Tuesday, October 16, 2007

The Super Conduit--New Clothes for Banks?

The largest banks in America—Citigroup, Bank of America and J.P. Morgan Chase—have announced that they are sponsoring an investment vehicle (called the Master Liquidity-Enhancement Conduit), which will supposedly have $75 billion to $100 billion to bail out bank-related structured investment vehicles (SIVs) that hold mortgage-backed securities, by buying some of their assets. The new investment vehicle, which we will call the Super Conduit, is a creature of structured finance, like the conduits and SIVs that we’ve discussed previously in http://blogger.uncleleosden.com/2007/09/conduits-and-sivs-chill-from-shadow.html and http://blogger.uncleleosden.com/2007/08/were-subprime-mortgage-risks-hidden.html.

The conduits and SIVs were set up by major banks as investment funds for riskier assets, such as CDOs, that the banks may have underwritten but didn’t want to hold directly. The conduits and SIVs raised a lot of capital by issuing commercial paper, which was 10% to 50% guaranteed by the banks sponsoring them. Some of these SIVs have been hit upside the noggin by the decline of the real estate markets and the subprime mess. Many of their assets have lost value, sometimes sharply. When they’ve tried to sell assets in the open markets, they have frequently been offered discounted prices by skittish and skeptical buyers. And for some CDOs containing subprime mortgages, the SIVs been offered their choice between nada, zip or zero.

The SIVs face potential big-time losses if they keep liquidating assets. Thus, as the SIVs’ commercial paper falls due, the banks that sponsored the SIVs confront the prospect of having to honor their guarantees. Nothing could be less attractive to the banks, since some of the SIVs’ losses might become the banks’ losses if guarantees have to be fulfilled. Executive bonuses could suffer.

So the Super Conduit has been organized to ride to the rescue. Sponsoring parties, including the U.S. Treasury, which provided cheerleading although no money, have tried to sound like cavalry bugles signaling a charge. But let’s put our ears to the ground and think carefully about what we hear.

First, the Super Conduit has to find backers and investors. The backers would consist of banks that would guarantee the commercial paper the Super Conduit would issue to raise money to buy assets from the distressed SIVs. And investors would have to be found to buy the Super Conduit’s commercial paper. The banks backing the Super Conduit would apparently receive fees for services provided to the Super Conduit. Investors would presumably receive a premium in the interest rate on the commercial paper, especially if the bank guarantees aren’t 100%.

Most major banks on Wall Street reportedly haven’t committed to backing the Super Conduit yet. They may be wondering why they should bail out their competitors. After all, this is Wall Street, and if you want a friend, head for the Humane Society’s chapter in Manhattan. Wall Street logic dictates that when a competitor is in trouble, wait for it to really go downhill and then buy its assets at a massive discount. Participating in a bailout could mean losing an opportunity to buy at a cheaper price. Let's remember that Wall Street was built on the notion of buying low and selling high.

The sponsors of the Super Conduit attempt to address that issue by saying that the Super Conduit will only buy high quality mortgage-backed securities from the distressed SIVs. Moreover, they will charge the SIVs fees and pay discounted prices. This sounds more like banking: when the customer is desperate, smack him with fees and lend him the least you can for the most you can extract. So, maybe the Super Conduit's sponsoring banks apparently aren’t asking other banks join in a bailout. Perhaps they’re asking them to join in a feeding frenzy.

This is where the cross-currents of the Super Conduit proposal churn into a vortex. To induce the other sharks—pardon us—the other banks to participate in the Super Conduit, the sponsoring banks have to make the Super Conduit a good deal for them. But doing so comes at the expense of the distressed SIVs. They’re the entities that will be paying the fees and receiving the discounted prices—and all for the sake of selling their best assets. The SIVs will be left with their less desirable assets, which they won’t be able to sell to the Super Conduit. Having only those less desirable assets will make it even more difficult to pay off their remaining commercial paper. So what’s in it for the SIVs, or the holders of their remaining commercial paper?

Of course, the banks sponsoring the SIVs benefit, at least temporarily. If the SIVs’ maturing commercial paper is paid off with money from the Super Conduit, the SIV sponsors won’t have to honor their guarantees or record the losses that might well come with honoring their guarantees. But with the SIVs further weakened by paying fees to sell their best assets at discount prices, isn’t it all the more likely that the SIVs will collapse and the SIV-sponsoring banks will have to book losses?

With the real estate market still declining and further mortgage distress likely in the next few years as more ARMs reset to higher monthly payments, perhaps many of the CDOs currently held by the SIVs are headed ever closer to the septic tank. This might include some of the “good” assets that the SIVs could sell to the Super Conduit. Why would the banks not sponsoring the Super Conduit choose to join in a guarantee of the Super Conduit's commercial paper when it's supported by potentially declining assets?

The Super Conduit, if it is successfully organized, might buy the SIV-sponsoring banks a little time. Maybe, just maybe, the commercial paper market will regain some confidence and the SIVs will recover the ability to roll over their remaining commercial paper. But what are the chances of that? There’s nothing on the horizon that would signal improvement in the underlying problem, the distress in the real estate markets. So, the Super Conduit could simply turn out to be another bit of Wall Street financial engineering that doesn’t change the fact that we live in a world of risk and losses, and eventually will have to deal with it.

Tech News: there are times when it isn't worth it to send a text message. http://www.wtop.com/?nid=456&sid=1270021.

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