October 26, 2007
Banks' Exposure to Subprime Mortgage Woes
Floyd Norris today in the New York Times (at C1) asks the question that has long troubled me. Why are banks so heavily exposed to the problems of defaults on sub prime mortgages? We are told that originators of sub prime mortgages, banks and brokers, offload the obligations to independent legal entities (SIVs or SPVs) and collect fees. The SIVs fund their purchase with sales of securities (some rely on asset-backed commercial paper, other rely on tranches of debt (CDOs)). If the sub prime market dries up banks will suffer a loss of origination fees, but we now learn that they are suffering losses on the defaults themselves. How can this be? Wall Street investment bank income is based on fees, not investments, is it not? Apparently banks found a way to accept exposure to sub prime mortgages in a variety of ways -- through internally run investment (hedge) funds, thorough guarantees to and swaps with SIVs ("security enhancement devices") and through ownership of some of the securitization vehicles (conduits). All the devices are racking up huge losses and many of the losses are difficult to value. Their primary solution -- a new super SIV run by all the banks that will buy paper from the struggling SIVs -- will postpone accurate valuations and exacerbate our problems.
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This is a real problem. And the Fed shares in the blame - it was the regulator and should have put a stop to this. It's Enron all over. I've got no problem with SIV's per se. But if the SIV required an ongoing guarantee from the originator-of-the-securities/founder of the SIV, then it's not a true sale and the founder is retaining downside/equity risk. In that case, the SIV has to end up on the balance sheet in some fashion. Enron did the exact same thing to get things off the balance sheet. It's unbelievable that the banks were allowed to do it too. Or that they'd even want to, quite frankly (Don't they remember what killed the S&L's?). But they did. Someone needs to pay a real price for this.... other than the US taxpayer.
Posted by: Bill | Oct 28, 2007 10:41:51 AM