In Case You Thought the Credit Crunch Was Over….(SIV Rescue Edition)

The recent record highs in stock market were presupposed on the notion that the credit crisis of the summer was now history and that growth would resume its former course.

Investors chose to regard large writeoffs at UBS, Citigroup, Merrill, and Deutsche Bank as signs that they were all putting the problems behind them. That was an interesting interpretation, since all these institutions are required to mark to market and are under heightened SEC scrutiny to provide accurate and consistent pricing of illiquid positions. Yes, equity investors hoped that they not only took losses that needed to be recorded and also reserved for potential losses. But there is no way of knowing what they did, or whether any reserves for future losses were adequate.

Articles in the Wall Street Journal and Bloomberg on discussions orchestrated by the US Treasury over the last few weeks to orchestrate a rescue plan for mortgage-related paper held by structured investment vehicles shows that the recovery in the credit markets is tenuous. We have pointed out that despite a return to near-normalcy in some sectors of the debt markets, such as a resumption of LBO lending, there has not been much improvement in the most troubled area, the commercial paper market, which was the proximate cause of the liquidity injections by central banks around the world in late August and early September and the Fed’s September 19 discount rate cut (the little bit of good news is too early to call a trend, and is contradicted by the Treasury meetings).

Note that this is the first time a regulator has convened meetings to address an impending problem for the securities industry since the Fed hosted meetings to facilitate a bailout of troubled hedge fund Long-Term Capital Management in 1997. That effort was perceived to be necessary to forestall a collapse that might represent systemic risk. While Paulson is awfully close to the securities industry and therefore might have a lower risk threshold than the Fed did a decade ago, these meetings are at a minimum highly unusual and signal that the Treasury regards the issue as very serious.

By way of background, many banks set up structured investment vehicles (SIVs) which are off balance sheet entities that bought mortgage-related paper and sometimes other asset backed paper, like credit card receivables, and funded it in the commercial paper market, a classic lend long, borrow short operation. Commercial paper secured by assets backed instruments is called asset backed commercial paper, or ABCP.

The problem was twofold: the short term funding dried up and these vehicles weren’t as off balance sheet as they appeared to be.

Many banks gave backup lines of credit to the SIVs, often their own entities. After two German banks had to be rescued due to subprime exposure, suddenly no one wanted to hold ABCP, and these vehicles could no longer roll their CP. They had to use their backup lines of credit (in some cases, the parent bank might not have be required to support the SIV, but have decided to anyhow out of concern for their reputation). Thus the belief is that these banks are hoarding cash for their own needs, to the detriment of normal market operation.

As reported in the Journal and Bloomberg, the proposal is to form an entity to acquire the mortgage assets now held by some SIVs (European banks may also participate). The notion is that having a bigger vehicle with the participation of large banking entities will alleviate the stress in the money markets, and potentially forestall a crisis in the mortgage markets. If a lot of SIVs liquidated because they couldn’t get funding, that volume of paper would swamp immediate demand, forcing it to be sold at distressed prices. Those distressed prices would in turn require dealers and investors to mark down any similar instruments they owned. Investors who had financed those holdings would face a margin call if their collateral value had fallen enough. In many cases, that would trigger forced sales. Dealers would also have to write down their inventory, which would lead to losses and reduce their capital bases, which would in turn force them to shrink their balance sheets at precisely the time when it would be most useful for them to step to the plate.

But will this approach work? The problem started because money market investors didn’t want to buy paper that was exposed to subprime risk, and the SIVs were opaque, so they couldn’t readily ascertain what they held (and even if they did. some of this paper, like collateralized debt obligations, is sufficiently arcane that it isn’t worth the investment of time to verify its creditworthiness. It’s easier simply to buy something else). Remember that money market players are not in the business of taking big risks. They are looking for a safe place to park short-term dough. For the most part, this crowd isn’t paid to speculate, and they don’t.

So how is this proposal an improvement over the status quo? At least as described in the Journal, the new vehicle is guaranteed by a consortium of banks who are contributing assets. That ought to succeed unless the former ABCP buyers have gotten nervous about the creditworthiness of big banks. If that turns out to be the case, we really have a mess on our hands.

I find it curious that this new entity is apparently going to seek funding exclusively in the money markets. Those investors, as we just noted, seldom have charters that allow them to take much risk. It would seem much more prudent to reduce the maturity mismatch and seek somewhat longer dated funding. 2-3 year duration funds are offering yields not much higher than money market yields. But, quel horreur, even a modest increase in funding costs would force the banks to take losses.

An aside: it’s ironic that Citigroup seems to be the institution most at risk. Recall that they nearly went under in the early 1990s and had to be bailed out by Saudi prince Al-Waleed, a move widely believed to have been orchestrated.

From the Journal:

In a far-reaching response to the global credit crisis, Citigroup Inc. and other big banks are discussing a plan to pool together and financially back as much as $100 billion in shaky mortgage securities and other investments.

The banks met three weeks ago in Washington at the Treasury Department, which convened the talks and is playing a central advisory role, people familiar with the situation said. The meeting was hosted by Treasury’s undersecretary for domestic finance, Robert Steel, a former Goldman Sachs Group Inc. official and the top domestic finance adviser to Treasury Secretary Henry Paulson. The Federal Reserve has been kept informed but has left the active role to the Treasury.

The new fund is designed to stave off what Citigroup and others see as a threat to the financial markets world-wide: the danger that dozens of huge bank-affiliated funds will be forced to unload billions of dollars in mortgage-backed securities and other assets, driving down their prices in a fire sale. That could force big write-offs by banks, brokerages and hedge funds that own similar investments and would have to mark them down to the new, lower market prices.

The ultimate fear: If banks need to write down more assets or are forced to take assets onto their books, that could set off a broader credit crunch and hurt the economy….

Citigroup has nearly $100 billion in seven affiliated structured investment vehicles, or SIVs. Globally, SIVs had $400 billion in assets as of Aug. 28, according to Moody’s….

Many SIVs had trouble rolling over their short-term debt in August because of concerns about the quality of their assets. That contributed to the broader seizing up of credit markets.

The Financial Services Authority, the United Kingdom’s markets regulator, has suggested that U.K. banks consider participating in the plan, a person familiar with the situation said. HSBC Holdings PLC, the largest U.K. bank, has an affiliate SIV called Cullinan Finance Ltd. with $35 billion in senior debt. An HSBC representative wasn’t immediately available to comment.

If the banks agree, the plan could be announced as early as Monday, people familiar with the matter said. Citigroup announces third-quarter earnings Monday. The tentative name for the fund is Master-Liquidity Enhancement Conduit, or M-LEC.

The plan is encountering resistance from some big banks. They argue that Citigroup is asking others to help bail out its affiliates and an industry-wide bailout isn’t needed. Citigroup bankers created the first SIV in the late 1980s in London.

The new fund represents a way for Citigroup and other banks to “outlast the current market conditions that are so dry right now,” says Jaime Peters, an analyst at Morningstar Inc.

Traditional buyers of debt issued by SIVs include money-market mutual funds, municipalities and other risk-averse investors attracted by the high credit rating of the vehicles.

By providing a receptacle for assets backed by subprime mortgages and other creations of Wall Street, the SIVs contributed to the big expansion of credit in recent years whose aftereffects are now roiling the economy.

The Citigroup plan would create a “superconduit,” a fund backed by some of the world’s biggest banks that would issue short-term debt and serve as a buyer of assets currently held by SIVs affiliated with the participating banks.

According to the people familiar with the plan, these assets include securities tied to U.S. mortgages as well as debt pools called collateralized debt obligations.

Because the superconduit would be backed by the big banks themselves, it’s expected this would reassure investors and make them more willing to buy its short-term debt, or commercial paper…. The superconduit’s debt would be fully backed by participating banks, they said.

One supporter of the effort is Treasury Secretary Henry Paulson, who decided to assemble the banks after conversations with businesspeople who expressed concern about SIVs and their impact on the economy, said a person familiar with the matter.

It’s the second time in two months that U.S. authorities helped arrange for financial institutions to discuss steps to avert a credit crisis. In mid-August, at the request of the New York Fed, financial leaders met with Fed officials who explained the Fed’s steps to open up the supply of cash to the nation’s banks.

The new plan would be challenging to pull off. Bank-affiliated SIVs selling assets into the superconduit will have to agree on how to price those assets. Some SIVs may value the securities differently. There have been several meetings since the initial Sunday meeting, both at Treasury and in New York

Some additional detail from the Bloomberg coverage:

Citigroup Inc., JPMorgan Chase & Co. are leading a group of banks that are in talks with the U.S. Treasury about a plan to revive the asset-backed commercial paper market….Under one plan being considered by the banks, lenders would establish a fund of as much as $100 billion to buy assets from the SIVs….

“If the firms get together to improve the quality, that’s a good development,” said Mark Amberson, who runs the $5 billion Russell Money Fund for the Russell Investment Group in Tacoma, Washington. “It would be a positive credit event if you wind up with a better vehicle.”….

SIVs that issued commercial paper to buy the securities found they could no longer roll over the debt, forcing them to sell about $75 billion of their assets.

The amount of asset-backed commercial paper outstanding tumbled to $899 billion in the week ended Oct. 10, from a high of $1.14 trillion at the end of June, according to the Federal Reserve…

“Some markets have been experiencing illiquidity,” San Francisco Fed President Janet Yellen said in an Oct. 9 speech in Los Angeles, referring to mortgage-backed securities and asset- backed commercial paper. “This illiquidity has become an enormous problem for companies that specialize in originating mortgages and then bundling them to sell as securities.”

As yields on asset-backed commercial paper climbed amid the exodus from the market, some companies found their access to borrowing cut off. Countrywide Financial Corp., the biggest U.S. mortgage lender, had to tap an entire $11.5 billion bank line on Aug. 16 after being unable to fund itself with commercial paper….

Holdings by SIVs have dropped to about $320 billion from about $395 billion of assets in July, Moody’s Investors Service said this month.

“SIVs are all losing money right now,” said Chris Low, chief economist at FTN Financial in New York. “If any one of the conduits dumps” their holdings of distressed securities, “it could trigger selling by the others as well, and that’s the scenario they’re to avoid,” he said.

Note that JP Morgan does not have an SIV and therefore would act only as an arranger/placement agent for the conduit.