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"Superfund pill fails to treat the SIV illness"

A concise comment by Francesco Guerrera in the Financial Times on why the SIV rescue plan is misguided and therefore will be ineffective. Although some of the issues have been discussed elsewhere, Guerrera gives a crisp treatment, and takes issue with a key assumption, that the bank sponsors can’t afford to take SIV assets on to their balance sheets. He also starts with a nice riff, comparing the crisis and “calm the market” effort to that of the Panic of 1907.

From the Financial Times:

SIVs are predicated on the idea that you can make money by issuing cheap short-term commercial paper and investing in higher-yielding long-term debt.

Far from being an exotic invention, SIVs are a riff on the old, and dangerous, banking trick of borrowing short and lending long…..

This apparent no-brainer came unstuck during this summer’s credit squeeze…. Which is where the superfund comes in.

Backed by up to $100bn in credit lines from Wall Street banks and run by the investment firm BlackRock, the fund has two goals. To persuade increasingly desperate SIV investors not to dump billions of dollars in long-term debt to pay for their losses.

And to revitalise the ailing commercial paper market by setting a “fair price” for assets now regarded as toxic. Unfortunately, the plan is almost as bad as the problems it is addressing.

Take the fire sale issue. Under its rules, the fund is only allowed to buy highly-rated securities from SIVs (ie no subprime).

The restriction is needed to prevent the whole exercise from turning into a risk-free bail-out of failed investments. But it will not stop jittery SIV investors from unloading junk-rated assets faster than you can say “asset-backed”.

The fund’s ability to aid “price discovery” in commercial paper is not great either.

As an independent asset manager, BlackRock ought to advise the fund to buy SIV paper at the best price.

If that happens to be the very low one the market currently ascribes to this stuff, why should the super fund bid it higher?

As for “systemic banking risk”, there isn’t any. Most of these assets are owned by hedge funds, not banks, one of the reasons why SIVs were off balance sheet in the first place.

A large sale of SIV paper, which does include bank debt, would increase Wall Street’s cost of capital and damage its reputation. But it would not break a bank.

If Citigroup, the largest SIV manager, were to take the $66bn in assets held by its SIVs onto its balance sheet, its capital adequacy ratio would fall by just 0.1 percentage point.

But neither Citi nor any of its US peers will do that. Wall Street, with the Treasury’s not-so-tacit backing, prefers to hide behind their legal right not to save the SIVs.

Such a head-in-the-sand approach could have dire consequences. The financiers and politicos appear oblivious to the possibility that the fund could fail to buy enough SIV assets. Forget a fire sale, how would they like a “backfire sale” as their fund flounders?

If US banks really want to shore up market sentiment they should follow HSBC, Standard Chartered and Rabobank and use their own cash to rescue their SIVs.

Delaying the day of reckoning by cowering into a mutual back-scratching fund will do little to persuade investors that Wall Street has a solution to their problems.

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10 comments

  1. Anonymous

    That should read, “SuperFund Suppositories” Fail To Treat SIV Illnesses…or are you trying to tell us something we dont know (yet)??

    Re: “Superfund pill fails to treat the SIV illness” – Dec 9, 2007

    Moe

  2. Doc Guru

    NAR has joined an industry group coalition, that include the Mortgage Bankers Association, the Real Estate Roundtable and others to urge the IRS to modify the REMIC rules to allow common modifications to collateral so long as the basic terms of the securitized loan do not change. On April 30th, the REMIC coalition submitted comments to the IRS in response to notice 2007-17 on how the REMIC regulations can be improved. The main points made include: 1) allowing collateral modification, 2) allowing prepayment of the loan, 3)allowing the addition or substitution of an obligor.

    What became of this?

    Doc Guru

  3. doc guru

    On October 11, 2007, Internal Revenue
    Service (“IRS”) officials disclosed that the
    IRS has initiated a compliance project
    targeted at REMIC sponsors who purportedly
    have misinterpreted or disregarded
    the applicable tax rules. According to these
    officials, the amount of underreported
    income associated with REMIC securitizations
    could be “staggering,” potentially
    running into the hundreds of billions of
    dollars. One IRS official indicated that
    more than 23,000 REMIC related returns
    have been sent to the IRS’s Office of Tax
    Shelter Analysis for scanning and review.
    It is anticipated that the scanned returns
    ultimately will be sent to IRS field agents
    for the purpose of initiating audits of the
    applicable REMIC sponsors.
    The focus of the IRS compliance project
    is the purported undervaluation by REMIC
    sponsors of retained regular interest
    classes, particularly those in the “first-loss”
    position. IRS officials allege that some
    REMIC sponsors have systematically
    undervalued these retained classes by
    basing their value on unreasonable or
    clearly erroneous assumptions, including
    using projected mortgage default rates
    that are well above historical averages
    and unreasonably high discount rates.

    http://www.hunton.com/files/tbl_s10News/FileUpload44/14726/IRS_REMIC_Alert.pdf

  4. doc guru

    Proposed IRS Regulations Would Modify REMIC Loan Rules
    Nov 9, 2007

    This week the Internal Revenue Service issued proposed regulations updating the rules for modifications of loans held in real estate mortgage investment conduits–or REMICs, according to a legal alert by the Law firm Kilpatrick Stockton L.L.P. A significant modification could make a loan no longer a “qualified mortgage,” which could disqualify the REMIC that holds the loan or subject the REMIC to tax, the law firm has advised. The proposed regulations are designed to expand the class of permitted modifications of securitized loans.Current rules have four exceptions to the rule prohibiting significant modifications of loans held in REMICs. The proposed rules would add to these: Modifications that release, substitute, add or alter a substantial amount of collateral for, a guarantee on, or other credit enhancement for the loan; and modifications that change the recourse or non-recourse nature of the loan. For servicers dealing with performing loan requests, the biggest impact of the proposed regulations would relate to collateral changes. Under the current rules, modifications that affect a “substantial amount” of the collateral for a securitized non-recourse loan could result in a significant modification of that loan. Under the proposed regulations, such a modification would not cause an adverse REMIC event so long as the loan continues to be “principally secured by” an interest in real property following the modification.

    http://www.commercialpropertynews.com/cpn/content_display/finance/investment-banking/e3i5eca1b5094193b55919d22eae5f94366

  5. doc guru

    Reverse engineer this, i.e, what were these people thinking about 3 or 4 years ago and why did this problem explode?

    CDOs for B-Note Could Mean Greater Risk
    MBA (6/17/2004) Murray, Michael

    NEW YORK—As real estate collateralized debt obligations (CDOs) gain importance to B-piece buyers, some analysts wonder how these CDOs could affect B-piece buyer “discipline.”

    “There is a new generation of real estate CDOs where you’re taking the B-notes and putting them there [in the CDOs],” said Brian Lancaster, managing director at Wachovia Securities, Charlotte, N.C., speaking at the Commercial Mortgage Securities Association’s annual convention. “You’re going to see linkage to that part of the market now.”

    A CDO is an asset-backed security (ABS) that usually includes a portfolio of corporate or sovereign bonds or bank loans. Real estate CDOs are multi-sector deals in which the collateral is a mix of CMBS, residential mortgage-backed securities (RMBS), real estate investment trusts (REITs) and ABSs.

    Lancaster said the B-note market is not as efficiently priced as it once was.

    “They [real estate CDOs] play a really critical role,” Lancaster said. “If that market were to diminish, I think it would have a very significant impact. But I think at this stage of the game, it will only grow.”

    Benedict Aitkenhead, managing director at Credit Suisse First Boston LLC , New York City, said B-piece buyers could be less stringent about kickouts and credit characteristics when they would refinance themselves out of the risk position in a CMBS deal in anticipation of doing a CDO within six months of their buying position. Aitkenhead wondered whether CDOs bring a greater risk to the discipline of the B-piece buyer.

    Mark Warner, managing director at BlackRock , New York City, said that no matter how a B-piece buyer finances the risk, it is still the investor’s risk. “For most of us who are public entities, there is the public accounting and public financial discipline that you own the risk and however you finance it, it’s still yours,” Warner said.

    Warner said that BlackRock uses CDOs as financings for General Accepted Accounting Principles (GAAP) rather than sales so it owns all of the liabilities and the assets.

    “In any event, you are going to own the credit risk of the lowest grade of the equity of the double-BB [bonds] in the CDO,” Warner said. “If you put in unrated bonds in the single B-minuses all the way out to the triple-Bs, somewhere along the line the credit risk hasn’t been shifted. It may be masked, it may be more opaque to the triple-A buyer but somewhere that credit risk still exists. Whoever owns it, will have to be just as diligent to determine the bonds that go in and how the workout strategies affect the bonds.”

    Warner added that the bondholder or B-piece buyer would still need to consider interest shortfalls, how they affect the cashflows, who is receiving cashflow and who is not, as well as other tests.

    “If you own bonds in a CDO that are not receiving cashflow because you failed some of the triggers, that would be an impact on your balance sheet,” Warner said.

    Lancaster said CDOs should grow as a long-term source of funding and serve similar functions to collateralized mortgage obligations (CMOs) in the pass-through market.

    “I can see it all the time,” Lancaster said. “Once you see that sector [CMOs] cheapening and the arbitrage opening up, real estate CDOs come on.”

    Lancaster said he liked the older real estate CDOs because they consist of strong seasoned CMBS and real estate investment trust (REIT) debt. But he noted that the ratings agencies have and will take issue with real estate CDOs as they generalize the security. Also, some investors hesitate at CDOs as it is a relatively new product.

    Warner said CDOs were essential to fixing “balance sheet mismatch” between 10-year fixed-rate CMBS and floating rate liabilities, and in using CDOs to create fixed rate liabilities without being a rated-corporate buyer.

  6. doc guru

    From Fitch, Re: Subprime Feeeze as it might also relate to REMIC/RBMS/CDOs, etc (yield enhancements):

    Excess interest is an important source of credit enhancement which compensates for loss of cash flow due to mortgage losses. Uncertainty around the benefit of loan modifications is centered on the relative reduction in loss, versus reduction in excess interest that could be incurred. On balance, Fitch believes that stabilization of loss rates can outweigh excess interest reduction when analyzing the impact on senior RMBS. Greater refinancing opportunity can also help senior bond performance, as it will cause those bonds to prepay and reduce the risk of principal loss.

    For subordinated RMBS, excess interest is a much greater component of credit enhancement, and in some instances only substantially lower loss rates would offset a reduction in excess interest.

    Fitch also noted the potential problems associated with slowing repayments, sort of the “default later, instead of defaulting now” issue. HW readers who read an earlier post (”More on the Bailout: Tripping on the Trigger“) will remember a discussion of how excess interest is released to subordinate bondholders as a deal matures over time. Fitch notes that because the rate freeze essentially keeps borrowers in an “unseasoned” state, traditional loss assumptions around deal seasoning may not hold up over time — doubly so if you consider the potentially substantial decreases in housing prices that could occur between now and then.

    For more information, visit http://www.fitchratings.com

  7. Ginger Yellow

    That’s a pretty poor article, actually, and I say that as someone who has become very skeptical of MLEC. The central point, that the ideal solution is for banks to pony up a liquidity line for their own SIVs, is indeed correct. But many SIVs are not sponosored by banks, and Citi has told shareholders it will not take any action requiring it to consolidate the SIVs.

    On to specifics:

    “The restriction is needed to prevent the whole exercise from turning into a risk-free bail-out of failed investments. But it will not stop jittery SIV investors from unloading junk-rated assets faster than you can say “asset-backed”.”

    What’s he trying to say here? SIVs can’t fund their senior debt at the moment, outside their sponsors anyway. It makes no difference in the short to medium term whether or not investors in SIV paper sell their holdings. The idea is to provide a replacement source of liquidity for the assets, so that redemptions can be met without a firesale.

    “As an independent asset manager, BlackRock ought to advise the fund to buy SIV paper at the best price.

    If that happens to be the very low one the market currently ascribes to this stuff, why should the super fund bid it higher?”

    Again, the idea isn’t to avoid current market prices, but the prices that would follow a firesale. This is a critical difference. SIV assets have been sold on average only 1.6% below par, according to Fitch. If they have a firesale, the price will be much lower. Obviously, SIV sponsors will want a higher price than MLEC sponsors, and there are conflict issues where the two are the same, but Guerrera’s comments don’t address that.


    As for “systemic banking risk”, there isn’t any. Most of these assets are owned by hedge funds, not banks, one of the reasons why SIVs were off balance sheet in the first place.

    A large sale of SIV paper, which does include bank debt, would increase Wall Street’s cost of capital and damage its reputation. But it would not break a bank.”

    This is very confused. The nature of SIV assets has nothing to do with why they’re off balance sheet. That’s to do with who owns the capital notes, or in the case of restructured SIVs, who provides the liquidity. Citi taking its SIVs on balance sheet wouldn’t break it, and it probably should take it back on – but again, it’s already promised its shareholders it wouldn’t, and you can hardly blame them for not wanting to take another large balance sheet when they have no contractual obligation to do so. And bringing SIVs and ABCP vehicles on balance sheet did break two German banks.

    “Such a head-in-the-sand approach could have dire consequences. The financiers and politicos appear oblivious to the possibility that the fund could fail to buy enough SIV assets. Forget a fire sale, how would they like a “backfire sale” as their fund flounders?

    If US banks really want to shore up market sentiment they should follow HSBC, Standard Chartered and Rabobank and use their own cash to rescue their SIVs.”

    They are, to a certain extent. Citi is stumping up capital and liquidity for MLEC as other banks are. But again, what about the non-bank SIVs, or the ones sponsored by smaller banks? If those go under, that damages the larger banks’ SIVs. That’s what they’re trying to avoid.

    I think the plan is going to founder on the lack of appetite among investors for credit arbitrage ABCP (as opposed to multiseller vehicles used for client financing). But the argument made here are off base.

  8. Yves Smith

    Ginger Yellow,

    Your points well taken. What I found interesting was the point that Citi taking its SIVs on to its balance sheet would have so little impact on its capital ratios. The discussion, at least in the Wall Street Journal, has implied that Citi would be in bad shape if it did not avail itself of the vehicle.

    Similarly, another article in the FT said that Citi now might not use the MLEC given its fee structure.

    In addition, smaller SIVs such as Cheyne have been liquidating, and I haven’t seen any reports that their sales have been disruptive. So I would think smaller banks could let smaller SIVs fail, or have them liquidate some of their assets and support the rest to attenuate the sale process.

    Even though the IKB collapse was due to the failure of its conduit Rhineland which some commentators have called an SIV, its structure was not like that of typical SIVs and therefore I believe the term has been too broadly applied. Rhineland had backup lines of credit at IKB in case it couldn’t roll its CP. It was the drawdown on those credit lines that put IKB under. SIVs do not have backup lines of credit with their parents, and my understanding is the compensating mechanism is the restrictions put on the vehicle when NAVs drop below certain trigger points.

  9. Ginger Yellow

    “Similarly, another article in the FT said that Citi now might not use the MLEC given its fee structure. “

    Citi have said from the beginning that they didn’t plan to use it for their SIVs. If anything, the deterioration in NAVs for Citi’s SIVs has made it more likely they will.
    “In addition, smaller SIVs such as Cheyne have been liquidating, and I haven’t seen any reports that their sales have been disruptive. So I would think smaller banks could let smaller SIVs fail, or have them liquidate some of their assets and support the rest to attenuate the sale process.”

    There’s liquidiating and there’s liqidating. All SIVs, apart maybe from Gordian Knot’s Sigma and Theta which operate on a different model, have been selling assets for most of the year. But even Cheyne hasn’t had a firesale – the receiver has allowed time for a restructuring/orderly sale. The firesale risk comes less from defaulting SIVs, but from SIVs trying to meet their senior liabilities without defaulting. There’s also the risk that other receivers will be less accommodating. As for whether their sales have been disruptive, European prime RMBS spreads rallied to the mid 20s at the end of September, and are now in the 70s. Interpret that how you will.

    “Even though the IKB collapse was due to the failure of its conduit Rhineland which some commentators have called an SIV, its structure was not like that of typical SIVs and therefore I believe the term has been too broadly applied”

    Agreed. It annoys the hell out of me when people call MLEC a Super-SIV. The whole ideais that it’s not a SIV but a credit arbitrage conduit. My point was that the restructurings effected by HSBC, WestLB and others, and recommended in the FT article for US banks, involve providing full liquidity to SIVs even where there is no contractual obligation (it should be noted that Citi has provided $10bn of such liquidity to its SIVs). In the case of smaller banks, this could well have a material impact on capital.

    “my understanding is the compensating mechanism is the restrictions put on the vehicle when NAVs drop below certain trigger points.”

    It’s not just that. SIVs have 5 and 15 day net cash outflow tests, which require them to have enough liquid assets (as defined in the transaction documents) to redeem all outgoings for those periods over the next year.

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