Eric Dash of the New York Times reports that the sponsors of the oft-criticized SIV rescue plan, the Master Liquidity Enhancement Conduit, have passed an important hurdle; they have agreed on a deal structure.
As we have commented before. one of the things that has been perplexing from the outset was that the organizers, Citigroup, JP Morgan, and Bank of America, tried to solicit commitments from other financial institutions. That was never going to happen in the absence of an outline of key terms. Now we will see how much support the MLEC attracts.
The story is thin on particulars, since this is a leak rather than an announcement, and most of the article recounts the history of this initiative. From the New York Times:
The country’s three biggest banks have reached agreement on the structure of a backup fund of at least $75 billion to help stabilize credit markets, a person involved in the discussions said yesterday, ending nearly two months of complicated negotiations against a worsening economic backdrop.
Officials from Bank of America, Citigroup and JPMorgan Chase reached agreement late Friday, settling on a more simplified structure than had been proposed, said this person, granted anonymity because he was not authorized to talk for the group…
Now, the proposed fund could begin operating by the end of December, this person said. The banks could begin asking roughly 60 financial institutions to contribute to the fund by Friday or early next week.
“We cleared all the big hurdles,” this person said. “We agreed to a much simpler structure that we think can get done rather than optimize it for everyone.”….
The fund’s organizers say it is intended to avoid a severe credit market disruption. The hope is that it will allow time for asset prices to recover, although most market analysts call that improbable. More likely, it will discourage SIVs from dumping their holdings all at once, causing securities prices to plummet.
The proposed fund could help thaw the frozen market for asset-backed securities by establishing a ready buyer, even if no SIV uses it. SIVs are currently struggling to find buyers for their assets; no investor wants to be the first one into the market, only to watch prices drop even more a few hours or days later. “We are hoping that this will grease the wheels a little bit to start more trading,” the person involved in the discussions said.
The agreement reached Friday makes several changes that simplify earlier proposals. SIVs will no longer have to get the approval of at least 75 percent of their investors if they want to participate in the backup fund. And the backup fund will not distinguish between the assets it buys from each SIV; instead, it will assign the same risk level to all their troubled securities.
Of course, participants have been overly optimistic about their previous efforts, only to see them struggle to take flight. The backup fund still needs the blessing of the major credit rating agencies. A fee structure from 75 to 100 basis points, higher than initially proposed, is also being worked out. And several crucial tax, legal and regulatory issues await approval.
Maybe I am missing something, but it is not obvious what is meant by “the backup fund will not distinguish between the assets it buys from each SIV; instead, it will assign the same risk level to all their troubled securities.”
Does that mean ALL SIVs get treated as if their assets, are, say A-? That can’t be correct, for it would create big time perverse incentives. The worst SIVs would go to the MLEC; any with assets higher than the rating used for purchase purposes would have an incentive to sell them on their own. That is the reverse of what Paulson had initially talked about, that the MLEC would buy only the best assets. If I were a bank being asked to provide credit support to the vehicle, I would not like this concept.
Or else it could mean for each SIV, the MLEC would establish a single rating that would be a rough overall estimate for the quality of its assets.
But either way, this move appears to the finesse for setting a price for the assets to be transferred to the MLEC. Setting a global rating, and then presumably somehow deriving an overall price from the global rating (that too will be a bit of artwork) presumable enables the MLEC to avoid prices for individual assets, which would then trigger revaluation of similar assets owned, at a minimum by the sponsors and sellers (anyone who knew of this market price would likely be required to use it under new accounting rules coming into effect now). The seller would probably have to then allocate the sale proceeds to individual assets in the SIV, but that would presumably be seen as an accounting/tax exercise, not a market pricing.
One of the objectives of this exercise has appeared to be to avoid price discovery for these assets while attenuating the time horizon for selling them. That is pretty hard to do if you are going to convey them to another legal vehicle to accomplish this goal, since the transfer requires using a price. I will be very curious to see how this mechanism works and whether it will be acceptable to investors. The most important audience that the MLEC has to satisfy is buyers of its commercial paper and medium term notes that will fund the MLEC. They have made it clear that they want the assets going into the MLEC to be priced in line with current market values.
In the end, there may be no way to satisfy both the needs of the SIV owners and the requirements of the prospective MLEC investors.
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If you look at the ABX and CMBX indices, the fire sale that the banks have feared is already well underway. My guess is that they were more motivated by fear than anything else.
I wonder where Citigroup will get the money? It doesn’t have money to throw around anymore. It doesn’t have credibility. Merrill Lynch, you would think, has already dumped a relatively large amount (41%) of its toxic paper, and has comparatively little to gain.
Maybe more banks will jump in if they think that the prices really are reaching truly distressed levels. But Citigroup et al. aren’t going to get the money handed to them from burned Asian investors, and the additional writedowns in the past week for all the major players has to have been catastrophic. Where would the money come from?
alex,
Ah, but you see, neither Citi nor the sponsors will provide the dough.
The way it works is: they have fronted the money for the deal structure (trust me, I am sure they will have millions of dollars of lawyering in this before it is launched, plus the sponsors as managers will have a lot of administrative duties).
The next step is they round up a bunch of other banks to join with them in providing credit support. There will be some credit backstop here, but I am pretty certain it will be a long way from a full guarantee (I can’t imagine the banks would eat that much risk, especially when they are facing further fourth quarter writedowns. Or put it another way: a full guarantee would cost so much that the fees the MLEC would have to charge would make it unattractive to all but the weakest SIVs. The stronger one would deal with the problem on their own). There might also be a bridge liquidity facility of some sort to provide funding on a short-term basis (like a few weeks).
But the money from the MLEC will come from institutional investors. Part of the funding is certain to be commercial paper (that’s why some advocates say that a benefit of the MLEC would be to “unfreeze” the CP market) and medium term notes. The ultimate funding source is therefore institutional investors, like money market funds, fixed income funds, pension funds, insurance companies.
And they won’t tolerate inflated asset prices in the MLEC. That’s why I am still doubtful that this will fly.
The MLEC cannot prevent SIV forced liquidation that results from failing to meet the capital loss test (usually 50% of original NAV).
These capital loss tests are at imminent risk of being failed this month on the majority of these SIVs. The average NAV for SIVs are on track to hit 50 cents on the dollar very soon.
The MLEC is only designed to mitigate the forced liquidation problem resulting from a failure to roll over the SIV’s debts.
The risk of “capital loss test” forced liquidation makes the MLEC totally irrelevant.
As long as the mortgage credit markets (i.e. ABX indices) keep breaking down, then SIV forced liquidation is a guaranteed certainty—MLEC or no MLEC.
The media is completely overlooking this.
Have you ever seen in a restructuring sixty banks agreeing on something?
The rating agencies are reviewing their « Gaussian models » which should have never existed and are only starting to review the assets re ratings and banks have agreed to fund a melting pot of assets still dubious in nature?.
The effective purpose of the MLEC is to amortize losses over time by stabilizing the ABX market now.
Seems like a bailout to me. This will put a floor on the recovery rate, say 70%. Everyone will contribute their worst assets, and the govt will pony up any losses beyond the average recovery rate (70%?) that the participants do not agree to own up.
“The banks could begin asking roughly 60 financial institutions to contribute to the fund by Friday or early next week.”
So they’re going to get 60 banks to contribute to Citibank’s bailout?
Speaking as a Citigroup employee, all I can say is: That’s sweeeeeeeeet.
These were all good comments.
Bernard, you are absolutely correct. I’ve beem remiss in that I’ve mentioned the forced liquidation issue only occasionally (and not in my last post or two on this topic). So as market values keep falling, the forced liquidations will accelerate.
Peter, I am pretty sure this is sloppy drafting on the part of the writer, unless the structure has morphed radically (which is possible). As of earlier descriptions of the concept, the role the banks would play was to provide some form of credit support/enhancement, and a portion of the fee for selling assets to the SIV would go to those syndicate banks for that credit support.
OK, I’m just a dumb prole and I think all this financial intermediation that is really financial disintermediation of the real, productive economy just imposes huge information losses on the latter, while attempting to mint profits by nickel-and-diming small financial differentials, if not rearranging the deck chairs on the Titanic, likely also leading to intersectoral misallocations of capital. But, that said, AFAICT, here’s what I think might be up with MLEC. It’s possible through astute selection of assets or just dumb luck that an SIV would have a value of 1.05 of par through capital gains on assets, such that its NAV would be 12/7 or about 158%. It also doesn’t make sense, given the highly leveraged structure of SIVs, that the assets held would be highly risky crap like the mezzanine tranches of MBSs or CDOs. The proposal apparently is not to attempt to price all the individual assets of each SIV, which would be time intensive and futile, but to take on a cross-section of the NAV of each SIV, at current best estimate, but at a discount or haircut, less that fire-sale prices, which would likely be less than value at maturity, but lower than current estimated NAV. Hence MLEC would have a NAV above that of the current SIVs, while removing a portion of such assets from the current fire-sale auction, preventing the worst of fire-sale pricing and slowing the auction process, while, still more wishfully, restarting the frozen ABCP market.
OK, that was my comment cross-posted from CR. I’ll add that it’s kind of like a catchment basin concept, like pre-Army Corps wetlands during Mississippi floods, though less the earthly image than its mirror inversion from Hades.
Let’s see: someone just “happened” to have leaked out more details of the plan, and this leak “happened” to occur before another week of expected bloodletting. Sounds to me like a poorly disguised PR move to shore up the stock price of Citi/JPM/etc. and hopefully entice the financial press into uselessly debating the terms of the moribund MLEC rather than digging deeper into the financial mess that these companies are in.
Last week, the press smelled blood. Everytime a company came out with a writedown, someone was on TV talking about how it was just the beginning and there would soon be much more. I think this is just an attempt to throw some more chum in the water to distract the sharks from the real meal.
Does anyone else think it’s interesting that these three ended up being the ones to step-up? I just wonder where all the money-centre banks are. The article mentions that the LTCM situation was a smaller problem. But the initial number of counterparties that stepped-up for LTCM was much larger than 3, right?
Thomas,
In the LTCM crisis, the investment banks committed capital to facilitate an orderly wind-down of the firm. However, they already had credit exposure to LTCM. They were on the other side of margin loans. I didn’t go and check, but I don’t recall whether Roger Lowenstein, in his book When Genius Failed went though what the various banks had in the way of direct LTCM exposure (but the big worry was indirect exposure, that if LTCM collapsed, it would create havoc in a lot of markets).
As for the SIV deal, Citi is in it to save its own skin, and a lot of critics have wondered if it will do any organization beyond Citi much good. B of A and JP Morgan are in it for the fees.
Cynically, I anticipate that other banks will sign up for a token role to look like they are supporting the effort.
The backup fund still needs the blessing of the major credit rating agencies.
Why? Why does anyone believe the rating companies now?
steve j,
I am almost done with a new post on this topic, so please check it out.
Unfortunately, ratings still matter hugely, thanks to regulations. Banks have to carry less capital against assets with an AAA rating than lower rated paper. Many institutional investors are effectively required to buy “investment grade” (better than BBB-) paper (for example, pension funds can devote a portion of their holdings to unrated investments, but they prefer to use that for private equity and hedge funds, not commercial paper, which will be the main source fo funding for the MLEC),
Yves,
I understand that ratings matter but the ratings companies have been making mistakes rating derivatives since the early 90s.
Isn’t it time the market tries some other way to get ratings?