Tuesday, October 16, 2007

How I Learned to Stop Worrying and Love M-LEC

I miss Slim Pickens and Peter Sellers!

There has been a lot of rhetoric being tossed around in the news outlets and in the blogosphere about M-LEC.

Some have called it a "Ponzi Scheme." Others have made similar statements.

SIVs are complex entities. Many on Wall Street have just become familiar with them over the last two months.

The plan is also, necessarily, complicated. Furthermore, there is only an agreement in principal, so the details are sketchy at best.

That said, there are clearly suspicions that have been raised.

After Enron, Worldcom, etc. it is easy to understand the source of these suspicions.

Furthermore, this is tied - however tangentially - to the mortgage mess that we will be cleaning up for the foreseeable future.

All that said, M-LEC is meant for a very specific purpose; and it isn't to resolve all the excesses of the last few years.

Mark Palermo has posted some reasonable questions relating to M-LEC on his blog. Others have similar questions.

I have posted my comments from his blog below:

As per your request: This is not the plan!

You have the outline somewhat correct, but you're getting tied up in the
hyperbole being spread in the blogosphere (I will not attempt to describe the motives of those spreading it) and, surprisingly, in some of the news outlets.

There is a lot that we don't know.

What we do know is that SIVs have been around for nearly 20 years (the first one was established by Citi in 1988). They have functioned, under the radar, without any real problems until now.

Another thing we know is that these off-balance sheet vehicles are off-balance sheet for a reason - they are not owned by the banks. The banks have, as far as we've been told, no obligation to support the SIVs other than agreements that have been written to provide short-term back-stop funding.

The banks are under no legal obligations to take SIV assets on their balance sheets, even if they sponsored them.

The risk the banks face, if they don't deal with this problem, is reputational (both tangible in the form of angry customers, and intangible in terms of future business).

A continuing theme of those who denigrate the idea of M-LEC is that the underlying assets of the SIVs are "bad" and that this is a way to avoid taking a hit.

We DON'T know what assets are in the SIVs. The publicly available information indicates, however, that the holdings are primarily in structured securities.

It just so happens now that structured securities have fallen into disfavor (and that's an understatement). SIVs issue structured commercial paper that is backed by structured securities.

In other words, the opacity of both the SIVs and their underlying assets is reducing demand for these securities.

One thing that needs to be remembered is that there is often a difference between Price and Value.

Since there are no reasonable bids for the underlying assets, forced sales of the SIV's assets could, in the current environment, only be transacted at severely distressed levels. Prices will almost certainly be below, and perhaps significantly below, the values of the assets.

Furthermore, given that many other owners of the same securities must mark their assets to market, there could be a fire sale of assets - regardless of their quality. THAT would be a significant threat to the financial markets.

The idea of M-LEC is to act as a bridge so that the assets can be sold in an orderly fashion (with gains and losses being recognized by the appropriate parties at that point).

The Treasury and the banks are hoping that an entity that will have the explicit backing of the banks (regardless of the value of the underlying securities) will comfort investors enough so that they will continue to purchase the asset-backed
commercial paper of the SIVs (and M-LEC).

I have been discussing this subject at some length on my blog, and you can find links there
for some reports and other material that may give you greater comfort (one posting with a number of supporting documents is here).

This is a complex topic. We're effectively dealing with derivatives of derivatives.

I intend to discuss some of the broader issues in the near future on my blog.

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4 comments:

Palermo's Blog said...

Larry,

Thanks for your post. I know that mine was a bit dramatic, and in fact I have drafted the documents behind a few conduits (although many years ago), so I know they have been around for a long time. You are absolutely correct that they have functioned very well and provided exceptional liquidity to many corners of the financial markets.

Unless things have changed, the sponsoring bank provides two lines of credit, one for the liquidity issues (that we are having now) and one for credit issues (credit quality of the assets - that we may be having now). The lines are often proided by a group of banks, so no single bank takes the entire risk. That said, the banks have a legal obligation to fund a loan to repay a commercial paper lender who wants to get paid if the conduit cannot refinance the paper. This may be a short term loan obligation, but who is going to pay the bank back if the conduit cannot float new paper? That's why the bank may end up with the asset on its balance sheet, because it is the only asset the conduit has.

Regarding value and price, the current value of any investment is the price the market will pay. If the market will only pay 80% of face, then that is the investment's current value. If the assets are fine, they should be sold. If they can't be sold without a substantial discount they are not fine. If the issue is to prevent a flood of these on the market at one time because that would cause their value to decline through supply and demand forces, then what we want is to delay. I believe that is what this structure is meant to do - delay. However, it is obfuscating market forces through behavior that would, in most circumstances, be collusive. How would we feel if this were H-P and Del agreeing to hold back on excess inventory of computers?

Finally, if the explicit backing of the banks is all that this structure is resolving, then why are the banks funding it with cash? I don't see how that works. They already back these things with credit lines, no? If my basic premis that the banks back these up with lines of credit is wrong, please let me know. That would certainly change everything.

Thanks,
Mark Palermo

Lawrence D. Loeb said...

Mark:

I appreciate your comments.

Since I haven't seen the docs, I only know what has been reported by the credit agencies and the newspapers. One would think, however, that if lenders to the SIVs or conduits had unrestricted recourse to the banks, the banks wouldn't have any choice (as it appears that they do have); and the banks would have to set aside reserves for that contingency (and it appears that they haven't).

I would love to hear from somebody with direct access to recent conduit/SIV documents to clarify this issue.

As for value versus price, the intent of the conduit was to hold securities to maturity. These securities are somewhat illiquid normally, and very illiquid today.

"Fair market value" is generally defined as "the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts."

In this case there would be compulsion to sell and it is questionable that anyone knows the relevant facts.

As for the comparison to Dell and HP, I really don't believe that there are anti-trust issues here. The banks and SIVs don't want to sell the assets. It's more like trying to buy a house from an owner who is having trouble paying the mortgage. If a bunch of owners got together and were able to, together, provide timely payment of their mortgages would that be a violation of anti-trust?

Mark said...

No compulsion to sell, they could buy and hold. The problem is they can't buy and hold because they have over-extended themselves, and this is a way to work around that problem. Had these been on balance sheet they would have had to hold reserves for this contingency and this would not be a problem. Many believe this would have also slowed the bubble in real estate. It is the job of banks to manage their exposure, and they failed to do that here. They were able to fail because these obligations have remained obscure.

Regarding your homeowner example (which is, by the way, a good one) I am not sure about that. Would the homeowners be selling their properties to a single jointly owned entity where they put in some additional equity and refi the balance? Is there a third party obligated on a mortgage guaranty? I need to think about that one a little more:-)

Lawrence D. Loeb said...

Mark:

As far as compulsion, SIVs would be forced to sell because of the mismatch of assets and liabilities. Whether the SIV managers were at fault or not, the sale would be compelled by the need to pay off commercial paper.

SIVs were not the main, or only source of the housing bubble. I plan on speaking to the problem in a future post, but there is tremendous need for yield to pay for future liabilities. This created the demand that drove the development of the structured products with higher yields (for the same rating).

The housing bubble, like all bubbles, was a result of a complex combination of capital providers and speculators/borrowers.

As for my analogy, I was proposing a simple entity that the parties would pay into (in varying sums based on when they have the means), that would pay out the even stream required by the mortgages.