can you tell me if i have understood this paragraph on banks and credit and mortgages right ?

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SIVs used short-term commercial paper, sold at low interest rates, to buy longer-term mortgage-backed securities and other instruments with higher rates of return. With the seizure of the credit markets, many SIVs had trouble selling new commercial paper to replace upcoming obligations on older paper. The collapse in sub-prime mortgages and in the commercial paper that supported them has simply adjusted the value of the principal to make up for the outsized returns that these investors got over the past five years.

The money that banks owe on their commercial paper didn’t change. These banks are going to offer more commercial paper to buy mortgage assets; in other words, they are going to borrow more short-term money in order to buy long-term assets from themselves! That is, if they can borrow the money in the first place. One of the casualties in the rout was the commercial paper market; investors are realizing that it backs a lot of lousy mortgage debt, so they are backing away from investing in the commercial paper that backs the mortgages.

NOW – IS MY UNDERSTANDING RIGHT ?

Borrowed money – The SIVs sold short-term commercial paper at low rates of interest – so they borrowed money for a ST at a low IR. They did this regularly to keep getting funds.

Lent money – The banks told the people that we will give you money – mortgage your house at 12 % IR. ( Or the banks bought mortgage investments from investors.) The banks took the cheaper loans from CP and invested it in longer term mortgage-backed securities and other instruments with higher rates of return.

But when the market collapsed, the value of the house collapsed, borrowers could not pay loans and high IR, and the bank was left with a house which was not worth 25% of the loan they had given. Oversized interest rates often mean that the investment is in fact sucking money out of principal. Sometimes investors can get away with the gambit for awhile, but eventually somebody pays the bill.

Secondly, with the seizure of the credit markets, many SIVs had trouble selling new commercial paper to replace upcoming obligations on older paper.

Thirdly, The money that banks owe on their commercial paper didn’t change. Sounds like trouble.

Now the banks have paid Rs 100 to the borrower, in return they have a house which is worth Rs 20. How do the banks cover the balance Rs 70 ? These banks are going to offer more commercial paper ( and take ST loans at low IR ) to buy mortgage assets; in other words, they are going to borrow more short-term money at low IR in order to buy long-term assets from themselves!

That is, if they can borrow the money in the first place. One of the casualties in the rout was the commercial paper market; investors are realizing that it backs a lot of lousy mortgage debt, so they are backing away from investing in the commercial paper that backs the mortgages.

1 Comment
  1. Reply
    BobWang
    May 3, 2011 at 5:27 am

    An important aspect is the total lack of faith in SIVs, CDOs, and the agencies that purport to rate them.

    [Quote]
    Most of these are mortgage-based securitizations, such as CDOs. The reason for the general gun-shyness is because no-one knows what’s in them. This point was made last Thursday evening on CNBC, where Thomas Patrick presented a plan to take the performing mortgages out of CDOs and SIVs at par. It was shot down by CNBC reporter Charlie Gasparino on the grounds that performing mortgages may not perform at all in the future. Because no-one knows what’s in those securitizations, they’re not really buyable. This impression explains why mortgage-rooted CDOs and SIVs are selling way below what their present cash flow indicates, a disparity that Mr. Patrick’s plan depends on.
    [/Quote]

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