The Big Mess Going on In the Background that Most of Us Are Ignoring Because it Seems too Complicated or too Boring or Both
Yves Smith at Naked Capitalism has been writing about a topic we’ve been ignoring lately, the SIV rescue. What the heck – SIV rescue?
Investors chose to regard large writeoffs at UBS, Citigroup, Merrill, and Deutsche Bank as signs that they were all putting the problems behind them. That was an interesting interpretation, since all these institutions are required to mark to market and are under heightened SEC scrutiny to provide accurate and consistent pricing of illiquid positions. Yes, equity investors hoped that they not only took losses that needed to be recorded and also reserved for potential losses. But there is no way of knowing what they did, or whether any reserves for future losses were adequate.
By way of background, many banks set up structured investment vehicles (SIVs) which are off balance sheet entities that bought mortgage-related paper and sometimes other asset backed paper, like credit card receivables, and funded it in the commercial paper market, a classic lend long, borrow short operation. Commercial paper secured by assets backed instruments is called asset backed commercial paper, or ABCP.
The problem was twofold: the short term funding dried up and these vehicles weren’t as off balance sheet as they appeared to be.
Many banks gave backup lines of credit to the SIVs, often their own entities. After two German banks had to be rescued due to subprime exposure, suddenly no one wanted to hold ABCP, and these vehicles could no longer roll their CP. They had to use their backup lines of credit (in some cases, the parent bank might not have be required to support the SIV, but have decided to anyhow out of concern for their reputation). Thus the belief is that these banks are hoarding cash for their own needs, to the detriment of normal market operation.
But will this approach work?
So how is this proposal an improvement over the status quo?
Here’s his post from yesterday:
Perhaps I am too pessimistic, but the lack of a functioning trading market for many of the assets in these SIVs is what made this mess so intractable in their first place. If you had market prices, you could get valuations from neutral, credible parties for the contents of SIVs. That would have gone a very long way in calming CP investors’ frazzled nerves. All these machinations by Citi et al. look like a very convoluted attempt at a finesse. Am I the only one who suspects the emperor has no clothes?
So why, with all the foregoing, do I believe this program will get done? Answer: because the Treasury has put its prestige at stake. The principals will do everything in their power to make this truly terrible precedent stick. The Treasury has become deeply involved in assisting a private concern at no evident risk of failure rather than let it take its lumps (by contrast, the Fed did relatively little in the LTCM bailout beyond convene a meeting and tell everyone it would behoove them to sort the matter out). The key actors want this to be a happy experience for Uncle Hank so they can come back for more.
His latest on the subject is here. To heavily cherry pick his post (I suggest you read the whole thing), here are some key points:
If you want a rescue program, you don’t lard it up with fees beyond what is necessary for costs and risk assumption.
If the spin is that this vehicle is being established to prevent a possible crisis, then it behooves the organizers to do so on a cost recovery basis. Anything else raises questions about the real motives (including are the fees yet another way to shore up Citigroup?).
The MLEC, by cherry picking assets, will make thing worse for the remaining SIVs.
Pricing the assets to be purchased is an impossible problem. We raised this issue yesterday; if there was a market price for the assets in the SIVs to being with, we wouldn’t have a problem. But we have prospective sellers who don’t want to recognize losses (these assets have deteriorated fundamentally) and buyers are skittish because prices could fall further.