SIVs, Conduits and the Credit Crises in Our Future

Esoteric investment vehicles called SIVs and conduits have become cocktail party topics. The U.S. Treasury and the nation's largest commercial banks are sponsoring a bailout of banks affiliated with distressed SIVs and conduits, to the tune of $80 to $100 billion dollars. The G-7 and IMF issued statements at meetings held this weekend expressing concern about the credit crisis and encouraging central bank action to limit its impact. Financial journalists write about the losses sustained and the losses to be incurred in the future, and the financial engineering games that created the losses. Economists are quoted on cable television predicting recession, or not.

It's clear from both the Fed's surprise half-point interest rate cut in September and the Treasury's sponsorship of the super conduit that supposedly will stabilize the debt market that the government thinks the credit crunch is serious and an ongoing problem. There's plenty of speculation about whether or not the Fed will cut interest rates further, and even a little commentary on the possibility that the taxpayers will have to provide some money to bail out the big banks. In other words, there's plenty of talk about how those responsible for the mess can be insulated from risk. But there's little discussion about the need for increased government oversight to prevent the kind of reckless excess that characterized the CDO market until recently.

The government that simply reacts to the crisis of the moment, and doesn't plan for the next recurrence of problems, is doomed to be unprepared for the next mess. Generals and admirals are sometimes accused of preparing to fight the last war. But at least they are doing something about the future. While the financial regulators and Congress have issued some statements and even held a few hearings, no substantial steps have been taken to prevent a recurrence of the problem.

Market forces have worked poorly in this situation. We have to consider that markets aren't machines or automated processes. They consist of the interactions of people, and people can be irrational, oblivious, gullible, and, most importantly, greedy yet fearful. All of this means that people--and therefore markets--can screw up.

First, over-investment in mortgages resulted in the creation of vast quantities of risky derivatives (CDOs and others of their ilk) that few understood. The valuations ascribed to these investments were based on the assumption that the real estate market would continue rising indefinitely. That a perpetually rising real estate market had never before occurred in the history of the world was no impediment to the belief that it would happen now.

Then, when the ship hit the fan (well, you know what we mean), investors froze up and refused to invest in anything except gilt-edged investments like U.S. Treasury securities. Investors didn't conduct much of a reasoned analysis of anything, especially if it might have something to do with asset-backed securities. They simply wouldn't touch private sector debt. Perhaps this was an overreaction. But it was understandable in light of the absence of transparency in the derivatives markets. In the absence of reliable information, why risk your capital?

Contrast the credit markets with the stock markets. Even with Friday's drop, the Dow Jones Industrial Average is up about 8.5% for the year. The stock markets are vastly more transparent than the derivatives markets. Even though they are sometimes volatile, there hasn't been a freeze up in the stock markets since the Depression. Even after the 1987 crash, investors kept buying, because there is so much information available about stocks that many felt they could reasonably assess their chances.

Without an improved regulatory regime in the derivatives markets and for hedge funds, future crises like the current one are a given. The financial services sector of the U.S. economy has grown larger even as the manufacturing sector has shrunk. Whether or not this makes much sense from the standpoint of national policy can be questioned. There is nothing about America that gives it any special advantage in financial services. Unlike our pool of intellectual capital in the Silicon Valley, our pool of creative talent in the entertainment industry (entertainment is America's second largest export, after commercial aircraft), or our vast farmlands, Wall Street's talents and products are fairly easily replicated in other nations. And that's happening. London is a serious challenger to New York. And China is promoting the growth of its financial markets. Much and perhaps most of the growth in investment capital (i.e., savings) today is overseas. The Chinese, Japanese and other Asians are compulsive savers. The OPEC and other oil producing nations are piling up vast amounts of oil profits to reinvest. There is no particular reason why those savings must flow to Wall Street, and increasingly, they won't, especially with the dollar falling in value.

Nevertheless, the government seems intent on protecting the financial services industry. In that case, it should do so the right way, and build for the long term. Although not without its faults, America does two things really well compared to most of the rest of the world. Americans truly believe in integrity and honesty, and these values have been infused into the processes of American life. When Americans go to a government office, they expect to be able to conduct their affairs in accordance with law, and not have to pay petty bribes to petty functionaries just to get the day-to-day processes of the government to operate. There really aren't that many other places in the world where this is true.

Similarly, Americans expect to be treated fairly and honestly when buying or investing in something. They expect prices to be fair, and howl when they think they've been taken advantage of (witness the controversy over Apple's recent $200 price cut for the iPhone). In most other countries, bargaining is a way of life, and you have live with the bargain you made. Opacity in the market is an advantage for the seller that the seller will strive to maintain.

Thus, Americans do integrity and honesty really well. Let's infuse a serious dose of integrity, honesty, transparency and responsibility into the derivatives markets and the hedge fund industry. Sure, this means increased regulation. But it also means greater investor confidence and a competitive advantage over other nations that don't do integrity and honesty as well.

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The Super Conduit--New Clothes for Banks?

The largest banks in America—Citigroup, Bank of America and J.P. Morgan Chase—have announced that they are sponsoring an investment vehicle (called the Master Liquidity-Enhancement Conduit), which will supposedly have $75 billion to $100 billion to bail out bank-related structured investment vehicles (SIVs) that hold mortgage-backed securities, by buying some of their assets. The new investment vehicle, which we will call the Super Conduit, is a creature of structured finance, like the conduits and SIVs that we’ve discussed previously in http://blogger.uncleleosden.com/2007/09/conduits-and-sivs-chill-from-shadow.html and http://blogger.uncleleosden.com/2007/08/were-subprime-mortgage-risks-hidden.html.

The conduits and SIVs were set up by major banks as investment funds for riskier assets, such as CDOs, that the banks may have underwritten but didn’t want to hold directly. The conduits and SIVs raised a lot of capital by issuing commercial paper, which was 10% to 50% guaranteed by the banks sponsoring them. Some of these SIVs have been hit upside the noggin by the decline of the real estate markets and the subprime mess. Many of their assets have lost value, sometimes sharply. When they’ve tried to sell assets in the open markets, they have frequently been offered discounted prices by skittish and skeptical buyers. And for some CDOs containing subprime mortgages, the SIVs been offered their choice between nada, zip or zero.

The SIVs face potential big-time losses if they keep liquidating assets. Thus, as the SIVs’ commercial paper falls due, the banks that sponsored the SIVs confront the prospect of having to honor their guarantees. Nothing could be less attractive to the banks, since some of the SIVs’ losses might become the banks’ losses if guarantees have to be fulfilled. Executive bonuses could suffer.

So the Super Conduit has been organized to ride to the rescue. Sponsoring parties, including the U.S. Treasury, which provided cheerleading although no money, have tried to sound like cavalry bugles signaling a charge. But let’s put our ears to the ground and think carefully about what we hear.

First, the Super Conduit has to find backers and investors. The backers would consist of banks that would guarantee the commercial paper the Super Conduit would issue to raise money to buy assets from the distressed SIVs. And investors would have to be found to buy the Super Conduit’s commercial paper. The banks backing the Super Conduit would apparently receive fees for services provided to the Super Conduit. Investors would presumably receive a premium in the interest rate on the commercial paper, especially if the bank guarantees aren’t 100%.

Most major banks on Wall Street reportedly haven’t committed to backing the Super Conduit yet. They may be wondering why they should bail out their competitors. After all, this is Wall Street, and if you want a friend, head for the Humane Society’s chapter in Manhattan. Wall Street logic dictates that when a competitor is in trouble, wait for it to really go downhill and then buy its assets at a massive discount. Participating in a bailout could mean losing an opportunity to buy at a cheaper price. Let's remember that Wall Street was built on the notion of buying low and selling high.

The sponsors of the Super Conduit attempt to address that issue by saying that the Super Conduit will only buy high quality mortgage-backed securities from the distressed SIVs. Moreover, they will charge the SIVs fees and pay discounted prices. This sounds more like banking: when the customer is desperate, smack him with fees and lend him the least you can for the most you can extract. So, maybe the Super Conduit's sponsoring banks apparently aren’t asking other banks join in a bailout. Perhaps they’re asking them to join in a feeding frenzy.

This is where the cross-currents of the Super Conduit proposal churn into a vortex. To induce the other sharks—pardon us—the other banks to participate in the Super Conduit, the sponsoring banks have to make the Super Conduit a good deal for them. But doing so comes at the expense of the distressed SIVs. They’re the entities that will be paying the fees and receiving the discounted prices—and all for the sake of selling their best assets. The SIVs will be left with their less desirable assets, which they won’t be able to sell to the Super Conduit. Having only those less desirable assets will make it even more difficult to pay off their remaining commercial paper. So what’s in it for the SIVs, or the holders of their remaining commercial paper?

Of course, the banks sponsoring the SIVs benefit, at least temporarily. If the SIVs’ maturing commercial paper is paid off with money from the Super Conduit, the SIV sponsors won’t have to honor their guarantees or record the losses that might well come with honoring their guarantees. But with the SIVs further weakened by paying fees to sell their best assets at discount prices, isn’t it all the more likely that the SIVs will collapse and the SIV-sponsoring banks will have to book losses?

With the real estate market still declining and further mortgage distress likely in the next few years as more ARMs reset to higher monthly payments, perhaps many of the CDOs currently held by the SIVs are headed ever closer to the septic tank. This might include some of the “good” assets that the SIVs could sell to the Super Conduit. Why would the banks not sponsoring the Super Conduit choose to join in a guarantee of the Super Conduit's commercial paper when it's supported by potentially declining assets?

The Super Conduit, if it is successfully organized, might buy the SIV-sponsoring banks a little time. Maybe, just maybe, the commercial paper market will regain some confidence and the SIVs will recover the ability to roll over their remaining commercial paper. But what are the chances of that? There’s nothing on the horizon that would signal improvement in the underlying problem, the distress in the real estate markets. So, the Super Conduit could simply turn out to be another bit of Wall Street financial engineering that doesn’t change the fact that we live in a world of risk and losses, and eventually will have to deal with it.

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