MBS Values and House Prices

Atrios explains why he thinks the banks’ toxic assets probably aren’t undervalued:

The possibility that the assets in question are not fundamentally undervalued seems like a very serious possibility to me (I’d say a likelihood). Indeed, if one makes the seemingly plausible assumption that property values will continue to decline until they reach something in the neighborhood of pre-bubble trendlines, they’ve got a fair amount left to fall, which is one of several reasons the ‘undervalued’ assumption looks potentially suspect.

I think this is a bit off base. The assets aren’t backed by the houses, they’re backed by the income streams flowing from the mortgages. People don’t automatically default on their loans if their house falls in value. The relationship goes the other way ’round—people in danger of defaulting used to be able to avoid that scenario by selling their house. With prices way down, that doesn’t work any more and defaults are up. But how much defaulting we see over the next two years should have less to do with the price of houses (which is going down) than it does with the unemployment rate. People who don’t have jobs don’t pay their mortgages on time.

The result is a situation in which there’s no unequivocal answer to what the “right” price for mortgage-backed securities is. On our current trajectory, their value is extremely low since the economic outlook is so bleak. But if the administration’s recovery efforts—including this asset business—actually work, then the unemployment rate will be lower, the default rate will be lower, and the assets will turn out to be worth more than people are currently willing to pay for them.

I still think it would be better to do this in a way that didn’t have the “free money for financiers” structure to it. But on the narrow question of whether or not it will “work,” the gamble isn’t that the assets are “really” valuable and people just “think” they’re worthless, the gamble is that it’s the bad state of the economy that’s making them so worthless and that if you solve the bank capitalization problem the asset values will rise.