From the beginning, many ABS professionals greeted the master liquidity enhancement conduit (M-LEC) plan with hearty skepticism.
Why should a group of commercial banks pool their capital and create a support facility for $100 billion of structured investment vehicle (SIV) assets, especially when it was unclear if the large conduit would have enough credit enhancement and liquidity to effectively shelter the struggling assets?
"The super conduit may help stabilize some SIVs and temporarily lower borrowing costs, but is essentially window-dressing," wrote UBS analysts in October. "Unless the super conduit has much more credit enhancement and bank-sponsored liquidity than do traditional SIVs, the super conduit will be unpalatable to ABCP investors, and SIV assets will end up on bank balance sheets."
In mid-December, two events bore out early skepticism about the project. Citigroup announced that it would consolidate the SIVs' assets and liabilities onto its balance sheet. At the time of the announcement, Citi expected the move to affect $49 billion in SIV assets. Eight days later, Bank of America Corp., JPMorgan Chase and Citigroup decided to pull the plug on M-LEC, at least temporarily.
Those events also underscored two long-held market sentiments that are being expressed more boldly as investors continue to withhold capital from SIVs and other complex structured finance instruments. First, the capital markets will have to endure a sloughing off of overly levered financial assets and the levered investors that supported them. Second, some market players say that bank regulators might wonder whether banks should be allowed to continue treating SIVs like off-balance-sheet instruments.
"It is a fundamental shift; the market has just changed," said one managing director at an asset management firm. "You have to go back to the actual fact that lending got out of control. A lot of loans were made to consumers who should not have had those loans made to them."
The immediate and palpable effect on the securitization market is that leveraged investors and overly leveraged instruments are being squeezed out of the sector. SIVs had about $400 billion in outstanding assets early this summer, but after a series of rating agency downgrades on subprime MBS deals caused a crisis of confidence among investors and sparked the liquidity crisis, the SIV market shrunk to about $265 billion in outstanding senior debt in early December.
Liquidity might begin to return after about three months, but the pricing of such instruments based on credit might take as much as 18 months to cure itself, said that managing director.
In the meantime, market professionals are beginning to wonder to what extent the bank regulators might change their opinions about SIVs. They might challenge the whole notion that SIVs are in effect orphaned, with no ties at all to the sponsor banks and no need for those banks to hold capital against them, one attorney said.
"This is a policy issue that someone is going to raise," the attorney said. "You had these banks not computing these things, saying it's OK,' when at the first sign of trouble they buy it back. Should it be that banks that sponsor and set up these vehicles are able to not have the assets treated as theirs, or do we need to toughen up the test for when you cannot consolidate it?"
That attorney said he was not aware of regulators or members of Congress questioning SIV eligibility for off-balance-sheet treatment.
"I'm not sure it makes a lot of sense for them to do so," he said, "but I think there has always been at least the possibility that if you have the vehicles with little capitalization and all that reputational risk, there might be issues."
Accounting specialists say this situation also generates more heat because of an already hot topic: asset valuation and the impact on regulatory capital requirements.
"It is a relatively straightforward process, fair value," said an accounting expert. She added that determining fair value is much harder now, especially because trading activity is so light.
A new accounting pronouncement, FAS 157, reminded market professionals that they are supposed to be looking at observable data. That accounting expert described the FASB pronouncement as a re-articulation of current standards. Fair value would be determined based on whether investors like an asset or whether there is very little market data about it, said the source.
For its part, Citigroup said that given the high credit quality of the SIV assets, the credit exposure under its commitment was very limited. About 54% of the SIV assets are rated 'AAA' and 43% were rated 'AA' by Moody's Investors Service, it said. The financial group said it had no direct exposure to subprime assets.
"Citi still expects to return to its targeted capital ratios by the end of the second quarter of 2008," according to a statement. The company added that, based on Sept. 30, 2007 capital ratio disclosures and applying the current asset levels in the SIVs, the estimated impact of this action would have been approximately 16 basis points in the Tier 1 capital ratio and would have resulted in an approximately 12 basis point decline in the TCE/RWMA ratio.
"As assets continue to be sold, Citi's risk exposure, and the capital ratio impact from consolidation, will be reduced accordingly," said the company.
The Road to Perdition
Very few market players expected the M-LEC to get off the ground and function actively. Still, say analysts, it was understandable that banks would want to band together to address what they saw as a market-altering crisis.
"If [the market] were in a position where none of these banks could absorb assets onto their balance sheets, then you would have to execute a fire sale of assets," said one analyst, "which nobody wanted to see."
Proposing the M-LEC might have been a way to force banks to do something, although, as one market player said, the motivation was not "to do the right thing."
"JPMorgan and Bank of America had less exposure [to SIVs] directly, but indirectly they had just as much exposure to the vehicles," said the managing director. "They may have lent and owned the notes and provided repos to the SIVs. It was in everyone's interest for this not to go bad."
M-LEC's feasibility was further undermined when HSBC decided to consolidate Cullinan Finance and Asscher Finance into one SIV and consolidate some $45 billion in SIV asset onto it's balance sheet. Standard Chartered soon joined the list of European banks to go it alone. Because the SIV sector is a European creation and several European banks clearly did not support the M-LEC idea, it made the American solution look even less attractive, said sources.
"From the beginning, the idea was that M-LEC was being used to bail out Citi," one analyst said. "JPMorgan was always lukewarm on this topic, although Bank of America was more supportive."
Market sources also noted that from a capital standpoint, JPMorgan is in the best shape, followed by Bank of America. While capital markets professionals were laying plans to put M-LEC together, they were also pressuring Citigroup to share some of the burden. During meeting breaks, apparently, admonishments to Citigroup officials were blunt: "Guys, just take these assets back onto your balance sheet," one market source said. Citigroup might have gotten a handle on its SIV liabilities in the short term, but several capital markets and equity market sources say that Citi's decision to consolidate the SIV assets is just one step on the long road to fiscal fitness. Also, while JPMorgan and Bank of America were relieved of the task of bailing out the U.S. SIV market, they also face some tough choices in their securitization programs.
"They [Citigroup] were undercapitalized, and this just takes up more capital," the managing director said. "That's why the new CEO is going to foreign entities and trying to raise money. He's been in the Middle East, Asia and Europe. They've got a big write-off coming, but it's better if you can avoid a downgrade."
In a Christmas Eve research note, Morgan Stanley analyst Betsy Graseck presented the equity markets with a sobering outlook. Citigroup will probably have to take heavy write-downs, in part because of its CDO exposure. In terms of the bank maintaining its target 7.5% Tier 1 debt ratio, Morgan Stanley said Citi would have to cut dividends and issue more hybrid capital in 2008.
All three banks might have to contribute to the excess spreads of their credit card securitization programs, given higher funding costs that they might not be able to pass on to depositors, wrote Graseck.
Picking Up the Pieces
Meanwhile, market professionals are wasting no time making ultra-levered ABS structures, such as SIVs, more appealing to investors.
"There are definitely newer structures out there that are being tested as we speak," one market source said. "You may find supported structures, where it's not just the collateral (used to provide liquidity)."
Without a doubt, said another market source, some SIV vehicles are being restructured.
"Some investors might take hits, but they will work out better than they would have if they (are) not restructured."
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