Blown Mortgage

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The New York Times is reporting on the efforts of some of the largest banks in the world to establish a $75 billion super-fund to purchase distressed structured investment vehicles backed by poorly performing subprime mortgages. The fund, which would be comprised solely of bank money would be used in the event that mortgage-backed investments are sold off in large numbers.

From the New York Times:

Citigroup, Bank of America and JPMorgan Chase, along with several other financial institutions, have been meeting to come up with a plan to create a fund that could prevent a sharp sell-off in securities owned by bank-affiliated investment vehicles.

…

While there are signs that the broader credit markets have begun to stabilize after the Federal Reserve lowered interest rates last month, a pocket of the commercial paper market remains under siege: structured investment vehicles, known as SIVs. The fear is that problems with these vehicles could infect the broader economy.

SIVs, which issue short-term notes to invest in longer-term securities with higher yields, are often organized by banks but are not actually owned or held by them. They are supposed to be financed through the issuance of commercial paper backed by pools of home loans and credit card debt, but the loss of confidence in the quality of subprime mortgage bonds has also tainted these securities.

Analysts say that investors have all but stopped buying SIV-affiliated commercial paper, and the worry is that the 30 or so SIVs will unload billions of dollars of mortgage-related assets all at once. That would put intense pressure on prices. As Wall Street firms and hedge funds mark value of similar investments they held to their new lower values, they face potentially huge hits to their profits.

This is the domino effect of mark to market that has everyone on edge. A couple of key players decide to fire-sale their mortgage-backed securities and it sets of a chain reaction of write downs and margin calls that freezes up the system again. It’s interesting to see this happening in the face of politicians, Fed members and the mainstream media repeatedly touting the return of stability to the credit markets.

The truth is stability is a mirage. One large sale of these assets can create that credit-crunch tidal wave. These banks know it and are investing a huge amount of money in an attempt to stave off such a scenario.

Still, the impact on the biggest banks is even more severe. In times of crisis, they are committed — either legally or to maintain their reputations — to stepping in to buy those securities. Banks have already been buying significant amounts of commercial paper in recent weeks, even though they did not have to. But if they are forced to bring those assets onto their balance sheets, they might be less willing to lend to businesses and consumers. That could set off a credit crunch and thrust the economy into a recession.

This development is timely as prices on the ABX indicies that track credit default swaps (an insurance against mortgage default) has taken another nose dive similar to the one seen in February (when Fremont and New Century failed) and again in July when American Home Mortgage and others went bankrupt. This cliff, while smaller than the others points to increased price pressure in the MBS market - a potential harbinger of further credit issues.

Now in my opinion, this is what a bail out reorganization should look like - private sector, using profits and assets that they’ve acquired, putting up their own money to right a situation in an orderly fashion. The question is, is $75 billion enough? We know there is nearly $1 trillion in subprime backed issuances sitting in portfolios around the world. Compared to that number $75 billion doesn’t look all that impressive or reassuring.

Drop in the bucket, or enough of a cushion to calm nervous investors and get the market moving again? What do you think?

More great coverage over at Naked Capitalism.

Last 3 posts by Morgan

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