Why aren’t toxic asset prices already rising?

Caution urged as value of toxic assets fails to rally
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Amid the general euphoria over Tim Geithner's plan to tackle toxic assets there is one note of caution: while bank stocks have rallied strongly on the plan, the underlying toxic assets have not.

The ABX index, which tracks subprime mortgage-backed securities, has barely lifted from its record lows. The leveraged loan LCDX index has gained a little but is still sharply down on the year. Top-rated commercial mortgage-backed securities have rallied but are only back to mid-February levels, while lower-rated tranches have rallied much less.

It is possible that the lack of movement reflects a lack of trading in some of these markets. Problems accessing finance may be preventing investors from anticipating the impact of the government plan to finance -purchases of such assets by bidding up the price of these assets until the actual -government cash arrives to fund such trades.

Equity investors may also be most enthusiastic about the effect of the plan on loan portfolios that are not traded. Or, they may be taking broader comfort from the administration's apparent commitment to support big banks as going concerns come what may.

But the plan's modest impact on toxic asset prices nonetheless raises questions as to the sustainability of the rally in bank stocks. It is a reminder that even this plan, which most experts believe is well crafted, may not work.

In particular, it suggests that the liquidity risk premium - the price discount imposed by difficulty obtaining financing - in these -markets may not be as big as policymakers hope, implying that prices may not rise very much when government financing comes on stream, leaving banks with still large capital holes.

The bigger these capital holes - and the greater the uncertainty over the value of the remaining assets on bank balance sheets - the less plausible it is that they can be filled with private capital and the more likely it is that the government will have to provide that capital instead.

Experts highlight three reasons why the credit markets have not responded as vigorously to the Geithner plan as has the equity market.

First, the history of failed rescue plans has left credit markets wary of responding to any government plans until there are clear signs that they will be implemented.

"Credit investors are likely to watch the effectiveness of the scheme before taking a more positive view on the markets and drive spreads tighter," said a research note from Dresdner Kleinwort.

Second, credit market investors are not convinced that the low prices on risky mortgage-related assets are necessarily too low.

Specifically, the government's assumption that by injecting liquidity into the markets, prices will rise may not prove correct, not least because prices on the underlying collateral - property - continue to fall.