Wednesday, September 12, 2007

SIVs, Spivs, And Roosting Chickens

Blimey- the chickens are roosting all over our bonuses

Listening this morning to BBC R4 Today's "business" correspondent struggling to grasp what's happening in the commercial paper market was toe curling. Apart from the well known fact that capitalism is evil, everything else is pretty well a closed book to him and his colleagues.

So just to be clear, here's the deal.

In all major economies, bank lending is increasingly regulated by central banks, which are justified in doing so because they ultimately guarantee bank depositors. What that means in practice is that banks can only lend to high paying but risky long-term borrowers if they also hold big chunks of low earning reserves to back those loans. Which clearly reduces their overall returns.

Naturally, profit chasing banks don't like that very much, so are constantly looking for ways round the rules. One approach used over the last several years has been to set up special off-balance sheet funds called "conduits". The conduits do the borrowing and lending, and the banks earn fees for setting them up and running them.
Oh, and they also provide what are known as backup credit lines, which the funds can call on in the presumed unlikely event they can't borrow enough money in the markets. Providing a backup credit line is another fee earner for the bank (yes, there are some regulated reserving requirements, but less onerous than for direct bank lending).

The conduits soon spawned another set of funds- Structured Investment Vehicles (SIVs). They operate under slightly different and riskier arrangements, but crucially also have backup credit lines from the banks. The SIVs spawned yet another variant, the SIV-lite, lite referring to the fact that they're even lighter on prudential type investment restrictions. They also have backup lines from banks (see here for excellent Reuters primer).

These funds are involved in what bankers like to call "securities arbitrage", which basically boils down to our old friend borrowing short and lending long. They invest in long-term illiquid high yielding debt, including those notorious sub-prime mortgages, and borrow in the money markets via 1-3 month commercial paper issuance.
Buyers of their paper- including corporate treasurers- are attracted by the fact that they pay a bit more interest than alternative cash investments- around 0.1-0.2% pa. Although of course, that's much less than the rate being earned on the fund's long-term investments- which is why the whole thing has been so profitable for the bankers.

But now, faced with all those stories about bad mortgage debts and the fact that these special funds are actually pretty opaque, the commercial paper buyers have taken fright. Quietly at first, they stopped buying it. And since it's such short maturity- three months maximum- that's led to the current problem. In the face of a buyers' strike, the banks are having to stump up the cash instead, via those backup lines.

Barclays seems to have been particularly exposed to all this- see here for latest on all the bale-out loans it's having to make to its extensive family of SIVs and SIV-lites. It's likely to cost their shareholders dear, which of course is why they've been leading the alarming cries for the Bank of England to ride to the rescue. But since the head of Barclays Capital reckons they're still profitable, that sort of answers it.

Overall, we still think the Bank's tough-it-out approach is the right one (see this blog). Lessons must be learned, and the bankers must find a way of reassuring their SIV investors that they are as low risk as they pretended to be. Which probably means putting more of the debt back on to regulated bank balance sheets- where it belongs- and much more transparency.

The roosting chickens should be left to get on with a bit of creative destruction.
PS Let this be a lesson to all those who think that moving debt off balance sheet is a jolly good wheeze. You can run but you can't hide. Now, who else do we know that's done that?


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