Tuesday, October 30, 2007


Many in finance found to be SIV-positive

Many financial institutions of the world's economy have discovered they are SIV-positive. The disease was first noted with alarm at the inception of the Bush administration but was allowed to spread unchecked. Indeed, it could even be said that George Bush encouraged it with his dream of the "ownership society" and the promise that the free market would house the poor and working class. This allowed a pool of infection to grow in the suburbs.

The disease has a long latency and symptoms are only now emerging. The full symptomatology and the long-term course of the disease remain unknown. Initial symptoms include the disappearance of what some people thought was money and multiple home foreclosures. So far only one death has been reported but more may follow.

Central banks, financial institutions and neoliberal economists are working feverishly to find a free-market cure, though as yet none has been found. The true tragedy of the disease is that a vaccine was available—government regulation of the financial sector—but there was no market for it.

Have I exhausted the metaphor yet? Nah.

SIV—What it is and how you get it

Though there were definitely some simians involved, SIV does not mean "simian immunodeficiency virus." It stands for "structured investment vehicle." There are many variants, but the form that has become most virulent involves loans for housing—mortgages, in other words—to subprime clients, like me.

NY Times columnist and economist Paul Krugman explained it this way—

Today, when a bank makes a home loan, it doesn't hold on to it. Instead, it quickly sells the mortgage off to financial engineers, who chop up, repackage and resell home loans pretty much the way supermarkets chop up, repackage and resell meat.

It's a business model that depends on trust. You don't know anything about the cows that contributed body parts to your package of ground beef, so you have to trust the supermarket when it assures you that the beef is U.S.D.A. prime. You don't know anything about the subprime mortgage loans that were sliced, diced and pureed to produce that mortgage-backed security, so you have to trust the seller -- and the rating agency -- when it assures you that it's a AAA investment.

Let me attempt my own naive explanation of the mortgage-based SIV and the ensuing crisis—

It used to be that heavily regulated commercial banks were the primary source of mortgages. Because of that regulation—that ensured that banks couldn't just do anything with your money, no matter how risky—only the finer upstanding citizenry could obtain a mortgage.

But how could the rest of us participate in a George Bush ownership society and move into our own homes if no one would lend us the money? God knows we didn't have much to begin with and had even less after a few years of the Bush administration.

Since anyone with a wad of cash can issue a mortgage and since anyone lending to you or me would have to charge pawn-shop rates to offset the higher rate of defaults, that's exactly what they did. All good free-market stuff so far. The loan was known as a "subprime mortgage," which of course was still backed by the value of the property it was used to purchase.

If it had stopped right there, the market might have taken care of itself, as they like to say over at the Treasury Department. The higher interest rates would have offset the higher rate of loan failures. In other words, though it was expected that some of the subprime borrowers would eventually lose their homes and their engagement rings, the losses on the loans would be covered by the higher interest rates paid by the remainder. A "market equilibrium" would be reached and things would settle down.

Of course the increased demand for homes brought on by this surge of new home buyers meant that housing prices went up. So a number of things happened at that point.

In addition to the people who actually needed homes (the "subprimes"), other people ("prime borrowers") who already had homes began buying other homes as an investment. They planned to sell them to the subprimes and to each other. Loans were even more readily available to these borrowers. And this of course drove the demand for houses still higher, along with the price. Thus was born the "housing bubble."

The folks making the loans hadn't seen the promise of such high returns on their investment since Willie Sutton invested in a tank of gas to make his getaway from a bank. They then did two things to increase their profits: (1) They made the terms of the loans much easier "upfront," so that people who couldn't pay wouldn't have to worry about it for a few years, thereby guaranteeing more customers and a further rise in home prices. (2) They sold off the loans they had already made so they would have more money to make more loans.

Now here's where the structured investment vehicle comes into play. You take the loan and sell it at a discount to a middleman. The middleman gives you the money so you can continue to make more loans (you're now free and clear of the risk). The middleman takes the loans and claims them as an asset to back the value of a salable piece of paper—let's say a bond—that promises to pay the holder a fixed interest over a number of years. This is known as a "mortgage derivative." The beauty of it is that the middleman gets his money back, so he can now buy more loans from you.

To increase the salability our middleman gets a rating agency (Moody's, for instance) to certify that the paper is really backed by a solid asset and not just a bridge in Brooklyn. Of course, the value of homes, which underlay this house of cards, was going up, up and up, so things were looking copacetic. Other investors—your pension fund, perhaps—bought the paper with the expectation of holding it as a conservative long-term investment.

Then the trouble began. The easy payment terms that had been offered upfront on many of the mortgages came to an end, and subprime borrowers couldn't make the higher payments. And of course subprime borrowers who weren't faced with a leap in their monthly payment still had the challenge of making the current payments when their incomes haven't risen as steadily as the daily increase in the price of food, fuel, healthcare and additional children.

Foreclosures ensued, and with more homes on the market, prices began to fall. This meant that the prime borrowers who had borrowed to own a second property were making payments on a home that might not even be worth what they paid for it. Naturally they wanted to sell as quickly as possible, further depressing the value of the homes.

The issuers of the mortgage derivatives—that unregulated "structured investment vehicle"—watched the value of what they had used to back up their promise to pay evaporate. They were up the proverbial creek without a paddle.

Are you still with me? This is where the fun begins.

The investors who had bought the SIVs realized they had no way of knowing the value of what they were holding, but that it was probably a great deal less than they had supposed. The paper still presumably has some value, since it is backed by mortgages not all of which will be foreclosed (it is hoped!). Also, the paper is salable to the next fool.

But here's the problem. You'd love to sell that hot little potato, but you don't know how much it's worth and neither do the potential buyers. For SIVs that have traded, the God of the Free Market sets a "value," which is just the point where whatever you're willing to sell them for matches the point where someone else is willing to buy them. But these SIVs were originally bought with the expectation of holding them for the long haul, so no trading had occurred. And from the standpoint of a potential buyer, your hot little potato looks remarkably like a pig in a poke.

Now not only do investors not want to buy your hot potato, they don't want to buy anything that even resembles a potato. Since SIVs have become the coin of the realm, the reluctance to hold them is what's known as the "credit crunch."

The treatment

The initial treatment was to declare this to be an Act of God (the Free Market) and to deny there was a problem. The losses, it was said, would be borne by a few players in the financial sector who had been playing fast and loose with their cash and by those silly subprime borrowers who deserved whatever happened to them anyway. After all, the financial sector is only a small portion of the overall economy.

As uneasiness grew and foreclosures increased, the Bush administration then attempted an appeal to "compassionate conservatism." Lenders should renegotiate the mortgages to keep borrowers in their homes, not to mention to sustain the worth of the mortgage derivatives. Of course "compassionate conservatism" turned out to be just as empty of meaning in the markets as it was on the campaign trail. The original lenders had already shed the risk and couldn't give a damn what happened after that.

But as funds began to evaporate, capital sources felt a sudden reluctance to buy SIVs of any sort, preferring to sink their money into U.S. treasury bills. But much of the rest of the economy is financed through this marvelous sale of paper. This of course means that sooner or later, there will be no "money" for "growth."

So the US Federal Reserve and the European Central Bank made more money available to the banks and lowered the interest rate on it in hopes that cheaper money would encourage investors to borrow more and sink more money into these "investment products." That has not proven to be a great success but has lowered the value of the dollar, as you will see shortly at the gasoline pump.

Now the latest treatment has been undertaken by a benevolent consortium of banks such as Citigroup and Bank of America. They have proposed a "superfund," the Master Liquidity Enhancement Conduit (M-LEC), with which they intend to buy some of these SIVs and thus restore public confidence in their value.

Selling dog turds

It's an ingenious plan and Richard Daughty, the "Mogambo Guru" describes it best—

Obviously, the purpose of the bailout is simplicity itself; nobody trusts the mortgage derivatives that the banks have created, which have now imploded and are revealed as being toxic crap that may not be worth anything, since the financial instruments do not have any demonstrated market value simply by virtue of the fact that they have never traded on the open market, and so nobody wants to buy them. Now everybody is sitting on trillions of dollars' worth of these stupid, mysterious things. What to do?

So, the Fed and the Treasury have all decided that they are going to set up a huge special fund, with untold billions of pretend dollars, drawing in more investors to which the banks will sell short-term paper to finance the bailout, so that the banks can trade derivatives around amongst themselves, thus establishing their "market price"! Hahaha!

Suddenly, I realize that I may be too hasty in dismissing this scheme! This remarkable idea has given me a terrific business idea! You are going to love this! You and I will go into business, see, and each of us will (believe it or not) sell dog turds back and forth to each other, priced at the same per-ounce price as gold! Hour after hour, we will busily sell them back and forth between us, you buying mine and me buying yours, thus proving that there really IS a market for dog turds, and they are provably worth their weight in gold! We, like these banks, will both make a fortune! Whee! Hahahaha!

Reuters decided not to report on my fabulous new Mogambo Business Venture (MBV) or my new Mogambo Dog Turd ETF, but they did report essentially the same thing when they wrote, "The fund that is being contemplated would bail out funds known as 'structured investment vehicles', or SIVs."

This comes at a time (as just a coincidence I am sure! Hahaha!), when "Banks including Citigroup, Merrill Lynch & Co, and UBS have in recent weeks announced billions of dollars in asset write-offs and are still struggling to sell off billions of dollars in loans that financed acquisitions globally."

Ooops! If banks can't get rid of their own turds, then perhaps my own dog turd business may struggle too! Damn!

We have a great deal yet to look forward to.

Related posts
A note on understanding elites (9/3/07)
The subprime debacle continues at home and abroad (10/11/07)


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