Monday, September 22, 2008

Limits of Liquidity 

With all due respect to Paul Krugman and Tom Maguire, the argument over the Treasury paying 'premium' prices seems misplaced.

The trouble is that we really don't know how much these "Mortgage-related" assets could be worth. It is the uncertainty of their valuation that makes capital raising difficult. The capital providers don't know how much more of their fresh new money will simply be marked down and not earn a return.

Krugman, taking an unusually dim view of government, is sure that the Treasury will 'overpay' and suggests that if they don't , it won't help financial institutions. Krugman may be wrong here, as simply removing the cloud of uncertainty will clear the path for capital raising in future.

Maguire notes that simply providing liquidity against these assets will help free up capital. However, if they are worth $0.05 on the dollar, this will simply provide the near total loss of capital at the low end of mortgage-related asset valuations.

The trouble is we don't know how these assets will behave because we haven't seen home prices behave this way, borrowers haven't been this leveraged and we haven't put as much 'structure' around mortgage instruments in the past.

The capital adequacy of several large banks hangs on $0.05-$0.10 cents of difference in ultimate value of their mortgage portfolios. If the price is good enough to remain solvent, providing certainty will be a big help. If it isn't high enough, simple liquidity won't be enough.

I predict only institutions that can achieve certainty *with* capital adequacy will sell in this structure. Plus maybe those already in liquidation.


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