Thursday, September 13, 2007

ImploSIVe Structures

I had a long conversation with a bank treasurer recently and among other things we discussed ABCP's and SIV's. His bank had just lost a small amount of money (for banks small is relative - it was in the low seven figures) in one of the SIV's that went belly up. The very first thing he mentioned was that the financial engineers' excuses about rare 5 or even 25 sigma events being the cause, was absolute nonsense. We both agreed that these instruments, even the tranches rated AAA, were bound to fail catastrophically if market values for the underlying collateral dropped by even as little as 10%.

The reason was the combination of tranche structure and 10x leverage. For example, an SIV typically issued a bottom "equity" tranche, then a consecutive "middle range" series of tranches rated BBB, A, AA and AAA, plus a top "super-senior" tranche. The middle range that was sold to investors carried the 10x leverage through issuance of ABCP in order to produce the extra yield, or LIBOR "plus" that everyone wanted. With a mere 10% correction in the assets backing the SIV the value of all tranches it issued, from equity to AAA, immediately goes to ZERO. The super senior tranche still retains value, but it is necessarily a very small portion of the original SIV. This is exactly why ABCP investors won't roll their paper and demand their money back, instead.

The combination of leverage plus tranche structures makes a mockery of credit ratings, at least as we used to understand them in the past. In this "innovative finance" context, AAA apparently meant that "the market price for the collateral won't ever go down by more than x%" - which is plainly nonsense. If anyone insists in calling a 10% correction in MBS prices a 5 or 25 sigma event, they really need to stop reading financial comic books and concentrate on studying the history of credit default effects of the business cycle. Then they can go back playing with their Lego(R) blocks.

------------------
In the meantime - and most certainly NOT coincidentally - the ECB had to pump in 75 billion euro ($104 billion) into the market yesterday. This was 3 month money and it was a record. They might as well issue credit cards, eh? In case anyone hasn't figured it out by now, the ECB is doing the Fed's laundry...


16 comments:

Edwardo said...

"Doing the Fed's laundry?" This may not be related to that comment, but my sense is that should the Fed administer lower rates next week their allegiance will become crystal clear (as if it isn't already) that they intend to bail out the banking/speculative community at the expense of the currency.

At that point, Bernanke and his fellow travelers should be removed from office as they will have abandoned their price stability mandate most egregiously.

In the meantime, with nothing, ABSOLUTELY NOTHING supporting the greenback we can look forward to much higher prices for just about everything. Bring on the Amero!

Anonymous said...

...they intend to bail out the banking/speculative community at the expense of the currency.

It's not clear to me what will happend to the dollar. For years now buyers of T-bill have been taking a big hit -- look at a chart of the dollar index -- and this does not seem to have seriously affected their appetite.

I don't see how a rate cut can help anyway. The problem is looming asset deflation: a lot of bad debt and derivatives based on that bed debt is spread all over the place -- what another commentator is calling "fictitious capital".

And they are trying like hell to disguise this for as long as possible:

And what he senses now is a massive effort to conceal the extent of the toxic sludge buried beneath some of the biggest names in the business.

"Everybody is hiding and not disclosing losses," he says. "They're all winking and nodding at each other because they've all got this stuff on their books."


Trying to buy time while they and the PTP figure out what to do, I suppose.

IMO, what makes the most sense is to find some way to keep homeowners making payments, if at a reduced level; a rate cut may help somewhat there, but for subprime people more will be needed. This is the best way to try to control/limit the asset deflation. But even this will only help some, as homes will continue to lose value, and then many people will have negative equity.

Of course I'm 100% opposed to any and all such measures, which means that in a contrarian sort of way something like that will probably happen.

eh

Kicker said...

IMO, what makes the most sense is to find some way to keep homeowners making payments, if at a reduced level; This is the best way to try to control/limit the asset deflation.

The symptom of a recession is lower asset prices. The cause is over-extended household or corporate balance sheets.

The problem can be fixed in any of three ways. The first is as you suggest. Consumers are encouraged to reduce consumption pay down debts.

This is the path that Japan took. Almost 17 years later, they are still dealing with "reduced consumption" and deflation.

The second is through inflation. The Federal Reserve prints enough money until some of it finally trickles into wages.

Of course, this would probably blow a huge bubble in commodities. If the Fed starts really pumping SOMA even I may be willing to tap my home equity line and invest in oil and metals. Fixed debt against assets would be the only way to protect yourself.

The third is through the bankruptcy courts where the pain is distributed equally to the creditor and the debtor. But, the creditor walks out with most of its purchasing power intact.

This has the effect of being very painful, but very quick.

Anonymous said...

The second (scenario) is through inflation. The Federal Reserve prints enough money until some of it finally trickles into wages.

You mean dumping this currency that is now mostly in the hands of foreigners and still is the base of most international trade.

I hope you are joking. BB is trying hard to convince the world that this paper still hold some value after all the damage done to this great US achievement. Dumping it would be one a one-ticket.

Your scenarii number one and three are definitely not mutually exclusive by the way.

Your first scenario may not develop as it did with Japan since USA would for sure react in a different manner.

Can't we can expect a rougher recession but possibly a faster recover as well? Let us hope so.

Kicker said...

I hope you are joking.

It's not a rational course of action, and I'm hardly suggesting it.

But, we had a Federal Reserve in the 70's that were willing to try printing their way to prosperity and balanced trade.

Edwardo said...

True enough what you say about the action of the T-bill market to date. But my sense is that the strain on the T-bond and bill markets (see the evolving ominous patterns of bill to cover ratio)is fast reaching lethal proportions.

Printing their way to (false) prosperity was the may of the Maestro and this coming Tuesday will be a day or reckoning of sorts to see if that pattern continues. You better pray it doesn't.

dave said...

So why are so many people not making mortgage payments? After listening to Bush and congressional pandering, they are all waiting for the coming bail-out.

So why arent banks marking their REO properties down to market? They remember the RTC took all the bad properties in the S&L crisis, and they are all waiting for the bail-out.

So why are all the investment banks not marking their CDO, etc toxic waste to market? They have already been told they are too big to fail, and they are waiting for the bail-out.

We still call it Capitalism, but it looks like something completely different.

Anonymous said...

So why are so many people not making mortgage payments? After listening to Bush and congressional pandering, they are all waiting for the coming bail-out.

So why arent banks marking their REO properties down to market? They remember the RTC took all the bad properties in the S&L crisis, and they are all waiting for the bail-out.

So why are all the investment banks not marking their CDO, etc toxic waste to market? They have already been told they are too big to fail, and they are waiting for the bail-out.

We still call it Capitalism, but it looks like something completely different.

Jim Grant said...

Absolutely.

"...capitalism without financial failure is not capitalism at all, but a kind of socialism for the rich."

Robert Mugabe said...

America could learn a lot from Zimbabwe.

Hellasious said...

Re: marking to market

Those who know how bank accounting works will not be surprised if I say there are a myriad ways to hide the trash under the carpet.

For example, trading losses can be hidden from the income statement by switching the damaged securities to the "long term portfolio investments" section of the book instead of "trading securities". No real mark to market is then necessary - they can carry them at cost.

Another way is to take the loss against balance sheet equity, as opposed to income statement profit. Just about everybody concentrate on the income side and ignore the balance sheet.

And how many businesses do you know that can LEGALLY keep enormous pieces of exposure OFF balance sheet? Derivatives are almost always kept off balance sheet and given their current importance this is very worrisome.

Listen, banks have a million ways to cook the books if they want to - of course not all, or even many, do so.

But those that do, always end up in deep trouble and always in the same way: one day they look fine to the casual outsider and the next day the bank examiners swoop in and shut the place down.

Except for the very big ones: those are ultimately salvaged by selling themselves very, very cheaply.

Regards

Anonymous said...

Just check out FASB 157...at BKUNA, 85% of their option-ARM portfolio clients PAY LESS THAN THE INTEREST each month. BKUNA can come out next quarter and say, we think Hillary will be elected president and pay off the investment condo mortgages for all illegals in Florida, therefore we are taking no impairment on these loans. That would adhere to GAAP standards under FASB 157.

Think the SEC would step in and not stand for this nonsense? Think again:

“The SEC’s position lets institutions overseeing bonds backed by subprime and other risky mortgages to keep the assets off their balance sheets and avoid a regulatory requirement to hold more capital in reserve.”

- Shawn H

Guaranteed google rank said...

Shanghai Fashionorganic makes
Bamboo Clothing,Bamboo fabric ,
Hemp clothing,Organic Cotton,
Organic cotton clothing,Hemp Sandal
Soybean clothingVinyl Bag
Vinyl Packaging
laser engraver which is also the perfect choice for stamp making.cnc router
Super file encryption,folder encryption,A powerful and easy-to-use program for encrypting and protecting your data
iVANTEE is a professional outsourcing consulting and management company which focuses on outmanaging service
include software outsourcing.website development outsourcing
webサイト 開発ソフトウェア 開発

Anonymous said...

We review the bestonline poker bonus
online poker rooms
online poker guide
poker room reviews
poker sites
and so on.
We offer the highest quality flowers melbourne from around Australia at excellent prices
onlinecasino.com - online casino reviews
with best online casino,
usa online casino, strategy, news!

Anonymous said...

Laser marker,Laser Marking Machine,Laser Engraver
MCSEflexible coupling
stair lifts
stairlifts
bath lifts
bathlifts
wheelchair ramps
access ramps
disabled ramps
wheelchair ramp
mobility scooters
wheelchairs
rug
rugs
Counselling Aberdeen
Hypnotherapy Aberdeen
Hypnosis Aberdeen

Anonymous said...

louis vuitton replicahandbag wholesale
replica baghandbag replica