The Double-Con: Who Really Owns An SIV?

My business partner and I were discussing the legal and accounting questions surrounding SIVs, in the wake of this recent (Friday) post, which itself is the latest in a series concerning SIVs and the prospective, commercial-bank funded M-LEC.

I wrote on Friday, in that post,

"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."

My partner voiced the opinion, with which I concur, that the fundamental problem affecting credit markets right now is the attitudes and practices of management by senior commercial banks (Citigroup, BofA, Chase) and a retail brokerage (Merrill Lynch) firm, to have systematically ignored the risk of such opaque 'structured financial instruments,' both holding them in portfolio, while now attempting to delay the day of marking to market, having underwritten their originations and sold them to institutional customers far and wide.

In short, CEOs, risk officers and senior managers across many of these institutions behaved as if the omnipresent realities of credit markets and instruments were somehow suspended or abolished in the case of CDOs and the SIVs formed to hold them.

I wrote, in conclusion, in that earlier post,

"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.

...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."

It seems to me that the question of ownership of the SIVs is crucial in the following sense.

Last week, I used Google to attempt to locate, for free, on the web, some reasonable estimate of the total US equities market value, as listed on the NYSE or NASDAQ. I found a seven year old paper by the University of Pennsylvania's Marshall Blume, valuing the US equity markets at roughly $19Trillion, as implied by this statement,

"Again according to the flow of funds, individuals held directly 7.3 trillion dollars
or 39 percent of the total market value of equities held by US investors."

It's reasonable to assess the current market's valuation at somewhere in the neighborhood of $24Trillion, by adding the S&P500's nearly 28% rise since 2000 to the estimate in Blume's paper.

This morning, I heard Bill Gross, of PIMCO, the giant bond fund house, estimate the size of the sub-prime mortgage volume outstanding at roughly $1Trillion, and forecast an ultimate loss to defaults of some $250B.

Now, in the equity markets, a couple of bad days can result in a 1% loss. This is not at all an atypical occurrence. That is, based upon the prior market size estimate, about $240B.

So, Bill Gross' worst-case loss estimate on sub-prime mortgages, whether securitized or not, is only about a one-two day loss in the US listed equity markets.

See my point yet? It's echoed in this piece, in which I found Gross' loss estimate that reinforced his remarks this morning on CNBC.

Here is a rough, current equity market value of the five largest US commercial banks:

Citigroup $181B
BofA 199
Chase 144
Wells Fargo 107
Wachovia 80

The total market equity cap is roughly $711B. If these banks hypothetically owned all the bad mortgages, and wrote them off, they'd lose more than a quarter of their capital.

Not a good thing for our financial system's stability, is it?

But wait! We know many of these loans were packaged up, or securitized, into CDOs. Many of those are in SIVs, like the seven funds, once worth some $80B, that Citigroup operates. Many others were simply sold to institutional investors the world over.

If the US commercial banks only hold, say one quarter of the bad loans, then writing off $60B in value is no big deal. Heck, Merrill and Citi have already written off, or promised to write off shortly, nearly half that amount.

In the meantime, let's revisit those SIVs and buyers of CDOs. As I noted in the earlier SIV-related post, a lot of those SIV-issued commercial paper were institutional investors. They were being offered unheard-of yields on supposedly-, typically-safe commercial paper.

To illustrate, here's a completely hypothetical conversation that might have occurred (except for the more blunt, honest statements), in abstract, to illustrate my point.

BigCityCommercialBank SIV commercial paper (CP) salesman: Have I got a deal for you, Ms. institutional investor!

OldBlueIvyUniversityEndowment Investment Committee Member: Really? Do tell?

BigCity: Oh, yes. Have you heard about our new SIV? We're issuing high-yielding CP.

OldBlueIvy: High-yielding? Sounds risky! You know, we can only invest in high-grade
securities here at OldBlueIvyEndowment.

BigCity: Yes, I know. But this is a sweet deal. We here at JPCity are operating the SIV. We don't actually own the entity. We have some 'senior note holders' for that. But we, JPCity, wouldn't leave our valued customers holding a bag of worthless paper, you know.

OldBlueIvy: Tell me more about the structure of this 'SIV?'

BigCity: Well, we've raised $5B from the 'owners,' or note holders. Then we're piling on about $95B more in CP. We're going to take that $100B of money, 95% of it short term CP, and buy $100B face-value of high-yielding CDOs with long maturities. It's a lock!

OldBlueIvy: Sounds pretty generous. How do you at JPCity get paid? Why aren't you putting this on your own balance sheet?

BigCity: Well, we're only receiving management fees of 1-2%. Really quite modest, you know, for all of our hard work here. We aren't doing this on-balance sheet because, as you know, for the better part of several decades now, our own credit ratings are often below those of our customers. Thus, we don't really have a balance sheet advantage to give, and it makes no sense for us to hold what the market will risk-price more accurately. Comprende?

OldBlueIvy. Si, I comprende. So OldBlue's endowment won't suffer, because you have locked in a juicy long term spread, to fund your rolling over the CP I'm buying several times a year, right?

BigCity: Yes.

OldBlueIvy: What sort of yield will we get on the CP?

BigCity: Several hundred basis points better than the usual CP you can buy!

OldBlueIvy: Such a deal! Wow. What's the added risk for that extra, unexpected, totally atypical CP yield?

BigCity: Not really much at all. As I said, JPCity won't let our customers down on this deal.

OldBlueIvy: Will you be putting that in writing in the CP agreement? Is this CP being sold with recourse?

BigCity. No, of course we won't. But, as I said, we here at JPCity consider you a valued institutional customer. We'd never leave you with defaulted CP. *Wink* *Nod*

OldBlueIvy: Gee, let me think. You're offering me, as a trusted, experienced OldBlueIvy investment committee member, a chance to buy wildly-underpriced CP, without recourse. So I am evidently getting something- that extra yield- for nothing- because you tell me that, although you won't put it in writing, I effectively have recourse to JPCity on this paper.

OldBlueIvy: I'm in. Put us down for $5B!

BigCity: Great! You won't regret it! You're going to be getting some real juicy financial gravy in the form of this extra CP yield. Of course, the only real risk you run is that JPCity lets the SIV default, with its razor-thin 5% equity financing, and you hold worthless CP. With such high leverage, the SIV can't stand much of a fall in the CDO assets it holds, or the whole thing will crumple like a house of cards on a windy day. Now I can tell my bosses at JPCity that I've closed the last tranche of CP funding on this SIV, at no risk to us! We're getting something- your CP purchase- for nothing- we don't have to write into the CP agreement that you have recourse to put back the paper for some minimal value, or its face value.

Admittedly, this is an exaggerated, hypothetical conversation. But I wish to explicitly highlight the implicit 'deal' being struck between the parties.

The investment committee member of the university thinks she is conning the commercial bank by reaping outsized commercial paper yields. The commercial bank SIV debt salesman thinks he is conning the endowment's investment committee by selling them risky commercial paper without recourse.

I think this is, essentially, the case. The investors in SIV CPs have no recourse. And they knew this when they freely invested in the debt instruments of the SIVs.

So, back to my question. If the institutional investors decided, one day, to buy tens of billions of dollars of SIV commercial paper, or even CDOs directly, and they see a $250B loss in market value the next day, what's the big problem?

They comprise a component of the investing market. The US debt markets, in fact, are far larger than the US equity markets. Why is a loss of $250B in value via debt so much worse for institutional investors than the same loss over one or two days in the equity markets?

So long as the commercial banks do not, in fact, own the SIV losses, and CP defaults, their equity capital isn't at risk. Their debt financing reputations might be, but not their capital, per se.

Seems to me that what we have here is, as my partner observed, a lot of managerial corner-cutting by both bank-related SIV operators, and their institutional investment committee customers.

It's fair to say that a lot of these people should probably be suffering serious career consequences for their part in this $250B double-con game. Both parties thought they were playing on the other's naivete and confidence. Many players on both sides look to get burned.

But in comparison to the size of US equity and capital markets, let alone our multi-trillion dollar annual GDP, it's a drop in the bucket.

The biggest problem continues to be that of financial sector companies stalling on taking what losses are appropriate on these ultimately untradeable structured instruments, and the vehicles created to hold them. Once losses are taken, and clean, believable values are quoted, markets will resume their normal operations.