Randall Bennington

Pricing The Unknowable

Barry Ritholtz makes the point that valuing toxic assets is not just part of the problem, it is THE problem for which the Fed and Treasury have no good solution:

There are Markets, and then there are markets. I am less sure that Larry Summers understands the differences between the two.

Summers is part of a group whose ideology is that Markets are a solution to many of our economic woes. I don’t necessarily disagree with this, except on the definition of what a market is. Indeed, what many economists and free market zealots call “Markets” are somewhat misleading. A place where people come together to buy and sell goods is a small “m” market — a bazaar or flea market — and may not be ideal for what some people expect from capital “M” Markets. Consider purposes of price discovery, information transmission, transaction efficiencies that are less than ideal in markets where the goods are non-uniform, information is expensive or time consuming to obtain, where transactions are infrequent, and where expertise is rare. (I’ve made many of the same point regarding prediction markets, also).

And that pretty much describes the RMBS and CDO markets. Its is one of the primary reasons why there was no exit when toxic securitized paper needed to be dumped.

The major Markets — Equities, Fixed Income, Commodities, Futures, Options and Currencies — have on a daily basis billions of transactions worth trillions of dollars. They are broad, deep, liquid. You can sell any of these assets, in size, instantaneously.

And this points out why the decision to buy any size in RMBS, CDOs and even CDS was so problematic. The commercial and investment banks and funds that chose to invest in these “financial products” –  difficult to value, thinly traded, non-uniform — was the root of the problem. That they happened to be so poorly constructed is almost besides the point. Its the non-existent market place for these hold-to-maturity securities. If you are looking for the underlying cause of why some arcane accounting rule is an issue, this is it.

This is why smart funds don’t buy beanie babies or Star Wars collectibles. Its hard to to justify the risk of owning hard to value, thinly traded, very difficult to sell items.

I would like to see a good estimate of how much would be needed for a full-blown national bank reconstruction program. Assuming away the political pit-falls, I’d like to compare the at-risk costs of one plan versus another. Simply put, the cost savings would have to be pretty dramatic to balance out the political costs that such a path would entail. Even if nationalization is the most economically efficient plan, pushing it through Congress, and through the political process such as it is now; means the likelihood of getting the plan intact on the other side is slim.

This point is what makes Treasury’s plan so problematic, and they have not presented a way around it.  Yet, given the political world in which we live, it maybe the ONLY option that will be effective. A stupidity premium, while infuriating, is also unavoidable.