Of SUVs and SIVs

It’s great to see the price of gas at $2.45! When was the last time we saw that? And it looks like we are finally beginning to pull out of the freeze on short term borrowing (short term meaning a day to 3 months) between banks. Ever wonder why bank to bank borrowing froze up in the first place? Why money market funds that traded “commercial paper” became so shaky they had to be bailed out by the government’s guarantee that their holdings of a dollar would return you a dollar?

The fancy term for what happened is “flight to quality.” What that means is smart investors (like money market funds) didn’t want to buy commercial debt because they realized those were risky, bad investments. They fled in droves from the banks and financial institutions who were selling them. Commercial paper became so worthless banks wouldn’t even buy it from each other. How on earth did that happen?

Because banks and financial institutions created trusts called “structured investment vehicles” (SIVs) by tossing together the loans and complex debt of lots of different companies. These “vehicles” then sold “commercial paper” to investors who had little idea what was behind the paper, but trusted their banks.

In addition, SIV investments were highly rated. Standard and Poor’s once said in a remark that’s come back to haunt it, that it would rate a deal “structured by cows.” SIV assets were what backed commercial paper. As subprime borrowers and other borrowers began defaulting, smart investors realized their danger. SIV assets were likely to be far less than they cost.

In the beginning SIVs were a terrific deal for banks because the commercial paper being sold just “passed through” the banks. The banks never owned the SIVs. That means banks didn’t have to report them on their books. SIVs were invisible—until they failed!

Citigroup created a ton of SIVs and got itself in trouble. So the government got two other banks together (JP Morgan/Chase and Bank of America). The government asked them to help it bail out Citigroup’s bad short-term commercial paper.

The other two big banks presumably didn’t sell SIVs. Now all three banks are “guaranteeing” to the government that their SIVs are good. Some people are buying that story and investing in SIVs again (hopefully not bovine-backed ones!). The commercial paper market is loosening up a bit, but the bad news: banks aren’t making more loans.

Corporations that rely on banks for loans to keep their businesses going probably aren’t going to see cheap loans or even any loans coming their way. Just today, twenty four U.S. nonprofit hospitals are in trouble because they guaranteed they’d buy back 8 billion dollars of “variable rate demand notes” (VRDN), and they can’t get bank loans to refinance their debt.

The bailout to banks so far is simply keeping them in the business of selling SIVs and/or for buying up smaller banks who are about to fail, even though the Fed protests the latter action isn’t what it wants banks to do with our bailout funds. But at least gas is cheap again!

Copyright © 2008 by Nancy K. Humphreys

[For the full explanation of SIVs, see Kathleen Pender October 16, 2008 [typo says 2007] “Bank bailout plan doesn’t solve the underlying problem” at www.SFGate.com.

Source for Bovine S&P quip is FT October 20, 2008 “Moody Moody’s” p12.

Source for non profit hospitals is FT Oct. 20, 2008, “Hospitals Face Threat of $8bn Debt Repurchase” on page 1.