'Super' Fund Remains a Mystery

Date: Friday, October 19, 2007
Author: Emma Trincal, Senior Financial Correspondent, Hedgeworld.com

NEW YORK (HedgeWorld.com)—They're calling it the Master Liquidity Enhancement Conduit, though right now, no one exactly has figured out what it is.

On Monday [Oct. 15] Citigroup Inc., JPMorgan Chase & Co. and Bank of America Corp. announced the creation of the MLEC as a way to generate liquidity and hopefully rescue the troubled structured investment vehicle market. SIVs are off-balance sheet vehicles sponsored by banks that issue billions of dollars of commercial paper on an ongoing basis. The commercial paper market is on hold because investors are backing away from paper that is hard to price because it is backed by residential mortgage-backed securities and collateralized debt obligations that have become difficult to value.

SIVs typically buy those higher-yielding assets and finance the purchases by issuing short-term paper and medium-term notes that carry lower interest rates. As in every structured finance instrument, the off-balance sheet vehicle makes money off the spread between the yields on the assets and liabilities. And the banks that sponsor those off-balance sheet vehicles generate revenues by charging fees.

But when investors stop buying the short-term debt issued by the SIVs, liquidity suffers. Issuance of short-term paper slows down, which has been one of the factors behind this summer's credit crunch. Thus, the liquidity conduit essentially is a fund created to solve the liquidity crisis that arose from this summer's credit crunch.

Citigroup, JP Morgan and Bank of America created the liquidity conduit to buy securities from SIVs that are having difficulty funding themselves Previous HedgeWorld Story . The size would be unprecedented: between $75 billion and $100 billion. It is meant to be up and running by year-end. On Tuesday [Oct. 16] Wachovia Corp. announced that it would join the effort.

"We plan to participate at an appropriate level because we want to help improve stability of the market," Christie Phillips Brown, a Wachovia spokeswoman told HedgeWorld. She declined to be more specific.

The idea of the nation's largest banks joining forces in an effort to solve the liquidity crisis, with the U.S. Department of the Treasury's blessing, looks like a good idea. But it is also raising many questions.

What the Skeptics are Saying

Among the three banks backing the conduit, only Citigroup has exposure to the SIV market, which is estimated to be $400 billion, spread out among 30 global vehicles. Analysts said that Citi's SIV exposure alone represents one-quarter, or $100 billion, of the global SIV market. People familiar with the conduit have confirmed that neither JP Morgan nor Bank of America have SIVs.

Wachovia's role is unclear but appears limited. According to its recent annual report, Wachovia administers what it calls a "structured lending vehicle" with a total of $7.6 billion under management as of December 2006. But the vehicle is not technically an SIV, though it functions in a similar way. A Wachovia representative declined to comment beyond the annual report.

So is this new SIV liquidity conduit a special treat for Citigroup? Probably not. It makes no sense for several large banks to join forces to rescue a competitor. As Citigroup spokespeople have stressed, the liquidity conduit is not a bailout for Citigroup. Rather, the banks have created it to jump-start a struggling commercial paper market. Even if they're not sponsors of off-balance sheet SIVs, banks need the commercial paper market to function in an orderly way to maintain their lending roles and to originate mortgage, credit card and other loans. Banks need liquidity, which they won't have it if the whole commercial paper market grinds to a halt.

SIVs: The Key to Liquidity

Right now, this market is on hold because the SIV machine has ceased to function. With investors' appetite for asset-backed commercial paper gone, SIVs have been unable to roll over that paper. This has put pressure on banks to either liquidate the collateral of those SIVs at a loss or put it back onto their balance sheets. Such liquidations in current market conditions would force other banks to mark down similar assets, adding more selling pressure on those mortgage-related assets. The result of this could be months, if not years of a damaging credit crisis.

The Federal Reserve Bank was aware early on of the risk posed by a general liquidity crisis and of the potential for such a crisis to impact the economy and the credit market. This is why it took the unusual step in August of cutting the discount rate, which is the rate the Fed charges banks for loans. The Fed also cut the federal funds rate in September by 50 basis points, and the market expects more cuts to come. Yet, the liquidity problem remains unresolved.

A good illustration of what happened in the SIV market this summer can be traced back to August when London-based hedge fund Cheyne Capital Management LLP began liquidating its $6.6 billion SIV to repay debts Previous Reuters Story. Since this summer, some SIVs have begun to sell assets at declining prices in order to reimburse investors unwilling to roll over their investments.

The SIV liquidity conduit structure is designed to prevent disorderly asset liquidations like that which occurred at Cheyne. In fact, the super fund began to operate with Cheyne. On Thursday [Oct. 18] Cheyne announced that it would no longer pay its short-term debt as the four MLEC banks are now biding on its assets Previous Reuters Story. The conduit aims to give banks the means to buy the SIV securities without having to hold fire sales or place those assets onto their balance sheets. The fund was designed to unwind the banks' SIVs in a smart way. In creating a higher-quality "super" SIV, the participating banks are selling their SIVs to a new buyer and are hoping to restore investors' confidence in this market.

But some say banks are just transferring their bad debt from several vehicles into a new, consolidated one. And the process is raising more questions than it is providing answers for at this point.

Is the operation an attempt to resolve the liquidity crisis in the commercial paper market, or is it a "self-serving" device designed to protect banks against brutal write-downs? It's more of the latter said Mark McQueen, president and chief executive of Wellington Financial LP, a $400 million, privately held bridge financing and venture debt fund based in Toronto, who wrote on the blog Seeking Alpha that he is "not buying" the banks' PR line regarding the SIV liquidity conduit.

Another question is who will participate and why?

So far, Wachovia joined the trio of banks, and Fidelity Investments also reportedly offered to support the plan. But others, especially foreign banks, may have vested interests in solving their own SIV messes. Paradoxically, the more successful the liquidity conduit is, the less of an incentive other financial institutions may have to join in, said Marc Chandler, global head of currency strategy at Brown Brothers Harriman, in a note.

"If a few large U.S. banks and a couple of other financial institutions are going to try to stabilize the asset-backed commercial paper market, why shouldn't some players stand on the sideline and accrue the benefits if the operation is successful without bearing more risk?" he wrote.

Which raises another point: What will SIVs have to pay to be able to sell to the conduit? Word is out that it won't be cheap, which could explain why JPMorgan and Bank of America—banks that are not involved in any SIVs—would participate. They will charge a fee for the transactions and for administering the conduit. No one would expect financial institutions to take on risk for nothing, and there is nothing wrong with this business model. But for now, the amount of those fees is not known.

Another point that remains unclear, but which is perhaps most important, is if investors are demonstrating wariness in investing in individual SIVs, why would they jump into buying the SIV liquidity conduit securities, or the securities of a "super SIV?"

The first explanation might be that the conduit will only purchase high-quality assets rated double-A and up. A person familiar with conduit even said none of the assets will contain CDOs. But that in itself is an interesting paradox. The fund would buy highly rated financial instruments from troubled structured investment vehicles. How the banks assess the risk associated with undertaking these transactions—even if done off-balance sheet—also is unknown.

"As some analysts have observed, it is not the high-quality assets of the SIVs that have impaired the credit quality of ABCP, but the questionable assets on their books such as subprime mortgage-related securities," said Paul Kasriel, chief economist at Northern Trust. "To a skeptic, this MLEC might appear akin to re-arranging the deck chairs on the Titanic."

Another mark in favor of the conduit's marketability is that supposedly, participating banks would offer investors in the conduit some sort of insurance or guarantee against future losses. It is not clear how they will accomplish this. The banks could put their names and reputations on the line, or they might actually offer some form of insurance, promising to absorb some part of any losses the conduit may incur. No one knows at this point.

And it's going to be hard to tell, in any event. SIVs are some of the most obscure structured finance instruments. Their performance does not appear on banks' earning statements, since they are off-balance sheet. Some pundits have even said that SIVs are reminiscent of "Raptor," the off-balance sheet vehicle created by Enron to hedge volatile assets against declining prices.

This comparison is unfounded and unfair, as Enron's Raptor was a fraud. Yet, the lack of transparency of SIVs and the lack of information in regard to this new "super SIV," has led some to take a skeptical, even cynical, view of the new fund.

The market did not exactly welcome the announcement of the SIV liquidity conduit. It was the first cooperative effort of this scale between banks since the 1998 bailout of Long-Term Capital Management. But while the LTCM bailout boosted stocks in 1998, the market was down in reaction to news of the SIV conduit, as the announcement was viewed as nothing but a confirmation that the mortgage problem was in fact worse than it appeared to be.

Some have argued that the conduit is another way to recognize losses and will only serve to buy time for the banks. Bill Gross, managing director at bond shop Pacific Investment Management Co. LLC, said in an interview on CNBC that, "There are a lot of dead bodies off-balance sheet that we still can't find. The SIV idea is a little lame in my opinion. Let me twist an old phrase and say that a SIV by any other name is still a SIV."

His view reflected the position of others who said that transferring risk from multiple SIVs into a bigger SIV is just another way to hide the same problem.

"What the MLEC is really doing is generating liquidity against a higher quality pool of assets, leaving behind ... the dreck," said Roger Ehrenberg, president of New York-based Monitor110, Inc. and former CEO of Deutsche Bank's fund of funds business, in his blog, Information Arbitrage.

"The simple fact that the large banks agree to buy the paper issued by the MLEC doesn't actually provide any comfort that the assets have been appropriately valued," said Mr. McQueen. "It is no different than extending a bad loan after the due date."

But perhaps, the most vehement critique comes from those who are really concerned about the subprime mess. Although they think the new conduit may bring some liquidity into the commercial paper market, they fear it will fail to resolve the key underlying issue, which is subprime mortgage defaults and the falling housing prices and recession risks these entail.

Mr. Kasriel pointed to the $683 billion in non-prime residential mortgages that Merrill Lynch has estimated will be subject to interest rate resets between the second quarter of 2007 and the fourth quarter of 2008. To him, the negative impact on the economy is a certainty. "It looks to me as though the establishment of the MLEC is another attempt to turn a sow's ear into a silk purse," he said.

The conduit's distinction is that banks participating in the super fund will only buy high-quality assets, as it was the only way they could attract investors. But by the same token, the choice of "good" assets may fail to address the subprime component of the SIV market, the sick part that requires the strongest medicine.

Free market purists are also critical of an initiative that has received the full backing of the Treasury Department. "The U.S. Treasury's involvement in this situation is frightening," said Richard Bove, analyst at research firm Punk, Ziegel & Co. "The Treasury's primary job is to fund the United States government. It is not expected to, nor should it be involved in, working out debt problems in the private sector. This is the job of the Federal Reserve. Yet, the Federal Reserve has not commented on this proposed program."

Mr. Bove speculated that either the Fed sees no merit in the plan, or that it has no desire to spend its political capital in a project many already see as a bailout plan.

More than a Bailout

The SIV project also has supporters. For them, it is wrong to call the fund a bailout.

While the Treasury Department facilitated the discussion, there is no taxpayer money involved, Mr. Chandler noted. Mr. Ehrenberg also disputed the idea of the bailout, arguing that the government has not offered any implicit or explicit guarantee.

Another potential benefit of the plan is it could help banks that are facing mounting pressure from shareholders due to high levels of mortgage-related losses. Some supporters of the conduit said banks are going in the right direction in consolidating the high-quality rated paper into a single vehicle because they're diversifying their risk.

Mr. McQueen is one of these supporters. He noted that by agreeing to pool $100 billion of assets, banks reduce their exposure to individual SIVs. For instance, he said, if Bank of America owns 100% of a $5 billion SIV, it will likely own 5% of the $100 billion conduit once it is operational in December. "The simple fact that the bank in question doesn't own all of the specific SIV themselves will take some pressure off their accountants," Mr. McQueen said.

Looking at the macroeconomic picture, some said the conduit is a sound idea because it addresses a severe liquidity crisis that is a threat to the U.S. economy.

"The recent announcement reflects a continuing need for liquidity on the part of the financial community," Mr. Gross told CNBC. "The three-month LIBOR is still 35 basis points higher than it should be. Banks need to roll a tremendous amount of ABCP over the next few months."

Other optimists pointed out that the government is supporting the private sector initiative because it sees that the mortgage bubble is worse than what one would have thought a few months ago.

"In general banks have liquidity problems, investment banks have liquidity problems, hedge funds have liquidity problems. We're seeing an implosion of liquidity, which is the major problem for the U.S. economy and the global economy," said Mr. Gross.

So if the SIV liquidity conduit was created to buy time for the markets, so be it. It may not transform the billions of dollars of subprime losses into gains, but it may give banks enough time to absorb those losses.

The cynics, of course, would say it might just be postponing for the banks a problem that will eventually come back to haunt them.

ETrincal@HedgeWorld.com