Banks get burned again and again by cheap funding

NEW YORK (Reuters) - It's a familiar plot line for U.S banks and hedge funds: They finance illiquid, high-yield assets and then get burned when their funding -- cheap short- term debt -- dries up.

The interplay between long-term assets and short-term funding can pose a fundamental problem for banks, said Steven Davidoff, a law professor at Wayne State University who writes about capital markets.

The savings and loan crisis of the 1980s, which required a bailout of more than $150 billion, was partly caused by an outflow of low-rate deposits amid rampant inflation, while lenders had their money tied up in long-term mortgages.

In the late 1990s, hedge fund Long Term Capital Management failed partly because its funding source -- Wall Street banks extending credit -- turned out to be fickle.

Investment banks were eager to do business with Long Term Capital, but the hedge fund never locked up those funding commitments because it thought the money would always be there. The loss of liquidity is what ultimately led to the hedge fund's high-profile failure, said Duncan Hennes, who was in charge of liquidating the fund after its crash.

"If short-term financing is slightly structured where there is very little spread, the second there's a whiff of danger, the lenders are gone," Hennes said, adding there is no reward to justify the risk.

But memories can be short on Wall Street. And fortunately, banks or government always come up with ideas for a fix.

This time, a group of banks, including the three largest in the United States -- Citigroup Inc (C.N), Bank of America Corp (BAC.N) and JPMorgan Chase & Co (JPM.N) -- are pooling money to prevent investment funds from having to sell billions of dollars of bonds linked to risky subprime mortgages and other debt.

In this case, structured investment vehicles, or SIVs, are the culprit. Large banks or investment managers sponsor SIVs to exploit the differences in yields between long-term assets -- including risky subprime mortgages -- and cheap short-term debt such as commercial paper. Problems arise when the short-term debt comes due and needs to be refinanced, but no one is interested in funding the vehicle.

The allure of SIVs, of course, is that they make money by earning more from their investments than they have to pay to fund them.

In a research note titled "Here we go again," Bernstein Research analyst Brad Hintz said the lack of demand for commercial paper cannot be ignored because SIVs hold substantial amounts of collateralized debt obligations and mortgage-backed bonds linked to mortgages made to people with weak credit.

"To defer the day of reckoning on these securities, several banks are attempting to band together and establish a 'mutual conduit' that will hold these troubled assets so that they won't have to be immediately liquidated," Hintz said.

Hintz said this idea is simply a new spin of the Resolution Trust Corporation, which was established to hold the mortgage assets of insolvent savings and loans for orderly liquidation.

Today, seemingly safe investments such as money market funds are tied to SIVs and most investors probably do not know it, Davidoff said.

"It's a risk that I think people don't appreciate," he added.