BUB Two

I started thinking about one of the articles I cited under “Sources and additional reading” in my BUB post. The article was a TigerHawk post called “Did Enron beget AIG?” In my earlier post, I said this about that:

Thoughts on mark-to-market regulations; links to a Wall Street Journal article that claims that the fact the market wasn’t moving meant the value of mortgage-based assets was marked down more than was justified by the drop in value of the real estate at the bottom of the heap. Interesting but it is still the case that if no one wanted to buy a mortgage-based asset then that asset’s value was zero regardless of the value of the underlying real estate.

I went back and reread the TigerHawk post and the WSJ article it linked to and the comments on the TigerHawk post (Charlottesvillain is particularly helpful). Then I reread neo-neocon on “Naked shorts and other wonders of the financial world” and the articles she links to.

I still stand by my original statement that “if no one wanted to buy a mortgage-based asset then that asset’s value was zero regardless of the value of the underlying real estate.” To use a simple (and probably simplistic) analogy, imagine I am going to make cupcakes for a bake sale. I purchase $10 worth of ingredients and produce 48 cupcakes. That makes the underlying value of each cupcake about 21 cents assuming my labor is not considered. I price the cupcakes at 50 cents each. A couple sell quickly but when the buyers try them they discover the cupcakes taste terrible. Word spreads and no one will buy my cupcakes. Finally someone offers me 5 cents a cupcake - his dogs love sweets and he figures they won’t be too picky. I can argue until I’m blue in the face that the underlying value of my cupcakes is 21 cents each but the fact remains that their market value is 5 cents. Period.

What is clearer from my reading is that the market price of mortgage-based assets is not tightly tied to the value of the real estate on which they’re based. Home prices declined 20% while the market price of some mortgage-based securities apparently declined nearly 100%. Given this my idea to save the financial system by having the government buy up mortgages themselves rather than the distressed mortgage-based assets may not make a bit of difference to the market price - or liquidity - of those assets. It simply won’t matter that the underpinnings of those assets is now secure - the assets themselves will still be undesirable.

Rather than being a reason to do away with requiring mark to market pricing isn’t this actually a reason to do away with products that are so far removed from reality? The WSJ describes them thus:

Among its many products, AIG offered insurance on derivatives built on other derivatives built on mortgages. It priced those according to computer models that no one person could have generated, not even the quantitative magicians who programmed them.

If no one can understand how these products are priced perhaps we should consider not creating them and not selling them. Or if we believe its important to continue to do so then we need a way to segregate exposure to incomprehensible and unpriceable exotics from more mainstream investment and banking - especially if we are going to insist that mark to market valuation is not applicable to such airy-fairy investments.

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Updated October 24, 2008, with links to my subsequent BUB posts

Since I keep adding BUB posts, I updated this on December 13, 2008, to put all BUB posts in their own category. That way they can easily be found without my having to keep updating all the existing ones each time I add a new one.