Maybe the Real Reason for the SIV Rescue Plan?

The negative reactions on the proposed SIV rescue plan (officially known as the Master Liquidity Enhancement Conduit) have become so widespread that I haven’t been reporting as closely on this topic as I did earlier. However, some of the recent coverage has finally surfaced at least one reason for the plan that at least makes sense (whether readers regard it as legitimate is another matter entirely).

Recall that one of the ongoing mysteries about this program is that it involves a great deal of fuss and expense for what appears to be little or no gain.

The new MLEC will buy high-quality assets from exiting SIVs (which begs the question of what happens to the crappy assets left behind). The old SIVs get cash and some securities from the MLEC. The MLEC has some credit enhancement and issues commercial paper and medium term notes.

The problem is that the MLEC is not going to be fully guaranteed by the banks providing credit enhancement, so the investors will want the assets in the MLEC to be price within hailing distance of current values. That, of course, is what the SIV sponsors want to avoid, or at least minimize, since selling assets into the MLEC at realistic prices will require them to take losses.

In addition, there has been no discussion as to the end game for the MLEC. There have been some comments that indicate that it will sell the assets it holds, but over a long-ish period of time, thus reducing market impact.

But if any bank sponsor is not stressed financially, it too could simply fund its SIV and simply liquidate more gradually. So then the question becomes whether the benefit exceeds the fees the MLEC will charge. For banks that aren’t in duress, the answer would appear to be no.

But a new piece of the puzzle emerged yesterday in the Wall Street Journal:

Supporting these off-balance-sheet funds, known as structured investment vehicles or SIVs, is the heart of the rescue effort led by Citigroup, J.P. Morgan Chase & Co. and Bank of America Corp. Accounting groups have raised the question of whether Citigroup and other managers of the SIVs should account for the funds, many of which face potential losses, on their own balance sheets.

A spokeswoman for Citigroup said, “Citi is confident that it has accounted for the SIVs it sponsors on behalf of investor-clients properly and in thorough accordance with all applicable rules and regulations.”…

If it doesn’t work, Citigroup and other SIV managers could find themselves in a bind that could force them to take financial hits.

If the rescue plan failed and buyers continued to stay away from the commercial-paper market, the bank might feel pressure to pony up cash to backstop the SIVs to preserve its reputation with the vehicles’ investors, who would otherwise incur the bulk of the losses. But that prospect has raised the issue among accounting professionals about whether the bank shares in potential losses to such an extent that it should consolidate the SIVs onto its own books..

So the MLEC keeps the losses from being consolidated. That now appears to be a clear benefit, and perhaps the only benefit, of this scheme.

The New York Times today, in two different stories, indicated that the pressure, generally and on Citi, the biggest SIV sponsor, is increasing. From “$75 Billion Fund Is Seen as Stopgap“:

Nearly three weeks after the country’s biggest banks announced a $75 billion fund to help stabilize the credit markets, the reality is sinking in that the plan will provide hospice care to troubled investment funds, not resuscitate them….

The proposed bank fund “is more a towline to get them to the scrapyard,” Lou Crandall, chief economist at Wrightson ICAP, a financial research firm, said….

Citigroup’s seven SIVs are under pressure to repay investors. Several less robust funds could face downgrading. Over all, the 30 or so SIVs have been forced to sell assets at an alarming pace — shedding roughly $75 billion since July and shrinking the industry by a fifth. Market participants expect SIVs to unload even more, as much as $15 billion a week….

“People get the idea that this is a total solution or a complete rescue,” a person involved in the plan said. “But the goal is actually much less ambitious: it is really to provide an orderly unwind or promote a restructuring.”

According to people briefed on the fund, the plan will encourage SIV investors to extend their short-term notes by at least six months…

Analysts say the fund will not benefit all SIVs equally, with those sponsored by big banks gaining the most. All this has turned the spotlight on Citigroup — which, skeptics suggest, shaped the plan specifically to ease its troubles….

At least 10 other foreign banks — including Dresdner Kleinwort of Germany, HSBC and Standard Chartered of Britain, the Bank of Montreal and Rabobank of the Netherlands — manage SIVs.

Market players say they are under just as much, if not more, strain than Citigroup. To delay the day of reckoning, they have been buying commercial paper and riskier notes from the SIVs they sponsor. Some are also looking to restructure, too.

A second New York Times article, “Analyst Raises Doubts About Citigroup Dividend,,” focuses on the fact that even before the SIV crisis, Citigroup was more thinly capitalized than other large banks. The “$30 billion capital shortfall” is thus the analyst’s estimate of what it will take, between increasing reserves and equity, to bring the bank in line with industry norms:

A long-time banking analyst said late last night that Citigroup may be forced to cut its dividend or sell assets to stave off what she said was a $30 billion capital shortfall, moves that could pull down its shareholder returns for several years.

The analyst, Meredith A. Whitney of CIBC World Markets, downgraded Citigroup’s stock to sector underperform, from sector perform, and called for the bank to bring precariously low capital levels more in line with its peers.

“We believe the stock will be under significant pressure and could trade in the low $30s,” she wrote. That would be as much as a 28 percent decline from yesterday’s $41.90 closing price for Citigroup shares.

If correct, the findings could be yet another blow to Citigroup’s chairman and chief executive, Charles O. Prince III, who has endured a barrage of criticism in the last few years for his failure to control costs and improve results. A 57 percent earnings drop in the third quarter, when both its big investment banking and consumer operations suffered heavy losses, raised doubts about his attention to risk management and his ability to lead the company….

In the third quarter, Citigroup said it lost $1.3 billion from mortgage-related securities amid the credit market downturn. Executives conceded they did not pay enough attention to credit risk or adequately hedge their positions.

But Ms. Whitney’s report turned the spotlight on other potential miscues, including Mr. Prince’s growth strategy. The report points out that Citigroup’s capital levels have declined to their lowest levels in decades after a recent spate of acquisitions. Citigroup’s tangible capital ratio stands at 2.8 percent, nearly half of the level of its peers.

While Mr. Prince has long promoted internal and international growth, Ms. Whitney’s report points out that Citigroup has spent more than $26 billion on acquisitions since spring 2006. That, on top of the $5.9 billion in losses and a 10 percent dividend increase in January, has strained its capital position.

Citigroup’s management has said that it expects capital to return to its target levels in early 2008. It plans to use stock in its Nikko Cordial purchase, improving its balance sheet management, and not repurchasing stock until it bolsters its capital cushion.

Other banking and risk experts agree with Ms. Whitney’s analysis, however, and some suggest that it may even be conservative. Citigroup’s capital position “is too low based on the risks on the trading side but the kicker is that Citigroup is going to have a lot more losses” on the consumer side, said Christopher Whalen, the managing director of Institutional Risk Analytics. “It is going to be a one-two punch.”

The more news that comes out, the more it looks like the MLEC is all about Citi.

Update: 11/1, 12:00 PM: More coverage from Bloomberg on the analyst earnings downgrades for Citi:

Citigroup Inc., the largest U.S. bank, fell to the lowest in four years in New York trading after three analysts cut their ratings and CIBC World Markets said the company may have to reduce its dividend to shore up capital.

CIBC and Morgan Stanley recommended investors sell the shares, while Credit Suisse analyst Susan Roth Katzke reduced her rating to the equivalent of hold from buy. Citigroup may have to sell assets, shrinking opportunities for growth, CIBC said.

Analysts are souring on Citigroup after the company reported $6.5 billion in writedowns and losses from credit markets, jeopardizing Chief Executive Officer Charles Prince’s promise to increase earnings faster than costs. The combination of $25 billion of acquisitions in the past 19 months and the lowest cushion for losses “in decades” increases the risk of owning the stock, CIBC’s Meredith Whitney said.

“The Citigroup news is a wake-up call for those who think these issues will go away with the Fed cutting rates,” said Michael Metz, the New York-based chief investment strategist at Oppenheimer Holdings Inc., which manages $60 billion. “We’re not going to get resolution on these credit issues for months.”….

Citigroup fell $2.19, or 5.3 percent, to $39.17 in composite trading on the New York Stock Exchange at 10:55 a.m., after falling as low as $38.13…..

Prince began making acquisitions after the Fed lifted a ban on deals by the company in March 2006. The “buying binge” increased assets while earnings stagnated, Whitney said.

Profit fell to the lowest in three years as the company reported writedowns from credit and trading losses. The ratio of Citigroup’s tangible equity to tangible assets fell to 2.8 percent, half the average of its peer group, Whitney said. She cut her estimate of Citigroup’s earnings per share for this year to $3.68 from $3.75, and reduced her outlook for next year to $4.20 from $4.55.

Citigroup’s tier 1 capital ratio, a measure used by regulators to make sure banks have enough cash to cover losses, fell to 7.4 percent at the end of the third quarter from 8.64 percent at the same time last year..

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15 comments

  1. mbartv

    I have a hypothesis that it is even simpler than that, going back to the good bank/bad bank structure that the fdic used sometimes. Assume the stuff in the MLEC is actually ok and can be priced near par. then it is off the balance sheets of the banks, funded by the cp markets and out of everyone’s hair. Then the banks/investors/world at large will have to deal with the rest of the impaired dreck – so be it. By this reasoning the the point is to take out the good stuff that can stand on its own, so that it isn’t tainted by the rest of the SIV assets. Its a theory.

  2. Anonymous

    How does putting $75 billion in SIVs on Citi’s balance sheet result in a $30 billion capital shortfall? There seems to be more to come from under the rug….

  3. Yves Smith

    It’s hard to know what the analyst was referring to from an article, rather than seeing the research report itself. However, the article on the capital shortfall did not mention SIVs. Citi was already undercapitalized relative to its peers, and per its recent earnings report, it has been increasing its reserves in anticipation of greater losses in its consumer business. It also was the leader in LBO lending, and therefore has taken losses on repriced deals, and I am not certain whether it has taken all the writedowns there it needs to.

  4. Toquam

    Help me out – set aside who is the sponsor and just how good or bad the assets.

    Somebody is providing the liquidity facility for the commercial paper, which means an almost unconditional commitment to pay-off the outstanding commercial paper if and when roll-over proves impossible.

    The superfund seems to protect the liquidity folks, far more directly than the sponsors, who could in theory and by the documents stand by and watch the SIVs crater (e.g., because the liquidity provider defaulted).

    Assuming that’s all in footnotes, but not sure just how it’s broken-out. Citi uses a non-bank affiliate of the holding company, last I looked (okay, that might be a decade ago ;-), and the liduidity providers are almost always non-affiliates of the sponsor.

  5. Yves Smith

    Toquam,

    No, unlike asset backed commercial paper, which does have backup lines of credit, SIVs do not have liquidity support (that is why they are funded only 30ish% by commercial paper, while ABCP is 95%+ CP funding).

    The sponsors do not have to bail them out. They could let them go bust, but for some reason this is being treated as An Event to Be Avoided.

    The concern seems to be 1) that any sponsor who let an SIV tank would never be able to do any less-than-fully secured vehicle again and 2) most of the sponsors also have money market funds. If a lot of SIVs bit the dust, some of these funds would “break the buck” or decline below $1 in net asset value. That is an unthinkable event.

    It is also possible that 3) the sale of SIV paper at distressed prices might cause them to have to remark other assets or exposures (for example, Citi also has a prime brokerage business that lends to hedge funds. If any hedge funds were using mortgage paper as collateral, Citi would have to mark that down, which would lead to a margin call, which would likely lead to forced sales).

  6. Ginger Yellow

    I think it’s mainly a mix of 1 and 3. Certainly Citi has a lot to gain from it, but its SIVs are in fact among the least likely to use it, as in all but one case their asset values have fallen less than the market average and any SIV that uses it is basically finished (arguably all SIVs are finished in the long term, but I don’t think Citi wants to admit that yet).

    What people have to realise, and mostly don’t seem to, is that SIVs are the single largest investor class for triple-A asset backed securities in Europe and a very large part of the US investor base as well. In some asset classes they make up 80% of the triple-A investor base. If multiple SIVs are forced into a fire sale, the effects on European securitisation would be disastrous – spreads would at least double from their already record wide levels. This would in itself have some pretty terrible consequences – hugely increased funding costs for consumer finance companies, especially subprime lenders; effectively closing a major funding source for banks; huge mark to market losses at investment funds and for bank treasuries. It would also drag the rest of the credit markets out as well, partly because of the effect on banks and partly because of relative value.

    There are many flaws with the superconduit, particularly around the pricing, but the conspiracy mongering seems to me to be driven largely by a failure to recognise this fact. There just isn’t enough capital in the banking system for large volumes of these assets to be taken fully on balance sheet, so the superconduit is a way of prolonging the winddown process.

  7. ignoreland

    I have nothing to contribute to the conversation, except to say thanks for breaking it down for me. I can rely on the ‘real’ news outlets to studiously ignore this story. Nor are there analysts published in my local paper who understand or will write about the implications. If not for you…

  8. Anonymous

    ginger: I firmly hope and pray the scenario you layed out actually happens. When those spreads widen, we can be sure the tier capital (23A) exemptions will be recalled by the Fed, and the banking system will return to fiscal solvency.

    Fundamentally, this whole scenario was caused by banks that made bad loans. Citi should be BK’d.

  9. Yves Smith

    Ginger,

    Aha, that is an important piece of the puzzle. I hadn’t realized that the SIVs were so significant relative to the total asset backed securities market.

    But I am still skeptical that this will buy enough time…More time is better, but the MLEC will be at most $80 billion out of a total $320 billionish remaining market. It seems too small in size, and questionable as to whether it will hold enough paper off the market long to allow for an orderly liquidation, particularly since investors will be reluctant fund assets that are almost certain to decline in price over their time horizon.

    If the consequences are this serious and the problem is this big, it suggests the need for a state-sponsored solution, with the guys who created the mess having to take some significant losses or pay some very steep charges to avail themselves of whatever solution is crafted. They most certainly can’t get a free pass.

  10. Ginger Yellow

    Well this was a Treasury initiative, but it would be very difficult politically (and morally) for the government(s) to prop up declining asset prices with taxpayer money.

    I too am skeptical that this vehicle will achieve all that much directly. As you say, it represents a small proportion of the assets involved, and you have to persuade CP investors to cough up.

    That said, it might work anyway. Let me explain.

    “investors will be reluctant fund assets that are almost certain to decline in price over their time horizon.”

    Well, that depends on which investors you’re talking about. The CP investors, who will be doing most of the funding, are only exposed to the credit risk of the assets, which is pretty minimal (no subprime will be included, and it’s all triple-A or double-A, much of it international) and of the liquidity providers. The value of the assets is irrelevant to them.

    The liquidity and capital providers, on the other hand, care very much about the price, because they are directly exposed to market value risk. Even so, if the vehicle holds assets to maturity, as I understand it is being designed to be able to do, then it should all be upside assuming no defaults. Even if it sells after several months or a year, nobody I speak to in the European market expects spreads to be wider in six months than they are now, absent a SIV firesale. Even so, it may be hard for bankers to justify to their risk managers tying up capital in ABS right now.

    It seems to me that the idea behind MLEC is that it gives existing CP investors comfort that there will be a liquidity outlet for the worst off SIVs a few months down the line, thereby encouraging them to extend/roll their CP rather than demanding redemption when it’s due. By the time the extended CP maturity comes around, ABS prices will (so the idea goes) have recovered enough to take the SIVs’ net asset value out of danger, even if they’re effectively defunct in the long run. In other words, if MLEC works, it won’t be used. I’m far from convinced that CP investors will agree to that, however.

  11. Spec

    Just a note on scenario #2. Today in their 3rd qtr results, CSFB reported a fair value markdown of $146mm CHF -roughly $120mm USD relating to purchases of asset backed cp from its money market funds. Based on WB’s disclosure of a $40mm loss on $1bln in securities purchased that would be a nice use of $3 bln for CSFB. The State of CT has also disclosed holding SIVs in their investment pool and King Cty, WA may have their rating downgraded because of their SIV holdings.

    MLEC will most likely help out the SIVs in the least trouble, those with the best assets, not the worst.

  12. Yves Smith

    Ginger,

    Agreed that the powers that be don’t step in until the train wreck has occurred.

    While it would be better if the MLEC worked, let me continue being devil’s advocate. First, we have the problem of the remaining assets in SIVs who sell the better stuff to the MLEC. That stuff is likely to be regarded as even worse than it is.

    And with the housing market continuing to deteriorate, and a Fitch report saying 44% of SIV assets are mortgage related, and only 2% of the total subprime, that says that the reservations go well beyond subprime. While the CDOs and subprime securities are taking the steepest downgrades, the concern seems to be widespread. Who knows how long the supposed AAA paper will remain AAA?

    And in all the press reporting, I can’t recall seeing an investor express much enthusiasm. Aside from ones like Federated that own SIV paper and are therefore self-interested, the most positive responses have been along the lines of, “Yes, we’ll look at the details.” And conversely, I have heard a number of money market fund investors say they would sell out their holdings if their fund bought any MLEC paper.

    Spec,

    Interesting. Thanks for passing the info along.

  13. Anonymous

    Yves,

    An additional concern is why the ratings agencies are sitting on their hands and have not yet downgraded these SIVs. With SIV NAVs now in the low $70s and near certain likelihood that the SIVs will fail to pay their coupons and need to write down their capital notes, the ratings agencies appear almost blind to the obvious. While the agencies may not want to create further pressure in the SIV space which create further asset selling, the role of the agencies is to opine on the payment profile of the instruments they rate; let the capital markets look after themselves.

    This begs the question, to whom are the rating agencies responsible to -issuer or user of the rating? If the agencies don’t act, it looks like another example of collusion by the agencies with fee paying issuers. Washington Mutual and eAppraisal could learn from these practices!

    Mike, Portland, OR

  14. Ginger Yellow

    Many SIVs (off the top of my head Cheyne, Rhinebridge, Kestrel, Harrier, Axon and Victoria) have been downgraded. As for the others, you need to bear in mind that only a portion (it used to be 100bp, not sure what it is these days) of the capital note coupon is rated. Moreover the market for most underlying SIV assets is in better shape now than it was a month ago. There’s a very strong argument that they should have been downgraded back then, but NAVs have recovered in most cases.

    One more thing – we need to differentiate between capital notes and senior debt. To their credit the rating agencies changed their methodology (too late, of course) after Cheyne and Rhinebridge ran into trouble and said (in October or late September) that AAA notes would only stay AAA if they could withstand market value falls of four times what we’d already seen (already the largest ever fall in ABS values). That seems like a pretty reasonably assumption.

  15. Ginger Yellow

    New information comes to light: Citi’s quarterly filing says that despite having no contractual liquidity arrangements with or capital not investments in their SIVs, they have provided $10bn of liquidity, of which $7.6bn had been drawn at the end of November. This changes the picture quite a bit, and they are still not consolidating the SIVs (presumably because the liquidity exposures remain a minority of the expected risk/reward of the assets). I’d be very interested in the terms of this liquidity. I’d heard that Citi had been buying the SIVs’ CP, so it may just be that, or it may be a more conventional 364 day liquidity facility.

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