Why Cheyne really collapsed
Hereâ€™s a shocker: Cheyne Finance didnâ€™t collapse because it had liquidity issues. It collapsed because its investments went sour. By FT Alphavilleâ€™s reckoning some $3.3 bn could have been wiped off Cheyneâ€™s portfolio in the last fortnight.
For weeks - nay months - sensible SIV managers have been acting to shore up their liquidity lines since, unlike a bank conduit, SIVâ€™s donâ€™t have massive credit facilities to fall back on.
A SIV basically works by issuing short term commercial paper to raise money, and then investing in long term assets. The solvency of the SIV depends on its ability to continually finance its short-term debts by issuing more short term debt.
The received wisdom, as stated in the FT and elsewhere, is that any seizure in the commercial paper market affects SIVs badly - without the buyers for their new short term debt, they canâ€™t pay off their existing maturing short term debts and so they have to sell assets. Hence the Cheyne Finance debacle.
But actually, liquidity problems did not force Cheyne Finance to wind down.
Cheyneâ€™s letter to investors is quite specific. The SIV breached its major capital loss test - a ratio between the fundâ€™s outstanding equity principal and the value of its assets:
Due primarily to mark-to-market losses experienced in its Investment Portfolio, today, 28 August 2007, the Investment Vehicle experienced a breach of the Major Capital Loss Test, as described in Section 2.1(b) of Schedule 8 to the Management Agreement.
That test - usually, we are told, kept absolutely secret in the Management Agreement - has been dug out by FT Alphaville:
The issuer shall breach the Major Capital Loss Test if the net asset value of the total Euro capital notes outstanding is less than 50 per cent of the Dollar equivalent of the outstanding principal amount of the Euro capital notes outstanding.
**In other words, the $6.6bn Cheyne Financial fund has lost half of its capital value - $3.3bn.
And itâ€™s lost it in two weeks, because on August 15th, Standard & Poorâ€™s - who received mandatory daily updates on the health of Cheyne Finance - gave the SIV a triple A rating.
Indeed, it was only after it tripped the Major Capital Loss covenant that Cheyne drew down all three of its credit lines - to keep it ticking over until November - which again implies that liquidity wasnâ€™t the major issue that sunk the fund.
Here then, are two thoughts on what that could mean:
Cheyne may well have had a fairly massive subprime exposure. Anywhere between 30 and 50 per cent - is one rumour going round. Moodyâ€™s have confirmed that 48 per cent of the Cheyne portfolio was invested in US residential mortgage backed securities.
Or, in a story all too familiar, Cheyne could simply have been crucified on its own leverage. Were it levered 10 to 15 times - as most, if not all are - a SIV like Cheyne would only have to suffer a proportionately minor percentage shift in its overall levered asset value to lose 50 per cent of its note holder asset value and trigger that Major Capital Loss Test.
Levered five times, to $33bn, for example, and it would only take a 10 per cent drop in overall asset value ($3.3bn) to wipe 50 per cent off of the note holderâ€™s assets ($6.6bn) - after the $26.4bn of leverage debt had been paid off.
Both of these scenarios have worrying implications. Firstly, surprise surprise, Cheyneâ€™s collapse would seem to present fresh evidence that the rating agencies have been away with the fairies. Hereâ€™s S&P on the wonders of the SIV:
[They] encourage diversification, best-of-class asset selection, and defensive leverage managementâ€¦. SIVs are generally structured to have incentives to maintain asset portfolio and liability profiles that would help them in the face of volatile markets.
But with a 48 per cent exposure to US RMBS, Cheyne was anything but diversified.
Secondly, if we assume that most SIVs are leveraged, the problem, unsuprisingly, gets bigger. It wouldnâ€™t take a huge decline in asset values - triggered by, say, the mandatory Cheyne sell-off - to hit other SIV funds and trigger their Major Capital Loss tests.
If thereâ€™s high convergence between different SIVsâ€™ investment portfolios then the damage isnâ€™t going to be caused by liquidity in the CP market - itâ€™s going to come from behind: as price decreases trigger those Major Capital Loss tests.
SIVs wonâ€™t have any room to manoeuvre either - once the Capital Loss test is triggered, a sell-off is legally enforced.