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Bailout Shell Games

Super-Conduit or Super-Bailout Shell Game?

Nouriel Roubini | Oct 15, 2007

What should we make of the SIV rescue plan, the so called Master Liquidity Enhancement Conduit (MLEC), also informally referred to as the Super-Conduit? Does it make financial and economic sense? Is it all a smoke and mirrors con game or a serious attempt to deal with the liquidity crunch in the SIV/ABCP market? Is it another case of moral hazard – with the US Treasury playing a critical role – or is Treasury only solving the collective action problem of coordinating the actions of many players? And is this just another musical chairs game or “don’t ask, don’t sell” game – reshuffling SIVs assets and liabilities with nice fees for the participating dealers – with no financial effect on the underlying illiquid assets or a way to defrost such illiquid assets? And how similar is this rescue plan similar or different to that of LTCM? Is this effectively a scheme to bail out Citigroup that is the most SIVs-exposed US bank?  And are the implicit claims of Treasury and the Fed that this is not a bailout where there is no public money at risk credible?

The most generous and benevolent – but faulty - interpretation of this rescue plan would be that it is a way to resolve the collective action problem both on the asset and liability side of the SIVs in a situation where there is a liquidity run as the liabilities of the SIVs (the ABCPs) are being rolled off in a panic. In this interpretation SIVs assets are mostly sound but now illiquid given the “panic”. But since there is a run on the liabilities of SIVs (the roll-off of the ABCP paper) such a roll-off would force banks with SIVs to dump illiquid assets in the market and cause sharp losses that are avoidable. So the rescue plan is another way to resolve the problem of a typical bank run where a run on the liquid liabilities of a bank with illiquid assets leads to severe and avoidable losses. In this sense there are some similarities to the LTCM rescue plan. Then, the collective action problem was the risk was of the roll-off (redemptions) of the claims of LTCM creditors that would have force LTCM to dump illiquid assets and thus cause severe losses to such creditors. In the SIV case there is a double collective action problem: the roll-off of the liabilities of the various SIVs would force the same dumping of illiquid assets as in LTCM. But on top of that there is a second collective action problem: if there is no rescue plan each individual SIV would want to be the first one to sell its assets to get the best price for them. But if each SIVs does that the increased supply of assets would lead to a sharp fall in their market value and lead to losses for all of the SIVs. Thus, you need to resolve a double coordination game: avoid the roll-off of liabilities by inducing SIV creditors to switch exposure to the super-conduit; and avoid the joint dumping of SIV assets by pooling those assets into a new super-conduit or super-SIV that would dispose of those assets only when market liquidity conditions are restored. It is like resolving a systemic bank run on many illiquid but solvent banks by pooling all the illiquid assets in a solvent super-bank whose deposits would be those of the depositors exiting the perceived risky banks.

Can this financial engineering work? If the problem was only one of pure illiquidity and a generalized bank run then that solution may in principle work as you may resolve the double collective action problem. But the reality is different in this case as the assets of the SIVs are not only sound (i.e. AAA or AA) but illiquid assets. Many of these assets are toxic MBS, CDO tranches and other ABS assets of dubious quality; thus, there is a problem of credit or solvency on top of illiquidity. This is the main reason why – unlike LTCM that held mostly illiquid but truly high quality assets – resolving the collective action problem is not enough to resolve the SIV mess. The proposed solution thus looks like a game of musical chairs that may not work. Indeed, if we assume that many of the assets held by the SIVs are of low quality, the attempt to avoid losses that would be incurred by selling these assets in secondary markets would not be possible. It is true that impaired assets of poor quality may also suffer of illiquidity and thus their current market price would be even lower than the low fundamental price given their low credit quality. But putting such assets into a super-conduit would not resolve either the liquidity problem or the solvency/credit problem of these assets. Banks will have to accept that they bought lousy assets whose true value is now well below par – even leaving aside any current discount due to illiquidity – and that these losses cannot be fudged or eliminated by creating a super-SIV.

Also, it is not clear what will be the quality of the assets of the new super-conduit. If, as allegedly argued, the new super-conduit would avoid the toxic waste of subprime MBS and CDOs, the better acquired assets would have to be purchased at current market value: and, since those market value today of even better assets are below par because of credit risk and liquidity premium, if Citi and other banks were to dispose of the SIVs assets into the super-conduit at current market values, they would still suffer the same losses as in the case of selling now in the secondary markets the same illiquid assets; thus, their objective of avoiding such losses would not be achieved. Also, if only better assets were to be sold to the super-conduit, the SIVs would be left with only the bad assets (the toxic subprime MBS, CDOs, etc.) and thus the roll-off of the commercial paper backing those assets would accelerate rather than be reduced. It is like stripping a bank that has a run from its best assets and keeping only the bad assets on its balance sheet; the run would accelerate. So, this scheme of shedding only the best assets of the SIVs cannot work. And if the assets to be shed were the lousy ones, of course no one would want to fund such super-conduit as this conduit would be made out of only toxic waste radioactive assets.

What it seems to be the case is that banks managing the super-conduits want to avoid the losses of dumping the illiquid and impaired assets into the open market and/or taking those assets that are off their balance sheet and putting them now on balance sheet. The former solution would imply recognizing mark-to-market losses; the latter would hurt both the capital ratios of the banks as well as their liquidity. So the super-conduit becomes a shell game that can allow banks to avoid losses – at least for the time being – if the illiquid assets that are sold to the super-conduit are being sold at prices that are above their current market value. But if this shell game were to be attempted the super-conduit plan may fail: why would potential creditors of the super-conduit want to fund it if the assets of this fund are value at values that are much above market values. It is only if the assets are sold at current distressed market value that distressed debt investors would we willing to fund the super-conduit. So the entire scheme seems like one that can work only if banks fully recognized now the losses on their SIV assets – in which case there is no need for this complex plan as assets can be disposed of at low prices today – or if such losses are not allowed to be recognized the scheme cannot work. It looks like banks are really trying to create value via financial engineering where there is not way to create such value via this game of musical chairs.

And the role played by the official sector in this fishy scheme is also suspect. It is true that, on surface, there is no public money at stake here, in the same way in which the “rescue” of LTCM did not involve any public money: then the New York Fed and Treasury only avoided the collective action problem of the rush to the exits of the LTCM creditors by playing a role in this “rescue”. Similarly a benevolent view – leaving aside the fact that Paulson and other senior Treasury officials are coming from Wall Street – of the current rescue plan is that Treasury is only playing such coordination role. Also, the Fed in this case claims to be fully uninvolved into this rescue plan. But things are more complicated than the façade. Notice specifically that the Fed played a major role in this SIV mess by providing regulatory forbearance to Citi and other banks by allowing them to breach the rule on how much they could relend to their broker dealer and SIV affiliates of the funds lent by the Fed during the August and September liquidity crunch. Formally, Fed's decide to waive Section 23A of the Federal Reserve Act (Reg W) and allow Bank of America, Citigroup, and JPMorgan Chase, Wachovia to make large loans to their broker dealer units. As Chris Whalen clearly put it:

Section 23A is one of the most important parts of the Federal Reserve Act. It prohibits "covered transactions" with any one affiliate of a Fed member bank in excess of 10% of the bank's capital and surplus, and up to 20% in aggregate for all bank affiliates. The purpose of the section is to protect the capital of the bank, even if that means allowing non-bank units or the parent holding company to be decapitalized or even fail in a "market resolution."…. The Fed's August 20, 2007 letter to BAC [Bank of America] allows the lead bank to extend up to $25 billion in collateralized loans to affiliates, an amount equal to 30% of the bank's regulatory capital. The "securities financing transaction" will effectively allow the securities affiliate of BAC to "serve only as a conduit" for the bank to lend to "unaffiliated third parties." The letter notes at the bottom of Page 3 that any such loans will be eligible for excemption from the automatic stay in the US Bankruptcy Code, a comforting legal distinction that may have little impact on the increasing rancid economics of financing CDOs.

This is a serious moral hazard problem created by the Fed with its regulatory forbearance. Citi alone accounted for 25% of all SIV assets ($400 billion) given its $100 billion (now down to $80 billion given a partial disposal of assets) in seven SIVs. Such banks played a reckless game of regulatory arbitrage by creating risky off-balance sheet SIVs, loaded with risky assets and funded with the most short term asset backed CP in order to avoid the Basel capital charges for similar on balance sheet assets. The whole point of bank capital regulation is that banks that get the lender of last resort support of the central banks need to have enough capital to avoid the gamble for redemption games of playing at a casino with the money of depositors. But banks first avoided those capital charges by creating the off-balance sheet SIVs with lower capital charges and then, when the roll-off of the liabilities of such SIVs occurred amply relied on the Fed’s lender of last resort lending – and on explicit Fed bending of strict rules on how much the banks could re-lend to their affiliated and SIVs – to avoid the losses that they would have incurred by their reckless creation of illiquid SIVs (as well as accepting for repo operations assets whose true quality is dubious as the Fed has not clearly explained what assets it now accepts in its repo and discount window operations).  This is moral hazard of the first order: avoid capital regulations via off balance sheet dangerous schemes characterized by serious maturity mismatches, high liquidity risk and gambing for redemption by investing in toxic waste securities; and then get free lender of last resort support when the liquidity roll-off occurs.

So the  US banks - sarting with Citi - already obtained – via regulatory forbearance - a significant partial bailout of their SIV mess. So, for the Fed to now pretend that it is not part and parcel of the bailout of U.S. banks in their SIVs operations is totally disingenuous. And since the Fed is in touch with market participants, and since this super-conduit shell game cannot work without the grease of extra liquidity provision by the Fed, the central bank’s claim that it is not involved in this rescue plan is unbelievable. Indeed, in spite of the waving of Section 23A the amounts that banks can relend to their affiliates are still too small to resolve the SIV mess and the illiquidity of their affiliates given the size of these affiliates illiquid assets and liabilities being rolled off.  Thus, more regulatory fudging and effective Fed bailout will be necessary to grease this super-conduit scheme.  

The right solution would have been to punish the banks that created these dangerous schemes in the first place by forcing them to take the losses on their illiquid and/or impaired asset; or to bring such asset on balance sheet and take the capital charges or liquidity charges required to do that.  Forcing the banks to sell the asset and take the losses would have helped to create secondary markets for these illiquid assets; thus, while losses would have occurred this would have reliquified a frozen market. The super-conduit scheme, instead, is a shell game to prevent the losses to be recognized and, as a by product, it will keep the SIVs asset off the market for a long time and thus avoid the losses to be recognized and the secondary market for such assets to be created and made liquid.   But the Fed, instead of letting the market mechanism work, first flooded the banks with liquidity to allow them to have enough liquid assets to deal will roll-off of liabilities and then allowed banks – in an arbitrary regulatory forbearance - to relend such funds to their off-balance sheet affiliates. So the banks avoided the capital charges, avoided the liquidity crunch and got a nice bailout in exchange for their reckless behavior. But since the size of the bailout funds is not sufficient to dispose of all the SIVs liabilities that are being rolled off the current super-conduit scheme can work only if the Fed will provide enough liquidity that banks and creditors can put into this new shell game. Otherwise, as discussed above, the scheme does not add up and does not work. And with lots of SIVs debt coming due in November – for the relatively more thinly capitalized Citigroup but also for other U.S. banks – the urgency of creating this super-conduit becomes clear.

So the argument that there was has been no bailout of the financial system and of reckless lenders and investors is naïve. The Fed was forced to cut the Fed Funds rate by 50bps and effectively providing banks and the financial system with a significant explicit subsidy; it already bent important bank regulations to let banks to try to rescue their dangerous SIVs schemes, thus effectively bailing out banks; it started accepting a wider range of collateral than usually admissible in its open market operations; Countrywide was literally rescued by being allowed to borrow $50 billion from a public home mortgage company; and it will be now effectively forced to provide more liquidity to the financial system – regardless of its official statements to the contrary – to allow this super-conduit scheme to fly.

Even the stock market – that has been recently blasé about the liquidity and credit crunch in financial markets – smelled today a stinking scheme in this super-conduit and moved sharply down in response to the heightened perceived credit risks and a worsening mortgage carnage ahead that Citigroup and other US banks now face. It took the September 18th Fed Funds cut to cheer the stock markets and bail out the financial system in the attempt to bail out the real economy. It would take much more action by the Fed to make this half-baked scheme fly. With the CDO market being now a zombie, the sub-prime mortgage market being effectively dead, the ABCP market being now comatose and even highly rated asset backed securities in the $400 billion of SIV being altogether frozen it will take more than an half-baked $75 billion rescue plan to resolve the current liquidity and credit crunch that will get worse once the roll-off of the SIVs liabilitities surges in the months ahead. How about being honest and starting to accept some of the existing and unavoidable losses on such toxic assets rather than fudging them by trying to put them in another shell scheme? Stock markets have been recently cheered by banks recognizing a whole “$18 billion” of losses when the actual numbers will eventually be –for subprime alone – between $100 billion and $200 billion. This mess was in part caused in the first place by the opacity and lack of transparency in financial markets. So it will take a lot more transparency – rather than half-baked shell games of reshuffling assets and liabilities while charging more fees in the process – to restore investors’ confidence.

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