Yet More Reservations About the SIV Rescue Plan

I am beginning to feel like announcer at a prizefight where it’s obvious that one boxer is hopelessly outmatched, but the contest will still go a full twelve rounds due to the stubbornness of the underdog and the failure to land a knock-out punch.

The SIV plan continues to take body blows, the supporters appear to be rope-a-dope. If it wasn’t for the occasional clever turn of phrase, and the challenge of trying to piece together the status and prospects of the SIV market, this would be no fun at all.

True to form, Warren Buffet offered a useful suggestion wrapped in corn pone, namely, that the SIV rescue entity, the so-called Master Liquidity Enhancement Conduit (MLEC) ought to sell a portion of its assets to establish the validity of its pricing. From the Financial Times:

The US banks creating a $75bn-plus “superfund” to buy the assets of troubled investment vehicles should sell 10 per cent of the fund into the open market to ensure it is properly priced, the renowned investor Warren Buffett said on Thursday.

The billionaire is the latest leading figure – including Alan Greenspan, former chairman of the Federal Reserve – to pour scorn on the fund promoted by Citigroup, Bank of America and JPMorgan Chase with the US Treasury’s encouragement.

“One of the lessons that investors seem to have to learn over and over again, and will again in the future, is that not only can you not turn a toad into a prince by kissing it, but you cannot turn a toad into a prince by repackaging it,” Mr Buffett said during a visit to South Korea

“But very imaginative people in the securities market try to do that. If you have bad mortgages they do not come better by repackaging them. To some extent the chickens are coming home to roost for the mortgage originators and securitisers,” he said….

“I think there should be a requirement that before the securities are put into the new super-SIV, 10 per cent of the holdings should be sold into the market to people who are not associated [with the subprime problem],” he said.

“That way we can be sure that they are being put in at appropriate market prices . . . They should give the market the opportunity to price the super-SIV themselves so we can see what they are really worth.”

While Buffet is no doubt correct, the problem with his idea is that price discovery is the very thing that the sponsors hope to avoid.

Gillian Tett, the Financial Times’ capital markets editor, similarly give the SIV rescue idea a thumbs down. She picks up on themes we have discussed before, such as investors want the assets that go into the superfund to be valued at current market prices, while that is what the SIV owners are trying to avoid; that the real goal for this plan may be to protect money market funds rather than banks. But she adds a new twist: the SIV workouts (Cairn and Cheyne) are viable models, and the SIV problems are mounting too fast to wait for the establishment of the MLEC, particularly since it may be stillborn.

From the Financial Times:

Financial panics often breed dodgy ideas and the so-called superfund is starting to look as if it may turn into one….

What makes the superfund particularly questionable is its raison d’être. After all, according to proposals circulated so far, the purpose of this fund would be to purchase assets from troubled structured investment vehicles – and thus prevent them from needing to dump securities – or put them back on to banks’ balance sheets.

But while bankers in New York are apparently trying to delay market-driven workouts for SIVs, financiers in London are already organising restructurings. The $360bn question is why anybody needs a government-blessed superfund at all, least of all in the supposedly free-market bastion of Wall Street.

Take the restructuring of the troubled Cheyne SIV fund revealed in the Financial Times this week. The restructuring is being initiated in London but organised partly under US law. This is not the first restructuring of a SIV. That dubious honour went to a fund run by Cairn Capital six weeks ago.

The Cheyne move is significant, however, because its SIV is worth a hefty $6bn and its investor list features many heavyweight US and European financial institutions (some of which might be expected to back the superfund). No doubt some of these investors feel a little aggrieved. After all, the Cheyne restructuring is likely to mean the value of some notes in the SIV will be drastically reduced.

But, as any business school student knows, that is what restructuring is supposed to do…

We are told, for example, that the fund will start in a couple of months. But troubled SIVs need to sort out their problems now. Hence the fact that the Cheyne (or Cairn) models are already being quietly copied by financiers and lawyers in charge of the troubled SIV attached to IKB, the German lender. They simply cannot afford to wait for the superfund.

Given all this, it is no surprise that some policymakers and senior investment bankers have quietly confessed to me in recent days that they suspect the superfund idea will soon die a quiet death. That may be optimistic. Bankers at Citigroup, for example, still seem keen on the idea, but I suspect that the more the private sector redoubles its restructuring efforts, the harder it may be for this particular superfund to fly. * Meanwhile, if you want to understand one piece of political pressure that may have hastened the birth of the superfund idea, it is worth keeping a close eye on the concept of “breaking the buck”.

Outside America, this phrase carries limited resonance. But for American financiers, it is laden with emotion. During the past century of American history it has been widely assumed that money market funds should always pay back funds they have collected from investors (ie “return the buck”) – plus any accrued interest.

This principle has almost always been respected, which is why these funds are loved by retail investors. But two months ago, fears emerged that some funds could break the buck, because of potential losses on commercial paper notes issued by . . . er, SIVs

In the event, this scenario was averted. But in the eyes of some powerful American observers, the financial system briefly seemed near a tipping point. If the buck had been broken, the tale goes, the turmoil on Wall Street could have spread to Main Street.

That may explain the sense of US policy urgency that emerged last month in relation to SIVs (and much else). But it also has an implication for the future: if fears re-emerge about the money market funds, US policymakers may get more active again too.

In other words, we have a regulatory regime to protect banks. But we have all these businesses that operate as non-banks (presumably because they find it too costly or cumbersome to be a bank) that the banking regulators have decided cannot be permitted to fail. How did we get in this mess of extending bank-like importance to un or lightly regulated entities, like SIVs and money market funds?

Another set of concerns comes from Bloomberg, which not surprisingly, sees the Merrill Lynch writedowns as a bad omen for the MLEC:

The collapse of confidence in Merrill Lynch & Co. after the world’s biggest brokerage lost six times more than it forecast earlier this month helps explain why Treasury Secretary Henry Paulson’s attempt to rescue SIVs is troubled.

Merrill Chief Executive Officer Stan O’Neal told shareholders yesterday that the New York-based firm had a loss of $2.24 billion, the biggest in its 93-year history, after reducing the value of mortgages and asset-backed bonds. Those are the same hard-to-trade securities owned by structured investment vehicles, or SIVs, that Paulson is attempting to keep afloat with a new $80 billion fund.

Paulson’s plan, announced last week, may do little to address the lack of transparency that has roiled global fixed- income markets since July 31, when two hedge funds managed by Bear Stearns Cos. went bankrupt following losses on securities tied to subprime mortgages. Investors aren’t willing to rely on estimates by Wall Street traders to value these bonds and there’s no central trading system or exchange. Fitch Ratings says the value of SIVs, which own more than $320 billion of bonds, fell to 73 percent as of Sept. 28 from 100 percent in July.

“Continuing to mask transparency by means of rearranging risk without actually offloading or recognizing the true value of that risk is not going to help anyone,” said Joseph Mason, an associate professor of business at Drexel University in Philadelphia and a former financial economist at the Office of the Comptroller of the Currency…..

Many of the 30 SIVs worldwide can’t find buyers for their commercial paper — debt that comes due in 270 days or less. The concern is that without the funding, the SIVs would have to sell their investments and might have to accept fire-sale prices. That would force owners of similar securities to assign new, lower values to their holdings, causing losses to spiral.

As an alternative, banks could take over the assets, though that would tie up capital and restrict lending, putting a drag on the economy…..

Asset-backed commercial paper maturing in less than 30 days yields 20 basis points more than the Fed’s target rate for overnight loans between banks, up from 5 basis points three months ago. The amount outstanding fell in each of the past 11 weeks, tumbling 25 percent to a seasonally adjusted $883.7 billion.

On average, about 44 percent of SIV holdings are in mortgage-backed securities, 2 percent of which is in subprime mortgage bonds, and 11 percent is collateralized debt obligations, which package pools of debt, according to a report last month by Zurich-based UBS AG, the world’s biggest money manager to the wealthy. The rest is finance company bonds and other asset-backed debt.

The lack of trading in mortgage securities has made it almost impossible to reach a consensus on the value of much of the SIV’s holdings. More than 80 percent of fund managers surveyed last month by Greenwich Associates, a Greenwich, Connecticut-based consultant, said they “experienced difficulty” in getting a price quote from dealers for asset- backed securities and CDOs….

The average net asset value of SIVs rated by Fitch fell to 73 on Sept. 28 from more than 100 in July. A 0.5 percent drop in value of assets is equivalent to a 7 percent decline in the so- called NAV, Fitch said.

Citigroup, the biggest U.S. bank, is the largest owner of SIVs, with seven pools that have a combined $80 billion in securities, according to spokesman Jon Diat.

The company said on Sept. 6 that its $22.4 billion Beta Finance SIV had a net asset value of 85.3 at the end of August. That fell to a range of 75 to 80 by Oct. 8, according to Fitch. Citigroup’s $15.1 billion Sedna Finance SIV ended August with a value of 81 and declined to as low as 70 in mid-September before recovering this month to between 75 and 80. The bank’s $13.4 billion Five Finance had a value of 81 in August, before dropping as low as 70 by Oct. 8.

The largest SIV, the $52 billion Sigma Finance Corp., declined to let Fitch disclose its value. ….

Once an SIV’s net asset value falls below 50, a clause is typically triggered requiring the fund to liquidate.

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