Superconduit

The Wall Street Journal describes it as a “superconduit”,
the New York Times refers to it as a “super-SIV”,
and the Washington Post is calling it a
“Master-Liquidity Enhancement Conduit”. Whatever you call it, does it make any sense?

The Wall Street Journal yesterday reported:

In a far-reaching response to the global credit crisis, Citigroup Inc. and other big banks are discussing a plan to pool together and financially back as much as $100 billion in shaky mortgage securities and other investments.

The banks met three weeks ago in Washington at the Treasury Department, which convened the talks and is playing a central advisory role, people familiar with the situation said. The meeting was hosted by Treasury’s undersecretary for domestic finance, Robert Steel, a former Goldman Sachs Group Inc. official and the top domestic finance adviser to Treasury Secretary Henry Paulson. The Federal Reserve has been kept informed but has left the active role to the Treasury.

Here’s the background as reported by the New York Times:

SIVs, which issue short-term notes to invest in longer-term securities with higher yields, are often organized by banks but are not actually owned or held by them. They are supposed to be financed through the issuance of commercial paper backed by pools of home loans and credit card debt, but the loss of confidence in the quality of subprime mortgage bonds has also tainted these securities.

Analysts say that investors have all but stopped buying SIV-affiliated commercial paper, and the worry is that the 30 or so SIVs will unload billions of dollars of mortgage-related assets all at once. That would put intense pressure on prices. As Wall Street firms and hedge funds mark value of similar investments they held to their new lower values, they face potentially huge hits to their profits.

Still, the impact on the biggest banks is even more severe. In times of crisis, they are committed– either legally or to maintain their reputations– to stepping in to buy those securities. Banks have already been buying significant amounts of commercial paper in recent weeks, even though they did not have to. But if they are forced to bring those assets onto their balance sheets, they might be less willing to lend to businesses and consumers. That could set off a credit crunch and thrust the economy into a recession.

The proposal being floated calls for the creation of a “Super-SIV,” or a SIV-like fund fully backed by several of the world’s biggest banks to provide emergency financing. The Super-SIV would issue short-term notes to finance the purchase of assets held by the SIVs affiliated with the banks, with the hope of reassuring investors.

And here’s the rationale offered by the Wall Street Journal:

The new fund is designed to stave off what Citigroup and others see as a threat to the financial markets world-wide: the danger that dozens of huge bank-affiliated funds will be forced to unload billions of dollars in mortgage-backed securities and other assets, driving down their prices in a fire sale. That could force big write-offs by banks, brokerages and hedge funds that own similar investments and would have to mark them down to the new, lower market prices.

The ultimate fear: If banks need to write down more assets or are forced to take assets onto their books, that could set off a broader credit crunch and hurt the economy. It could make it tough for homeowners and businesses to get loans. Efforts so far by central banks to alleviate the credit crunch that has been roiling markets since the summer haven’t fully calmed investors, leading to the extraordinary move to bring together the banks.

Before we jump into any such plan, I think it’s helpful to reflect on what are the basic principles on which any government intervention should be based. I would urge the Treasury to embrace the position of the Federal Reserve as articulated last month by Fed Chair Ben Bernanke:

It is not the responsibility of the Federal Reserve–nor would it be appropriate–to protect lenders and investors from the consequences of their financial decisions. But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy.

The goal should not be to bail out Citigroup, but rather to protect innocent bystanders from any potential adverse consequences of their decisions.

I definitely acknowledge that a “fire sale” of assets is an example of an event with a clear potential for precisely these sorts of adverse external consequences, and is something that there is a strong policy interest in avoiding. But the alleged “liquidity crisis” has now been with us for two months. Let’s be honest about the situation. The problem is that no one wants to buy many of the assets held by these SIVs at a price that is anything close to what they are carried on the books for. Nobody wanted to buy them two months ago, and nobody is going to want to buy them two months from now. Mish describes the superconduit idea as “don’t ask, don’t sell”: don’t ask what the asset is worth, and don’t sell or you will find out and not like the result.

We therefore need to be asking, Why doesn’t anyone want to buy these assets? Are we to believe that private investors are incapable of correctly valuing their true worth, whereas Treasury Department officials are? To me the puzzling phenomenon is not the current reluctance of people to buy securities backed by U.S. subprime mortgages. The puzzling behavior was the enthusiasm with which the current set of owners lapped them up.

How then would a superconduit, or whatever you want to call this proposed entity, solve the basic problem? Apparently the sheer size and participation of multiple banks along with the Treasury is supposed to give investors confidence. In my opinion, part of what created the current problem was the perception that participants were too big and too many to fail. If the government won’t let Citigroup fail, could it allow a superconduit to go down?

I am skeptical of any claims for a feel-good, this-will-solve-all-the-problems fix. The reality is that someone must absorb a huge capital loss. The question we should be asking from the point of view of public policy is, Who should that someone be?

My answer is: the shareholders of Citigroup.



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30 thoughts on “Superconduit

  1. mort_fin

    Prof.,
    I am curious about your opinions here. We keep see overwhelming evidence that the bulk of the subprime risk has been held by Hedge Funds, Investment Banks, and now depositories via complex off-balance sheet entities. We also know that the GSEs have had extremely limited exposure to subprime. In past postings you’ve expressed your concern about GSEs having somehow been at the root of the current subprime expansion because of their implicit guarantee. With subprime credit losses increasingly reported by various unregulated (or perhaps in the case of off balance sheet SIVs poorly regulated) entities do you still assume that the GSEs are at the heart of the subprime credit expansion?

  2. Anonymous

    “Who should that someone be?
    My answer is: the shareholders of Citigroup.”
    “Should” isn’t a word much used in Wall Street circles. “Will” is more current. Thus “Who will that someone be? My answer is: it will NOT be the shareholders of Citigroup for sure.”

  3. JDH

    Mort fin, my position was (and remains) that while the problem may have begun with the GSEs, it certainly didn’t end there. There is no question that the most egregious problems today are outside the GSEs. The process by which I believe that the GSEs may have played a role is in the initial development of the “too big to fail” concern– the financial herd may have reckoned that the policies necessary to keep Fannie and Freddie solvent would be enough to keep their heads above water as well.

    Understanding the history is relevant for crafting a solution– for example, I oppose the suggestion of having the GSEs buy up even more mortgages as a way out of this problem. But I apologize if in calling attention to the role of the GSEs in the initial explosion of mortgage debt I may have left the impression that the GSEs are the ones currently holding the worst stuff. That unquestionably has never been the case.

  4. James I. Hymas

    To me the puzzling phenomenon is not the current reluctance of people to buy securities backed by U.S. subprime mortgages. The puzzling behavior was the enthusiasm with which the current set of owners lapped them up.

    I suggest that both phenomena are equally puzzling. There’s nothing wrong with the highly senior AAA tranches of subprime trust paper, yet it is trading at a deep discount.

    But ‘headline risk’ is irrational by definition and the pendulum never swings half-way.

    What is the real capital hit to the financial system due to subprime? $200-billion, tops? I won’t deny that that’s a lot of money but compare it to the Tech Wreck: Nortel – a single company – was worth $400-billion at the peak and … er … much less today.

    I don’t think I’d buy commercial paper issued by the super-conduit without a rock-solid liquidity guarantee from a (consortium of) major bank(s), but term notes could be interesting, depending on the price.

  5. Insurance Guy

    James Hymas, I think your Nortel example proves the opposite of what you’re trying to argue. The actual asset write down at Nortel – something like $19BN, but I’m too lazy to look it up – was minuscule in comparison to the market drop you reference above. The correction to share price and market cap came as investors reassessed the future prospects of the firm.
    But as to the question of government intervention, I think Mark Thoma has an apt perspective:
    http://economistsview.typepad.com/economistsview/2007/10/the-narrative-i.html
    So long as private actors are acting in their own self-interest, I don’t mind the Treasury nudging them to move in any particular direction. Sometimes markets don’t work as effectively as possible. Obviously a guaranty or actual bail-out would be another story.

  6. annonymous

    professor,
    what i have not understood about this approach is this: if the initial intent was to create off balance sheet entities so as to leverage the balance sheet, isnt this putting these liabilities back on the balance sheet(by creating the need for a direct bank guarantee)? and, wont this limit lending to other areas of the economy as a result?

  7. Thomas Mayer

    When Glass-Steagal was repealed it was with the understanding that any problems that bank subsidiaries get into will not weaken banks, and hence involve no costs to the FDIC and the Treasury. Now banks want to bail out their subsidiares and, via the too-big-to-fail doctrine, pass some of this cost on to taxpayers. Those of us who believe in free markets rather than in generosity to business should strongly oppose this.

  8. calmo

    I still do not understand how the dilution of ABCP solves the liquidity issue…and therefore this solution looks like a desperate attempt by Citi (and maybe a few others) for a sharing of the pain…such a co-operative damn near socialist sentiment, let’s all hug.
    Who is going to buy the diluted rotten ABCP issued in this M-LEC? Recall that Everquest was hooted off the stage. People are just supposed to roll over when they hear the word “structured”? They know it means something else now (subterfuge, subreption, submerged…).
    Good thing we have a fair and balanced Secretary Treasurer.

  9. Chrerick

    I wonder what the effect of the superconduit will be on the balance sheets of banks — or more to the point — the blunting of the effect on bank balance sheets. It is an error to paper over true declines in the fundamental value of assets; doing so is exactly what allowed the S&L crisis of the 1980s to get out of hand.
    We have had situations with 500 bank failures in one year in the past. Nasty but we survived and even thrived. But the secret is to recognize the true capital position of the banks in question and liquidate them at or close to the point at which capital is zero.

  10. DickF

    I hear that Citi is in great financial shape and that they really are not suffering from the loan crisis. That makes me look deeper into such an announcement. Was it initiated by Treasury or by Citi and the boys? If it does become reality how is Citi going to profit?
    I don’t see this as any kind of bail out but I do see it as a way for Citi to strengthen its position and use the power of the Treasury to improve its position. I am not sure how they will do it but I suspect, without proof at the moment, that this is just another unholy alliance between big business and government to limit competition.

  11. JS

    Correct me if Im wrong. I would assume the SuperConduit scenario works by: The consortium buying assets at below book value ensuring a small profit, long-term. On the other side of the transaction holders, must sell them at the agreed upon price locking-in losses. This by itself helps to liquidate the market, as the assets arent currently trading regardless of price. The SuperConduit then holds the assets waiting for the worst to pass and making a small profit along the way. When the worst has past and the assets can be fairly valued it slowly sold off.
    Is my understanding correct here? I view it much like LTCM although my understanding of that situation might be bad, I was in high school then. Therefore the shareholders of Citi and other SIVs would have to lock-in losses when they sell the securities to the Super-SIV. To put it shortly, they gambled and lost and they must pay some cost. To me its totally unrealistic to expect other banks, not left holding the bag, to share in the losses. And as a jr. shareholder I would expect to see some profit, albeit small, from participating in the SuperConduit.

  12. Anarchus

    While details are sketchy, considering that the whole point of SIV’s and Conduits is to keep highly leveraged assets OFF the banks’ balance sheets, I’d expect this SUPER-Conduit or M-LEC to be off everyone’s balance sheets as well.
    It’s worth remembering, also, that the problem at the moment isn’t that the majority of the assets in SIV’s and Conduits have gone sour (that issue at present is unique to recent vintage subprime mortgages), but that the ABCP market has balked completely at providing rollover financing to the plethora of SIV’s and Conduits because of their lack of transparency and high leverage.
    It’s hard to see how the Super-Conduit solves this basic problem . . . . . . unless it also offers Super-transparency and a Super-strong balance sheet, which I do not think will be the case.
    One thing this highlights for me is the extraordinary visibility and underappreciated value of exchange-traded securities. According to a recent WSJ article, substantially more than half of all securities traded in the U.S. these days trade “only by appointment” at extreme intervals in the non-exchange non-market. And there’s not much you can do to generate real transparency for valuing securities that rarely trade . . . . . . .

  13. DickF

    There is no public money involved, but how about government guarantees? More and more it is looking like Citi is using the loan crisis to get the government to help it clean its books of bad paper. It is interesting that Morgan and BOA are involved because they have no SIVs. Could it be cover for Citi so that it doesn’t look like a government bail out? But then Citi doesn’t really need a bail out.
    Then the Washington post reports that the fund would not buy securities backed by subprime mortgages! This just doesn’t pass the smell test for me.
    The whole thing stinks from where I sit. Citi dumps trash with the help of BOA and Morgan who reap commissions for loaning their names with the whole thing administrated and guaranteed by the Treasury.

  14. Michael Raydt

    If one bank trusts in the value of the assets underlying the commercial papers it should buy them and it should have no incentive to share the profit. If they all have little conviction then this is clearly a rather disappointing signal. Instead they create a fund that basically takes over the systematic risk as by buying the commercial papers of SIVs it will hold a very brought portfolio of underlying assets that should make a profit unless the real estate market truly collapses but then at least they can rest assure that the state has a vehicle that will cry for a bail out. If it is a profit it goes into the covers of investment banks if it is a loss it goes to the treasury, not exactly the way the system should work!

  15. Unsympathetic

    The reason this happened in the first place is that Citi guaranteed the SIV’s.. but didn’t include the guarantee as an added risk on their balance sheet.
    Color me in favor of forcing Citi to BK. They wanted the tier capital exemption, fine.. now, instead of just BK’ing their fixed income trading desk, they BK the entire corporation.
    Thanks for playing, now go home.

  16. Anarchus

    Nothing about this goofy thing makes any sense.
    Kind of like putting cardboard wings and a propeller cap on a pig and trying to get it to take flight: The SIV’s are supposedly a $400 billion market and Citi has the lion’s share and the MLEC is only supposed to be $80 billion and won’t take any subprime assets. So, by definition launching the MLEC will leave Citi with A BIGGER PROBLEM financing the remaining SIV’s in its non-control since the better quality Citi SIV assets will have been put into the MLEC! Just barking crazy.
    What they should try to do is put the WORST QUALITY $80 billion of assets into the MLEC and then cobble together a financial guarantee of some sort from the government/GSE’s. So you could get funding for the MLEC with ABCP because of the guarantee and then maybe the remaining $320 billion of SIV’s could get normal ABCP funding because their asset quality would have been upgraded. It wouldn’t be a good plan either, but at least it would have a shred of a chance of success.
    No way this poor excuse for a plan gets off the ground in anything like its present supposed form. Not a chance.

  17. mp

    The only good idea I’ve read here is to let Citibank serve as an example to the rest of the financial community and burn it to the ground. It’s a floating crap game, an absolute embarrassment to the American financial system, and has been for many years.

  18. HZ

    But the President did call for an “ownership society”, so the tax-payers should shoulder some pain as well? In the end the social cost of letting large swath of homes getting foreclosed probably outweigh the cost of shoring up the collateral.

  19. JJL

    It seems the plan by CITI and Pals was able to call more attention to the problems in the commercial and mortgage backed paper market. If things were supposed to be wrapped up in those rough 3 weeks of late August and early September, a seemingly desperate move by the banks may cause some market participants to rethink the “worst is over” mantra. Perhaps the bulls will look in their car mirrors, see the goliath of a true credit crunch, and realize the little sign on the mirror is true:
    “WARNING: Objects in Mirror are Closer Than They Appear”

  20. Anarchus

    Anon: It makes a little sense, if and only if you assume that the federal government is intentional trying to hasten and encourage Citi’s demise . . . . . and I’m quite sure that Bernanke, Paulson and Co. are NOT intentionally trying to wreck Citi as quickly as possible because that particular outcome reflects so badly on THEM.
    I suppose it’s more likely that the government and Paulson were and are trying to help but instead ended up calling a huge amount of attention to Citi’s predicament and to the government’s inability to create a workable constructive way out for them . . . .

  21. PrefBlog

    October 15, 2007

    The Web is alive with commentary on the plan to create a super-SIV, which would hold about $80-billion in non-sub-prime ABS, finance with commercial paper and be guaranteed by the super-major banks – notably Citigroup, which took a beating today on cre…

  22. Norka West

    The MLEC scheme reminds me of a pony raffle at a county fair.
    The raffle promoters scour the county selling raffle tickets to win a pony. On the last day of the fair, the promoters hook up a cart to a tractor, drive from stall to stall, muck out the contents from the floor of each stall onto the cart, pull the cart to the middle of the fair grounds and dump the contents.
    As the children who were dreaming of ponies look on with tears in their eyes and fingers holding their noses, the promoters tell the horrified, raffle ticket holding parents Everyone is a winner! We know that there are ponies in there somewhere. Start digging.

  23. jm

    “Should” be the shareholders???
    But shareholders nowadays have absolutely no say in how a company is run.
    No, it “should” be the managers who put the company in this position. Their pay, pensions, assets — all the money they paid each other to create this debacle — should be forfeit. Like the “names” at Lloyd’s, they should be liable to the last collar button.

  24. Anon

    Anarchus,
    What if Citibank’s a goner and they’re willing to let it go, but they’re trying to do so with as little damage to the rest of the economy as possible. They may be worried that Citibank will end up taking the ABCP market down with it and are trying to do anything they can to save the ABCP market.

  25. MadLudwig

    Anyone remember the late 80s’ Resolution Trust Company? I do.
    It’s not just Citibank, but the entire mortgage industry that is sweeping up a huge deluge of capital losses under their collective rugs. A concrete example of this SuperConduit on a micro scale: a foreclosure auction of a California house that sold last year for $550K, where the owners have defaulted on a first mortgage of $440K. Comparable houses have asking prices now of around $370K. Instead of letting the auction process work as it was intended, and letting other bidders take the house off their hands at close to a current market price, the lenders choose to add it to their growing inventory of repossessed property with a bid of $440K. They are accepting a certain decline of the asset’s value in real terms, in order to defer the immediate capital loss. They’ll keep that house on their books at $440K… until the Liquidation Day Deluge.
    Why would they do this? The only answer is that they are accumulating such a huge pile of toxic waste that only the government can deal with it. And how must they deal with it? By conjuring up close to a trillion in new dollars to cover the bad bets of the rich and powerful, debasing the currency, and adding to the accelerating decline in the dollar’s real value, inevitably impoverishing the rest of us.
    I’d really be happy to see a realistic alternative plotline to this unfolding story. Anyone got one?

  26. Neal

    I think the credit crisis is bad and getting worse by the day.
    Why would the 3 major banks get together with the Treasury Dept. unless they were trying to find a way to cover themselves, and look for federal assistance?
    I feel the problem is much larger than the banks can handle, they know it, that’s why this “super siv” is being considered, and why they have turned to the Treasury Dept.
    Taxpayers, hang onto your wallets!

  27. DickF

    Here is a lot of good information shared with me (typos and all) by a friend for those interested.
    I think the market is beginning to realize that there is something seriously wrong with this deal….and with Citibank.
    The extent of the SIV exposure that Citibank holds is serious. Essentially it created structured investment vehicles, ‘SIV’s’, that were set up off balance sheet to avoid Basel Capital rules so they could be leveraged at 10 to 15 times. The SIV’s borrowed short term commercial paper…from Citi other banks and hedge funds and then invested those ‘pomissory notes’ in riskier, longer term paper, usually Asset Backed Securities..backed by mortgages, credit cards, student loans.
    The commercial paper is generally 90 day paper and much of the paper is coming due in November. Previously the SIV would roll the paper over and trade its longer term ASB bonds as needed. Presently they can’t roll over the paper, CP, and they can’t sell the ASBs…so they are illiquid and depending on the quality of the ASB bonds, potentially insolvent.
    Citi is the largest U.S. sponser of these vehicles in the U.S. but Barcleys and HSBC are up to their necks in these vehicles in Europe. One fear is that if these are not bailed out before Nov. they will race to dump ASB assets…as the first in will get the higher prices, even in a distress market, and as the others are forced to liquidate the ASB’s they will get less and less. If Banks like Citi had to take these assets back on thier books in this sort of liquidation it would have to take losses of more than 80B on top of the 20B it already took. Total losses to banks on these SIV’s would be more than 200B.
    What makes matters worse is that these SIV’s have been carried from the August freeze up to this point on the back of the Fed. Discount funds were made available and section 23A of the banking act was suspended to allow Citi and others to lend discount money out to the SIV’s (Sec. 23A otherwise prohibits lending more than 10% of Bank capital to related non bank entities). By some reports banks have made loans approaching 35% of capital to such entitites.
    The super fund deal is designed to move these troubled assets out in time and keep them off the market so the Banks do not have to take the losses and write down their capital reserves. Basic idea is to push this out till late next year and hope for the best.

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