Friday, October 19, 2007

Maybe Stalling Is Viable (The Master SIV) 10/22 update

Revised again - see the end. I have added a quote from a New York Times article on this topic.

I was going to revise this entire post (it was very dramatic and some people were offended by the Shamco reference – I was poking fun) but decided that an explanatory preface would suffice. So here goes:

The SIV structure is different from the ABCP Conduit structure on which this post was originally based. As details have emerged, it appears the SIV structure has less in the way of direct recourse to the sponsoring bank, although there is some [some more recent commentary suggests the recourse is only for reputational issues - "On SIVs, Citi is a manager of roughly $80 billion in SIVs. While they do not have liquidity backstops to their SIVs, they will lend at arms-length, exposing Citi to potential losses. Given that there is no disclosure on these loans, it is hard to estimate the magnitude of these potential losses, but we do bake in deteriorating corporate credit in the investment bank" From FT here:, citing Mrogan Stanley comments]. These entities use a different capital funding structure than other conduits. Because information has been so slow to come out on these, reports (including mine) based analysis on the ABCP Conduit with traditional liquidity and credit enhancement lines from the banks. I assume that the reason the current problem is more pronounced in SIVs is in part because they do not have as much support from the bank sponsors as the traditional ABCP Conduit and the structures are weaker given the impact of current market conditions.

Either way, I believe the accounting issues discussed below remain relevant to any restructuring of these off-balance sheet entities and their sponsors whether they are SIVs or not. In the end, if the CP market that funds these structures were to dry up, bank liquidity would be negatively impacted and the resulting lack of credit availability could cause major economic damage. The extent of the direct hit to the sponsoring banks depends, in part, on the level of support they provide, and I have not found any definitive source of information regarding the level of support or the sponsors’ liability with respect to SIVs (which is probably one reason why the reporting has been based on the more widely understood conduit structure).

ABCP Conduits are also off-balance sheet entities that use liquidity lines directly from the sponsoring bank (often a group of banks) to deal with liquidity risk, and these lines could be called upon to fund if the market for commercial paper issued by these entities evaporates. The potential cascading effect should not escape us. If bank quality deteriorates because of depreciation of assets both on and off the balance sheet, which could be sparked by the SIV issue, the risk of the ABCP Conduits will also increase and should reduce the demand for their commercial paper as well. This could ripple through the market, especially if forced liquidation of assets occurs further depressing asset values on the balance sheets of banks and in both SIVs and ABCP Conduits.

According to a September 12, 2007 Moody’s Investors Service Report, “Bank-sponsored ABCP conduits are the oldest and largest segment of the asset-backed commercial paper market. As of June 30, 2007, there were over 200 such conduits worldwide, with approximately US$900 billion of ABCP outstanding, comprising two-thirds of the outstanding ABCP rated by Moody’s.” There are three types of these conduits, and “all three types of bank-sponsored programs – multi sellers, securities arbitrage and hybrids – rely on liquidity and credit enhancement provided by Prime-1 rated entities. For most of these programs, most of this support is provided by the sponsoring bank. Therefore the credit rating of these programs is also linked to the rating of the sponsoring bank. Should a liquidity or credit support provider be downgraded below Prime-1, Moody’s would review the ABCP conduit rating and might downgrade the conduit’s rating.” In other words, if the banks that sponsor the Conduits are downgraded, so goes the commercial paper they issue. You can find this report here: . As it turns out, according the The WSJ Online edition, Citibank "has nearly $160 billion in SIVs and conduits, but its shareholders wouldn't get a clear view of this from reading the bank's balance sheet. Instead, footnotes only disclose that the bank provides 'liquidity facilities' to conduits that had, as of June 30, $77 billion in assets and liabilities." This article can be found here: [Subsequently I have reviewed the financials myself, and I believe the $77 billion number relates to multi-seller programs only.]

So, if you decide to read the original post, simply replace SIV with ABCP Conduit. If the SIV problem escalates into a larger problem, we could be looking at the same situation there anyway. And, the accounting issues remain relevant in any event. And, if anyone can give me (and others) some specific guidance on SIV sponsor liability, I would be grateful.

With that lengthy but necessary introduction, here is the original post:

Updated 10/18 - see below.

I just don’t get it. Everyone knows what this is about – stalling. It’s about using financial reporting flimflam to protect the banks from major problems. Here’s what this is about, as far as I can tell, in kind of simple terms (it’s not really simple). I am making assumptions about the structure for lack of details in the reported information. I did, however, hear from an under-secretary (I think that was his title) of the Treasury on Nightly Business Report tonight who said this beast would be funded by the banks and by commercial paper investors, so I have an idea what they plan to do. Here is the latest from The WSJ Online Edition as of this writing:

Banks (it seems Citi is the name that keeps popping up) have structured investment vehicles. What are these? Well, lets say you want to borrow some money to invest in mortgage-backed securities, but you don’t want the loan on your credit report. So instead you form a company called Shamco, and Shamco borrows the money. Of course Shamco has no credit history so you end up guaranteeing the loan that is also secured by the mortgage-backed securities you plan to purchase. The money from the loan comes in and Shamco uses it to purchase mortgage-backed securities that pay 6.5% interest, while borrowing at 3.5% interest. Borrow short term at 3.5%, lend long term at 6.5%, and go home with more money! What allows this to happen is your personal guarantee and the fact that some analysts at the rating agencies opined that there was very little risk in lending to Shamco in part because you will pay up if there is a problem. The loan is not on your credit report (or balance sheet). (Welcome to financial engineering.)

Everything is fine for a long time. Then, one day, it turns out that the investments Shamco purchased are bad. The mortgages aren’t getting paid, so the value of the mortgage-backed securities Shamco purchased for say $100 are only worth $80. Well the lender finds out about this and says, “Pay me back.” Here is the problem. You can’t really pay the loan back because Shamco has no cash (it used it all to buy the mortgage-backed securities) and you don’t have enough cash reserves to make good on your guaranty. Shamco can’t sell the mortgage-backed securities because it’s no secrete that they are bad investments and nobody wants them. But you guaranteed the loans, so if push comes to shove, you are on the hook. You would have to buy the investments for the amount you owe even though they are not worth that much, or sell the investments and chip in the rest. This could cause you major problems, including ginormous losses.

I give you the SIV. This is what the banks have done. The SIV is the new company, and it issues commercial paper (which is very short term stuff). The commercial paper is purchased by money market mutual funds (and such) at very low rates because S&P and Moody’s have given the commercial paper high ratings for safety. The SIV uses the proceeds of the commercial paper loans to purchase assets, like mortgage-backed securities (and lots of other stuff). The bank guarantees the commercial paper investors that if there is a problem, the bank will come in and pay them. None of this debt or assets is on the bank’s balance sheet. (There is a footnote somewhere that tells investors the bank is the guarantor on these loans.) The bank charges the SIV a fee, and that goes right into fee income for the bank.

Well, Houston we have a problem. There is a lot of commercial paper coming due in November and the banks don’t think investors are going to be interested in taking new commercial paper for old commercial paper when the collateral stinks. They will want to get paid. Oh sh$&%^t.

Bring in the M-LEC! What is this M-LEC (master liquidity enhancing conduit) thing? Well, it’s like a Daddy SIV. The major banks will put some cash into Daddy’s account, and that pool of cash, together with new commercial paper issued by Daddy, will be used to purchase the bad investments that the SIVs cannot finance. Now, the investments haven’t gotten any better, they still stink. But, instead of accepting that the investments are worth $80 and recognizing the loss, they are sold to Daddy who is willing to pay $95 instead of $80. Daddy gets $15 from the banks (the cash they gave Daddy) and $80 by issuing new commercial paper. The commercial paper lenders are OK with this (everyone hopes) because the banks will take the first loss if the investments end up not paying off.

Wait a minute, something is missing. Oh yes, those darned accounting rules. I wonder how the investment will get valued when it is sold to Daddy. Now, in reality, it is only worth $80 and I would think it should be sold for its market value. Anyone want to make a wager that these assets will move from the SIVs to Daddy at something higher than that? Lets say at $95. The “loss” to the bank that guaranteed the selling SIV is only $5, and not $20! The hope, I suppose, is that in time investors will be less scared about the value of the investments and the investments may rise in value again. Lets say they go back to $100. Everyone gets their money back! If not, the losses will occur over time, giving the banks a chance to fund reserves for the losses.

Lets review. My guess is that according to accounting rules, these assets should be “sold” from the SIV to the M-LEC at market price, a price of $80 and not more. This would result in a loss to the bank guaranteeing the selling SIV of $20. Instead, a much smaller loss is reported because Daddy purchases the investment for $95 instead of its true value of $80. Where did the other $15 go? Probably something like “Investment in Daddy” on the bank’s balance sheet. Hocus Pocus!So, what is going on here? Are the banks, with the help of Treasury, inflating the value of their assets? By the way, at the same time they are deflating the value of their liabilities. If you want to know about that, click here: So, inflate the assets, deflate the liabilities. This of course increases the equity capital and makes the banks look much better. Problem solved! (I wonder how are they calculating the deposit insurance fees to the FDIC? Isn’t that supposed to change with capital inadequacy? “Good” banks may be upset with all of this.)

Please, someone tell me this is not the plan! If it is, then this is the highest level of financial flimflam, right up there with Raptor III (Enron). In fact, it’s worse because it is being done out in the open (sort of) and with the blessing of the United States Treasury. If this is the plan, we know there are real problems out there. Even so, this sort of magical mystery accounting tour should never be contemplated by those entrusted with our financial survival. How can regulators ever fault a company for this sort of accounting engineering if they are party to it? My guess is that if this is the plan then fear (and in some cases greed) will keep everyone who can stop it from doing so. If this is the plan, it is a sad day in the world of business.

PS: What if this were H-P and Dell withholding inventory from the market because they overproduced? Think collusion.The Latest from David Reilly at The WSJ Online Edition here:

"Changes enacted after Enron Corp.'s collapse were supposed to prevent companies from burying risks in off-balance-sheet vehicles. One lesson of Enron was that the idea that companies could make profits without taking any risk proved to be as ridiculous as it sounds."

David Reilly again on accounting:

Response to ongoing questions: I have had a couple of people ask questions about this post. I want to clarify the link between the off-balance sheet piece and the need for help. If these entities were on balance sheet, banks would have had to hold reserves for possible losses. [Banks hold minimal reserves for off-balance sheet entities like these. For more information on this you can see my post on Bank Regulators]. Then we would not have this problem because the banks would have adequate liquidity to deal with it. Sure, there may have been less money available for mortgage and other financing if they had to hold reserves, but looking back, would that have been such a bad thing? The fact that they did not have to hold reserves is, in part, why we are in this mess to begin with. There is no free lunch - when will we learn this? I hammed this one up a bit, I know that. But I get aggravated when the same thing happens over again - we don't learn.

Good post on this at

Update - good article in today's WSJ on this structure. Note the "junior notes." These are what I referred to above as "Investment in Daddy." From the article, SIVs "didn't require banks to cover fully the fund's debts if the commercial-paper market dried up." Details Please!!!! Here is the URL:

Revision - 10/22

I was reading an article by Ben Stein today published in The New York Times yesterday here and I thought it was very well done (I love it when the pros do it). He has a different slant on the whole MLEC issue, although he comes to the same basic conclusions that I do (here and in my other post about Citi). Here is an excerpt from his article, but I encourage you to read it all at The Times. It is free, although registration is required.

"THE deal, as far as I can tell, is that they buy the most secure levels of debt that Citigroup and others own, get large fees and allow Citigroup and the others to keep the debts off their balance sheets. But there are at least two giant issues here.

"One is that it’s a bit too predictable that Mr. Paulson would basically pooh-pooh the subprime problems until major Wall Street powers got in trouble and then — presto! — swing into action. It might have been inspiring had he stepped up to the plate when smaller players like home buyers were getting burned, but that’s not really his style.

"The other is that it’s hard to see what good the maneuver would do. Suppose Citigroup or some other lender has a perfectly good loan to sell. Why does Citigroup need a big Treasury-sponsored organization to sell it? They can sell it to anyone right now. The problem is with the questionable loans. And they seemingly are not part of the plan from the Treasury.

"The Treasury plan is either just plain foolish (an explanation not to be sneered at) or it’s the thin edge of the wedge: what may follow is to have a government fund to buy the slightly less fragrant parts of the portfolio. Indeed, that would seem inevitable to me, and I’ll tell you why.
The goal is to keep Citigroup and others from taking large losses on bad loans. If the loans are sold to supershrewd buyers of debt like Leon Black or David Tepper or our resident megagenius, Warren E. Buffett, those buyers will demand a big haircut on the deal. Losses will have to be taken. The only buyers who might step in to pay full price are — drumroll, please — you and I, the taxpaying suckers.

"I could easily be wrong, but I suspect that at the end of the day, you and I will be bailing out the hundred-million-a-year finance titans who messed this up in the first place. This is what happened with the savings-and-loan disaster. The S.& L. chieftains — very often connected with Michael R. Milken and Drexel’s junk-bond world — became multimillionaires and billionaires by wheeling and dealing with government-insured money. When the loans went bad, you and I picked up the bill while the bankers went shopping for their Bentleys."

PS - can anyone help me with formatting this stuff? I can't seem to carry it over from Word.

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Palermo's Blog said...

A comment to my own blog! I have read an article that claims my comparison to Raptor is unfounded and unfair because that was outright fraud. I have two questions. The first - how is moving an asset from one place to another while falsly recording its value not fraud? The second - is this not market manipulation? If I did this wouldn't I be accused of fraud? It is not manipulation or fraud because it is banks and they may be big enough to actually manipulate the market? Please explain.

Palermo's Blog said...

Go here for a really good post on this topic.

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