Redstate

By blackhedd Posted in Economy — Comments (2) / Email this page » / Leave a comment »

There was a comment by Silverice9 to my recent front-page piece about the mortgage industry that I thought was worth responding to here, by way of providing better information that others can see.

If you read my piece, you will recall that Citigroup, the Bank of America, and JP Morgan Chase are setting up a new investment company (called a Master Liquidity Enhancement Conduit, or "M-LEC"), with the help of personnel from the Treasury Department. Actually, it appears that a senior official at Treasury (Robert Steel) hatched the idea in the first place.

There's a lot of bizarre terminology in this story and it seems to be throwing people. I never watch financial news on television, and almost never read the WSJ or the Economist, etc., so I can only guess what misinformation they're putting out.

What's happening is that Citigroup in particular, but other large banks as well, have been sponsoring what are called "Structured Investment Vehicles" (SIVs). A SIV is a financially-engineered mechanism for performing yield-curve arbitrage in a market-neutral way. SIVs are not a new idea, although there have been a lot more of them lately than in the past.

The SIVs we're talking about here will purchase and hold mortgage-backed securities which yield a relatively high rate of interest, and fund their purchases by issuing short-term debt ("commercial paper") at lower rates of interest. The idea works well as long as you can keep selling the commercial paper. (The SIV achieves market-neutrality by selling the interest-rate risk to someone else, probably a hedge fund.)

SIVs are "off-balance sheet items." This is a term you will hear a lot, because Treasury Secretary Paulson has recently started to say that such things are not well understood by regulators or the accounting profession. That means there is the risk of new regulations on them, which of course will probably make them less attractive.

To say that a SIV is "off-balance sheet" means that you won't find its assets and liabilities listed anywhere in the consolidated financial statements of the sponsor. In this case that makes a whole lot of sense. Although the sponsor (Citigroup, for example) does provide the initial funding to capitalize the SIV (and thus holds much of its equity), the sponsor does not guarantee the liabilities of the SIV. The SIV is an independent investment company. Its liabilities are guaranteed by its assets, which are the mortgage-backed securities that it owns.

A SIV that issues commercial paper to fund itself is in trouble if it can no longer do so. In the very worst case, it will need to sell out its long-term assets and liquidate itself. That's the fear in the current situation. It appears that some $320 billion in mortgage-backed securities are at risk of being sold, with no significant market available to sell them into.

What happens then? Well, you could just allow the global financial system to melt down, throw tens of millions of ordinary people out of work, and replay the Great Depression. Wait, that's not a very good idea.

Ok, you can go to Citigroup and tell them to absorb the mortgage-backed securities as an asset of Citigroup itself. In effect, this changes them from off-balance sheet items to on-balance sheet items. Citigroup doesn't like this idea because of the impaired value of the assets (which is impaired because no one wants to own them). Because of how accounting works, Citi will have to balance this against their earnings, and suddenly their stock price will be flushed down the toilet.

That may sound like poetic justice, but it's not really right to transfer this problem from the people who bought the SIVs to the shareholders of the sponsor. Nonetheless, this is the default solution, and it's essentially what happened to Bear Stearns this summer.

You may remember that Bear had a pair of hedge funds that had made leveraged purchases of mortgage-backed securities. When these funds went bad in late spring, Bear's lenders (including Merrill Lynch and Deutsche Bank) insisted that Bear Stearns re-capitalize the hedge funds with its own money. It was the mother of all margin calls.

In the Bear Stearns case, they had to come up with something like 2 or 3 billion dollars (I can't remember for sure). In Citigroup's case, it'll be nearly $100 billion to recapitalize the senior notes in its SIVs. That's a very different story. And remember, we're no longer in a world where anyone wants any exposure to mortgage-backed paper.

So the banks are going to fund this liability themselves, with what amounts to a structured vehicle (the M-LEC) on top of a structured vehicle. Everything (except the equity of the M-LEC) stays off the balance sheets of the sponsoring institutions.

There's still no bailout here, folks. Not unless you believe (as do Silverice9 and several other internet commentators I've read) that the credit quality of mortgage-backed securities is fatally impaired, and they are doomed to liquidation at essentially a zero mark-to-market.

For that to happen, a big chunk of the subprime mortgage market needs to go to zero. That means a much larger percentage of the roughly $1 trillion in such mortgages would default.

Don't be silly, people. Even though housing prices are falling in many parts of the country, subprime default rates (now around 0.5%) aren't going to go to 100% or anywhere near it. People just don't screw around with their own credit ratings like that, and they also don't abandon their primary residences like that either.