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In a previous article title “Structured by Banks, Built on
Froth” I posed several questions and based on the
information that was available at the time, made some speculative comments. Well,
some time has passed – almost a month, and several new developments
have surfaced.
The Structured Investment Vehicle or SIV
proposed by Henry Paulson, US Secretary Treasurer has faltered. This
superfund was to be financed by major banks and financial institutions as a way
to get many of the bad sub-prime loan risks off of the balance sheets of
institutions that lacked the capital on hand to cover the losses or potential
losses. There were basic problems with the idea from the beginning.
No one was quite sure – even those
that held the investments what exactly was in them. That lack of transparency
and the rather low margin of yield for taking such a risk left many potential
members less than willing to join. The idea of the superfund was to provide a
new way to benefit from bad choices made by otherwise smart firms. But as
Blackstone Group, once the great outside of the industry hope for the fund
pointed out, the profit margin may have been too low for the risk involved.
Inside this SIV are real tangible
assets. Unfortunately, the owners of the mortgage-backed securities are
unsure exactly what they are. With the announcement on Wednesday by Wells
Fargo that there may also be trouble in the home equity loans and the rumors
from other banks that there may be an increased possibility that
loan-to-value borrowers may be at risk, has created additional ripples in the
markets. Loan-to-value borrowers are those who may be financially able to
make the loan payments under the current interest rates, but the value of the
underlying security, namely the house, may be losing value faster than the
borrower anticipated. This makes refinancing the loan difficult and gently
shifts what would have normally been considered prime, to the edge of the
sub-prime.
Peter S. wrote me with several questions
about how these SIV are financed and because of these recent developments,
there are some answers available that were not when I wrote the first
article.
“If the consortium of banks,” he writes “is using borrowed money to buy the SIV's
which no-one wants as they are obscure and contain toxic mortgage, who is
lending the bank consortium the money, the Fed or the Treasury?” It
will be the Federal Reserve’s job to provide as much liquidity as
possible to the borrowing banks at the most favorable rate. The recently
extended the “repo” rate on some short-term loans to 45 days is
an effort to get some of these banks to borrow more.
Unfortunately,
it will be the Treasury that bails any banks out of the mess they are
in.
He
asks: “How is this toxic rubbish,
which has to stay obscure, eventually dealt with? Is it going to be held
there till the housing market recovers, which could take years? Who is paying
the interest on the borrowed money?” These loans have value and the
banks must continue to pay interest to the investors. Taking the loss quickly
may seem like the best answer but to do so, you need to find someone willing
to buy your loss. In the global marketplace, investors are currenlty not
willing to pay anything close to what these vehicles are worth. That being
the case, holding them might be the best way to appease shareholders.
The
other option is to sell a portion of the institution to foreign investment
funds. Now this approach, which was used by Citigroup this week when it sold
a portion of itself to Abu Dhabi’s sovereign fund for $7.5 billion, may
not set well with isolationists but, as the globe shrinks and petrodollars
gather into the funds, the sale sign is on America’s front lawn.
Peter’s
last two questions deal with fear mostly. Asking “how long can 'they' keep this deck of cards, or the world's greatest
scam, from collapsing” and whether this will lead us “all down the path to Armageddon?”
can rattle those of us who are truly bearish.
If
there is a recession in the offing, and many believe that there is, the
Federal Reserve Board will cut rates dramatically over the next several
months. The markets are increasingly anticipating a 50 basis point cut on
December 11th – although the European banks seem reluctant
to follow.
It is
important to remember two things: First, the Fed seems to know as much as we
know and as soon as we know it. This is not transparency and continuing to
use the phrase “we don’t know” is not adding any legitimacy
to the institution nor is it adding comfort to the markets.
Second:
Any changes in rates, dramatic or otherwise will take months to work their
way through the system. It may be too late to hope for a short-term end to
this mess, Peter, but you can rest assured, because of the global
marketplace, the landing will be softer than it would have been twenty years
ago.
Paul Petillo
www.BlueCollarDollar.com
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