PrefBlog

Controversy continued regarding the US ABCP Super-Conduit mentioned yesterday. Noriel Roubini dislikes the plan, but bases his reasoning on a somewhat dubious assumption:

Indeed, if we assume that many of the assets held by the SIVs are of low quality, the attempt to avoid losses that would be incurred by selling these assets in secondary markets would not be possible.

Sadly, his alternative to what he perceives as regulatory interference in the market is simply more interference; different interference:

The right solution would have been to punish the banks that created these dangerous schemes in the first place by forcing them to take the losses on their illiquid and/or impaired asset; or to bring such asset on balance sheet and take the capital charges or liquidity charges required to do that.  Forcing the banks to sell the asset and take the losses would have helped to create secondary markets for these illiquid assets; thus, while losses would have occurred this would have reliquified a frozen market.

Meanwhile, Naked Capitalism supports my hypothesis that the super-conduit is not so much of a bail-out fund as a vulture fund, although he doesn’t yet know it!

If you want a rescue program, you don’t lard it up with fees beyond what is necessary for costs and risk assumption. In this case, that would mean market fees for any credit enhancement provided by third parties, plus a mechanism for recovery of costs (and we mean real costs) of establishing and running the entity. That means no debt placement fees, since the old SIV owners were capable of doing that for themselves. If the spin is that this vehicle is being established to prevent a possible crisis, then it behooves the organizers to do so on a cost recovery basis. Anything else raises questions about the real motives (including are the fees yet another way to shore up Citigroup?).
…
The MLEC, by cherry picking assets, will make thing worse for the remaining SIVs

How do I see this working? Let’s say we have an SIV with $100 “good” assets, $5 “bad” assets, financed with $100 ABCP and $5 subordinated or equity financing. The asset pool is earning $7 annually, but due to increased spreads in the ABCP market, it’s costing them $8 to finance and operate. So the sponsors have no equity and negative carry; they’d love to get out of the business, but they would only be able to realize $80 if they sold out. That’s too much, so they struggle along.So along comes a friendly super-conduit. “Hi! I’m from the Big Bank, and I’m here to help you!”. Super-Conduit offers $95 for the “good” assets. Accepting the offer will let the sponsors get out of the business gracefully, so they accept. Super-Conduit can finance with a positive carry AND make a fat capital gain on maturity of the assets AND eliminate competitors, so everybody’s happy.

Is this the case? I don’t know; I don’t have access to all the details on the assets. But most of the underlying remains highly rated – it’s only the speculative junior tranches of ABS that are genuinely impaired.

Could it be the case? Most certainly. I’m going to let you in on a little secret here: investment management has nothing to do with managing investments. It’s all about selling. Huge pools of capital are controlled by guys who, frankly, don’t really know what they’re doing. If they do know how to do it, guess what? Their clients have to be kept happy. Look at what happened in August – US T-bills dipping to three percent and change, simply due to a public relations effort on the part of money-market funds desperate to have a higher quality portfolio than the next guy, even if it meant giving away money.

I’m sure there were quite a few portfolio managers and traders executing those purchases while holding their noses; knowing that what they were doing was best defined as “panic”, but either having been given the orders, or having to provide window dressing for the paying customers.

As far as I have been able to make out, the current crisis has everything to do with fear and greed, and nothing to do with analysis. The super-conduit will make boatloads of money for its sponsors and Treasury will achieve its objective of a functioning ABCP market.

As an example of how this might work, and to get a ballpark idea of the numbers, let’s  look at Global DIGIT (DG.UN) again. This is cheating, because DG.UN has sub-prime exposure through derivatives, but let’s look anyway. There are about 9.75-million units outstanding, supporting $1.4-billion in ABCP via the net asset value (NAV). The NAV is most recently estimated as $7.92; the units are trading on the TSX at a little less than $3.00.

So lets say Super-Conduit comes along and says – ‘I’ll bail you out, with enough to pay the unitholders $3.50. Or you can just wait until the ABCP holders bankrupt you. Choose!’

So Super-Conduit makes the loan of $1.4-billion and pays the unitholders $34-million. That’s an immediate profit of $43-million  (about 3% of the loan) AND the $1.4-billion is in a comfortable positive-carry situation. To me, this sounds like good business.

How may such interuptions in the smooth functioning of capital markets be avoided in future? Well, I’ve already given one possibility: increase the capital charge on Global Liquidity Guarantees, preferably on a sliding scale based on bank capital, to decrease the attractiveness of issuance. Other adjustments to this charge could include a charge for the term mis-match between the guarantee’s assets & liabilities … it seems reasonable that if a conduit has 8-year liabilities, a guarantee of financing via 1-2 year FRNs is less risky – given staggered maturities – than a guarantee of financing via 30-day paper. One may also wish to increase the charge when the bank is thinly capitalized to begin with; that is, pay more attention to what will happen if the guarantee is actually triggered. There is news today that:

the Bush administration will review accounting rules for the off-balance sheet units that large U.S. banks set up to invest in assets including mortgage-backed securities.

In somewhat related US brokerage news, there are reports that CITIC will buy a piece of Bear Stearns – which has lost a lot of value due to sub-prime contagion and the blow-up of two of its hedge funds – while Merrill Lynch’s CEO O’Neal is facing criticism due to its quarterly loss, which is in no small part due to its investment in a sub-prime mortgage originator last year. This is happening while Morgan Stanley is bulking up its mortgage servicing unit via a purchase from an originator that is desperately trying to survive. Sub-prime is casting a long shadow!

Good volume in the preferred share market, but no returns as the slide continued.

There were twenty-three other index-included $25.00-equivalent issues trading over 10,000 shares today.

This entry was posted on Tuesday, October 16th, 2007 at 9:42 pm and is filed under Market Action. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.