naked capitalism

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.