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PATHOLOGY OF DEBT by Henry C K Liu
PART 1: Banks as vulture investors
PART 2: Commercial paper and pesky SIVs
PART 3: The credit guns of August
PART 4: Lessons unlearned
PART 5: Off-balance-sheet debt
PART 1: Banks as vulture investors
Vulture restructuring is a purging cure for a malignant debt cancer. The reckoning of systemic debt presents regulators with a choice of facing the cancer frontally and honestly by excising the invasive malignancy immediately or let it metastasize through the entire financial system over the painful course of several quarters or even years and decades by feeding it with more dilapidating debt.
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Commercial paper is a short-term unsecured promissory note maturing in less than 270 days issued by banks for a fee on behalf of corporations and other borrowers to raise funds from investors with idle cash. It is a low-cost alternative to bank loans. US issuers are able to efficiently raise large amounts of funds quickly and without expensive Securities and Exchange Commission (SEC) registration by selling paper, either directly or through independent dealers, to a large and varied pool of institutional buyers.
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Evidence of global contagion surfaced in August as a string of German banks ran into trouble with their leveraged bets on collateralized debt obligation (CDO) instruments and the even more toxic "'synthetic" CDO derivatives: securities that contain top-rated tranches of US unbundled subprime mortgage pools. A series of emergency actions by the European Central Bank (ECB) injecting a further US$85 billion in liquidity through various mechanisms in the third week of August highlighted the seriousness of the crisis.
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Moody's' bullish 2005 report
Moody’s Investors Service has developed a rating methodology for structured financial operating companies (SFOCs). The ratings agency has recognized the similarities by which various forms of vehicle operate and has developed a new classification and ratings process for this group of structured finance entities. SFOCs are operating companies that apply detailed, pre-determined parameters to define and restrict their business activities and operations. The SFOC designation applies to a number of different structures including:
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Moody’s Investors Service has developed a rating methodology for structured financial operating companies (SFOCs). The ratings agency has recognized the similarities by which various forms of vehicle operate and has developed a new classification and ratings process for this group of structured finance entities. SFOCs are operating companies that apply detailed, pre-determined parameters to define and restrict their business activities and operations. The SFOC designation applies to a number of different structures including:
- Derivative product companies (DPCs)
- Collateralized swap programs (CSPs)
- Credit derivative vehicles (CDVs)
- Structured investment vehicles (SIVs)
- Structured lending vehicles (SLVs)
- Interest rate arbitrage vehicles (IRAVs)
- Issuers of guaranteed investment contracts (GIC Issuers).
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Conduits and special investment vehicles (SIVs) allow companies and banks to take on off-balance-sheet debt. These vehicles usually hold highly rated, short-term debt that offers a higher yielding alternative to ultra-safe Treasury debt. Banks use the low-cost proceeds to buy longer-term debt such as auto-loans, credit card loans, or mortgages to profit from their high cash flow. Banks that have stakes in the conduits have provided ''liquidity back-stops'', promises that the vehicles’ debts will be paid by the banks when they come due even if the vehicles are not able to pay them.
Banks are reluctant to consolidate the distressed vehicles because it would have to put the liabilities on bank balance sheets, thus restricting lending. Also, allowing conduits or SIVs to fail could damage a bank's reputation and might even create financial systemic risk if investors should lose faith and stop purchasing commercial paper altogether. This creates possible scenarios where banks must lend the distressed vehicles money in the hope of riding out a storm or take substantial immediate losses.
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Banks are reluctant to consolidate the distressed vehicles because it would have to put the liabilities on bank balance sheets, thus restricting lending. Also, allowing conduits or SIVs to fail could damage a bank's reputation and might even create financial systemic risk if investors should lose faith and stop purchasing commercial paper altogether. This creates possible scenarios where banks must lend the distressed vehicles money in the hope of riding out a storm or take substantial immediate losses.
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