An Imperfect World
Is the housing market overbuilt? You bet. Will the glut of unsold properties continue to weigh on prices? Yep. Will foreclosures remain at the highest level since the great depression? Uh-huh. Are mortgage-backed securities - such as those at the root of the recent collapse of financial service providers - fairly valued? Almost certainly not.
Every institution that failed or was taken over in September (so far) was hobbled by massive losses on mortgage-backed securities (MBS), whether of the plain vanilla or more exotic variety. But it's doubtful the depressed value of these securities accurately reflects their fundamentals, including the probability of loan default and the magnitude of ultimate economic loss. In a perfect world, such considerations would be paramount, but the world we live in is far from perfect.
In particular, we now find ourselves in an environment where institutions have already taken enormous MBS losses. These losses, in turn, leave them with a stark choice - raise capital (to compensate for any depletion) or reduce assets (to realign them with reduced capital levels). The former is difficult, however, when uncertainties are great and fears prevail. That leaves the alternative - dumping assets, even at already depressed prices. But this "capitulation trade" (in the parlance of The Street) further depresses prices, which further increases losses, and so on...
According to research at the Bank for International Settlements - often called the central bank of central banks - this vicious cycle has already taken hold. Specifically, economists there tried to account for the precipitous decline in various ABX indices that reflect the underlying value of subprime mortgages* and concluded that "declining risk appetite and heightened concerns about market illiquidity have provided a sizeable contribution to the observed collapse in ABX prices since the summer of 2007." Further, "ABX prices are unlikely to be good predictors of future default-related cash flow shortfalls on outstanding subprime MBS." Stated differently, fear and uncertainty have increased dramatically, thereby depressing asset values and increasing losses.
In the perfect world of undergraduate text books, of course, this would never happen. Shrewd investors would seize the opportunity to scoop up these undervalued assets, ride out the momentary panic, and profit by the ultimate rebound in prices.
But once again, the real world we live in is far from perfect; brave contrarians who've taken this long-term view have, thus far, proven no match for deteriorating short-term sentiments.
An alternative to this Catch-22 is for the government to fill the void, stepping in to buy securities that others are shunning (as with planned purchases of Fannie Mae and Freddie Mac MBS), or directly recapitalizing weak companies (e.g. Fannie, Freddie and AIG). By stepping in where others fear to tread, the government's deep pockets offer the prospect of staunching the vicious cycle, albeit while exposing taxpayers to the risks. Call it an imperfect solution for an imperfect world. (9/16/08) * The ABX: how do markets price subprime mortgage risk? in BIS Quarterly Review, September, 2008.
