Financial Love Canal

How to make a startling headline if you’re a financial reporter:  just look for owners of junk bonds that might be in trouble, and make that your story.

Remember SIVs?

Not many people seem to remember that the very first bailout proposed by Treasury Sec. Paulson wasn’t for mortgages. It was for Structured Investment Vehicles (SIVs), and he proposed it in late 2007.  He wanted the government to sponsor a $100 billion “super-SIV” to buy performing assets from bank-sponsored SIVs if they had a problem selling the paper that they relied on for funding.

What SIVs did was buy highly-rated floating rate debt and issue CP to fund it.  There was a junior class that paid numbers like L+400 and a tiny slice of equity, but 95% or bit more of the total financing came from commercial paper.  They bought AA and AAA rated floaters, and played off the higher spread that comes with longer maturity, even though the rates reset every month or quarter, so traditional rate risk didn’t apply.

The first, and biggest independent SIV was called Gordian Knot, and it was set up by some ex-Citi guys in the 90s.  At Citi and the other big banks, they sponsored these things as a great way to offload new ABS the banks originated for their mining, commodity producers, appliance makers, credit card accounts, car company, energy, and adjustable rate mortgage clients.  The sponsoring bank would provide a “put” to the SIV if the CP failed to roll, but it was really hard to imagine a situation where it wouldn’t, since the paper paid a few BPs above A1/P1 CP, and not too many corporates had that kind of rating, anyway.  They called it ABCP, or asset-backed CP.

In 2007, after Bear Stearns’ two mortgage hedge funds collapsed, some innumerate reporters started combing through every statement they could find to make headlines about “subprime mortgage exposure” wherever they could find it.  And yes, they found some in the portfolios of the SIVs that issued ABCP.

Nobody seemed to care that they only found $8 billion of mortgage paper in the $400 billion in assets (2% of holdings), and that it was all the AAA mortgage paper that ended up paying in full even with the meltdown.  After the headlines, all the ABCP holders simply refused to renew when their CP matured, and the banks had to step up and take $400 billion in assets onto their balance sheets.

Then the reporters had lots of fun writing headlines about the banks increasing their subprime MBS exposure.

You know the rest of the story.

I’m just pointing out that all the arguments about how strong most energy bonds are even if oil goes to $30 (most of which were nowhere near AAA ratings when issued), and how they won’t effect other energy companies or other industries could be in for a truly ugly surprise if people start looking for the troubled bonds as though they turn everything else toxic just by their presence.  Think financial Love Canal.

A lot of those AAA subprime bonds that never missed a payment and paid in full still ended up getting liquidated for prices as low as 50 cents on the dollar.  So some people did lose a lot of money on them, because they were forced to sell.

By the way, the indirect losers in the SIV disaster were soft commodity companies, the community banks, smaller insurance companies, the energy companies, manufacturers that had floorplan financing for retailers, and others, since their floating rate bonds were more like 60% to 80% of the SIV holdings.  They lost their funding.

See the story in more detail in Chapters 8 and 9 of Finance Monsters.

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One Response to Financial Love Canal

  1. Kyle says:

    Especially since investors can’t just sell the energy bonds in their ETFs. If they wanted no part of that exposure, they’d have to dump the whole basket of investments. I could be wrong but I believe I heard that on Bloomberg.

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