It's easy to conclude that sub-prime mortgages are the reason that the US, and now the global, banking systems are coming unglued. However, it is incorrect.
Most of us on this forum, probably, have had one or more mortgages at one time or another, so we've acquired a familiarity with just what's involved. We've also heard "sub-prime" over and over again, to the point that we've come to believe it
is the problem. In truth, it is only the most visible symptom of a much, much larger problem - derivatives.
Even with all the predatory lending abuses, the "liar's loans" and the insane speculation in the real estate market, had the problem been confined to the American real estate market and the inevitable crash occurred just the way it did, it could never have resulted in the worldwide collapse of the credit markets. Yet that's where we are now, so how did we get here?
Fannie and Freddie weren't the cause of the collapse, either, but they did create the template that the math-modeling genii in the back rooms of the investment banks used to cobble together the collateralized debt obligations that moved the problem up several levels. Even then, had investments in CDOs not been leveraged, the problem could have been contained, though not without significant pain.
But once the Securities and Exchange Commission, in 2004, gave the greenlight to the five major American investment banks to increase their allowable leverage to 30:1 and then 40:1 from 12:1, the problem was magnified by orders of magnitude.
Further compounding the problem was the fact that there was never a market for the structured investment vehicles that the quants had created and the sales force was easily able to peddle on the basis of the attractive yields. Much like the simple-minded house-buyer who only wants to know what the monthly payment will be, the "investors" in SIVs only wanted to know what the yield would be and naively (as it turned out) believed the AAA credit ratings attached to the products.
As long as the vast majority of borrowers made their payments, a reliable stream of interest income was generated, the buyers of the vehicles were content, the sales force kept placing the product with entities throughout the western world and collecting their staggering bonuses each December, and all was right with the world. Even today, well more than 90% of all home-buyers are current with their mortgage payments, but because of the compounding effects of the highly-leveraged investments, only a small percentage of defaulting mortgagees was necessary to knock over the first domino.
That first domino was the revelation in May, 2007 that two Bear Stearns hedge funds were in trouble. One collapsed entirely, the other suffered staggering losses. In itself, that should have only meant "tough ****" for Bear Stearns and the firm's investors, but it meant far more than that.
Since their inception, SIVs were "mark-to-model" investments, meaning that they were deemed to be worth what their creators, and then the entities that bought the "investments," said they were worth. Why? Because, in the absence of a transparent market to provide legitimate price-discovery, there was simply no way to place a meaningful valuation on them.
When the Bear Stearns funds collapsed, and BS tried to sell the SIVs the funds held to cut their losses, it would have placed a market-price on the damn things for the first time. All of the other entities holding SIVs were apoplectic at the ramifications of that. It would have meant that they could no longer place a "value" on their own SIVs, and if they had to be marked-to-market at the fire
sale prices BS would get, then all the other entities would have to drastically cut the valuations of the SIVs in their own portfolios. The net loss, and subsequent necessity to raise funds to meet capital requirements, would be devastating - perhaps fatal.
Thus, the flaw in the otherwise brilliant creations the quants had concocted was finally evident - no one had thought it would ever be necessary for there to be a two-way market in SIVs. You bought them, you held them for their lifetimes and you collected a tidy yield. While you held them, you were able to place a value on them and that value was reflected on your
books.
Not surprisingly, entities increased the assumed valuation over time. These "valuable" pieces of paper were then used as collateral to borrow more money to buy more SIVs,
ad infinitum. Once such a scheme begins to unravel, however, it quickly gains momentum, and although efforts to control the damage have grown at an equally dizzying pace, they have thus far proven inadequate to turn the tide.
That is why $700 billion "rescues" are brushed aside by the markets - it's too little, too late.
Someone, earlier in this thread, suggested that the Chinese were the primary purchasers of SIVs - that is incorrect. Most structured investment vehicles were purchased by western financial entities. The huge
trade surplus that the Chinese have accumulated is held almost exclusively in the sovereign debt of their trading partners.
In other words, they have traded the foreign currency that was used to buy Chinese renminbi with which to
purchase Chinese-manufactured export items, for short-, medium- and long-dated Treasuries of the countries buying their products.
Whether or not these foreign debt
instruments will maintain their value over time (particularly, American Treasuries) is debatable.
TaoJones
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