The F-LEF, or the Federal Reserve Liquidity Enhancing Facility

The Federal Government is in full swing on the current crisis in the financial markets. We have the FHA refinancing subprime loans and financing purchases with no money down (they claim 3% is required but this can be satisfied with a Seller’s Concession for closing costs, and we all know that’s code for raise the price to cover the concession); we have the Federal Home Loan Banks lending hundreds of billions of dollars to the banks on mortgage collateral; we have pressure on the GSEs Freddie and Fannie to step up their participation in the mortgage markets at a time when they are experiencing large losses themselves; we have the fiscal stimulus package (that, in part, increases the amount FHA and the GSEs can lend against homes from the high 300ks/low 400ks to $729k in many markets); and we have the Federal Reserve not only lowering interest rates but also providing $100 billion in liquidity for the banks through the new Term Auction Facility, or TAF. Wow! I have written on all of the foregoing steps taken to blunt the impact of the financial crisis that started with subprime mortgages except the TAF. You can find these articles by clicking on the “bailout” keyword on the list of keywords below. Today I want to look at this TAF.

Several months ago many commentators, including me, where writing about the Treasury plan to create a master liquidity enhancement conduit, or M-LEC. The purpose of this conduit was to be a buyer for assets that struggling SIVs, or structured investment vehicles, needed to liquidate. SIVs, at their core, take advantage of short-term financing at low rates to invest in longer-term assets that pay higher rates making a profit on the spread. When the short term funding dried up because of concern over the value of the assets held by SIVs they were forced to look elsewhere for funding or sell their assets. The problem was that the SIVs could not sell many of their assets into an unfavorable market without suffering losses on those assets. If they were sold at losses investors would suffer and the market could be permanently harmed. Enter the M-LEC that could purchase and hold these assets until the markets returned to “normal” and then sell them or simply hold them until maturity, thereby eliminating the need to sell them at a loss. Of course this raised accounting issues, among others, because if the market value of these assets was below the amount they were sold for the accounting really didn’t work. In the end the M-LEC was never formed. Instead, some banks that sponsored these SIVs ended up taking the SIV assets onto their balance sheets in order to avoid very embarrassing and reputation devastating results of SIV failures. Others were restructured into longer-term debt or liquidated at a hair cut to investors. (There were also liquidity lines from banks to these SIVs at stake, although the reporting on these was and is very confusing.) So in the end, the assets that caused the trouble ended up sold or on the balance sheet of the sponsoring banks.

Now enter TAF, or the Federal Reserve’s Term Auction Facility. This was introduced in December, around the time the M-LEC was originally to be finalized. The TAF is a loan facility from the Federal Reserve to banks. The Federal Reserve has been increasing the amount of the TAF facility in the aggregate from an original $30 billion to $60 billion, and last week to $100 billion. Here is what it does. Bank A needs liquidity to meet deposit withdrawals and/or loan commitments. It can try to get more deposits if it can, but apparently the banks can’t. It can borrow from other banks, but apparently the banks don’t want to lend enough to each other right now either. It can sell an asset on its books to raise liquidity, although this would reduce its profits by shrinking its balance sheet. Or, perhaps it can’t sell an asset on its books to raise the needed liquidity because the market value of the assets is below the carrying value and Bank A would take a loss. Hum, food for thought.

Enter the TAF, where Bank A can pledge assets to the Federal Reserve in exchange for a loan as long as 28 days in duration. Problem solved, Bank A has the liquidity it needs and the markets are not flooded with assets no one wants to purchase. All of this has me wondering – has the Federal Reserve become the Master Liquidity Enhancing Conduit that the banks and Treasury could not work out? The amount, about $100 billion, seems about right. The timing seems about right. It walks and talks like a duck, so maybe it is. I call it the F-LEF, or the Federal Liquidity Enhancing Facility.

The next question that follows is what assets is the Federal Reserve taking against these $100 billion in loans to the banks? Are they those same assets that moved from SIVs and perhaps other asset backed commercial paper conduits sponsored by the banks to the balance sheets of the banks? Seems like a very logical sequence of events viewed this way, so I decided to try to verify whether this was in fact the case. (The banks can pledge collateral that includes mortgage-backed securities, even ones that may contain subprime mortgages). Unfortunately, the Federal Reserve has not, to my knowledge, published a schedule of the collateral it has taken for these loans. So, the usually transparent Federal Reserve has hit a wall of opacity. It is not publicizing which banks are borrowing and it is not disclosing what assets are being pledged against those loans.

I, for one, would like to know what collateral the Federal Reserve is accepting and how it is being valued. Until these facts are made public, I will assume that the Federal Reserve has done what the M-LEC failed to do by creating the F-LEF through which the banks are delaying sales of assets that have been negatively impacted by the changing markets in order to preserve liquidity (or is it the appearance of solvency?). At the same time the banks are being openly encouraged to raise additional capital. So just how solvent are the banks?

Some very interesting questions and issues have been raised by this TAF. On the one hand, some commentators believe it could be the first step to nationalizing the banks (see this article by Steve Randy Waldman). If there are margin calls on the collateral that the banks cannot meet, what is the Federal Reserve to do? Convert the loan to equity? Interesting point. One colleague of mine suggested the Federal Reserve could simply forgive a portion of the debt, or “write it down”, just like the Federal Reserve Chairman Ben Bernanke is suggesting lenders should do with mortgage loans that are more than the property values securing them. That would raise a lot of very interesting issues. Others have said this is just a more effective way to provide needed liquidity to the banking system and should be well down the list of current concerns (see this article by Caroline Baum in Bloomberg).

Stay tuned – I have a feeling this isn’t over yet.

(Ordinarily banks that are solvent can borrow from the Federal Reserve using the Discount Window. The TAF is different in several ways. First, the Federal Reserve will not publish the names of the banks that win the auctions so we just don’t know which ones they are. These loans are also much longer in duration at 28 days and the Federal Reserve has assured the markets that it will provide these lines of credit for at least six months unless market conditions clearly show they are no longer needed and will increase the size if necessary. In the Federal Reserve’s words:

First, the amounts outstanding in the Term Auction Facility (TAF) will be increased to $100 billion. The auctions on March 10 and March 24 each will be increased to $50 billion--an increase of $20 billion from the amounts that were announced for these auctions on February 29. The Federal Reserve will increase these auction sizes further if conditions warrant. To provide increased certainty to market participants, the Federal Reserve will continue to conduct TAF auctions for at least the next six months unless evolving market conditions clearly indicate that such auctions are no longer necessary.)

For more details about the TAF visit the Federal Reserve's website.

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

10/22
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: http://ftalphaville.ft.com/blog/2007/11/01/8559/consumer-contagion-coming-says-morgan-stanley/, 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: http://americansecuritization.com/uploadedFiles/Moodys_ABCP.pdf . 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: http://online.wsj.com/article/SB119249738008460181.html?mod=todays_us_money_and_investing [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: http://online.wsj.com/article/SB119245287618859154.html?mod=hps_us_whats_news

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: http://polecolaw.blogspot.com/2007/10/hocus-poke-us.html. 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:http://online.wsj.com/article/SB119249738008460181.html?mod=todays_us_money_and_investing

"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:http://online.wsj.com/article/SB119257816857761266.html?mod=hps_us_whats_news

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 http://www.financialarmageddon.com/2007/10/the-crowding-ou.html

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:http://online.wsj.com/article/SB119266856453862839.html?mod=hps_us_pageone

Revision - 10/22

I was reading an article by Ben Stein today published in The New York Times yesterday here http://www.nytimes.com/2007/10/21/business/21every.html?ex=1350619200&en=bfe48f041e1a9aaf&ei=5124&partner=permalink&exprod=permalink 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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