Well, let’s take a quick survey of the issues that have been plaguing the capital markets. (Note, these aren’t all completely in order, but the spike in “mind-share” of any given story should correspond with the order.)
First there is sub-prime. This problem can best be described as fundamental. I won’t bore anyone with the issues plaguing this market, they have been well documented and aren’t even the least bit vague. Go to the always complete Calculated Risk to read all the details. Do you know how banks would make money off of sub-prime securitizations? Once a group of whole loans was securitized, the banks would keep the bottom most piece–it would get marked to a high yield at a conservative speed and it would get held on balance sheet. Banks would be monetizing the mismatch between the bonds issued and the interest rates being paid by the sub-prime loans. Essentially these structures allowed a more leveraged return for their equity. To do this, the mismatch between shorter and safer assets was exploited.
Second, there was the C.D.O. issue. This was where enterprising structured product people went out and issued bonds with low interest rates off of underlying bonds with higher interest rates. This was done by creating credit support and safety for AAA bonds, which, due to the (perceived?) lesser risk garner less of a need for returns. The party holding the “equity” tranches take the difference between the underlying and the bonds issued. Essentially these structures allowed a more leveraged return for their equity. To do this, the mismatch between shorter and safer assets was exploited.
Third, there was the S.I.V. issue. This was an issue where some banks were funding longer liabilities with shorter ones and exploiting the difference in rates required for a more senior, safer (again, perceived?) set of bonds issues off of the underlying bonds. Sub-prime mortgage bonds were backing some of these vehicles’ liabilities, thus the problems. Essentially these structures allowed a more leveraged return for their equity. To do this, the mismatch between shorter and safer assets was exploited.
Fourth, there was an issue with overnight liquidity for banks. Here banks would borrow on a shorter time frame to fund liabilities by borrowing overnight. The Fed then lowered the discount window rate to facilitate borrowing because overnight funding had spiked and there was a major shortage of liquidity. Banks borrow overnight to more efficiently fund their balance sheet to match their ever-changing cash needs. To borrow more than they need would be “bad” if they paid interest on too large an amount, this would lower their earnings. By only borrowing overnight banks’ liabilities are minimized, and they maximize the spread between what their assets are paying and what the banks are required to pay to hold all the necessary capital against said assets. This works until liquidity is horded by banks and they can’t fund their liabilities when the current funding comes due. Essentially these structures allowed a more leveraged return for their equity. To do this, the mismatch between shorter liabilities was exploited.
Fifth, the T.O.B. market began to see problems (actually, a post I discovered on a blog I read, Accrued interest–he actually alludes to the same parallels I’m alluding to here).. This was caused by bond insurers having less capital and the overall (perceived?) credit quality of insured municipal debt securities declining. T.O.B. programs allow an exploitation in rates that arise from municipal debt securities being structured to provide a higher amount of credit support. The enhanced credit support allows bonds to be issued with different rates and different durations from the bonds that back them. Essentially these structures allowed a more leveraged return for their equity. To do this, the mismatch between shorter and safer assets was exploited.
Sixth, the auction-rate securities market began to hit the skids. This audience probably remembers the WSJ article about the not-that-bad situation involving some rich people. Well, the way those securities work is actually pretty simple. One takes some long term bonds and auctions off bonds, with a shorter maturity, backed by longer bonds. The interest rate required to take on the risk of default or some other risk during the short term of the auction-rate securities is, obviously lower because the risk is (perceived to be?) lower (isn’t it less risk to bet on something defaulting in the next year versus it’s entire life?). Essentially these structures allowed a more leveraged return for their equity. To do this, the mismatch between shorter and safer assets was exploited.
Hmmmmm… As credit issues begin to build up, I wonder what might be next? Perhaps commercial paper issued by corporations as their credit quality deteriorates? Maybe real-estate holdings funded by shorter term loans mean to “bridge” to full financing?I guess we’ll find out.
Dear John Thain 