What Elephant? Where?

Kevin Drumm raises an interesting question on his blog:

[I]s it really that hard to figure out the value of all the assets rolled up into the various CDOs and SIVs (the "who knows where" in Jared's post above) that caused this mess in the first place? I know it's not trivial, especially when the market is in freefall, but there are underlying assets behind all these vehicles. The proposition that nobody really knows what any of this stuff is worth just doesn't seem all that plausible. Anyone care to explain this too?

The answer is no, it's not all that hard. The real problem is, no one wants to. Look, all the major financial institutions have this stuff on their books. So long as "nobody rally knows" what it is worth, they can continue to keep them on their books as asstes with valuations in line for what they paid for them. As soon as that changes, however, lots of bad things happen.

1) If they are correctly valued, lots of those bonds drop dramatically in value, instantly forcing banks to write down their assets and causing huge near term losses to show up on balance sheets.

2) If they are correctly valued, the credit risk of monoliners that have invested heavily in insuring these bonds skyrockets.

3) this causes ALL the bonds so insured to lose their AAA status reflecting increased risk of the insurer going busto (even if the bond itself is still low risk).

4) if bonds are degraded, many funds that hold these bonds are forced to sell them. Why? Because there are lots of funds that are regulated (for example, pension funds) and they, by law, may only make very safe investments. So if a bond goes from AAA to -A, these funds will have to sell by law.

5) if 4 happens, bond prices crash EVEN MORE, because of supply and demand (suddenly, tons of supply!).

Now one might say, isn't this delaying the inevitable? Well of course that's true. But just now no one wants to admit there's an elephant in the room and it's eating all the cake.

As we've seen with Bear (and likely will continue to see) this stuff will eventually come out. It's a matter of time though, and it will get worse before it gets better.

Image from Flickr user exfordy, used under creative commons license.