SIV Rescue Plan: From Smoke and Mirrors to Jawboning

Last Sunday, we made this observation about the SIV rescue plan, the so-called Master Liquidity Enhancement Conduit (MLEC), sponsored by Citigroup, JP Morgan, and Bank of America:

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.

What we meant by “Northern Rock effect” was the the revelation that the situation was bad could do more damage than the rescue plan could repair.

Midweek, the SIV bailout plan appeared to make sense only at the one-line, high concept level. Yes, it would be good to find a way to restore confidence in the commercial paper and get gun-shy buyers back in the market. But once you got past a two or three sentence description, the idea looked problematic at best, a tremendous amount of asset shuffling for at most a paltry gain (delaying the sale of a portion of Citi’s and perhaps others’ SIV assets, but at the cost of likely tainting an even larger dollar amount in the same SIVs). And there were tremendous practical obstacles to getting it done, one of the biggest being whether the actors could agree on a price for the assets to be bought that would be acceptable to the sellers, guarantors, and prospective investors.

The only investors and possible credit sources who voiced any support at that juncture (and even that was pretty tepid) were ones who had a fairly large vested interest in Doing Something. And the responses from disinterested parties ranged from notably cool to highly critical. Even Alan Greenspan said it could do more harm than good.

And the biggest cause for pause is the singular lack of enthusiasm among prospective investors. The MLEC simply will not work if CP investors aren’t keen to buy the paper, particularly since this is a very large program. Yet the focus has been on trying to structure the deal and round up fellow perps, rather than determine what is needed to induce investors to purchase the paper. The tacit assumption is that the intermediary group will know the answer, and while that might be valid for established products, that is a risky assumption for a new structure in turbulent markets.

The rational response would be to go back to the drawing board, or scale back the program so as to save face (that way, the participants could declare victory and go home). But unfortunately, Hank Paulson has put himself at the center of the equation.

Paulson, the former CEO of Goldman Sachs, is even by Wall Street standards, a high-testosterone, can-do type. He came up through Investment Banking Services, which was the sales team for Goldman’s service to big corporations (such as M&A, underwritings, real estate finance). Being cerebral is not a plus in IBS. They are paid to close deals, not to question whether the deals make any sense.

Now some people manage to overcome their upbringing, but Paulson does not appear to be one of them. He is unduly identifying himself and the Treasury with this plan (which as we said before and will address later, is a terrible precedent), and is refusing to see the widespread criticism as probably well founded (everyone on the Street wants the problem solved. Industry participants have if anything a bias in favor of a solution). Instead, he is marshaling resources to press onward regardless.

The signs of Paulson’s bulldozing? The first is this truly remarkable revelation in the New York Times via Reuters:

Paulson’s lobbying efforts in support of the fund were expected to continue over the weekend as top bankers gather on the G7 sidelines for a meeting of the Institute for International Finance, a global bankers’ association.

Paulson is likely to meet with the head of Deutsche Bank, Josef Ackermann, head of the IIF and host of the meeting. Deutsche Bank is thought to be reluctant to join the fund, which some say will primarily benefit Citibank.

This is a completely inappropriate use of a session convened to discuss serious policy matters, particularly when the global financial system is looking a tad fragile. The MLEC has been positioned consistently as a private sector solution. What the hell is a Treasury secretary doing acting as its shill?

And the G-7 has much much bigger fish to fry. The two big topics on the agenda are the global credit crunch and the dollar. Even if it works, the MLEC is only a partial solution to one aspect of the problem. By lobbying so aggressively, Paulson is diverting resources (if nothing else, his time and that of everyone else he buttonholes) from more fundamental concerns.

The second sign is that Paulson is getting loud and defensive about the SIV program. From the Financial Times, “Paulson HIts Back as Superfund Critics“:

Hank Paulson, the US treasury secretary, on Friday night hit back against critics of the plan to create a $75bn-plus investment fund to buy the assets of troubled investment vehicles, suggesting it is based on a misunderstanding of how the new “superfund” would work.

“The concept is not to buy bad assets” that have credit problems, Mr Paulson told the FT. “The concept is for the end investors working with the banks to buy assets that are not credit impaired.”

He said that by focusing on the “very best assets” the proposed fund would “accelerate the return of liquidity to parts of this market” for asset-backed commercial paper.

Mr Paulson said “we have had a lot of conversations with market participants and conversations with the president’s working group” of regulators including the Federal Reserve about the asset-backed commercial paper market.

He said “there was a view we heard from the market – from banks, and from those that operated SIVs [special investment vehicles] and from investors that something like this would be constructive.”

But he added “I cannot emphasise enough that this is market driven – 100 per cent market driven” with the Treasury playing only “a convening role and a facilitating role to help participants come together.”….

The Treasury secretary said he was in daily contact with Federal Reserve chairman Ben Bernanke and spoke to New York Fed president Tim Geithner “multiple times a week” to discuss developments.

He suggested that there was nothing untoward about the fact that the Federal Reserve had not come out publicly in support of the plan, since it lay in the Treasury’s area of responsibility rather than the central bank’s.

We’ll be polite and merely call this disingenuous.

First, Paulson’s attempts to blame the negative reaction toward the MLEC plan to misunderstanding is remarkable. I have not seen a single report in the financial media that implied the MLEC would be acquiring low quality assets. All have either pointed out that the cutoff was AA, or said in more general terms that the Entity would be acquiring high quality paper. Almost every blog I’ve seen has also gotten that right (the only exception were two that convinced themselves that it really must be a vulture fund because the high quality idea made no sense to them).

But for those who haven’t been following the story, it’s a clever way to discredit critics (but it shows how weak his position is if he has to misrepresent them to do so).

Second, the “a lot of conversations with market participants” is also disingenuous. Narrowly, his statement is true, but they have spoken to a few participants (press report have said 10-15 institutions) intensively, and at least two of them (JP Morgan and BofA) don’t know the market. That doesn’t give you a very good picture. And the parties that really do, the big European banks, have not been consulted.

Third, the invoking of the Fed is a nasty bit of business, and if I were Bernanke or Geithner, I’d be plenty unhappy. Paulson is basically saying that the Fed is fully in the loop, and implies that they are also fully on board, but can’t say so for jurisdictional reasons.

Now there are other developments that I suspect emanate from the Treasury, but can’t prove. Even though there has only bit a bit of progress in the last day or so, the tone of the coverage in the Journal and Reuters (and not the Financial Times). The most obvious is the Journal engaging in revisionist history.

Recall that there was a meeting Thursday afternoon between the sponsors and prospective participants which was reported in the Financial Times and the New York Times to have elicited at best a few very guarded expressions of interest and much more open criticism. The meeting sounded as if it went badly, and our post summarized these articles saying, “SIV Bailout Plan Having Trouble Enlisting Supporters.”

But mirabile dictu, the Journal today reports “Banks May Pony Up $60 Billion for SIVs.” Now how did such a bad session produce results? First, it turns out the Journal is putting an awfully positive spin on where things stand. Second, the Treasury may have done some arm-twisting. Third, someone has clearly beaten up on the sponsors to be more positive with the media (that plays into but does not fully explain the Journal’s spin).

It is also important to understand what this $60 billion is. It is not commitments to fund the MLEC, that is, to buy its commercial paper or medium term notes. This is merely the backup credit lines. To wit:

The push to line up what would be one of the largest backup credit lines in history was kicked off by an organizational meeting Thursday afternoon, at which bankers disclosed the interest tally, the same person said. The credit line is needed to enable the planned fund to raise cash by issuing short-term debt. Those funds would then be used to purchase assets from SIV investment funds, some of which are facing collapse if they can’t generate funds to repay their own debt.

Moreover, the claim of $60 billion lined up is never supported. The story reports that the sponsors will provide credit support for roughly $40 billion. I don’t buy the other assertions:

The three banks leading the loan syndication, Bank of America Corp., J.P. Morgan Chase & Co., and Citigroup Inc., would contribute as much as half of that total. Citigroup, which manages the most SIV assets of banks globally, is expected to contribute more than the other two. The group has about a half-dozen indications of interest of $2 billion to $7 billion, one participant said.

Are the sponsors playing on the ignorance of the reporters? “Indications of interest” is a term that has a precise meaning in an underwriting and order placement context. While they are not legally binding, they are pretty close. If you make a habit of making indications and don’t follow through, you will quickly become a pariah. As a consequence, indications of interest are made after the investor has reviewed the terms of the offer.

In other words, even if as many firms have expressed interest as has been reported, the use of the term “indications of interest” suggests they are more firmly committed than they realistically can be at this juncture.

This section of the article also gives the impression that some of these “indications” may be a bit overstated:

A review of communications on Monday and Wednesday from bankers involved in the effort to round up participation indicates that they hope that the five major Wall Street firms will kick in $2.5 billion apiece.

A Wednesday memo from one banker said Merrill Lynch & Co. and Lehman Brothers Holdings Group Inc. “have indicated they will be involved.” However, neither firm has yet made a decision, according to people on Wall Street.

So the we have evidence that the sponsors are exaggerating the level of commitment.

Consider this:

A Monday memo from a banker identifying about 20 possible participants gave target dollar levels for several, the largest of which is $5 billion to $15 billion for HSBC, depending on whether the bank’s SIVs sell assets to the fund.

The same memo indicated Dresdner has informally committed at the $3 billion level. The funds managed by HSBC and Dresdner rank among the world’s largest, with $64 billion in debt as of mid-July, according to Citigroup research. Dresdner officials declined to comment.

The banks are also planning to hit up other non-U.S. banks such as Bank of Montreal, Barclays PLC, Royal Bank of Scotland Group PLC and Standard Chartered PLC. Bank of Montreal’s SIV is Links Finance Corp., with some $22 billion in senior debt. Standard Chartered has two SIVs, Whistlejacket Capital Ltd. and White Pine Corp., with a combined $16.7 billion in senior debt in mid-July.

But the same memo indicated two other European banks, Deutsche Bank AG of Germany and UBS AG of Switzerland, are “unlikely” to participate. The memo projected a possible contribution of $2 billion to $7.5 billion by Wachovia Corp., a North Carolina neighbor of Bank of America.

Reading between the lines, it appears the reporter was given some memos on the syndication strategy for the MLEC, but was unable to verify the chatter from the various bankers. It appears that there is real information mixed in with targets.

Here’s another example of the quality of reporting in this story:

An aggregate loan commitment of this size would likely set a record, though three European companies have arranged commitments topping $40 billion for acquisitions. The largest was for $48.6 billion last November for E.On AG, according to Reuters Loan Pricing Corp.

The largest U.S. commitment was a $26 billion line for Procter & Gamble Co. last November, and commitments of $20 billion for creditworthy companies can get done “without breaking a sweat,” said Meredith Coffey, director of analytics at Reuters. As a result, she said, “you would think a larger one could get done.”

Huh? Those numbers were all before the credit crunch, when liquidity was abundant and credit spreads were tight. How can anyone generalize from that market to this one?

Reuters reported progress as well, but its claims were more modest and more credible:

Fund giants PIMCO and Fidelity have joined the so-called super SIV fund set up by three big U.S. banks, boosting confidence in the plan, Bank of Italy Governor Mario Draghi said at the close of a meeting of finance officials from the Group of Seven rich industrialized nations.

Draghi said U.S. Treasury Secretary Henry Paulson had discussed the fund with officials attending the meeting of central bankers and finance ministers from the United States, Canada, Italy, France, Germany, Britain and Japan.

“Paulson has done a short briefing on the SIV fund,” Draghi told journalists. “PIMCO and Fidelity have joined.”

Again, clearly the result of Paulson arm-twisting, although Fidelity had put its hand up at an early stage. Pimco is more surprising, given co-head Bill Gross’s critical comments, although the new co-CEO, Mohamed El-Erian, has been supportive.

Finally, John Gapper of the Financial Times does a great job of saying why the Treasury’s aggressive sponsorship is wildly inappropriate, in his article, “Washington, avoid doing favours for Wall Street:.” From the Financial Times:

There was something troubling about this week’s initiatives by Hank Paulson, the US Treasury secretary, to address the country’s deteriorating housing market and the credit and liquidity problems that this is still causing for banks.

His speech in Washington on Tuesday, predicting that the subprime mortgage crisis would spread further, unnerved markets. Mr Paulson’s close-cropped hair, bald pate and intense manner, combined with his gloomy message, made him look like Dr Doom. His hobby is bird-watching, but I would not care to be the bird that he stares at through a pair of binoculars.

Mr Paulson has another appearance problem. Before going to Washington he was a powerful figure on Wall Street as chairman and chief executive of Goldman Sachs, the investment bank. And, under him, the Treasury has taken an unusually active role in promoting the $75bn “superfund” intended to ease commercial paper problems affecting some big US banks.

Governments usually avoid getting involved in such plans, for fear of being seen to be bailing out private-sector financial institutions. Yet Mr Paulson and Robert Steel, the under-secretary for domestic finance (and another Goldman Sachs alumnus), have waded in over the past month. The Treasury convened meetings and encouraged banks to sign up….. It has not offered any money to the structured investment vehicles (SIVs) that could benefit from the idea…..

For all that, there is a whiff of Wall Streeters in Washington doing their chums a favour – a variety of what is known as “moral hazard”.

It does not help that Wall Street’s influence has been evident since August on the remedies for the credit squeeze implemented by the US Federal Reserve, the central bank. The Fed’s first response was to pump more liquidity into credit markets by lowering the rate at which it lends to banks. When that was not enough, it went on to cut interest rates.

The Fed avoided propping up individual institutions that had over-exposed themselves to the credit turmoil, and some mortgage lenders and investment funds went bust. Still, its policy shift recalled the infamous “Greenspan Put” – the belief in financial markets that while Alan Greenspan, the former Fed chairman, would not attempt to prick asset price bubbles, he would cut interest rates to ease distress if they popped.

The Fed’s actions were probably justified on their own terms, even if they followed Wall Street wailing and consultations between Ben Bernanke, the current Fed chairman, and figures such as Robert Rubin, vice-chairman of Citigroup (and a former co-head of Goldman Sachs).

But although the New York Fed, the Federal Reserve bank closest to Wall Street, was consulted first by the superfund’s banker architects, the Fed did not volunteer to help organise it. That is notable because the Fed, rather than the US government, is the natural co-ordinator for such efforts. It was the Fed that convened bankers in 1998 to rescue Long-Term Capital Management, the hedge fund, and it took flak as a result.

A week has gone by since the first details of the superfund were announced, and it is still not clear why Mr Paulson then got involved. I doubt whether he is simply scratching the back of those who used to scratch his. There are no reasons to doubt his probity, and Goldman Sachs is among the investment banks that remain wary of the superfund.

Mr Paulson, nonetheless, made a mistake. Given the moral hazard risk, which is increased because of his and Mr Steel’s Wall Street past, governments should get involved in rescue plans only very rarely – even more rarely than the Fed. Although these are worrying times for financial markets, this is not such an occasion.

For one thing, the Treasury’s initiative failed the basic justification for official intervention – to restore confidence. In fact, it did the opposite. Financial markets were spooked by the idea that the US government felt it had to cajole banks into organising a fund to relieve pressure on SIVs. It raised the spectre of a disorderly sale of debt securities.

A second problem is that the Treasury has endorsed an initiative that may turn out not to work. The superfund is so complex that some investment banks say they do not understand it. The strongest defence offered by one banker is that “it is not as nutty as it sounds”. If the superfund initiative falters, it will not reflect well on the Treasury.

Above all, it is not obvious that government-endorsed intervention was needed in the first place. Some of the smaller SIVs are in trouble, but banks such as Citigroup have been able to fund their own structures. If the worst occurs, and banks have to take subprime assets back on to their balance sheets, even Citigroup, the most exposed bank, has enough capital to take the hit.

I suspect that Mr Paulson, a forceful and driven leader at Goldman Sachs, saw something wrong in his former back yard and was temperamentally inclined to jump in and do something about it. But the principle that banks ought to be forced to get out of their own messes in their own manner is important; it is almost always best for governments to leave well – and not-so-well – alone.

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  1. Anonymous

    Great analysis again Yves.

    I think the markets are now realizing that the emperor has no clothes (that the Fed/Treasury cannot save the world). This widespread blind faith in the power of government intervention is being destroyed.


  2. a

    Thanks again, Yves. One comment: I think there are some dots to connect when you write the all-too-true, “The two big topics on the agenda are the global credit crunch and the dollar. Paulson is diverting resources … from more fundamental concerns.” Surely Paulson, at this stage, doesn’t give a flying fig about the dollar and surely doesn’t want to listen to his European counterparts jawboning him about how he must increase the dollar/euro. It’s pretty clear – and I think they are correct – that everyone in the American financial establishment only care about the inflationary aspects of a dollar fall; if there is not too much inflation, the dollar can go to Hell, and it’s just not their problem if it does. So Paulson is diverting resources – precisely. He’d rather talk about anything other than the dollar. The Europeans are also probably asking him to “do something” about the American credit mess – he turns around and asks DB, one of the Europeans’ own, for money. I think it’s a brilliant strategic move.

    Slightly OT, there was a cute article in Le Monde today by Eric Le Boucher, complaining about the dollar fall and the petrol rising.,1-0@2-3232,36-969303,0.html First, he doesn’t seem to grasp that the dollar falling means that petrol is rising less in euro, surely a good thing. Secondly, and more germane to the discussion at hand, his paragraph at the end calls for the U.S. and the Chinese to do something about the dollar and the RMB, and the Europeans – to do nothing. Well, the Europeans got together to create a currency that they wanted to rival the dollar and become a major reserve currency. In order for a currency to be a reserve currency, central banks and others have to buy it and (relatively) sell the dollar. When lots of people buy your currency, it goes up. So if the Europeans want to ask who is at fault for their predicament, they should look in the mirror. Yes, the dollar is weak against European currencies, but it is too strong against Asian currencies. So the European currencies are *really* much too strong vis-a-vis Asia. So it’s not up to America to do anything, its currency is in the Middle; it’s up to the Europeans and the Asians.

  3. Anonymous

    Asset quality cutoff may be AA but haven’t we seen that what are often model-based ratings
    may not accurately capture quality.

  4. Anonymous

    How much faith can be put into the ratings on these securities? Cheyne was downgraded to D from A- only after it defaulted.

    What type of covenants will be in place for the liquidity bank to be able to walk?

  5. James I. Hymas

    First, Paulson’s attempts to blame the negative reaction toward the MLEC plan to misunderstanding is remarkable. I have not seen a single report in the financial media that implied the MLEC would be acquiring low quality assets. All have either pointed out that the cutoff was AA, or said in more general terms that the Entity would be acquiring high quality paper. Almost every blog I’ve seen has also gotten that right (the only exception were two that convinced themselves that it really must be a vulture fund because the high quality idea made no sense to them).

    Was one of the two blogs mine? If not, then make it three blogs!

    At any rate, I just want to note that in using the term “Vulture Fund” as the paradigm of choice for Super-Conduit, I did not mean to imply that it would be purchasing distressed assets.

    My use of the term is due to my speculation that is modus operandi will be to buy high quality assets from distressed SIVs.

    I’ve written another post trying to explain myself a little better.

  6. "Cassandra"

    a said –
    “Well, the Europeans got together to create a currency that they wanted to rival the dollar and become a major reserve currency. In order for a currency to be a reserve currency, central banks and others have to buy it and (relatively) sell the dollar. When lots of people buy your currency, it goes up. So if the Europeans want to ask who is at fault for their predicament, they should look in the mirror.”

    There were a whole host of reasons why the europeans pursued a single currency, all which were based upon reasonable assumptions of more or less continued rational actions by other major players. When some or all of your parters and other major systemic participants exirt the orbit expected rationality, and pursue highly inflationary monetary, & fiscal policies and , unsustainable trade policies, something has to give. It is unreasonable to expect any single paper reserve currency (and the nations to which it is tethtered) to withstand such pressures. The only way “rivaling the dollar” in this sense can be sustained would be to join the party, shadow the dollar (and Yen CHF, RMB etc.) loosening both monetary and fiscal policies to stay on level ground. They thus would Rival the dollar in terms of market liquidity and size required for a reserve unit, but like the Yen to the RMB, not yield an inch of competitive advantage due to higher moinetary or fiscal morals or sense of responsibility.

    Make no mistake: the Europeans didn’t choose this route, and much would have preferred to see the ROW – like the EU in aggregate – in greater trade balance, with tighter monetary & fiscal policies, which irrespective of the benefits of temporary exuberance yielded by the more profligate mix, they see as more sustainable and thus preferable medium to long-term. They are caught like Heller’s almost-heroic airman, in that famous scene when the Army Shrink is interrogating Yossarian Cath-22…

    Army Shrink: Why don’t you want to fly any more missions?
    Yossarian: There’s lots of young people like me at home in the states going out drinking having a good a time. I want to do that too.
    Army Shrink: But we’re at war, against a ruthless enemy. What if everybody felt that way?
    Yossarian:Well then I’d be a fool to feel any different…

  7. Useless Message Poster

    “This is a completely inappropriate use of a session convened to discuss serious policy matters, particularly when the global financial system is looking a tad fragile. The MLEC has been positioned consistently as a private sector solution. What the hell is a Treasury secretary doing acting as its shill?”

    I agree with your derision and inappropriateness of Paulson’s actions.

    Lets go one step further. What causes him to push this so hard and seemingly inappropriately?

    My hypothesis: The enormity of the problem and its pending smashing impact on the markets/economy causes him to take every opportunity he can find/create to get people on board. Simple as that. He knows directly whats coming and that the fuse is very short at this point. Sadly, the time to start this process was last February/March with the initial shot across the bow.

    Hank Paulson now becomes an indicator…..the sweat indicator….the more he sweats and the harder/more vocal he pushes this agenda correlates directly to the distance we are from the Sh*t hitting the fan……

  8. Bernard

    Isn’t this the same Henry Paulson that said the housing market “hit bottom” in July?

    And if I’m not mistaken, didn’t he also say around the same time something like: “This is the strongest global economy that I’ve seen in my entire career”.

    It’s reassuring to know that we have leaders with such foresight.


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