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?