What fire sale? The credit crisis and asset pricing

The reason given for the new super bank fund to solve the credit crisis in SIV’s is that if this is not done securities will have to be sold at fire sale prices. The CP market has not responded well to the crisis and it is argued that CDO prices do not reflect the reality of their value. There is no question that prices have taken a significant discount but it is hard to define what is meant by fire sale prices. If these securities are so cheap why don’t more investors buy them? What are they waiting for?

Perhaps the prices actually do reflect reality at this time!

Why is the reprising of these assets so slow? Clearly, there is no capital to take the other side of the trade. With the cut in the Fed funds rate liquidity is present in the market, so there must be other reasons for the lack of capital to buy these securities.

1. These securities are riskier than before

a. The subprime mortgages serving as collateral for many CDO are experiencing higher default rates and delinquencies. The levels have not only risen but have become more volatile which makes for riskier securities. This will not change in the near-term and may actually continue. This increase in riskiness has actually been occurring for some time. The August crisis is just a point in time where the level of risk has started to move above a critical threshold.

b. Price adjustments of the collateral will have to be reflected in the price of securities. If collateral declines by x% there will have to be a similar decline in the value of securities. It may not be spread across all securities equally but there will have to be a decline. This is the principal of conservation of risk. Risk cannot be destroyed. It can only be transferred among parties.

2. Uncertainty is greater than before

a. The rating agencies have changed the standard for the game through rerating many deals. This was an uncertain event which is ongoing. If the ratings for deals change or are uncertain, the price has to go down. The process of what and how the ratings will change is unprecedented and is hard to price.

b. The subprime problem is unique. We have not had this type of problem in the housing markets before because lending was not conducted with the wide range of products and will such a wide range of borrowers.

3. The underlying economics have changed

a. The housing market has gone through a bubble and there has been a slowing of the economy. There are few investors who believe that growth in the US will swing up and allow for new buyers in the housing market to materialize in the near-term.

b. The housing cycle takes time. Housing as an asset market takes longer to clear than would be the case of other asset markets; consequently, we cannot impose a time frame on CDO’s that is not similar to what may be happening to the collateral.

4. Size of the problem

a. The size of the subprime market problem is very large so there has to be more time to raise the appropriate capital to add liquidity in the market.

b. Expertise has to increase. Associated with the size of the problem is the need for expertise in evaluating these securities. There will have to be a discount for those whose are less educated in pricing these securities to have them compensated for buying these securities.

So is this a fire sale or the normal behavior of markets? There have to be a discount for risk and uncertainty. There have to be discounts for the underlying collateral which has not reached its maximum decline, and there has to be compensation for the size of the problem. Any structure to solve the problem will have to still address these issues.

What is the size of the discount is hard to say but we may not be in a fire sale. Just because you do not like the price you get does not mean that it is the wrong price.