SIVs Remain In The News

SIVs, a/k/a "structured investment vehicles," continue to make headlines in the business press. With Merrill Lynch, they seem to be dominating this week's headlines and columns.

I wrote four posts about them between the 20th and 26th of October, found here, here, here, and here.

Yesterday's Wall Street Journal featured two prominent pieces on SIVs. One was Holman Jenkins' very clear and forceful editorial portraying the M-LEC SIV rescue fund as a way of simply aiding some inept financial firms, not actually saving our economy or financial system.

In his piece, he writes,

"A bit of bumf came across your desk recently from economist Donald Luskin, who says that though some banks may be in trouble, "other investment banks such as Goldman Sachs have thrived on the recent chaos and have emerged in superior competitive positions, poised to accelerate their profit growth. We're seeing not the impairment of a sector, but rather the realignment of the competitive landscape -- which is usually a healthy thing."

He makes a valid point. If contributing to the superfund were a patriotic and profitable duty to help protect the broader economy, that's one thing. But contributing just to save a few banks from having to own up to their slippery dealings with a few SIVs?"

Jenkins also echoes my own prior comments with this passage,

"The Ugly: Banks are supposed to know better than to borrow short and lend long, which can be profitable as heck until short-term rates skyrocket or short-term lenders disappear altogether. No, banks didn't commit this folly directly. They set up off-balance-sheet SIVs to borrow short and lend long, while shifting some of the proceeds back to the bank sponsors as fat "fees." Citigroup, for one, collected $24 million last year from its biggest SIV, equivalent to about 38% of the profits funneled to outside investors.

But weren't the outside investors supposed to bear any loss? Otherwise the banks were obliged to recognize the SIVs on their own balance sheets with suitable reserves. Yet now you hear murmurs that banks offered informal guarantees and staked their "reputational capital" to lure investor cash into the SIVs. Some say that contributing to the superfund would be contributing to "moral hazard," i.e., encouraging bad behavior."

Exactly. You can't help but believe that commercial banks tried to get the best of both worlds- imply their backing of the SIVs, but carefully avoiding legal, technical ownership of any of the assets, the better to keep them as off-balance sheet entities.

Now that the SIVs are imploding, the banks are weighing the long term risk to their market reputations by letting them fail, versus the immediate hit to their balance sheets by taking responsibility and making good on the about-to-default commercial paper which these leveraged entities issued.

Luskin's comments strongly reinforce my initial comments that only the commercial banks are behind the M-LEC 'solution' to the SIV situation. The investment banks are playing the other side, waiting to profit from judiciously timed investment in distressed financial instruments.

Meanwhile, yesterday's Journal's lead article in the Money & Investing section was entitled, "For Citi, Stakes Get Higher." The graphic accompanying the article details the role the M-LEC would play in buying time and liquidity for the commercial banks caught in the above-mentioned dilemma between long-term reputational and short-term balance sheet risk.

That article states,

"Accounting groups have raised the question of whether Citigroup and other managers of the SIVs should account for the funds, many of which face potential losses, on their own balance sheets.

The funds still owe money to commercial-paper holders. If they can't raise money by selling new commercial paper, they could be forced to unload the securities at fire-sale prices.

If it doesn't work, Citigroup and other SIV managers could find themselves in a bind that could force them to take financial hits.

If the rescue plan failed and buyers continued to stay away from the commercial-paper market, the bank might feel pressure to pony up cash to backstop the SIVs to preserve its reputation with the vehicles' investors, who would otherwise incur the bulk of the losses. But that prospect has raised the issue among accounting professionals about whether the bank shares in potential losses to such an extent that it should consolidate the SIVs onto its own books."

As I stated in my initial piece on this topic,

"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."

Suspending the usual, well-known rules for valuing assets, paying financial claims due the holders of commercial paper, etc., should be enforced. Let the investors who unwisely took excessive risks by trying to earn outsized yields on questionable commercial paper take their lumps.

To suddenly change the rules for these banks and the investors they hoodwinked is to invite more morally hazardous behavior going forward in our financial markets.