All That Glitters / The Real Failure in the Corporate Bonds Market

Let's go back six months in time, to October 2008. The crisis was roaring and the price of corporate bonds fell to a fraction of their peak worth. Seasoned capital market animals reached a fairly simple conclusion: that there was a severe market failure in Tel Aviv. Bond prices had fallen far below their true value, they felt.

Their explanation for the problem was also simple enough: The general public and generally inexperienced investors had panicked, and dumped their holdings in provident and mutual funds without discrimination. The result was that the provident and mutual funds had to sell their assets massively in order to give people their money, which depressed asset prices.

The market can't be right, said the market animals, because if it is right, then most of Israel's companies are bankrupt. They're worthless.

Six months later, the financial environment has changed. First of all, the panic has died down. Redemptions from provident and mutual funds have stopped. There are no more indiscriminate corporate bond selloffs. Secondly, investors have had time to think, read financial statements, come to terms with the new reality and reach conclusions about how much the corporate bonds are really worth.

Third of all, since November 17 the market has been recovering. From the worst of the crisis, the Tel Bond-60 index (which includes the 60 bond issuers with the greatest market capitalizations) has gained 25%. Many bonds trading at double-digit yields have returned to single digits. Last week some traders remarked that there aren't that many opportunities remaining in the corporate bond sphere. If so, can we say that even if there had been a market failure, it isn't there any more?

That question is all the more urgent for Americans, and indeed the whole global financial community. The entire plan that U.S. treasury secretary Tim Geithner has put together to rescue the banks and restart the economy is based on the thesis that the toxic assets the banks held had been mispriced - that there had been a market failure. Asset prices represent a market that has seized up, and Geithner is throwing a trillion dollars in cash and guarantees in order to restart trading in these assets and determine what the prices "really should be."

Americans, whose main trouble is with mortgage-back securities, tend to think that even if housing prices are declining, the value of a security based on the house can't drop to zero - the house is standing there, after all. Somebody lives in it.

But a new study, "The Economics of Structured Finance," by the economists Joshua Coval and Erik Stafford of Harvard and Jakub Jurek of Princeton looked into the toxic assets typically found in bank balance sheets these days, and found that the market is pricing them perfectly well. The arguments postulating market failure were wrong, they say. The assets really are worth a tiny fraction of their pre-crisis price.

That's a dramatic claim, and the study did indeed trigger a shockwave in the financial community last week. If the trio is right, their conclusion has far-reaching implications for the American economy, and probably for us in Israel too.

For Americans, if the present low prices of toxic assets are correct, then the big banks are insolvent and Geithner's plan is fundamentally wrong. All it will do is inflate asset values based on illusion, make the problems in the market even worse, and massively transfer money from taxpayers to banks, their owners and bondholders without any good coming from it.

If we follow that argument to its logical conclusion, the only answer to the trouble today is to nationalize the problem banks, write off everything that has to be written off, give the bondholders a severe haircut (meaning, they lose most of their money) and start from scratch.

Naturally, the economists from Harvard and Princeton didn't look at our local bond market in Tel Aviv. But their study hints that the market is valuing the corporate bonds correctly. The market failure or liquidity crunch - if they'd been there at all - are over.

What happened is that prices had been unrealistically swollen, they say. People may have thought that the value of a bond couldn't drop to zero, but they're wrong. Their intuition failed them.

If bond prices in Tel Aviv are correct, there are implications. Israel's banks haven't been evaluating the loans they gave corporate Israel based on market prices, but on their own subjective assessment. If the three economists are right, then the banks' assets are worth a lot less than they realize, even after the writeoffs they've done. And if there is no market failure and prices are right, there is no economic justification for government plans to rescue the big companies, which would just artificially inflate the price of their securities again.