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Even as heads roll on Wall Street, the nations three largest banksCitigroup, JPMorgan Chase, and Bank of Americaare getting set to launch their newest exotic investment vehicle: a massive desecuritization. The banks and the Treasury Department didnt describe it quite that way when they announced the plan last month, but thats what their upcoming, roughly $80 billion Super Structured Investment Vehicle amounts to. And the plan could have implications that last far beyond the credit crunch that began this summer, when lenders and investors started to sour on many borrowers.
The nations largest banks are creating the Super SIV in an effort to prevent ordinary structured investment vehicles, or SIVs, from dumping on the market the hundreds of billions of dollars in mortgage-backed and other asset-backed securities that they hold. Banksmost notably Citi, which fired its CEO last weekend for hugely miscalculating the banks risktakingas well as other investment institutions manage these SIVs in return for fees or a portion of investment gains. But the SIV funds have their own outside investors and lenders and arent officially part of the banks or other sponsoring institutions. Nor have the banks contractually guaranteed the funds performance, or even their solvency. If the funds do poorly and investors lose their money, theyre theoretically on their own.
Now the SIVs are in trouble. They, and their sponsoring institutions, thought that they could use short-term debt to fund long-term mortgage-backed assets and similar securities. However, this strategy can be riskyfar riskier than funding long-term assets with long-term debt. If a long-term asset runs into trouble, short-term lenders who fund that asset will take their money out as soon as the trouble becomes apparentand the fund wont be able to find a new short-term lender to replace the fleeing one.
The SIV managers, as well as many other institutions that invest in mortgage-backed securities, werent worried about that scenario becauseor so they thoughtthey had transformed their long-term assets into short-term assets through the magic of securitization. Its important to understand what that word means. Banks and other financial institutions have done spectacularly well in recent years partly because of their increasing sophistication in making a marketable security (similar to a stock or bond) out of almost any loan or other long-term payment obligation. The banks started with the simplest home-mortgage securities a few decades ago, packing thousands of such mortgages into big debt packages and selling them to outside investors. This innovation meant that the banks could free up more of their own money for other uses, rather than tying it to mortgages that wouldnt be paid off for 30 years. Since the securitization of 30-year, fixed-rate mortgages began, banks have gone on to structure marketable securities out of almost every conceivable future payment flow, from mortgages to corporate loans to tobacco companies promises to pay state governments billions of dollars a decade ago. Most recently, the banks aggressively securitized debt backed by adjustable-rate-loans approved for low-credit home buyers.
Crucially, the banks could do all this only by turning once long-term, hard-to-sell investments into continually repriced securities that were easy to sell and resell. If an investment manager got tired of one security in his SIV, the thinking went, he wouldnt have to wait 15 or 30 years for the ultimate borrowers to pay off the mortgages that constituted that security; he could just sell it to another buyer. What this line of reasoning ignored was that someday, buyers might not be willing to pay a price that sellers were willing to accept. In other words, the banks ran the risk that at some future point, a security or a given class of security would be worth little or nothing at current market prices.
This summer, that possibility became reality. Since then, few short-term debt providers have wanted to make loans to SIVs; theyre worried, for good reason, about the quality of the assets that their money is backing. Specifically, theyre worried because lenders made many mortgages to borrowers with questionable ability to pay back the loans, especially after their low, one- or two-year teaser interest rates expire. Theyre also worried because many mortgages were made for 90 percent, or even 100 percent, of the value of the underlying homes: if property values fall enough, many property owners will balk at paying off a loan thats worth more than the underlying asset. And because investors have gotten a glimpse of how tenuous some of the models that drove the securitizations wereincluding, seemingly, the expectations that real estate values would keep rising and that interest rates would stay lowtheyve balked at buying some other types of asset-backed securities.
Today, nobody knows what these mortgage-backed securities, and other securities made out of them, are worth. But certainly their value is not what financial institutions and SIV investors believed a few months back. So the SIVs face the fact that they must pay back their short-term lenders.
To avoid a mass-scale sell-off of the SIVs securities at distressed prices, Citi, JPMorgan Chase, and Bank of America, under the benign gaze of the Treasury Department, are creating the $80 billion Super SIV fund to buy the best assets from the SIVs. The SIVs can then use the proceeds to pay off at least some of their short-term debt so that they dont have to dump everything all at once. Proponents of the new fund point out that it isnt a bailout, because no federal money is involved; its the banks that will be putting their names on the line.
But it is a bailout of sorts: an accounting bailout, a chance for banks and investors to rethink having structured, sold, and bought all of these assets without having done much analysis of the underlying debt. The banksand Treasurythink that, because nobody will buy these securities right now for a reasonable price, the market has stopped working. In fact, the market may be working just fine, if brutally: if nobody wants to buy these securities at reasonable prices, perhaps theres a good reason. After all, cookie-cutter, easily marketable securities in most sectors are usually worth only what a buyeroptimally, an unrelated third party, not a bank-controlled Super SIVwill pay for them at a given time.
Both the banks and Treasury are coming to understand the implications of real-time accounting of assets when such assets are backed by such short-term liabilities. Just as you cant put a scrambled egg back into its shell, the banks cant simply desecuritize scrambled investments now. But they can try to use the new Super SIV to house at least some of the best such investments for an undetermined amount of time, while giving the worst such assets more of a chance to recover while sequestered cozily in their SIVs, instead of being dumped on an uncooperative market.
This massive desecuritization effort doesnt mean that its curtains for the entire securitization world. After all, the plummeting in value of pets.com stock nearly a decade ago didnt kill confidence in, say, GEs stock. But without the new Super SIV, current market conditions likely would have made many financial institutions, particularly Citigroup, even more terrified than they are now. Even though Citi and other brand-name institutions have no contractual or legal obligation to support their SIVs if something goes wrong, its quite likely that to save their own reputations, they would step in and pay back the SIVs short-term lenders if the SIVs couldnt sell the funds assets to third parties at high enough values.
The potential for such an action is already worrying shareholders at publicly traded institutions like Citi, who could protest that they didnt sign on to such obligations. And it raises tough questions about whether publicly traded banks that run SIVs accounted for these massive jack-in-the-box liabilities properly, disclosing the possible risks to shareholders who would bear the loss.
Its still not obvious that the Super SIV, which should launch within the next few weeks, will work. First, if the Super SIV is going to buy the smaller SIVs best assets, who on earth will buy a security left behind in a smaller SIV without assigning a deep discount to its price? Second, how can investors be confident that the Super SIVs purchases reflect true market prices, since it wont be an independent, arms-length market buyer?
But even if the Super SIV succeeds in reducing, rather than simply stalling, deep losses, institutions may already have learned that not everything can be securitized and backed by short-term liabilities, at least not without incurring significant, uncontrollable market risk. This realization could alter indefinitely the demand for future securitizations, which was relentless before this past summer. Lower demand on investors part for securitizations would sharply cut activity in what has been one of Wall Streets biggest bread-and-butter operations for the past decade. And it would also make loans more expensive, or even unavailable, for all but the most desirable borrowerswell past the few months that the term credit crunch implies.
Nicole Gelinas, a City Journal contributing editor and the Searle Freedom Trust Fellow at the Manhattan Institute, is a Chartered Financial Analyst.