Commercial Paper: Structured investment vehicles struggling due to mortgage backed securities


A-B-C-P may be the four most influential letters in today’s financial environment. The fate of those four letters over the next few weeks will determine the fate of the US stock market and the US dollar. The wellbeing of the entire US economy might also hang in the balance. At least that’s our guess…and that’s the reason we will be closely watching A-B-C-P over the coming weeks.

These four letters stand for Asset-Backed Commercial Paper. “Commercial paper” – or CP – refers to short-term corporate debt. Specifically, unsecured short-term promissory notes issued by corporations with maturities that typically range from 30 to 270 days. Asset-backed CP is that which is collateralised by an asset-backed entity – i.e. an entity that owns assets like mortgages or credit-card receivables.

The asset backed commercial paper market is struggling mightily at the moment. Almost no one will provide financing to an asset-backed entity, especially not an asset-backed entity like a “structured investment vehicle” (SIV) that is full of mortgage-backed securities (MBS).

In a perfect world, SIVs borrow short-term money in the commercial paper market, then invest the proceeds in debt instruments like mortgages, credit card receivables and collateralised debt obligations (CDOs). But as we observed in the September 24 edition of the Rude Awakening, “The borrowing part of this formula has dried up completely. The asset-backed issuers of commercial paper cannot find any lenders to finance their toxic cocktails of lousy mortgages and ‘new math.'”

Since almost all the investors who comprise the free market refuse to purchase asset backed commercial paper, the Federal Reserve has stepped into the breach. In other words, the Fed is now financing the very same stuff that the world’s private investors refuse to finance. What more do you need to know about the gravity of America’s credit crisis?

The asset backed commercial paper market has nearly ceased functioning. In early August, ABCP outstanding totaled nearly US$1.2 trillion – representing about half of the entire commercial paper market. Since then, however, ABCP outstanding has tumbled by US$279 billion, while the other half of the CP market has remained exactly the same. In other words, traditional corporate borrowers like IBM may still tap the CP market, but not asset-backed entities.

This harsh reality becomes even more alarming when one considers that a complete CP cycle is 270 days…which means that the SIVs who effortlessly obtained 270-day commercial paper commitments last April, May or June have not yet attempted to roll over their CP in the now- hostile environment.

In all, another US$894 billion of asset backed commercial paper will mature over the next six or seven months. Who will provide that funding?…Maybe the same nameless “top tier” institution (the Fed is our guess) that just provided an US$80 billion credit line to Citigroup. Already, the Federal Reserve appears to have absorbed about US$25 billion in MBS securities via “temporary” repurchase agreements. (We realise that this stuff is as boring as heck, but that’s also why it escapes scrutiny…and why it may be so important to investors, especially, dollar-based investors).

Repurchase Agreements, “repos” are also called Sale and Repurchase Agreements. Under these agreements, the seller (usually a bank) sells securities to a buyer (usually the Federal Reserve) for cash. But the seller (bank) agrees to re-purchase the securities from the buyer (Fed) at a later date. Typically the banks use Treasury bonds or Agency bonds as repo collateral. Lately, however, mortgage-backed securities (MBS) have become the collateral of choice.

In the early part of this year, the Fed rarely “repoed” an MBS. Weeks would pass between MBS repos. But as springtime arrived, MBS repos started popping up like so many daffodils. Just a few at first, then a few more, then eventually enough to absorb a money center bank’s entire short-term liabilities…for example.

As the nearby chart clearly shows, the rolling 2-week total of “temporary” MBS repos soared from about zero in June to a whole bunch in August…and the repos are on the rise again, despite the “recovering” credit markets.

The Fed’s newfound interest in MBS contrasts sharply with the utter disinterest of free market investors. The disinterest of real-world investors comes as no surprise. It is an open secret among many hedge fund managers that the institutional holders of mortgage-backed securities and derivatives have not even come close to marking their assets to market. It is also an open secret that two critical pieces of knowledge remain utterly unknown: How big is the total MBS risk? Who’s holding the risk?

Until these questions receive credible (and quantifiable) answers, no one will provide financing to AB entities, except the Fed.

Could the Fed conjure up US$1 trillion worth of AB financing between now and President’s Day, 2008? Maybe, but probably not without also conjuring up a dollar crisis, or a bond market crisis…or both at once. The only viable path toward recovery and normalcy requires a legitimate mark-to-market. But marking MBS and CDOs to real-world prices might clip tens of billions of dollars from bank balance sheets…and might kick a few dozen millionaire-bankers to the curb.

Unfortunately, because the millionaire-bankers still control the flow of information – and still hold meetings with the Treasury Secretary to concoct shell games – the “fantasy pricing” regime remains in effect. Merrill’s US$8 billion write-down was at least a good start because it broke new ground: it acknowledged impairment of AAA-rated securities – “a level of detail that other banks have so far failed to give,” analysts from the Royal Bank of Scotland politely observed.

To begin to illustrate the magnitude of the crisis, let’s examine the unfolding SIV meltdown. According to professional estimates, 36 SIVs worldwide deploy about US$400 billion in capital. According to unofficial “whisper” estimates, these 36 SIVs have leveraged their capital to about US$2 trillion worth of actual exposure. [If the number is less than US$2 trillion, we’d love to hear about it. But the SIV operators are conspicuously mum on the topic. In fact, the SIV operators ain’t sayin’ nuthin’ about nuthin’.]

And even when they do say something, they don’t say anything useful. Late last week, Citigroup claimed to have “secured funding through year end for the US$80 billion in structured investment vehicles it manages…” But of course, the giant bank neglected to disclose the source of this astronomically large credit line. There aren’t too many lending institutions with US$80 billion to toss around. In fact, there’s only one we know of, and it’s run by a guy named Ben Bernanke.

Citi also announced that its SIVs had succeeded in selling “many billions of dollars” of short-term commercial paper to “top-tier name institutions.” Again, we wonder, what’s the big secret? Why not just tell us which “top-tier institution” is in a position to purchase “many billions of dollars” of SIV commercial paper? Why not just tell us…unless that top-tier institution is also the one run by Ben Bernanke? We are also struck by the coincidence that US$80 billion happens to be the exact sum that the Citi-led syndicate of banks is supposed to be providing to the Super SIV.

Maybe we’re way off base here, but we’re not way off base in fearing non-disclosure. Any investor with more than two days of investment experience should know that non-disclosure is never good news.

Meanwhile, the SIVs that can’t secure financing from the US Federal Reserve must liquidate their portfolios at “fire-sale” prices (i.e. real-world prices), or default on their debts…or both at the same time.

One week ago, the US$6.6 billion Cheyne Finance Plc became the first SIV to default on its commercial paper. A couple European SIVs are in the process of liquidating their US$15 billion portfolios. We predict others will follow in their footsteps. According to the Financial Times, “More than US$42 billion of assets in SIVs…are facing limits on their operations.” But that still means about US$300 billion of SIV assets are struggling for survival. And they will likely continue to struggle, not merely because they cannot access funding, but also because their assets are deteriorating.

Just read the newspaper.

The housing bust is triggering a deepening mortgage bust, which is triggering a deepening MBS bust. And the evidence is everywhere. Last week, S&P downgraded US$23 billion worth of mortgage-backed securities that had been issued less than 9 months ago! 1,713 different securities in all; and each one from the class of 2007. Meanwhile, the housing market is trending from bad to worse. As the nearby chart clearly shows, home sales and home inventories are both heading in the wrong direction. The inventory of unsold homes nationwide totals more than 10 months worth of sales – a 23-year high.

Enter the US$80 billion Citi-Paulson “Frankenfund” – the Master Liquidity Enhancement Conduit, or MLEC – to finance the stuff no one else will touch. We are skeptical of this rescue attempt, as noted in the October 17 edition of the Rude Awakening, “Bail-Out Nation.” The MLEC advances the cause of obfuscation, while preventing the price discovery that would enable the ABCP market to recover, and bring an end to the crisis.

Just yesterday, Former Chairman of the SEC, Arthur Levitt, described the Citi-Paulson MLEC scheme as “problematic.”

“Transparency is the issue,” said Levitt. “These [MBS] products are opaque. And our mechanism for overseeing the products, for regulating the process is virtually non existent.”

Translation: Its time to clear the fogged mirror, not fog it up some more. The crisis will continue deepening until the market-improvers at Treasury and the Federal Reserve abandon their price-support schemes. The crisis will deepen until MBS securities fall to the real-world prices that will attract real-world investors.

The asset backed commercial paper market will probably provide an early clue as to when that moment has arrived.

Eric Fry
for The Daily Reckoning Australia

Eric J. Fry
Eric J. Fry has been a specialist in international equities since the early 1980s. He was a professional portfolio manager for more than 10 years, specializing in international investment strategies and short- selling. Mr. Fry launched the sometimes-abrasive, mostly entertaining and always insightful Rude Awakening.
Eric J. Fry

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  1. The onus is on SIV / CP issuers to demomstrate product transparency,fee transparency and value to people like me.

    This is not a tall ask – but it is yet to happen. Transparency will result in reduced fee margins for the issuers but its their problem and their choice!

    Coffee Addict
    October 29, 2007
  2. […] mum on the topic. In fact, the SIV operators ain’t sayin’ nuthin’ about nuthin’.]“ article provides a good, easy to understand overview of how we got into the credit […]


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