Non-Toxic Assets Priced Properly. Therefore, Toxic Assets Priced Properly

That seems to be the argument in this paper by Harvard's Joshua Coval and Erik Stafford and Princeton's Jakub Jurek, which is being touted as evidence that Treasury is wrong to believe that the toxic assets are underpriced.

The introduction states:

On March 23, 2009, the Treasury announced that the TALF plan will commit up to $1 trillion to purchase legacy structured credit products. The government's view is that a disappearance of liquidity has caused credit market prices to no longer reflect fundamentals. ... The main objective of this paper is to determine whether fire sales are required to explain prices currently observed in credit markets.

Sounds like the paper is going to examine the prices of the toxic assets that the Treasury is planning to buy, right?

Wrong. Instead, the authors examine investment grade corporate credit risk, using the CDX.NA.IG index. But ABS and CDOs backed by investment grade corporate bonds are not eligible for either the TALF or the PPIP. In other words, investment grade corporate bonds aren't considered "toxic assets."

The authors conclude that market prices of investment grade corporate credit risk are accurate—which isn't surprising, seeing as the CDX.NA.IG is the most liquid contract in the CDS market. Amazingly, however, the authors use this to conclude that the Treasury's plan to buy up the banks' toxic assets is misguided:

Policymakers are rapidly moving towards using TARP money to purchase toxic assets—primarily tranches of collateralized debt obligations (CDOs)—from banks, with the aim of supporting secondary markets and increasing bank lending. The key premise of current policies is that the prices for these assets have become arti…cially depressed by banks and other investors trying to unload their holdings in an illiquid market, such that they no longer refect their true hold-to-maturity value. By purchasing or insuring a large quantity of bank assets, the government can restore liquidity to credit markets and solvency to the banking sector.

The analysis of this paper suggests that recent credit market prices are actually highly consistent with fundamentals.

Are they serious? The Treasury is arguing that the prices for mortgage-related securities are artificially depressed because of illiquidity and fire sales. No one is arguing that investment grade corporates are underpriced due to illiquidity and fire sales. That's why ABS and CDOs backed by investment grade corporates aren't eligible for the TALF or the PPIP. The fact that prices for tranches of CDOs backed by investment grade corporates are accurate is completely irrelevant to whether prices for mortgage-related securities are accurate.

To repeat: the fact that the prices for non-toxic assets are accurate does not mean that the prices for toxic assets are accurate.

What's the deal with the ivory tower recently? Did everyone decide to take extra-strength stupid pills?