Those who are conscious of financial and economic matters know that this summer a crisis of “sub-prime lenders” hit the United States mortgage market. I knew that bad mortgages were written and people bought homes they could not afford. At a summer barbeque this topic came up when I spoke to some businessmen. (I am not a businessman but rather I am under the category of professional — the best I can tell.) We all agreed on the facts but they were at a loss that I did not understand why the banks, in particular, would be so concerned. My position was that since the banks essentially owned the homes they can just wait until more favorable economic conditions. Eyes were rolled toward me and the conversation was essentially shut down —although I never received an adequate answer.
Sure, like many others, the specifics of what happened eluded me. Beyond bad loans / can’t pay / in default I wanted to understand this crisis a bit deeper. Now, fortunately Floyd Norris has come to the rescue on these questions. His article 3 Major Banks Offer Plan to Calm Debts in Housing (NY Times October 16, 2007 ) provides the best explanation I have read to date in answering the fundamental questions of what happened without overloaded financial jargon!
At issue is a borrowing crisis facing a group of institutions known as structured investment vehicles, or SIVs, that were little known even to many on Wall Street until the credit crisis erupted this year. These vehicles essentially are private banks, albeit ones without the benefits of deposit insurance or the right to borrow from the Federal Reserve. They lend long term, and borrow short term. If they cannot borrow money, they are in trouble.
The vehicles, often started by banks like Citigroup, were financed by issuing commercial paper, a form of short-term credit, for 90 percent or more of the value of their securities. The expectation was that the cushion of 10 percent or less would be enough so that the commercial paper could readily be sold at low interest rates, often to money market funds. Because commercial paper usually matures within months, not years, it is necessary to sell new commercial paper as the old paper is paid off.
Now, however, it is practically impossible to sell such paper, and the SIVs are faced with the threat of having to sell many of their securities into a market with few buyers
Norris explains cogently how three major institutions (banks that also offer SIVs I believe) are proposing to remedy this crisis without federal government monies but with federal help: Citigroup, JPMorgan Chase and Bank of America.
Rather than “liquidate” the SIVs they want to “restructure” them in the form of a new financial vehicle: a Master Liquidity Enhancement Conduit (M-LEC). This proposal is essentially a re-packaging of SIVs: creating and opening a new financial spigot to “fund the SIVs”. I've read that this plan would want to raise around $80 Billion! (I also read reports of $200 Billion.) Bloomberg reports that SIVs have $320 Billion in holdings.
Well, the M-LEC plan is not universally hailed. In short, my position (from the summer barbecue) has been vindicated by Josh Rosner, “an expert in mortgage-backed securities at Graham Fisher, an independent research firm in New York.”:
“If they really believe these are good assets being mispriced in the market,” he said, the banks could just buy them and wait for the asset values to recover. “This raises the question of whether the banks are doing this [creating M-LECs] just to avoid taking their losses.”
Avoiding a government bailout is desirable in my estimation. Re-packaging SIVs as M-LECs may take patience. Its feasibility is beyond my grasp, although I understand its desirability. I suspect this may just be postponement of the illness. Waiting for market appreciation of housing assets would be my course, although I understand that banks want to avoid “write offs” and the like and continue their cash flow. This course of holding may trigger further housing market deterioration and affect other economic sectors.
We'll wait and see. In the meantime I’ll be sure my guy does not have me directly invest in either SIVs or M-LECs.
Update December 21, 2007: The so-called Super-SIV plan is dead. See Banks Abandon Plan For Super - SIV (N.Y. Times, December 21, 2007)