Beware stock investors: Credit problems remain INVESTING:

October 22, 2007

Seemingly unbeknownst to the stock market, problems continue to lurk in the credit markets. Regulators are concerned about the market upheaval caused by structured investment vehicles. Large banks set up SIVs as off-balance-sheet investments to leverage their investment capital and earn higher returns. There are reportedly some 30 SIVs with $400 billion in assets.

SIVs employ a simple strategy to make money: They borrow short term (at low rates) and invest in longer-term securities (at higher rates), thereby earning the spread difference in interest rates. SIVs issue short-term commercial paper to investors and put the proceeds into longer-term securities such as mortgages.

The problem is that many SIVs invested funds in subprime mortgages that have lost significant value. As a result, investors are shunning the purchase of the short-term commercial paper that provides the funds for SIVs. Even if the banks wanted to sell the subprime mortgages held in SIVs, they could not do so because there are no buyers for those securities except at fire-sale prices.

Thus, in a move that conjures up memories of the bailout of failed hedge fund Long Term Capital Management in 1998, the government is getting involved. Under the direction of Treasury Secretary Henry Paulson, the three largest banks in the country-Citigroup, JP Morgan and Bank of America-are forming a $100 billion fund to buy assets from SIVs.

Known as the Master-Liquidity Enhancement Conduit, this fund is being created out of fear that a mass liquidation of troubled SIV assets would cause a market meltdown. The MLEC would be allowed to purchase only the higher-rated securities from SIVs. The idea is that this will provide liquidity to the commercial paper market.

However, there are flaws in this maneuver that have some educated observers skeptical. Since the MLEC would purchase only the highest-quality securities from SIVs, the vehicles still would be saddled with illiquid subprime securities. Also, critics say this smacks of bailing out the big banks that made poor investment decisions.

There are other significant repercussions surrounding the valuations of subprime securities. For investment portfolios to be accurately valued, the securities held are required to be "marked to market." In other words, the price of any security should reflect the value that could be obtained on the open market if it were sold. Since the true value of these illiquid subprime securities is murky, some are questioning whether the portfolios of the mutual funds, hedge funds, banks and insurance companies that hold them reflect reality.

The Securities and Exchange Commission has said it will be vigilant in reviewing the methods firms used in pricing these illiquid securities, particularly since these firms charge fees to investors based on the value of the assets they manage. In addition, the accuracy depends on the proper valuation of securities. Already, some analysts are questioning the securities values used by Goldman Sachs that recently enabled the firm to deliver a stellar earnings report.

The troubles in the credit market bear watching. So far, the stock market seems unconcerned, but that could change. In the meantime, we have moved cash balances into money market funds that invest only in U.S. Treasury securities.

Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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