Via John Carney at Clusterstock, we have a study by Harvard’s Joshua Coval and Erik Stafford and Princeton’s Jakub Jurek, who concluded that Treasury Secretary Timothy Geithner’s assumption regarding the “inherent economic value” of toxic assets is bogus:
The analysis of this paper suggests that recent credit market prices are actually highly consistent with fundamentals. A structural framework confirm s that bonds and credit derivatives should have experienced a significant repricing in 2008 as the economic outlook darkened and volatility increased. The analysis also confirms that severe mispricing existed in the structured credit tranches prior to the crisis and that a large part of the dramatic rise in spreads has been the elimination of this mispricing.
In short, the toxic assets clogging up the banks are worthless, and not, as Geithner believes, stuck at a depressed value due to our lousy economic climate. This is a problem because Geithner’s entire bank rescue plan hinges on the notion that these assets are worth something. If that notion is wrong, then the plan will, at best, “simply fizzle,” and at worst, be a very expensive subsidy to savvy investors that does nothing to relieve banks of their toxic waste.
Like Nouriel Roubini, Coval, Stafford, and Jurek believe that “many major US banks are now legitimately insolvent.” Therefore, they write, “any taxpayer dollars allocated to supporting these [toxic asset] markets will simply transfer wealth to the current owners of these securities”:
To the extent that these assets reside in banks that are now insolvent, the owners are essentially the bondholders of these banks. The reason their bonds are currently trading far below par is that the assets backing up their claim are just not worth enough (nor expected to become worth enough when their bonds mature) to repay them. And so while they will be cheered by any government overpayment for the toxic assets backing up their claims, their happiness will be at the taxpayer’s expense since, to the extent that current prices are fair, they will be receiving more than fair value for their investments.