Tuesday, October 30, 2007

Will Price Fixing Be Part of the Bank-SIV Bailout?

On Monday, Oct. 29, 2007, Allan Sloan, a Fortune magazine columnist, reported that the proposed bailout vehicle for SIV-bedeviled banks--which we call the Super Conduit--would "pool not only money but analytical information as well." Here's a link. http://money.cnn.com/2007/10/26/magazines/fortune/citishelter.fortune/index.htm?postversion=2007102914.

The mortgage-backed securities and derivatives that are held by the SIVs, and which would be bought by the Super Conduit, are creatures of mathematical models. Their structures and supposed values have been derived from mathematical modeling. "Analytical information" would be central to placing valuations on these things.

The pooling of pricing information is a feature of price fixing schemes. Airlines reservations systems and stock markets (which consolidate quotes from a number of dealers) are examples of potential venues for collusion. Indeed, the Antitrust Division of the Justice Department and the SEC have found collusive behavior in certain such venues.

The collection of analytical information by the Super Conduit could provide an opportunity for the banks participating in the Super Conduit to compare notes and reach agreement on prices. Such an amiable way of doing business would probably be, for those banks, a welcome change from the free market low-ball/no-ball bidding of independent third parties that might have been asked for quotes in recent months. Assemble at 3:00 p.m. and swap analytical information, establish prices at 4:00 p.m., and be at the gentleman's club by 5:00 p.m. for cocktails. No need to get their French cuffs soiled by short, nasty and brutish experiences in competitive markets.

Think of the benefits of such a process. Prices can be set high enough to soften the losses of SIV-burdened banks. The same high prices can be used as reference points for accounting valuations--what a relief to be able to use a monopolistic price instead of a competitive price. Vulture funds and other third party bidders offering bona fide free market prices can be smugly shooed away, or at least told to go around back to the kitchen door of the gentleman's club, where they might be sold a few table scraps that no one else wants. The Super Conduit doesn't need to trade with anyone except the banks that it's meant to bail out. So there can be a nice, closed derivatives market for banks only. Non-banks need not apply, thank you.

The banks sponsoring the Super Conduit might well try to use the involvement of the Treasury Department as protection from antitrust liability, under a legal doctrine called Noerr-Pennington. Whether or not that approach truly works is unclear, since Noerr-Pennington traditionally applies to the notion of members of an industry petitioning the government to act. In this case, the Treasury Department isn't taking any real action. It's just offering encouragement and moral suasion. It has no significant jurisdiction over the banks' mortgage and derivatives problems, and couldn't act in a formal way. So its presence may have no prophylactic legal effect.

So what if the Super Conduit rigs prices? Who loses?

For one, the investors in the Super Conduit will eventually lose out if it overpays for its assets. Mortgage-backed and other asset-backed securities are nothing more than streams of income that pay out whatever they pay out, and overpaying for them doesn't increase that stream of income. These investors will primarily consist of the purchasers of commercial paper issued by the Super Conduit. The commercial paper will probably be guaranteed by banks participating in the Super Conduit (otherwise, no one in their right minds would buy the stuff). So if there are losses, then those losses may well eventually rebound back at the guaranteeing banks. The Super Conduit may be nothing more than a vehicle for deferring recognition of losses. That's unlikely to foster safety and soundness in the banking system. A banking system won't be healthy if it's got a bunch of losses hanging like the Sword of Damocles over its head. Take a look at Japan in the 1990's, if you want an example.

On a larger scale, the biggest loser will be the U.S. financial markets. The subprime mess and credit crunch are a serious blot on the reputation of the derivatives markets. The path to redemption and recovery lie in standardizing derivatives products (to make pricing easier) and making the market more transparent--publicly displayed quotes and trade reporting would probably do much to rebuild investor confidence. Concocting a vehicle that could be used as a smoke-filled room to swap pricing information and come up with unusually high prices available only to Wall Street insiders would only confirm suspicions that model-based derivatives have little value to Main Street and are mostly used to benefit the big players on Wall Street.

Animal News: is Bigfoot in PA? http://www.wjactv.com/slideshow/news/14447006/detail.html.

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