SIVs and Commercial Paper

Structured Investment Vehicles (SIVs), like Mortgage-Backed Securities (MBSs), are an option banks have to lend more money than deposits alone would allow, and are simple in concept but tricky in detail. Looking at the big picture, with SIVs banks expand their deposit base by selling short-term bonds. In essence, bond investors become depositors. Like deposits, capital is given to banks for which interest is paid in return, and then banks lend it out a higher rate, which is called the "carry trade."

Now, the detail. These bonds are called “commercial paper,” and typically mature in a month. They are regarded as very low risk, about as safe as cash, while paying moderate returns. Their advantage over regular deposits is they pay more. Their disadvantage is they are not FDIC insured (generally, except for CDs which are included in the term), and require more oversight. These are sold month-to-month at auctions. As long as there is an endless stream of buyers, banks have this source of extra capital to work with.

So, say Sally wants $300,000 for a mortgage, and the bank has no capital to lend. But she appears to be a good risk. So, on January 1, they sell $100,000 commercial paper, with a term of one month, to Tom, Dick, and Harry, at 5% (per annum month adjusted). They now have the $300,000 to lend Sally, at a rate of 7%. February 1 rolls around, and Tom, Dick and Harry want their money with interest. So the bank puts more commercial paper up for auction: three $100,000 bonds are sold to Larry, Moe, and Curly, at 5%. With that money, they pay Tom, Dick, and Harry their principle, and with Sally’s first mortgage payment of 7% (per annum month adjusted, plus a little more for the principle) they pay the 5% interest to Tom, Dick, and Harry, who are made whole. The bank profits by 2% (per annum month adjusted); that’s $6000 per year the bank gets for managing the SIV (plus other fees). March 1 rolls around and it’s the same thing, month after month, for the life of the loan.

Pretty smart, no? Yeah, smart until the buyers of commercial paper go elsewhere, which is what happened in Fall of 2007. Maybe all the news about subprime mortgages spooked them a little. Maybe with Federal funds rates rising there are just better investments in other places. Without this monthly turnover at auctions, commercial paper freezes. The system collapses if the bank can’t find new buyers to pay off buyers from the prior month. It would be in a pinch; they have to scramble to get that money from somewhere else.

Maybe they could by answering all the credit card mail they get—or maybe from Papa Luigi’s Sharks-r-Us Emporium. No, banks get helicopter money instead. Even more, Bernanke happily took their garbage high risk securities and gave them treasury bonds in exchange. This is what happened in November 2007-March 2008, and perhaps this is only the beginning.

ADDENDUM (8/8/08): Recent events around banks forced by regulators to pay delinquent auction rate securities reveal that I was a little bit off in how this works. If Tom, Dick, and Harry each buy $100,000 worth of commercial paper, at 3% interest, with a 30-day cycle, the bank does not refund the principle at the end of 30 days. Rather, investors get their interest payment, the bank continues to hold the capital, and then investors can continue to hold the bond for another month or put it up for auction where their principle would be repurchased by a new buyer.

Fed Holds at 2%

Hardly a surprise but worthy of note, today the Federal Reserve held its overnight interest rates at 2%, abruptly halting a precipitous downward trend since September 2007. At that time the Fed was faced with the task reversing a sudden credit freeze throughout the financial industry. As far back as the last rate drop in late April there was talk of halting, and since then that position has only been reaffirmed, with subtle suggestions of a reversal later this year. Apparently, 2% seems adequately low to keep credit coming for those who still want to take on loans. The last time we saw rates this low, we saw the rise of the housing bubble. Now, we see an economy holding on by its fingertips as this behemoth slides into a recession.

Securities, Tranches, and Alphabet Soup

If a bank wants to free up its deposits to do more lending beyond its fractional reserve capacity, securitized loans are one way to go and structured investment vehicles (SIVs) are another.

In this post I’ll cover the mortgage backed securities (MBSs). They are simple in concept: banks originate a loan, then investors pay off the principle and collect the monthly payments. Banks earn dues by bundling loan packages, and charging to service the individual loans. For every dollar of securities sold to investors, that is a dollar freed up for the bank to lend

But it gets more complex, and the devil is in the detail. How it works is a bank takes a pool of loans, say 1000 mortgages, and bundles them together, and sells off shares. Not all shares are the same; they are ranked in different "tranches." AAA, AAa, Aa-, BBB, BB, B, and then “unrated” are the kinds of tranches you might see. When the borrowers mail in their monthly payments, shares in the AAA tranch get paid first, then AA next, and so on, and then B would be next to last, and “unrated” would be dead last. But by accepting more risk, the B tranch gets the highest interest rates, while the much safer AAA tranch gets the lowest interest rate… hardly more than treasury bonds.

But, say, 100 of our 1000 mortgages don’t pay, like when option payments adjust and the owner can no longer afford the mortgage, then the unrated tranch, who is paid last in the lineup, isn’t paid at all. Conversely, those who hold AAA paper will likely ride out the credit crunch, even with many foreclosures and a significant decline in house value, since AAA tranches are paid first. It would take a really major collapse of that pool of mortgages for the highest-rated tranches not to be paid.

Now, enter Credit Default Obligations (CDOs). MBSs are risky, especially subprime, but CDOs are the toxic waste of the market place. Banks have to keep the unrated tranches as directed by regulators to do. Only the lower-risk tranches can be sold to free up the balance sheet. If banks want to sell their loans to others, they have to keep the riskiest tranches. Fair enough. But banks can offset the risk with CDOs, which is basically bond insurance from private investors. CDO holders have to reimburse banks if the unrated tranches go bad. In 2007 this collapsed two Bear Stearns hedge funds. Investors were left with literally nothing. Basically their CDO fund was getting money from banks as premium payments, so to speak, until the subprime market went sour. When the worst tranches did go bad, the capital of those hedge funds reimbursed banks for their losses. In no time, those hedge funds were depleted to nothing.

So, the ability of banks to offload debt as MBSs is limited by their ability to accept the riskiest tranches, which is limited by the ability to offload the risk through the sale of CDOs. When people stop buying CDOs, MBSs grind to a halt. As of now, the CDO market is dead.

MBSs kept the credit market red hot. As long as banks could find buyers of securitized debt and CDOs, they could keep lending. But with enough banks now holding on to enough troubled tranches, without swap investors to bail out loses, all foreclosures in those MBS packages would be a square hit to their capital base. So the subprime market is also dead. The Alt-A market is soon to follow.

The 12,000 Blues

On October 9, 2007, the DJIA peaked at 14,280. Last Friday, the Dow-Jones Industrial Average dropped below 12,000 points, like twice before this year—on January 22 and March 10. Those prior times it quickly rebounded amid talk of bailouts for investment banks, lowering federal funds rates, and increasing TAFs. Today, talk seems more muted lately on bailouts of any kind for anybody. I haven't heard anything about further expansion of TAFs, and last time Bernanke spoke on the Federal Funds Rate it sounded like they were going to hold due to inflation, particularly of oil prices. We hear some recent yammering by Henry Paulson about expanding the Fed's role in our economy, but it is vague, and there hasn't been much else said.

The DJIA rebounded before, despite a generally recessionary economy, due to further access to easy credit, with consequent devaluation of the dollar. We'll have to see what cards will be played this round, but I wonder how much is left to keep stock prices afloat.

The Carry Trade

A general understanding of the credit bubble requires a general understanding of how banks make money. For producing nothing, one has to give them credit (sorry) for being possibly the most politically influential industry in society. CEO bonus packages for questionable leadership—maybe with short-term profits but long-term calamity—are second to none among the financial sector. Mainstream media and popular culture have us oriented to believe that what is best for the private-interests of banks is best for all society; hence a legacy of huge government bailouts and ongoing morally hazardous regulatory policies.

Certainly credit and lending plays a role in the success of western industrial democracies, but the relative importance of banks seems out of place. Their operation is conceptually simple: borrow at low interest rates, and lend at high interest rates. That's it: this is called the "carry trade." Traditionally people put their money into checking and savings accounts, money markets, and cd's, which right now earn around 3% at best, and banks lend it out on the order of over 6%, with the difference of interest rates reflecting their profit. It's an easy system with the primary cost to banks being to accept the risk of default.

Back in the day most of their capital came from deposit accounts, but lately, during the credit bubble of the last few years, that was not enough. Even with a fractional reserve rate of 10%, banks still needed more. In order to underwrite the demand for credit instigated by suppression of interest rates by the Federal Reserve Bank (the pattern of rate drops to below 2% began in January 2001 and stayed there until September 2004), banks would have to rely on other sources of capital.

Where banks turned was to bond investors: either those buying commercial paper or securitized loan packages. Each played their own role in the unsustainable credit expansion of the early part of this decade, whose reactive contraction has only just begun.

As always, I argue, as credit contracts, then cash strengthens. The next two non-news posts will discuss these alternative sources of banking capital: mortgage-backed securities and structured investment vehicles.

Estimating Money Supply

This Blog is about the value of the U.S. dollar. It has presented a formula for estimating the value of the dollar that I have not seen elsewhere, and argues that, despite current appearances and conventional wisdom, the value of cash will rise as the recently explosive credit economy collapses.

The cash value equation depends on knowing the supply of money in circulation. There is widespread acknowledgement that in a fractional reserve system money supply is the sum of printed currency and unpaid credit.

The Fed's way of estimating money supply is by adding printed currency and deposits. MO is base money supply, M1 is MO + money in checking accounts, M2 reflects M1 + money in CDs, savings accounts, and money market accounts, and M3 reflects M2 + money in long-term CDs. In this system, deposits are the mirror image of credit: so long as the money the seller receives when a buyer borrows money for an item is then deposited back in the bank.

For example, if Peter takes out a loan from a bank to buy a used car from Paul, and Paul deposits that money in his bank account, then that deposit reflects the car loan. Furthermore, in fractional reserve lending, if 10% reserves must be kept, then 90% of Pauls recent deposit can be lent further from the bank. If that money is then bundled with other deposit accounts to provide the loan for a mortgage, and if the seller of the house deposits the money in a bank account, the outstanding credit for the house can be estimated by the sellers deposit. The assumption is that all money lent by banks to purchase a good eventually is deposited (either directly by the seller or in a roundabout way changing hands first) back into banks. This is probably not a bad assumption.

Customarily, banks lend out money they have in deposits. Over the past few years, banks have used other sources of capital to originate loans. The next few non-news-related posts will reflect ways credit has entered the economy independent of deposit accounts.

ADDENDUM [2/1/09]: Looking back, I need to make a clarification: the Fed stopped publishing M3 in March, 2006, which I knew when I wrote this.

$1 Billion for MBIA

Though small in comparison to some recent cash infusions for major banks--i.e. Washington Mutual and Wachovia--the $1 billion stock sell off for MBIA deserves comment. The bond insurance duo, MBIA and Ambac, have been struggling to maintain their Aaa rating through Moody's lately, which it seems almost no one takes seriously. Nonetheless, the $1 billion infusion reflects an attempt to maintain a stable enough balance sheet to keep the rating.

Where they fit in to the credit economy is this: they insure bonds, including mortgage backed securities. If one buys a bond insured by MBIA or Ambac, and it defaults, MBIA and Ambac will pay off the principle, which if all goes as planned then investing in bonds is nearly risk free. If only a small number of bonds falters the system works, but MBIA and Ambac cannot handle massive bankruptcies and foreclosures.

Massive subprime foreclosures is already here, and once MBIA and Ambac run out of capital to pay them off they are basically defunct as it would not be sensible to invest in them if they cannot sell any more insurance for bonds. It sounds like they are nearly out of capital now, and so in order to maintain the least shred of credibility in the rating system, Moody's at this point is forced to reconsider their highest rating.

My guess is, MBIA wanted a much bigger infusion than $1 billion, but this is all they could get. The loss of MBIA and Ambac would have severe implications for the safety of investments, and the credit freeze that already exists is about to get worse. As the credit market falters, cash will become stronger.

Wachovia, WaMu Fire CEOs

Troubled news has been frequent, but small, in the financial sector over the past couple of weeks—probably due to the lowering of the Federal Funds Rate and expansion of TAFs at the beginning of May, offering short-term support of a faltering industry.

However two CEOs of major banks being ousted by their boards can't be good, and perhaps signal the return of the long-overdue correction of our credit-laden economy—at least until the Fed thinks of something else to compound the problem and delay the solution. The article thankfully mentions no multi-million dollar retirement packages. The rationale for the removal of Wachovia's CEO was in part due to the "ill-timed" acquisition of Oakland-based Golden West Financial Corp, which heavily underwrote Option-ARM subprime loans during the rise of the housing bubble.

One wonders if this is going to have any impact on Bank of America's similar misbegotten effort to procure Countrywide.