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?).
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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.

The Web is alive with commentary on the plan to create a super-SIV, which would hold about $80-billion in non-sub-prime ABS, finance with commercial paper and be guaranteed by the super-major banks – notably Citigroup, which took a beating today on credit concerns.

The Wall Street Journal has used the word “Bailout” in describing this plan; James Hamilton at Econbrowser asks:

The reality is that someone must absorb a huge capital loss. The question we should be asking from the point of view of public policy is, Who should that someone be?

My answer is: the shareholders of Citigroup.

Accrued Interest has taken a more nuanced view:

if the assets are valued correctly, a significant loss will still be realized by the sellers, because even very strong non-resi ABS have widened significantly in recent months. The losses might only be like 1-2% of par, … We’ll see how well the assets are indeed valued. Call me highly skeptical.
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SivieMae will supposedly have a limited life, although I’m skeptical on that as well, perhaps as short as 1-year.
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Here we have some banks, particularly Citigroup, who were using off-balance sheet vehicles to increase their leverage. … Those that choose to stay away from the SIV structures were still dragged down by the liquidity crunch.
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Now squint your eyes a little and what do you see? One bank paying another bank a fee to avoid reporting their complete assets and liabilities on their balance sheet.

I find it rather surprising that this move should arouse so much interest, frankly. $80-billion in financing is a big deal, but not an incredible deal. What interests me much more about the deal is the banks motivations. Liquidity guarantees are charged to the banks’ risk-weighted assets at a 10% CCF. If the banks actually have to implement those guarantees – either directly or through buying the commercial paper – then it gets charged at a 100% CCF.

Naked Capitalism notes:

Citi can provide funding for however many days and weeks until the conduit is functioning, but it seems highly unlikely that this entity will be up and running before Citi starts feeling squeezed.

I have previously speculated as to the adequacy of the 10% number, suggesting that:

perhaps something like … “10% on the first capital-equivalent, 15% on the next, 20%…” might permit the market to operate efficiently while keeping the number of lines under control.

However, Citigroup’s Tier 1 Capital Ratio has declined to 7.4% in 3Q07, from 8.6% in 1Q06. That’s a hell of a drop, and it has occurred even as Shareholders equity increased from $114.4-billion to $127.4-billion. Note that HSBC had a Tier 1 ratio of 9.3% at June 30, 2007, while Bank of America was at 8.64% at year-end and 8.52% at the half. Bank of America, it will be recalled, recently purchased LaSalle Bank as part of the ABN AMRO deal for USD 21-billion. Bank of America has issued a press release stating:

consortium of leading global banks today announced an agreement in principle to create and provide liquidity support to a master conduit to enhance liquidity in the market for asset-backed commercial paper and medium-term notes issued by structured investment vehicles (“SIVs”).
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Bank of America Corp. (NYSE: BAC), Citigroup Inc. (NYSE: C), JPMorgan Chase & Co. (NYSE: JPM) and several other financial institutions have reached an agreement in principle to create a single master liquidity enhancement conduit (“M-LEC”). Once established, M-LEC will agree, for a set period of time, to purchase qualifying highly-rated assets from certain existing SIVs that choose, in their sole discretion, to take advantage of this new source of liquidity. Access to such liquidity is intended to allow participating sellers to meet pending redemptions and facilitate asset-backed commercial paper rollovers.

Now: why?

All the comment so far is to the effect that this is a bail-out of Citigroup. Is it? Is it really?

Citigroup’s Tier 1 ratio is low for a global bank, but it not yet anywhere close to the point where they have to make room for extra Fed Inspectors. Given Citigroup’s exposure to the SIV market of about $100-billion, they clearly have the most to gain from a re-normalization in ABCP … but are they really afraid of financing or are they afraid of spreads?

I’m not going to stick my neck out too far here. I haven’t studied the market in detail, I’m not hearing the gossip. But I will suggest that there’s a reasonable chance that the consortium is pulling a JPMorgan.

We all remember, of course, the Panic of 1907. In the denouement to that crisis, Morgan stuck it to a fellow banker, purchasing a big whack of stock extremely cheaply – and I’m afraid I cannot remember the name of the company off-hand. I don’t think it was the US Steel deal; US Steel had to be bullied into buying whichever it was they bought. This was Morgan’s bank buying common equity in something else, a railroad, perhaps, if memory serves. At any rate, once Morgan had become convinced the world was not going to end, he got down to the serious business of sticking it to the competition.

Update: I am remembering two different versions of the same incident. Geisst claims that “Morgan agreed to rescue Moore & Schley if it would sell him its holdings in Tennessee Coal & Iron at $45-million, considerably less than the market price…. US Steel acquired the stock, Moore & Schley and the Trust Company of America were saved, and the steel trust became larger and more influential than ever. … Almost all were in agreement that the deal found remarkably little resistance given that Morgan made at least a $650 million profit”. The story in Bruner & Carr is more complex, and has US Steel resisting the importunities to take over TC&I. For sources, see The Panic of 1907

So how about this scenario? The ABCP market could really use a helping hand, and this consortium is going to provide it. A decline in spreads will benefit Citigroup. And note, from BofA’s press release:

Once established, M-LEC will agree, for a set period of time, to purchase qualifying highly-rated assets from certain existing SIVs that choose, in their sole discretion, to take advantage of this new source of liquidity. Access to such liquidity is intended to allow participating sellers to meet pending redemptions and facilitate asset-backed commercial paper rollovers.

We know, from the continuing decline in US ABCP that I have been gleefully documenting every Thursday for the past month or so, that there are some US conduits that are on the ropes. And Canadian conduits, of course, are on the mat, but there’s no indication as yet whether these conduits will be eligible to sell assets to the consortium.

I suggest that the following hypothesis at least be considered: the consortium is willing to extend itself to bail out the non-bank conduits. With every expectation of making an obscene profit from the deal.

As support for this idea, I’ll go back to the Naked Capitalism post:

That takes us to the problem of the assets that will go into the MLEC. As the New York Times tells us:

To maintain its credibility with investors from whom it would raising money, the conduit will not buy any bonds that are tied to mortgages made to people with spotty, or subprime, credit histories. Rather, it will buy debt with the highest ratings — AAA and AA — and debt that is backed by other mortgages, credit card receipts and other assets.

Huh? The market is objecting to the crappy assets in the SIVs, not the better quality ones. It would seem more logical to take the lousy assets, issue a guarantee, and seek funding for them, and let the banks keep the good assets in existing SIVs, which ought to be marketable once the dodgy assets are excised. The banks are on the hook for the SIVs, anyhow, since they are having to fund the SIVs via backup credit lines, so any mechanism that enables them to get third party funding advances the ball.

My point exactly. Everybody’s screaming bail-out here, worried about Citigroup’s finances and deeply suspicious of Treasury’s involvement … but the actual structure looks a lot more like a vulture fund than anything else to me – with, perhaps, Citigroup as weak sister, but still a member of the family … especially as it benefits so directly from tighter spreads on ABCP in general.

I’ll look up the details on the 1907 Morgan thing shortly.

Good volume in prefs today; perpetuals continued to slide.

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

Update: I have updated the reference to Morgan in the body of the post.

There’s no commentary today, I’m afraid! What with PrefLetter production, seeing whether the IIF had anything interesting to say, admitting that I cannot time the markets and so on, I’m just running out of time!

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