[quote=TheBreeze] Further, bank runs haven’t really been a problem (except for maybe at Indymac?). The problem was that the bigger financial institutions borrowed short, lent long, and, when one day they weren’t able to roll over their short-term financing, they were toast.
In your original post in this thread, you said this:
[quote=davelj]
Now, let’s assume for the sake of the argument that these AAAs are mispriced (that is, too low). The question is: Why? The answer is simple: Liquidity.
[/quote]
Well, I don’t think the answer is so simple. How do you value an asset when the collateral underlying that asset is decreasing in value at the rate of 4% a month? Liquidity may be part of the problem, but the fact that the value of the underlying collateral is suspect (as well as the future income streams) makes these assets very hard to value.
You also said:
[quote=davelj]
In this environment, illiquidity trades at an enormous discount. Many professionals I know and trust are as highly confident as they’ve ever been that some of these MBS represent the best risk-to-reward they’ve ever seen, but outside of their personal accounts they don’t have the proper (long-term) vehicle to buy and hold the securities. So the selling continues, the prices decline, and there’s not enough long-term capital out there to reverse things. The old negative feedback loop.
[/quote]
May be the selling is continuing because the value of the underlying collateral is continuing to decline?
That being said, you haven’t convinced this layperson that lack of liquidity or the banks having to engage in fire sales is the reason why the MBSs/CDOs/etc are continuing to decline in price.[/quote]
In order:
Bank runs have been the problem. Whether depositors are skittish and removing funds, or short-term lenders refuse to renew lines, the effect is the same: short-term liquidity disappears. In both cases it’s a run on liquidity.
All banks borrow short and lend long to varying degrees. This isn’t really the problem, per se. It’s how you go about matching your assets and liabilities. There are lots of ways of structuring a balance sheet through interest rate swaps and funding terms that can effectively leave a balance sheet “flat” (or match funded). But you have to want to do that. And you generally have to give up some profits (in the form of spread income) as well in exchange for reducing your exposure to interest rate risk. The problem (among others) with the bigger banks that have run into problems is that too much of their funding was “non-core” funding that required being rolled over, as opposed to “core” deposit funding, which is more stable. I have a general distrust of the funding structure of large banks – not enough core deposits to fund their lending and investing activities.
You asked how you value an asset when it’s value is falling X% per month. The market is forward looking. The bank doesn’t sit down and say, “Well, this MBS is worth X because the value of the underlying collateral has fallen Y% so far.” Instead they make assumptions about further falls in the value of the underlying collateral to come up with a value. And this is what folks buying various tranches of MBS in the market are doing now. They’re making assumptions about how bad things will be in the future in order to come up with a price they’re willing to pay today. In many cases, things will turn out worse than what’s imputed into the current price. And in some cases, things will likely turn out better. It’s going to vary by security.
If I haven’t convinced you of anything, that’s ok. That’s what makes a market, after all. If everyone agreed on the future, there would be no need to open up the exchanges each day.
