Tuesday, October 23, 2007

The Single Mother of All Liquidity Enhancement Conduits

What’s behind the Single Master Liquidity Enhancement Conduit (M-LEC) aka 'Superfund' proposed by Citigroup, JPMorgan Chase and Bank of America, with the active verbal encouragement of the US Treasury?
Exploding amounts of opaque financial instruments held by growing numbers of opaque financial institutions made a significant contribution to the perfect storm that resulted in widespread disruption of wholesale financial markets throughout the OECD (with the exception of Japan). Interbank lending dried up, and interbank spreads over official policy rates rose sharply; many collateralised debt obligations (CDO) markets, collateralised loan obligations (CLO) markets and asset-backed commercial paper (ABCP) markets closed down completely.

Prominent among the opaque financial instruments are a wide range of complex structured finance products based on the securitisation, bundling, tranching, enhancement and recombination of securitised illiquid assets and cash flows like mortgages, car loans and credit card receivables. Leading examples of opaque financial institutions are the Structured Investment Vehicles (SIVs) and Conduits (SIVs closely associated with a particular bank) whose assets M-LEC is supposed to purchase. All these SIVs, Conduits and similar constructions are off-balance-sheet vehicles created mainly by commercial banks (some by investment banks), mainly to avoid regulatory burdens, including capital adequacy requirements, reporting requirements, governance requirements and other restrictions on the asset and liability sides of banks' balance sheets.

This raises the obvious question as to whether the proposed sale by a number of opaque off-balance sheet vehicles of between $75 bn and $200 bn of illiquid opaque asset-backed securities (ABS) to a single huge opaque off-balance sheet vehicle, M-LEC, funded by the three above-mentioned American banks (and any other institution willing to join) represents a move towards better functioning ABS and ABCP markets and towards fair-value or fundamental-value pricing of these securities? It is possible, but not likely.

Clearly, if SIVs and Conduits have to unload large quantities of illiquid opaque financial instruments on an unwilling market because these SIVs and Conduits can no longer refinance their short-maturity liabilities in the defunct ABCP markets, the ‘fire sale’ prices realised by such distress sales would indeed be distressing to the sellers. These same prices would, however, be exhilarating to the buyers - the vulture funds and other deep pockets/smart money investors that are always on the look-out for just such opportunities. Since these SIVs and Conduits have no significance for systemic stability, their losses (which are mirrored by profits earned by their counterparties) are of no policy relevance, and even their bankruptcy (which would inevitably involve some net real resource cost) would be a second-order issue.

The ‘fire-sale’ prices that might be realised if these SIVs and Conduits had to dump their illiquid assets on a reluctant market would also impact adversely on holders of similar illiquid assets, even if these assets were not offered for sale at the same time. ‘Fair value’ accounting may require marking to market of these assets using the distressed valuations achieved in the sales by SIVs and Conduits. Any institution holding such assets, including banks, could take a serious hit on their balance sheets as a result.

An obvious alternative to a fire-sale of illiquid structured finance instruments by the SIVs and Conduits to the market would be for commercial banks either to purchase the instruments directly from these off-balance-sheet vehicles, that is to take the securities ‘on balance sheet’, or to purchase the SIVs and Conduits themselves, that is, to take the off-balance-sheet vehicles ‘on balance sheet’. The argument against that, from the perspective of the banks, is the same as the argument for creating the off-balance-sheet vehicles in the first place: it would use up capital and impose commercial banking standards of reporting, transparency and governance on the securities/former off-balance-sheet vehicles.

If Citigroup, JPMorgan Chase and Bank of America are exposed to such vulnerable SIVs and Conduits, whether as shareholders, as creditors or providers of (as yet) undrawn lines of credit, for reputational reasons or simply because they would not like to have to value their own holdings of opaque structured finance vehicles at bargain-basement prices, it is their right to try and limit the damage to their bottom line through any set of actions that does not violate laws or regulations. It is possible that by trying to make a market in illiquid securities (especially if a wide cross-section of US and international banks were to participate in the venture) they would restore liquidity to a currently illiquid set of markets and do some social good as well.

Even if we grant this argument, is this the best that could be achieved from the perspective of the efficient functioning of the financial system? Hardly. If, as I believe to be the case, the proliferation of regulation-avoiding off-balance-sheet vehicles is a major contributor to our current problems, scant progress is made by the creation of M-LEC - yet another gigantic off-balance-sheet vehicle. If banks are going to bid for the complex and poorly understood securities held by non-transparent SIVs and Conduits, they should do so directly, taking the illiquid securities or the off-balance-sheet vehicles themselves onto their own balance sheets, rather than through this off-balance-sheet vehicle to end all off-balance-sheet vehicles. With a bit of luck, the sponsoring banks will in any case have to consolidate their shares in M-LEC with their own accounts, but this issue is still unresolved.

In view of the widespread lack of enthusiasm among the rest of the US and international banking community for signing up for M-LEC, however, it seems more likely that the institutions that proposed this Mother of All Liquidity Enhancement Conduits are the institutions most exposed, directly or indirectly, to the opaque SIVs and Conduits holding large portfolios of the most opaque and illiquid structured financial instruments targeted by M-LEC, and to the likely fallout from any forced, rushed liquidation of these portfolios. The deafening silence of the Fed about the merits of M-LEC reinforces this impression.


Anonymous said...

"These same prices would, however, be exhilarating to the buyers - the vulture funds and other deep pockets/smart money investors that are always on the look-out for just such opportunities."

Precisely why the superfund is in every sense a price fixing cartel. While Paulsen et al may argue that there is no taxpayer money being sacrificed, the loss is being socialized through monopoly rents to Citibank and deadweight loss beyond that.

Anonymous said...

I'd love to see a FT editor going to work on that article... :-)

Anonymous said...

Given that we are where we are, and looking at the SIV's being either taken onto banks' balance sheets or liquidated, the M-LEC does mitigate the situation a bit by allowing the better quality part of this business to continue off balance sheet. It will be important however, that the assets are transferred into M-LEC at realistic prices, and that these prices are not used to favourably value the crud that remains and has to be funded by the banks.

If Bloomberg is to be believed, the Fed do approve of M-LEC: