Understanding contagion

I think I’m beginning to slightly understand the credit market melt down. The issue isn’t the collapse of the subprime mortgage market – although that is a part. The real issue seems to be the leverage built on top of that subprime mortgage market, especially the banks’ Special Investment Vehicles (SIV). SIV are off-book entities banks have set up to hold some of these assets. As a recent Wall Street Journal story explains:

There’s nothing special about how SIVs invest their money. They own the usual assortment of bank debt, mortgages and other asset-backed instruments. What’s striking is how they are set up, with huge amounts of leverage on a slim capital base; with bank sponsors that don’t own them but instead collect management fees for running them; and with their funding derived mostly from short-term commercial paper.
Put those three factors together, and it’s clear that SIVs can make tidy profits for banks when things go well. But they are vulnerable to a liquidity squeeze if the commercial-paper market dries up. That’s what happened this summer.

Or as another story says:

SIVs sell short-term debt and then use the proceeds to buy longer-term, higher-yielding securities. But SIVs have had trouble in recent months selling debt, and some of their roughly $350 billion in assets are backed by U.S. mortgages — a market that has seized up amid the housing slump and subprime-lending shakeout. Typically, money-market funds, municipalities and other risk-averse investors buy SIV debt.

But when these investors stop buying and the short term debt comes due, the liquidity problem sets in. To compound it, prices of the long-term investments drop in the thin market. Caught between an inability to raise new short term cash and an inability to sell their long term assets, bankruptcy (either official or unofficial) is the result.
I point this out because of the relevance of the subprime market fiasco to the monetization of intangible assets. Like the mortgage market, intangibles such as brand names have been packaged into special purpose entities and bonds backed by those assets sold as securities. In both cases, the cash flow from the original assets — the mortgage payments or the brand royalties — is what backs the original bond. With the rising defaults in the subprime market, that cash flow to support the subprime mortgage backed bonds became unstable. But that is not what caused the panic. Properly treated, that was containable. Owners of those bonds would have simply taken as right off of some portion and move on. But this only works if the owners don’t need to sell these assets to cover other debt. So what caused the panic was the banks high-low game of essentially interest rate arbitrage using the subprime backed bonds as the vehicle on the high end (and the commercial paper market on the low end).
So far, I don’t know if any intangible asset backed bonds have gotten into any cash-flow problems recently. There have been some in the past. But unlike the covenant-lite deals with subprimes, these intangible asset backed deal have all sorts of trip-wires and covenants to deal with cases of inadequate cash flow.
Having said that, the subprime and SIV meltdown will certainly have a negative impact on any future intangible-asset backed securitization deal. Guilt by association is likely to be the rule. The trick of those trying to push the concept of intangible securitization will be to convince investors that these assets are different. That may be a very hard row to hoe.


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