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?