Citigroup, Pandit & The $49B SIV Assets

Yesterday's big financial sector news was that Citigroup, newly headed by CEO Vikram Pandit, to reverse course and take $47B of SIV assets onto its balance sheet.



Shortly after Thanksgiving, last month, I wrote this post about these SIV assets. In contrast to my earlier belief that a bank couldn't legally, without exposure to shareholder lawsuits, assume the liabilities and, thus, the assets of its SIVs, I determined, on the basis of the then-new information, that Citigroup effectively owned its SIVs.



Yesterday's move confirms my contention. Due to the bank's agreement, in the SIV formation, to be the buyer of last recourse if the SIVs' notes were unsalable in the market, Citigroup has, indeed, become the owner of much of the debt obligations of its SIVs and, thus, its assets, as well.



This led to more downgrades of Citigroup, both in its debt, and as an equity investment. As the nearby Yahoo-sourced one-year chart of Citigroup's and the S&P500 Index's stock prices reveals, the large bank has really been punished by the equity markets beginning in mid-year.

Several things come to mind as I have read the recent Friday and weekend editions of the Wall Street Journals, both containing prominent pieces related to Citigroup and Pandit.

First, given how badly Citigroup's stock price has collapsed since June, one should expect that sometime in the next two years, Pandit will receive credit for when the inevitable snap-back from this huge drop occurs. It could have been anybody, really. At some point, when bad news stops hitting the bank, some institutional investors will probably buy in at the bottom, and send the stock soaring from its depressed values.

So, no matter who would lead Citi right now, it's almost certain that sometime in the next 18-24 months, some Wall Street Journal article will crow about how great the CEO is at having 'turned Citi around,' despite the fact that it will have only been a reactionary pop in the stock price due to the cessation of bad news.

The matter of the $49B in SIV assets coming onto the Citigroup balance sheet probably will be seen as confirming the precedent set by HSBC recently. For all practical purposes, I suspect the charade of these being arms-lengths creations is over for good. Which may result in some added downgrades for affected commercial and investment banks.

Friday's article concerning Pandit's options at Citigroup went into considerable detail about various breakup options, and their drawbacks. Primarily, the alleged constraints involve regulatory opinions, capital adequacy, and taxes on gains of sales of units.

I'm of two minds about these sort of analyses.

From my own experiences at Chase Manhattan Bank, I know that these can become serious impediments to the sort of strategic maneuvering in which a bank CEO may engage. Allocating losses in retained earnings such that some units would have to take those hits upon dissolution of parts of Citigroup is no theoretical issue. Neither are taxes on gains of units having some original purchase value.

On the latter point, by the way, a spinoff to shareholders would, I believe, be tax-free. Then, the putative CEO of the spun-off unit could simply agree to merge with another entity.

However, to the larger point, I would say that this really puts Citigroup shareholders, both present and prospective, in a major bind. It effectively forces them to choose between a slimmed-down, manageable bank with regulatory challenges on the road there, or the dismal prospect of being constrained to continue operating a discordant collection of businesses in a mediocre manner which, in total, stand almost no chance of ever consistently offering shareholders better returns than those of the S&P500 Index.

To tell shareholders that muddling through with the current stew of businesses is the least bad of various unpleasant options is to invite a gradual bleeding of market value from Citigroup, until it simply becomes too irresistible for someone to acquire, then split up.

Pandit had better hope he's not constrained from any business disposals at Citi, or he's in for a very sobering and unhappy tenure at the helm. I will forecast that the bank, in its current incarnation, won't reach the point, as Goldman has, of becoming a consistently superior total return performer, relative to the market. Without the freedom to simplify Citigroup's cumbersome and ineffective business mix, Pandit's virtually guaranteed to preside over more bitter years for shareholders.

More Evidence On The SIV Reciprocal Con Game: Florida's LGIP

Just over a month ago, I wrote this post on the topic of what I called the SIV "Double Con." That is, the belief by both experienced institutional investors at various endowments and public entities (municipalities and other government or union entities), and their counterparties at SIVs, that each was getting 'something for nothing' from the other in the sale of SIV commercial paper.

I won't bother pasting my example from the linked post. You can just read it in its entirety via the above link.

However, this morning's Wall Street Journal carries two articles concerning Florida's Local Government Investment Pool's crisis arising from its purchase of SIV commercial paper. One of these articles is by the folks at breakingviews.com. Once again, they confirm my earlier contentions.

To wit, they note,

"A much bigger Florida state-run fund with SIV exposure had nearly half its $27 billion of assets pulled out by local governments, school districts and other depositors before its managers froze withdrawals last week and brought in BlackRock to find a way to limit the damage. Around $2 billion of the most problematic paper is being carved out into a separate fund.

At least one head has already rolled in Florida. In Orange County, checks and balances put in place since 1994 may have kept investments at the relatively safe end of the SIV spectrum. Still, you would expect the county's treasury staff to have been particularly skeptical when Wall Street peddled highly rated paper paying interest at rates usually associated with riskier assets. If it looks too good to be true, it probably is."

Note that last sentence, "If it looks too good to be true, it probably is."

By all rights, a lot of heads ought to be rolling at various similar funds which are also experiencing these SIV-related problems.

But not bailouts. These entities obviously didn't exercise sufficient oversight of their own investment committees to assure that prudent investment policies were followed. They must answer to their members or voters, depending upon what type of entities they are. But their losses are their own. Nobody else's tax money should be rescuing these giant investment pools.

More On SIVs: Citigroup's Purchase Its SIVs' Commercial Paper

Earlier this month, I wrote this post regarding SIV ownership. In that piece, I wrote,

"If a commercial bank, such as Citigroup, were to voluntarily offer to take back the commercial paper issued by an SIV which it created and operates, or simply absorb the SIV's balance sheet onto its own balance sheet, thus bringing it 'on balance sheet,' it could well be subject to lawsuits by some of its institutional investors.

By having structured SIVs as separate entities, companies like Citigroup specifically and legally sidestepped ownership of liabilities connected with the SIVs. To now assume those liabilities, which might default if left alone on an SIV's balance sheet, would be effectively assume an obligation with no adequate offsetting benefit."

However, in today's Wall Street Journal, Citi is reported to have purchased $25B of its SIVs' commercial paper over the summer, in addition to $18B that it already held. This comes to a total of $43B of short-term SIV debt that Citigroup now holds to finance a reported $84B of CDOs in the SIVs.

To be honest, I hadn't thought about this particular scenario. It seems to me that by purchasing the debt of its own arms-length SIV, Citigroup is demonstrating, de facto, if not de jure, that it considers itself the ultimate owner of the SIV.

For example, if Citi had let the commercial paper go unsold, it probably would have triggered the default of the SIV, wiping out the equity-like 'senior note holders,' and dumping the CDO assets of the SIV onto the market.

But Citigroup's purchase of SIV debt begs the question,

"At what price did Citigroup buy the paper, and on what valuation assumptions?"

If Citi bought the commercial paper with the assumption that the assets were fully, and correctly, valued on the SIVs' books, then it perhaps overpaid, given the true risk of the vehicle, and its assets.

If Citi had been less involved, and more hard-nosed, might it not have paid less for, and demanded higher returns on the commercial paper? Of course, that would have necessitated a write-down or sale of some of the SIVs' CDOs, in order to preserve equality of assets and liabilities for the structured vehicles.

Granted, Citi has cleverly sidestepped legal actions which could be brought by its own shareholders for taking the SIVs onto its balance sheet, after having claimed them to be separate for so long.

However, as the Journal article details, there is now a debate over whether Citi's purchase of commercial paper from its own SIVs constitutes a "reconsideration event."

The term refers to conditions under which accounting determinations may be reversed, or changed, to reflect subsequent actions that change ownership of assets.

Citigroup claims its original SIV covenants, which obliged it to fund the vehicles by buying commercial paper which was unsalable in financial markets, obviates any reconsideration event.

However, other observers maintain that, as Citigroup's ownership of debt of the SIVs climbs, it effectively does own the vehicles, and, indirectly, the assets.

But, let's step outside the arcane world of interpreting accounting rules, and consider a common sense perspective.

If the SIV had been unable to roll over its commercial paper in the market at large, it could have attempted to sell some of its CDO assets to pay off the existing holders.

What if Citi had simply negotiated to buy said CDOs in a direct transaction? Whatever valuation it placed on the CDOs would be, of course crucial. If the SIV offered the CDOs and attracted no bids, or very low bids, and Citi stepped in with a higher bid, that would obviously constitute a bailout by the bank of the SIV.

It also would have been one way that Citi could effectively begin to bring the CDOs onto its own balance sheet, without technically repossessing the entire SIV.

But look at what we are describing. Whether Citi buys the SIVs' commercial paper, to prevent the SIVs from liquidating their CDO assets and becoming insolvent, or buys the SIVs' CDOs, in order to let the SIVs pay off their creditors and shrink their balance sheets, Citigroup is clearly giving their own SIVs special treatment.

Would they be doing this for, say, the SIV of another bank? Unlikely.

So just by Citigroup's own actions, especially if mandated by the SIVs' agreements that Citi buy any otherwise-unsold commercial paper, the bank pretty clearly behaves as if it owns the SIVs, and/or their assets and liabilities.

If you were to consider buying Citigroup stock, in light of this information, you'd be foolish not to assume Citi effectively owns the SIVs which it manages.

Despite the legal and accounting legerdemain, Citigroup's actions tell you all you need to know about who really owns its SIVs.

Contrary to what I believed in my prior posts, I would say, at least for Citigroup's SIVs, because of the new (to me) information regarding its requirement to supply commercial paper funding to its SIVs, that the bank owns those SIVs.

Henry Kaufman On Large Financial Conglomerate Regulation

Henry Kaufman wrote an editorial in today's Wall Street Journal entitled, "Who's Watching the Big Banks?"

Kaufman writes, in part, in his piece,

"The problem is that the Federal Reserve and Treasury have failed to come forth with solutions that will limit future financial excesses. They've also failed to keep pace with a series of fundamental structural changes that have transformed markets in recent decades. As a result, in an age when "transparency" is the business watchword, financial markets have become increasingly opaque. This in turn has fostered doubts and fears about the underlying strength of markets and their institutions. Compared with a generation or even a decade ago, financial markets today are much more complex, an order of magnitude larger, and filigreed with new and often arcane credit instruments. Risk taking -- driven by the mystique of quantitative risk modeling -- has become more aggressive. And these structural changes, many of which were initiated in the U.S., are rapidly gaining acceptance in other major financial centers around the globe.

This new, highly securitized financial regime can work well only if securities are priced accurately. Stated differently, weaknesses and failures in securities pricing are wreaking havoc in financial markets. Traders and investors are learning the hard way that not all assets are the same when it comes to pricing. There is a sharp difference between marking-to-market U.S. government securities or large high-quality private-sector issues versus lower quality issues for which pricing is done off a model or matrix."

Kaufman covers a lot of ground in just these two paragraphs. His first statement is a contention worth pondering at length,

"The problem is that the Federal Reserve and Treasury have failed to come forth with solutions that will limit future financial excesses."

Is it? Is this actually what we wish these entities to do? Are the Fed and Treasury primarily in place to limit future financial excesses? More on this a little later in this post.

Kaufman's second contention, following the first, is,

"They've also failed to keep pace with a series of fundamental structural changes that have transformed markets in recent decades."

This statement is, I believe, easier with which to agree. And, on the face of it, true, in terms of the two entities, the Fed and Treasury, having the ability to do much about these new forms of credit monetization.

Later in his thoughtful piece, Kaufman proposes,

"What is urgently needed is a new kind of institution that I will provisionally call the Federal Financial Oversight Authority. This regulatory body would oversee only the largest U.S.-based financial institutions -- the giant conglomerates engaged in a broad range of on- and off-balance-sheet activities that I noted above. The new authority would monitor and supervise these huge financial conglomerates -- assessing the adequacy of their capital, the soundness of their trading practices, their vulnerability to conflicts of interest, and other measures of their stability and competitiveness.

I am not proposing comprehensive supervision of most or all financial institutions. Oversight of the 10 to 20 largest financial conglomerates would fill the much-needed regulatory void, given the vast reach of those dominant players. The 15 largest institutions in the U.S., for example, have combined assets of $13 trillion. They dominate many key areas of trading, underwriting, and investment management. Many command an overwhelming position in derivatives and in many of the esoteric financial instruments that have grown so rapidly in the past decade.

This is not to say that other financial institutions should be allowed to do what they please. For them the current official regulatory and supervisory authorities should remain in place. But insuring the safety and soundness of the dominant firms would go a long way toward assuring the smooth functioning of financial markets, even if smaller institutions occasionally failed.

The new Federal Financial Oversight Authority should function under the auspices of the Federal Reserve because its insights into market developments would fill the present-day void in central bank deliberations on monetary policy. To underscore the importance of the new Authority's mission, it should be required to submit annual reports to Congress on the safety and soundness of the financial institutions under its purview. And in light of the increasing globalization of financial institutions, other leading economies throughout the world should consider a similar approach. There, too, relatively few institutions would come under supervision, because financial conglomerates dominate throughout the leading nations of the European Union as well as Canada and Japan as they do in the U.S."

I confess to not being swayed by Henry Kaufman's plea for yet another, albeit, super financial regulatory agency. Underscoring its importance by reporting to Congress means nothing. It only assures us that the appropriate head of said agency would cover his/her ass equally appropriately and carefully, knowing full well that any subsequent burp by the financial markets would immediately be charged to that official and, by extension, directly to the sitting Secretary of the Treasury and the President.

To me, the more interesting and relevant questions are those in my set following the first quotes from Kaufman's article.

Do we indeed want the Fed and Treasury to be the lead in limiting future financial excesses?

This itself presupposes another important question- Can we, in any meaningful capacity which does not infringe on individual rights, limit future financial excesses?

I'm not at all sure that each of us, individually or, collectively as a corporation, does not have the right to engage in financial excess.

I don't think any government agency will ever succeed in limiting or preventing financial excess. The post-Depression fixes of Glass-Steagal and unitary, single-state banking laws only lasted a comparatively brief 70 years. Global trading, differing sovereign regulatory environments, and technology proved too much for them to handle.

Between the invention of Eurobonds in the 1960s, ubiquitous credit cards, Merrill Lynch's CMA account, commercial paper, etc., the financial regulatory framework of the US circa 1933 became totally overwhelmed. Upon that contention, I agree with Kaufman.

But he misses the fundamental lesson of this current reality. Whatever rules, agencies, etc., are devised, intelligent, greedy minds on Wall Street and, in imitative fashion, among commercial bankers, will find ways which exploit the clear, well-defined and, thus, self-limiting language of such regulations.

To me, the more interesting and important point is how our financial market participants have liquified heretofore untradeable risks.

For instance, the creation of 'money' via private issuance of credit instruments, culminating in private equity firms going 'public,' pretty much has ended any hope of Treasury and the Fed rigorously controlling dollar-denominated money creation as it could back in the late 1950s. Nobody seriously thinks about DDA account limitations or credit card regulation anymore.

We've seen 40+ years of vibrant, constant financial innovation in US markets, since those first offshore Eurobonds were issued to avoid a Treasury-mandated holding tax in the early 1960s.

How do we expect anyone inspecting the books and records of various large US financial entities to actually preclude a financial crisis? Until defaults and credit freeze-ups occur, who can say what is good, and what is bad? Further, do we want any governmental bean-counter to blow a whistle and declare the legal actions of any large US financial institution to be wrong and dangerous?

Who among us believes that anyone working for Federal government scale is qualified and motivated to make that decision correctly?

No, I don't think any governmental regulatory initiative, even that proposed by Kaufman in his Journal editorial, can pre-empt painful financial excesses.

The best I think we can hope for is to limit the damage of financial excesses.

Today, this is generally done via careful counterparty trading vetting. Most large entities won't trade with entities which have not gained access to trading systems without the assurance of sufficient liquid assets, or collateral, to settle their obligations. We don't need to 'belt and suspender' this area. We can trust private parties to generally police each other with regard to settlement risk.

It seems that the major new risk we have encountered is the inability of various parties, some of whom are large, diversified US financial institutions, to distinguish between listed, truly liquid financial instruments, and structured financial instruments.

Hmmm. Funny, how that name is so prominent, isn't it?

Structured......financial instrument.

To paraphrase the currently, seemingly endlessly-running New York Times 'Weekender' ad concerning the word 'weekend,'

"the word alone makes me suspicious."

There are liquid markets for a wide variety of financial instruments: small, medium and large-cap equities, corporate bonds, corporate and bank commercial paper, US Treasuries and bonds, listed options and futures, commodities, commodity futures.

All of these tend to be self-explanatory, and require either full payment, or some carefully regulated, collateralized situation to exist in order to trade.

To my knowledge, nobody, i.e., financial institution, has ever stepped forward and pledged to be a 'market maker' of structured financial instruments.

My friend B, a longtime business colleague, sometime business partner, and creator of one of Wall Street's larger mortgage businesses, had an interesting take on this whole question some years ago.

He opined that perhaps the basic business of deposit-taking should be, once again, a la Glass-Steagal, separated from all other activities. To safeguard the basic banking system, he thought that making it into a sort of simple, financial utility, capable of taking consumer deposits, insuring them, and investing in only the safest financial instruments, would go a long way toward quelling many fears of financial excess damaging our basic credit and banking systems.

In today's world, I'd add that such utilities would be forbidden to invest in any structured instruments. That, to qualify for FDIC insurance, they could only invest in instruments that were AAA rated and unstructured. A sleepy business, to be sure. Such deposits, of course, would earn the lowest rates available in the financial markets, because there would be absolutely no possibility of the financial utility to take extra risk with the deposits and make a larger spread.

Anyone wishing more return would, of course, be obliged to take more risk.

But even B's suggestion doesn't really address Kaufman's central question. Or, more properly, the central question which has occurred to me, in light of Kaufman's thought-provoking piece in the Journal today.

Do we actually want to limit financial excess? That is, financial innovation and technological advances? Or do we simply want to limit the damage of financial excesses, gone wrong, to those who knew the risks, and had already been vetted as capable of withstanding the losses thereto?

In the final analysis, I don't believe Kaufman's focus is correct, nor his solution probably effective to actually preclude the next financial excess. It's just the nature of our financial system.

People stand to reap handsome rewards from intelligent, well-managed financial innovations. Structures like private equity, hedge funds, mono-line mortgage banks and credit card companies come to mind. Even the original, residential-finance-only CMOs probably constituted a reasonable advance in housing finance.

But mixed-asset CDOs crossed a threshhold of ability to be easily priced and to assume a continuous market for the instruments. And, to my knowledge, thus far, the only victims are the sophisticated purveyors of these instruments, and their sophisticated institutional investors/buyers.

It may be financial excess, but I still seriously doubt it's either preventable, nor desirable to create significant new regulatory structures to attempt such prevention.

Another Note On SIV Ownership

As I discussed recently in this post, it appears that the money center banks which created the SIVs which hold so much of the questionably-valued CDO assets, do not own those SIVs.

As structured, it appears that some 'senior note holders' stand as equity participants in the vehicles, by virtue of their reaping the gains, net of financing costs and management fees, accruing to the entities.

One thing I neglected to cover in my prior SIV-related posts (found by reading the posts under the 'SIV' label located on the right side of the page) is why commercial banks, or other entities managing an SIV which they created, are unlikely to assume the SIV liabilities, i.e., take back the commercial paper issued to fund the SIVs.

If a commercial bank, such as Citigroup, were to voluntarily offer to take back the commercial paper issued by an SIV which it created and operates, or simply absorb the SIV's balance sheet onto its own balance sheet, thus bringing it 'on balance sheet,' it could well be subject to lawsuits by some of its institutional investors.

By having structured SIVs as separate entities, companies like Citigroup specifically and legally sidestepped ownership of liabilities connected with the SIVs. To now assume those liabilities, which might default if left alone on an SIV's balance sheet, would be effectively assume an obligation with no adequate offsetting benefit.

It's hard to believe a major commercial bank's institutional investors would stand by silently while a company in which they hold substantial positions engages in such foolish use of its capital.

I think that's why the M-LEC structure is being used, with cover from the Treasury's blessing.

Participating in the M-LEC isn't technically taking back and/or owning any of the SIVs' commercial paper. But it is supposed to, under ideal conditions, liquify the SIVs' assets, in order to provide them with cash with which to pay commercial paper holders. By investing in the M-LEC, banks in effect issue commercial paper through this entity, to replace the individual SIV commercial paper, without, per se, owning the latter.

If the M-LEC can somehow manage to not lose money on the same 'borrow short, lend long' basis that the SIVs employed, but, instead, borrow short and lend short, by effectively doing repurchase agreements on the better quality SIV assets, then the commercial banks might be able to mitigate the losses of commercial paper holders of the SIVs which the same commercial banks created and operated.

I think, in retrospect, that the M-LEC structure was originally conceived in part to avoid the legal problems of the relevant banks attempting to take ownership of SIVs which would only saddle them with more liabilities than assets, at this time.

It remains to be seen, however, whether the M-LEC will actually be created, and whether it will avoid some of the challenges predicted for it, and cited in some of my prior posts on the topic.

The Double-Con: Who Really Owns An SIV?

My business partner and I were discussing the legal and accounting questions surrounding SIVs, in the wake of this recent (Friday) post, which itself is the latest in a series concerning SIVs and the prospective, commercial-bank funded M-LEC.

I wrote on Friday, in that post,

"Senior commercial bank executives formed SIVs to access cheap, short-term funding for the purposes of buying long-term CDOs, paying the difference to the 'owners' of the SIV, and pocketing a fee for this service. The central, and only important question, is, did these executives, as legal representatives of their financial institutions, assure the investors, and/or commercial paper purchases, recourse, under some conditions?

Under parole evidence rules of contract law, large dollar agreements and conditions must be reduced to writing. If they aren't, generally, they aren't considered in existence and, thus, enforceable.

So, were any recourse assurances written into the various and sundry legal documents surrounding these SIVs?

You can bet that if they were, the holders of the commercial paper, and or the so-called 'senior note' holders, a/k/a 'owners' of the SIVs, would be putting those instruments back to the issuers, thus exercising the recourse clauses.

They don't appear to be, so we can reasonably infer that the banks, to the extent they winked and nodded, gave implicit recourse assurances."

My partner voiced the opinion, with which I concur, that the fundamental problem affecting credit markets right now is the attitudes and practices of management by senior commercial banks (Citigroup, BofA, Chase) and a retail brokerage (Merrill Lynch) firm, to have systematically ignored the risk of such opaque 'structured financial instruments,' both holding them in portfolio, while now attempting to delay the day of marking to market, having underwritten their originations and sold them to institutional customers far and wide.

In short, CEOs, risk officers and senior managers across many of these institutions behaved as if the omnipresent realities of credit markets and instruments were somehow suspended or abolished in the case of CDOs and the SIVs formed to hold them.

I wrote, in conclusion, in that earlier post,

"It seems to me that they have only two choices. On one hand, simply adhere to the existing rules of valuation, and force greedy investors, who should have known better than to take implicit guarantees from these bankers, to take their losses, as SIVs crater and default on all of their obligations. Suffice to say, it will be a long time before anyone trusts oral assurances from these financial institutions. And that is likely a good thing.

...the solution to unfreezing credit markets is to inject trust and confidence in them by doing something to recognize a value of the assets held in SIVs, and elsewhere, for which there are, in reality, no continuously functioning markets.If you think this means a clutch of senior bankers who dreamt up these instruments and vehicles in the first place should be cashiered, you're probably on the right track."

It seems to me that the question of ownership of the SIVs is crucial in the following sense.

Last week, I used Google to attempt to locate, for free, on the web, some reasonable estimate of the total US equities market value, as listed on the NYSE or NASDAQ. I found a seven year old paper by the University of Pennsylvania's Marshall Blume, valuing the US equity markets at roughly $19Trillion, as implied by this statement,

"Again according to the flow of funds, individuals held directly 7.3 trillion dollars
or 39 percent of the total market value of equities held by US investors."

It's reasonable to assess the current market's valuation at somewhere in the neighborhood of $24Trillion, by adding the S&P500's nearly 28% rise since 2000 to the estimate in Blume's paper.

This morning, I heard Bill Gross, of PIMCO, the giant bond fund house, estimate the size of the sub-prime mortgage volume outstanding at roughly $1Trillion, and forecast an ultimate loss to defaults of some $250B.

Now, in the equity markets, a couple of bad days can result in a 1% loss. This is not at all an atypical occurrence. That is, based upon the prior market size estimate, about $240B.

So, Bill Gross' worst-case loss estimate on sub-prime mortgages, whether securitized or not, is only about a one-two day loss in the US listed equity markets.

See my point yet? It's echoed in this piece, in which I found Gross' loss estimate that reinforced his remarks this morning on CNBC.

Here is a rough, current equity market value of the five largest US commercial banks:

Citigroup $181B
BofA 199
Chase 144
Wells Fargo 107
Wachovia 80

The total market equity cap is roughly $711B. If these banks hypothetically owned all the bad mortgages, and wrote them off, they'd lose more than a quarter of their capital.

Not a good thing for our financial system's stability, is it?

But wait! We know many of these loans were packaged up, or securitized, into CDOs. Many of those are in SIVs, like the seven funds, once worth some $80B, that Citigroup operates. Many others were simply sold to institutional investors the world over.

If the US commercial banks only hold, say one quarter of the bad loans, then writing off $60B in value is no big deal. Heck, Merrill and Citi have already written off, or promised to write off shortly, nearly half that amount.

In the meantime, let's revisit those SIVs and buyers of CDOs. As I noted in the earlier SIV-related post, a lot of those SIV-issued commercial paper were institutional investors. They were being offered unheard-of yields on supposedly-, typically-safe commercial paper.

To illustrate, here's a completely hypothetical conversation that might have occurred (except for the more blunt, honest statements), in abstract, to illustrate my point.

BigCityCommercialBank SIV commercial paper (CP) salesman: Have I got a deal for you, Ms. institutional investor!

OldBlueIvyUniversityEndowment Investment Committee Member: Really? Do tell?

BigCity: Oh, yes. Have you heard about our new SIV? We're issuing high-yielding CP.

OldBlueIvy: High-yielding? Sounds risky! You know, we can only invest in high-grade
securities here at OldBlueIvyEndowment.

BigCity: Yes, I know. But this is a sweet deal. We here at JPCity are operating the SIV. We don't actually own the entity. We have some 'senior note holders' for that. But we, JPCity, wouldn't leave our valued customers holding a bag of worthless paper, you know.

OldBlueIvy: Tell me more about the structure of this 'SIV?'

BigCity: Well, we've raised $5B from the 'owners,' or note holders. Then we're piling on about $95B more in CP. We're going to take that $100B of money, 95% of it short term CP, and buy $100B face-value of high-yielding CDOs with long maturities. It's a lock!

OldBlueIvy: Sounds pretty generous. How do you at JPCity get paid? Why aren't you putting this on your own balance sheet?

BigCity: Well, we're only receiving management fees of 1-2%. Really quite modest, you know, for all of our hard work here. We aren't doing this on-balance sheet because, as you know, for the better part of several decades now, our own credit ratings are often below those of our customers. Thus, we don't really have a balance sheet advantage to give, and it makes no sense for us to hold what the market will risk-price more accurately. Comprende?

OldBlueIvy. Si, I comprende. So OldBlue's endowment won't suffer, because you have locked in a juicy long term spread, to fund your rolling over the CP I'm buying several times a year, right?

BigCity: Yes.

OldBlueIvy: What sort of yield will we get on the CP?

BigCity: Several hundred basis points better than the usual CP you can buy!

OldBlueIvy: Such a deal! Wow. What's the added risk for that extra, unexpected, totally atypical CP yield?

BigCity: Not really much at all. As I said, JPCity won't let our customers down on this deal.

OldBlueIvy: Will you be putting that in writing in the CP agreement? Is this CP being sold with recourse?

BigCity. No, of course we won't. But, as I said, we here at JPCity consider you a valued institutional customer. We'd never leave you with defaulted CP. *Wink* *Nod*

OldBlueIvy: Gee, let me think. You're offering me, as a trusted, experienced OldBlueIvy investment committee member, a chance to buy wildly-underpriced CP, without recourse. So I am evidently getting something- that extra yield- for nothing- because you tell me that, although you won't put it in writing, I effectively have recourse to JPCity on this paper.

OldBlueIvy: I'm in. Put us down for $5B!

BigCity: Great! You won't regret it! You're going to be getting some real juicy financial gravy in the form of this extra CP yield. Of course, the only real risk you run is that JPCity lets the SIV default, with its razor-thin 5% equity financing, and you hold worthless CP. With such high leverage, the SIV can't stand much of a fall in the CDO assets it holds, or the whole thing will crumple like a house of cards on a windy day. Now I can tell my bosses at JPCity that I've closed the last tranche of CP funding on this SIV, at no risk to us! We're getting something- your CP purchase- for nothing- we don't have to write into the CP agreement that you have recourse to put back the paper for some minimal value, or its face value.

Admittedly, this is an exaggerated, hypothetical conversation. But I wish to explicitly highlight the implicit 'deal' being struck between the parties.

The investment committee member of the university thinks she is conning the commercial bank by reaping outsized commercial paper yields. The commercial bank SIV debt salesman thinks he is conning the endowment's investment committee by selling them risky commercial paper without recourse.

I think this is, essentially, the case. The investors in SIV CPs have no recourse. And they knew this when they freely invested in the debt instruments of the SIVs.

So, back to my question. If the institutional investors decided, one day, to buy tens of billions of dollars of SIV commercial paper, or even CDOs directly, and they see a $250B loss in market value the next day, what's the big problem?

They comprise a component of the investing market. The US debt markets, in fact, are far larger than the US equity markets. Why is a loss of $250B in value via debt so much worse for institutional investors than the same loss over one or two days in the equity markets?

So long as the commercial banks do not, in fact, own the SIV losses, and CP defaults, their equity capital isn't at risk. Their debt financing reputations might be, but not their capital, per se.

Seems to me that what we have here is, as my partner observed, a lot of managerial corner-cutting by both bank-related SIV operators, and their institutional investment committee customers.

It's fair to say that a lot of these people should probably be suffering serious career consequences for their part in this $250B double-con game. Both parties thought they were playing on the other's naivete and confidence. Many players on both sides look to get burned.

But in comparison to the size of US equity and capital markets, let alone our multi-trillion dollar annual GDP, it's a drop in the bucket.

The biggest problem continues to be that of financial sector companies stalling on taking what losses are appropriate on these ultimately untradeable structured instruments, and the vehicles created to hold them. Once losses are taken, and clean, believable values are quoted, markets will resume their normal operations.

Back To Basics: SIVs, CDOs, Banks and Valuing Securities

As the financial markets fallout of sub-prime mortgage lending continues to affect both equity and fixed income markets, it may be instructive and useful to return to some basics about these markets, the institutions in them, investors, and rules about valuation.

Back in the 1980s, as a strategist at Chase Manhattan Bank, I had the occasion to be involved in a project regarding increasing our presence in the mortgage origination business. As part of this, I attended a few conferences on CMOs. These were the original, private-labeled securitizations of mortgages by the likes of Salomon Brothers, First Boston and Kidder Peabody. Names like Lew Ranieri, Dexter Senft and Larry Fink (yes, that Larry Fink) predominated the burgeoning sector's conferences.

The conferences were held by these investment banks in order to facilitate the sale of securitization services to S&L executives. After we all listened to long talks by investment bankers about the mechanics of CMOs, the usual forgettable conference lunch was served.

I spoke with an S&L executive at my table regarding the complexity of issuing CMOs. Yes, he said, they sure were complex. That's why he needed the likes of Kidder, Salomon, et.al., to know how to create and price them to sell.

I then asked him if his S&L also bought CMOs.

"Of course," he replied.

"Well, if they are complicated to price for sale, and you need help for that, how do you know at what price to buy them from these same investment bankers," I asked him?

Rather than answer, he turned away to the man on his other side, and engaged him in conversation, instead.

Nothing has really changed in twenty years. Structured finance instruments have always begged the question of valuation and, thus, the ability to presume true 'market' conditions. That is, continuously priced, and a seller always available for every buyer, and vice versa.

Senior commercial bank executives formed SIVs to access cheap, short-term funding for the purposes of buying long-term CDOs, paying the difference to the 'owners' of the SIV, and pocketing a fee for this service. The central, and only important question, is, did these executives, as legal representatives of their financial institutions, assure the investors, and/or commercial paper purchases, recourse, under some conditions?

Under parole evidence rules of contract law, large dollar agreements and conditions must be reduced to writing. If they aren't, generally, they aren't considered in existence and, thus, enforceable.

So, were any recourse assurances written into the various and sundry legal documents surrounding these SIVs?

You can bet that if they were, the holders of the commercial paper, and or the so-called 'senior note' holders, a/k/a 'owners' of the SIVs, would be putting those instruments back to the issuers, thus exercising the recourse clauses.

They don't appear to be, so we can reasonably infer that the banks, to the extent they winked and nodded, gave implicit recourse assurances.

With regard to the SIVs, the question that is troubling credit markets is, essentially,

"Will the SIVs have to sell their structured finance assets to pay off their commercial paper liabilities, what will be the (very low) prices of those assets, and will there be resulting commercial paper defaults?"

It's the uncertainty of the answers to these questions that is 'seizing up' credit markets. Lenders don't lend to counterparties whose financial conditions they do not, for certain, know, without collateral.

Citigroup, BankAmerica and Merrill Lynch have just taken very public, large writedowns summing to roughly $15B over the past month, all attributed, except perhaps BofA's, directly or indirectly, to capital markets activity involving mortgage-related CDOs.

Until holders of suspect CDOs either explain the (presumedly lower) values at which they are marking these instruments, counterparties, including those in traded fixed income markets, will not be showing up to lend money or buy paper.

The banks and related financial entities have only themselves to blame for this 'seizure' of fixed income markets. If they would be forthcoming about valuations, then their true financial condition would be known, risks could be assessed, instruments priced, etc.

Rick Santelli, CNBC's Chicago-based fixed income expert, said it best this morning when he likened the banks' situation to what he would face if he had lost money on assets in a margin account. He'd have to make the margin call, or lose his collateral.

He questioned why banks should be 'different,' and be allowed to delay valuation of CDOs, or be given special license to create the M-LEC to buy more time.

Here's a novel idea. If banks and other entities truly believe that the securities involved should not be marked down as fire sale items, why don't they simply buy the putative owners/losers out of their positions, at face value, and hold the suspect securities themselves?

By doing so, they would literally put their money where their collective mouths are, indicating they believe values will rise in the future, making ownership of the troubled structured finance instruments a benefit, not a loss.

As I observed in this recent post, that's what the legendary financier, J. Pierpont Morgan, did to halt the panic of 1907. Of course, he was the one buying at fire sale prices. In our current situation, this is precisely what banks are trying to avoid- the writedown.

It seems to me that they have only two choices. On one hand, simply adhere to the existing rules of valuation, and force greedy investors, who should have known better than to take implicit guarantees from these bankers, to take their losses, as SIVs crater and default on all of their obligations. Suffice to say, it will be a long time before anyone trusts oral assurances from these financial institutions. And that is likely a good thing.

Or, the banks can make good on the alleged implicit guarantees, take back the commercial paper and senior notes at some artificially high price, and hold the associated assets, absorbing losses into their investment accounts over the next few years.

Either way, the solution to unfreezing credit markets is to inject trust and confidence in them by doing something to recognize a value of the assets held in SIVs, and elsewhere, for which there are, in reality, no continuously functioning markets.

If you think this means a clutch of senior bankers who dreamt up these instruments and vehicles in the first place should be cashiered, you're probably on the right track.

I think that anytime someone 'structures' financial instruments in such a way as to prevent their easy valuation and market maintenance, they better be ready to hold them as if they were a painting, real estate, or some other lumpy, illiquid asset.

Because, in truth, that's what they are.

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.

More on The M-LEC and SIVs

A Wednesday Wall Street Journal article in the Money & Investing section, entitled "SIV Situation: Will Rescuers Arrive in Time?" confirms my understanding and diagnosis of the SIV situation, as I described in a post here recently.

According to the Journal piece,

"SIVs need to find investors for $100 billion in debt coming due in the next six to nine months, even as ratings firms continue to come out with reports that lower the ratings of securities in moves that could further depress the value of SIV holdings."

Thus the targeted $100B size of the M-LEC fund proposed by the Treasury. The article further reports that SIVs have some $350B of assets, mostly in mortgage-backed structured finance paper.

Echoing my post of last week, in which I wrote,

"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,"

The Journal opines,

"Besides tapping the superfund (M-LEC), SIVs are likely to re-structure their debt, wind down, or, in a worst-case scenario, become a dead SIV that can't pay debt investors."

Contrary to my friend's contention, in a conversation I reported here last weekend, that SIVs are levered 3-4:1, the Journal article says that most have only a 5% equity-like investment in 'Capital -notes.' This makes the leverage 19:1.

The Journal pieces continues,

"Capital-notes holders face two options: risk losing money if the SIV sells assets to the banks' fund at a loss, or try to keep the SIV going by buying more of its debt. In recent days, SIVs have been trying to persuade capital-notes holders to buy medium-term notes to fund the SIVs and protect their investments, people familiar with the matter say. Some capital-notes holders -- and SIVs -- say they are skeptical about the banks' plan, because selling assets at today's prices will require the SIV and the notes holders to recognize a loss on those investments.

The lead banks have provided little public guidance on their plans for the fund, leaving themselves open to criticism. Executives working on the fund see it not as a silver bullet but as one of several options open to SIV operators, according to a person familiar with the effort.

The plan would benefit a lead participant, Citigroup, because it is a large operator of SIVs. The SIV industry has become a key part of the U.S. economy, because the funds buy securities backed by mortgage loans to U.S. home buyers. The industry, at its peak earlier this year, totaled about 30 funds with $400 billion in assets.

The three banks have many issues to work out, according to people familiar with the situation. They need to figure out how participating banks would divide any profits or shoulder losses when the rescue fund is wound down, according to people familiar with the plan. They need to decide if participating banks will be ranked based on how much funding they provide, just as banks take lead and supporting roles in stock offerings."

These are some of the issues which I mentioned in my initial piece on this topic last week, providing more reinforcement for my views on this evolving financial services issue.

As a former Chase Manhattan corporate strategist, I can't but help muse about how these events have been triggered by the last decade's evolutions in commercial banking roles. As I wrote here, last month, concerning another article appearing in the Wall Street Journal,

"But a larger issue struck me in this piece. Maybe credit markets went too far in their evolution to total market pricing of credit and debt.

Commercial banks seem, after all, to have a few advantages that were unapparent in a consistently up-market.

Could it be that, rather than a uni-directional march toward market pricing and underwriting, credit markets are, in reality, about to swing between extremes? Moving from all-bank balance sheet valuation and warehousing, to heavily market-priced and securitized, and now back toward the original pole of bank-sourced and distributed credit instruments?

It's not something I've read anyone else hypothesizing. Even I just assumed that banks had pretty much become a mere origination platform for credit.

Now, with this latest credit market debacle, the first since really heavily asset securitization of mortgages and corporate loans have kicked in, we are learning that there are market conditions under which non-banks may not be viable for very long, if they originate and/or hold volatile fixed income assets.

It's an interesting phenomenon. Who would have guessed that there was life in the old commercial bank model, yet?"

The passage in Wednesday's Journal article citing the importance of the SIV sector, "at its peak....about 30 funds....$400 billion in assets," causes me to ponder how the three largest commercial banks- Citigroup, Chase, and BofA- and perhaps a few more, would have managed the mortgage assets on their own balance sheets a decade ago.

Back then, the largest banks built or bought large mortgage origination businesses, feeding into the banks' own large lending portfolios. The rise of securitization, with its liquidity and market-based risk pricing, made it economically feasible and sensible for the commercial banks to cede the portfolio lending business to a market of CMOs and, now, CDOs.

If the commercial banks had remained portfolio lenders, would this current SIV sector have reached $400B in assets? Or would the risk management functions of the banks have slowed as the mortgages began to decline in quality, hitting the sub-prime market? For example, one-time high-flying manufactured housing lender Green Tree Financial was rescued by an Indiana-based insurer, not a commercial bank.

As inept and stodgy as commercial banks can be, including their own prior mortgage lending problems which helped lead to the RTC creation to clean up the last housing finance mess, I think they perhaps exercise a bit more focused risk oversight than a widespread free market in CDOs.

While free financial markets more accurately price risk over time, they are prone, naturally, to excesses, as they swing from birth, to growth, to excessive growth, to default and contraction.

Hopefully, the long term response to this latest housing finance cycle won't be Congressional legislation which hamstrings the market with excessive and clumsy regulation. Given some time, it's likely that the market will provide its own blended solution of a return to portfolio lending by commercial banks, mixed with a modest re-emergence, in time, of securitized residential mortgage paper. And, next time, it's likely that investors will be more wary, and rating agencies will be more sanguine in the development and operation of their loss prediction models.

The M-LEC Silk Purse

As I inquire about, and listen to comments concerning, the M-LEC structure being touted by the Treasury department, I hear similar responses to mine, about which I wrote earlier this week, here.

Last night, while working out at my fitness club, I ran into an old colleague from my days at Chase Manhattan Bank. Bill was a savvy, up and coming IT guy with a lot of business sense. Always well grounded amidst the false sense of grandeur that Chase still espoused in those days, he would frequently lampoon the senior management's "big cigahs and motorcahs.'

These days, Bill heads the American arm of a mid-sized European bank. He hasn't lost his sense of humor, as evinced by this exchange,

Me: Hey Bill, want to buy some structured finance instruments?
Bill: No thanks, I already have a bunch.
Me: Well, how about we each sell each other some troubled structured instruments at falsely-high prices, like Mike Milken used to arrange among his high yield customers at Drexel?
Bill: *Nods his heads and laughs heartily*

Funny, when you think about it, isn't it? What Milken was excoriated for allegedly doing twenty years ago is now being advanced by our Treasury as the way to alleviate the current SIV liquidity dilemma. What is frowned upon as securities market manipulation when done by an investment bank is considered proper when the Federal government sponsors the same behavior.

I don't actually think my friend's bank has much exposure to structured instruments. But when I asked what he thought of the M-LEC concept to save the SIVs, he agreed that it would make real market price discovery very difficult. And make it hard to know when 'normal' market conditions had returned for them, allowing the wind-down of the M-LEC.

Then he chortled, noting that, ironically, Bear Stearns, which triggered the whole mess with its two crippled mortgage-instrument hedge funds this past summer, has actually come out clean in the subsequent act two of this financial drama.

Then, this morning, on CNBC's Squawk Box program, guest host Jack Welch, when asked what he thought about the M-LEC idea, replied, to paraphrase the former GE CEO,

'You can wrap up this pig, but it's still going to be a pig.'

Just so.

He also, tellingly, referred to the 'three banks' which are now identified with the fund. Make that three commercial banks. As I wrote here, recently, it's evident that the investment banks are steering clear of buying into the master SIV concept.

One of the CNBC reporters mentioned that he had spoken recently with Larry Fink, of Blackrock, the now-partially-public private equity firm, concerning the M-LEC. He stated that Fink noted how market bottoms require written-down prices of damaged financial instruments. Without that market-clearing action, the market can't resume its growth.

The reporter went on to opine,

'And that's what this master SIV will do. It will allow these instruments to be marked down.'

But that's not true. The stated intent of the M-LEC is to allow crippled SIVs to exchange high quality instruments for cash, thus functioning as a stand-in to supply commercial-paper sourced liquidity to SIVs which can no longer access that market. Nobody, to my knowledge, nor according to the articles I've read, believes that the worst paper will be sold, at true, open market prices, to the M-LEC.

Reinforcement for My M-LEC & SIV Comments

In this recent post, I discussed the wisdom of the proposed M-LEC fund, to alleviate the difficulties in the commercial paper markets resulting from the much-feared, possibly imminent defaults of various SIV funds.


On Saturday, I happened upon a friend at my fitness club. He manages some fairly sizable institutional funds for a large, diversified financial services firm which resulted from the acquisitions of his old company.

In discussing the M-LEC and SIV situation, he agreed with my assessment of the situation, as well as my questions regarding the difficulty of exiting the M-LEC solution.

To that, he added that nobody knows what is the nominal value of the bad SIV assets. Thus, the time involved to either write down the assets 'safely,' or declare their return to nominal value, is unknowable.

He didn't find fault with my analysis of the need for market-clearing prices. Only that nobody knows how badly equity markets could be damaged, for a time, by the loss of capital in the fixed income markets, as commercial paper is in default and CDO losses are realized.

Which is to say, another seasoned professional, looking at the same situation, sees essentially the same picture. And expresses doubts that anyone really knows how large the problem may be, nor just what will occur if/when we see the true marking-to-market of the complex instruments which triggered this entire situation.

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.