Yet More Doubts About the SIV Rescue Plan

Sometimes I feel like I am beating a dead horse, or in this case, an about-to-be-stillborn one.

The leak over the weekend revealed that the sponsors of SIV salvage operation, the so-called Master Liquidity Enhancement Conduit, had come up with a deal structure. That’s an important hurdle, but it still puts the concept a long way from implementation. The structure still needs to be formally approved by the three sponsors (Citigroup, JP Morgan, and Bank of America) and rated by the rating agencies.

The Financial Times, Wall Street Journal and Bloomberg offered a few additional details; the longest and most critical piece was from Eric Dash in the New York Times, “Some Wonder if the Banks’ Stabilization Fund Will Work.” That certainly isn’t putting too fine a point on it.

The Times said the fund would charge fees of 100 basis points to funds that sell assets to the MLEC. SIVs only have 1% equity, so the fee is going to look steep to SIV sponsors.

The comments on how the SIV will be funded are still confused, and this statement from the Journal verged on nonsensical:

This month, bankers are expected to complete a term sheet that will lay out details for other banks that want to invest in the fund. The three big banks are expected to reach out to about 70 financial institutions. Banks participating in the plan would receive a fee structure of 0.75 percentage point to 1% of assets, providing them with an incentive to get involved, said a person familiar with the matter.

I had read earlier descriptions that had indicated that the fund would have credit enhancement and then would raise money in the normal process, by selling some combination of commericial paper and medium term notes. The article in the Financial Times said the MLEC would be funded by sales of CP. And the idea of paying fees for credit enhancement or backup liquidity lines is normal practice, so that profile makes conforms with normal practice.

But the outline by the Journal above doesn’t separate the credit enhancement role from the funding role: it implies instead that the banks (note that the article mentions only banks) would get the fees for investing. That implies that what they get is an enhanced yield: whatever normal CP rates would be, plus the fees as an further inducement.

If this is how this works, it will do absolutely nothing to “unfreeze” the commercial paper market. The investors are getting a special goosed up return to invest in assets that are otherwise unsaleable. And notice that the plan is being marketed only to banks. Money market funds are big players in the CP market, yet there is no mention of them. That also suggests that the sponsors cannot craft a deal that will appeal to arms-length buyers, merely ones like banks that have a vested interested in keeping SIVs from cratering.

Keep in mind that the Journal paragraph could simply be poorly drafted, but if it is correct, the MLEC is coming out looking more and more to be designed for the needs of the sponsors rather than investors (and with those fees, and the condition that it will buy only the better assets, it doesn’t look so hot for the SIVs either). Thus, it will do nothing to improve market conditions for asset backed commercial paper. Yet that was the problem that the Treasury was trying to solve in the first place.

The reference to the financing process in the New York Times story is less specific, but not inconsistent with the Journal’s presentation:

….the three banks have committed to put up only around $5 billion to $10 billion each, leaving the remaining portion of the $75 billion to be funded by other financial institutions, according to a person involved with the plan.

The phrase “put up only around $5 billion to $10 billion each” suggests they are buying the MLEC’s commercial paper, rather than providing credit support.

However, the description in the Financial Times suggests a more conventional structure, so these worries may be misplaced:

Bank of America and JPMorgan joined the initiative but some of the SIV managers have been wary as have other banks needed to put up some of the $75bn in back-up financing for the commercial paper.

And as reader Bernard pointed out in comments on a weekend post, this effort is likely moot anyhow. SIVs’ net asset values are starting to hit levels where they are forced to liquidate. The timetable increasingly looks irrelevant to most SIVs save Citi’s, which secured additional financing through year end.

Before we get to the New York Times piece, some pithy remarks, first via Bloomberg:

The plan still has to win the confidence of investors, who may remain leery of assets whose market value has tumbled, said Graham Fisher & Co. managing director Josh Rosner.

“The whole thing is flawed,” said Rosner, whose New York- based firm analyzes structured finance and real estate investments. “As opposed to recognizing losses, we’re trying to roll those losses into the future, regardless of the sanity or safety and soundness of doing that.”

And from Willem Buiter, professor at the London School of Economics:

If all banks were required to mark to market or mark-to-model their assets and off-balance-sheet exposures using a common, verifiable methodology, we would not have the current situation where everyone is either trying to pass possible badly impaired illiquid hot potatoes on to a less well-informed counterparty, or trying to delay recognising the losses on those assets they cannot get rid off, in the hope that something will turn up and make all the bad things go away. It has even led to a proposal to create a kind of private market maker of last resort (the Single Master Liquidity Enhancement Conduit aka ‘Superfund’ proposed by Citigroup, Bank of America and J P Morgan Chase). There is a real risk that a facility of this kind would permit on a much larger scale the reciprocal taking in of each other’s dirty laundry at sweetheart prices that is rumoured to take place already among some banks. There is a grey area, with a thin line hidden somewhere in the middle, between wanting to prevent panic sales at fire-sale prices and trying to manipulate the market to as to avoid the recognition of the true magnitude of the losses that have occurred. In the mean time, lack of trust combines with ignorance about the true value of what’s being offered for sale to produce a de-facto buyers strike.

Now to Eric Dash at the New York Times:

Having settled on the fund’s composition, officials from Bank of America, Citigroup and JPMorgan Chase will now have to raise more than $60 billion of the fund from dozens of financial institutions around the globe in the next few weeks. The goal is to have the fund operating by the end of the year. But the big question is: Will it actually help?

The answer, some analysts and big investors say, is probably not much. The backup fund will not save troubled structured investment vehicles, or SIVs, that hold billions of dollars in packaged loans, though it could delay their demise. It may help calm the turbulent credit markets by preventing a sharp sell-off of securities, though analysts say the fund will probably not be able to offset the deteriorating prices of the securities.

Banks, meanwhile, may benefit if the backup fund can reignite trading in the packaged loan market and keep SIV assets from bogging down their own balance sheets.

“It is quickly being realized that it doesn’t really solve the problems,” said Joshua Rosner, a managing director at the research firm Graham Fisher & Company who had been skeptical of the proposal. “The path they have taken of skimming off the cream from the top doesn’t resolve the fact there is poison at the bottom.”….

Markets tend to overshoot. The big fear is that SIVs would be forced to dump their holdings all at once in order to pay back investors, causing prices to collapse. That could wipe out both investors who bought the riskiest slices of SIV debt as well as risk-averse money market investors who hold its commercial paper.

By encouraging SIV note holders to extend their notes by assuring them of a ready buyer, the backup fund could buy SIVs a few months of extra time.

The hope is that the backup fund will allow time for asset prices to recover, although most market analysts call that improbable. But if the backup fund helps SIVs avoid sell-off, those investors may lose less money. Prices vary, but even amid a deteriorating market, some analysts say that the bulk of SIV assets are still fetching between 97 cents and 98 cents on the dollar….

Banks may benefit most from the fund. To be sure, those that participate could probably find more profitable homes for their money. But it is tough to ignore the lucrative fees they would receive from the new fund. Banks will benefit if the fund helps prop up the packaged loan market, a huge profit engine until the recent market turmoil.

But the other big benefit is that providing a path for SIVs to unload their securities in an orderly manner means that banks will not have to absorb those assets onto their balance sheets. SIV commercial paper tends to have low yields, yet banks are required by regulators to put up huge amounts of capital to safeguard against losses. That depresses their overall returns.

The backup fund will not purchase the most distressed assets in the SIVs. Bank organizers agreed that it would not accept any subprime mortgage-related assets and only certain types of risky complex instruments like collateralized debt obligations.

But the criteria means that SIVs, or the banks that sponsor them, will be left holding their most battered securities or worse — they may be forced to sell them at fire-sale prices.

Meanwhile, the backup fund is expected to charge SIVs a fee of up to 1 percent for participation, making it prohibitively expensive for them. In fact, most SIVs have already unloaded their securities on their own, working on the assumption that it would not work or is only a last resort….

“Will this resolve the basic issue of the assets of the SIV trading below what they were originally?” asked Steven Abrahams, the chief interest-rate strategist at Bear Stearns. “No, it defers the day of reckoning.”

“If the people who organized this are right and the market gets better six months from now, they will look like geniuses,” he added. “If they are wrong, six months from now the problem will just remerge.”