Further Developments on the SIV Rescue Front

In the absence of an announcement by Citigroup, JP Morgan, and Bank of America on the structure of their proposed SIV bailout vehicle, the MLEC, today’s news consisted mainly of reactions by interested parties, many of which were revealing.

However, there were a few substantive developments (then to the commentary).

First was the leaking of a few more details. The Wall Street Journal reported:

According to people familiar with the plan, though, the price of admission for SIVs will be high. SIVs will only be allowed to sell assets rated AA or better and likely will be unable to sell collateralized debt obligations — pools of debt repackaged into slices with different levels of risk and return — backed by subprime assets. In addition, the SIVs will have to pay a fee to the super conduit and accept a discount in the price of the securities they are selling. In return for that discount, the SIVs will receive notes in the “junior” layer in the conduit — which will take the first hit if losses are incurred.

The restructuring of SIVs also raises the specter that certain SIV note holders may find themselves stuck with unexpected losses.

If you want a rescue program, you don’t lard it up with fees beyond what is necessary for costs and risk assumption. In this case, that would mean market fees for any credit enhancement provided by third parties, plus a mechanism for recovery of costs (and we mean real costs) of establishing and running the entity. That means no debt placement fees, since the old SIV owners were capable of doing that for themselves.

If the spin is that this vehicle is being established to prevent a possible crisis, then it behooves the organizers to do so on a cost recovery basis. Anything else raises questions about the real motives (including are the fees yet another way to shore up Citigroup?).

Oh, but I forgot. Public spiritedness went out of fashion in the Paul Volcker era. And in keeping, other Wall Street firms haven’t yet seen a reason to support the MLEC venture (but expect them to be pressured to fall into line):

So far, most major Wall Street firms are hanging back. Among those that haven’t given a commitment are Goldman Sachs Group Inc., Morgan Stanley, UBS AG, Deutsche Bank and Credit Suisse Group, according to people on Wall Street. Other firms whose initial responses couldn’t be determined included Merrill Lynch & Co., Lehman Brothers, and Bear Stearns Cos.

Indeed, Dick Bove of Punk Ziegel & Co who was on a conference call with Citibank’s CEO and CFO Monday morning, said that the organizing banks themselves were not yet committed to the deal. He also rated the plan on a “dumb meter” as an 8 1/2 out of 10.

The Wall Street Journal’s BreakingView column notes that the three banks will “partially backstop” the MLEC purchases, meaning a less than full credit guarantee.

The reaction of the markets was fascinating. We’ve noted the surprising and sustained divergence between the stock and bond markets. The stock markets have cheerily waved off the worsening prospects for housing and the continued fragile conditions in the credit markets and have risen to new highs.

The MLEC announcements brought a jolt of reality to the stock markets, bringing their views a bit more in line with the fixed income markets. This was a the “Northern Rock” issue we raised yesterday: that the announcement of a rescue plan could actually worsen fears, since it would lead many to recognize that conditions were more dire than they thought. As one investor noted:

“People are nervous and wondering why the banks need a big fund,” said Anthony Conroy, managing director at BNYCovergEx in New York. “What do they know that investors don’t?”

Conversely, according to the Financial Times, the news gave a boost to the credit markets:

Signs of relief were seen in the credit markets after news on Monday of plans to launch a “super fund” to take on the assets of troubled investment vehicles.

The cost of buying protection against US corporate default dropped to a three-month low amid hopes that the new “super conduit” fund being set up by three big US banks could inject liquidity and confidence back into opaque corners of the market. The cost of funding in the commercial paper market also tumbled.

Even though the debt market uptick was consistent with the oft-expressed view that this plan would be salutary if it worked, there were quite a few doubts. Some of the main themes:

Doubts that the MLEC will achieve any substantive improvement. Some comments from a column by Floyd Norris at the New York Times:

“I don’t really see that this is going to make a significant difference,” said Jan Hatzius, chief United States economist at Goldman Sachs. “It seems a little more like a P.R. move, frankly.”

Mr. Hatzius said he wondered “why this is going on when previously the official word was that things were getting better.”…

Details remained in flux yesterday, but some were not persuaded that the new structure would really do much. Josh Rosner, an expert in mortgage-backed securities at Graham Fisher, an independent research firm in New York, questioned why the banks needed to establish such a vehicle.

“If they really believe these are good assets being mispriced in the market,” he said, the banks could just buy them and wait for the asset values to recover. “This raises the question of whether the banks are doing this just to avoid taking their losses.”

The MLEC, by cherry picking assets, will make thing worse for the remaining SIVs. WSJ BreakingViews gives some practical objections, namely, the the MLEC will make life more difficult for other SIVs and thus might not turn out to be a net plus:

A big new issuer of asset-backed commercial paper….could soak up a lot of demand for such paper, especially if credit investors stay skittish. Competing with M-LEC for investment dollars could make the SIVs’ own fund-raising efforts even harder.

Meanwhile, those SIVs that sell their top-rated assets to M-LEC may not endear themselves to remaining investors, who will be stuck with exposure to bigger concentrations of what may be perceived as riskier assets. SIVs may try offering richer yields than M-LEC to attract investors. But, if traditionally conservative commercial-paper buyers worry that an SIV’s asset sales are the beginning of a death spiral, they might stay away in droves anyway.

One doesn’t even need to invoke the death spiral scenario. CP buyers were afraid that SIVs held doggy assets. CP buyers do not take risks. There simply isn’t enough additional yield opportunity in the short end of the market to warrant it. So if you take the better assets in an SIV away, CP buyers will assume that what is left is dreck. So why would they have any part of it?

Pricing the assets to be purchased is an impossible problem. We raised this issue yesterday; if there was a market price for the assets in the SIVs to being with, we wouldn’t have a problem. But we have prospective sellers who don’t want to recognize losses (these assets have deteriorated fundamentally) and buyers are skittish because prices could fall further.

Noriel Roubini elaborates on how pricing is a circular, and likely unsolvable, problem:

If…. Citi and other banks were to dispose of the SIVs assets into the super-conduit at current market values, they would still suffer the same losses as in the case of selling now in the secondary markets the same illiquid assets; thus, their objective of avoiding such losses would not be achieved….

So the super-conduit becomes a shell game that can allow banks to avoid losses – at least for the time being – if the illiquid assets that are sold to the super-conduit are being sold at prices that are above their current market value. But if this shell game were to be attempted the super-conduit plan may fail: why would potential creditors of the super-conduit want to fund it if the assets of this fund are value at values that are much above market values. It is only if the assets are sold at current distressed market value that distressed debt investors would we willing to fund the super-conduit. So the entire scheme seems like one that can work only if banks fully recognized now the losses on their SIV assets – in which case there is no need for this complex plan as assets can be disposed of at low prices today – or if such losses are not allowed to be recognized the scheme cannot work. It looks like banks are really trying to create value via financial engineering where there is not way to create such value via this game of musical chairs….

And finally, we have the philosophical/moral hazard objections. Bloomberg reports that free marketeers are unhappy with the proposal, seeing it as another example of the Bush administration not walking its talk (the steel tariffs are a sore point) and not letting private institutions bear the consequences of their decisions.

When the Cato Institute and I wind up on the same side of an issue, you can imagine something must not pass the smell test. But what is amazing is the salvo from the Wall Street Journal in its editorial “House of Paulson?“:

The less-good news is that Hank Paulson and the Treasury seem to have gone out of their way to leave their fingerprints on the announced “conduit,” going as far as to talk-up their behind-the-scenes role.

At the time of this writing, the conduit-to-be raises more questions than it answers. Banks such as Citibank — which is heavily involved — have substantial off-balance-sheet exposure to the asset-backed commercial paper market. And the SEC and regulators are breathing down their necks to write down the assets in their structured investment vehicles. It may be true that, in some cases, good assets are being marked down because investors can’t distinguish the good debt from the bad.

But get this: The announced vehicle, dubbed the Master-Liquidity Enhancement Conduit, will only buy highly-rated paper, to ensure investor confidence. The trouble with this theory is that investor confidence has been shaken because people no longer feel they can trust the ratings. This in turn has resulted from the fact that much of the now-dubious debt was rated not on the value of the collateral, but on the strength of the bank (such as Citibank) that issued it.

This is a structural problem with the asset-backed commercial paper market. And while Mr. Paulson has called for greater transparency in part to address the issue, MLEC is not going to fix it by itself. It’s even possible MLEC will try to operate in the old, discredited paradigm of assembling and rating these securities.

So we’re left to wonder whether Citibank isn’t trying, in effect, to pull off the same trick twice. The conduit would issue debt and use the proceeds to buy otherwise illiquid commercial paper. But why would anyone buy the conduit’s debt? Because J.P. Morgan, Citibank and Bank of America stand behind it! And, for good measure, Hank Paulson says the consortium is doing the right thing. That’s not exactly the same as telling people the new paper is safe, but it’s not exactly a federal disclaimer, either….. The open question, however, is whether this superconduit will establish realistic prices for the illiquid securities or will serve to mask the real value of misrated assets in order to spread out the pain and buy time for the banks most exposed.

Christopher Whalen of Institutional Risk Analytics describes asset-backed commercial paper as a market that has been “shot in the head” by the recent market turmoil and accompanying write-downs. If he’s correct, there are two possibilities: Either the superconduit won’t find buyers, or it will do so only because Treasury seems to have endorsed the concept.

Of the two, the former seems preferable. To the extent there are bad loans, the public interest is served by having the market clear. If MLEC has the effect not of clearing the market but of preventing it from clearing by throwing good money after bad, then we risk a banking paralysis of the kind Japan suffered during the 1990s because its banks refused to write down bad assets. The current credit problems are causing enough trouble without letting them hang over the fixed-income market for many more months or years. There’s also the risk that the assets on which the paper is based, such as real estate, will fall further in value and jeopardize the banks backing MLEC. That’s when banks and investors alike start begging the feds for a bailout.

In the Panic of 1907, J.P. Morgan, the man, eventually restored order to troubled markets by stepping in with his own capital and those of other banks to buy up undervalued assets and shore up institutions that still had value. Today’s crisis resembles that era in the way that murky asset-backed securities have come acropper without much capital cushion. If the banks are stepping up to provide that capital, and more transparency, that’s a plus.

But the 1907 lesson, still relevant today, is that Morgan relieved the panic by stepping in as a buyer on his own nickel, reassuring the market that there were things worth buying. He also forced write-downs when there was nothing left to save. If Mr. Paulson wants to be a modern J.P. Morgan, he’d better make sure the banks aren’t using him to delay their day of reckoning.