William R. Cline writes,

The challenge is for the Federal Reserve and Treasury to develop internal reference prices applicable to each rating class and vintage of mortgage-backed securities that reflects reasonable medium-term values. These should be based on default probabilities and loss given default. The default probabilities should be based in part on prospective housing prices, for example taking account of the Case-Schiller housing prices futures. Application of this type of approach will tend to generate medium-term (e.g. three-year-horizon) prices that exceed the fire-sale levels of today’s prices on these securities.

This analysis, which comes from a leading international economist, merits exactly the response that I gave to the House Republicans: “I appreciate that you raised your hand and tried to answer, but no. Anyone else?”

It is not expected future home prices that determines the default probabilities. It is the distribution of the possible paths of future home prices. Under scenarios where prices hold steady or rise, defaults will be less. Under scenarios where prices fall, defaults will be more.

The problem is that the impact on security values is asymmetric. The upside is limited. The better the scenario for house prices, the fewer defaults. However, the benefit of house prices rising by, say, 10 percent as opposed to 5 percent, goes to the homeowner, not the security holder.

In the other direction, the worse it is for house prices, the worse it is for the securities. As prices fall, not only do you get more defaults, but you recover less of your loan balance on each foreclosure.

Because of this asymmetry, security prices tend to have low values relative to the “expected” path of house prices. In my view, these low security prices are correct. The conventional wisdom, as represented by Cline, is that the securities are undervalued. That is why the conventional wisdom is that this is a profit opportunity for the government.

In fact, what this represents is a classic opportunity for government to do what Nassim Taleb criticizes Wall Street for doing: taking short option positions that work out well most of the time but which under rare circumstances blow up.

It is exactly like the game I describe in which we roll a 6-sided die and you win $1 if it comes up 1,2,3,4, or 5 and you lose your whole bank account if it comes up a 6. If house prices stay close to where they are today, that is like rolling a 1,2,3,4, or 5, and the bailout will show a profit, of perhaps tens of billions. On the other hand, if house prices fall another 30 percent, the $700 billion will be pretty much wiped out.

The U.S. Treasury will be betting a lot of the net worth of the the American people that there won’t be a severe further decline in house prices. Feelin’ lucky, punk?As an aside, I should point out that the profit opportunity looks terrific today because of the low rates on Treasury securities. Being able to borrow at several percentage points lower than everyone else is the ultimate wet dream for a hedge fund. But if market psychology improves quickly (and that is the whole point of the bailout, is it not?), then people who have been running to Treasuries for safety will run the other direction. Treasury borrowing costs will rise, and the profit opportunity will shrink.