The SIV Rescue Plan: Dissed Again by the Journal

Hank Paulson must be very unhappy with the Wall Street Journal. While the newspaper briefly fell into line and issued one story that reported that the his pet project, the structured investment vehicle rescue plan, was getting traction, pretty much all its news coverage coverage has been skeptical, and its editorial comments have been downright hostile.

Today, while the other major financial news outlets left the SIV plan, (formally, the Master Liquidity Enhancement Conduit, or MLEC) largely alone, the Journal kept soldiering onward. Today it features a combo plate of a news story and an editorial. The article, “SIV Situation: Will the Rescuers Arrive in Time?” explains that the MLEC may be too late, since as SIVs are starting to unravel, it’s getting harder to find new funding for them. And a page two piece by George Anders says, in essence, that no one has made a credible case that SIVs failing would seriously damage either financial institutions or the economy, which begs the question of why a salvage operation is necessary. The placement is odd, since this is an editorial planted in the news section.

First to the highlights from the news story:

As three of the world’s biggest banks try to finalize a rescue plan for some shaky investment funds, the funds themselves face mounting problems….

Meanwhile, the funds at the heart of the situation — known as structured investment vehicles, or SIVs — need to find investors for $100 billion in debt coming due in the next six to nine months, even as ratings firms continue to come out with reports that lower the ratings of securities in moves that could further depress the value of SIV holdings.

SIVs sell short-term debt and then use the proceeds to buy longer-term, higher-yielding securities. But SIVs have had trouble in recent months selling debt, and some of their roughly $350 billion in assets are backed by U.S. mortgages — a market that has seized up amid the housing slump and subprime-lending shakeout. Typically, money-market funds, municipalities and other risk-averse investors buy SIV debt…..

Some SIV operators, such as Citigroup and Rabobank of the Netherlands, have been selling assets. In the United Kingdom, the Whistlejacket Capital Ltd. fund operated by Standard Chartered PLC is considering alternative funding plans, a Standard Chartered spokesman said.

Meanwhile, the types of assets held by some SIVs continue to come into question. Moody’s Investors Service Inc. recently downgraded $33.4 billion of securities issued in 2006 and backed by subprime mortgages in moves that could make it more difficult for SIVs to unload assets.

Holders of SIV capital notes are bearing the brunt of the SIV fallout. Investors in capital notes typically supply an SIV with as much as 5% of its money. In return, these noteholders — often European banks and insurers — receive a share of the SIV’s profits or losses. They are ranked lower than the other debtholders and thus could be the first to bear losses if SIVs sell assets to the banks’ rescue fund.

Capital-notes holders face two options: risk losing money if the SIV sells assets to the banks’ fund at a loss, or try to keep the SIV going by buying more of its debt. In recent days, SIVs have been trying to persuade capital-notes holders to buy medium-term notes to fund the SIVs and protect their investments, people familiar with the matter say. Some capital-notes holders — and SIVs — say they are skeptical about the banks’ plan, because selling assets at today’s prices will require the SIV and the notes holders to recognize a loss on those investments…

The lead banks have provided little public guidance on their plans for the fund, leaving themselves open to criticism…

The three banks have many issues to work out, according to people familiar with the situation. They need to figure out how participating banks would divide any profits or shoulder losses when the rescue fund is wound down, according to people familiar with the plan. They need to decide if participating banks will be ranked based on how much funding they provide, just as banks take lead and supporting roles in stock offerings.

A point of clarification: We’ve noted in previous posts that data provided by readers from Fitch and other sources indicates that the level of capital notes is typically much greater, in the 65-70% range, which is consistent with other information. Put it another way: if these vehicles were 94% commercial paper, with most CP maturing in 90 days or less and the asset backed CP market refusing to roll CP related to many of these vehicles starting as of the beginning of August, this market would be in a severe crisis already. But it doesn’t change the fact that getting the capital notes holders on board is crucial.

Now to the editorial, um, article by George Anders, “SIV Fund Gives Banks an Unnecessary Break.” Note his basic observation is very similar to one made by the Financial Times’ Martin Wolf: banks can too easily hold regulators hostage.

From Anders:

When Lee Iacocca ran Chrysler in the 1980s, he complained about a double standard for enterprises in trouble.

Ailing industrial companies got no sympathy, he said. Economic Darwinists urged them to make drastic cutbacks or even perish, in the name of market discipline. And it took many months of struggle before Chrysler got U.S. loan guarantees. When banks stumbled, it was a different story — no matter how foolish their mistakes. They were rescued in the name of protecting the global financial system.

Several of the world’s biggest banks are going through strange gyrations to avoid owning up to missteps in the London market for structured investment vehicles. SIVs are funds the banks set up as a way to make money without taking the risks involved onto their balance sheets.

The banks have dropped hints that if they don’t succeed in raising a $75 billion rescue fund, dangerous ripples could spread into the broader commercial-paper market and beyond.

Such talk roused the U.S. Treasury earlier this month….

For all the drama of late-night rescue talks, though, the banks have danced around two crucial questions. First, is the SIV market so important to world economic health that it should be saved in its own right? Second, are global markets in such perilous shape that a shakeout in SIVs could trigger collapses in other capital markets?

It’s hard to say “yes” to either question. SIVs exist mostly as a way for banks to do business without putting up their own capital. The market hardly existed 15 years ago; today, its total assets amount to $350 billion.

There’s nothing special about how SIVs invest their money. They own the usual assortment of bank debt, mortgages and other asset-backed instruments. What’s striking is how they are set up, with huge amounts of leverage on a slim capital base; with bank sponsors that don’t own them but instead collect management fees for running them; and with their funding derived mostly from short-term commercial paper.

Put those three factors together, and it’s clear that SIVs can make tidy profits for banks when things go well. But they are vulnerable to a liquidity squeeze if the commercial-paper market dries up. That’s what happened this summer.

Even Citigroup, one of the most active SIV sponsors, isn’t portraying these conduits as the bankers’ equivalent of the eight essential amino acids, without which we can’t live….

So if SIVs aren’t vital per se, do we still risk Armageddon if they fade away too quickly? Anyone familiar with the Depression-era wave of bank failures has to be mindful of the risks that panics can spread, crippling sound institutions….

If banks ever could absorb a few hits, now is the time. Current conditions differ sharply from 1982, when the Latin American debt crisis hit as major U.S. banks were struggling with a recession and the aftermath of lofty short-term rates that squeezed lending margins. In 1982, regulators had good reason to worry about a domino chain of defaults. There’s more padding in the system today.

Hasty rescue plans amount to an amnesty for sloppy banking and an invitation for it to continue. Japan’s experience in the 1990s is a case in point. Rather than owning up to banks’ poor judgment in real-estate lending, Japanese authorities tried for years to shore up shaky loan portfolios. That produced economic stagnation.

Even worse, painless rescues protect the careers of bankers who ought to pay the price for their poor judgment. So far, no CEO of a major U.S. bank has been held accountable for the SIV mess. There haven’t even been any widespread purges of their lieutenants.

People involved in the SIV rescue fund say it will buy troubled funds’ holdings at prices that both shore up the market and are economically rational. Hmmn. It was fascinating to hear Alan Greenspan, former Federal Reserve chairman, weigh in last Friday with doubts about how investors would feel if “some form of artificial non-market force is propping up the market.” But if the SIV rescue fund tries too hard to make prices levitate, that’s just throwing good money after bad.