It's not worth zero, but if the market says it is . . .

If you put your nice leather jacket on eBay, which you believe to be worth some sum in the hundreds of dollars, and nobody will bid anything for it, how much is it worth?

When it comes to valuing an asset, the simple fact is that the asset is worth whatever somebody will pay for it. If the highest bid for your jacket is only eleven dollars in any market that you can shop your jacket to, then your jacket is worth only eleven dollars until you can get someone to pay twelve dollars for it. Of course, if you have some fame or notoriety, people may be willing to bid thousands of dollars (or much more) for a jacket that you have worn.

In regards to the current credit crisis, there are now assets on the books of many companies for which nobody knows the price. In many cases, because buyers across the board are refusing to buy certain assets (mainly those composed of mortgage loans), there is no market at all.

Buyers are afraid to buy asset-backed loans because they don't know what they are worth. In the absence of any buyers, it's hard to say what the real market value is for those assets, but based on the "eBay definition" above, they aren't really worth anything if nobody will pay anything for them.

However, different from the jacket on eBay example, in this case the mortgages actually pay a certain yield. It's as if you had a jacket in which magically every morning a one-hundred-dollar bill showed up in the pocket. If you had a jacket which did that, and you put it on eBay, you would be shocked if the highest bid you could get was eleven or twelve dollars.

Yet that is the situation that is taking place in financial companies who own such assets. Because the market for those assets has frozen in place, they are suddenly forced to write down their balance sheets to reflect the fact that, according to the markets, certain of their assets are worth much less than they may be worth in future months.

If you had a "magic hundred-dollar-bill jacket" and nobody would pay you more than eleven dollars for it, you would probably just shrug and say, "I'll hold on to it for a year or two and then try again." But if you are a public company, and you have to mark all your assets "to market" periodically, you would have to write down your balance sheet accordingly, and that might impact your credit rating and your ability to obtain loans that you need in order to run your business.

At the heart of the problem is the uncertainty as to how long those hundred-dollar bills are going to keep appearing in the jackets, because the jackets in question are actually composed of mortgage loans, the value of which are subject to the ability of borrowers to keep making payments. In the wake of the Federal Reserve's easy money policy of 2003-2004, the strength of instruments composed of those loans may be well below what the rating agencies once said they were.

Yet they are not zero, though in the absence of a market companies may have to mark their balance sheets as though they are zero or close to it, and companies -- even those with all high-quality mortgages on their balance sheets -- are being treated as though they are worth zero by their creditors, and some may go under because of it.

In the wake of all this, there are calls for the government to enact tighter regulation of mortgage lending and of the packaging and securitization and marketing of mortgage loans in the financial world.

But it may be that the real problem was the government in the first place. It was not all that long ago that congressional committees chastened lenders for so-called "discriminatory lending". In many ways this pressure removed the natural self-regulation lenders have against making loans to people who can't repay them. It is notable that the reprimand eminating from congress today is for "predatory lending" supposedly practiced by lenders. It strikes us that this presents an impossible dilemma for a lender to negotiate.

In addition, government regulation exacerbated the fallout from loose lending, with the 1991 requirement enacted by the Financial Accounting Standards Board (FASB) that corporations mark to market all assets on their balance sheet. Another contributor to the problem is the requirement for rating debt-instruments by just three government-approved ratings agencies (S&P, Moody's and Fitch) which also helped short-circuit the "self-regulating" due diligence that would have taken place in a market where buyers of assets judge the risk of lending or of buying loan-based securities for themselves.

It is likely that the level of defaults will be much lower than the market for mortgage-based instruments currently suggests, because the market for those assets has failed. The Fed's creation of a swap for those assets this week was a major step in the right direction. Eventually, people will realize that these assets are not worthless, just because the market right now says that they are. However, the damage is serious, and some good firms may go under because of it.

For later posts dealing with the same topic, see also:
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1 comment:

  1. great post! I am wondering what it will take to get investors to buy mortgages again.