The SIV Bailout: The Search for Bagholders is On

The prospective SIV bailout plan, officially called the Master Liquidity Enhancement Conduit (MLEC) or informally called The Entity, retreated a bit from the public eye yesterday as the perps, whoops, organizers, seemed to be focusing their energies on firming up arrangements so that they can announce progress and have the appearance of momentum. (if you are new to this topic, this post provides some helpful background).

But aside from all the open and troublesome issues we’ve discussed in previous posts (the biggest one being pricing of the assets to be sold to the MLEC, since the interests of current SIV owners and prospective funding sources seem hopelessly in conflict), the biggest obstacle the organizers, Citigroup, JP Morgan, and Bank of America face is finding bagholders, meaning investors that will buy either the commercial paper or the senior debt of the MLEC. Our understanding, based on a short and rather amusing post at Conglomerate, is that the junior debt will be held by the SIVs that sell assets to the MLEC (ah, the ways of Wall Street).

The finding of bagholders is an interesting exercise, since (from what little we have seen to date), the credit support provided by the perps appears to be non-existent (note that the original reporting gave the impression there would be guarantees of some form). Reader Bernard pointed out a passage that I had overlooked in New York Times story yesterday :

The new conduit will offer to buy many of the securities owned by SIVs, but at a cost to those vehicles. First they will have to pay a fee for the right to sell anything to the conduit, and part of that fee will be passed on to the banks, increasing their profits.

Most of the proceeds will be paid to the conduits in cash, which they can use to redeem commercial paper. But a part of the payment, perhaps 5 percent of it, will instead be in junior securities issued by the conduit.

Because those securities would bear the first losses suffered by the conduit, it is the SIVs, as a group, that will take the first risk that the securities turn out to be worth less than the conduit pays.

From what we have been able to discern, historically SIVs have had either two or three tiers, with the vast majority of the debt funding coming from “senior notes” which are in fact commercial paper. The junior notes are generally the equity layer.

Now since the structure of The Entity has yet to be disclosed, it isn’t clear whether there will be a senior-subordinated layer. If so, someone (the perps) will have to round up investors to take that risk. If not, and if the Times is correct, there is only a 5% loss cushion for the commercial paper investors. (Note that it is possible there will be credit enhancement, almost certainly for a fee; we simply haven’t seen any confirmation).

If anyone had any faith in this paper, that might be adequate. But CP investors are loss intolerant, this program is untested, and highly respected people in the fixed income game like Bill Gross at Pimco, are already calling the MLEC bad names:

There’s a lot of dead bodies off balance sheets that we still can’t find. This SIV idea is a little lame, in my opinion. And let me twist an old phrase and suggest that a SIV by any other name is still a SIV.

In the interview, Gross calls the SIV “sieve” to underscore his point.

Even a politician (and one who ought to be supporting this program) depicted the program as a band-aid at best. From the Wall Street Journal:

Sen. Charles Schumer of New York, a supporter of Wall Street, said the “superconduit may be a good short-term response, but it’s not going to solve the problem in the long run. In a certain way, it’s taking money out of one pocket and putting it in another.”

With such ringing endorsements, the search for bagholders, um, supporters is going slowly. Again, from the Journal:

Yesterday, Wachovia Corp. said it will participate in the fund. “While it’s not a significant issue for us, we plan to participate at an appropriate level because we want to help improve the stability of the markets,” a spokeswoman said.

Among the firms offering support for the plan are Fidelity Investments and Federated Investors Inc. Both hold debt issued by an arm of Gordian Knot Ltd., one of the SIVs that could benefit from the fund.

Fidelity’s $10.4 billion Prime Money Market Portfolio owned $402 million medium-term notes from Gordian’s Sigma Finance Inc. arm as of the end of August. A spokesman said he believed that such holdings “continue to represent minimal credit risk” and said the firm’s “money-market funds continue to perform strongly.”

So at least so far, only one bona fide end investor who doesn’t have ulterior motives has put up his hand and said it will go along, and that is for public-minded reasons. If Wachovia really is just showing support, that means it will only buy a token participation.

Now other names are also being bandied about as “participants,” but they do not look like the really scarce part of this equation, the prized bagholders who will buy the debt of the MLEC, either commercial paper or any senior-subordinated notes. But the help of these other participant would be useful if nothing else, to increase perceived legitimacy.

Wall Street firms are considering signing on, presumably as placement agents (and perhaps sharing any credit support) on a fee basis. Thus for them, the tradeoff is fee potential versus any reputational (and possible credit) risk the venture might entail. As the Journal notes, wide-scale participation from the Street isn’t essential, so if one or two firms sign up to validate the idea, that will probably do:

Four Wall Street firms, Goldman Sachs Group Inc., Merrill

Lynch & Co., Lehman Brothers Holdings Inc. and Bear Stearns Cos., all participated in the exploratory talks about the plan, according to participants, but haven’t yet indicated they would join. Morgan Stanley is studying the plan, one person on Wall Street said.

The European banks are coy so far. Their alleged value is “their expertise in structured finance,” which is code for “they know who used to buy this stuff and might buy it again.” The implication is that they could help in either choosing the assets to go into the MLEC or liquidating some or all towards the end of its life:

European banks such as HSBC Holdings PLC, Barclays PLC, Deutsche Bank AG, UBS AG and Credit Suisse Group are hanging back, according to people on Wall Street. Such banks have both the big balance sheets and track records in structured finance needed to help generate the broad participation.

Separately, Gillian Tett of the Financial Times gives a very good treatment of a major criticism of the SIV rescue plan, namely, that it is designed to avoid market clearing, and thus bears a parlous resemblance to the Japanese refusal let its big banks carry bad loans because calling them in would have led to widespread business failures.

While I am generally sympathetic to this line of argument, those who makes it tend to offer polar choices: either you hold the market in stasis, or you have wide scale price discovery and let the chips fall where they may. While it may be difficult to devise policies that attenuate the market clearing, that seems to be a preferable course of action. (Note that the Resolution Trust Corporation example she cites is widely believed to have sold many assets at overly cheap prices, in part because Congress didn’t like its ongoing working capital requirements and pushed the RTC to wind things up faster than was optimal).

Furthermore, I am skeptical of the party line on Japan. First, most observers forget that the real estate/stock market bubbles were so massive that they would have to be socialized to a fair degree no matter what. Second, the costs to the Japanese deflation appear to be considerably exaggerated (I’d be curious to get the views of those on the ground in Japan, like Cassandra). Remember, it is in Japan’s interest to present itself as a basket case so no one gets upset about its huge trade surpluses (contrast how they are treated with China, when both have currencies that are undervalued and less than open markets).

Had Japan taken its tough medicine, it would have had a huge drop in GDP. Yes, it would have had faster growth after the economy got back on its feet (and how long might that have taken?), but from a much lower base. I doubt it would have come out as far ahead as most critics believe. Just as the French would rather consume more vacation and less housing than Americans, the Japanese gave up some growth to avoid massive social disruption.

From the Financial Times:

A decade ago, when Asia was facing a financial crisis, American bankers and government officials regularly travelled to the region delivering homilies about the best way to exit a banking mess.

After all – or so the lectures typically went – America had suffered bank crises in the past, such as the Savings and Loan debacle of the late 1980s. This experience had shown that the best route to recovery was to establish realistic prices for distressed assets, by conducting fire sales if necessary, and then write the losses off.

A decade later, however, it seems that some US financiers need to take another hefty swig of the medicine they used to wave at Asia.

In recent weeks, signs have emerged that parts of the debt world are starting to recover from the turmoil of the summer. Trading activity has resumed in risky corporate debt, helped by the fact that some large banks have written down the value of these loans.

However, it remains an open question whether these write-downs have been large enough (not least because some banks have entered into sweetheart deals with hedge funds to flatter the terms at which loans are “sold”). More pernicious still, some banks appear to remain unwilling to face up to the potential scale of losses bubbling in another important sector – namely mortgage-linked securities.

Take the issue of the so-called Master Liquidity Enhancement Conduit, the investment vehicle that is now being created by Citigroup, Bank of America, JPMorgan and others (or so the founding trio desperately hope).

The financiers behind the clumsily named scheme like to present this as a clever way to rebuild confidence in parts of the financial markets currently gripped by paralysis, most notably in the area of structured credit and commercial paper.

More specifically, what the M-LEC will apparently do is purchase assets from bank-affiliated structured investment vehicles (SIVs) that cannot fund themselves in the commercial paper market. It will restructure these assets into a form that will be more appealing to investors, thus hopefully enabling the M-LEC to do what SIVs cannot – namely issue commercial paper. However, precise details of what kinds of assets will be bought – such as mortgage assets – are yet to be revealed.

In itself, this is not a bad concept. After all, some SIVs do need to be restructured or refinanced, given their current funding woes. This is difficult to achieve on a unilateral basis and in a timely manner, given the complexity of assets that SIVs typically hold.

However, it is possible that the M-LEC could provide one neutral forum for doing this without needing to place these assets on the banks’ balance sheet. It is even conceivable that future historians will come to regard the M-LEC as the 2007 equivalent of America’s Resolution Trust Corporation – the state-owned body that helped resolve the S&L mess by buying up bad assets.

But there is a crucial catch. The RTC helped to solve the S&L mess because it auctioned off the assets it acquired – initially at ultra-low prices – believing that the US needed to create a true “clearing price” of S&L assets in order to rebuild market confidence. It is far from clear that those running the M-LEC will have the courage to repeat this trick. On the contrary, one raison d’etre of the fund – if not the crucial imperative – is that some banks apparently want to avoid asset sales because they fear they would depress prices and hurt balance sheets.

Moreover, many banks also appear to think that the recent price fall in structured credit is simply a “temporary” affair that will be corrected soon (or at least during the life of the M-LEC). This seems odd, given that the fundamentals for mortgage securities are continuing to deteriorate. It also means that when the M-LEC organisers say they will purchase assets at “market” prices, this could potentially cover a multitude of sins.

Thus, if the M-LEC is to produce a genuine solution to the current financial woes, it is imperative that it buy assets at genuine, clearing prices – not artificial prices created by banks. If not, investors will retain nagging fears that prices have further to fall.

To see just how damaging it can be when there are not genuine clearing prices for assets, just look at Japan in the 1990s, when banks refused to recognise their losses and were rightly criticised by the Americans. The consequences can be debilitating. History may not repeat itself precisely but in the financial sector it often rhymes.

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  1. Anonymous

    Correct me if I’m wrong, but this is how see this Super-SIV proposal:

    It takes the total SIV assets and splits those assets between the Super-SIV and all the other SIVs.

    The Super SIV will have backstop bank credit lines just like all the other SIVS had to begin with IN THE FIRST PLACE.

    The only difference is they are redistributing the AAA/AA rated assets to the Super SIV, while the remaining junk assets will sit with the other SIVs.

    The ONLY change they are really making is simply shuffling the ABS assets among different SIV entities (like a deck of cards).

    But the overall assets are still the same, the overall debt is still the same, and the backstop credit lines are still the same!

    If this is the case, then this “plan to save the world” is totally cosmetic and has no substance.


  2. bob

    If they truly shield the MLEC from the toxic crud, (is this even possible?), and this could be demonstrated to be the case, wouldn’t this allow at least some of the CP to be sold on this stuff to other-wise skittish investors?

    Of course, if that can be done, why aren’t the banks doing it in their own SIVs to get them partially unfrozen?

    It doesn’t address the toxic crap that remains in the banks SIVs, though, just postpones the day they have to deal with it. (note – I am not an economist or investor.)

  3. Anonymous

    I was just wondering if any of you millions of pundits who love to use the “history rhymes” nostrum ever stopped to think that a rhyme is one of the weakest imaginable connections between two lines. The rhyming words need have no logical, causal or even correlational significance. It’s not even clear that the original utterance wasn’t a sarcastic jibe at our tendency to see patterns where none exist.

  4. a

    Here’s a modest proposal as to why this may make sense. Nobody wants to invest in the old SIV because they know it’s sludge. So the old SIV is going to go belly up. If it were to go down without restructuring, then Citibank would have to sell at the same time both the really bad sludge and the stuff which is okay, which would (I guess) impact the price they would get on the stuff that is okay. So they want to hive off the okay stuff to another SIV, which I presume investors are supposed to have confidence in because the Treasury is behind this. Then when the old SIV goes belly up, they don’t have to sell the okay stuff, only the sludge stuff, at the proverbial “firesale” price. So Citibank doesn’t lose quite so much money.

  5. Anonymous

    Allow me to correct myself regarding my earlier comment.

    Apparently, I’ve learned that the SIVs have very little in the way of backup credit lines.

    So with the Super-Conduit, they are effectively converting the SIV conduit into a regular ABCP conduit (by adding the backup credit line).

    Nonetheless, the banks will still face the issue of having all that $100 billion of ABCP for the Super-Conduit potentially go on their balance sheet (resulting in further credit contraction) if the Super-Conduit’s ABCP fails to rollover. The issue of rollover failure is the same just like for all the other ABCP out there.

    The main purpose for the banks in doing this is to avoid SIV forced liquidation of ABS assets (which could be catastrophic for them).

    However, as I understand it, large amounts of CP for the SIVs are maturing in November. This is when the issue of SIV forced liquidation will come into play.

    But this Super-Conduit plan will only come into effect in 3 months (January 2008). So won’t all of this be TOO LATE?


  6. Anonymous

    The lead three banks and Wachovia had a collective 300bn in credit enhancements and liquidity commitments to ABCP conduits June 07 up 30% from year earlier.

    SIVs meanwhile are dynamically managed with strict but varied terms, levered and credit enhanced by subordinated and junior “tranches” financed by Medium Term Notes and CP.

    Last summary I saw had financing 67% MTN and 25% CP remainder capital.

  7. Anonymous

    From Fitch on SIV operating states:

    “In the Normal operating state the vehicle is free:
    – to increase the asset within the vehicle’s investment parameters; and
    – to issue new CP, MTNs or capital to fund any asset growth.

    In the Restricted Investment operating state the vehicle:
    – is prohibited from investing into new assets;
    – is prohibited from issuing CP and MTNs except for the purposes of refinancing;
    – is not permitted to increase the risk profile of the asset; and
    – has to restrict its payments to capital notes.
    Events that cause the vehicle to enter the Restricted Investment operating state include the
    breach of the capital test. Once a breach has been cured the vehicle may return to the
    Normal operating state.

    In the Restricted Funding or Defeasance state the vehicle:
    – is prohibited from issuing CP and MTNs;
    – is not permitted to increase the risk profile of the asset;
    – can only make payments to CP and MTN investors and any senior-ranking
    liabilities; and
    – has to liquidate assets or draw on liquidity to redeem maturing liabilities.
    There are various events that can cause the vehicle to enter the Restricted Funding
    operating state. They include breaches of a capital or liquidity test or, for older SIVs, the
    downgrade of certain debt levels below a specified level. It is important to note that most of
    the older vehicles launched before 2002 do not have a 50% market value capital test for the
    Restrictive Funding state or Enforcement, whilst most vehicles launched since 2002 do
    have such triggers in place.
    While some vehicles may return to a higher operating state once a breach has been cured,
    others are permanently prevented from re-entering the normal operating state and have to
    wind down their portfolios orderly.

    In Enforcement the vehicle:
    – is prohibited from issuing CP and MTNs;
    – has drawn all committed liquidity;
    – can only make payments to CP and MTN investors and any senior-ranking
    liabilities; and
    – has to liquidate assets or to draw on liquidity to redeem maturing liabilities, or upon
    the request of a security trustee or receiver, declare all liabilities due and liquidate
    the whole portfolio immediately.”

  8. Yves Smith

    These are all good comments. One thing that is frustrating at this point is that most of us who aren’t directly involved in the markets for this stuff are dependent upon the press. And that’s a spotty way at best to get nitty gritty details.

    So Wachovia is also an interested party, which means so far no disinterested parties have come on board.

    The last two comments (Anon of 6:10 and 6:14 PM) were particularly helpful. I saw some dated info on SIV structures that indicated much higher levels of CP. Some of the Citi SIVs are pretty old. Wonder if they are structured along the current lines or older lines.

    But the fact that some (many? all? )have 25% CP is revealing. The size of the Citi program is roughly 25% of its SIVs. So is the MLEC to refund its CP? And if so (remember the MLEC holds the best assets), why can’t Citi et al. just sell the assets themselves? The argument is that too much would be sold and it would tank the market, but as we noted before, the CP market has been shrinking since August, and September was a big month for CP maturing, yet we got through that. Which again begs the question about whether this is really about helping Citi more than helping the market (and Bernard’s point about this being too late anyhow is well taken; we raised that notion in one of our first posts on this).

    The detail about the structure raises another point I should have thought of. Would the creditors in the old SIV have a basis for a suit if the best assets were sold and the proceeds weren’t used to take them out to any degree? Under the scenario where you are using the proceeds to replace maturing CP, you don’t get into a class warfare scenario, but here you might.

    And for Anon of 11:07, the rhyming comment came from Gillian Tett of the Financial Times, so if it bothers you, you need to take it up with her.

  9. Anonymous

    3 Citi funds seen (~55% of total) have 63% MTN,31% CP,4.6% rest mezz and capital. Also have no market value capital tests.

    Other SIVs may have a range from all CP to any mix I guess.

    The number given above was a Feb 2007 S&P average for all SIVs.

  10. Yves Smith

    Anon of 7:37 PM,

    Thanks for the helpful details. They will prove useful as this situation evolves.

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