naked capitalism

The Wall Street Journal and the New York Times report that Citigroup obtained funding through the end of the year for $80 billion of SIVs (for background, please see here and here). This development is newsworthy, since Citigroup had indicated it faced a crunch in November as commercial paper funding SIVs mature, yet the widely announced SIV rescue plan (the Master Liquidity Enhancement Conduit), was almost certain not to be in place by then. Citi faced the possibility of either taking a large amount of assets onto its balance sheet or unloading some or all of them, and that volume of selling would yield lousy prices and could create widescale distress.

From the Journal:

Executives of Citigroup Inc. say the giant bank has secured funding through year end for the $80 billion in structured investment vehicles it manages after selling $20 billion in assets since the midsummer credit crunch.

The steps taken by the bank’s alternative-asset management unit, run by former Morgan Stanley stock-division chief John Havens, mean the Citigroup SIVs can avoid the kind of forced selling at distressed prices begun by some other European SIV managers, the executives said.

However, the financial press is wondering whether the MLEC plan will ever get off the ground. The New York Times gave a caustic assessment in “Banks’ Plan to Help May Itself Need Help.” The story indicated that many details of the fund’s operations remain unresolved:

Does the rescue plan for the credit markets need to be saved?

The plan is still being developed, but the roughly $75 billion effort to snap up troubled securities is struggling to get off the ground….Citigroup, Bank of America, and JPMorgan Chase back the plan but are just beginning to hammer out the details. Bank regulators are aware of the discussions but some say they are out of the loop. And market participants are puzzled, with investors like Pimco and T. Rowe Price balking at buying in…..

But the plan, which was hatched in August but leaked last week, has been plagued by uncertainties…How will the plan work? Who will participate? How much will its backers put in?

“Until we know the answers, it is tough to say just how much impact this is going to have,” said Christian Stracke, a CreditSights analyst who follows S.I.V.’s. At this point, “It’s a big mess.”

Yesterday, the big banks convened an organizational meeting at Citigroup’s headquarters in Manhattan. Each bank will have about 15 executives take part in various committees. A detailed proposal is expected in about two weeks….

But each bank has something different at stake.

Citigroup, which operates the four largest S.I.V.’s and could be on the hook for $100 billion, has a clear interest. If the fund was able to buy those assets, Citigroup would minimize the impact on its balance sheet. Some suggest that the plan is a Citigroup bailout, which the bank denies….

Bank of America and JPMorgan Chase, on the other hand, do not operate S.I.V.’s but they do run large money market funds that invest in them. Even if their funds were never in jeopardy, any news that could rattle the overall money markets might worry their investors.

The new fund is intended to buy many of the securities owned by the S.I.V.’s, but at a cost. A S.I.V. would pay a fee for the right to sell to the fund, and part of the fee would be passed along to the banks, increasing profits.

The three big banks are still negotiating how much money they would put into the plan. Several Wall Street firms, like Goldman Sachs and Morgan Stanley, and European banks, like Barclays and Deutsche Bank, are waiting to see if there is enough incentive to participate.

The banks have also pledged that the new backup fund would not buy risky assets, like subprime mortgage bonds. But the banks are debating the extent to which the fund will be able to purchase other risky securities, like collateralized debt obligations.

Money market fund managers are also divided over participating. Some say the effort will just delay the inevitable by repackaging bonds backed by mortgages, loans and other assets that investors know little about and that have fallen in value.

“This is just taking money from one pocket and putting it another, with admittedly slightly stronger credit backing,” said William H. Gross, the chief investment officer of Pimco, the huge bond manager.

Mr. Gross, whose firm manages about $700 billion in assets but does not hold asset-backed commercial paper issued by S.I.V.’s, said the situation reminded him of Japanese banks that refused to sell or write off troubled loans at distressed prices in the 1990s. Jim McDonald, a T. Rowe Price portfolio manager who holds commercial paper issued by four S.I.V.’s, said his initial reaction was negative. “Our credit analysts have more questions,” he said. “Their take on the whole thing is that the only benefit to this program is that it might give S.I.V.’s a longer time to sell their assets.”

Others like Fidelity Investments and Federated Investors say the plan can be effective. They note that subprime mortgages are a tiny part of most S.I.V.’s and that many of the assets are higher-quality loans…

The backup fund began to take shape in August after the asset-backed commercial paper market seized up…. Watching a crucial funding source dry up caused concern among banks and regulators….

Throughout September and October, the proposal picked up steam as a sort of inexpensive insurance policy against the possibility that a liquidity crisis could recur in the market.

There are two intriguing revelations. First is that, nearly a week after the leak, no progress has been made on the substance of the MLEC. A week is an eternity in deal-land. This to me suggests that there are fundamental obstacles.

I suspect one stumbling block is that structuring the deal is turning out to be a circular problem. To figure out fee structure, you need to know what sort of assets are likely to go into the MLEC (that will determine the cost and nature of the credit support). However, the only one of the organizers that is a serious participant in this market is Citi, and while Citi is a big player, it can’t be assumed to be representative. Hence the organizers probably need the input of other banks to sort out what the range of possibilities of asset composition are.

But those other banks won’t give that information unless they have agreed to participate. But they won’t sign up if they don’t know what the fee structure is (and some firms may care about other details as well). But per above, the organizing group probably can’t firm up the structure without the outside input.

The second is that the MLEC idea was apparently more a contingency plan than a full-on initiative, but in classic Schrodinger’s cat fashion, the act of observation (in this case, the leak) forced it out of an indeterminate state and the organizers decided they wanted it to be alive rather than dead, so they pressed ahead.

A very good post at Accrued Interest tries to work out the MLEC pricing conundrum based on data from Bear Stearns. He assumes that the fund will go down to singe A paper (which contradicts their statements so far, that it will buy only AAA and AA assets) and the same distribution as current SIVs. The latter assumption is not a given, but it is the place to start. He comes up with an average of 12% losses on the assets versus beginning-of-year valuations.

Accrued Interest works through two scenarios: one in which the MLEC buys highly rated instruments, the other in which it acts as a vulture fund. The latter is at odds with every press report to date, so I’ll stick with his observations about the difficulties with the high quality asset program:

The SIVs will benefit because the sale of assets to the MLEC will give them a nice infusion of cash. The losses they incur as part of the sale will be marginally less than had they gone into the market themselves, but in real economic terms, this will be all but offset by the fees paid to create and insure the MLEC. If the assets are all viewed as very high quality, then I suspect MLEC won’t have any trouble getting funding from CP issuers, and every one will hail its creation as a smashing success. However, the whole thing will be nothing other than a tool to obfuscate the balance sheets of SIV sponsors.

Or as one reader put it, rearranging the deck chairs on the Titanic.

But even that view may be optimistic. Selling assets to the MLEC could be seen as an admission of financial problems. That alone would keep other SIV owners away.