Banker, heal thyself

Banks seek life in the debt markets

Oct 16th 2007 | NEW YORK
From Economist.com

CAN a group of banks succeed where the monetary authorities have failed? Despite the best efforts of central banks to deal with the credit crunch that took hold over the summer, some debt markets remain dysfunctional. Buyers are still on strike in an important part of the market for commercial paper (short-term corporate debt): the bit in which so-called structured investment vehicles (SIVs), which have mushroomed in recent years, borrow in order to invest in higher yielding assets. Now many of those vehicles are finding it difficult to roll over their debts and the banks that stand to lose most from their demise are scurrying for solutions.

On Monday October 15th three of the largest banks launched the first big effort by the private sector to alleviate the crisis. Citigroup, JP Morgan Chase and Bank of America unveiled an agreement in principle for a fund, expected to be worth up to $100 billion, that would buy highly rated assets from troubled SIVs. Other financial institutions are said to be considering joining. Although no government money will be available, America’s Treasury played an important role in the talks that led to the fund’s creation. The authorities worry that “disorderly” markets could drag down the economy.

SIVs suffer from the same mismatch between assets and liabilities that afflicts regulated banks: they borrow short-term and invest long-term. This worked well when markets were humming along. But now the mounds of mortgage-backed securities and other assets that the vehicles hold have suddenly turned horribly illiquid and their market value—to the extent that it can be ascertained—has plummeted.

Some SIVs have had to sell assets at fire-sale prices to repay investors, many of whom have become reluctant to roll over debt. Since SIVs hold some $325 billion in assets, further forced sales could have a chilling effect on the prices of asset-backed securities across the board. Banks also worry that they might be forced to take the assets of SIVs they helped to set up on to their own balance sheets. That would put great strain on their capital ratios.

The new fund, which has been clumsily labelled the Master Liquidity Enhancement Conduit, or M-LEC, will buy commercial paper issued by SIVs and then issue its own short-term debt, which will be backed by the founding banks. It will buy assets at a “market price” but there is a twist. SIVs that sell discounted securities to the conduit will share in the gains if the paper subsequently rises in value. The aim is to overcome their reluctance to part with assets they consider undervalued by a barely functioning market.

Though comparisons have been drawn with the 1998 bail-out of Long-Term Capital Management, a hedge fund, there is a notable difference. Back then, the Federal Reserve brought banks together to help a failing counterparty. This time, there is an element of self-rescue. That is certainly true of Citigroup, which has set up more SIVs than any other institution; it is exposed to some $100 billion of assets held by such vehicles. The two other co-ordinating banks have no SIVs of their own. They seem drawn primarily by the fees they will be able to earn managing the conduit.

Whether the scheme works remains to be seen. It looks rather like the Resolution Trust Corporation that was set up to liquidate America’s failing savings and loan institutions in the 1980s, points out Brad Hintz of Sanford Bernstein, a research firm. But while the design is proven, the banks may struggle to reach agreement on a host of issues, not least the price at which to mark assets bought. Though the banks say they want to get the fund off the ground within 90 days, some analysts think it will never fly.

Even those who support the fund admit that it is, at best, a temporary solution. As one banker puts it, it is about buying time so that the real problems facing the debt markets can be sorted out. In the case of asset-backed commercial paper, the two biggest are the inherently unstable structure of SIVs and their lack of transparency. Not only do they sit off their creators’ balance sheets but they do not even have to publish their holdings. Only when these underlying issues are addressed is confidence likely to return.