Dangerous Waters for a Bailout
The megafund that the nation's three biggest banks are hoping will resuscitate a chunk of the credit markets was initially greeted with enthusiasm. But it isn't clear how the plan, hashed out in six weeks, will work—a weakness that could undercut its original intent.
When the credit markets seized up this summer, it became clear that so-called structured investment vehicles (SIVs) simply wouldn't survive. Those entities, which the banks can keep off their balance sheets if they follow certain accounting rules, are investment pools that use short-term commercial paper to buy higher-yielding securities, including collateralized debt obligations (CDOs) backed by risky subprime mortgages. Now those SIVs can't refinance their short-term commercial paper. With $325 billion in assets, SIVs could cause widespread damage across the credit markets. "The last thing anyone needs is the assets being sold at fire-sale prices," says Sylvie A. Durham, a structured finance lawyer in New York with Greenberg Traurig.
But there's plenty of uncertainty surrounding the $80 billion rescue plan. The proposal, which is being aggressively pushed by the Treasury, hasn't been fully developed, in part by design to test the degree of interest from potential investors who might want to weigh in on the specifics. And some elements of the plan that have been worked out seem to be at cross purposes with what Citigroup (C), JPMorgan Chase (JPM), and Bank of America (BAC), the main sponsors of the megafund, are hoping to achieve. With so much still unresolved, there's no way of knowing how effective it might be.
Part of the problem is the inherent contradictions in the proposal. For one thing, the superfund plans to buy only the best-rated securities from the SIVs, mainly those that haven't been tainted by subprime. So the SIVs still won't be able to unload the most troubled investments in their portfolio. It's a bit like trying to keep a mortally wounded patient alive while harvesting the good organs for transplant. Although selling securities to the superfund would allow the SIVs to scrounge up cash to pay off their debts, a growing percentage of their portfolios would be toxic. And if the credit ratings on their remaining investments sink too low, some of the entities may have to liquidate their assets as required by their charters. That could potentially trigger the fire sales the rescue plan was designed to prevent. "SIVs will be even more exposed to erosion of credit quality in the remaining assets," says Christian Stracke, an analyst at CreditSights.
There's also a real likelihood that those already bruised assets will continue to rot on the vine. Some are CDOs contaminated with securities backed by subprime mortgages. On Oct. 11 rating agency Moody's Investors Service (MCO) cut the grades on a raft of mortgage securities worth some $33.4 billion. Downgrades on CDOs that own those investments will follow. Standard & Poor's downgraded $4.6 billion of mortgage-related investments on Oct. 15. "The banks are hoping the more questionable stuff becomes more attractive to the market in time," says Stracke.
It's also not clear how the superfund will value the assets it does pick up from the structured vehicles. It will certainly buy them at a discount to their original prices. But there are no reliable market prices now. Paying too much will threaten the superfund's returns and its ability to raise money from investors. On the flip side, if prices are too low, that could further damage the SIVs that the rescue fund was supposed to help.
Of course, the banks have their own set of interests. There's concern that the banks that sponsored the SIVs and collected the fees from them will use the superfund to avoid having to take a hit on earnings. Then there's the worry that Citi, which created about a third of the SIVs now in trouble, may use its influence to push the fund to pay higher prices for the securities from its own SIVs, says a person looking at the deal. Meanwhile, the Citi-led consortium will get fees from the megafund as well.
Those sort of potential conflicts, which bankers close to the fund say they'll guard against in the final structure, will only make it more difficult to attract investors. The banks are currently talking to investors to find out how much they might pony up and on what terms. Foreign banks, which have been especially big buyers of stakes in SIVs, would seem a natural group to woo. But they might be hard to convince. They've already been burned by SIVs, and the rescue initiative doesn't do much to save their stakes in those vehicles. To win them over, the superfund will likely have to offer higher yields.
It's not even clear how many SIVs will want to sell their assets to the fund, says a person studying the idea for a rating agency. SIV managers, who don't work for the banks, have been quietly exploring alternative ways to restructure for weeks. "It might be that there's not much interest," he says.
A "Significant Drag"
Then there's the matter of timing. It will take as long as 90 days for the superfund to be up and running; the banks haven't even hired a manager for the operation. Given the lag, the fund may be too late to help the SIVs with short-term debt coming due in the interim. Roughly $30 billion of debt is set to mature in the next three months, the start of a wave that goes out to mid-2008, according to JPMorgan Securities.
The SIV debacle blindsided the credit markets, to say nothing of the casual observers who'd never before heard of them. In the wake of the fraud at Enron, regulators rewrote rules to prevent companies from offloading big risks from their books. Now there's a new push to beef up the requirements, with Treasury Secretary Henry "Hank" Paulson Jr. calling for a review of such vehicles.
All that adds up to a big headache for banks, which across the board have been reporting dismal earnings. On Oct. 15, Citigroup announced a 57% drop in third-quarter profits. Merrill Lynch (MER) is taking a $4.7 billion writedown. The pain may not be over, either. Federal Reserve Chairman Ben S. Bernanke, in an Oct. 15 speech, said the trouble in the housing market would be a "significant drag" on the economy through 2008.
But the banks may be hoping the mere existence of the superfund will give players, particularly those in commercial paper, confidence in the market so the SIVs won't have to sell their assets to the fund at all. Says Peter J. Wallison, a senior fellow at the American Enterprise Institute: "[The superfund] might not work, but it's worth a try."