Fear and Greed Blog

This item, from FT's Alphaville, reports on changes that are in the works at the Financial Accounting Standards Board ("FASB", the entity that sets the standards in the US for Generally Accepted Accounting Principles - or "GAAP") that may well kill the off-balance sheet entities that have been blamed for much of the credit crises of the last eight months.

While creative minds at the leading investment banks and accounting and law firms may resurrect Special Purpose Entities, their use as off-balance sheet mechanisms seems doomed.

Of course, accounting rules change over time, and these discussions may not yield any results, but we probably won't be hearing about new SIVs and (off-balance sheet) SPEs for some time.

Death by accountancy for the SIV could mean more asset creep

It’s hard to get excited when there’s so many acronyms flying around. But the bottom line is that the FASB last week tentatively voted to remove the QSPE concept from FAS 140.

Now before you get partying, a little background.

Qualified Special Purpose Entities (QSPEs) are vehicles sometimes used for off-balance sheet securitisations, and as such, have come in for quite some flak over the past few months.

The QSPE enshrines the idea that in securing off-balance sheet or “sale treatment” for assets, the bank or originator must have given up control of those assets.

Yet when SIVs hit trouble, and the banks that spawned them were prompted by reputational concerns to step in and help out, the supposedly “sold” assets came back on board those institutions’ balance sheets.

Explains the FEI blog, the QSPE concept has also been criticised by some because the restrictions prohibiting the management of underlying “sold” assets (unless pre-specified in the securitisation documentation) were seen to have hampered the ability of lenders, say, to modify mortgage terms to help borrowers avoid foreclosure in the light of the credit crunch.

In cases where restructuring did occur, with the originator also acting as the servicer often making these calls, in what sense have the assets really been “sold”?

The blog links to the details of the board meeting held last week at the Financial Accounting Standards Board, the US standard setter. In the meeting the FASB considers changes to when vehicles can be “derecognised” or transferred off balance sheet.

The issue of QSPEs has been on the FASB’s agenda since back in 2005, but has been stepped up since last summer. As board member Larry Smith is quoted as acknowledging:

For five years now we’ve struggled with application of [FAS] 140 [and] the fundamental question related to servicer discretion. We said, it’s almost impossible to structure a vehicle with the objectives the board had in mind when they created QSPEs: that is, an entity that has no decision making whatsoever relative to the run-out of these assets.

The latest draft of simplified guidance on asset transfer is expected in the second quarter.

What next then?

Credit Suisse analyst David Zion noted the FASB’s move to eliminate the QSPE concept and warned that changes, which could see a new rule by the end of the year, may mean more assets coming back onto corporate balance sheets.

Eliminating QSPE’s, along with other changes the FASB will discuss in the coming weeks may end up bringing more assets back on corporate balance sheets—along with the debt from the securitizations. However, the Board is considering allowing the assets and liabilities of certain entities to be shown on the company’s balance sheet in a new way; a “linked presentation” where both may be shown together on the asset side of the balance sheet (i.e., the liabilities are treated as a contra asset).

Either way, adds Zion, investors require better information on what companies may have parcelled off in such vehicles. Current disclosures are inconsistent and incomplete.

And next up for potentially burgeoning balance sheets, the FASB is set to discuss FIN 46R, the accounting rule that covers everyone’s favourite - the variable interest entity (VIE), an acronym which hit the headlines - thanks to another round of banking disclosure - in February.

Says Zion:

The FASB could decide to change how companies determine if they control a VIE (focusing on more qualitative factors) and force companies to reconsider whether or not the VIE stays off balance sheet more often than they do today, changes that could land more off-balance-sheet activity back on balance sheet. We plan to follow these developments and follow up with future reports on off-balance-sheet accounting. Stay tuned…

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This evening CNBC broadcast a discussion, moderated by Maria Bartiromo, between CNBC's Charlie Gasparino and David Ruder (former SEC Chairman and the William W. Gurley Memorial Professor of Law Emeritus at Northwestern).


Mr. Gasparino was arrogant, belligerent, and rude. He appeared to have come to his, rather simplistic, conclusion; and simply wanted to use Professor Ruder as a piñata as he castigated the Securities Exchange Commission.

Mr. Gasparino, rather than discussing his thoughts with Professor Ruder, chose to prove who could display the worst manners and speak loudest. That was a good strategy if his goal was to win, because his position was idiotic (at least he never managed to make a valid point to explain how his position made practical sense).

Mr. Gasparino, like most of his colleagues, was educated as a journalist. His knowledge of the securities industry is, primarily, second-hand as he has written about the markets for a number of publications. I don’t know why CNBC gives its "bully pulpit” for a reporter, like Mr. Gasparino, to present his opinion as fact. While he may be an expert at obtaining and reporting facts, his ability to analyze and present coherent arguments relating to economic/business issues is minimal (if it exists at all). Somehow, the FT manages to present reporters that can analyze and argue.

Apparently the old maxim of “those who can do and those who don’t teach" (no offense meant to Professor Ruder, he has done both so he is a "doer") has to be extended for Mr. Gasparino to include: “and those who can’t teach, report.”

Mr. Gasparino's position, as I understand it, is that the SEC should have stepped in to regulate the ratings agencies (S&P, Moody's, Fitch, etc.); thus preventing the agencies from issuing AAA opinions on CDO and other derivative products that later defaulted (how they would have been able to identify the problems given the opaque nature of what the agencies do is, to me, unclear). While he seems to recognize that Congress never gave the SEC that authority, he believes (or "a lot of people on 'The Street'" believe - unnamed sources, priceless) using that as an excuse for the lack of action is a "cop out."

He states that, given the New York City crisis in the '70s, the "dot coms," Enron, and Worldcom, the SEC should have known to go after the ratings agencies. He believed that the SEC should have found a way to "use a back door" to regulate the ratings agencies.

He seems to believe that, had the SEC kicked and screamed to expand its duties, Congress would have given in. His lack of insight into politics is unbelievable!

While there are many holes in Mr. Gasparino’s arguments, the most obvious to me is how do you pay for it?!

Where would the money come from to expand the size of the SEC to take on more responsibility?

Congress does not have much of a record for creating safeguards prior to a crisis (and it's hard to blame the SEC for not uncovering the frauds at Enron and Worldcom). Giving an agency new authority without prompting is, I believe, unusual. Raising an agency's budget to exercise that authority (and any consequent increase in taxes) would not be popular. Even after SarBox, I don't believe that the leaders of the SEC believe they have sufficient funding and resources for their existing responsibilities.

The SEC, itself, was created as a result of the 1929 crash. People of that period could have pointed to the 1907 crisis (much discussed recently in relation to the current crisis) when asking why did it take so long. Of course, the Federal Reserve System was established after the 1907 crash (in 1907, J.P. Morgan led the rescue).

It’s always annoying when critics come out of the woodwork to ask why the government didn’t step up to protect the “little guy” – whoever that is. It is usually the same people who, in more normal times, get angry over having the government looking over their shoulders.

I believe that Mr. Gasparino would be more comfortable in Beijing. The Chinese markets are regulated to a degree where the penalty for corruption, when prosecuted, is death. The Chinese markets, at their present stage, don't have dangerous derivative products (or the benefits that they provide in transferring risk). He wouldn't like it there for long though; China's leaders appear to be intent on integrating free financial markets into their system.

The complexity of our markets has increased beyond what was contemplated in the past. Over time, different regulatory authorities have been created for specific purposes (like the CFTC and the SEC); and there are now products that are regulated by nobody, or by more than one regulator. We need to overhaul our market regulatory system so that we maintain our position as the world’s preeminent country for financial markets (assuming London hasn’t overtaken us already).

In my opinion, we need regulation; but we still need investors to take personal responsibility for their actions.

My question for Mr. Gasparino is, given that he has had a "bully pulpit," why didn't HE get on a soapbox to address the issue.

The ratings agencies were known, by all of the institutions that are involved, to have some level of conflict (although there is some expectation that the agencies would lose their influence because of the "reputation risk" if they were found to be prostituting themselves). The investors in the securities under discussion (Collateralized Debt Obligations, Collateralized Loan Obligations, Asset Backed Commercial Paper, etc.) were sophisticated investment firms. Those firms are motivated by profit (as are their employees). They chose to accept both the ratings and the risk (in anticipation of rewards).

My conclusion, at least for now, is that bubbles are a necessary evil of our free market economy. I cannot see any way that risk can be eliminated, nor do I believe that it should be.

There are all sorts of arguments for how we can modify our regulatory system to address the weaknesses exposed by the recent/current crisis. Ascribing blame, except for criminal acts, is a waste of time and, generally, results in witch hunts (anyone remember Joe McCarthy?).

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This multimedia feature, from the web site of Condé Nast Portfolio, gives a good explanation of how Structured Investment Vehicles (SIVs) work(ed).

A number of SIVs did make sense. Commercial banks offered their corporate customers the chance to finance their receivables through SIVs. In those cases, the bank was able to earn a fee for managing the SIV, the companies were able to retain more of the value of the receivable, and the bank didn't need to include the funding provided to their clients on their balance sheet (they were able to effectively work with no capital requirement).

The companies would sell their receivables to the vehicle. The funds would be provided by the jointly owned SIV (which would have little, if any equity). The SIV would be funded by issuing asset backed commercial paper (ABCP). The receivables, however, would generally have similar maturities to the paper backing it; so if the ABCP market dried up, the assets could be quickly run off to liquidate the SIV.

The first SIV was structured by Citi in 1988. Since then the structure became more popular and morphed into the structure shown by Portfolio.

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As I said in my last post, I fully expect that the authorities will investigate potentially fraudulent practices.

This article, from the January 4th (today's) edition of the Wall Street Journal reflects another example of an investigation.

In this case, the Financial Industry Regulatory Authority, Wall Street's self-regulatory body, appears to be investigating if CMOs were sold to individuals that either were not fully apprised of the risks, or who weren't in a financial position to take on such risks. The probe is specifically focusing on a period when demand for CMOs weakened.

The article also states that the SEC is will conducting a parallel investigation.

This article, from Bloomberg, provides further information.

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There has been a tremendous amount written about the credit crisis; its origins; who's to blame; potential solutions, etc. Some of this has been excellent; some, not so much.

I am still trying to catch up and provide, perhaps, my own observations.

In the mean time, Gillian Tett and Paul J. Davies of the FT wrote a particularly good article in December that's worth a look. That paper continues to provide insightful information and analyses.

Bill Gross and Paul McCulley, of PIMCO, are also providing good insights that are available here and here.

One thing that I continue to find troubling is that so many of the holders of effected securities (ABCP, CDOs, etc.) seem surprised that it was possible for them to incur losses on their investments. The perception of increased risk for increased return seems to have eluded them.

Perhaps their surprising losses were due to fraud on the part of those who sold the securities to them. I'm sure we'll learn more about this in time.

The entire structured world and the banking system will likely be examined, to various degrees, as the situation in the markets becomes clearer.

It was well known in the financial world that risk was being priced at unusually low cost. Spreads on lower grade securities were squeezed as demand for higher returns apparently outweighed the fear of associated risk.

Given that the positions of many SIVs and conduits have been taken onto the balance sheets of the financial institutions associated with them (CitiGroup being the largest example), there will (appropriately, in my opinion) be a reexamination of what types of entities should be subject to regulation and how their assets and liabilities should be presented on financial statements.

On the other side, however, is the question of what constitutes an "accredited investor" and/or who should be allowed to make the decisions to purchase specific investments.

Personally, except for cases of fraud, I am offended by investors that claim to be sophisticated (the definition of "accredited investor" is an attempt to clearly state who is sophisticated), until they incur a loss.

It's understandable that people/institutions don't want to lose money, but I think it's childish to claim ignorance when investments generate losses.

These parties want to have access to all of the wizardry the financial houses can devise, but not the ones that lose money (I'd like that too, if only the world worked that way).

Perhaps the SEC and other regulators should consider a licensing exam to purchase unregulated investment products instead of assuming that having assets/income makes investors qualified to understand what they are buying.

Agents have to be licensed, why not their customers? It should generate a more sophisticated group of investors, whether or not they pass the test.

I, at least, think it's an intriguing idea.

People and institutions that were defrauded should be protected, but I have a problem with rewarding laziness and/or stupidity. Sophisticated Investors are supposed to be able to understand the risks involved in what they purchase and to be able to bear the burden of any related losses (which is why the Securities Act has an asset/income definition).

The ratings agencies, who are being picked on as the implied regulators, made their own mistakes. They always stated that investors should not rely on their ratings; and almost everyone knows that they are compensated by the issuers.

More later.

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Long time, no post.

Sorry about that. Life happens.

A lot has happened over the last month. I will attempt to add my point of view to the areas that I think are worthy of discussion. Please feel free to agree (or disagree) using the "Comments" link below.

I find the idea of a borrower bailout extremely interesting. I agree with Fed Vice Chairman Kohn's statement that the moral hazard related to acting is less of a problem than not acting and allowing innocent bystanders bear some portion of the cost.

What I find particularly interesting, however, is the part that fraud and sloppiness seems to have played in the sub-prime crisis.

Fitch put out a report entitled The Impact of Poor Underwriting Practices and Fraud in Subprime RMBS Performance (in case you were wondering, RMBS is an acronym for "Residential Mortgage Backed Securities)."

One source that they relied on in their analysis was a report put out by BasePoint Analytics, LLC. BasePoint's analysis found that up to 70% of mortgage early payment defaults can be linked to a significant misrepresentation on the original loan application.

Fitch conducted their own analysis using a very small sample of early defaults from 2006, many of which had what appeared to be strong credit characteristics. Fitch reviewed the loan files for the sample and found problems with more than half! Some of these problems were technical (borrower's balance sheet and income didn't support the level of stated income) and some of them were close to fraud (receiving credit for being "authorized" to use other people's credit - the credit agencies have stopped raising FICO scores for this method of "credit enhancement").

If fraud played such a large role in the current crisis, I don't think it's the borrowers that the government should be looking to bail out.

I suggest that you read the report if you find this subject at all interesting.

Given the potential cost to the US taxpayer, I would expect most US citizens to have some interest.

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I think everyone reading this has heard about the turmoil in the credit markets that became incredibly obvious this summer.

Now we're seeing a domino effect as fears run rampant.

While I was well aware of Special Purpose Entities (SPEs) and other off-balance sheet structures generally, it wasn't until this summer that I heard of Structured Investment Vehicles (SIVs). A SIV is a special type of SPE (aren't acronyms great?).

Recently we heard that some banks, with the support of the Treasury Department, were creating MLEC (a sort of "Super-SIV"), however no specifics were ever announced (and may not have been agreed). Of course this didn't stop bloggers and columnists from coming out with their opinions on it (mostly negative). I merely voiced the opinion that I didn't see how it would work unless there were specific guaranties made by the institutions creating the entity. I am in favor of giving market players an opportunity to figure out what they own so they can clean up the mess.

I have some specific comments to make about one recent column, but more on that later.

Merrill Lynch shocked the market with $8.4 billion in write-downs last week, $4.9 million more than they had estimated on October 5th. Why did this happen?

Rachel Beck of AP wrote an article today that may answer that question.

On October 3rd, the Center for Audit Quality, an organization founded early this year by the American Institute of Certified Public Accountants (I earned my CPA, but am not presently a member) and eight audit firms, issued three white papers. These were Measurements of Fair Value in Illiquid (or Less Liquid) Markets, Consolidation of Commercial Paper Conduits, and Accounting for Underwriting and Loan Commitments.

These white papers, which I am in the process of reading (but which are described by Fitch Ratings in a very timely report), provide guidance to auditors on how to interpret recent, and not so recent, statements and interpretations by the Financial Standards Accounting Board and the AICPA, principally FASB-157, FIN 46(R), and CON 7 . Fitch also notes that IAS-39, issued by the International Accounting Standards Board, is being employed by some financial institutions.

If you have trouble sleeping, I highly recommend that you read the FASB documents. It might give you nightmares, but you might understand what the financial institutions are actually saying in their filings (a lot of this is relatively arcane, but the original pronouncements can provide a sort of Rosetta Stone).

While quarterly reports are not audited, it is apparent that the new guidance led several institutions, including Merrill Lynch, to make more conservative estimates in anticipation of the year end audit. It is highly likely, in my opinion, that when Merrill made their original estimates they had not yet read (and/or implemented) the October 3rd guidance.

In a way, it appears that E. Stanley O'Neal lost his job over the timing of a change made by a new audit industry governing body. Of course the magnitude of the losses might have created the same environment, even if they had been part of the pre-announcement. Reports, however, seem to point to concerns due to the huge difference from the initial estimate within such a short period of time.

Oh well. He got a good severance package.

I'm really looking forward to reading/skimming these documents together with the SEC filings to get a better picture of actual exposures (at least what is disclosed).

I figured it would be better to provide this information now and give readers a chance to make their own assessments rather than waiting for me to read all that material.

Enjoy. If nothing else, I highly recommend that you read Rachel Beck's article and the Fitch report.

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Professor Ed Altman graciously allowed me to attend his Corporate Bankruptcy & Reorganization class at NYU last night. I had taken the course when I attended NYU's graduate business school, but this was a different experience - in a positive way (when I have a chance, I will write about the improvements I observed).

Professor Altman opened the class with a simple question. Who is responsible for the recent problems in the credit markets (this is my attempt to paraphrase, I'm not sure of the exact wording of the question)?

This is a question that has been the subject of much speculation in the blogosphere and in the news. Much of what is being said through those media is, in my opinion, way off base.

The students identified many of the same parties that have been cited elsewhere, but generally with better insight than the public discussion.

They pointed to the regulators, ratings agencies, loan originators, investment banks, etc. We even had a student that had been with a bulge bracket firm point out that, in the summer of 2006, his firm had identified similar issues and aggressively cut back on risk. That shows that, at an individual investor/firm level, losses could be averted.

In my opinion, all of those entities were party to the conditions creating the housing/sub-prime/structured debt bubble - I just don't believe that they were "responsible."

It is true that there were frauds and other improper activities that occurred; many of which would not have been possible without the lax lending environment. I strongly believe, however, that such activities were more the exception than the rule (I believe that this will be eventually borne out by any future investigations).

My statement, in the class, was that the blame falls on an unregulated capitalist system. It is normal for markets to overreact, both positively and negatively.

Not to beat a dead horse, but it comes back to Fear and Greed!

Each party in the process acted in their own interest, as they perceived it at the time. In the case of the consumer real estate market, the momentum of the market led to that special level of fear and greed - Euphoria!

When markets move to extremes, participants are driven by the fear of not taking advantage of the "sure thing," and the desire to make as much money as possible (greed).

Don't get me wrong. I'm a capitalist. I'm not in favor of excessive regulation. I just recognize that manias are part of the price of participating in our economy. There is no acceptable way, in my opinion, to regulate against crowd psychology.

Ultimately, as happened this year, something occurs to prick the bubble. Either too much product (stock, CDOs, oil, etc.) becomes available - overwhelming supply; or demand dries up as the marginal buyer is no longer willing to pay a premium, recognizing, perhaps, that there's no such thing as a free lunch (remember, supply equals demand at equilibrium).

The effect of declining bids is then magnified as parties that used leverage to buy in (or are, like hedge funds, vulnerable to redemptions) are forced to liquidate positions.

In today's market, the biggest problem is opacity.

While hedge funds and proprietary trading desks are always engaged in some form of poker in their trades, usually at least they understand their positions. With all of the CDOs, CLOs, ABCP, etc., most of the parties really don't know what they own.

Because of this lack of clarity, the bid/ask spreads tend to be enormous.

Given that most investors now have to mark their investments to market, this means huge problems. If holders mark their investment to the bid, they would have to report significant losses - whether or not the asset has greater value. If they don't use the bid, then it's hard to justify another measure.

David Einhorn gave an interesting lecture at Columbia a few weeks ago discussing some of the issues specific to this bubble.

Bill Gross, in his November Investment Outlook, also had some interesting insights.

It appears that this situation is going to take a long time to play out.

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There seems to be a great deal of confusion as to what SIVs are, how they work, and how M-LEC may provide time for the market to regain confidence in the commercial paper market.

To start off with, SIVs are not vehicles that provide banks with the ability to manipulate earnings, misappropriate funds, or to do anything else that is illegal. Comparisons to Enron are way off base.

I can understand people's willingness to assume the worst of businesses in the wake of Enron, WorldCom, etc., but that simply is not the case here.

I highly recommend the following articles/publications that are available on-line:

1. This article from Hedgeworld (requires free registration) that gives a good explanation of what is known about M-LEC;
2. This Wikipedia article, which gives a decent explanation of SIVs; and
3. This DerivativesFitch report (requires free registration) that speaks to seven specific SIVs that Fitch rates, including information on the assets and capitalization of each SIV.

I hope you find these helpful in getting a better feel for what is currently a little understood aspect of our financial markets.

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I had an opportunity to speak with some people on Wednesday that have been directly involved with Structured Investment Vehicles (SIVs).

After that discussion, and further review of published information, I thought it would be helpful to summarize what I know about M-LEC:

1. The first thing that needs to be understood is that M-LEC is a proposal. There is an agreement in principal, but the lead banks are still looking for partners and have not settled (at least as reported) on the specific structure and how M-LEC would interact with the SIVs.


2. I cannot stress this enough, but I have been assured that lenders to the SIVs have no legal recourse to the banks! There is no obligation for the banks to bail out the SIVs. There ARE lines of credit that were intended to provide liquidity, but they generally require that the banks would lend 10% of the SIVs' assets (and we don't know what, if any covenants there are related to these "back-stop" lines of credit). Even if the banks were to provide the backstop, they wouldn't be taking the SIVs' assets onto their balance sheet.
   
   That said, there are reputational and client relationship issues that might be judged to be important enough to justify one or more banks taking on the assets of related SIVs, despite their lack of obligation.


3. Unlike what some have been saying in the blogosphere (and in at least one newspaper), M-LEC would be intended to solve one problem and one problem only - revive liquidity in the asset-backed commercial paper market. SIV commercial paper is held by, among others, money market funds that are not supposed to be taking risks with the capital that is provided to them. Should the SIVs start to default, the problem would quickly spread to other fixed-income, and probably equity, prices - perhaps removing a great deal of liquidity from the economy. That scenario would touch a LOT of Americans (and Europeans and Asians, etc.).


4. News reports have been sketchy (as previously mentioned) on whether, and to what extent, the participating banks would guarantee the solvency of M-LEC. The original Wall Street Journal article implied that there would be a guarantee from the banks. The press release does not speak to that issue.


5. M-LEC, if implemented, will give time for the SIVs to liquidate their assets, as necessary, in an orderly fashion. If nothing is done, there is a lot of fear as to what would happen.

My personal belief is that, without bank guaranties, M-LEC would have great difficulty surviving and/or providing effective relief to the commercial paper market.

I believe that, if the banks guarantee M-LEC's borrowings, then the plan could work. I don't know if the fund needs to be $80 billion, $100 billion, or some other amount.

I believe that, for investors to purchase the SIVs' debt, there needs to be a greater degree of confidence that the investors will be repaid. Without the banks standing solidly behind this "super" SIV, it is not clear to me how confidence could return to the marketplace.

Clearly, there is a lot that we do not know about M-LEC. Hopefully we'll find out more in the coming weeks.

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In contrast to some other news sources, the Financial Times has been providing some of the best coverage of the SIV/Commercial Paper situation.

In today's FT, Gillian Tett and Saskia Scholtes (two reporters who have been doing excellent work on this subject), wrote a very good article summarizing the M-LEC concept.

If you have today's copy of the paper, there is a graphic on page 18 (in the US edition) that does a explains the situation very well.

Another article on that page by David Wighton and Deborah Brewster gives a good explanation of the pricing aspect of executing M-LEC transactions with the SIVs.

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I couldn't believe my eyes when I read the top story in this morning's New York Times:

3 Major Banks Offer Plan to Calm Debts in Housing

Wow! Something new must have happened!

But noooooo! Floyd Norris' article was about M-LEC.

Apparently the front page editor at the Times felt that stretching the truth would sell more papers.

M-LEC's effect on the housing market is extremely tangential. The focus, as the article states, is on fixing the commercial paper market.

I have no problem with the text of the article, although I think two of their "experts" were talking outside their competency.

One, an economist said "It seems a little more like a P.R. move, frankly."

Another, an expert in mortgage-backed securities, was quoted as follows: "'If they really believe these are good assets being mispriced in the market,' he said, the banks could just buy them and wait for the asset values to recover. 'This raises the question of whether the banks are doing this just to avoid taking their losses.'"

The "P.R. move" comment is off the mark, as there is a clear risk reduction to SIV ABCP investors in having multiple banks legally obligated to back-stop their investments.

It's not clear that buyers will reemerge based on M-LEC, but it's more than a publicity stunt.

The other comment seems to reflect a complete misunderstanding of the nuts and bolts of SIVs and M-LEC (or, he's right and I am completely misreading this - I have been doing quite a bit of research on the subject, so I'm highly confident in my interpretation).

If the SIVs sell the assets to their sponsors today using market prices, the SIVs would generally suffer steep losses and be unable to pay off their outstanding commercial paper (which, given that much of the commercial paper is held by money market funds, could create a much larger crisis of confidence of ALL Wall Street products). On the other hand, the banks would be able to profit if, as they believe, the assets are priced below value (in other words they would gain).

The alternative would be for the banks to purchase the assets at, or close to par. This would allow the SIVs to liquidate in an orderly fashion, but the banks would have to cut back on loans (due to reserve requirements) and - when they mark to market - absorb losses (which may be temporary).

Another alternative would be for the banks to purchase new commercial paper from the SIVs. This, however, has the same reserve requirement issue as the second alternative.

The objective here is to minimize direct exposure of the banks' balance sheets so that the commercial paper market will continue to provided financing. The new wrinkle is the back-stop by a group of large banks (not just one, reducing fears of individual bank insolvencies).

As I said, the article is pretty good; it just has a ridiculous headline and some, apparently, misinformed expert quotes.

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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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Now we have something to discuss.

Here's the press release from 8:30 AM EST 10/15/07:

Global Banks Announce Plans for Major Liquidity Facility to Bolster Asset-Backed
Commercial Paper Markets

NEW YORK, Oct. 15 /PRNewswire/ -- A consortium of leading global banks today announced an agreement in principle to create and provide liquidity support to a master conduit to enhance liquidity in the market for asset-backed commercial paper and medium-term notes issued by structured investment vehicles ("SIVs").

Bank of America Corp. (NYSE: BAC), Citigroup Inc. (NYSE: C), JPMorgan Chase & Co. (NYSE: JPM) and several other financial institutions have reached an agreement in principle to create a single master liquidity enhancement conduit ("M-LEC"). Once established, M-LEC will agree, for a set period of time, to purchase qualifying highly-rated assets from certain existing SIVs that choose, in their sole discretion, to take advantage of this new source of liquidity. Access to such liquidity is intended to allow participating sellers to meet pending redemptions and
facilitate asset-backed commercial paper rollovers.

M-LEC will issue new short-term credit instruments to finance its purchase of eligible assets from participating sellers. The instruments issued by M-LEC are intended to benefit from various features, including a cushion of support from junior layers of capital and liquidity backstops. The size of the vehicle, the scope of the liquidity backstops, and the underlying cushion of capital are intended to enhance the liquidity and marketability of the short-term obligations of M-LEC.

The three major banks and other participating financial institutions will coordinate on a process, the terms of which are still being finalized, for determining asset eligibility for M-LEC. A syndication process is currently underway to identify the liquidity backstops to include several additional financial institutions, in order to
scale M-LEC to a size and funding structure deemed appropriate by the consortium. M-LEC could be operational within 90 days. Multiple investment management firms have been engaged in discussion with the consortium and expressed support for the
plan.

Recently, refinancing in the asset-backed commercial paper markets has been difficult despite the high quality collateral underlying many of these securities. The objective of M-LEC is to facilitate these re-financings and to complement other
market-based solutions in supporting an orderly and efficient market environment.

The Department of Treasury facilitated the discussions among the consortium of banks and investment managers.

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There is an interesting discussion of M-LEC on the nakedcapitalism blog, although I think there are misunderstandings about what it is supposed to accomplish.

Here is the comment that I left on that blog:

The last comment seems to be closest to the mark.

From what has been reported (since that is the extent of our knowledge at this point)
M-LEC has a very limited purpose. It is not intended to fix the MBS, CDO, CLO, etc. markets. The purpose would seem to be two-fold:

1. Improve liquidity in the asset-backed commercial paper market; and

2. Free up bank reserves for new loans.

The SIVs are non-recourse vehicles. The banks have no actual obligation to take the assets onto their books (although they do provide back-up credit lines). There is, however, the risk of damaging relationships with customers and hurting bank reputations if they allow the SIVs to liquidate.

This problem arises because the SIVs relied on short-term paper to fund their investments. Uncertainty related to SIV assets has led to lack of demand in the commercial paper market and the sale of $75 billion in SIV assets.

If the SIVs are unable to fund themselves in the commercial paper market, they will be forced to liquidate - creating fire sale prices on assets.

These low sale prices will not only hit investors in the SIVs, but will cascade through the system as other holders of the same securities are forced to mark their investments to the distressed sale prices (leading to other liquidations, particularly from leveraged funds).

The alternative to liquidation is for the banks to wind up the SIVs and take the assets on their balance sheets, tying up reserves and limiting their ability to lend.

If successful, M-LEC will provide greater credibility to the SIVs (as commercial paper will be backed by SIV assets AND bank guarantees). This will free up reserves and limit the collateral damage.

It is a bit more than optics.

Yes, I also worked on Wall Street.

I have commented further on this on my blog at blog.lawrencedloeb.com.

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While Bloomberg is reporting that only Citi and B of A are putting together a fund of $80 billion; The Wall Street Journal is still reporting that JP Morgan Chase would participate in the creation of a $100 billion fund.

The Journal article adds quite a bit of useful background and a good framework for understanding the intent of this effort. Among the statements in the WSJ article is the following:

According to people familiar with the matter, the Treasury hopes the plan, which could be announced as early as this morning, will jump-start demand for commercial paper, which froze up this summer amid the credit crunch that roiled global financial markets.

Companies depend on commercial paper to finance day-to-day expenses like payroll and rent. Some financial commercial paper -- known as asset-backed paper -- has been able to find buyers in recent weeks. But investors have remained skeptical of other types, including paper issued by certain bank-affiliated investment funds.

The lack of buying signaled that the markets weren't working properly, despite the efforts of central banks, and that investor confidence was low, since commercial paper typically is considered a safe investment.

We will see what is reported later today.

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There has been a lot of discussion this weekend about the proposed Master-Liquidity Enhanced Conduit.

The latest report from Bloomberg indicates that an $80 million conduit, backed by Citigroup and Bank of America will be announced on October 15. Additional banks may join in the future.

Some have been negative about this, saying that the plan can't succeed. I'm not certain, but I think it is worth a chance.

One negative blog is Mish's Global Economic Trend Analysis, where I have posted the following commentary:

As I understand the plan (from what has been described by the news), M-LEC would only buy loans from the SIVs of participating institutions. Given that the
total amount of SIV assets is estimated at $325 mm to $400 mm (depending on
which version of Moody's you read), a $100 billion fund as a backstop to the
SIVs could work.

If I understand the structure, SIVs (which currently are free-standing, with no guarantor) will have the ability to sell assets to M-LEC (which WILL have several guarantors - the participating banks).

The concept is to free up the asset-backed commercial paper market for both the SIVs and M-LEC.

As I understand it, this will be a "closed system" with no outside participation. The hope is that, by creating this backstop, the banks wouldn't have to make a choice between letting SIVs that they, or their top clients, sponsored go under; or taking the assets onto their balance sheets (which would reduce funds available for new
loans).

While the worst part of the crisis may be over in the interbank market, there appears to be some hoarding of reserves by banks to prepare for the potential need to assume the assets. If M-LEC works, some of these reserves could be freed up for new loans to customers or other banks.

The success depends on whether the commercial paper market is willing to rely on the $100 billion backstop, which seems fairly reasonable.

As the SIVs reportedly have limited sub-prime exposure, their funding difficulties are directly related to fear of the unknown (exactly what the underlying assets are). When liquidity returns to the system, the market may return to normal or the positions can be unwound (just not in forced sales).

As for the anti-trust argument, that isn't applicable. The banks are stepping forward (potentially) to avert a system shut-down created by complex structures developed by Wall Street. The alternative would be a government body directly intervening, but that would create more problems than it would solve.

At least that's what I think.

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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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Saskia Scholtes, of the Financial Times, wrote a very good piece in this weekend's FT that gives the best explanation - that I've seen - of the role, and the processes, of the rating agencies in the creation of sub-prime/structured securities:


Ratings game that turned into a guessing game
By Saskia Scholtes

Published: September 29 2007 03:00 Last updated: September 29 2007 03:00

As the subprime mortgage saga rumbles on, it is rare to hear anyone stick up for the rating agencies these days.

They stand accused of granting high ratings to complex securities backed by risky mortgages that have since suffered sharp drops in value. This week they were called before the US Senate to defend their role in the sorry subprime tale that has rocked financial markets.

When it comes to rating corporate debt, the rating agencies are, for the most part, very good at what they do. And they should be. After all, the two dominant agencies, Moody's Investors Service and Standard & Poor's, have been rating corporate bonds since 1909 and 1916 respectively.

This means that when they rate the debt of companies in the steel industry, for instance, they can back up analysis with empirical data spanning several economic cycles.

Over the years, the rating agencies have grown used to criticism from disgruntled investors who have lost money in economic downturns, but they have always had the data to fall back on.

This time it is different. The rating agencies still say they analysed the historical data - only this time the data did not work.

"We have learned some hard lessons from the recent difficulties in the subprime mortgage arena," said Vickie Tillman, executive vice-president at S&P in testimony before the Senate committee on Banking, Housing and Urban Affairs this week.

"We are fully aware that, for all our reliance on our analysis of historically rooted data that sometimes went as far back as the Great Depression, some of that data has proved no longer to be as useful or reliable as it has historically been."

Ms Tillman said some of the changes in borrower behaviour were not predictable, such as the unprecedented level of defaults on mortgages in the first few months after origination, and the fact that, while borrowers who bought homes had generally made their mortgage payments before paying off their credit cards, that no longer appeared to be true. The rating agencies have pointed to other factors that contributed to unexpected losses, including fraud in the mortgage origination process and deterioration in underwriting standards.

But the real problem, say critics, is that the "historically rooted data" the agencies used was not necessarily relevant in the first place.

These critics argue the rating agencies were too dependent on performance data for more traditional mortgages - such as those issued by the government sponsored mortgage agencies Fannie Mae and Freddie Mac. Such "conforming" mortgages bore little resemblance to the private-label subprime home loans characteristic of the recent lending boom. Many subprime borrowers who in the past had little or no access to mortgage credit, for example, took out so-called "interest-only" mortgages. A mortgage is "interest only" if the monthly payment the borrower is required to make consists of interest on the loan, rather than any portion of the principal. The option to pay interest only lasts for a specified period, usually 5 to 10 years. Such mortgages were previously offered only to borrowers with good credit, making comparison with any historical data unreliable at the outset.

Meanwhile, raters left it up to Wall Street underwriters to perform the necessary "due diligence" on risky mortgages and the borrowers backing a given security. That is because under securities laws, rating agencies are not required to do so. Rating agencies assigned ratings based on the information provided by the underwriters, without always asking for more.

An April report from Moody's, for example, shows the rating agency did not until recently consider debt-to-income ratios as a primary piece of data in mortgage models, although this is considered one of the three key predictors of mortgage default. And then came the structuring. Subprime mortgages were packaged into bonds, which were packaged into innovative complex debt securities, for which the rating agencies provided ratings.

So these were structured securities that had never existed before the current cycle, containing mortgages that had never existed, taken out by borrowers that had never been granted mortgage credit. Rating them was surely as close to a guessing game as you could get.

saskia.scholtes@ft.com

Copyright The Financial Times Limited 2007

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In case you haven't run across these terms (and there was little discussion of them until a few weeks ago), banks and other financial institutions created conduits. These conduits, under a variety of names (including Structured Investment Vehicle), were created as separate entities. They purchased CDOs and other asset-backed securities and were funded, primarily, through the issuance of Asset-Backed Commercial Paper.

It was concerns about the value of the conduits' assets that led to a freeze in the commercial paper market; and the possibility that the conduits' bank sponsors would have to bail out the conduits that led to problems in the inter-bank market.

There were other factors, but it seems that these conduits were at the root of the recent liquidity crisis (together with mortgages, again).

This opinion piece from last week's Financial Times gives a good explanation of how increased opacity has led to risk concerns and troubles in the inter-bank markets. Bill Fleckenstein's commentary from Monday is also worth reading for a further discussion of off-balance sheet conduits and how they have contributed to the turbulence.

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