Monday, October 15, 2007

With our combined strength... Episode Two

Several weeks ago I wrote about a hypothetical plan to create a new entity, jointly owned by various banks, to buy some of the "hung bridge" LBO loans that banks are holding. While the idea was widely derided as an accounting gimmick, I wanted to point out that it didn't have to be anything as nefarious. Which isn't to say that it might have turned out that way, just that the so-called "LoanCo" plan could have been perfectly legitimate.

Fast forward to the now public plan to create a similar jointly owned entity to bail out the asset-backed commercial paper market (ABCP). I feel similarly about this plan on the surface. It doesn't have to be a balance sheet shell game. Such a plan could be set up as a perfectly legitimate attempt to come together for mutual benefit. The bank's could report the assets and liabilities of the joint venture on their books, or in a supplemental report if consolidation of the venture wouldn't be GAAP. After all, all these big banks make heavy use of the commercial paper market, and hence providing stability and assurance to that market benefits each of them. Even the Treasury Department's involvement isn't automatically offensive, if indeed all they did was invite the banks in question to Washington for some tea, biscuits and a nice chat.

Of course, what it could be and what it will be are two different things.

Anyway, here is how it sounds to me like this will work. First, a new entity will be formed, we'll call it SivieMae. SivieMae will be owned by various banks, which will have to infuse it with some amount of cash, although likely a very small amount. SivieMae will sell ABCP, which will carry what sounds like a joint and several guarantee from the owner banks. Given that the banks involved that have been made public are AA/Aa rated, SivieMae will carry a very strong credit rating, probably AAA/Aaa. For those who care about real bond trader shit, CP isn't rated using the same coding as bonds. The top rating is A-1+ for S&P and P-1 for Moody's. In most cases, AA/Aa or AAA/Aaa banks would both have a A-1+/P-1 CP rating.

Prior to selling the ABCP, SivieMae will have entered into agreements with various SIVs to buy certain assets. Some scheme will have to be cooked up to value the assets. Apparently SivieMae won't be buying mortgage-related securities, and if this is true then valuing the assets shouldn't be too difficult. Of course, if the assets are valued correctly, a significant loss will still be realized by the sellers, because even very strong non-resi ABS have widened significantly in recent months. The losses might only be like 1-2% of par, so if every one was being ethical about this, that loss would pass through to the bank that owned the SIV. Of course, if every one was being totally ethical, they'd hire an independent accounting firm to value the bonds to avoid self-dealing. But I haven't heard anyone talking about such a thing. So... We'll see how well the assets are indeed valued. Call me highly skeptical.

The banks issuing the guarantees on SivieMae's CP are going to do so for a fee. That's how someone like Bank of America who hasn't been in the SIV game is motivated to get involved. SivieMae will supposedly have a limited life, although I'm skeptical on that as well, perhaps as short as 1-year.

I don't have a problem with the concept behind SivieMae. I don't care about the banks collecting fees either. My problem is with Citi's position in all this. Let me quote another classic movie, and imagine this is Chuck Prince speaking to the other banks in one of Treasury's conference rooms:

"Times have changed. It's not like the old days, when we can do anything we want. A refusal is not the act of a friend. If [Bank of America and J.P Morgan] had all the [liquidity], and the [funding capacity] in New York, then he must share them, or let us others use them. He must let us draw the water from the well. Certainly he can present a bill for such services; after all... we are not Communists"

I'll bet most of AccruedInterest readers recognized that as Don Barzini's speech from the Godfather during a meeting of the Five Families. Consider the parallel here. In the movie, Barzini and his allies had ventured into the drug business, something that Corleone had steadfastly avoided. But because of Barzini and other's actions, the Corleone's were dragged into a costly war. The Corleone's ultimately couldn't avoid the problems of the narcotics trade no matter what they did.

Here we have some banks, particularly Citigroup, who were using off-balance sheet vehicles to increase their leverage. Other banks, such as Bank of America and J.P. Morgan, decided not to get involved, for whatever reason. Now Citi's structures are struggling to refinance their liabilities, and forced selling from various leveraged players is hurting every one. Those that choose to stay away from the SIV structures were still dragged down by the liquidity crunch. No matter what, the over leverage was going to end badly for every one.

Like the meeting of the Five Families in the Godfather, the Ten Banks have gotten together to hammer things out. But the banks aren't on equal footing are they? Citigroup really needs what Bank of America and J.P. Morgan have. There's no obvious reason why Bank of America or J.P. Morgan would help out Citigroup. Yes, LIBOR and CP spreads got very wide while quality asset
spreads got killed
(thus dragging everyone else down), but all that's improving on its own (or with help from the Fed). The mainstream media stories are acting as though the ABCP world needs rescuing, but really it doesn't. ABCP spreads have improved substantially and are moving in the right direction. I don't think investors are generally leery of ABCP as a concept, more what kinds of assets are backing the program. Besides, if JPM and BAC aren't involved in SIVs, what the hell do they care what happens in the ABCP world? Why wouldn't Jamie Dimon just tell Chuck Prince to go drive through a toll booth?

There are two possibilities. One is that the Treasury department strong-armed them. Second is that the fees were set at such a high level that it became an offer the other bank's couldn't refuse.

I'd guess it was more the latter than the former. I have no particular reason to discount the former, I just don't know what Paulson could offer/threaten BAC or JPM that would be as persuasive as a gigantic fee.

And if you think about it, although the stories say that Citi will get a fee as well, this will wind up working to where Citi pays a de facto fee to the other banks. Think about it. If Citi is the biggest seller of SIV assets, Citi will either own more of SivieMae than others, take large losses on the sale of assets to SivieMae, provide extra cash funding to SivieMae or some combination. Or something else perhaps, but I'm certain no bank will agree to put up their money to back Citi's mistakes without some concession. Like I said, the banks that avoided SIVs have all the power here, and if I know anything about Wall Street, its that those who have the power use it.

Anyway, so if Citi actually owns more of SivieMae but the banks equally guarantee its solvency (and equally collect fees) then Citi is de facto paying the fee to the other banks. In exchange, Citi gets to avoid bringing the SIVs onto their books, which would greatly impact their regulatory capital. I think it's the regulatory capital issue that is driving this proposal. If it were just about paper losses, I think Citi wouldn't be as concerned.

Now squint your eyes a little and what do you see? One bank paying another bank a fee to avoid reporting their complete assets and liabilities on their balance sheet. Now, when Vito Corleone pays a customs official a fee to not look in the blue container coming off that ship, that's called a bribe. What do we call this?


Accrued Interest said...

Found this commentary with similar tone: from naked capitalism.

Anonymous said...

Oh, we are getting snarky now, aren't we?

Pretty soon you'll be saying that all those crooked loans that Sandy and Chuck peddled to poor people in the South, when they were just starting out, were a bad thing, were morally putrid.

Gosh, what's an average investor to say!

Anonymous said...

Just out of curiosity, would you happen to be willing to hazard a guess what the effect on Citibank would be if it had to bring the off-books stuff onto the books?

Would they fail?

Accrued Interest said...

Anon @12:25: What are you trying to say? Am I usually too nice to Wall Street? Ayes just calls 'em like Ayes see's 'em.

According to the Wall Street Journal, Citi sponsors $80 billion in SIVs. They have $2.2 trillion in assets. So it really wouldn't hit them that hard.

I think the problem is that if it comes on balance sheet, then they have to make their regulatory capital work. And in order to do that, they have to liquidate some stuff. And if they do that, they'll realize more losses. If anyone out there is a banker and wants to correct me on that, by all means, but that's my understanding.

Anonymous said...

SivieMae will sell ABCP, which will carry what sounds like a joint and several guarantee from the owner banks.

I was thinking about this, and it isn't clear to me how any of this benefits them. If Citi has to guarantee the new SivieMae CP debt, then it still has the same amount of assets on balance sheet (and hence using up reg capital, although prehaps a different amount).

But then I got to thinking that maybe a little regulatory arbitrage is going on. If no guarantee is given, but a back-stop liquidity facility is put in place, then my limited understanding of CP/SIV's/reg cap requirements is that if a bank provides a back-stop liquidity facility of less than a 1 year duration, then the bank doesn't have to put capital against it.

So by taking assets from its balance sheet, moving them into a SIV and providing a liquidity backstop for that facility (not a guarantee), it then doesn't need ANY reg capital against those assets (even though it seems to me that they still have a pretty decent amount of risk to the performance of those assets).

Not sure if this is what is going on, but makes more sense than banks formally guaranteeing debt (CP) backed by cr*ppy assets. And achieves the goal of freeing up some capital for Citi. If they really are this desperate for capital, it sounds like the stock should be a great short.

Unknown said...

and not for nuthin, it sounds to me as if this post, tddg, ties in perfectly with your post from Friday re owning Treasuries. Suppose i'd like to be one of those bond fund managers down a boat-load and still gainfully employed ... much like the weather people ... seems the more incorrect they are, the bigger the tv contracts they get with the snazzier suits, etc etc etc ... seperate but different is this new'ish crop of financial engineers coming up with the mother of all off-balance sheet funds that is getting a big ole slap on the back by Hank Paulson at Treasury...seems as though there is real desperation out there to produce some alpha HENCE the under-ownership of Treasuries. as a lowly bond-salesman, cannot say how many times we've heard the argument that there's no VALUE to 2yr notes when FedFunds are (now only) 50bps above them ... can only say it's not ONLY about definition of value but of percieved value ... somethin' i read sometime in highschool, i think about mkts being a future discounting mechanism. whatever. point IS that for today, stocks down on Citi news (says consumer credit is deteriorating) makes good ole fashion sense given the 'other stuff' folks are NOT really talking about today ... hillary looking like a strong'ish candidate (stocks plunged last thurs on cnbc interview), oil is UP over $85/bbl and Turkey (US friend) thinking about Iraqi incursion ... right. Lets take on some MORE risk, buy some TXU lbo debt and oh yea, some master off balance sheet fund ABCP! sounds like a plan, stan! ???

flow5 said...

"A sworn fore of bureaucrats, Mr. Wriston often joked: “Regulators sit by while snails go by like rockets.” He devoted much of his career to diving through loopholes in bank holding-company legislation or wriggling free of interest-rate restrictions. As Mr. Zweig shows, Mr. Wriston presided over an encyclopedic range of innovations-among them negotiable CDs, term loans, syndicated loans, floating-rate notes and currency swaps-that ended forever the moribund bonking of the 1950s and ushered in our razzle-dazzle age of finance. The old prudential banker’s ethic was eclipsed by the hedonistic freedom of the consumer culture. By the 1960s, Mr. Wriston had inverted traditional bankers’ wisdom and proclaimed: “Our job is to help people spend money, not to save it.”

While Mr. Zweig admires the freewheeling, entrepreneurial verve that Wriston brought to Citibank..."

We don't have capitalism. We have regulated capitalism.

We have an “elastic” currency “aided and abetted” by “elastic” legislators. We have perennial Walter Wriston caricatures pressuring the House Committee on Financial Services & the U.S. Senate Committee on Banking, Housing, and Urban Affairs. We have a conspiratorial organization that goes by the name of the American Bankers Association - with its well funded lobbyists.

The Board of Governors is self-described as: “subject to oversight by Congress, which periodically reviews its activities and can alter its responsibilities by statute” Even so, the Fed is “connected at the hip” with Congressional allies, a la Greenspan, who the New York Times called a “three-card maestro”.

The Fed’s research is politically coordinated, targeted to justify its monetary policy objectives - those that appease the banking community. It’s as the university professor said: “innovate away from home”. Academic freedom has become the “barbarous relic”.

If Citi doesn't get what it wants, they will bribe the appropriate authorities. We live in a predatory society.

This is conceptually over my head. It just seems to be an end-around. All of this put & take to rob Peter to pay Paul? Probably Paul ends up with less than Peter.

Anonymous said...

if a bank provides a back-stop liquidity facility of less than a 1 year duration, then the bank doesn't have to put capital against it.

As far as I know, the capital requirement is 10% of what the requirement would be if it was on-balance-sheet.

Anonymous said...

If the banks are really worried about liquidity in the ABCP market, why don't they just buy the ABCP themselves in the market? This new conduit is not consistent with the stated objectives.

Accrued Interest said...

CDS Trader: I think you are right that they will have a de facto guarantee but it might take some unusual form. FWIW, my Citi salesman already called me about "multi-issuer CP conduits" without mentioning this new plan. In other words, they want me to be up on how a multi-issuer CP program might work just in time for them to issue a zillion dollars of the stuff. I don't even buy CP!

Accrued Interest said...

Steve: Don't follow.

James: Perfect. I knew my friends on the internet would provide. I had faith.

Anon: That's why I'm far more suspicious of this plan vs. the LoanCo plan. This just doesn't seem necessary at all, and yet they're doing it. There's something we don't yet know, and I don't know what it is. If I had Citi bonds, I'd be getting out of them just for the uncertainty. I never liked Citi bonds though. Citi and JPM always seem to be on the short end of some dumb loan, so I've never owned either.

Anonymous said...

So as of last July (when Citi published numbers "pre credit fiasco"), Citi claimed their Tier One Capital ratio was 7.9%. More than a few people pointed out this was a little low for comfort -- but since Citi has such a "broadly diversified portfolio" maybe we can let it slide.

Then the credit fiasco hit. Citi recently acknowledged loosing a boat load of money (see 3rd quarter earnings release) and there are probably other mark to market losses that they cannot really say because there are no market quoted prices.

According to tddg, Citi is sitting on about $80 billion of CDO loans, CP backup credit lines, etc. I have heard other people say the number is much higher, and others say the number is much lower. I fear Citi doesn't really know either, but that's a different discussion.

Lets go with the $80 billion guestimate, and lets say it really should be valued at $40 billion. I think some loans are probably decent (valued close to par) and other loans are garbage. Meet somewhere in the middle, and you need to subtract some more because of uncertainty. So I somewhat arbitrarily guess $40 billion value, and $40billion that needs to be buried somewhere (sticking with the Godfather theme). Since Citi isn't saying (and may not know), we are all guessing.

If Citi has $2.2trillion and had a 7.9% cap ratio, that gives them $174 billion Tier One capital (I am doing back of the napkin calcs here, please don't nitpick. Also, this number is before the 3rd qtr loss). If Citi takes a $40 billion write down (in whatever form), Tier 1 ratio is going to fall to about 6%... and we haven't even looked at stuff outside the CDO area like non-agency mbs.

Now 6% ratio is not the same thing is bankrupt -- but if 7.9% was a little shaky, 6% spells trouble. Will international banks be willing to enter swap agreements with what is clearly not a AAA bank?

Remember all the "too big to fail" Japanese banks of the early 1990s - I think they were 7 of the 10 largest in the world? Well, officially, none of them "failed"-- but technically they did. All had limited access to the swap market for many years. All were sitting on billions of USD equivalent non performing loans.

Citi was already bailed out from defacto insolvancy 15 years ago by a Saudi prince. After 9/11 and the xenophobia afterwards, will he repeat? What about Dubai after the seaport debacle? Will Congress allow a Chinese bank to take a large position in a flagship US bank? Who else has money to burn? (hint: they fill out 1040s every April 15)

As tddg points out, this MLEC thing seems a bit of a shell game. We can all pretend for a little while, but we know a lot of CDO are backed by original 110% LTV loans that are now 125% LTV. Many others had totally fictitious income and/or delusional appraisals.

Somewhere, somehow, someone has an economic loss-- a big one. Until someone says "its me!" or "its us!", the fat lady has not sung

One victim of collateral damage may be Henry Paulson. Here's a guy with a stellar reputation at GS-- and he seems to be encouraging a very Enron like off balance sheet vehicle to, umm solve? with creative accounting, what is obviously an economic loss in real life

Anonymous said...

There are two possibilities. One is that the Treasury department strong-armed them. Second is that the fees were set at such a high level that it became an offer the other bank's couldn't refuse.

One more possibility. This is really a vulture fund in sheep's clothing.

Anonymous said...

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.”

Anonymous said...

"One more possibility. This is really a vulture fund in sheep's clothing."[James I. Hymas]

What he said.

After its all over, we may indeed find elements of this.

cburn69 said...

Spreads on first and second loss pieces are currently 20-30 points in many cases, which isn't necessarily unusual, but the quantity and lack of trading is. Setting up this fund to provide some liquidity helps Citi and other firms that back SIV's, BofA and JPM in the form of fees, and the market in general for 2 reasons, buy-side guys can more easily sell their paper and also have a reasonable approximation of where to mark the paper they don't sell. I don't see what the big deal is. Everyone seems to gain something, w/o taking from anybody.

A single firm is hesitant to make a market in this paper because what if nobody follows them and the market continues to weaken, even if the fundamentals support higher prices. With the impact of the housing market on the consumer unknown, and hundreds of billions of resetable mortgages coming due in the next 12-18 months, this market is likely to be a problem for a while, and potentially for other ABS as well. By pooling risk to shore up the non-RMBS ABS market seems positive for everybody involved.

Accrued Interest said...

To James, Psycho, and CBurn's comments, my understanding is that only AAA and AA, non-residential stuff will be put into the MLEC. The losses on that stuff isn't 20-30 points. Its more like 1-5, maybe 10 on a few select pieces.

So I don't see the "vulture" element of this at all. Not enough losses to justify it. Not on the surface anyway.

Now I don't care if a bunch of banks want to pool their assets to create a big SIV with the idea that it will be more diversified. But based on the kinds of assets I'm hearing will be in this thing, I question whether that benefit is all that large. If its all non-resi ABS, I'd argue its pretty highly correlated.

Anonymous said...

"only AAA and AA, non-residential stuff will be put into the MLEC"[tddg]

Thank you for your patient recapitulation of the salient points you addressed so directly and fully in the Original Post.

It could well be that I've fallen behind, but I thought the original issue was restoring the ABCP market. What better way than to have a Sivie Mae, filled with the best gilt-edged paper, issuing short term paper using it as collateral. With a positive(ish) yield curve like now, it could even prosper.

At some point in the future, Sivie Mae might could even modestly engage in very short term repurchase agreements, loaning money on the basis of (ahem) inferior collateral, but very short term.

This already lets the Fed off the hook of liquidity provision, Sivie Mae could do it without any gov't backing.

As it prospers more, Sivie Mae could grow in financial strength until it could buy "junk" long term paper, still issuing short term ABCP backed by the gilt-edged stuff.

The longer this "long term", the cheaper the junk paper might get.

I probably misunderstood the term "vulture fund", but since this all started (last April-June for me) I've often caught a whiff of one of those runs Jesse Livermore used to manage for the Great Pools, where they'd drive an asset price way down so the Pool could buy it up really cheap.

Anonymous said...

AccruedInterest: Its more like 1-5, maybe 10 on a few select pieces.

Any day I can eliminate a competitor by buying their assets at a 1-, 5-, maybe 10-point discount to fair value is a day well worth getting out of bed!

I don't know; I'm only putting the vulture thing up as a possibility. But it's a possibility that makes more sense to me than any of the other explanations.

Many of these SIV's will be in a negative carry situation at this time; perhaps wanting to get out of the business but unable to find any bids to hit. The avowed purpose of MLEC is to avoid a fire sale. If the sponsors have confidence that a fire sale is imminent, I can't see them paying full price.

cburn69 said...

The point isn't to diversify credit risk, it's to provide a market for the paper. I personally don't know, but I suspect the buyers of ABCP are cash guys, managing short term investments, and probably have no idea, nor do they care, how to value the collateral in a SIV. If enough of them don't roll over the cp, there's going to be tens of billions of ABS flooding the market, at a time when even people who play in the ABS market are scared. The 20-30 points I mentioned wasn't a reference to losses, it's a reference to bid-ask spreads I see everyday. Granted, those aren't Aa pieces, but there will still be a liquidity problem if the cp buyers don't roll. Some SIV guys are begging -

If the cp guys don't roll, and this fund isn't around, I suspect those AAA pieces won't be selling at 1-5 off. Not that this is good for the market, I personally like being able to buy bonds at 10 cents on the dollar, but for the guys that own this stuff, preventing a fire sale is good for the entire ABS market, and really the only thing that changes is that the holders of ABCP that don't want anymore get out to be replaced by whoever buys the M-LEC paper.

Anonymous said...

Some of the targetted SIV's may be near (or even past!) violating their covenants as well.

Anonymous said...

Did MaxedOutMama get it right when she states that the 23A exemption was only for $25B?

In other words, before fees are added in, this conduit will hold the crap that was bad enough that it forced the banks to get another way to pay its margin calls?

Color me X-cited! I can't get into debt fast enough!

Accrued Interest said...

Well I guess if the thing is structured where 10 banks each own 10% of the MLEC, AND the 10 banks agree on how to value the assets purchased, AND they are all equally on the hook for the CP if the MLEC fails, AND Citi is only one of the 10 banks...

Then I might agree that its not shady. Because if Citi is essentially asking 9 other banks to take liabilities off their hands, but the 9 banks become defacto owners of the liabilities, then the 9 new owners are going to only buy at a "fair" price.

I'm skeptical that's how it will work.

flow5 said...

Everything seems peripheral to me. What about evaluation? Don't these assets generate payment records?

Anonymous said...

10 or 20 years ago a rating agency would change an issue's rating, and maybe the issuer's as well, when analysis merely indicated payment performance would change, much less when it actually happened.

Don't know why that wouldn't be the case here. Hope someone offers to explain.

I do wish sources other than tddg would emphasize that:
"only AAA and AA, non-residential stuff will be put into the MLEC"

Accrued Interest said...

Psycho: I'm hearing conflicting information. Some are saying no resi, some are saying no subprime resi. Some are just saying "highly rated" which is anyone's guess as to what that means. I'm going to write another post tonight with some new information I've seen today.

Accrued Interest said...

BTW, one very funny play on my Godfather theme is here:

"Leave the SIV, take the cannoli."

Anonymous said...

Thanks for the link.

Kudos for the notice/reference.

Original Blogger "Asparagirl" made unqualified compliments for gramps' comment here.

"some new information I've seen today"
I don't fault you. They could be redefining it daily, based on lolcats blog responses.

(I never even knew stuff like that existed...phew!)

Accrued Interest said...

DO you have a link to Aspragirl?

Anonymous said...

Fumbled the link.
Compliment to gramps comment is here

Anonymous said...

1)"DO you have a link to Aspragirl?"
Will that latest link suit?

2)In light of your new handle accrued interest, can we still call you tddg?

Accrued Interest said...

Yeah you can call me whatever. I just don't want a lot of people to realize who I am in real life. If that happens, I'll lose all creative freedom and this blog will become boring as well.

Anonymous said...

cburn69 referred to the Cheyne SIV above.

It's in the news again today: Cheyne Finance Plc, the structured investment vehicle managed by hedge fund Cheyne Capital Management Ltd., will stop paying its debts, a receiver from Deloitte & Touche LLP said.

Deloitte is negotiating a refinancing of the SIV or a sale of its assets, according to an e-mailed statement today. Cheyne Finance's debt with different maturities will now be pooled together, rather than shorter term debt being repaid sooner, Neville Kahn, a receiver from Deloitte said today in a telephone interview.

``It doesn't mean we have to go out and fire-sell any assets, quite the opposite in fact,'' Kahn said. ``The paper that falls due today or tomorrow won't be paid as it falls due.''

Anonymous said...

You can say what you want about Prince, but in my opinion Jamie Dimon is a financial and management genius . He has succeeded at every step Chuck Prince has failed at. Bet Citigroup holders are wishing Dimon wasn't forced out 10 years ago.

Anonymous said...

"Prince is a Pimp. He never could have outfought Santino. But I never knew until today that it was Dimon all along...."