It was a regular weekday morning. I woke up and headed straight for the microwave. I needed the adrenaline rush from the coffee before anything would make sense. I picked up the Wall Street Journal and browsed through it. The anchor on “Morning Call” was talking about a funny instrument that the markets have been seeing off late, “SIV”. I looked up from the paper. What does that mean, I wondered?
It begins with the mortgage lenders. When you and I go out to buy a house we obviously do not have the cash to pay for it. So we head to the nearest lender. They do a background check on you figure out that you are a worthy borrower. So the lender gives you a loan which you repay through regular payments including an interest on that loan. So it is easy for you to see that the lender makes money through the interest that you pay.
But how does the lender get the money to lend? Ok, so the lender obviously doesn’t have all that money. So he goes around shopping for people who would buy the assets that he holds on his books. The assets meaning the houses for which it has already leant money. Ah ha! So another company comes into the picture. Let’s call him company X. So X agrees to buy a bunch of these assets from the lending company thereby providing the lender with more money as capital to continue lending to you and me.
Hey wait a minute; X doesn’t print cash, so where does X get the money to buy the assets. Okay so I forgot to mention that X sells corporate notes into the market to raise capital to buy these assets. These notes are short term debt notes which promise to pay a flattering rate of return to the holder.
Ok, but that doesn’t explain why anyone would trust these “no name” companies with money. Well that is because these “no name” companies are being managed my behemoth banks that you hear about everyday. So they manage the selling of these notes and the buyers feel safe that these notes are backed by the “big name”.
So why cant the banks do this without X? Simple, because this is a high debt business and nobody likes debt on their balance sheet. So the banks let X keep the debt and charge a management fees to manage the fund. That way they get to keep the cake and eat it too. The investors of the banks do not see this debt risk on their balance sheets and obviously see the earnings from the management fees.
So what’s the problem again? Well the problem is that the assets that X holds today is not quite as precious as they were few months ago and no one wants to buy new notes issued based on these assets. So X is left holding the asset and the old debt with no capital to continue their work. Oh dear.
So let them go down in flames! Well can’t allow that either. When X goes down in flames, it will sell its assets at 30-40% of its “true” value and then banks have a serious problem on hand because the assets they hold gets hammered too. So to stop the stampede all they can do is to move those assets on to their books. Dude, come on. I thought the whole purpose of “managing” them was to stay away from getting it onto your books. Well too bad I guess. And by the way, the assets are going to be written down in value since they are not worth as much.
Wow this is really messed up. Good thing I am not involved in it. Ah ha! Think again. Where do you think your money market accounts make their money? The money that they need so that they can pay you that incredible interest rate that you were so attracted to. That’s right. Guess who bought those notes that X issued in the first place. And by the way, if you happened to buy bank stocks, say goodbye to positive cash flow and hello to high debt ratios. Suckers!!
And so the wheel goes round. Nothing “structured” about this investment vehicle now is there?