From the Economist: Banker, heal thyself

[Guy Berger]

Financial markets

Banker, heal thyself

Oct 16th 2007 | NEW YORK

From Economist.com

Banks seek life in the debt markets

Photodisc

CAN a group of banks succeed where the monetary authorities have failed? Despite the best efforts of central banks to deal with the credit crunch that took hold over the summer, some debt markets remain dysfunctional. Buyers are still on strike in an important part of the market for commercial paper (short-term corporate debt): the bit in which so-called structured investment vehicles (SIVs), which have mushroomed in recent years, borrow in order to invest in higher yielding assets. Now many of those vehicles are finding it difficult to roll over their debts and the banks that stand to lose most from their demise are scurrying for solutions.

On Monday October 15th three of the largest banks launched the first big effort by the private sector to alleviate the crisis. Citigroup, JP Morgan Chase and Bank of America unveiled an agreement in principle for a fund, expected to be worth up to $100 billion, that would buy highly rated assets from troubled SIVs. Other financial institutions are said to be considering joining. Although no government money will be available, America’s Treasury played an important role in the talks that led to the fund’s creation. The authorities worry that “disorderly” markets could drag down the economy.

SIVs suffer from the same mismatch between assets and liabilities that afflicts regulated banks: they borrow short-term and invest long-term. This worked well when markets were humming along. But now the mounds of mortgage-backed securities and other assets that the vehicles hold have suddenly turned horribly illiquid and their market value—to the extent that it can be ascertained—has plummeted.

Some SIVs have had to sell assets at fire-sale prices to repay investors, many of whom have become reluctant to roll over debt. Since SIVs hold some $325 billion in assets, further forced sales could have a chilling effect on the prices of asset-backed securities across the board. Banks also worry that they might be forced to take the assets of SIVs they helped to set up on to their own balance sheets. That would put great strain on their capital ratios.

The new fund, which has been clumsily labelled the Master Liquidity Enhancement Conduit, or M-LEC, will buy commercial paper issued by SIVs and then issue its own short-term debt, which will be backed by the founding banks. It will buy assets at a “market price” but there is a twist. SIVs that sell discounted securities to the conduit will share in the gains if the paper subsequently rises in value. The aim is to overcome their reluctance to part with assets they consider undervalued by a barely functioning market.

Though comparisons have been drawn with the 1998 bail-out of Long-Term Capital Management, a hedge fund, there is a notable difference. Back then, the Federal Reserve brought banks together to help a failing counterparty. This time, there is an element of self-rescue. That is certainly true of Citigroup, which has set up more SIVs than any other institution; it is exposed to some $100 billion of assets held by such vehicles. The two other co-ordinating banks have no SIVs of their own. They seem drawn primarily by the fees they will be able to earn managing the conduit.

Whether the scheme works remains to be seen. It looks rather like the Resolution Trust Corporation that was set up to liquidate America’s failing savings and loan institutions in the 1980s, points out Brad Hintz of Sanford Bernstein, a research firm. But while the design is proven, the banks may struggle to reach agreement on a host of issues, not least the price at which to mark assets bought. Though the banks say they want to get the fund off the ground within 90 days, some analysts think it will never fly.

Even those who support the fund admit that it is, at best, a temporary solution. As one banker puts it, it is about buying time so that the real problems facing the debt markets can be sorted out. In the case of asset-backed commercial paper, the two biggest are the inherently unstable structure of SIVs and their lack of transparency. Not only do they sit off their creators’ balance sheets but they do not even have to publish their holdings. Only when these underlying issues are addressed is confidence likely to return.

[Guy Berger]

A few days later and a much more cynical article:

Credit markets

Curing SIV

Oct 18th 2007 | NEW YORK

From The Economist print edition

A bail-out fund raises more questions than answers

YOU know a market has seen better days when some of its leading actors are compared to a deadly virus. With many traditional buyers of commercial paper (short-term corporate debt) still on strike, Wall Streeters with more wit than taste have branded the sickliest of the structured investment vehicles (SIVs) that issue such paper to punt on longer-term assets “SIV-positive”.

As the feeble struggle to roll over their debt, the banks with the most to lose from their demise are reaching for a palliative. Citigroup, JPMorgan Chase and Bank of America plan to set up a fund, expected to be worth up to $100 billion, that would buy assets from troubled SIVs. Though no government money will be available, the Treasury played a key role in its creation.

As demand for the asset-backed securities that SIVs buy has evaporated, some have had to sell holdings at fire-sale prices to repay investors. Since SIVs hold paper nominally worth $325 billion, further dumping could have a chilling effect on prices in other credit markets.

The new entity—clumsily labelled the Master-Liquidity Enhancement Conduit, or M-LEC—will essentially be a buyer of last resort, using the proceeds of its own debt issues to purchase assets from troubled SIVs. It will take only highly rated paper. By splitting this off from dodgy subprime assets, the hope is to tempt investors back and avoid an avalanche of forced selling. “Most commercial-paper buyers will touch only top-quality assets. A few are still happy to punt on rough stuff. But no one wants a murky mix of the two, which is what you have in many SIVs now,” says a person close to the fund.

There is a whiff of self-rescue about the enterprise, especially with regard to Citigroup, which is more exposed to the asset-backed commercial-paper market than any other bank (see chart). However, rumours have been circulating that British banks were also keen to see a rescue fund established, as they hold a large share of the SIVs' most toxic tranches.

Nevertheless, it is too early to say whether the scheme will work, or even happen. Much is still to be thrashed out. The banks may struggle to reach agreement on a host of issues, not least the price at which to buy assets. Nor is it clear that other banks, investors or even SIVs will participate. European banks are conspicuously absent, so far, as are investment banks. Commercial-paper investors may find the M-LEC's complexity a turn-off. And it will not be lost on them that the bankers peddling the scheme are the same whose misvaluation of debt securities caused the problems in the first place.

Participating SIVs will have a stake in the enterprise, but taking part may prove expensive. Some 4% of the payment will be not in cash but in junior notes, which will end up worthless if the assets don't perform. The fund will also charge them a fee for taking on their assets. It is structured to keep most of the credit risk in the SIVs it helps. The banks that provide credit lines to it will incur losses only after lower tranches held by the SIVs and outside investors have been wiped out, which seems unlikely even in current conditions.

Joseph Mason, a finance professor at Drexel University, sees bigger problems. He argues that voluntary co-guarantee schemes like this are doomed to failure because only the weakest institutions want to participate. Like Groucho Marx, the SIVs that most easily qualify for membership of the club will be the least likely to want to join, since they will have cheaper funding alternatives. He also worries that the fund's creation suggests “we now have an entire market that's deemed too big to fail.”

Even those who support the fund admit that it is, at best, a temporary solution, buying time so SIVs can find other sources of finance or wind down gracefully. It may also provide breathing space in which to sort out deeper problems facing the market, such as the unstable structure and opacity of SIVs. “The market has to move to a new business model,” says a senior Treasury official.

That means wrenching change, which may explain why stockmarkets fell on the day of the announcement. To some, the Treasury's participation signalled that things were worse than feared. Much of the week's other news seemed to bear this out: Nomura, Japan's largest securities house, said it would take a $620m write-down on mortgage-backed securities; and Citigroup posted a 57% drop in quarterly profits and said parts of the debt market might not recover soon.

The consolation for banks is that they, too, have buyers of last resort. Citic, a Chinese bank, this week said it had considered bidding for a stake in Bear Stearns, a Wall Street firm whose share price has slumped thanks to hefty mortgage exposure, though no deal was imminent. If M-LEC fails to take off, the bottom-fishers will soon have others to nibble at.