Comment 50: Tracing the liquidity squeeze (3): Oil price, SIV, Super-SIV and bail outs
The price of crude oil is rising since the early part of September. The surging oil price implies that the US trade deficit must be expanding again. Ironically it has been the stagnation of the US trade deficit that has induced the deflation of the debt bubble and in turn triggered the current liquidity squeeze as is pointed out in Comment 46 and discussed further in Comment 49. Equally ironically the slight expansion of the US trade deficit due to higher oil price is probably easing the liquidity squeeze. As if complying to this line of argument, the interest rate spread between one month CD and one month Treasury Bill is indeed shrinking and the spread has dropped below 1% level by Oct. 15. The narrowing of the interest rate spread is achieved mainly by the rising yields of Treasury Bills, indicating that the money parked in the treasury market since the onset of the financial panic of late summer is leaving the safe haven of Treasuries. However, the money flowing out of the treasury market is not going back into the commercial paper markets to bail out the holders of tainted mortgage backed securities, but is flowing into the stock markets and is pushing stock prices to new highs. As stock prices correct, the money flows back to Treasuries, causing the interest rate spread to continue its wide gyrations.
The interest rates of commercial papers did not show any abnormal behavior during the financial panic of late summer and have come down accordingly following FED's lowering of the target rate of federal funds. Only looking at the reported interest rates of commercial papers, one may even start to doubt the existence of the late summer financial panic surrounding the commercial paper markets. What has happened is that the holders of tainted mortgage backed securities are totally shut out of the commercial paper markets, and have not be able to sell commercial papers at any interest rate. The reported interest rates of commercial papers only reflect the deals with entities not tainted by mortgage woes and that is why the reported interest rates have not shown any abnormality. If those tainted entities have been allowed back to the commercial paper markets, even gradually, as some on the Street are desperately want to hint, we should see a significant rise of reported interest rates of commercial papers since those tainted parties surely must pay a much higher interest rate on their newly issued commercial papers than other healthy parties. Of course, we do not see such rise in reported interest rate of commercial papers. As a rebuff to those wishful thinkers on the Street, on Oct. 15 The Wall Street Journal reported the problems of SIVs and the idea of setting up a Super-SIV. Let us study the situations of SIVs and evaluate the pros and cons of the idea of a Super-SIV.
SIV stands for “structured investment vehicle”. They are independent financial entities often set up by large banks. SIVs borrow from financial markets by issuing short-term commercial papers and use the borrowed money to purchase risky mortgage backed securities for their higher yields. The buyers of those commercial papers are mostly money market funds and some hedge funds. Since SIVs are independent entities, their liabilities are not carried on the balance sheets of the founding banks. Most SIVs call London as their home base, but one large US bank is heavily involved in SIVs. The aggregated assets of all the SIVs before the financial panic was estimated to be around 400 billion dollars. Since the financial panic of late summer SIVs have been shut out of the commercial paper markets. In coming months SIVs need to roll over about 100 billion dollar maturing commercial papers. With no means to raise new money to redeem the maturing commercial papers SIVs will be forced to sell their holdings of risky mortgage backed securities. Such fire sales will depress already depressed prices of those risky securities further. At the end many SIVs will not be able to raise enough money to redeem their maturing commercial papers and will go into bankruptcy, and many money market funds holding their commercial papers will suffer substantial losses. Money market funds are touted as the super safe way to save with a decent return to their depositors. As the news of the losses suffered by money market funds spreads, depositors will withdraw their deposits and transfer them into super-super safe funds specialized only in short-term US treasuries. The tainted money market funds will be forced to liquidate all commercial papers at hand, even those not tainted by mortgage backed securities, in order to satisfy the massive withdraws by their depositors. The businesses not related to any mortgages will also be denied borrowing in the commercial paper markets as those markets stop functioning, whereas the yields of short-term US treasuries will plunge, widening the interest spread to an amazing level. On the other hand the collapse of the prices of those tainted securities due to the fire sales of SIVs will also hit large financial entities even though they are not legally obliged to shoulder the losses of SIVs that they founded. Before Oct. 15, large US financial entities have already announced the write-downs of risky securities carried on their balance sheets. The aggregated amount of write-downs add up to about 20 billion dollars. With the assumption that they have written down 5% to 10% of the value of the risky securities in their possession, we estimate that those large financial entities are holding about a few hundred billion dollars worth of tainted securities. The collapse of the prices of those securities due to the fire sales of SIVs will force those financial entities to make much larger write-downs. When banks write down the value of their securities, they must apply their own capital to cover the losses; as the consequence less capital will be available for lending to businesses and consumers. Thus many adverse forces will converge to form a perfect storm to hit the financial system and will bring the US economy into a recession. US Treasury Department is probably scared by such a catastrophic scenario and is promoting the idea of the Super-SIV to prevent such a financial disaster.
The idea of the Super-SIV is for large banks and Wall Street firms to contribute money, say 100 billion dollars in total, to set up an independent financial entity called the “Super-SIV”. The Super-SIV will also borrow a substantial sum from financial markets by issuing short-term commercial papers, and will use the funds at hand to buy up the troubled securities from SIVs to prevent the fire sales. As mentioned before that SIVs need to raise about 100 billion dollars in the next few months. The first batch of purchase will be easy since the Super-SIV can just use its own capital to buy the securities from SIVs. However, the attempt for the Super-SIV to borrow from financial markets by issuing short-term commercial papers will probably fail. Those commercial papers from the Super-SIV will be backed by exactly the same tainted securities as held by SIVs now. If buyers reject those commercial papers from SIVs now, they will reject similar commercial papers from the Super-SIV, too. If the Super-SIV only buys securities backed by higher quality mortgages to enhance its credit quality and leave risky portion of the securities in the hands of SIVs, SIVs will still fail and a chain reaction of fire storms will still sweep through the financial market as discussed previously. Even if the Super-SIV is formed as planned, we should expect that it will only be able to postpone the day of reckoning by several months.
To grasp the depth of the liquidity squeeze we need to estimate the size of the potentially tainted securities backed by mortgages and loans. From 2003 to the second quarter of 2007 the outstanding mortgage debts in the US have increased by about 4 trillion dollars. It is said that about 40% of those new mortgages are adjustable rate mortgages. Among those 4 trillion dollars of new mortgages 14% are classified as subprime and additional 6% are classified as non-prime the rating of which lies between the prime and the subprime. An adjustable rate mortgage carries lower interest rates in the first several years, called the teaser rate period, than a fixed rate mortgage of similar size and of similar credit rating, but the interest rate will be adjusted according to the prevailing market interest rates for that category of credit ratings when the teaser rate period expires. In the environment of higher interest rates borrowers of the adjustable rate mortgage will usually pay a much higher interest rate than during the teaser rate period. Some borrowers of such mortgages willingly jump into the fire, hoping that the rapidly rising housing prices will allow them to sell the house with a hefty profit before the teaser rate period expires. Some step into the quagmire by assuming that the interest rates will continue to fall so they can convert into a fixed rate mortgage at a lower rate later on. Many are simply talked into the fire by sweet agents of mortgage and real estate businesses. When the liquidity squeeze starts, the adjustable rate mortgages are at much higher risk of default than the fixed rate mortgages the monthly interest payments of that are fixed for the life of the mortgages. Assuming the financial wizards of the Wall Street have packaged the adjustable rate mortgages in a class of securities separated from the securities backed by fixed rate mortgages, we should view 40% of the 4 trillion dollars of new mortgages, that is, 1.6 trillion dollar worth of securities backed by adjustable rate mortgages as potentially tainted. Then we need to estimate what fraction of the adjustable rate mortgages will eventually fail. The delinquency rate of subprime mortgages, currently about 6%, as floated on financial media is not adequate for our purpose, since this rate is comparing the number of currently delinquent loans with the total amount of such loans the teaser rate period of many of that have not yet expired. We should look at the rate of failure among the loans the teaser rate period of that has just expired. If this meaningful rate is, for example, 20%, we must consider 20% of all the outstanding adjustable rate mortgages will eventually fail within a few years. If we use this 20% rate as the guide, we should expect 20% of the 1.6 trillion dollars of adjustable rate mortgages, that is, about 320 billion dollars worth of mortgages will eventually fail and be foreclosed. On top of the tainted mortgage backed securities there are securities backed by consumer credits and securities issued related to the merger and acquisition activities. The total amount of securities of the latter two categories is about 1 trillion dollars. As the liquidity squeeze advances, more and more of those categories of securities are also become tainted. As a whole we value the total amount of tainted securities as about 2 trillion dollars.
Besides analyzing the borrowers, we should also pay attention to the buyers of those tainted securities. If the buyers are deep pocket pension funds and endowments without any leverage, the loss from the tainted securities will be spread out for many years and does not pose as an imminent threat to the financial system. However, for those who borrow heavily in short-term and load up with those tainted securities using the borrowed money, their imminent demise will touch off a fire storm in the financial system. The revelation of the existence of SIVs allows us to count 400 billion dollars of those tainted securities. The write-downs by large financial entities push another several hundred billion dollars of such tainted securities into the open. We still do not know the identities of the holders of more than one trillion dollars of such tainted securities. The situation is like encountering a large number of hidden financial time bombs. Each time when those time bombs explode as the mystery holders get into trouble one by one, financial markets will be rocked. We should expect that this financial disaster drama will play out for quite a while.
US Treasury Secretary Paulson seems to think that the ultimate solution to the problem is to bail out the subprime borrowers. Let us see how such kind of bail out works. Many subprime mortgages have the clause of prepayment penalty, so such penalties need to be waived. New mortgages with much lower fixed interest rates than the old interest rates applicable after the teaser rate period will replace the original adjustable rate mortgages. However, this kind of actions is equivalent to ask the lenders to liquidate their positions at the market price, that is, to take a loss. If the lenders are mortgage banks and commercial banks, they better have deep pockets to withstand such losses. If the lenders are heavily leveraged buyers of tainted securities, this kind of forced liquidation will put them into bankruptcy and will touch off a financial fire storm as explained before. Apparently such bail outs cannot be undertaken in large scale by the private sectors alone. It is reported that Secretary Paulson is lobbying White House to use public funds to subsidize the losses of lenders when the subprime mortgages are bailed out. Such a proposal apparently is encountering strong oppositions from various political spectra since the bail out will also bail out Wall Street dealer who are considered to have reaped enormous profits by instigating such a scheme and pushed the system into the current crisis when the liquidity squeeze starts. Political conservatives believe strongly that private sectors should be allowed to do whatever it likes to do and to take the consequence of their own actions without any government intervention. Political liberals favor the bailout of subprime mortgage borrowers but are strongly against bailing out Wall Street dealers and speculators. We deem the chance of such kind of bail out to be enacted very slim.
Many on the Street think that if only FED lowers interest rates aggressively, all the problems in the market will be solved. This kind of belief is the dogma inherited from the pre-globalization era when the flow of currencies and trades across national boundaries are restricted and their effect on the economy is small. In the globalization era, if FED lowers interest rate aggressively, dollar's demise will accelerate, US trade deficit will start to shrink with a time lag, liquidity squeeze will not only come back but intensify, and the moderation of liquidity squeeze caused by FED easing will be short lived. The only means to avoid this dilemma is to ask Japanese Government to buy up a large amount of dollars to prevent its wholesale collapse against yen just as it did in 2003 when FED lowered the short-term interest rate to 1%. However, as Japanese Government buys a large sum of dollars, the matching amount of yens will be released. This means that in Japan near zero interest rates will stay as far as the eyes can see. More than 10 years of near zero interest rates have devastated Japanese workers and consumers. We should remember that in Japan an average worker retires at age 55, not at age 65 as his counter part in the US. Shorter working period means far less accumulation of retirement benefits. Thus Japanese workers need to save much more to foot the living expenses after their retirement. Near zero interest rates have reduced interest income to near zero in Japan, and as the consequence many Japanese elderlies are deprived the means of living after they exhausted their saved capitals, whereas large exporters in Japan prosper enormously due to the artificially suppressed yen. The deprivation of interest income is also having a profound effect on working age Japanese population. It is prompting them to spend much less to preserve their saved capital for old ages, and becomes the root cause of the never ending deflation in Japan. The widening wealth gap between the exporters and ordinary Japanese is creating a strange phenomenon that we call “voluntary prisoners”. After exhausted their saved capital due to the near zero interest income, many elderlies deliberately commit some petit crimes, like shop lifting, for the purpose of been jailed in order to avoid starvation. Japanese Government even dedicates some prisons especially for such voluntary elderly prisoners. If Japanese Gvoernment buys an enormous amount of dollars to prevent the wholesale collapse of dollar as FED ease aggressively and allow a massive amount of yen to be released into the market, it can then issue a massive amount of near zero interest rate bonds to soak up the unwanted yen liquidities. Japanese Government in turn can use proceeds from the bond sale to build more prisons to house more voluntary prisoners; indeed a most ridiculous picture created by this globalization process. During the last dollar buying spree of 2003-2004, a rare public discord was aired in Japan (see article 8 for details). Whether Japanese Government will serve as the white knight again this time to save the whole global financial system if FED eases aggressively is still an open question.
Surveying the situation of this prolonged liquidity squeeze, there seems to be no single magic bullet that will remedy the situation. For the time being policy makers will use the Super-SIV to prolong the day of reckoning, FED will lower interest rates in small steps with one eye gauging the reaction of the dollar, and all of them are probably secretly praying for even higher oil prices to reenergize US trade deficit so that the liquidity squeeze will ease.