Back To Basics: SIVs, CDOs, Banks and Valuing Securities

As the financial markets fallout of sub-prime mortgage lending continues to affect both equity and fixed income markets, it may be instructive and useful to return to some basics about these markets, the institutions in them, investors, and rules about valuation.

Back in the 1980s, as a strategist at Chase Manhattan Bank, I had the occasion to be involved in a project regarding increasing our presence in the mortgage origination business. As part of this, I attended a few conferences on CMOs. These were the original, private-labeled securitizations of mortgages by the likes of Salomon Brothers, First Boston and Kidder Peabody. Names like Lew Ranieri, Dexter Senft and Larry Fink (yes, that Larry Fink) predominated the burgeoning sector's conferences.

The conferences were held by these investment banks in order to facilitate the sale of securitization services to S&L executives. After we all listened to long talks by investment bankers about the mechanics of CMOs, the usual forgettable conference lunch was served.

I spoke with an S&L executive at my table regarding the complexity of issuing CMOs. Yes, he said, they sure were complex. That's why he needed the likes of Kidder, Salomon, et.al., to know how to create and price them to sell.

I then asked him if his S&L also bought CMOs.

"Of course," he replied.

"Well, if they are complicated to price for sale, and you need help for that, how do you know at what price to buy them from these same investment bankers," I asked him?

Rather than answer, he turned away to the man on his other side, and engaged him in conversation, instead.

Nothing has really changed in twenty years. Structured finance instruments have always begged the question of valuation and, thus, the ability to presume true 'market' conditions. That is, continuously priced, and a seller always available for every buyer, and vice versa.

Senior commercial bank executives formed SIVs to access cheap, short-term funding for the purposes of buying long-term CDOs, paying the difference to the 'owners' of the SIV, and pocketing a fee for this service. The central, and only important question, is, did these executives, as legal representatives of their financial institutions, assure the investors, and/or commercial paper purchases, recourse, under some conditions?

Under parole evidence rules of contract law, large dollar agreements and conditions must be reduced to writing. If they aren't, generally, they aren't considered in existence and, thus, enforceable.

So, were any recourse assurances written into the various and sundry legal documents surrounding these SIVs?

You can bet that if they were, the holders of the commercial paper, and or the so-called 'senior note' holders, a/k/a 'owners' of the SIVs, would be putting those instruments back to the issuers, thus exercising the recourse clauses.

They don't appear to be, so we can reasonably infer that the banks, to the extent they winked and nodded, gave implicit recourse assurances.

With regard to the SIVs, the question that is troubling credit markets is, essentially,

"Will the SIVs have to sell their structured finance assets to pay off their commercial paper liabilities, what will be the (very low) prices of those assets, and will there be resulting commercial paper defaults?"

It's the uncertainty of the answers to these questions that is 'seizing up' credit markets. Lenders don't lend to counterparties whose financial conditions they do not, for certain, know, without collateral.

Citigroup, BankAmerica and Merrill Lynch have just taken very public, large writedowns summing to roughly $15B over the past month, all attributed, except perhaps BofA's, directly or indirectly, to capital markets activity involving mortgage-related CDOs.

Until holders of suspect CDOs either explain the (presumedly lower) values at which they are marking these instruments, counterparties, including those in traded fixed income markets, will not be showing up to lend money or buy paper.

The banks and related financial entities have only themselves to blame for this 'seizure' of fixed income markets. If they would be forthcoming about valuations, then their true financial condition would be known, risks could be assessed, instruments priced, etc.

Rick Santelli, CNBC's Chicago-based fixed income expert, said it best this morning when he likened the banks' situation to what he would face if he had lost money on assets in a margin account. He'd have to make the margin call, or lose his collateral.

He questioned why banks should be 'different,' and be allowed to delay valuation of CDOs, or be given special license to create the M-LEC to buy more time.

Here's a novel idea. If banks and other entities truly believe that the securities involved should not be marked down as fire sale items, why don't they simply buy the putative owners/losers out of their positions, at face value, and hold the suspect securities themselves?

By doing so, they would literally put their money where their collective mouths are, indicating they believe values will rise in the future, making ownership of the troubled structured finance instruments a benefit, not a loss.

As I observed in this recent post, that's what the legendary financier, J. Pierpont Morgan, did to halt the panic of 1907. Of course, he was the one buying at fire sale prices. In our current situation, this is precisely what banks are trying to avoid- the writedown.

It seems to me that they have only two choices. On one hand, simply adhere to the existing rules of valuation, and force greedy investors, who should have known better than to take implicit guarantees from these bankers, to take their losses, as SIVs crater and default on all of their obligations. Suffice to say, it will be a long time before anyone trusts oral assurances from these financial institutions. And that is likely a good thing.

Or, the banks can make good on the alleged implicit guarantees, take back the commercial paper and senior notes at some artificially high price, and hold the associated assets, absorbing losses into their investment accounts over the next few years.

Either way, the solution to unfreezing credit markets is to inject trust and confidence in them by doing something to recognize a value of the assets held in SIVs, and elsewhere, for which there are, in reality, no continuously functioning markets.

If you think this means a clutch of senior bankers who dreamt up these instruments and vehicles in the first place should be cashiered, you're probably on the right track.

I think that anytime someone 'structures' financial instruments in such a way as to prevent their easy valuation and market maintenance, they better be ready to hold them as if they were a painting, real estate, or some other lumpy, illiquid asset.

Because, in truth, that's what they are.