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Tuesday, October 16, 2007

Long Short Financial Gearing

People - even real life people - are asking me about the Super SIV conduit set up by JPM Chase, Citibank and Bank of America. I wanted to refrain from commenting because I had nothing good to say about it, and I didn't want to have any part in the ranting that's going on or contribute to what was likely to be a very bad week on the Street. But since they are holding the equity value burning party without me (what's happening is that most consumer-related businesses are coming up with lower profits, lower profit warnings or other weaknesses, and this is giving the Street the willies, especially since some of these companies are refusing to promise to buy back their shares to compensate), I guess I'll express my opinion.

First, most of what was written about this being a liquidity restoring maneuver is BS. It could have served that purpose, but it would have needed broader support to accomplish that goal. I believe Nomura's exit from the US scene (they are even closing down their Treasury ops) yesterday indicated that it has utterly failed. Nor is Deutsche Bank in the deal so far as we know, even though DB did get a Reg W exemption of its own. It seems that the foreign banks may have concluded that the Fed will support US banks first and that they are likely to end up with the raw end of the deal. This has major ramifications for the year to come.

So what is the real motivation? The three banks involved are the largest US banks that got Reg W exemptions, and they will use this to offload some of their excess lending to affiliates. This new vehicle won't improve the quality of the assets, but it will allow movement of obligations from affiliates to this new vehicle, provided that the new vehicle is structured correctly. You can bet that part of the negotiations involved getting a ruling from the Fed on how this would have to be structured to allow exclusion from the Reg W limitations.

Why do I believe this deal won't improve liquidity for the market in general? Because a big chunk of the market value of these funky loan instruments used for Asset Backed Commercial Paper (ABCP) ended up being not their expected return, but their capacity to be used for financial gearing to exploit the spread between short term rates and long term rates. In other words, if I take a bunch of these no-doc Alt-As, or auto loans made at an average rate of 4.5% and hold them for their lifetime return, their value is X.

Using financial gearing, which is the real function of ABCP, those same loans have an expected return of X + Y. It is true that Y is less than X, but it's still a substantial addition to value. When entity A makes a loan, it sells it to another entity. The loans are grouped and packaged into asset pools which are then often securitized in some form or another. Components of these securities may then be pooled and securitized again. Sooner or later, some chunk of this financial gunk is used to provide security for short term loans. So the entity holding the paper is supposedly getting payment at long term rates minus all the fees that are involved, and it recovers its money by making short term loans that constantly roll but that carry much lower rates.

Let's play Financial Engineer:
The key is to recovering the money so it can be circulated back and earn money for the intermediate whatever. If, in theory, my package of financial gunk is paying me an average rate of 5.5%, and I am recovering the vast majority of my principal by lending at rates of say 3%, I have a good thing going. I get the spread, and I get the principal back, which I can use for other money making purposes. Out of my returns I pay fees to someone to guarantee or facilitate the whole gearing operation, so I don't get all the spread. The value of Y is the spread minus my fees that I pay to the facilators plus any needed guarantors.

When the Fed cut short term rates so low after 9/11, these big outfits made a ton of money by profiting from the spread between short term rates and long term rates. It was like dumping fuel on financial engineers, who threw it into the maws of the financial engines, which accelerated the financial profit engines and sent them careening down the tracks into a bright financial future which generated absolutely superb year end bonuses.

Then the Fed started raising short rates, but the dauntless financial engineers kept the party going by using ABCP to restore the effective spread. You can do many things when you keep your eyes firmly fixed on your year end bonus package. (See the two graphs at the bottom and note the correlation between the rise of ABCP and the rise of short rates.) This was all completely wonderful for a while. The wonderfulness was such that the financial engineers experienced an insatiable appetite for these loans which could be used to manufacture financial gunk. In fact, the future was so bright that everyone had to don shades to protect themselves against the glare generated by those scintillating bonuses, so no one noticed for quite a while when the underlying asset quality of the financial gunk started to deteroriate. Those were just meaningless shadows flashing by as everyone hurtled down the track toward the Hall of Year End Riches. Eventually, the components of the financial gunk got so bad that they started imploding while they were still in the pipelines, and the blinding light of those explosions pierced the hopeful dimness of the shades.

Guess who guaranteed these deals, either explicitly or implicitly? Guess who is facing having to come up with the cash? Guess who was getting the fees?

Needless to say, this is all dependent upon the people who are willing to make short term loans to me at low rates backed by my financial gunk plus any guarantees. When that willingness fades, abruptly the value of Y disappears and my financial gunk's market value is once again only X.

So the loss of value of the financial gunk, plus the loss of the value of all the pipeline components (raw loans) that were destined to become future financial gunk is structural unless I can convince people to make me those short term loans secured by this stuff at low rates again. But this has not happened:

Note the correlation between the rise of ABCP and the rise in short term rates when the Fed readjusted:

From the first graph, we can see that close to 300 billion of the asset backed has not been renewed, and so someone is sitting on an abrupt and real decline of value for the underlying financial gunk. It is true that the underlying financial gunk was greasing the wheels of commerce for a while, but it become all gummy and is impairing the ability of the wheels of commerce to keep rolling down the financial tracks. And now the financial engines are smokin' due to the extra strain imposed by pushing these gunked-up wheels further down the tracks.

The three banks will somehow be backing the 80 - 100 billion that winds up in the M-LEC vehicle, so they are going to take a real loss. If anything, this is going to confirm to the general market that the losses involved in the crummier financial junk is real. The exemptions given to these banks were 25 billion each, so we can see how the size of the pool was decided!

The only benefit I can see is that the banks involved will be able to return to compliance under Reg W. They were forced to offer up over collateralization for the purpose, so as the market value of the gunk components drops they would have to keep throwing more and more into the collateral pool. Thus offloading does allow them to ungunk the wheels a bit.

MOM, can I get you a decaf cup of tea? I don't see where any of the contents get marked to market whether inside or outside of the IBs reserve requirements.

The only way I see the IBs getting out of this without monster losses is for them to talk up the product and make some fake trades for "institutional clients" all the while hedging that the M-LEC shares or whatever they get called shortly start trading at true market prices.

This looks like somebody selling stock in a pet shop based on the value of the inventory when the inventory is just a bunch of dogs valued at $10,000 each where they decide how much each dog is worth.
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Rob, that's a good description. I certainly didn't mean to imply that anything was being marked to market. There isn't a market for this stuff in its present form. Actually, this little coalition thang confirms to the market that this paper can only be used for its purposes via guarantees, and once that is confirmed, it takes a structural loss. If you have to guarantee it, you lose the spread.

Anon, that's it. I am deleting your comment. It's inappropriate for this post.
Thank you MOM,this is the clearest explanation I have come across of what Citi is trying to do.from my reading today I gather that the banks are trying to offer a very limited guarantee,which is understandable.The reaction I am seeing from most people is that "Wall Street" is trying to pull a fast one, and this may actually cause more uncertainty among the public.Not good.
A nice added feature of this is the banks are going to pay themselves fees for setting up this shell game. Somebody give me a gun so I can shoot myself.
CF, look at the bright side. Next year you can buy a few more jets at very good prices. There were quite a few leased in SoCal that will be looking for good homes soon.

No guns for Street guys until the whole thing settles down. You'll have to make do with jets. I nearly died laughing about the report of the London art auction. Who'da thunk? Crappy modern art is down and (gurgle) traditional moderate priced is up. Stop with all the hollering. You're a money-making machine. It's a beautiful way to reverse arbitrage currencies.

Thornburg lost $8.83 per share. I wonder if we are moving into the era when share buybacks are doomed because they no longer make things look better.
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