Friday, 26 September 2008

Mark to Paulson

Everyone is worried about the prices that Hank will pay with the taxpayer's money in his bailout plan. That is understandable, and I would be worried too if it was my money.

However there is some possibility that it won't be a disaster every time the MOAB buys an asset. Here's why.

On average, across the cycle, you are paid more to take credit risk than it costs you in defaults. So if you were arbitrarily well capitalised and could wait forever, simply buying a diversified pool of credit risky assets will make money. (Whether it has a decent ROE is another question.)

The reasons for this gap between fundamental long term buy and hold value and market value are numerous: cost of funds (not everyone funds at Libor flat), liquidity premiums, volatility of the spread (which requires capital to support it, at least for mark to market holders) and so on.

Now of course Hank isn't buying a diversified pool, and he is not buying across the cycle. He's buying what the banks want to sell, and he's buying in the next year or two.

Still, it is at least good to know that if you buy for more than the market price, and hold to maturity (or at least until the liquidity and funding premiums have fallen substantially), you _could_ (not will, but could) make money. (Bloomberg has more on the MOAB as a carry trade.)

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