Hey Imjimmy,

Glad you liked it.

Here is a link that gives a lot of good information on the topic:

http://www.riskglossary.com/link/securitization.htm

Let me know if that is not what you are looking for.

Best Regards,
Dave

Hi Jeevmania,

Sorry for the delay in reply on this one.

This is a tricky one but from what I can tell it is not that Off Balance Sheet entities are inherently bad as many companies use them legitimately to separate risk from the parent company in order to raise capital, to spin off entities etc.

As you have pointed out however in those cases if something goes wrong with the off balance sheet entity then the fact that it is off balance sheet should mean that the parent companies balance sheet is not affected.

What is different here and that can certainly be argued should not be or that should have been more readily disclosed is that these off balance sheet entities were in essence "clients" of the bank.

So basically off balance sheet entities need financing and other services that banks provide just like any other entity does. So because these entities were set up by the banks it is only natural that they are not going to give that business to some other bank so they took it on themselves.

This is I think the key that you are looking for is that the banks were the lender of last resort for the off balance sheet entities so when those entities got into trouble the banks got into trouble just like they would have if they had arranged similar terms with an entity that was simply a client and not an off balance sheet entity that they themselves had set up.

I don't know all the specifics but there is probably a good chance that the regulators didn't fully understand this relationship and the additional factor that was in play here because these entities were set up by banks.

Let me know if that is not what you are looking for.

Best Regards,
Dave

Hey David,
Really cool series, I finally understand some of the basics. Have you heard any estimates of how bad these SIVs are leveraged? I heard people say numbers like 1000:1, ie for every dollar in a real subprime mortgage there are $1000 worth of debt instruments just passed on to foreign banks, pension funds and townships. Is that true and how do you even begin to estimate this? Is this related to offshore bank secrecy, OTC derivatives and special purpose entities ala ENRON? if yes how?

Hi,

Thanks for the comment.

Rightly so when there is a large blowup like this there is a lot of suspicion as to how it happened and to who is to blame. In this case as with most others that are this large however it is in my opinion normally a lot more complicated than it is often made out to be.

One of the reasons why leverage comes up so often that people do not normally understand about these instruments is that the nature of how they are designed "embeds" leverage into the instrument. This means that even if leverage is not used by the purchaser to acquire the asset, they are still exposed to amplified market moves which are the result of leverage which is embedded into the instrument.

The most common example of this is the use of tranches as I mention in my explanation of the subprime financial crisis part 2 video (here is part 1 as well, in case you have not seen that).

Lets say for example you have a bunch of mortgages which are pooled together and the expected default rate on these mortgages is 5% so the pool carries an interest rate of 10% (making these numbers up for simplicity) By dividing this pool up into three sections or traunches where the first traunch is the first to take losses should anyone default, you automatically magnify the risk and potential return of that traunch. This is the embedded leverage part.

On top of the above many of the derivitave instruments which were built off of those CDO's also had embedded leverage.

Then on top of this many buyers of these CDO's used traditional leverage to purchase them.

With this in mind I don't think there is any way to know exactly how much leverage is out there when you include the embedded part however some estimates of the size of the different markets here are mentioned in the below two articles:

The Next Subprime Dominos to Fall: Junk Bonds and Hedge Fund Risk Insurers :: The Market Oracle :: Financial Markets Forecasting & Analysis Free Website

naked capitalism: CDOs: The Ticking Time Bomb

I don't really think this is related to off shore bank secrecy.

It is certainly related to OTC derivatives as a CDO and instruments which were used to hedge and speculate on the risk of default like Credit Default Swaps (CDS) are Derivatives which are traded off exchange or in other words Over the Counter (OTC).

For a discussion on the Enron connection see my post on Off Balance Sheet Entities Here.

If there are any other questions or comments on this please feel free to post them below.

Best Regards,
Dave

I am still a little confused about these entities. When Sharron Watkins was testifying I remember she said these were offshore because offshore taxhavens allows for these off balance sheet, over the counter type derivatives to be hidden on the asset side of their balance sheet. Ie. it would defeat the purpose of creating these SIVs in the US because a finacial audit would show right away that they are hiding their debt on the asset side. It's only because of offshore bank secrecy that this works... Am I getting this right, or not even close?

Regards,
Madashell Dude

i guess what I don't understand is how can anyone spin off a company and get away with passing on debt to them without getting caught in some kind of a regulation, unless the spinoff company is not transparent to auditors so there is no way to tell that this shell company is just hiding debt.

BTW, thanks for you explanations and links, it will take me some time to wrap my head around this mess, again thanks for the great videos too.

Thanks for the comment am glad you like the videos and are finding the explanations useful.

It is my opinion, and I know that I am probably in the minority here, that the Subprime crisis and Enron have very little in common. In my opinion there are two reasons why Enron keeps coming up in relation to the Subprime crisis which are:

1. Both these events sent tremors throughout the financial system.

2. Both involved the use of off balance sheet entities.

What I feel however that is not well understood when Subprime is compared to Enron however is:

1. Enron knowingly used off balance sheet entities to inflate earnings and hide debt which is outright fraud.

2. At least so far none of the high profile write downs by major banks have even been accused of fraud because, except for one possible exception which I will explain below, there was nothing illegal about what they were doing. This is unlike Enron where there were multiple flagrant violations of the law and how these entities can be used.

You see these banks were not using off balance sheet entities to hide debt like Enron was, quite to the contrary these entities were disclosed in the companies financial statements. Now while there may be an argument on how well the risks of these entities were understood by regulators and the public I don't think there is any argument that the banks were using these entities to hide debt as Enron was.

Here is an article to help better understand the legitimate and illegitimate uses of off balance sheet entities.

The one possible exception here is that as you can see from the article above, when an off balance sheet entity is used this is supposed to sheild the parent company from any liability resulting from the bankruptcy of the off balance sheet entity, thus the name off balance sheet. As you have seen however from all the high profile write downs by the parent companies of these off balance sheet entities this was really not the case here. The reason why is because the banks (parent companies of the off balance sheet entities) were acting as the lender of last resort to the off balance sheet entities. So what was happening is that while technically the parent company was not directly liable for the losses of the off balance sheet entity because they were a bank which had agreed to be a lender of last resort to the off balance sheet entity they in effect were liable. As I read somewhere in a blog post which I can find now "they were effectively transferring the risk off the balance sheet, to the market, and then back onto the balance sheet".

Unlike with Enron however this fact, while probably not well understood by the public and the regulators, was not hidden. While I am not saying this makes it right or will shelter the banks from lawsuit's related to this, in my opinion there is no where near the fraud if any here that existed with Enron.

Hope that helps. If there are any other questions or comments relating to this please feel free to post them below.

Best Regards,
Dave

David,

Fantastic overall explanation.

One quick question. Who, in this (byzantine) flow of the securities, has the right to call on the actual home in the instance of unmet debt obligations?

Since the lender who originated a loan has sold that loan off to a company who bundles/slices/sells the loan (or packages of loans) and then sells that bundle off to other investors/financial institutions, who, in the end can actually go to the homeowner and demand to take the collateral?

Is it the original lender, or the end holder of the security?

Thanks!

Carl

Hi Carl,

Good question.

The answer in this case is possibly the original lender, possibly the owner of the mortgage, and possibly neither;-) Let me explain:

Many of the firms that eventually buy these mortgage pools and end up holding your mortgage, are buying them as investments which is their specialty. So for example if a hedge fund that invests in mortgages buys a pool containing your mortgage then you can see how they do not want to have to deal with all the logistics of accepting your payments etc.

To deal with this issue there is something which is known as a Loan Servicer. These are companies or divisions of companies that specialize in servicing mortgages (ie collecting payments issuing statements etc.) These companies do this in exchange for a fee which is paid by the mortgage owner and fees which they can charge to the borrower for things such as late payments.

With this in mind there are basically two assets which can be sold by the company that originally gave you your mortgage. The first is the interest and principle payments, which is what investors such as hedge funds and investment banks buy, and the second is what is known as the servicing rights, which companies that specialize in mortgages like countrywide and retail banks buy.

After the origination of a mortgage, sometimes the principle and interest component will be sold off, sometimes the servicing rights will be sold off, and sometimes both will be sold off.

At the end of the day though, if a borrower defaults on their mortgage and their house is foreclosed upon, it is the mortgage servicer that handles the foreclosure on behalf of the owner of the mortgage. If those servicing rights have not been sold then it will be the original lender, and if they have then it will be whatever company they were sold too.

Hope that helps. If there are any other questions or comments please feel free to leave them below.

Best Regards,
Dave

Hi,

I am not an accounting expert but I think that what ENRON did was moving items from the liabilities side off the balance sheet (debt) in order not to have its rating decreased which could make it default due to increased payments on the existing debt. What the banks did on the other hand was moving their assets off the balance sheet in order to reduce the contraints of their balance sheet, which is the basic motive of why they created the SPV (special purpose vehicle). The banks did that because they are limited on how many loans they can make (regulated by the Basel II which states how much capital banks must have in order to have some security against the loans made i.e. to be able to repay the depositors in case of default on some loans). As such in order to be able to make more loans and hence make more money they moved the loans from their balance sheet to the SPVs. In that way they freed up their asset side, hence were able to give more loans not being forced to increase the regulatory capital (Basel II rules). Banks were now making money not from the difference in spread between the short term deposits and long term loans but from the fees stemming from arranging this whole process.

One thing which still interests me is why would the banks be willing to bail out the SPVs if those entities were OFF their balance sheet (as I believe that the sales of the mortgage loans to the SPV was a true sale; as such that mortgage was legally transferred from the bank's balance sheet)