Saturday, October 20, 2007

On The M-LEC Master SIV Fund: Part One

Tuesday's Wall Street Journal discussed the evolving, Treasury-backed Master-Liquidity Enhancement Conduit. Several more articles throughout the week developed the theme, with CNBC also covering the evolving efforts of Treasury and some commercial banks to create this entity.

As a result, I've been thinking about this concept all week, too. Weighing what I know from nearly 30 years in the financial services sector, plus its history prior to that. Frankly, it sounds like a bad idea. Anytime that asset prices are artificially propped up or manipulated, it's ultimately, in the long run, a bad thing.

Dress it up any way you like, there are really only two alternatives to the immediate marking down of assets to current selling prices:

-delay the recognition of loss via re-pricing, or no pricing changes, in hopes that 'real' prices will, in time, rise, avoiding the current recognition of loss, or

-provide liquidity to avoid the need to sell the damaged assets, thus allowing them to be falsely marked at a higher price.

The other day, a Wall Street Journal piece noted that the Japanese led their economy into a decade-long depression by encouraging banks to keep bad loans on their books at falsely high prices.The piece, which I believe was in the Breakingviews column, noted that in 1907, J.P Morgan- the financier, not his company- saved the US financial markets by personally buying distressed assets, thus injecting capital into the system.

But he bought those assets at their lowered, market-making prices. Thus clearing the market of damaged assets, maintaining true values for assets, and providing liquidity.

I think doing so here, meaning retaining falsely-high asset values, by any means, is a mistake. It will almost certainly trigger Gresham's Law. That is, good assets won't be exchanged for suspect assets.

So much for the theory, and some history, behind my views. But let's take a little closer look at the actual mechanics involved in Treasury's scheme.

There are an assortment of SIVs- structured investment funds. You can think of these funds as similar to mutual funds, and, particularly, similar to the two Bear Stearns funds which cratered this summer, leading to the ouster of the CEO of that firm.

Basically, a financial services firm, such as Citigroup, which operates a handful of SIVs, solicits investors to contribute to the fund. The investment is levered, and CDOs and other structured financial instruments are bought, the yields on which are anticipated to exceed the interest paid on the commercial paper which the fund issues to complement its equity base.

Now, with the market for commercial paper 'seized up,' these funds can't easily re-fund their assets.

It's important to note that while, say, Citigroup may be the operating manager of the fund, reaping fee income, they do not have any equity nor asset interest. That is to say, although they clearly, and cleverly, imply that their moniker confers a quality image on the fund, they are not, technically, liable for anything except managerial diligence. Much like Bear Stearns' two erstwhile mutual funds, from which the latter firm desperately tried to distance itself, before capitulating to public opinion and making good with bailouts of the funds' investors.

So we have SIVs conceived and managed by Citigroup, and others, such as Gordian Knot, according to Thursday's Wall Street Journal article, scrambling to fund the assets of these SIVs, or face unwinding them.

If they have to unwind them, this means selling complex assets, in order to ratchet down the balance sheets and avoid re-issuance of commercial paper.

Here's where Treasury became concerned. A clutch of SIVs, all invested in CDOs, dumping even the best ones on the market, will cause prices to drop. Then all of the funds will be marking asset values down, causing asset-liability mismatches, equity losses, and further dumping.

Simplistically, Treasury, and some commercial bank CEOs, believe that raising a hundred billion dollars to buy the "higher quality" assets of these SIVs will forestall price declines, by effectively creating a private capital pool to fund the SIVs.

It's as if this special M-LEC, short for Master- Liquidity Enhancement Conduit, will swap, or engage in repo-style funding of the SIV balance sheets, rather buy commercial paper. The M-LEC would issue its own commercial paper, thus becoming a sort of stand-in for the actual CP market place.

In effect, the M-LEC is being touted as a clean, safe, Treasury-sanctioned joint bailout fund which will hopefully be trusted by investors, so that it may issue commercial paper that the untrustworthy SIVs cannot.

Two criticisms which I have read about this solution ring fairly true to me. One is that investors may just step back from the whole mess, realizing that, without an explicit Treasury guarantee, like Freddie Mac or Fannie Mae, this fund is still a risky counter party. Its assets are still the stuff that is mis-priced and suspect for defaults.

The other worry is that this fund will further starve even the better SIVs, becoming the preferred, lesser-risk investment to the actual SIVs.

It's tempting to want to support this M-LEC solution, in order to prevent the presumed demolition of prices of complex CDO-type fixed income assets with which SIV portfolios are chock full.

Let's consider what would happen if the M-LEC did not take off, and the SIVs had to wind down their investments.

Some very specious assets would be sold at fire sale prices. Investors in the SIVs would be substantially wiped out. Some creditors of the SIVs, holding commercial paper, would be stiffed, too.

So far, I don't see how this is different from the fixed-income equivalent of a severe downturn in the equities market. Investors buy assets, misjudge risk, and lose principal.

The banks are allegedly not involved in this. That is, they allegedly do not have to make good on any commercial paper borrowings, or asset price declines. They ostensibly lose fees. And probably never return to this business again, their reputations for doing this sort of thing besmirched for perhaps the next decade. Or as long as it takes one of today's junior traders to rise to be a managing partner of an investment bank some years hence.

True, there's a contraction of capital in the market. But there are no false prices. What's in the market, is correctly priced.

Using the M-LEC solution, there is, as my first condition of falsely pricing assets too high for a time stated, a suspension of reality regarding the prices of complex SIV-held assets. What is to be the condition under which the M-LEC would be unwound?

With a sort of false prop under the real commercial paper market, when would we know that it's safe to dissolve the M-LEC?

Or would it become a sort of permanent, anti-trust-violating super-asset management fund, with preferred commercial paper underwriting status?

I guess what I do not see, yet, is how, when, under what conditions, the M-LEC will terminate. Would that not have to be the condition that SIV assets become, once more, valued nearer par?

What would make that happen, if there's no 'real' market trading in them?

No, I think in the final analysis, the M-LEC is a false solution which will lead US financial markets dangerously close to catching the "Japanese disease" of holding bad assets in portfolio at par value.

Like it or not, the quickest, fairest way to solve the SIV problem is to let them go bankrupt, let their equity investors and creditors pay the price for their decisions, and flush the bad assets down to appropriate, market-clearing prices. Once assets are correctly priced, and capital is lost, then the remaining players, and their capital, can invest with confidence that publicly traded prices for all financial assets are 'real' prices.

Next, I'll have a few words to say on who is supporting the M-LEC thus far, and who is not.

Hint: I just wrote a post here about one supporter. His fellows share some troubling characteristics which I will discuss in the upcoming second post on this M-LEC topic.


Anonymous said...

Who actuall owns the assets in the SIV? The shareholders of the SIV? What kind of capital do they have to be able to issue tens of billion of dollars of CP?

Borrowing short and lending long is one of those strategies that work 95% of the time. The 5% it fails you lose everything and more than you made during the good years.

The whole thing sounds like a version of the S&L.

C Neul said...

The investors in the SIV own the assets.

Think of an SIV as a special-purpose mutual fund that invests in only one type of security, a structured finance instrument. Thus the name, "structured investment vehicle."

They lever the capital up 2-3x. This is typical financial investment vehicle behavior. So for $10B of CP, they'd probably have a base of maybe $3-5B in capital.

Of course, if they own a corresponding initial notional, par value of $15B of CDOs, and those CDOs take a 33$ hit, guess what? The SIV is technically bankrupt.


Yes, you are correct about the long-short mismatch. Interesting, since commercial banks have had the most focused attention to this of any financial firms, due to their tendency to do portfolio lending.

As with all 'models' of financial instrument behavior, it seems ot be that 5% of the time that tanks companies, does it not?

Yes, this is somewhat similar to the technical bankruptcies of the S&Ls, but without the friendly, hometown S&L flavor.