusiveheart on Tue Apr 07, 2009 at 08:14:14 PM EST
    these toxic assets are not flying off the shelves like Pet Rocks no matter how hard the Administration is trying to sell them.

    Anyone have news of how the auction today went?  According to CNBC commentators this morning, "We need more buyers" based on the results of the first sale.  Ugh.

    It must be a fluke that this stuff isn't selling (5.00 / 1) (#18)
    by Militarytracy on Wed Apr 08, 2009 at 07:17:20 AM EST
    Because Krugman and Galbraith thought this was how this would go.......but they only said that because they hate Obama.

    You do realize that the credit study relates (5.00 / 1) (#3)
    by steviez314 on Tue Apr 07, 2009 at 08:27:51 PM EST
    to highly liquid corporate credit instruments, which can be arbitraged closer to fair value using CDSs, the underlying corporate equity, and put and call options (and are relatively homogeneous)  I'm not surprised pricing in that market is actually "correct".

    The applicability of this study to the Residential Mortage Backed Security market (and the HELOC secondary market) is not really examined in this paper, since that market has quite different features and no correlation to the S&P 500 or volatility indices.

    oddly enough, (5.00 / 1) (#7)
    by cpinva on Tue Apr 07, 2009 at 09:54:35 PM EST
    there tends to be a relationship between corp and non-corp credit instruments, in terms of both liquidity and value. the reason for this is simple, corps don't exist in a vacuum.

    corps, and their debt, are positively or adversely affected by the very same economic turns that impact individuals. who, exactly, do you think it is that's buying those corp's products and services?

    this isn't to suggest a completely linear relationship, but to point out that the economy consists of many interrelated parts, which tend to affect each other.

    to say this study only reflects the value of corp instruments, and bears no relationship whatever to the rest of the economy, is to demonstrate a lack of awareness of just how our economic model works.


    My point was that it is relatively easy to keep, (none / 0) (#25)
    by steviez314 on Wed Apr 08, 2009 at 07:42:03 AM EST
    for example, GM's corporate debt fairly priced.  You can reference the common equity, preferred stock, the implied volatility of GM's listed puts and calls versus its CDSs, etc.  There is a deep and liquid market in all those instruments.

    There is no equivalent hedging available for say, loans made in 2006 , 3rd tranche rated A, zip code X.  So it's much easier to see that pricing that in an almost nonexistant market can be way off.


    Stevie is absolutely correct. (none / 0) (#27)
    by Green26 on Wed Apr 08, 2009 at 09:50:11 AM EST
    I don't know why some of posters on this board can't admit that there can't be a valid market price when there isn't a real market. It's so basic.

    Or, as Atrios would no doubt put it.... (5.00 / 1) (#4)
    by lambert on Tue Apr 07, 2009 at 08:38:04 PM EST
    ... The Big Sh*tpile really is sh*t.

    Quelle surprise.

    Which begs the question . . . . (5.00 / 1) (#6)
    by nycstray on Tue Apr 07, 2009 at 09:39:28 PM EST
    is it now pony manure?

    Actually, that could have a higher retail value, what with all the "Victory" gardens springing up . . . .


    Pony manure is magic sh!t (none / 0) (#19)
    by Militarytracy on Wed Apr 08, 2009 at 07:19:20 AM EST
    This sh!t doesn't seem to possess many magical traits :)

    There is no market for many of the securities. (3.50 / 2) (#8)
    by Green26 on Tue Apr 07, 2009 at 11:01:58 PM EST
    Many of the securities, and ones similar to them, have not been traded for over 6 months. How can this guy argue that the market has properly priced the securities, when there is no market?

    Many of the toxic assets are loans, not securities. They are not traded. The study is not applicable to these assets.

    The study cited was for "investment grade securities". Are these guys trying to tell us that all of the toxic securities are investment grade securities?

    First hand knowledge and analysis of the assets is better than doing an analysis based on modeling, in my view.

    Academics and commentators who don't understand or have experience with either these types of assets or business in general, are not in the best position to judge the value of the assets. The private funds and management companies who will evaluate and bid for the assets are, or will be, in a much better position.

    Why are some of you so afraid of the Geithner plan? Are you afraid it will work?

    And please don't try to tell us that the government will be taking all the risk, because that is not true. Sophisticated private funds and management companies are not going to throw away billions of dollars of their own money, and the money of their investors.

    Look, you keep saying this stuff ... (5.00 / 2) (#10)
    by FreakyBeaky on Wed Apr 08, 2009 at 01:20:36 AM EST
    ... and what kills it is (1) we don't know what the market value of these so-called assets is because there's no market for them, and (2) to find out what their market value is, the taxpayers must create a market by providing 93% of the purchase price to private investors to buy these assets for more than they evidently think they are actually worth - oh yeah, and take the vast majority of the risk in return for a fraction of the theoretical upside.

    There's no market for dogsh*t because it is what it is.  I'll wager there's no market for legacy assets for the same reason - and given my druthers I'll not let the next guy gamble on finding the odd diamond in the sh*tpile with public money.  No, thanks.  


    No Freaky, no one is suggesting (none / 0) (#28)
    by Green26 on Wed Apr 08, 2009 at 09:58:27 AM EST
    or wants any TARP buyer to buy any toxic asset "for more than it's worth". The goal is to use the government money as a strong incentive for private investment funds and private asset managers to buy assets at a price they believe they can make a profit on in the future. This amount is believed to be more, or even much more, than anyone is willing to pay for the assets in what has essentially become a non-market (i.e. a situation in which there are virtually no bidders).

    Note that the sales will be designed as auctions, with multiple bidders. I'm not aware that anyone has tried to auction off any of these assets.

    While the government funds may constitute up to 92.5% of the debt and equity for the private investment funds, I believe I read that the asset managers and government would split their funding equally.


    The whole point ... (none / 0) (#36)
    by FreakyBeaky on Thu Apr 09, 2009 at 12:53:16 AM EST
    of the exercise is to get your private asset managers etc. to pay more than the thirty cents on the dollar they think these trash assets are worth.  It is stunningly obvious.  

    If private entities thought these trash assets were worth more, they'd buy them with their own money at a price at which the banks would sell.   They aren't worth say sixty cents on the dollar unless you are paying only 7% of the price, and sticking the taxpayers with the bill for the other 93% if things go wrong, as they probably will more often than not.


    A lot of the really bad stuff (none / 0) (#9)
    by gyrfalcon on Wed Apr 08, 2009 at 12:04:15 AM EST
    did get rated as "investment grade," unfortunately, which is how so many people and institutions got suckered into buying them.

    Be that as it may, it's simply nonsense to say all this stuff is entirely worthless since the vast majority of mortgage holders will continue to pay their mortgages.

    They're not inherently worth their initial price anymore, but they're not inherently worth nothing, either.  They're somewhere in between.  Whether the Geithner (modified Paulson) plan is the best way to go about solving this I still can't make a judgment on, but it's intended to do an entirely rational thing, which is to see what their actual market value is when buyers can overcome their fear with government help.

    If a consensus market value emerges from the auctions, then we'll know where the financial institutions holding them really stand on their balance sheets.  I freely admit it may be my lack of complete understanding of all this, but I can't for the life of me see why this isn't an entirely reasonable and relatively rapid way of removing a big chunk of the fear and uncertainty that's crippling the financial system and sorting this all out.


    Straw again (none / 0) (#20)
    by Big Tent Democrat on Wed Apr 08, 2009 at 07:20:31 AM EST
    "Entirely worthless" is simply not the issue. And by now, you damn well know it.

    Please stop with the straw.


    It is difficult addressing these people who (none / 0) (#23)
    by Militarytracy on Wed Apr 08, 2009 at 07:35:34 AM EST
    insist on focusing on what potentially this stuff is worth instead of whether or not this approach can even work to bail us out of this crisis or is beneficial to the ecnomy.  I could name names but I'm not, and not many of them hanging out here.  William Black crossed a line though yesterday that everyone who knows they aren't God was too afraid to cross because they'd be flogged to death.  He's probably a very "unpleasant" person too :)  When faced with the inevitable failure of this approach, does it have the potential to KILL this presidency.....and William Black said yes.  Only a real b#st#rd regulator who survived huge confrontations his whole life would the fortitude to say something like that.  Do the Bots ever think about that possibility though?

    The point is that, (none / 0) (#29)
    by Green26 on Wed Apr 08, 2009 at 10:02:16 AM EST
    given the lack of a market for many of these assets, there is a large gap between what buyers (to the extent there are any buyers, as there aren't many buyers) are willing to pay and what sellers are willing to sell for.

    In the meantime, the mark to market rule has caused some of these assets to be written down significantly.


    I'm sorry? (none / 0) (#37)
    by gyrfalcon on Thu Apr 09, 2009 at 01:38:08 PM EST
    I see people claiming they're "entirely worthless" all the time.  It appears to be a very common misconception.

    Help me out if I'm missing something? (none / 0) (#12)
    by rghojai on Wed Apr 08, 2009 at 06:28:43 AM EST

    These things are out there and it is alleged that it is not the price, but the lack of money keeping people from buying them.

    As I understand it, Goldman has a formidable pile of money, as do sovereign wealth funds... so why ain't they buying?

    Also, again, I wonder if I'm missing something or some things, doesn't this set up Goldman or someone else to think, "Sure, we might do some bidness on our own because we have the money and the prices are good, but why should we when the Great Big Government Deal is coming soon?"


    It is NOT the lack of money (none / 0) (#30)
    by Green26 on Wed Apr 08, 2009 at 10:12:05 AM EST
    that is keeping people from buying the toxic assets. It is the uncertainly surrounding the value of the assets, given the nature of the assets, the real estate market in the US, and the US economy.

    If real estate prices continue to go down, these assets will be worth even less. If the recession becomes more severe or continues for an extended period of time, these assets will be worth less.

    Potential buyers are sitting on the sidelines, waiting. The Geithner plan is designed to get the potential buyers off the sidelines and into the game. With the government money, buyers can minimize their downside (not eliminate it, as their money is still at risk), and have a large upside (because they will get 50% of any profits). One way of looking at this is that, in the private funds, the private investors will have 7.5% of the downside (which is 100% of their money, though), and 50% of the upside.


    The Geithner-Summers plan is worse than you think (none / 0) (#14)
    by Jacob Freeze on Wed Apr 08, 2009 at 06:39:08 AM EST
    Laurence J Kotlikoff and Jeffrey Sachs have written an essay for the Financial Times Online with the same title as this comment, and I didn't believe it, because I already thought Geithner's plan was very, very bad, but Sachs and Kotlikoff are right: It's even worse than I thought.

    Citibank can arrange to receive even more than $636m for its assets by setting up its own Citibank PPIF (CPPIF) to bid for its bad assets. The CPPIF will bid the full $1bn in face value for its own toxic assets!

    To see this, note that on a bid of $1bn by the CPPIF, Citibank would finance $71m in equity of the CPPIF, the Treasury would add another $71m in equity, and the FDIC would add $857m in loans to the CPPIF. The CPPIF will either break even (20 per cent of the time), or go bankrupt (80 per cent of the time). The CPPIF is therefore a washout - with no chance of profits, yet also zero liability.

    On the other hand, Citibank gets a sure boost of $1bn minus $360m, or $640m in net worth, for which it pays $71m. Citibank's gain from the CPPIF's overbidding is $569m, which exactly equals the taxpayer's expected loss that is incurred by the FDIC loan and Treasury equity.

    The real icing on the cake is that Citibank still ends up owning the toxic assets even after the assets are "auctioned," but this time in an off-balance-sheet structured investment vehicle called the CPPIF. The toxic assets revert to the FDIC when the CPPIF goes bankrupt.

    The whole article is definitely worth careful study, for anyone who isn't already too disgusted with Geithner, Summers, and Obama to read it without heaving.

    This was obvious... (5.00 / 1) (#21)
    by BigElephant on Wed Apr 08, 2009 at 07:26:25 AM EST
    That's actually something that is easily done in standard free markets too (think pump and dump for stock markets).  I'm not sure about the legality of it, but it could be illegal just as insider trading is.  In any case it's something that is very easy to monitor.  Which is actually another nice thing about the Geithner plan, if something does come up (either foreseen or not), it's a very easy plan to stop immediately.  In contrast to some other plans where once you start, you've become pregnant.

    I can't agree. (none / 0) (#35)
    by Jacob Freeze on Wed Apr 08, 2009 at 08:09:05 PM EST
    Why would the ownership of entities involved in bidding be "easy to monitor?"

    So far, it hasn't even been possible to monitor counter-parties of relatively simple financial instruments... meaning "simple" compared to the full set of debts and obligations of the institutions involved.

    How could the Treasury detect an interlocking web of agreements to buy another interlocking web of financial instruments?

    I can't see how such a thing could be detected, without enormously more transparency than anyone is even suggesting, and even though in the end it reduced to the banks buying back their own instruments at a profit, as described in the article I linked.


    I think it's highly unlikely (5.00 / 1) (#32)
    by Green26 on Wed Apr 08, 2009 at 10:14:33 AM EST
    that the government would allow this to occur. I'm pretty sure the government will pre-qualify bidders. While some TARP recipients may have affiliated entities that bid for the assets, I doubt that the government will allow affiliated entities to bid for their assets owned by their affiliates.

    Interlocking buys (none / 0) (#34)
    by Jacob Freeze on Wed Apr 08, 2009 at 08:02:21 PM EST
    The article which I linked actually discusses the possibility of interlocking buys, where a spinoff of Bank A buys instruments from Bank B, and vice versa. This dodge can obviously be refined, and it's hard for me to see which laws it would violate, or how the Treasury could prevent it, without full and detailed disclosure of the ownership of every entity involved, and that probably isn't going to happen, considering how opaque the whole process has been so far.