New Wall Street Gimmick: "Ring Fencing" Dead Assets

Several alert readers caught the Financial Times story, “Wall St banks seek to ring-fence bad assets,” and I held off from posting on the assumption it would merit coverage in the Wall Street Journal or the New York Times. Not so.

The Financial Times article says that investment banks are seeking to put dodgy assets in a separate subsidiary, with the hopes of offloading it to over-eager bottom-fishing chumps investors. Or if that doesn’t work, to taxpayers:

According to people familiar with the matter, banks are discussing a joint proposal to regulators to set up a fund, which would absorb US subprime assets and other troubled securities, as a way of restoring confidence in the banking system and ending the pressure to recognise mark-to-market losses.

I don’t give this proposal any hope of seeing the light of day, at least in this form, although a huge number of permutations later, something that might have germinated with this idea could come to life.

The biggest obstacle is the idea that this facility would be organized by the industry and all would participate on the same terms. As we found with the stillborn SIV rescue plan and the “bail out the monolines” firedrill, getting consensus among a large number of disparate players is well-nigh impossible.

This effort is likely to founder over the same issue that killed the MLEC, the hoped-for SIV garbage dump, which is how to value the assets going into the new vehicle. Prices need to be set for the instruments that will be moved out of a bank; this stuff by definition doesn’t trade so how to price it is legitimately subject to debate. But that’s assuming it even got that far. For participants to have a down-and-dirty discussion, they’d wind up shedding light, if in a general way, on their exposures and how much they had marked them down. I doubt that the involved parties would risk revealing that much.

The FT points to problems along these lines:

However, bankers say the prospect of a co-ordinated solution remain remote because of the difficulties in getting banks to agree on the terms and the scope of a common fund.

John Thain had said of the vastly simpler (and still unsuccessful) mononline effort that it would not work on a group basis, but institution by institution. So let’s consider that case:

Under UBS’s scheme, the bad assets will remain on the bank’s balance sheet because the Swiss bank will initially retain full ownership of the new fund. However, UBS is expected to sell all or part of it to outside investors, or to spin it off, according to people familiar with its plan.

Um, this works only if the price to which you have marked the assets is lower than a third party is willing to pay. Otherwise, you wind up worse off. Simple example: you’ve written this garbage barge down to 25 cents on the dollar, convinced that that it extraordinarily cheap. But then you try getting bids, and all you get is 20 cents on the dollar, You’d have to take another 5 cents on the dollar loss to sell it, which is another hit to equity, which is precisely what you were trying to avoid.

Or just as bad, word gets out that you shopped your little nuclear waste subsidiary, but didn’t like the offers. Now guess what that will do to your stock price, your counterparties’ confidence, and CDS prices on your debt. You were better off having everyone believe, or pretend they believed, that your write-offs put all your problems behind you.

So this does not appear a bona fide notion to unload this stuff onto third parties, despite chatter of hedge funds and distressed investors out buying MBS and mortgages (that stuff is a walk in the park compared the complexity of some of these structures). And the volume that would be on offer is certain to swamp demand.

This effort, then, despite the brave talk (and perhaps a bit of self-delusion), is preparation to somehow dump these toxic assets on the laps of the Powers That Be. But the Resolution Trust Corporation created good banks and bad banks out of failed banks. It’s an amazing bit if hubris if the industry thinks it can shove these assets onto taxpayers and carry on unimpeded.

There is also a lack of historical memory. The RTC was extremely controversial; Congress was not happy about funding its sizeable working capital requirements. And in contrast with 1990-1991, there are calls for relief from a lot more quarters. Wall Street may find it tougher than it thought to get its hoped-for rescue operation.

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  1. Anonymous


    Good write-up. It’s worth underscoring that RTC came about as a result of deposit insurance, not government concerns over `mispriced’ assets `a la De Long. I was at FDIC at the time, and I can tell you that much of the opposition to RTC came from politicians “friendly” with Federal S&Ls and with bankrupt developers who continued to get their loans rolled by their insolvent lenders. These folks wanted FSLIC to remain underfunded so the party could continue; they didn’t want an RTC with the cash to shut them down. Anyway, I’ve recently seen a few self-serving references to RTC as a supposed precedent for a bail-out of the Street, and I expect to hear more in the comings months as the hogs grow leaner.


  2. eh

    It’s MLEC, The Sequel. But expect the swine to keep trying; after all, they’ve got the BSC/JPM ‘bailout’ precedent going for them.

  3. a

    “It’s an amazing bit if hubris if the industry thinks it can shove these assets onto taxpayers and carry on unimpeded.”

    I’m afraid I think they may just get away with it. Look at all the proposals at this stage by the really serious people. They all involve the government spending hundreds of billions if not trillions. What’s another trillion? Especially when you’re guaranteed lots of reelection funds from grateful Wall Street execs?

  4. Anonymous

    Yves, what did happen in the end with the Monolines? I understand that some got a small capital injection and then the credit rating agencies just let them get away with it. When will those chickens come home to roost?

    This idea looks just the same – as FT Alphaville mentions, this is just PR. Something small might happen and everyone will keep their heads in the sand. I still can not quite believe equity markets’ reactions to UBS’ huge write-offs! Have you seen the Hang Seng recently? Can you imagine the bull market when Citi and Merrill give us their next bundle of fun?

  5. S

    LEH total assets rose last Q. When confronted with the question, they lob out some mumbo jumbo about match book, lower net leverage etc (with changing definitions). When pressed they say it is clearly a focus going forward and they hope to wind down the balance sheet – but don;t want to sell at “firesale” prices. Sounds a lot like the De long argument. Optimism knows no bounds for some. No doubt, the I banks, now with their Fed hall monitors, are looking to dump these on taxpayers. No doubt a gov’t entity takes the other side – hoping to have lost in the next few years. Going back to De long, it begs the question of curing the system to prepare it for what: a return to risk seeking behavior. If anything curing the problem hurts the valuation picture going forward and opens the Pandora’s box as to what these franchises are worth. Opco has been most vocal about this point and she was right on the dividends and she is right about the value of leveraged entities.

  6. cactus

    I’m with a. In the end, the only hope there is of saving Jim Cayne’s retirement package, which from what I can tell seems to be the big priority in this mess, is for the taxpayer to take over the problem. We’ve slowly inched our way toward that particular endstate.

  7. Anonymous

    Best Buy also announced that it holds troubled auction-rate securities. These are AAA/Aaa-rated bonds collateralized by student loans guaranteed 95 percent to 100 percent by the U.S. government. Unfortunately, the market for these securities collapsed in recent times, which made them virtually impossible to sell on the open market without taking a substantial loss.

    Normally, companies are required to write-down the value of these securities to this new value, but Best Buy reclassified the investments as non-core, which allowed them to forego that requirement.

    We’re all Non-core now.

  8. Anonymous

    France has proceeded that way some years ago with the Credit Lyonnais miss.

    All suspects assets were taken in a special “defeasence” structure, specially set up to liquidate bad investments and debt.

    But it was “only” 30 bn euros…

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