It is our opinion that if an investment is difficult to understand or lacks transparency, then it should generally be avoided. In recent years, Wall Street has created a massive debacle as they have become victims of their own excessively complex financial products.
One such product is called the Structured Investment Vehicle (SIV). A SIV borrows money by selling short-term paper to one group of investors at low interest rates and then they use that money to buy longer-term instruments with higher yields. They enhance the yield by utilizing leverage up to 15:1. SIVs are then sold to another group of investors in chunks of $1 to $30 billion.
Essentially, a SIV is what we call a ‘financial burrito’ with all sorts of goodies inside including some spicy leverage. Many SIVs invested in solid long-term investments including mortgages, credit card debts, auto loan debts, student loan debts, royalties of various kinds, credit default swaps and complex derivative transactions. What really got SIVs in trouble was a class of investments now referred to as ‘toxic subprime debt’.
The marketers of SIVs went up and down the financial world selling these ‘financial burritos’ to banks, insurance companies, pension funds, endowments, investment companies, brokerage firms, governments, sovereign wealth funds – you name it – anybody with a billion bucks to pony up. When the housing market peaked in the United States in August of 2006, the falling prices of homes reduced the value of mortgage debt in these SIVs. The leverage factor compounded losses and once yield-hungry investors quickly shunned these investments.
As home prices continued to fall in 2007 some SIVs completely imploded. The so-called ‘smart money’ ran the for the exits all at once and many SIVs lost significant value putting additional pressure on the balance sheets of the financials institutions who owned them. In fact, the ironic double whammy came for some institutions who had loaned money to these SIVs. As losses piled up, liquidity evaporated and the value of SIVs continued to plummet and banks were strapped to make loans even to their most credit worthy customers. By the middle of 2008, over ½ trillion dollars has been lost by financial institutions and some people have estimated that the total losses will eventually be over $1 trillion^.
The lesson we take away from this along with many other examples from Wall Street is that investments that appear overly complex, illiquid and lack transparency should be viewed with a large degree of skepticism. And make sure you know what is in your burrito.
^Bill Gross, PIMCO, Investment Outlook, Moooooo!, August 2008.
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