FYI | Aug 30 2007
By Greg Peel
“The liquidity crunch has seen the latest bank ‘risk flotsam’ to surface, being off balance sheet SIV/SPV /Conduit vehicles where the questionable quality of backing assets has seen short term funding withdrawn and back up liquidity facilities drawn down,” noted JP Morgan’s analysts in their weekly banking sector update this morning.
Okay. So 2007 has taught us all about subprime mortgages and collateralised debt obligations. So what on earth are SIVs, SPVs and conduits that are apparently tied up in all this mess? Well an understanding of these strange creatures goes some way to providing greater insight as to why we’re in this mess in the first place.
(Incidentally, if you want a very good definition of CDOs go to http://www.ampcapital.com.au/personal/research/invresearch/cdosdemystified.asp. Thank you AMP)
For the record, SIV specifically stands for “special investment vehicle” and SPV for “special product vehicle” and the latter is merely a variation on the former. To get an idea of the thinking behind them, the following is an extract from an article appearing on securitization.net on September 8, 2006:
“HSBC may set up a structured investment vehicle that would appeal to a different crop of subordinate investors than its only existing SIV.
“The entity, which could hit the market by April 1, would give the bank a new means of expanding an already growing portfolio of mostly structured-product investments that currently weighs in at $48 billion. Those holdings, consisting mainly of top-shelf asset-backed securities, mortgage bonds and collateralized debt obligations, are overseen by Dominic Swan in London.
“HSBC keeps about $8 billion of the investments on its books. The rest are split between its SIV, called Cullinan Finance, and a commercial-paper conduit known as Solitaire Funding.
“The new securities-arbitrage vehicle would be similar to Cullinan, with one major exception: Its senior securities would be supported by both single-A-rated capital notes and an unrated first-loss piece, mimicking a structure used by Citigroup’s Sedna Finance SIV.
“SIVs typically borrow against their capital notes by issuing senior asset-backed commercial paper and medium-term notes. As a rule, the junior classes carry triple-B ratings and serve as their only subordinate layers.
“Offering those securities in a mezzanine format would make them behave more like traditional asset-backed bonds that deliver specific returns as long as they don’t default. And they would present a lower level of risk that should attract a wider swathe of investors, Swan said.
Read that last paragraph again – there is the subprime crisis in a nutshell. “They” have begun to default. And yes, a swathe was attracted, from across the globe, and not just to HSBC. And further on in the article, here’s another clanger:
“Meanwhile, Moody’s and S&P are close to approving a new $24 billion funding limit for Solitaire, which only has $3 billion of room left before hitting its current ceiling of $18 billion. HSBC expects the conduit’s outstandings to reach $20 billion by year end.”
In some eyes, the ratings agencies are the true culprits in the CDO leg of the subprime crisis – if not complicit, at least duped into mis-rating junk paper.
Now let’s move on to an article in The Economist published on August 16, 2007:
“Conduits have been hugely popular in both North America and Europe, partly because their high ratings may eventually enable banks to reduce their regulatory capital and partly because they pay far better than, say, similarly rated American Treasuries. The first sophisticated conduits were established around 1998 by BayernLB and WestLB, two German Landesbanks. By the end of March some $507 billion of ABCP assets were in European conduits, according to Citigroup. The global ABCP market is estimated at $1.2 trillion, up from $650 billion three years ago.
“Yet the structured-finance geniuses did not stop at conduits. They ventured into structured investment vehicles (SIVs), which are similar, but more highly leveraged. SIVs have been one of the fastest-growing areas of structured finance, and they have been investing in riskier assets; Standard & Poor’s, a rating agency, estimates 23% of SIVs’ assets are in residential mortgage securities, half of which are American. They come with little bank credit-line support in a liquidity crunch, and rely on a cushion of surplus money or insurance called “credit enhancement”. To reassure their lenders, SIVs’ assets are marked-to-market daily, which is hard because no one in the market wants to buy some types of asset-backed securities.
“Making matters worse, some banks even manage SIV-lites (echoing the covenant-lite trend of the leveraged-loan market). These have fewer diversification restrictions and involve borrowings of up to 40 to 70 times equity collateral. Most SIV-lites made big, focused investments in American mortgage securities, including subprime and Alt-As, which are also troubled in spite of their better credit quality.
“One of the busiest in these markets is Deutsche Bank, Germany’s biggest bank. In a March filing with America’s Securities and Exchange Commission it estimated its maximum exposure to loss from structured products at E2.3 billion (US$3.1 billion). But it will not, indeed cannot, put a number on its exposure now. It is the same at other big European banks, such as Royal Bank of Scotland or HSBC.
“More worrying are the exposures of some German Landesbanks. On August 13th DBRS, an international rating agency, noted that rumours had been circulating for a week about the liquidity of some German banks, especially after IKB’s state-sponsored bail-out. Part of the problem, it noted, was that investors no longer trusted the ratings of the asset-backed securities that the banks had invested in. And who can blame them. As late as June, Moody’s issued a report calling SIVs ‘an oasis of calm in the subprime maelstrom’.
“WestLB, and SachsenLB, with conduit or SIV portfolios totalling E35 billion and E17 billion respectively, may have been acting pragmatically. Until July 2005 these banks were able to issue a huge amount of long-term debt, which is guaranteed by the state until 2015. WestLB’s line of credit to its conduit, Greyhawk, is also state guaranteed. The market knows, and the banks know, that a Landesbank will not be allowed to fail. Most banks elsewhere do not have that luxury, however. Which is why investors are so nervous.”
So having absorbed all that, now consider that JP Morgan noted this morning that Australian banks participate in these businesses “with reasonable Conduit exposures likely augmented by further liquidity facilities provided to third party SIV/SPVs.” JPM estimates the conduit exposures alone as ANZ (ANZ) $6bn, Commonwealth (CBA) $2bn, National (NAB) $10bn, Westpac (WBC) $5.5bn and St George (SGB) $1.3bn. And that’s just the majors.
In short, SIV/conduit vehicles borrow short term from the banks (1-6 months) and invest in higher yielding assets such as CDOs (3-4 years). Some institutions have previously described the practice as an “arbitrage”. Now that no one will buy the CDOs, and no one will lend money to the SIVs, banks have been forced to take the CDOs on to their balance sheets, ahead of marking their value (mostly zero) to market.
JP Morgan is quick to point out that given global SIV exposure of an estimated US$1 trillion, Australian bank exposure is very minimal. And Australian banks will not have delved into lending for subprime paper, only higher quality paper. The analysts estimate that all up, the funding required by the Australian banks to absorb SIV exposure would represent $1.2bn of bank capital, and they should easily be able to cope with that.
The same cannot be said for banks across the globe. Subprime contagion, notes JP Morgan, just gets worse and worse. This from Reuters yesterday:
“Cheyne Finance Plc, a structured investment vehicle (SIV) managed by British hedge fund Cheyne Capital Management, said it was seeking to restructure after being forced to start selling assets to pay down debt.
“Standard & Poor’s downgraded Cheyne Finance sharply. Just two weeks ago, the agency said ratings on SIVs – including the Cheyne vehicles – were weathering turmoil caused by defaults on US subprime mortgage lending”.
Bloomberg reports that this morning, Basis Capital Fund Management Ltd, the Australian firm that invests in collateralised debt obligations, filed for bankruptcy protection for its Basis Yield Alpha Fund, stoking concern more hedge funds face collapse. The fund has assets and liabilities worth more than $100 million.
In other local news, UBS reported in its weekly banking sector update this morning that Adelaide Bank (ADB) has increased its lo-doc mortgage rate by 30 basis points on September 9. This is on top of the cash rate hike of 25 basis points this month. While UBS expects non-bank lenders to follow suit, it suggests the major banks will see this as an opportunity to claw back market share by not raising their own rates so dramatically. The majors have large deposit bases to back up their lending, while Adelaide does not.
This is one reason UBS is maintaining an Overweight rating on the big banks, despite acknowledging that the credit crunch will no doubt force a slowdown in Australian credit growth. JP Morgan, on the other hand has been pushing the line hard that the new credit regime will impact negatively on all Australian lenders.
And over in Europe, there are clear problems. Yesterday saw a regular auction of European Central Bank long term (91 day) funding. The ECB released E50 billion, and the clammering crowd of banks bid for E119.75 billion. One trader noted “There is still a huge premium for cash, particularly in the three month area”.
As the Pythons would say, “Bring out your dead”.
