A new paper out of Harvard and Princeton arguing that toxic assets actually aren't underpriced has garnered a lot of attention. As well it might: if toxic assets aren't underpriced, we're all in big, big, BIG trouble.
But Economics of Contempt does not like this paper. No, he does not like it at all:
Sounds like the paper is going to examine the prices of the toxic assets that the Treasury is planning to buy, right?
Wrong. Instead, the authors examine investment grade corporate credit risk, using the CDX.NA.IG index. But ABS and CDOs backed by investment grade corporate bonds are not eligible for either the TALF or the PPIP. In other words, investment grade corporate bonds aren't considered "toxic assets."
The authors conclude that market prices of investment grade corporate credit risk are accurate--which isn't surprising, seeing as the CDX.NA.IG is the most liquid contract in the CDS market. Amazingly, however, the authors use this to conclude that the Treasury's plan to buy up the banks' toxic assets is misguided
This is why I'm still having trouble wrapping my brain around the notion that even a very large increase in the default rate can wipe out something like 2/3 of the value of these assets. Most of these loans will perform. And in the case of those that don't perform, while the value of the underlying collateral has fallen, it hasn't fallen to zero. They can't possibly be priced at any reasonable expected cash flow--or rather, if those expectations are reasonable, then we need to stop fannying about with the banking system, because where we're going, we won't need a banking system. We'll need canned goods and ammunition.