Monday, December 31, 2007

Precommitment

Given some of what I have seen on the net I need to do a serious (much more than this) post on asset prices and defaults. I think some people are conflating the decline in asset values from the bursting of the credit bubble with the value of defaults.

Indeed the former is significantly larger than the first. For example, if I told you that a bond you thought was perfectly safe when you bought it for $100,000 actually had a 25% chance of being worthless what would you be willing to sell it for? I guessing much less that $75,000.

Now suppose that a financial enterprise you were invested in had been raking in big profits by buying these $100,000 bonds that now have a 25% chance of default, how much less do you think your investment would be worth. Remember that this not only includes the fact that the bonds are worth less but the realization that the supposed big profits in the past actually came from buying stuff that is a money loser today. What does that tell you about the potential for future profits and how would that effect your valuation of your investment?

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