Credit-Bubble Datapoints of the Day

The financial markets were very wrong when it came to judging credit risk on subprime loans. Now, Haas School professor Nancy Wallace reckons that commercial mortgages, too, are mispriced.

Working with Haas Associate Professor Richard Stanton and Rice University Assistant Professor Christopher Downing, Wallace developed a new way to calculate the implied volatility of the return on properties underlying commercial mortgage-backed securities. The trio was the first to provide an empirical test of such a model, using a sample of 14,000 properties in 206 deals between 1996 and 2005. They found that the return volatilities by property types are substantially larger than those calculated by either rating agencies or investment banks.
"Our estimates suggest that some investment-grade (as opposed to speculative) bonds in commercial mortgage-backed securities are likely to be at greater risk of default than current ratings suggest," Wallace says. "We are concerned that defaults will be higher than expected if there are even relatively modest commercial property market corrections."

Meanwhile, half of the bond issuers in the world now have a junk rating, and it isn't costing them: they pay just 160 basis points more on their debt than an investment-grade issuer would. That's easily an all-time low.

OK, so let's assume that everything in the fixed-income market is mispriced. Now what? It's too late to do anything about it, so should we just sit back and enjoy the liquidity? After all, bubbles are good for you, right?