waterfall thesis (part one)
i was asked to explain my thesis for “waterfall” mode yesterday.
will refrain from my usual untempered nature and present
the structured finance pyramid for what it is and how it
continues to evolve.
derivatives square up twice a year, march & september as
counter parties either extend, dissolve or adjust their
risk profiles.
fair enuf, any good financial thesis requires a foundation
based in both fact & speculation supported by the fundamental
realities.
there is a tsunami fast approaching, one swelling up due to the
abuse of derived financial instruments from asset’s that
continue to erode in both value & confidence.
it is not complicated. it is merely confusing due to the
“opaqueness” of counter party arrangements.
there are three key variables to the a derivatives function:
duration, counter party, liquidity of the underlying asset
class.
by example; let’s assume you are a large multi-national
corporation in need of continuous cash flow to maintain
operations; both fixed & variable costs for given levels of
production from 15 to 90 days. frictional, seasonal and
structural gaps create hiccups in your cash flow.
you were able to tap the commercial paper market for funds with
durations under 90 days with money market funds acting as the
counter party. these funds are liquid and represent demand
deposits available to fund short duration obligations as the
risk are mitigated by the duration. corporation with access to
this market are unlikely to go out of business within 90 days,
thus the market remains highly liquid.
as a large multi national let’s assume your short term cost of
capital is 1.5% as the average money market is paying a little
over 1.25%. your capital division has the ability to structure
leases, loans and whatever structured finance vehicle they can
dream up at 5.5%. the spread is 4% and is pure gravy for your
lower margin products and services.
on a percentage basis the spread represents a massive gain to
your bottom line.
here’s where it gets interesting. the duration of your
structured finance vehicle is of a far longer term based on the
functional life and depreciation of the asset sold. in 90 days
your commercial paper offering has to be closed, but your
“lease obligation” is for 5 years. you have paid both fixed and
variable costs associated with producing the underlying asset
while it’s receivable is stretch out over 5 years.
this duration disconnect has sent up a number of red flags
recently. and the market to this type of financing has
essentially been closed. Inventory builds & channel stuffing
creates risks to cash flow as shipping airplanes to ensenada
does not create the flows necessary to make good on these
shorter term obligations.
more to follow... as this will be rather long winded.
