The self-serving but sensible "bailout"

It is too early to figure this entirely out just yet, but the momentum behind the creation of a new global fund to warehouse all of the icky AAA and AA asset backed securities sounds to be a stroke of genius by Citibank, JP Morgan and Bank of America. In some ways the concept is very similar to the Resolution Trust that served as the workout vehicle after S&L Crisis. With 30 global vehicles holding US$400 billion of investments, you can see why this is getting the attention of the U.S. Treasury.

As the announcement is merely a day old, the stewards of this nifty structure can be forgiven for not having all of the details worked out, other than some simple fundamentals: 1) the Master-Liquidity Enhancement Conduit (“M-LEC”) will buy only the AA and AAA rated assets that are currently having a hard time raising commercial paper; the single-A rated stuff and below (such as the true subprime mortgage market?) will be hived off, 2) the banks will essentially sell all of their currently off balance sheet Structured Investment Vehicles (SIVs) to the M-LEC, and use their own balance sheets to buy the commercial paper issued by the M-LEC to finance these purchases, 3) banks would be charged a yet-undertermined fee for selling their loan vehicles to the M-LEC, and they’ll also have to take a “haircut” in the form of a percentage of the face value of the SIV being vended in, and 4) participating banks will “insure” investors against some portion of future losses within the M-LEC.

Conceptually, the banks are going in the right direction. Although they are not yet dealing with the radioactive parts – the subprime loans – of these SIVs, consolidating the AA and AAA-rated paper into a simgle global vehicle elegantly serves three key purposes:

– disorganized, one-off open market sales of these assets are avoided, which means none of the banks needs to take a material mark-to-market loss on their ownership position of an SIV. If 8 banks each own a AA-rated package of loans, one would expect that each would have the right to vend that package in at the same price as the rest of the participating institutions. There’s going to be a fee and a haircut for using the facility, say 2 or 3%, which means the bank vends the AAA loan package into the M-LEC at 97/98 cents on the dollar…likely higher than what it should currently be valued at. Although as a off-balance sheet vehicle, banks may not have yet written-down the asset on their own balance sheet, given the lack of pricing information over the past 3 months. One would expect AA-rated packages will be charged a higher fee (read: haircut) to be sold into the M-LEC than the AAA class.

– by agreeing to pool US$100 billion of assets, banks are deftly reducing their exposure to individual SIVs, which should diversify their risk and improve the overall value of the collection of assets by virtue of the diversification. If Bank of America owns 100% of a US$5 billion SIV, they’ll likely own 5% of the US$100 billion M-LEC once its operational in December. If the weighted-average credit rating of the assets stays constant, the simple fact that the bank in question doesn’t own all of the specific SIV themselves will take some pressure off their accountants. The safety in numbers theory.

– by agreeing to buy the commercial paper issued by the M-LEC to pay for these loan packages, banks are achieving two things. Given the instability in the credit markets, it would be unlikely that J.P. Morgan would buy the commerical paper issued today by Citibank’s proprietary SIV and vice-versa. Tomorrow, once the two banks vend their own loan packages into the M-LEC, each will buy the paper issued by the M-LEC. Overnight, liquidity crunch is fixed. In political theory it is known as the Prisioner’s Dilemma, and it’s at work right here.

As a first step, it makes sense, even if the banks are repeating the same fundamental mistakes that got the mess started. If the assets in question aren’t worthy of commercial paper yesterday, why will they be worthy tomorrow? The simple fact that the large banks agree to buy the paper issued by the M-LEC doesn’t actually provide any comfort that the assets have been appropriately valued. It is no different than extending a bad loan after the due date. If your institution is the only one that thinks the loan is still worth face value then the question arises in the credit department: should we put an impairment provision against this loan?

By buying SIV-issued paper at prices that have recieved no 3rd party validation other than from participating banks themselves, the banks are breaking the very rules that credit departments have successfully lived by for decades.

This from the NYT:

“The idea that banks are playing the lender of last resort for themselves is on one hand a good sign,” said Joseph Brusuelas, chief United States economist at IdeaGlobal. “The size of the damage is going to be contained within the market. On the other hand, the downside to this is that this is an opaque facility that will make it more difficult to accurately price the true value of the wreckage from the subprime mess.”

Moreover, by not addressing the subprime component of the SIVs, the idea that the M-LEC itself will keep the global credit wheels turning is a fallacy. This proposal addresses just US$100 billion of the US$400 billion of global SIVs. Under this plan, none of the truly distasteful loans (single A-rated and below) will be tackled at this juncture. I can imagine that the M-LEC approach can be repeated (M-LEC 2?) for the junior-rated paper if enough banks buy into the concept, as Deutsche Bank and others seem ready to do. Consider this phase one.

It is curious, too, that many of the global banks that manage large SIVs are not at the forefront of these negotiations; so far, it appears to be the U.S. Money Centre banks taking the lead. According to the WSJ (as at July 13, 2007, taken from Standard & Poor’s and Citibank data), HSBC manages a US$35 billion SIV called Cullinan Finance; Dresdner has the US$29 billion K2; Bank of Montreal manages/advises on “Links Finance”, a US$22 billion SIV and Rabobank has the US$14 billion “Tango Finance” SIV.

(Is it just me or do the conduit names harken back to the inventiveness of the Enron off balance sheet vehicle, called “Raptor”? Makes one pause and ask, was “Links Finance” hatched on a Scottish golf course? Tango on a European dance floor?)

Credit is due to the teams at Citibank and B of A. In the space of a few weeks they’ve demonstrated that they have the brain power, political saavy and energy to bail out Countrywide, save Northern Rock, and lead the world’s institutions to a safe SIV harbour.

Obviously, these three large U.S. banks felt they needed to begin to solve the SIV problem. I agree, even if they need to drink their own bathwater. Local banks, such as BMO and CIBC (with their own proprietary SIV rumoured to be ~$2 billion in size) will have to look closely at the M-LEC idea. For CIBC, the chance to vend in 100% of a $2 billion SIV (unless it truly is made up solely of derivatives, and not actual loans) into the M-LEC and take back 2% of the entire pool will be inviting indeed. For BMO, I was completely unaware of their US$22 billion SIV role (rated in June 1999) until the Wall Street Journal’s piece this morning: my friends at the local DTM got some of the skinny from BMO Public affairs in this story, here.

For investors, all we can do is sit back and ride it all out. If the true subprime writedowns are pushed out a couple of quarters as M-LEC 2 and 3 are rolled out, so be it. With each of these banks earnings billions of profit per quarter, in the absence of a U.S. recession, bank book values will be in about the same shape a year from now as they are today. Advocates of “transparency” will have cause to complain about what has transpired – and what continues under the M-LEC plan – but shareholders will have been protected. And if you are an “the ends justify the means” type of person, you’ll sleep well.

If not, you’ve at least got to admit that George Bush’s one stroke of brilliance during his Presidency was to ask Henry Paulson to take on the top job at Treasury. Having a Wall Street guy in Washington right now certainly helps.

As for the bailout being “self-serving”, the PR line the lead banks are using is precious: it’s not about our balance sheets and avoinding brutal writedowns, its about keeping the credit markets ticking along and avoiding a recession — the very recession threat that the Fed’s 50 point rate cut was supposed to cure in one fell swoop.

Reminds me of late President Nixon’s line when he wouldn’t hand over his Watergate documents citing Presidential Priviledge, and I’m paraphrasing: “it’s not about this situation, but about future Presidents”. No one bought that line, either.

MRM