Saturday, October 13, 2007

WSJ Reports Plan to Normalize Market Liquidity

The Wall Street Journal is reporting, in its October 13th edition (for subscribers), that a number of large banks are discussing a plan to create a "superconduit," tentatively named "Master-Liquidity Enhancement Conduit" (or M-LEC). This pool would be capitalized at $100 billion and funded by the issuance of short-term debt that would be backed by the big banks themselves. M-LEC would purchase assets from Structured Investment Vehicles (SIVs) that are affiliated with the participating banks.

There are a number of hurdles to implementing this plan. They include how the assets purchased by M-LEC would be priced and the reluctance of some banks to participate in, what some banks apparently consider, an effort to bail out Citigroup (it is called a "Citigroup plan" in the article).

According to Moody's (also has a good overview of SIVs), SIVs had $400 billion in assets at August 28th (of which Citigroup is the largest sponsor). According to Bloomberg's article (cited below) Moody's believes that a more current number is $320 billion.

According to the above-referenced Moody's report, SIV assets are, in general, composed as follows:

  • 43% Debt from Financial Institutions

  • 23% of Residential Mortgage Backed Securities (RMBS) - all geographies (Sub-Prime RMBS consist of 2% of total assets, included in the 23)

  • 11% of Collateralized Debt Obligations (CDOs) - including 1% of RMBS CDOs

  • 23% are primarily other asset backed securities

  • This article, by Paul Davies of the Financial Times, gives a good explanation of how the SIVs have been unable to fund themselves.

    Bank sponsors need to resolve the funding problems of their SIVs because, while the SIVs have no recourse to the banks' assets, the sponsor of a failed SIV would likely damage both their relationships with some of their large clients and their reputation.

    One underlying problem is that these SIVs were structured to fund long term assets with short term funds (reminds me of Continental Illinois, which relied on short-term CDs to fund their balance sheet). Given that the markets are now particularly risk-averse towards structured investments, the SIVs have had difficulty placing the asset-backed commercial paper that they typically use to fund their balance sheet.

    The inability to roll over their ABCP means that the SIVs are faced with a need to liquidate the structured assets in their portfolios to meet their obligations. These assets, of course, have the same liquidity issues that the ABCP has, and would result in a cascade of losses if they were liquidated (other SIVs holding similar securities would have to recognize the deterioration in value and liquidate their securities, and so on).

    Another, related, underlying problem is the opaque nature of the SIVs and their assets, which is largely the reason for the lack of liquidity.

    By creating a conduit to purchase assets from the SIVs, or otherwise relieving the pressure on the SIVs, a much larger liquidity squeeze may be averted.

    The bank sponsors have, apparently, been hoarding reserves in case they needed to take the assets on to their own balance sheets. This reserve hoarding (see Reserves versus Required Reserves, which has improved significantly from August 15th) has put strains on the capital markets. By reducing the potential of the SIV problems having an effect on their balance sheets, banks should be able to end the liquidity squeeze by loaning against their reserves.

    When considered in comparison to the size of the overall market for private and government sponsored mortgage securities of $6.9 trillion and overall mortgages outstanding of $14.0 trillion, $100 billion is relatively small. If there isn't a significant shock in the mortgage market, however, then M-LEC may work. Given the upcoming resets, this may be optimistic. In my opinion, however, it is a good step.

    According The Wall Street Journal, the Financial Services Authority (the UK's markets regulator) has suggested that UK banks consider participating in the plan. Increased participation could increase the odds of success.

    Here are some other articles on M-LEC from the FT, Bloomberg, and Reuters.

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