By Eric J. Fry | 18 October 2007
Welcome to “Bail-Out Nation.”
The Land of the Free is quickly becoming the "Land of the Freebie," especially for members of the millionaire corporate elite who make multi-billion dollar mistakes… with other people’s money (OPM). This unfortunate state of affairs is jeopardizing the dollar’s value, as well as its reserve-currency status.
Once upon a time, American-style capitalism resembled a bare-knuckled fistfight— a continuous "Ultimate Fighting" match in which competitors would pummel one another until a victor emerged. But modern American-style capitalism is more like "arts and crafts" time in one of Manhattan’s pricey nursery schools. Every coddled kiddy’s "artistic" creation— no matter how inept or ghastly it may be— elicits praise from the nursery school instructors. Indeed, every grunt elicits praise… and every boo-boo finds a Band-aid.
Outside the walls of the nursery school, capitalism is just as brutal and Darwinian as it has always been, perhaps even more so. But on the inside, the privileged kiddies never shed a tear without receiving an immediate hug and a "There, there. It’s okay. It wasn’t your fault… and even if it was your fault, Uncle Ben will make it all better."
As for discipline; forget it. The coddled capitalists of America’s high finance never receive a slap on the wrist for any misdeed whatsoever. That would be child-abuse [[billionaire abuse!?!: normxxx]] Nor do they ever even receive a time-out for bad behavior. Worst case, [the] punishment [is soothed by being wrapped] in the form of [a] multi-million dollar severance package.
Who are these "nursery school" capitalists? They are the folks who receive millions of dollars each year to preside over public corporations and/or to speculate with the shareholders’ capital.
American corporations are crawling with these leeches. Using other people’s money, they engage in moronic speculations, knowing that success will multiply their net worth dramatically and that failure will produce negligible negative consequences. And, sometimes, even failure produces success, thanks to the Federal Reserve’s well-established penchant for bailing out speculators.
Because Wall Street’s privileged speculators receive continuous coddling, they never really learn to behave themselves. Thus, when the multi-millionaire, Nobel-prize winning operators of Long Term Capital Management fell down and got an "owy" in 1998, Alan Greenspan’s Federal Reserve rushed to their sides with Band-aids aplenty and emergency doses of financial Bactine. He slashed interest rates, while also cajoling Wall Street’s leading banks to provide a multi-billion dollar bailout.
Everyone called it a rescue plan for the capital markets. But the capital markets of 1998 required no rescuing. They had worked flawlessy; they had separated fools from their money.
But because the fools in question hailed from leading Wall Street institutions, and because the Wall Street institutions, themselves, stood to lose billions of dollars, LTCM would not be allowed to fail. Thus, the bailout of 1998 was nothing more than government-sponsored collusion to rescue speculators from the consequences of their ill-conceived speculations.
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During the early years of the 21st century, the Fed continued coddling Wall Street’s privileged few, by slashing short-term interest rates to unnecessarily low levels. Who [mostly] benefited? Lots of banks and lots of speculators… and lots of speculating bankers.
The speculators devised numerous ways to capitalize upon ultra-cheap short-term financing. The speculators become overnight investment geniuses by borrowing short-term and speculating long-term. But the sort of genius that relies entirely on short-term financing [[the time spread: normxxx]] often perishes at maturity. Only a complete moron would borrow short-term and invest long-term, without preparing an emergency back-up plan or exit strategy— only a complete moron… or a coddled capitalist [[relying first on the Greenspan Put and now on the Bernanke Put: normxxx]].
Fast-forward to the summer of 2007— the financial "Summer of Love"— and we find the same playpen of privileged kiddies making the same poopies in their diapers. [But suddenly] [a]ll the biggest banks and brokers on Wall Street found themselves on the losing side of some kind of ill-conceived loan. They found themselves on the hook for billions of dollars worth of loans that no individual of moderate intelligence would have ever issued with his own money.
Not only did Wall Street’s genius bankers issue billions of dollars worth of idiotic loans, they also packaged the loans into billions of dollars worth of mortgage-backed securities (MBS). The bankers then sliced, diced and reformulated various types of mortgages into various categories (tranches) of collaterized debt obligations CDOs and other asset-backed exotica.
Why did the whiz kids go to such great lengths to repackage mortgage loans? Because it was a great way to move these things off their own companies’balance sheets, and onto someone else’s. By moving the loans elsewhere, the bankers could originate new idiotic loans, create new idiotic mortgage-backed securities for public consumption… and collect hefty fees along every step of the process.
When the Wall Street bankers couldn’t find any real buyers for their idiotic mortgages and MBS, they would create ['virtual'] buyers called structured investment vehicles (SIVs). These SIVs would borrow money, just like a corporation[[ from the Commercial Paper markets: normxxx]], then use the money to buy mortgage-backed securities from the Wall Street bankers who had created the SIVs. The process would be something like setting up a shell company to buy your house from you.
As long as the shell company could obtain financing, it could easily buy your house, and might not even quibble about the price (but that’s a topic for another day). Unfortunately, if the shell company suddenly lost access to financing, it would have no choice but to sell the house it bought from you at whatever price it could obtain.
That’s exactly where we are today. Typically, SIVs borrowed short-term money in the commercial paper market [[where interest rates are normally lower: normxxx]], rolling over their obligations every few months. In essence, therefore, the SIVs financed their long-term mortgage assets with short-term CPO liabilities. The process worked brilliantly… until it didn’t.
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Unfortunately, "Option A" includes the distasteful side-effect of putting real-world prices on the billions of dollars worth of illiquid securities that still carry Wall Street’s fantasy prices. Replacing fantasy prices with real-world prices would force many American financial institutions to 'fess up to the billions of dollars of additional mark-to-market losses— losses that the institutions are [so far] pretending have not already incurred [[not unlike the 'naive' investor that assumes that as long as he doesn't sell his stock, "it's only a paper loss": normxxx]]. "Option B," therefore, seems like the lesser of two evils, but only in small doses. Large doses of "Option B" could cause serious indigestion on bank balance sheets.
Enter the beefy "Master Liquidity Enhancement Conduit," or M-LEC to save the day. This $80 billion fund-to-be, according to Bloomberg News, "will help SIVs, which own $320 billion of assets, avoid selling their holdings at fire-sale prices."
Here’s how the whole thing is supposed to work: Citigroup, Bank of America, JP Morgan, and a few lending institutions to be named later, will kick $80 billion into a fund. The fund will buy AA- or AAA-rated SIVs. Once these SIVs become the M-LEC’s property, they cease to require financing from the commercial paper market or, more importantly, from the lending institutions who are providing the $80 billion bailout. In effect, the banks are bailing out themselves.
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For one thing, Goldman Sachs is conspicuously absent from the consortium of participating banks, even though former Goldman CEO, and current Treasury Secretary, Henry Paulson, brokered the deal. Presumably, Goldman demurred because it has no interest whatsoever in stepping into the SIV tar pit that has ensnared its competitors… and that will continue to ensnare its competitors.
The second problem with the M-LEC ruse is that it will not commence operations for 90 days. That’s an eternity in the commercial paper world where the SIVs are fighting for their survival. The 90-day lead-time reveals the insincerity— or incompetence— of the M-LEC proposal. Many, many SIVs could implode over the next 90 days— many more, in fact, than an $80 billion fund could hope to rescue.
The entire SIV market totals more than $320 billion in assets, most of which relies on financing of less than 270 days. Do the math.
The third glaring problem with the M-LEC ruse is that it will buy only AAA- or AA-rated SIVs, where the least of the problems reside [[but corresponding to most of the stuff retained by the banks for their own account: normxxx]]. A genuine bailout fund would buy the most toxic securities first, and leave the highly rated stuff out in the marketplace to find real-world buyers. This curious aspect of the M-LEC, therefore, elicits the thought, "Gosh, maybe the banks are trying to support the prices of the highly rated stuff they haven’t [yet] marked to market, rather than the lowly-rated stuff they don’t own."
Net-net, the M-LEC is a joke— a very bad joke.
It is the kind of joke that attempts to rescue well-heeled speculators from the consequences of their recklessness… without providing any benefit whatsoever to the capital markets overall. The SIV world doesn’t need a bailout; it needs a mark-to-market. If SIVs were reflecting their real-world pricing, instead of Wall Street’s government-sponsored fantasy pricing, REAL capitalists would be lining up to purchase them or to provide financing [[and the reason is… because their nominal, mark-to-market values would go down by up to two-thirds, so their [nominal] interest rate payouts could triple in value: normxxx]]
The American capital markets do not need M-LECs, they do not need bailouts; they do not need rescuing… except from the "nursery school" capitalists who consider their wealth an entitlement, and who believe that their failures and their successes both deserve multi-million dollar paydays.
The "Bail-Out Nation" is costing us all dearly. Every bailout undermines the dollar’s value and international prestige. That’s a very heavy price tag. If the "Bail-Out Nation" does not allow its coddled capitalists to fail [[or at least suffer some penalty: normxxx]], the U.S. dollar itself might fail [instead].
To be continued…
[Joel Bowman’s Note: The systemic lack of accountability for anything the dollar touches— be they high-brow financial institutions or Congressional expense tabs— has seen the greenback plummet to its lowest levels against almost every other major currency in recent times. This drastic depreciation is not necessarily a bad thing… unless you hold all your savings in shot dollars.]
Gordian Knot: How London Created a Snarl In Global Markets
SIVs Fueled Debt Boom, But Now Banks Scramble To Prop Up the Funds
By Carrick Mollenkamp, Deborah Solomon, Robin Sidel and Valerie Bauerlein, WSJ | 18 October 2007
Now, the U.S. Treasury and the world's biggest banks are grappling with their own baffling knot: how to prevent the unraveling of an entire class of such funds— called structured investment vehicles— from turning into a financial and economic disaster. The industry that grew out of the efforts of the two bankers, Nicholas Sossidis and Stephen Partridge-Hicks, is in trouble. Fears are rife that dozens of huge, structured investment vehicles, or SIVs, many of them affiliated with banks, will be forced to unload billions of dollars of mortgage-backed securities and other assets. Such a fire sale could cripple debt markets that play a crucial role in the global economy by providing financing for everything from company payrolls to mortgage loans. |
• Definitions of SIVs, CDOs and other exotic credit products. • Debt Dilemmas: Complete coverage |
The two bankers are part of a small coterie of London bankers who engendered what became a $400 billion industry. The funds boomed because they allowed banks to reap profits from investments in newfangled securities, but without [having to set] aside capital to mitigate the risk [[Unlike for conventional loans, the banks were not required to set aside 'reserves', since the 'loans' were moved to the books of the SIVs.: normxxx]]
Now the industry has become a significant threat to the stability of global financial markets. After the recent meetings, Citigroup, Bank of America Corp. and J.P. Morgan Chase & Co. announced an extraordinary effort: They will attempt to raise a fund of as much as $100 billion by the end of the year aimed at supporting an orderly unwinding of many SIVs, with an eye toward restoring investors' confidence in the debt markets that the funds use to raise money [[translation: they hope to restore the independent commercial paper market for SIV issued short term debt: normxxx]]. They chose $100 billion as a goal for the superfund based on a back-of-the-envelope calculation— roughly one-third of the $350 billion in debt issued by SIVs would be coming due in the next six to nine months [[or roughly what the banks themselves were on the hook for through their SIVs: normxxx]].
Significant Obstacles
The plan faces significant obstacles. Some bankers have been hesitant to take part on the grounds that it would amount to a private-sector bailout of Citigroup— an assertion the bank denies. Citigroup is the largest player in the SIV market with seven funds holding about $80 billion in assets. Many investors are skeptical.
"Conceptually it's a good idea, but we prefer higher quality paper," said Chris Vincent, head of William Blair & Co., a Chicago-based firm with $2.5 billion in fixed-income investments. He added that the firm has not been comfortable with SIVs, "and this would be like a super version of one."
The fund's sponsors have countered that it won't be a sweetheart deal for the SIVs: They'll have to pay a fee to take part, accept a discounted price for their assets and help insure investors against losses. The fund has garnered the support of big investors such as Fidelity Investments and banks including Wachovia Corp.
The late 1980s, when the idea for SIVs was born, was a period of sweeping change in the credit markets. The concept of securities backed by home mortgages was evolving, and the junk-bond boom that made Michael Milken famous was going strong.
Mr. Partridge-Hicks, working in London, and Mr. Sossidis, based in New York, were looking for a better way for Citigroup clients— pension funds and banks— to profit from the nascent market for securities backed by assets such as commercial mortgages and credit-card receivables.
The two bankers hatched the idea of setting up a fund that would issue short-term commercial paper and medium-term notes to investors, then use the money to buy higher-yielding assets, typically longer-term ones. The bank would profit by collecting fees for operating the fund. The fund's assets would belong to its investors, so they would stay off the bank's balance sheet. SIVs had an advantage over conduits, a similar structure that was already gaining popularity: They didn't require banks to cover fully the fund's debts if the commercial-paper market dried up.
In 1988 and 1989, Messrs. Sossidis and Partridge-Hicks launched the first two such structures for Citigroup, called Alpha Finance Corp. and Beta Finance Corp. Both attracted investors, garnered high credit ratings and generated hefty profits for the bank. In 1993, the two men left Citigroup to form Gordian Knot.
Assets in SIVs ballooned into the hundreds of billions of dollars globally, but the business remained local, dominated by London-based bankers and lawyers, many of whom had some connection to Citigroup. After the departure of Messrs. Sossidis and Partridge-Hicks, Citigroup's London office launched five more SIVs with names such as Centauri and Dorada. Their combined assets reached $100 billion earlier this year. In 1997, two more bankers left Citigroup for Germany's Dresdner Kleinwort to help arrange an SIV called K2 Corp. Citigroup also earned fees by helping other banks arrange SIVs, such as Tango Finance Ltd., which it set up for Dutch bank Rabobank in 2002.
London law firms, too, got into the action. Last year, the London office of Chicago law firm Mayer Brown assisted German bank HSH Nordbank in the creation of an SIV called Carrera Capital Finance Corp.
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Most of the few dozen SIVs, typically registered in offshore havens such as the Cayman Islands [[which has no laws to hamper bankers and brokers: normxxx]], are managed out of London. Most players attribute the city's dominance to the fact that SIVs are extremely complex [[i.e., legally that is (to avoid any culpability of anyone connected with the SIVs; it's truly a case of caveat emptor for anyone fool enough to buy some of that SIV paper): normxxx]], often taking as much as a year to set up, so it is difficult for new players to enter. Because the business started in London, most people with the necessary skills and experience are in the United Kingdom, says Geoff Fuller, an attorney with Allen & Overy LLP in London, who has advised Citigroup and other clients on SIVs and other structured-finance products. "It's a small world where people know who their competitors are," says Mr. Fuller.
Mr. Sossidis says that as the SIV market peaked in recent years, many of the new players didn't fully recognize the perils involved in borrowing money short-term and investing it long-term. "These were the last ones to enter, the first ones to exit," he says.
In the wake of the 1998 collapse of hedge fund Long-Term Capital Management, Gordian Knot took precautions to protect itself from being forced to sell its assets if markets turned against it. Among other things, the company got rid of a trigger that would force its flagship Sigma fund to sell if the value of its assets fell. In addition, he says, the firm sought to better match the duration of its assets and liabilities. Analysts now say that veteran organizations such as Gordian Knot should be able to survive the current crisis.
When troubles with subprime mortgage loans in the U.S. sparked a broader credit crisis this summer, SIVs didn't appear to be affected because few had exposure to subprime loans. On July 23, Moody's Investors Service said in a report that SIVs were "an oasis of calm in the subprime maelstrom."
Within days, though, weaknesses began to show in the short-term debt market. In late July, a bank affiliate set up by German bank IKB Deutsche Industriebank ran into trouble. It had relied on extremely short-term financing in the commercial-paper market to finance investments in risky securities backed by subprime loans. A month later, Cheyne Finance, a $6.6 billion SIV operated by a London hedge fund, began liquidating assets to repay debts.
By now, investors in Citigroup's SIVs were growing concerned. Citigroup's London office issued a letter to investors in its seven SIVs saying that its funds were sound. On Sept. 6, the bank took the extraordinary step of stating publicly, through statements to the London Stock Exchange, that its SIVs had little subprime exposure. But Citigroup, too, was selling assets. Today the bank estimates the value of its SIVs at $80 billion, down from nearly $100 billion in August.
Throughout August, U.S. Treasury Secretary Henry Paulson and other top Treasury officials were watching with increasing concern as the commercial-paper market, on which SIVs rely for much of their funding, began showing signs of severe strain. Information from the Treasury's markets room, where staff sit in front of flat-screen monitors scrutinizing market movements, was painting an ominous picture. The difference between yields on Treasury bills, which are considered safe investments, and corporate commercial paper, which companies issue to fund day-to-day expenses, was growing sharply— a sign that investors were rapidly losing confidence.
Robert Steel, Mr. Paulson's top domestic finance adviser and a former Goldman Sachs Group Inc. executive, learned from colleagues on Wall Street that the crux of the trouble was SIVs. Investors in the commercial-paper market had all but stopped lending to the vehicles. Mr. Steel and others within Treasury began to worry that the bank-affiliated funds would engage in a fire sale of assets, a move that could exacerbate the credit crunch and damp the broader economy. "What you don't want is a disorderly liquidation," Mr. Steel explains.
Dumping of Assets
On Sept. 13, Mr. Steel began phoning Wall Street executives. That Sunday, Sept. 16, about 30 people gathered in a large conference room across the hall from Mr. Paulson's office. The group included executives from Citigroup, Goldman Sachs, Lehman Brothers Holdings Inc., Merrill Lynch & Co., Bank of America, J.P. Morgan Chase, Bear Stearns Cos. and Barclays PLC. As they munched on sandwiches provided by Treasury, a consensus emerged that large-scale dumping of assets was a likely outcome over the next year, people who attended the meeting say.
At first, some bank representatives were hesitant to get involved, saying they didn't see a need to participate if they didn't have exposure to SIVs, according to the people who attended. But Treasury officials stressed that even if the banks didn't have direct exposure to SIV assets, there was a broader risk that would eventually filter down to everyone, including those firms.
At least one bank representative suggested that Treasury step in with some money to help bail out the firms, the people who attended say. Mr. Steel told the group that that wasn't an option: Treasury would only back a private-sector, market-based solution [[but would wink at and see that those involved would have no worries about any applicable conspiracy or anti-monopoly laws being enforced: normxxx]]. "We bought the sandwiches, and that's it," Mr. Steel told those assembled.
In the room was Nazareth Festekjian, a 15-year Citigroup veteran who runs a group that deals with unusual situations, such as the restructuring of Iraq's debt in 2005. Mr. Festekjian, 46 years old, hadn't known what an SIV was until he received a call several weeks earlier from a government contact asking him to work on a solution.
He and his team came up with the idea to create a fund that could "bridge the gap" in the market by acquiring assets in a way that might give investors more comfort, according to a person familiar with the matter [[As Chris Vincent, head of William Blair & Co. had said, "a super version of" an SIV: normxxx]]. At the meeting, Mr. Festekjian unveiled his plan, which was printed up in color [[no doubt he could well afford it: normxxx]], says one person who was present.
Backing Away
The following week, the group again gathered in New York. There were fewer bankers, but they were joined by big SIV investors, including Fidelity and Federated Investors Inc., and by Messrs. Sossidis and Partridge-Hicks. SIV managers expressed frustration with investors for backing away from the market, according to two people who attended. Investors complained that the SIVs were not as reliable as they had been billed, one of these people says. Ultimately, all sides settled down and agreed that a solution would be important for the market [[As Benjamin Franklin once remarked, "either we all hang together or, most assuredly, we will all hang separately.": normxxx]]
The banks and investors held conference calls every other day until participants agreed on a plan. Richard L. Prager, Bank of America's head of global rates, currencies and commodities, who was considered an experienced but relatively neutral party, has since been leading the campaign to sell the superfund to other banks, investors and SIVs.
The plan still may not come to fruition if not enough banks agree to provide financing, or if SIVs decide that the cost of participation is too high. Some SIVs, including those sponsored by smaller U.S. banks, have started working out their own solutions with investors, and say they don't plan to join the superfund. Architects of the plan could be satisfied if no one at all ended up using the fund, so long as its existence staved off a collapse of the SIV market, according to a person familiar with their thinking.
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Normxxx ______________
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