Credit Markets SIV bailout plan has problems
A Wall Street Journal editorial raises questions about a Treasury Department-backed bailout plan for structured investment vehicles that was announced Monday by Citigroup and other big banks. The plan, the newspaper said, doesn't go far enough to bring transparency to off-balance sheet risks. The editorial calls on Treasury Secretary Henry Paulson to "make sure the banks aren't using him to delay their day of reckoning."
House of Paulson?
October 16, 2007; Page A20
The good news about Monday's announcement that a consortium of big banks is going to try to restore liquidity to the asset-backed commercial paper market with a $100 billion fund is that the effort seems to involve only private capital. The less-good news is that Hank Paulson and the Treasury seem to have gone out of their way to leave their fingerprints on the announced "conduit," going as far as to talk-up their behind-the-scenes role.
At the time of this writing, the conduit-to-be raises more questions than it answers. Banks such as Citibank -- which is heavily involved -- have substantial off-balance-sheet exposure to the asset-backed commercial paper market. And the SEC and regulators are breathing down their necks to write down the assets in their structured investment vehicles. It may be true that, in some cases, good assets are being marked down because investors can't distinguish the good debt from the bad.
But get this: The announced vehicle, dubbed the Master-Liquidity Enhancement Conduit, will only buy highly-rated paper, to ensure investor confidence. The trouble with this theory is that investor confidence has been shaken because people no longer feel they can trust the ratings. This in turn has resulted from the fact that much of the now-dubious debt was rated not on the value of the collateral, but on the strength of the bank (such as Citibank) that issued it.
This is a structural problem with the asset-backed commercial paper market. And while Mr. Paulson has called for greater transparency in part to address the issue, MLEC is not going to fix it by itself. It's even possible MLEC will try to operate in the old, discredited paradigm of assembling and rating these securities.
So we're left to wonder whether Citibank isn't trying, in effect, to pull off the same trick twice. The conduit would issue debt and use the proceeds to buy otherwise illiquid commercial paper. But why would anyone buy the conduit's debt? Because J.P. Morgan, Citibank and Bank of America stand behind it! And, for good measure, Hank Paulson says the consortium is doing the right thing. That's not exactly the same as telling people the new paper is safe, but it's not exactly a federal disclaimer, either.
It's possible this is too cynical a view. Perhaps the MLEC will allow an orderly write- down over the course of the next year or more, softening the blow and bringing investors back into the market. As a concept, it has a certain appeal. And with investment banks bottom-feeding in certain sectors already, there may even be some profit in buying up distressed debt right now. The open question, however, is whether this superconduit will establish realistic prices for the illiquid securities or will serve to mask the real value of misrated assets in order to spread out the pain and buy time for the banks most exposed.
Christopher Whalen of Institutional Risk Analytics describes asset-backed commercial paper as a market that has been "shot in the head" by the recent market turmoil and accompanying write-downs. If he's correct, there are two possibilities: Either the superconduit won't find buyers, or it will do so only because Treasury seems to have endorsed the concept.
Of the two, the former seems preferable. To the extent there are bad loans, the public interest is served by having the market clear. If MLEC has the effect not of clearing the market but of preventing it from clearing by throwing good money after bad, then we risk a banking paralysis of the kind Japan suffered during the 1990s because its banks refused to write down bad assets. The current credit problems are causing enough trouble without letting them hang over the fixed-income market for many more months or years. There's also the risk that the assets on which the paper is based, such as real estate, will fall further in value and jeopardize the banks backing MLEC. That's when banks and investors alike start begging the feds for a bailout.
In the Panic of 1907, J.P. Morgan, the man, eventually restored order to troubled markets by stepping in with his own capital and those of other banks to buy up undervalued assets and shore up institutions that still had value. Today's crisis resembles that era in the way that murky asset-backed securities have come acropper without much capital cushion. If the banks are stepping up to provide that capital, and more transparency, that's a plus.
But the 1907 lesson, still relevant today, is that Morgan relieved the panic by stepping in as a buyer on his own nickel, reassuring the market that there were things worth buying. He also forced write-downs when there was nothing left to save. If Mr. Paulson wants to be a modern J.P. Morgan, he'd better make sure the banks aren't using him to delay their day of reckoning.
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posted by Victor Lloyd Smith @ 1:35 PM
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