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The Problem With SIVs


Due to years and years of increased leverage we effectively have a banking system that is not functioning.

Let's not talk structures and Financial Engineering 501. Let's just describe in simple language what banks have been doing with the new phrase "SIV".

In order to conduct business, banks have to have capital on their balance sheets. Capital is the excess value of assets over liabilities: Capital represents a "cushion", the most a bank can lose and remain solvent. For example, the capital at Citigroup (C) is around $127 bln.

A bank makes its money through spreads in lending. It lends at a higher rate than it borrows at. The capital at a bank restricts how much lending and borrowing a bank can do. What has happened over the last decade is that banks have not been satisfied with this restriction. They began coming up with ways to effectively hide more lending and borrowing activity than they were allowed by regulation. I am not saying regulators did not know about this activity (off balance sheet lending and borrowing); I am saying these financially engineered structures circumvented not the letter of the law, but its spirit.

So Citi, unsatisfied with the amount of money it was allowed to earn by the amount of risk it was allowed to take, started doing stuff not included in its financial statements.

It lent money. Gobs of it. It didn't have the capital to support it so what did it do? It borrowed it from investors outside the normal channels of the banking system. And in doing so it committed the cardinal sin: it borrowed short-term and lent long-term.

Citi bought paper (lent money) predominately in mortgages. It got the money by borrowing from investors on a short-term basis at much lower interest rates and rolled the paper over and over again: it lent money for 20 years and borrowed from investors for six months.

This was great until investors caught on and realized it was lending at very low rates against collateral that wasn't worth what the bank said it was. It stopped lending.

So here was Citi with $100 bln in assets that it could no longer fund, so it began borrowing "money" from the Fed in an emergency situation called the discount window. This is why the Fed lowered this rate: if it did not C and others would begin incurring massive losses by borrowing at higher rates than they were lending. The second thing the Fed did was allow this stuff as collateral. If it did not, C couldn't borrow money.

The Fed can't keep this up and the banks know it. So they want to create a fund to put this paper in and fund it with longer term debt from investors. I doubt investors will be willing unless the government at least implicitly gurarantees the debt. Thus the Treasury and the Fed have now jumped in and "approved" the deal. An implicit guarantee can't be far away.

Why did they do this? Imagine the scenario where C can't find lenders to fund these "assets" off balance sheet. It would be forced to bring them back onto the balance sheet. Once it does that, it must mark them to market, which it is not doing. Fitch just put out an estimate that could be around 70 cents on the dollar. If C had to mark down $100 bln to $70 bln, what do you think would happen to that slim capital of $127 bln?

You guessed it... a $30 bln write-off.

Due to years and years of increased leverage we effectively have a banking system that is not functioning. This is why all the activity at the Fed and Treasury. It is the elephant in the room and there is no way this will not crush economic activity going forward. The economy is based on credit creation. You are seeing the first signs of credit destruction.

Risk is high.
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