Monday, October 15, 2007

Treasury Works With Large Banks to Ease Credit Crisis

OK -- this story is a bit complicated. So let's take this piece by piece.

First what is a structured investment vehicle?

A managed investment vehicle that holds mainly highly rated asset-backed securities and funds itself using the short-term commercial paper market as well as the medium-term note (MTN) market. Because of the rolling nature of its funding, an SIV is highly dependent on maintaining the highest possible short-term and long-term credit ratings. SIVs differ from cash CDOs of asset-backed securities in that their portfolios are marked-to-market, with their ratings based on capital models agreed with the rating agencies. SIVs also have simpler capital structures than CDOs, usually comprising a junior tranche of capital notes beneath a block of senior liabilities with the same seniority. They have smaller liquidity facilities than commercial-paper conduits - which also invest in high grade ABS. SIV managers include both commercial banks such as Citigroup and Bank of Montreal, and investment managers such as Gordian Knot.

So what we're looking at here is a short-term money management fund. They pool assets and sell commercial paper, making a difference on the interest rate spread between the two products. The fund issues different types of commercial paper with different credit profiles. This all looks like a pretty standard investment situation to me.

Now, let's get some background:

Encouraging the talks that led to the creation of the fund is the latest effort by officials to help restore liquidity to credit markets, a campaign started by the Federal Reserve in August, when it cut the interest rate on direct loans from the central bank. Fed officials have said this month that while there are signs of improvement, some markets remain under stress.

``Some markets have been experiencing illiquidity,'' San Francisco Fed President Janet Yellen said in an Oct. 9 speech in Los Angeles, referring to mortgage-backed securities and asset- backed commercial paper. ``This illiquidity has become an enormous problem for companies that specialize in originating mortgages and then bundling them to sell as securities.''

As losses in securities linked to subprime mortgages started to spread in July, investors retreated from high-risk assets. SIVs that issued commercial paper to buy the securities found they could no longer roll over the debt, forcing them to sell about $75 billion of their assets.

From the WSJ:

The popularity of SIVs has boomed since two Citigroup bankers, Nicholas J. Sossidis and Stephen Partridge-Hicks, invented the strategy in London in the late 1980s. (They later left to form their own company, London-based Gordian Knot, which operates the world's largest SIV.)

Behind Treasury's concern were banks like Citigroup, whose affiliates owned $80 billion in assets backed by mortgages and other securities. The world's biggest bank, by market value, held the assets off its balance sheet and was facing the prospect of either having to unload them in a disorderly fire-sale fashion or moving them onto its books.

Either scenario would have hurt financial markets and could have damped the economy by curtailing banks' ability to make new loans to consumers and corporations. Treasury envisioned a potentially "disorderly" unwinding of assets that could worsen the credit crunch, said a person familiar with the matter.

These funds have a big problem on the horizon. They have to sell a ton of debt within the next few months. Because the credit markets still haven't fully recovered, this massive selling could lead to the following situation.

1.) A large amount of mortgage-related paper hits the market. The market is already troubled.

2.) Because a large amount of paper hits the market, prices are already going to be lower (excess supply = lower price).

3.) Because the market is already troubled, bidders are offering lower prices for the paper

4.) This leads to a downward trajectory for certain assets' prices.

In other words, a situation that previously would have been akin of a normal position situation (standard selling of securities at normal times) could in fact lead to a situation that resembles panic selling.

First -- I am personally all for this action. It is highly doubtful the big banks would get together without some type of effort from a neutral third party. Hank Paulson's prior Wall Street experience is probably a key to this situation. I have maintained a position that the Treasury Secretary should come from Wall Street, and this situation illustrates the reason why.

Some people quoted in a few articles expressed concern the Citigroup would be a primary beneficiary of this program. This is true. Citigroup is heavily invested in the SIV market and faces the possibility of some big possible losses over the next few months if this situation isn't resolved. This is one of the primary problems of having large banks at the middle of the financial world. On the good side they provide liquidity. On the bad side, the concentration of assets means that a screw-up can lead of a pseudo bail-out.

So -- will this work? I have no idea. It's good that parties are trying to find an answer to this problem. However, most solutions are going to have their own problems built in.