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Strategies & Market Trends : Peabody Coal vanguard retirement forum
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From: sammy™ -_-9/17/2007 1:18:04 AM
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2 great articles:

An Iceberg Lurking Under
the Surface of the Credit Markets

by D.R. Barton, Jr.

Last week we opened the can of worms known as conduits. Conduits are simply companies that have been formed to turn clients’ assets into cash. Today we’ll look at how these “behind the scenes” companies work and why they matter. As a review here’s a short list from last week's article that illustrates why the financial solvency issue with conduit companies could have broad-ranging effects:

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It involves staggering amounts of money (over $3 trillion).
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It is an area of accounting alchemy that has little to no regulatory oversight.
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The liabilities are easily hidden from investors.
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The potential problems are big enough that they will require government bailouts if the situation in the credit markets worsen.

Why do conduit companies exist at all? Because they provide a useful function for three groups of entities:

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Companies who hold assets like receivables and securities and need to turn those into cash.
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Investors looking for short-term debt to buy at attractive yields.
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Banks that receive healthy transactions fees from the conduits they set up to match the buyer (company) with the seller (investor).

So a conduit’s role is to match up companies who need liquidity with investors looking for extra yield. They generate fees for providing this service. The banks collect these fees and take off-balance-sheet risk when they provide guarantees to backup the conduits. Let’s take a look at how these conduits operate:

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A company has assets (let’s say some receivables for products or services delivered) that it wants to turn into cash.
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A conduit buys these assets (the receivables) at a discount.
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The conduit either lumps a bunch of assets together (to ostensibly minimize risk) or sells them one at a time by creating short-term debt instruments known broadly as “commercial paper.”
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The conduit sells this commercial paper to investors who buy it because of its perceived low risk and higher-than-market rate yields.
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The cash raised from the sale of the commercial paper is used to pay for the assets bought from the company in the first step of this sequence.

So What’s the Problem?

Sounds like a reasonable transaction sequence so far. But here’s where it can break down: if the conduit can no longer resell the commercial paper (which it typically has to do every ninety days), the bank is on the hook to provide backup funding. Basically, the conduits are selling short-term debt (commercial paper) to fund the purchase of longer-term assets. This means that there are multiple sales cycles for each long-term asset bought. This is not a problem when all financial systems are strolling along at status quo or in an expanding market. But it starts to unravel when credit tightens or risk on the purchased assets increases, or both. And that brings us to the “off-balance-sheet” financing problem.

Part of the perceived safety of the commercial paper served up by conduits comes from the backstop guarantees provided by their associated bank. But these backup guarantees don’t have to be disclosed on bank balance sheets. Some well known banks are on the hook for huge amounts. The Wall Street Journal reports that just three banks – Citigroup, J.P. Morgan Chase and Bank of America have written more than $250 billion worth of backup insurance to their conduits. But, according to current accounting rules, this liability doesn’t have to show up on the books of the banking behemoths.

What this means for you and me is that the credit contraction crisis is far from over. In fact, it could be just beginning. Sub-prime loans have found their way into the asset baskets of many conduits. And that number “$3 trillion” is a really scary figure to be largely non-existent on bank balance sheets.

There will be a great temptation to start bottom fishing for bargains in the financial sector with the price reduction that has hit the sector. But investors should be wary that we may have only seen the tip of the credit contraction iceberg.

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