Although the details of the planned SIV rescue program, the so called Master Liquidity Enhancement Conduit (MLEC) have yet to be announced, enough has been leaked to allow us to speculate with slightly greater confidence.
Since this whole enterprise has a hall of mirrors quality to it, in the spirit of Lewis Carroll, we’ll start with sentence first, verdict afterward, or in this case, bottom line first, assessment afterward.
Yesterday, we voiced doubts that this program could get done. Now that we understand that the primary goals is legerdemain, we think that it is likely that some sort of entity will be put into existence, funded, and labeled a success no matter how short it falls of its initial target. Whether that initiative will be seen as an arm’s length, legitimate undertaking is very much in question. And there is a real risk of a Northern Rock effect.
Recall that what precipitated the run on UK building society Northern Rock was the revelation that it was in discussions with regulators about its deteriorating state. Before that, few outside the banking community were aware of its distress. Similarly, there has been very little coverage in the US financial media of the rocky state of the commercial paper market and Citibank’s exposure to it. Revealing those facts, without having a rescue plan firmly in place, may do the exact opposite of what the program is intended to do, namely weaken confidence rather than shore it up.
Now to the details, or lack thereof. As we suspected, this program, which is sounds as if has been designed mainly among the Treasury, Citigroup, and agents JP Morgan and Bank of America (with limited input by unnamed others) is not far beyond the high concept stage. The speculation at the New York Times, the Wall Street Journal, the Financial Times, and Bloomberg is that it will be announced today with the expectation that it will be up and running (which we assume means having closed) within 90 days. But the worrisome acknowledgment in the Times that many details need to be sorted out says a great deal needs to be negotiated with intended participants. both the other banks with SIVs and prospective investors.
That seems awfully ambitious for a new structure. My guess is the reason for going public without having a structure in place is that the working group had gone as far as it could without the press getting wind of it (as they did anyhow) so they had either decided or were forced to make a virtue out of necessity.
But is isn’t clear that this unrealistic, um, ambitious timetable is fast enough to solve the problem. The Journal in its article points out how heavily Citi is exposed to SIVs, with $100 billion out of a global market of $400 billion while also being more thinly capitalized than other big banks; the Journal’s Deal Blog raises the obvious question: is this a bailout for Citigroup? As the first page Journal story notes:
Citigroup took the lead in pushing for the rescue plan. Large sums of SIV debt were coming due in November. And increasingly debt analysts were forecasting a tough future for SIVs. A Citigroup research report, issued two days before the banks and Treasury met for the first time, noted, “SIVs now find themselves in the eye of the storm.”
On my calendar, November is a lot less than 90 days away. Admittedly, Citi can provide funding for however many days and weeks until the conduit is functioning, but it seems highly unlikely that this entity will be up and running before Citi starts feeling squeezed.
And that is still assuming the formation of this entity really solves the problem it is meant to solve, meaning, first, giving some liquidity to Citi, and second, restoring confidence in the SIV market. I have doubts on both counts.
To make this entity look like something other than what it is, namely Citi merely creating another SIV and perhaps seeking longer maturity funding (the Journal indicated the MLEC would last only a year, which seemed implausible, while the New York Times indicated it would have a longer life and seek mainly commercial paper funding) requires the participation of other banks. But the fund, as least as envisioned now, has a feature that other banks may find offensive: Citi will take fees out of it.
The Journal indicated that Citi, JP Morgan, and BofA will be paid for providing a credit backstop. If Citi is providing most of the assets to the MLEC, this merely looks less than arm’s length. Regardless, banks of comparable or better credit quality than Citi may argue against paying those fees. The three banks will also take placement fees for arranging the funding and one presumes they will share a management fee.
The New York Times has said the banks are drawing up guidelines for what assets will eligible for the MLEC. If Citi has a is involved in determining what assets from other banks’ SIVs go into the MLEC, the prospective participants could object, since Citi is a competitor in that market and might get some insight into their holdings.
That takes us to the problem of the assets that will go into the MLEC. As the New York Times tells us:
To maintain its credibility with investors from whom it would raising money, the conduit will not buy any bonds that are tied to mortgages made to people with spotty, or subprime, credit histories. Rather, it will buy debt with the highest ratings — AAA and AA — and debt that is backed by other mortgages, credit card receipts and other assets.
Huh? The market is objecting to the crappy assets in the SIVs, not the better quality ones. It would seem more logical to take the lousy assets, issue a guarantee, and seek funding for them, and let the banks keep the good assets in existing SIVs, which ought to be marketable once the dodgy assets are excised. The banks are on the hook for the SIVs, anyhow, since they are having to fund the SIVs via backup credit lines, so any mechanism that enables them to get third party funding advances the ball.
Experts are already deeming the MLEC as currently described to less than a substantive measure. From the New York Times:
One analyst, Christian Stracke of the research firm CreditSights, said the effort appears to be an attempt to soothe tense investors in the debt market, rather than to provide substantive relief to the worst-hit mortgage securities. He noted that many of the banks participating in the fund had already been working on their own to ease problems at SIVs.“For me, this is more of a P.R. blitz,” he said. The banks are “saying, it’s not just that we are doing this on an ad hoc, individual basis. Rather, we have a plan and consortium in cooperation with Treasury, which gives it a veneer of respectability.”
Stracke seems to be the preferred source on this topic. HIs comments to Bloomberg:
“This is mostly symbolic,” said Christian Stracke, a London-based strategist at CreditSights Inc., a New York bond research firm. “The banks were going to need to inject more liquidity into the SIVs anyway, so the public co-operation just makes the bail-outs of SIVs seem more orderly.”
And others question even if the program works, whether it will be adequate. Again from Bloomberg:
Alex Roever, a debt strategist at JPMorgan in New York who wasn’t involved in the negotiations, estimates that SIVs have at least $320 billion in assets.“Eighty billion is great, but it’s not that big a number,” said Roever. “It still leaves you with $240 billion. That’s a lot of dough. There may be enough money to pay the senior debt holders, but it’s not enough to pay off everyone else.”
The Journal also noted in passing that banks may not participate because the markets could see the use of the MLEC as an admission that they are worried about liquidity. That isn’t a trivial issue, as the reluctance to use the discount window shows.
But we’ve held off the biggest problem for the last. How are they going to price the paper? Even if all the other reservations prove to be groundless, the plan could founder on this issue alone.
Transfers of assets to the MLEC must be done at a specified price. I doubt if any third parties are going to be be willing to extend funding to the MLEC if they believe the assets are being priced above market. Yet any current market pricing, even for high quality assets, is likely to require the SIV to book a loss. Even if the SIV owners accept the general premise that their paper has to be sold at a discount, they may still not like the prices on offer from the MLEC. And if the very best paper in the SIV is sold at a loss, that says the crappy paper has to be written down. As Gillian Tett at the Financial Times noted:
One banker said last week: “The banks have varied enormously in terms of how much they have marked down their books – of course there are some that want to avoid the big write-downs.
The SIV owners may decide to fund the SIV themselves and sell later, particularly if they believe the Fed will cut rates down the road, rather than book losses that they may believe (correctly or not) are too high.
Perhaps I am too pessimistic, but the lack of a functioning trading market for many of the assets in these SIVs is what made this mess so intractable in their first place. If you had market prices, you could get valuations from neutral, credible parties for the contents of SIVs. That would have gone a very long way in calming CP investors’ frazzled nerves. All these machinations by Citi et al. look like a very convoluted attempt at a finesse. Am I the only one who suspects the emperor has no clothes?
So why, with all the foregoing, do I believe this program will get done? Answer: because the Treasury has put its prestige at stake. The principals will do everything in their power to make this truly terrible precedent stick. The Treasury has become deeply involved in assisting a private concern at no evident risk of failure rather than let it take its lumps (by contrast, the Fed did relatively little in the LTCM bailout beyond convene a meeting and tell everyone it would behoove them to sort the matter out). The key actors want this to be a happy experience for Uncle Hank so they can come back for more.
Anonymous 
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Don’t know, I don’t really object to Treasury getting involved per se. It is, after all, supposed to have a certain responsability to the economy. And its involvement seems limited to jawboning; no public money is involved. I’d contrast this with Rubin’s do-nothing approach when Greenspan uttered his famous “irrational exuberance” remarks. It seems to me that if Rubin had come to Greenspan’s assistance, rather than letting him twist in the wind when Congress shafted him, the U.S. economy might be in much better shape today.
With that said, I agree that there is a big question whether this was a wise thing to do. It certainly, as you point out, raises questions about Citibank, which few were really thinking about up to now. Who’s going to buy CP issued by its SIVs now, once the best CDOs are hived off?