Wednesday, October 24, 2007

What if the Super Conduit for SIVs Fails?

The Super Conduit proposed by three major banks and the Treasury Dept. seems to be moving forward. It has reportedly received indications of interest to the tune of $60 billion, mostly from other commercial banks. The Super Conduit is searching for $80 billion to $100 billion of funding, so $60 billion sounds pretty good. But maybe we should be cautious. An indication of interest isn’t a commitment. And a commitment these days is kind of like a wave of the hand on the Street. All kinds of people are trying to walk away from commitments. Private equity guys don’t want to do deals that no longer offer yacht-buying profits. Banks don’t want to fund private equity deals with bonds that offer them, the lenders, little in the way of meaningful rights. Mortgage companies don’t want to buy back stupid mortgage loans they made which, not surprisingly, have now defaulted. So the indications of interest for the Super Conduit might not quite make it to the altar if things start to look kind of hinky.

And there’s much about the Super Conduit that could be hinky. It will supposedly buy “good” mortgage-backed securities from distressed bank-affiliated SIVs, and will make money by charging them fees and paying them discount prices. If it actually operates that way, it will be the largest pawnshop on Wall Street.

But trying to make the Super Conduit profitable seems to involve a square hole-round peg problem. The assets that it would buy consist primarily of mortgage-backed securities, and the value of those puppies depends on the fortunes of the real estate market. No one, not anyone, not even economists on the payroll of real estate trade associations, is predicting anything except further decline in the real estate markets for the next year or two. How can you make a profit from assets that are likely to deteriorate? Only by being a real vulture and paying super-low prices that leave the bank-affiliated SIVs by the roadside, barefoot and pregnant. In that case, though, the Super Conduit wouldn’t serve its primary purpose of bailing out the SIV-bedeviled banks.

So the Super Conduit may end up paying not-such-low prices. And that would increase its risk of losses. What if it ends up being a bust? In order to avoid total breakdown of the credit markets, the participating banks would have to ensure that the investors that buy the Super Conduit's commercial paper would be paid out in full. If the banks did that, though, they'd be looking at taking the losses themselves.

But that’s where we are now. Banks are looking at taking losses, and have proposed the Super Conduit in order to avoid doing so. If the Super Conduit fails, what’s the next step? What is Plan B? Surely, all those really smart people on Wall Street and in the Treasury Department realize that the Super Conduit may sustain losses, and therefore have a contingency plan in their hip pockets ready to go. Otherwise, they wouldn’t have proposed the Super Conduit in the first place. Right?

We’re dealing with a severely weakened administration that has a demonstrable problem with contingency planning. A certain foreign policy adventure whose name shall not be spoken is Exhibit A in this regard. The emergency plan for Katrina is Exhibit B. You get the picture. These people struggle futilely to shift the point of aim away from their own feet.

The Super Conduit is intended to operate for about a year. Maybe the plan is to keep the SIV-bedeviled banks on life support until a Democrat takes office in January 2009. That’s a cute way of saddling the opposition with a nasty mess. But what if a Republican wins the 2008 presidential election? Not the highest-odds bet in London right now, but a nontrivial possibility given the Democrats’ demonstrable history of aiming at their own feet. In that case, the Republicans will have done it again to their feet.

The Treasury Department’s involvement in the Super Conduit implies the potential for a taxpayer-funded bailout if all else fails. The Treasury Department has vehemently denied that any such measure is within contemplation. Let’s hope so. If it happened, we’d be Japan in the 1990’s. After their stock and real estate markets crashed in 1989-90, the Japanese banks, with encouragement from the Japanese government, kept funding bad loans instead of recording the losses they had sustained. Japan lost the opportunity to invest in new industries and technologies. Instead, the Chinese became the new Asian powerhouse. While Japan still has a much larger economy than China, China’s vitality is much larger than Japan’s. It is a foregone conclusion that China will surpass Japan, probably before many of us begin to collect Social Security.

Wall Street has made a bunch of bad investments in real estate and related derivatives. We shouldn’t keep funding doggy investments. The banks should write off their losses and move on. If that means that some banks may be hampered for a while, so be it, even if there is a near term economic slowdown. If the troubled banks develop liquidity problems, funding is available at the Fed discount window. That’s what it’s there for. But let’s not fund the stupid real estate investments they made and then hid from view in SIVs and conduits. You can’t build wealth by throwing good money after bad. If America is to remain competitive with the rising economic powers in Asia and a resurgent EU, we shouldn’t deplete our capital assets by continuing to fund reckless and poorly conceived investments created by fast money financiers.

The losses from the SIVs and conduits are perhaps so great that they’d cripple some banks. If so, sell the banks to new owners. If they’re too big for any one buyer, break them up into constituent parts—retail, investment banking, credit cards, etc. Then sell or spin off the constituent parts. And fire some people with the nicest of the corner offices. If the big banks learn that they aren’t too big to fail, and their high-ranking executives learn the meaning of accountability, they’ll start evaluating and managing their risks responsibly.

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