Deafening is the thunder of hordes rushing, with their hard earned savings, to invest into bank term deposits or the very next financial instrument on the marketing block – large commercial bank backed perpetual securities of every hue. A close understanding of the details of these assets would not be amiss.
Still, these instruments have mopped up billions from investors, with an appetite for yet more it seems - for fear of yet another ‘rock solid’ finance company failure. In the recent history of New Zealand, the last thirty years at least, there has never been such a concentrated melt down of one product offering of any type - debentures.
Are we at the mercy of the international credit crunch or something more systemic and how has this filtered down to little ole NZ are great questions. Rewind time to September 2001 and a new name on our lips, Osama Bin Laden. Not only did we see the collapse of what were monuments to the free US of A we also saw the beginning of a money supply fed into the US economy the likes of never before - debt at very low interest rates was easy to get and truck loads were delivered to so called NINJI (no income no job) folk to purchase homes.
Interest rates were so low in US for a period after Sept 2001 that even inflation was greater – it was better to borrow than not. That liquidity and available debt saw a property boom firestorm along with the development of investment ‘packages of debt’. Collateralised Debt Obligations (CDO’s) Collateralised Loan Obligations (CLO’s), Structured Investment Vehicles (SIV’s) and Special Purpose Vehicles (SPV’s) that investors around the world purchased with an insatiable appetite.
They vary in construction and underlying assets, but basically the CDO principle is a corporate entity that holds assets as collateral and then on-sells packages of cash flows to investors constructed as follows: A SPV acquires a portfolio of credits which may include mortgage-backed securities and high-yield corporate loans of a range of quality. The SPV issues different classes of bonds and equity. The bonds and equity are entitled to the cash flows from the portfolio, in a hierarchy of ‘priority of payments’. The senior notes are paid before the junior notes and equity notes. In this way, losses are first borne by the equity notes, next by the junior notes, and finally by the senior notes. In this way, each tranche offers distinctly different combinations of risk and return.
The investment is in the cash flows of the assets, and the promises and mathematical models, rather than a direct investment. This differentiates them from an ordinary mortgage or a mortgage backed security (MBS).
A SIV is a fund which borrows money by issuing short-term securities at low interest and then lends that money by buying long-term securities at higher interest, making a profit for investors from the difference. The classic middle-man play. The risks that arise are, the SIV may be at risk if the value of the long-term security falls below that of the short-term securities sold or, the SIV borrows short term and invests long term. If withdrawals are greater than repayments, liquidity suffers. Unless refinancing short-term at favourable rates is possible, failure quickly looms.
2007 saw the US residential subprime mortgage crisis mushroom. US banks began borrowing from the Term Auction Facility (TAF), a special arrangement by the Federal Reserve Bank to help ease the market. The Fed continued to conduct TAF twice a month to ensure market liquidity. In February 2008, the Fed made an additional $200 billion available.
Bank of America's fourth quarter earnings for 2007 fell 95% due to SIV investments.
Northern Rock, the first UK bank to have substantial problems due to SIVs in August 2007 was nationalized by the UK government in February 2008. Others have suffered as well.
The unwinding of the great credit bubble continues with Bear Stearns almost failing and with many banks fearful of lending to other banks as they are unsure of exposures to suspect securities. The Fed is working to ensure the supply of money is managed but the crunch could see the US economy slipping into recession (many say they are there now) plus fuelling surges in gold, oil and other commodities priced in US dollars.
How does this impact us at the bottom of the world? Investors have a huge appetite for yield or return on their funds (but not risk of course). In 2003 and 2004 our interest rates were below those expected by or acceptable to the investor – we were in an interest rate trough in NZ terms. Financial engineering (including leverage or debt in some instances) was required to deliver higher yields. A number of product providers rose to the challenge both locally and offshore with a variety of options. They offered income investors high yields on CDO’s or similar but achieved these through exposure to structured credit markets which are now struggling or frozen, with either debt refinancing or market liquidity issues.
If these failures were say the so called ‘leaky home syndrome’, how would we respond? The Government was all over the regulations to such an extent folk are barely able to afford the new regulations in their home building efforts – and we now see acknowledgment that some of the hastily prescribed remedy might just be overkill.
While that reaction is not needed in the financial world we do need to be assured that our investments are actually doing as expected and that we are not being conned as it seems we may have been locally, on at least one or two instances.
All financial institutions trade on the margin between their cost of funds and what it’s possible to make from lending activities (plus fees of course). That ‘spread’ is challenged when interest rates are at the high end and liquidity is tight, as they are currently. Our banks mainly fund their obligations from offshore sources. These are not as liquid as previously. High term deposit rates and capital issues into the NZ market will prevail as long as international credit markets are tight.
Regardless of your investment preference; Shares, quality debentures issuers, property, term deposits or other fixed interest securities, diversification is still the key. However bumpy the ride the money will come to fix these problems in time – it always does.
Original Article published April 2008
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