“SIVs now find themselves in the eye of the storm.”
– Citigroup Research Report (subscription required)
“In other words, Citigroup is setting up a fund to buy assets from itself.”
– Mike Shedlock, “Super SIVs – A Fraudulent Attempt At Concealment”, Monday October 15, Mish’s Global Economic Trend Analysis
“They should now put it [the bad investments] back on their balance sheet.”
– John Makin (subscription required), Visiting Scholar, American Enterprise Institute
Okay folks, this isn’t going to be fun reading, but there’s big news on Wall Street today and it’s something you’re gonna want to know about.
Basically, Wall Street banks, headed by Citigroup, are setting up a Master Liquidity Enhancement Conduit (MLEC) in order to take on assets held by off balance sheet Structured Investment Vehicles (SIVs) that the banks would otherwise have to sell or take onto their own balance sheets.
Got it? 🙂
Okay, let’s break it down. Structured Investment Vehicles (SIVs) are investment pools set up by Wall Street banks that they invest in themselves and whose debt they back but which they don’t have to report on their balance sheets because they are not deemed to be the primary investors (outside investors who invest in the SIVs are).
This allows the Wall Street banks to participate in the profits of these investments without revealing the risk to investors and also without increasing the liabilities on their balance sheet which would hinder their ability to lever up. It’s essentially a way to increase leverage without appearing to do so and therefore running amok of regulations.
These Structured Investment Vehicles raise money by selling short term paper which they are able to issue at low interest rates because of the backing of the large banks. They then take the money raised by issuing this short term paper and invest it in longer term, higher yielding securities. It looks like a lot of what they invested in are subprime mortgage backed securities!
The problem these SIVs are running into is that as their short term paper expires, they are having trouble finding new investors to roll the paper over to.
The reason is that investors are wary of the subprime mortgage securities that are backing up the paper. Should these subprime mortgage backed securities tank, the SIVs wouldn’t be able to pay back their short term paper and the investors would be left holding the bag.
If nobody will take on new paper from these SIVs they will be forced to sell their assets, which nobody really wants to buy right now, at distressed prices in order to pay back their lenders. This will lead to huge losses for the SIVs and the banks will probably have to step in to make up the difference between what the SIVs are able to get for their assets and what they owe their lenders and take losses as well.
The other possibility is that the banks themselves take the unwanted assets onto their own books, rather than selling them at fire sale prices. But that would soak up some of their capital and force them to sell other investments and curtail lending which would tighten up credit.
Now those are the two honest options. But, of course, Wall Street doesn’t want to do that because it will look bad and put a crimp in their style.
So the solution they’ve come up with is to set up a big fund themselves, The Master Liquidity Enhancement Conduit (which will itself issue short term asset backed paper, but paper that is supposed to be more secure than that issued by SIVs because it’s backed by a bunch of different huge banks who will guarantee it) and then use the funds raised thereby to buy the unwanted assets from the SIVs!
Essentially, they’re trying to buy the unwanted assets from themselves at “fair value” rather than have to face the music. Then, they hope to be able to wait out the storm until these assets recover at which point they can sell them in the market or whatever.
Citibank appears to be the bank most at risk, with something like $80 billion in assets in SIVs.
And they spearheaded the effort to get the federal government involved. In fact, the big banks have been holding meetings with the Department of the Treasury over the last few weeks trying to put something together.
The Treasury today issued a statement saying it is pleased with the efforts by the private sector to “improve liquidity in the asset backed commerical paper markets” and that this “market based response” will “support more efficient markets” (Treasury Statement).
I guess that’s true if you define efficient markets as hiding losses from public investors by selling unwanted assets to yourself at inflated prices! (Somehow I always thought efficient markets depended on good information. Hmmm….. I’ll have to go back and look at my textbooks).
However, there’s one potentially fatal flaw in the plan: who in the heck is going to buy The Master Liquidity Enhancement Conduit’s paper?
If investors don’t step up, we’re looking at another freezing up of the asset backed commercial paper market that was a big part of the credit crucnh back in August.
Anyways, it’s this story that is driving markets down today with the financials leading the way:
S&P Financials: -2.53%
“U.S. Plays Role In Banks’ Talks On Rescue Fund” (subscription required), Monday October 15, The Wall Street Journal, A1
“Big Banks Push $100 Billion Plan To Avert Crunch” (subscription required), Saturday October 13, The Wall Street Journal, A1
“Plan to Save Banks Depends On Cooperation of Investors” (subscription required), Monday October 15, The Wall Street Journal, C1
“Treasury Statement on Private Sector Announcement Of Liquidity Facility for Asset Backed Commerical Paper”, Monday October 15, The U.S. Treasury
“Conduit Risks Are Hovering Over Citigroup” (subscription required), September 5, The Wall Street Journal, C1
UPDATE (Mon 10/15, 4:30pm): David Gaffen of the WSJ’s MarketBeat blog will heretoforward refer to the Master Liquidity Enhancement Conduit as “The Entity”. I think that suits its ridiculous nature. But then again so does the actual name!
UPDATE (Wed 10/17, 7:45am PST): Also check out David Reilly’s Tuesday WSJ article, “Risks Sparking Bailout Were Still in Shadows By Post-Enron Rules” (subscription required). Reilly reviews the accounting rules that allow banks to keep their conduit and SIV exposure off balance sheet – and therefore hidden from investors:
These SIVs, along with vehicles called conduits, don’t get recorded on banks’ books because regulators and accounting-rule makers gave banks a pass when crafting post-Enron rule changes meant to curtail off-balance-sheet activity.
All the banks had to do was structure the vehicles so that the risk of loss associated with them was ostensibly transferred to other parties. Then the vehicles could stay off a bank’s balance sheet. That allowed banks to make bigger profits without having to tie up capital on their balance sheet. Never mind that the banks created, ran and garnered fees from the vehicles.
But the bailout of some of these vehicles shows that banks, and in turn their shareholders, did shoulder a lot of the risk connected to some of these vehicles and essentially controlled them.
This belies the “whole legal fiction of separateness” as allowed by accounting rules, said Christopher Whalen, managing director of Institutional Risk Analytics, a Los Angeles research and risk-management systems firm.
“This is the Enron disease, we have not killed it,” he added.