On Toxic Waster And Other Matters

November 2007 Dr. Hans Black

A great deal has happened since the world began to focus attention on the current credit crisis in late June, triggered by the collapse of two Bear Stearns hedge funds. Investors quickly paid attention to what was wrong and what they were going to do about it. The immediate answer was to make sure they had no subprime exposure and, secondly, to learn a great deal more about collateralized debt obligations, about which we have written in previous letters. The rapid knock-on effects — other hedge funds that collapsed, banking problems that spread to Europe and Asia (notably Sachs Landesbank in Germany and Northern Rock in the UK), and finally the decision by BNP Paribas to freeze redemptions on three funds — further fueled the crisis. By mid-August the stock market was tumbling and the shares of financial stocks, banks, investment banks, mortgage brokers, etc. were down sharply. Then the Fed intervened, first by cutting the discount rate and then cutting broad interest rates again in September. These actions seemed to cure the problems briefly until some major banks reported huge losses in early October. Amongst the arcane financial vehicles that have been brought to light, SIVs (structured investment vehicles) have become the center of attention.

SIVs are not exactly a household name, but it is important to note that these vehicles have permeated the financial system in recent years and have been extremely profitable for the originators, which are often large multi-center banks. In a way, these vehicles were simply a variation on the carry trade, as they borrowed money short term in order to invest in higher-yielding or more risky assets longer term. The vehicles themselves were assembled by such banks as Citibank (the largest player in the field) through offshore and often unregulated facilities, and then sold to wealthy investors and hedge funds for their high yield. Funds would invest in a whole series of different vehicles, of which subprime mortgages were only a tiny part. It should be emphasized that all kinds of asset-backed securities typically filled the buckets of these vehicles, with varying degrees of risk and transparency. High fees were charged by the people putting the funds together and, of course, hedge funds could presumably offer their clients good returns provided the game could continue. In August, however, when things began to unravel, liquidity for people buying the funding side of the SIV simply dried up. These SIVs and their conduits were essentially off-balance-sheet vehicles that permitted banks and others who sold them to be exposed to a series of complex asset backed securities without really having any reserves to back them up. Although many SIVs were operated by banks, had banks as direct investors or even had arrangements to call on bank financing when their own sources of liquidity may have failed, they were not technically on the banks’ balance sheets.

All of this came under even greater scrutiny after October 17, when a relatively small SIV managed by a hedge fund known as Cheyne Capital essentially defaulted. This particular SIV had invested heavily in residential mortgage securities, both subprime and other categories. What made this even more complex was that although this particular fund still had a good amount of cash on their balance sheet, a U.K. court declared it in breach of insolvency tests, which in effect meant that they had to be reorganized or liquidated. It remains to be seen whether other SIVs will be caught in the same position. The bank behind Cheyne, namely the Royal Bank of Scotland, is obviously trying to sort this mess out and in good part the suggestion by U.S. authorities to launch a super bailout fund known as a Super SIV came about due to such controversies.

Under this new proposal, four large American banks and possibly others would create a $100 billion bailout fund, known as a Super SIV, or Master Liquidity Enhancement Conduit (MLEC) in order to prevent smaller orphan SIVs being forced to unload their assets at much lower prices. This in turn would have created a situation whereby all participants would have to use those market prices to rebalance and reprice their own SIVs. Importantly, it might have affected the $2.9 trillion money market funds industry, some of which own such vehicles. The problem with the Super SIV fund is that it is probably only going to buy the most credit-worthy notes from other SIVs, thereby giving them some liquidity, but leaving them with what is known as “toxic waste”. All of these actions, which are ongoing as this is being written, have prompted a flurry of emotionally charged comments. Perhaps one of the most telling was:

“One of the lessons that investors seem to have to learn over and over again, and will again in the future, is that not only can you not turn a toad into a prince by kissing it, but you cannot turn a toad into a prince by repackaging it”.

These comments, shared by Warren Buffett on a recent trip to Asia, echo the sentiments of many, including ourselves, who simply believe we have entered an extremely high-risk period in credit markets. SIVs, which some have called a “shadow” banking system, will have to undergo even greater scrutiny in the coming weeks and months. First we build up a regulatory and supervisory system led by organizations such as the Central Banks, the Bank of International Settlements in Basel and others, and then we allow large multi-center banks to circumvent them. The idea behind Basel I and II, which are supposed to regulate capital requirements in the international banking system, have been seriously called into question with some of these newer instruments. Not only have we reinvented complex ways to essentially borrow short and lend long, all of this has been accomplished under the very noses of the regulators who, as Alan Greenspan recently stated, “seem not to have caught up with some of the advanced products available.”

Furthermore, the pricing of these vehicles is so highly dependent on mathematical modeling as to make it incomprehensible to all but a few advanced PhDs. Risk control models or “value-at-risk” models are based on past volatility which is simply not operational when extreme events occur. The entire global banking system, which is based on a standard statistical approach to risk management on a so-called bell curve, may be called into question. Nobody worries about “black swans” or nine standard deviation events but, increasingly, one should worry a great deal about them. The problem in the very near term is figuring out how to build models for a pricing structure where liquidity could totally disappear overnight — something that we saw during some of the crazy hours in the week of the August 14. One lesson from this time was that U.S. treasury bills and futures were proven to be the most liquid instruments on the globe and despite what many say about the dollar, we see very little that will change this situation.

Many, including the Economist, are asking another obvious question: “Are the difficulties that we are seeing, i.e. Merrill Lynch and others, simply the tip of the iceberg?” (Merrill Lynch recently announced a $8.4 billion write-down and a $2.3 billion net loss for the third quarter, while big banks like Citigroup and Bank of America have also announced massive write-downs. Every day, it seems, there is another rumor about another financial organization deep in difficulties. AIG, for example, the world’s largest insurance company, has been rumored to have losses in excess of $30 billion in the subprime mortgage area alone. Washington Mutual, the largest Savings & Loan in the US, stunned Wall Street two weeks ago when it said it would have to set aside $1.3 billion to cover anticipated mortgage loan losses. But since its option-Adjustable Rate Mortgage portfolio amounts to $58 billion, even this provision looks very low, especially as in the year ended September 30, non-performing assets jumped 128 percent to $5.45 billion. As we have mentioned before, all of this is likely to get worse. As one of the original problems — the ratings of these instruments — is being increasingly called into question, both Standard & Poor’s and Moody’s used either AA or AAA ratings for many pools of CDOs (collateralized debt obligations) only one or two years ago. These kinds of high ratings made them senior in anybody’s book, but now Moody’s, which in the last ten days has begun to downgrade large numbers of CDOs, is turning the tables on these previous assumptions. All of a sudden, instruments that were AAA-rated are BB or less. As expected, this is causing tremendous changes in the ratings of such securities as instruments that were previously AAA are now priced perhaps 80 cents on the dollar, and any poor quality paper trades very infrequently below 20 cents. Grants Interest Rate Observer and other publications have also questioned the so-called monoline companies that insure corporate bonds and other structured products. MBIA, which is the largest of these companies, has been the subject of serious questioning regarding their solvency. In addition, AMBAC remains another company their very survival is in doubt.

For now we remain vigilant. It remains to be seen whether Treasury Secretary Hank Paulson will be as successful as Bob Rubin was during the Mexican peso and LTCM/Russian crises. We prefer to sit on the sidelines as far as the financial stocks are concerned, believing that few bargains are available. The period from now to the end of the year will be key, as SIV and conduits need to be refinanced while there is increasing evidence of pressure on the North American consumer. Frankly, we are not seeing any attractive toads out there, and even if we did, we would not be kissing them just yet!