from Follow the Money

Conduits, SIVs, cash-hoarding, commercial paper restructuring and such

August 17, 2007

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Yves Smith of Naked Capitalism is right – If Gillian Tett of the FT disappeared, we would be in a whole lot of trouble. I wouldn’t be surprised if a lot of central bankers rely on her reporting to understand developments in the arcane parts of the credit market almost as much as I do.

Her coverage of conduits and SIVs – basically mechanisms for banks to borrow short and lend long, but to do so in the modern “off-balance-sheet” and acronym-intense way – has been absolutely invaluable.

The troubles with these vehicles – it turns out that some of the acronyms they bought may not be worth quite as much as they paid, that the acronyms are difficult (if not impossible) to sell right now and that at least some of the money market funds who previous lend money to these “vehicles” would rather not continue to finance them – explain a large part of the recent liquidity crunch.

Tett, Davies and Cohen earlier this week:

“regulators are scrambling to understand what is happening in structured investment vehicles (SIVs), a breed of often huge, mainly bank-run, programmes de­signed to profit from the difference between short-term borrowing rates and longer-term returns from structured product investments.These have proliferated in recent years and control assets worth hundreds of billions of dollars.

Depending on whether they are fully rated by credit rating agencies and on how strictly they have to conform to certain rules, they are known as SIVs, SIV-lites, or conduits.They are typically quite opaque, invest in complex securities and often do not need to be displayed on a bank’s balance sheet.It seems they have played a key role in last week’s liquidity crunch. ....

These programmes typically invest in credit market instruments, such as US subprime mortgage-backed bonds and collateralised debt obligations. These assets tend to be the highly rated, supposedly safe versions of such debt, but in the recent fear-driven turmoil have shown just how illiquid and hard to value they can be.

The profit for those who run such programmes comes from the fact that the assets pay fairly high yields, while the conduits and SIVs fund their purchases with short-term borrowings in which interest and principal payments are backed by financial assets that are deemed to have stable cash flow. Collectively this so-called “asset-backed commercial paper” – or ABCP – lasts for anything between a few days and a few months before needing to be refunded.

If these vehicles cannot raise money in the money market, they will have to turn to the banks for financing. Some have backup credit lines with a range of banks. Some may have to rely on their parent. In other case, the banks needed liquidity. And since a lot of these vehicles are owned by European banks, even if they (formerly) raised money in dollar and bought dollar denominated acronyms— a lot of European banks needed to raise a lot of cash. Tett, Davies and Cohen.

“By early August, the problems in the ABCP market had become so serious that some European banks were preparing for additional calls on credit lines to SIVs. But the banks are also grappling with a backlog of unsold leveraged loans, which is placing additional pressure on their balance sheets.So early this month some European banks – and a few US institutions as well – quietly started trying to raise new credit lines themselves. That, however, triggered additional alarm, as rumours spread about the potential losses at SIVs – on top of problems in other corners of the financial world.”

The difficulties facing European banks likely explain why the ECB injected so much liquidity into the market last week.

It also explains (in part) why the banks are hoarding cash – cash they may need to lend to support their own “vehicles.” Tett.

These vehicles, which have proliferated in recent years, seem semi-detached from the banks, since they raise their own finance and thus do not (usually) need to be displayed on a banks balance sheet. But there is a crucial rub: if conduits cannot raise finance the normal way, they can go back to the banks to get emergency liquidity lines.

Right now, nobody knows exactly how many SIVs or conduits have actually asked banks for help. But what is crystal-clear is that the conduits and other vehicles are now facing funding problems, since investors are no longer willing to buy the asset-backed commercial paper they issue. Thus banks are responding by hoarding whatever funds they can, either because liquidity lines are being called, or in anticipation of such demands.

And, just as a frenetic stockpiling of baked beans tends to fuel panic, the very fact that banks are grabbing for cash is making investors even more nervous, particularly in the dollar market where many investment vehicles have raised funding in recent years, even if they are based in Europe (ironically, because the dollar market was supposed to be ultra-liquid.)

There is another solution. Rather than coming up with funds to pay the commercial paper that cannot be rolled over as it comes due, the maturity of the commercial paper could be extended. Call this the Canadian solution. Canadian borrowers and lenders all got together and agreed to extend the maturity of a bunch of paper – turning short-term commercial paper into longer-term (three to five year) floating rate notes. The New York Times reports:

“the group agreed to convert asset-backed commercial paper, which normally matures in 30 to 60 days, into long-term notes with a floating interest rate. Until that happens, they have agreed not to make margin calls on holders of the paper for 150 days and to drop all current liquidity calls.”

That sounds a bit like Korea’s agreement with the international banks to rollover their maturing loans to Korea back at the end of 1997. And, just as it was easier to get the banks to rollover loans to Korean banks (guaranteed by the Korean government) than to rollover loans to Indonesian firms, those holding Canadian commercial paper were likely more willing to extend the maturity of that paper because they are confident that the assets backing Canadian dollar denominated commercial paper are of relatively high quality.

There is another reason why the Canadian solution may not work more elsewhere. Tett notes:

“it is one thing to get two dozen Canadian banks to agree a swap; it is quite another to arrange a restructuring with the 6,200 financial institutions that deal with the ECB (or those interacting with the Fed).”

The proliferation of these vehicles also helps to explain a couple of things that have puzzled me for a while.

One is how the banks made money with a flat to inverted yield curve over the past few years. The answer seems to be a combination of leverage and taking on more credit risk. The leverage came from the SIVS. The Economist:

“Making matters worse, some banks even manage SIV-lites (echoing the covenant-lite trend of the leveraged-loan market). These have fewer diversification restrictions and involve borrowings of up to 40 to 70 times equity collateral. Most SIV-lites made big, focused investments in American mortgage securities, including subprime and Alt-As, which are also troubled in spite of their better credit quality.”

That is a lot of leverage. And the rating agencies aided the banks quest for yield. Borrowing short-term in the money market to buy long-dated Treasuries clearly didn’t work – not with an inverted yield curve. But you could make money borrowing short to buy CDOs and the like. Taking a bit of credit risk was essential. And since these instruments were highly rated, it was possible to gear up.

The other mystery? Why Europeans were such big buyers of US corporate debt. The TIC data doesn’t leave much doubt on this point. But I always wondered how those purchases were financed.

Europe after all doesn’t have a big current account surplus, so it doesn’t have lots of funds to invest globally (though it can – and does -- borrow from the world to buy the world’s assets). And borrowing euros to buy dollar-denominated assets seems, well, rather risky. The carry could not have consistently covered the losses associated with the dollar’s long slide. Yes, the currency risk could be hedged, but someone has to provide the hedge.

But if – as seems likely – a lot of “European” purchases of US corporate debt (a category that includes private MBS and host of acronyms) were financed by selling commercial paper to American money market funds, well, the European funds were only taking only the credit risk, not the currency risk. They also were not providing any net financing to the US – the inflows associated with European purchases of long-term debt were associated with short-term outflows from the US, as Americans effectively lent Europeans the money needed to buy US debt.

There is a bit more to the “European financing of the US” story. There are some strange correlations between oil and European demand for US debt. And some European vehicles might have tapped offshore sources of dollar liquidity, not just the US money market. More on that later – it takes us off in another direction.

UPDATE: Prier du Plessis has found a diagram showing out how CP funded conduits/ SIVs that bought high-yielding acronyms (CDOs and the like) can create liquidty (and perhaps solvency) problems for their sponsoring banks. Hat tip, Barry Ritholtz of the Big Picture.

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