What if the Current Price of Toxic Assets is Accurate?

Speaking of mechanisms for optimal allocation of goods and services given initial endowments, scarcity and desire, the issue of the pricing of toxic assets is the challenge that determines the future of the financial system. John Carney in Business Insider:

The government's official view that toxic assets are incorrectly priced due to illiquidity “fire sales” is wrong, a new study by Harvard and Princeton finance professors suggests.

You can read the whole paper by Harvard's Joshua Coval and Erik Stafford and Princeton's Jakub Jurek below. The striking conclusion is that the low prices of toxic assets actually reflect the fundamentals, rather than being driven by an illiquidity discount.

“The analysis of this paper suggests that recent credit market prices are actually highly consistent with fundamentals. A structural framework confirms that bonds and credit derivatives should have experienced a significant repricing in 2008 as the economic outlook darkened and volatility increased. The analysis also confirms that severe mispricing existed in the structured credit tranches prior to the crisis and that a large part of the dramatic rise in spreads has been the elimination of this mispricing.”

Here is a video of Coval on the issue.