December 13, 2007
Nesting
What, you ask, is an SIV? There are long-winded answers to that question, but I think Dr. Hypercube has the right short answer. An SIV is a financial matryoshka.
The outermost shell is the SIV, which looks like a fixed-income mutual fund. Inside the SIV there are CDOs (collateralized debt obligations), which are slices of mortgage pools, each slice carrying a different, but hard-to-determine, level of risk. Inside the CDOs there are mortgages, many of which are never going to pay off, because inside the mortgages are houses, some of which couldn't be sold for what is currently owed on them.
Each layer increases the opacity of the system, worsening the lemons problem that leads to unsalable assets and thus a liquidity crunch, and makes it impossible to know whether the liquidity crunch is just a short-term glitch or whether instead it covers a solvency problem for some of the financial institutions involved.
And that's why Citigroup has to pay several points above prime on its short-term debt.
Update Krugman says it's a solvency problem, not just a liquidity problem. But I'm not sure how he thinks he knows that.
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