We have been saying for some time that the policy premise of the Fed and Treasury has been that the financial crisis is that it is a liquidity crisis, not a solvency crisis. If you are of that school, the fallen prices of various assets is due to a combination of scarcity of funding plus irrational panic. Find ways to provide liquidity and give investors that magic elixir, confidence, and voila, crisis over.
Having watched the credit markets closely before the implosion, we’ll agree there was plenty of irrationality. But it was in the gross underpricing of risk. The snapback to current pricing to us thus seems a return to rationality plus new fundamentals based on borrowers who never should have been lent money in the first place defaulting on such a scale as to damage overall economic activity. And that means, as plenty of Serious Economists (Krugman, Buiter, Stiglitz, to name a few) have warned, the Geithner cash for trash program is a huge misallocation of taxpayer dollars. Even granting that something must be done about the banking system, this is a covert and wasteful way to go about it.
That thesis has been validated by Harvard’s Joshua Coval and Erik Stafford and Princeton’s Jakub Jurek in a paper “The Pricing of Investment Grade Credit Risk during the Financial Crisis” (hat tip Bill Black). It looks at the repricing of investment grade credits, which is easier to analyze than structured credits (you have other claims, namely stocks, on the same entities, which allows for a relative analysis).
The paper starts by mentioning the public private partnership and its belief that market prices are distressed:
The government’s view is that a disappearance of liquidity has caused credit market prices to no longer reflect fundamentals:2
An initial fundamental shock associated with the bursting of the housing bubble and deteriorating economic conditions generated losses for leveraged investors including banks … The resulting need to reduce risk triggered a wide-scale deleveraging in these markets and led to fire sales … [The Public-Private Investment Program] should facilitate price discovery and should help, over time, to reduce the excessive liquidity discounts embedded in current legacy asset prices…..
Yves here. Did you catch that? The price collapse is due mainly to “excessive liquidity discounts”. Please. Some of the exotic flavors of now junk paper (as in certain CDOs) were called “trades” because they were designed NOT to be resold. So the concept of a liquidity discount applying to paper anticipated to be illiquid from the get-go is quite a stretch.
As an aside, we have to mention the intellectual inconsistency. The logic of the PPIP is that current market prices are wrong. Yet the authorities failed to question prices (or more important, overall leverage) in the frothy days. Funny how that works. Now that prices are low, that can’t be right, since it’s way too inconvenient, so we are going to create a rigged market and claim it’s necessary to produce “better” prices. Back to the article:
Our results suggest changes in fundamentals, as reected in the equity market, account for a large portion of the repricing of credit that has occurred. In particular, the dramatic increase in the price of low cashow states can account for most, if not all, of the rise in credit spreads for cash bonds. The spreads on credit default swaps, which currently trade at a large and negative basis relative to the underlying bonds, appear too low relative to risk-matched alternatives in the equity
We also nd that the repricing of the investment grade structured credit securities suggests a correction of an ex ante failure of investors to appropriately charge for systematic risk. Prior to the crisis, Coval, Jurek, and Sta¤ord (2009b) argued that investors did not appreciate the systematic risk exposures of these securities and provided evidence that credit protection on the senior tranches of the investment grade CDX was underpriced (i.e. spreads were too low), while protection on the junior most tranche was overpriced.
Did you catch that little doozy, credit default swaps now look underpriced? Lordie. And CDS are still being written, some by firms that have Federal backstops.
I’d welcome the input of any hard core quants reading the paper, but I also note the authors use a modified CAPM approach. That I presume would still use Gaussian distributions, Although most quants resist using Levy type distributions (which are brutally hard to model, the Options Clearing Corp. since 1990 has used Levy distributions for setting margin requirements, which says it is not as impossible to implement as the crowd adhering to the conventional techniques asserts). Thus I wonder if even this approach understates risk, for if so, that would argue for even lower prices.