PrefBlog

 The box-score for today is:

• Fear: 1 Treasuries way up
• Greed: 0 Equities way down
• Analysis: What?

In more interesting news, the media has reported somebody saying something intelligent about regulation:

“If you intervene in the system, the vultures stay away,” [Former Fed Chairman Greenspan] said. “The vultures sometimes are very useful.”

“When it breaks, it’s very abrupt and you just have to wait it out,” he added.

This was in an interview with Emerging Markets, which was in turn linked by the WSJ.

More rules will not stop market booms, busts or outright fraud. They can – sometimes – mitigate and contain the effects; I have previously suggested that rules for the capital treatment of liquidity guarantees be reviewed with an eye to ensuring the banking system, as a whole, can withstand bigger shocks than this piddly little liquidity crisis. But there are far too many people around who rush to revise the rule book every time something bad happens. Life sucks. Get used to it.

Specifically, Greenspan was opining on Super-Conduit:

But Greenspan argued that that a delicate market psychology could be speared by the move. “It could conceivably make [conditions affecting investor psychology] somewhat adverse because if you believe some form of artificial non-market force is propping up the market you don’t believe the market price has exhausted itself.

“What creates strong markets is a belief in the investment community that everybody has been scared out of the market, pressed prices too low and they’re wildly attractive bargaining prices there,” he said.

“If you intervene in the system, the vultures stay away,” he said. “The vultures sometimes are very useful.”

Well, I’ve speculated that Super-Conduit is the vulture; and that the aim of the exercise is to wipe out the junior note-holders of the shakier SIVs to leave only the strong still standing. This got a little support in an unsubstantiated, anonymous comment on Accrued Interest:

From Total Securitization:

“Citigroup Won’t Use Super SIV To Save Its Own

Citigroup officials, reacting to claims that the master liquidity enhancement conduit it is creating with JPMorgan and Bank of America will be used to specifically rescue Citi’s more than $80 billion SIV exposure, is expected to announce that it will not utilize the fund at all.”

Well, it ties in with my thought on Super-Conduit; but I don’t have a subscription to Total Securitization, so I’ll have to wait for those remarks to be reported elsewhere.

Cheyne and Rhinebridge officially defaulted on their commercial paper today:

Rhinebridge has $791 million of commercial paper and a portfolio with a face value of $1.1 billion, S&P said. The market value of the assets is now 63 percent of face value, having fallen $69 million since Oct. 16 alone, S&P said. Revaluations of CDOs of asset-backed securities have caused a “dramatic” fall in value, the rating company said.
…
Cheyne Finance’s managers said its assets are worth 93 percent of face value, enough to pay back all of its $6.6 billion of senior debt, S&P said. CDOs of asset-backed securities make up 6 percent of Cheyne Finance’s holdings.

The SIVs aren’t the only outfits being affected by the market revulsion to all things sub-prime – after announcing mark-to-market write-downs of $1.3-billion, Wachovia has discussed its earnings:

“Next line addresses other structured products [Total of $438MM]. Here we have the marks on warehouse positions and trading inventory, both of which we hold in trading portfolios. This includes the positioning Ken referred to in reference to sub prime mortgage exposure and AAA rated securities. $308 million is associated with sub prime securities [Their slides say $347 of the mark was related to subprime of which $308 was AAA subprime]. Basically there, we never would have expected that you see AAA securities trade so far so quickly from par.”

The same comments thread on Accrued Interest yielded the following revealing exchange:

Anonymous: IF my money market funds invest in this SIV I will sell them and buy one that doesn’t. Plain and simple.

Accrued Interest: A **TON** of investors have moved into government money market funds to ensure they don’t own any ABCP over the last 2 months. I think that’s the right move. Money Market funds aren’t a place to take any risk at all as far as I’m concerned.

In other – No Analysis Necessary. As soon as the dreaded words of power are spoken – SELL! It is no wonder that, as I mentioned yesterday:

asset-backed commercial paper backstopped by real assets and a full bank credit backstop yielding more than unsecured commercial paper issued by the same bank—in other words, the real assets as collateral viewed by market participants as a negative rather than a positive,

To how many people does this make sense? Stick yer hands up!

I’ve said before that the danger of the credit crunch has not passed – that we’ve got a long way to go before we’re out of the woods (and, I hasten to add, I am not suggesting that market timing is the investor’s answer; analysis and diversification is the investor’s answer). Some of the specific risks to markets over the next six(?) months are outlined at the WSJ

This may be a little off-topic; but I want to point out that the benefits of diversification are everywhere:

The Utah scientists are trying to sell farmers on the idea that more bee diversity is needed, which was a hard sell because farmers had to pay more for wild bees. Now that honeybee prices are rising, farmers are more willing to try other species, James says.

Getting back to Canada and economic news for a moment, the Canadian CPI numbers were released today, and:

It was the highest year-over-year increase in the all-items index since May 2006, and the sharpest acceleration since February of this year.

Gasoline prices were the primary cause of an increase in the 12-month variation of the Consumer Price Index (CPI) in most provinces.

The year-over-year increase in gasoline prices (+12.7%) owed more to a sudden drop in last year’s prices than to any significant developments in the most recent month. Indeed, on a month-to-month basis, gasoline prices barely budged, rising a mere 0.8% from August to September 2007.

 

Of particular interest is:

On a year-over-year basis, consumer prices increased at a faster pace than the national average in only four provinces in September: New Brunswick (+2.9%), Manitoba (+2.8%), Saskatchewan (+3.8%) and Alberta (+4.6%).

In other words, inflation (such as it is) remains fairly well localized to the petro-provinces (with the exception of poor old Brunny). This suggests – to me – that there is nothing much in this report that would lead anybody to expect a rate-hike in the near future. Mind you, there are many who believe that the level was sufficiently high that we shouldn’t expect any lowering, either:

The Canadian dollar jumped 0.98 of a cent to 103.68 cents US – a level last seen in mid-1976 – after going as high as 103.71 cents US on expectations the higher CPI reading means the Bank of Canada won’t be lowering interest rates any time soon. The bank stood pat on interest rates Tuesday.

All this talk of inflation inevitably leads to the Fed. James Hamilton of Econbrowser attended a St. Louis Fed conference and reports that a hot topic of conversation was whether the Fed should operate according to a few simple and mechanical rules. Well, I haven’t read the papers yet, but my gut reaction is: “Sort of”. There should be enough mechanical rules so that Fed action is reasonably predictable; but none so binding as prevent reaction to special cases. Of course, there’s always going to be a lot of pressure to declare a special case so, as Poole said in his concluding remarks, central bankers need to be people of unquestionable integrity.

Mainly, though, I liked the graph:

Actual path of fed funds rate (black line), path predicted by a Taylor Rule that uses actual values of inflation and GDP (blue line), and path predicted by a Taylor Rule that uses forecasts of inflation and GDP (red line). Source: Orphanides and Wieland (2007).

Look carefully! Do you see the bit that has Greenspan blamed for the housing bubble? He was relying on forecasts, wasn’t he?

Another day of heavy volume for preferreds – and, er, yields were up! Yes, hold that thought firmly in your minds … yields, and therefore expectations of future returns, were up!

This is starting to get somewhat annoying. According to Canadian Bond Indices, long corporates are up 1.64% on the month, but prefs are getting killed … CPD is down a little over 1.5% month-to-date, perpetualDiscounts are down about 2.8%. Yield on long corporates is around 5.9% … about the same as it was on October 10, when I looked at spreads on One Bull Checks In. Since then, the perpetualDiscount yield has increased from 5.42% to 5.49%, and return for this index has been -1.28% (this doesn’t work out nicely with the Modified Duration in the range of 14.7 because of rounding errors and the obscuring effects of averages and outliers).

I think retail is mistaking preferreds for common again! And with things like CM.PR.D yielding 5.81% at the bid (interest equivalent of 8.13%) … well, they can mistake preferreds for common all they like, I guess!

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

ABCP is in the news nowadays – and the Fed reports that outstandings are down another $11-billion over the week, as the unwinding / delevering continues. The total outstanding is now down about 21% from the July month-end figure.

The WSJ has published an article blaming the mess on London bankers, a piece of revisionism to which Naked Capitalism takes violent exception. Naked Capitalism has also reviewed the failure of Cheyne discussed here yesterday; the S&P Pre-sale report for Cheyne, dated May, 2005, has, perhaps, been accidentally left on the Web. Brad Setser applauds Naked Capitalism and points out that, for all the talk of globalization, a lot of US money is simply making a round-trip via London/Offshore right back to the US.

I can present some more support for my conception of Super-Conduit as Vulture Fund:

AAA-rated mortgage-backed securities selling at 85 or 90 cents on the dollar

asset-backed commercial paper backstopped by real assets and a full bank credit backstop yielding more than unsecured commercial paper issued by the same bank—in other words, the real assets as collateral viewed by market participants as a negative rather than a positive,

3-month LIBOR (the interbank deposit rate in London for dollars) as high as 100 basis points above the fed funds rate target—certainly possible if the monetary authorities were in the process of tightening monetary policy aggressively, but nearly inconceivable given the widely held expectation that the central bank would likely be cutting interest rates,

Treasury bill rates rising and falling 100 basis points in a single day, and

nearly a failed Treasury bill auction—total bids were barely sufficient to cover the amount the Treasury was offering. This near-miss occurred despite the fact that money market mutual fund investors were fleeing to rather than away from Treasury securities.

And, reported in the context of a $1.2-billion whoopsee by Rhinebridge Plc:

SIVs worldwide have been forced to sell about $75 billion of assets in the past two months to repay maturing debt as investors balked at buying securities linked to money-losing subprime mortgages.
…
As of late August, 79 percent of Rhinebridge’s holdings were in the U.S. and 80 percent in mortgage-backed bonds, Fitch Ratings estimated in an Aug. 22 report. Eighty-three percent of the assets had the highest-possible AAA rating, Fitch said.

Even Warren Buffett has opined on Super-Conduit!

Buffett said he was skeptical about the U.S. Treasury’s plan to create an $80 billion fund to buy distressed assets from structured investment vehicles linked to home lending.

“I don’t see any way that pooling a bunch of mortgages, changing the ownership, is going to change the viability of the mortgage instrument itself — whether people can make the payments,” he said. “It would be better to have them on the balance sheets so everyone would know what’s going on”

I hesitate to question the wildly popular Oracle of Omaha publicly, but I don’t see Super-Conduit as being merely a vehicle to change ownership – I see it as a matter of wiping out the old equity-holders and injecting new equity while keeping the note-holders happy and senior.

However, the Super-Conduit plan seems to be having trouble attracting supporters; this may be an indication that the potential players see it more as Citibank bail-out than as a vulture fund; or it may simply indicate that potential players would rather be vultures all by themselves. Without disclosure of every nuance of the negotiations, it’s hard to guess! 

Nouriel Roubini writes a very gloomy assessment of the chances for a major 1987-style stock market collapse and concludes:

To avoid such a meltdown, we need many reforms: better regulation and supervision of mortgages and of financial institutions, including the lightly or unregulated hedge funds; more transparency on who is holding which risky assets; better risk management by investors; avoidance of a bailout of reckless lenders and investors; a more competitive market for ratings as the small set of only three rating agencies seriously misread very complex and risky instruments; and hopefully a modest and soft—rather than hard—landing for the U.S. economy.

In other words: it would be a really wonderful world if only there were more rules in it! I won’t reiterate my past arguments against Regulation Nirvana; I’ll just say again that regulators should ensure there is a solid banking system at the core of financial operations, then let the rest of us play with it as we will. And strengthen the concept of fiduciary responsibility, so that those who recklessly violate Prudent Man rules end up wearing the losses.

Default Risk has published a paper on Equity Implied Ratings:

Fitch’s Equity Implied Ratings and Probability of Default (EIR) model is estimated to provide a view of a firm’s credit condition given its current equity price and available financial information.

This is an enhancement that I have been longing to bring into HIMIPref™ … perhaps someday!

There aren’t many bank runs nowadays and some credible analysis of the Northern Rock run is getting done. Two major conclusions: Northern Rock was overleveraged and UK Deposit Insurance is inferior. Deposit insurance in the UK covers:

100% of the first £2,000 (about $4,100) and 90% of the next £33,000 (about $ 67,500)

Various forms of deposit insurance were reviewed by BIS in 1998; I am somewhat surprised to learn that deposit insurance is something of a novelty in Europe:

While most commentators see some merit in the idea of deposit insurance, there is more disagreement as to whether deposit protection schemes should be explicit or not. Most commentators seem to accept the former position. One part of the argument is that, in the middle of a crisis, olicymakers will be forced to offer explicit protection to everyone. Thus, the costs to taxpayers may be very high. In contrast, Demirgüç-Kunt and Detragiache (2000) seem to argue that poor design can make the explicit protection route even more costly. This design issue is returned to below. Explicit deposit insurance schemes are certainly much more widespread than they used to be. The first nationwide system was introduced in 1934 in the United States, but other countries only began to follow in the postwar period. This trend accelerated in OECD countries in the 1980s, culminating with the introduction of limited deposit insurance in the European Union in 1994.

The argument against deposit insurance is moral hazard:

Erlend Nier and Ursel Baumann find, in a cross-country study, that enhanced disclosure by banks seems to induce banks to limit their risk of default by keeping higher capital buffers for given asset risk. Their results also suggest that market discipline is stronger for banks that are funded by uninsured liabilities and weaker for those that benefit from wide deposit protection schemes or other safety nets. The latter may therefore be introducing a degree of moral hazard.

I don’t buy it. The average retail investor is doing well if he can balance his chequebook – how can he be expected to analyze the soundness of a bank during a crisis? He’s going to know nothing and know he knows nothing; he will therefore withdraw his deposits and contribute to a run.

The North American system of providing full deposit insurance on amounts up to $100,000 per institution per person is a good solution; but as I have previously mentioned, the CDIC doesn’t have enough cash in the till to be credible during a genuine crisis. They should have at least enough to recapitalize their largest member completely and the Royal Bank has capital of about $26-billion. And further, not a single dime of the CDIC’s reserve fund should be invested in Canada!

Menzie Chinn of Econbrowser continues to worry about the prospects for the national debt:

… following her assault on the implausible economic assumptions of the Bush administration:

But real change in American fiscal policy will not happen until they become very close to hitting the wall. And, for all the dollar drama, they’re a long way from that point. It will be interesting to see if record lows against the Euro become an issue in the 2008 elections. Oil at USD 90 ain’t going to help the economy much!

Remember the Moody’s mass downgrade of October 11? In a fascinating development, Global DIGIT (last mentioned October 16, with a full post regarding its suspension of dividends) has announced:

As at October 3, 2007, the reference portfolios of Global DIGIT contained 8 of the securities downgraded by Moody’s.

The total exposure to downgraded instruments is $463-million – out of a total portfolio of $1.4-billion. Whoopsee!

Very good volume in the preferred share market today, but the perpetual indices resumed their descent.

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

Update: Typographical error on RY.PR.G yield corrected. Revised number is approximate.

US Inflation numbers were announced today and seem relatively benign – while the headline number ticked up for the month and trailing year, the core rate remained steady at 2.1% for the year. Housing starts continued to decline to the horror of many so it would appear that, whatever else we have to worry about, a superheated US economy is not the greatest concern! As the Bank of Canada said yesterday when announcing that the bank rate would be unchanged:

the outlook for the U.S. economy has weakened because of greater-than-expected slowing in the housing sector. The Bank has revised down its projection for U.S. growth to 1.9 per cent in 2007 and 2.1 per cent in 2008. U.S. growth is expected to pick up to 3 per cent in 2009.

What’s going to happen in the US? Brad Setser is worried:

The August TIC Data was really bad.  Even Fox Business News would have trouble putting a happy face on it.

The net outflow in August – from a combination of foreign investors reducing their claims on the US and Americans adding to their claims on the world – was around $160b.   Most of that — $140b – came from the private sector, but the official sector also reduced its claims on the US.  The total monthly outflow works out to a bit more than 1% of US GDP.   Annualized, that is a 12% of GDP outflow.    To put a 12% of GDP outflow in context, it is roughly the magnitude of the private outflow from Argentina in 2001, at the peak of its crisis.

Meanwhile, there is on sub-prime securitization:

Many of the mortgages underpinning this housing expansion were resold. They were securitized – meaning a loan would become a tradable asset – and packaged – meaning many loans were put together to form a single asset. The resulting bundles, called credit derivatives, were then sold worldwide, most of them with high AAA ratings because the large number of loans that they included meant a very small risk on any single one of them.

As PrefBlog’s readers will know, that’s not how it works. The number of loans is basically irrelevant – you want to have enough diversification that you’re eliminating asystemic risk and reflecting the asset class’ systemic risk, but after that you’re simply increassing the size of the pool. The AAA ratings are only available through subordination.

The number of loans is basically irrelevant – you want to have enough diversification that you’re eliminating asystemic risk and reflecting the asset class’ systemic risk, but after that you’re simply increassing the size of the pool. The AAA ratings are only available through subordination.Ordinarily, of course, I’d make a snarky comment about the writer … but Angel Ubide is the Director of Global Economics at Tudor Investment Corporation. Well, I won’t be putting any money into that firm until I see some clarification!

A much more informed review is available on Econbrowser, where James Hamilton has put together some fascinating graphs and asks the question:

So here’s my question– why did the “most sophisticated” investors apparently become less and less sophisticated as time went on?

It depends on how you define “sophisticated”, doesn’t it? I suggest that

• if one performs a regression between trailing long term performance and assets under management, you’ll find little correlation
• regress trailing short term performance and AUM, high correlation
• AUM and future performance, little correlation
• trailing change in AUM and future performance, high negative correlation

The investment business is NOT, generally speaking, about returns.

The MLEC (or “Super-Conduit”) that was discussed yesterday and Monday got some public disclosure of its rationale today:

Cheyne Finance Plc, the structured investment vehicle managed by hedge fund Cheyne Capital Management Ltd., will stop paying its debts, a receiver from Deloitte & Touche LLP said.

Deloitte is negotiating a refinancing of the SIV or a sale of its assets, according to an e-mailed statement today. Cheyne Finance’s debt with different maturities will now be pooled together, rather than shorter term debt being repaid sooner, Neville Kahn, a receiver from Deloitte said today in a telephone interview.

“It doesn’t mean we have to go out and fire-sell any assets, quite the opposite in fact,” Kahn said. “The paper that falls due today or tomorrow won’t be paid as it falls due.”

I discussed Cheyne on August 28. Meanwhile the debate regarding the advisability of the Super-Conduit / MLEC / Whatever continued to rage. Naked Capitalism heaped scorn on the idea; but it seems to me that his initial opposition to the scheme is what’s driving his arguments:

the biggest one being pricing of the assets to be sold to the MLEC, since the interests of current SIV owners and prospective funding sources seem hopelessly in conflict

Well, sort of. Conflict is what makes a market, after all – buyers and sellers are always in conflict. My suggestion is that the conflict will be resolved by the prospective funding sources riding roughshod over the current SIV owners/investors, who will be forced to take a hit; I suggest that current SIV owners will be forced to pay off their ABCP holders and leave their junior tranche holders with nothing … or not much, anyway.

They (the current SIV sponsors and junior debt-holders) are between a rock and a hard place. I suspect that many of them are in a negative carry situation – this may be the reason why the Cheyne receiver has suspended redemptions – and if ABCP investors move to the new conduit, this will only get worse, if they’re able to finance at all. They will then be forced to give up all their equity in the SIV just to get out, by selling to the Super Conduit at the lowest possible prices – as suggested by the Financial Times:

Thus, if the M-LEC is to produce a genuine solution to the current financial woes, it is imperative that it buy assets at genuine, clearing prices – not artificial prices created by banks. If not, investors will retain nagging fears that prices have further to fall.

And, to repeat myself, it is my suggestion that the Super Conduit has been conceived as a vulture fund – that will seek to profit from the utter helplessness of the current SIVs. Another way of looking at it, perhaps, is as a cram-down: the senior note (ABCP) holders will get back their full amount (which might include Super-Conduits junior notes instead of cash); the junior note-holders will get Super-Conduits junior notes (if anything). I suggest that the current SIV junior noteholders will be forced to go along with the idea, because the ABCP holders always have the option of walking away as their notes mature … the current SIV junior noteholders are going to get what we in the investment management business refer to as “screwed”. And serve ’em right.

See my example with respect to the DG.UN holders (who are the junior noteholders of that particular SIV) yesterday.

Accrued Interest also discussed this issue today, but opined that operating as a vulture fund necessarily meant accepting second-rate assets. I’m not sure that’s the case … I suggest that Super Conduit aims to purchase first-class assets at second-class prices, using the power of (projected) lower funding costs and better liquidity guarantees.

I will be fascinated to see how this unfolds. There is no doubt that sub-prime is resulting in a big heap of losses; but it is my contention that market values have grossly over-compensated for these losses. Readers with good memories will remember the IMF Report which I have discussed previously:

Spreads have since widened across the capital structure, especially on lower-rated ABS and ABS CDO tranches, but also on AAA-rated senior tranches (Figure 1.9). Implied losses based on these spreads total roughly $200 billion, exceeding the high end of estimated realized losses by roughly $30 billion—an indication that market uncertainty and liquidity concerns may have pushed down prices further than warranted by fundamentals (Box 1.1). While many structured credit products were bought under the assumption that they would be held to maturity, those market participants who mark their securities to market have been (and will continue to be) forced to recognize much higher losses than those who do not mark their portfolios to market. So far, actual cash fl ow losses have been relatively small, suggesting that many highly rated structured credit products may have limited losses if held to maturity.

I’ll suggest that the discrepency between mark-to-market and hold-to-maturity values is even bigger today.

Meanwhile, back to sub-prime for a moment, Treasuries were up a lot today, helped by S&P’s mass downgrade of 2007-vintage RMBS:

Standard & Poor’s Ratings Services today lowered its ratings on 1,713 classes of U.S. RMBS backed by first-lien subprime mortgage loans, first-lien Alternative-A (Alt-A) mortgage loans, and closed-end second-lien mortgage loans issued from Jan. 1, 2007, through June 30, 2007. These classes are from 136 subprime transactions, 128 Alt-A transactions, and 19 closed-end second-lien transactions. The downgraded classes represent approximately $23.35 billion of original par amount, which is 6.28% of the $371.9 billion original par amount of these three types of U.S. RMBS rated by Standard & Poor’s between Jan. 1, 2007, and June 30, 2007, and 4.71% of the approximately $495 billion original par amount of all U.S. RMBS rated during this period.

In addition, we placed the ratings on 646 other classes from 109 transactions backed by U.S. RMBS first-lien subprime mortgage loans and U.S. RMBS first-lien Alt-A mortgage loans issued during the same period on CreditWatch with negative implications. We expect to resolve the CreditWatch placements within the next few weeks, and anticipate that the results of that review will be similar to the rating actions announced herein.

Finally, we affirmed the ratings on securities representing $245.1 billion original par value of U.S. RMBS backed by these three types of mortgage loans issued during the same period.

There’s a lot more detail in the S&P press release – read it all!

In preferred news, the PerpetualDiscount index actually rose today, making just the second trading day since September 19 that it has been in the black. It was aided in part by BAM.PR.M (which has been inaccurately “Distressed Preferred”) now bid at 20.45 to yield 5.87% while the virtually identical BAM.PR.N closed at 19.50 bid to yield 6.16%. Sometimes I despair of this market, I really do … especially since the fund swapped into the Ns when the spread was at a huge $0.35! *sigh* Oh well, sanity will return sooner or later. It always does.

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

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.