Out of the Crisis: SIVs, Big Banks, the US Treasury, LTCM and "Moral Hazard"

Question: what is going on here? Answer: the US Government, all branches of government, are afraid. Very afraid. The mortgage bubble is clearly much worse than was initially anticipated, and it was thought to be pretty bad at the outset. So what we have now is a Treasury Department, led by ex-Wall Street legend and "free-market pragmatist" (my phrase) Hank Paulson, that is seeking to mitigate the effects of private sector mistakes through public sector influence. And the stakes couldn't be higher, namely our economic and social well-being, especially in light of the intertwined nature of the financial meltdown bridging Wall Street (mortgage-backed securities and other less liquid assets) and Main Street (homeowners and consumers). And Hank & Co. just can't sit idly by and watch this slow-motion train wreck pick up speed - or can they?

Question: Is US Treasury intervention crossing into the realm of "Moral Hazard?" Answer: no.

Wikipedia describes moral hazard as it relates to finance as:

Financial bail-outs of lending institutions by governments, central banks or other institutions can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of losses. Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return. A moral hazard arises if lending institutions believe that they can make risky loans that will pay handsomely if the investment turns out well but they will not have to fully pay for losses if the investment turns out badly. Taxpayers, depositors, other creditors have often had to shoulder at least part of the burden of risky financial decisions made by lending institutions.

In my opinion, this is not what's going on here. There is no "bail-out," just as there was no bail-out in the midst of LTCM. In that case, the Treasury Department and the Federal Reserve played active roles in bringing key constituencies to the table. These constituencies were able to act in a coordinated manner to stave-off systemic risk. This seems to be exactly the role being played by Treasury in the subprime mess. Sure, they are urging the mega SIV issuers and others to create a new vehicle that will kick start the asset-backed CP market, but there is neither an implicit nor an explicit US Government guarantee. From the New York Times 10/15/2007:

The plan announced Monday involves no money from taxpayers, and it was negotiated primarily between the banks themselves. But it highlighted Mr. Paulson’s growing effort to marry two competing goals of the Bush administration: to stabilize the battered markets for mortgages and housing, but to avoid a government bailout that might encourage investors to take even bigger risks in the future — what economists call “moral hazard.”

“I have no interest in bailing out lenders or property speculators,” Mr. Paulson plans to say, according to an advance text of a speech he will deliver on Tuesday. “Still, we must recognize the very real harm to families affected by the housing downturn.”

This is far different, IMHO, than the very real moral hazard involved with FNMA and FHLMC, where these quasi-governmental agencies have been allowed to grow well beyond their original charter due to politics and the implicit Government subsidy. This is not Hank's gig. Hank is a free-marketeer, but also understands that sometimes markets fail, and isn't going to abdicate responsibility for some ideological purpose when he can facilitate a recovery through moral suasion, not moral hazard. He is smart and he is right. From the Wall Street Journal 10/16/2007:

In his first public comments on the plan, Treasury Secretary Henry Paulson said the huge, bank-affiliated funds that were kept off-balance sheet and that owned assets backed by shaky mortgages and other securities suffered from a lack of transparency and that regulators may need to step in to avoid future problems. "The regulators didn't have clear enough visibility with what was going on in terms of these off-balance-sheet SIVs," Mr. Paulson said to reporters after an event at the University of Texas at Austin.

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Some have criticized the Treasury for essentially helping big banks avoid the financial pain associated with risky bets that didn't pan out. The reaction in Washington, though, was more muted. Democrats sought to use the Treasury's willingness to get involved to bolster their demands that the Bush administration do more to help homeowners who are also suffering from the subprime downturn.

Question: Are the big banks in trouble? Answer: Some of them, to be sure.

Citigroup has taken a beating lately, and for good reason. Management instability. Poor transparency. Weak risk management. And a giant hole in its balance sheet due to a concentration of illiquid assets. As to the raison d'etre behind the super-SIV program, also from the WSJ:

They expressed hopes that the plan, announced as expected yesterday by the banks, would help jump-start the commercial-paper market, which provides financing for things including mortgages and big investment projects but has been struggling since late July. The fund would issue short-term notes to investors and use the proceeds to buy securities from specialized funds, known as structured investment vehicles, or SIVs, that are being forced to wind down their businesses.

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In the short term, Treasury officials said the financial markets were in danger of a large-scale dumping of assets by the banks, which would have hurt capital markets and potentially spilled over to the broader economy. To avoid that, Treasury stepped in to facilitate discussions among the banks for a private-sector solution, which culminated in the creation of a fund to buy SIV assets.

Question: What is this plan really going to do for the big SIV banks? Answer: generate liquidity for the good while warehousing the truly distressed, where the value of buying time is uncertain.

This vehicle, the Master-Liquidity Enhancement Conduit, or M-LEC, is not designed to hold a bunch of garbage, but only the highest-quality components of existing SIVs. From the WSJ:

According to people familiar with the plan, though, the price of admission for SIVs will be high. SIVs will only be allowed to sell assets rated AA or better and likely will be unable to sell collateralized debt obligations -- pools of debt repackaged into slices with different levels of risk and return -- backed by subprime assets. In addition, the SIVs will have to pay a fee to the super conduit and accept a discount in the price of the securities they are selling. In return for that discount, the SIVs will receive notes in the "junior" layer in the conduit -- which will take the first hit if losses are incurred.

So, what the M-LEC is really doing is generating liquidity against a higher quality pool of assets, leaving behind... the dreck. It is like a keeping well over a $100 billion of illiquid toxic waste in the current SIVs and using the better, more marketable stuff to generate liquidity. I guess the ultimate question is how much value there is in the stuff left behind, and how much of a hole will be blown in bank balance sheets if many of these residual SIV interests crap out. That said, the M-LEC structure does buy time for the markets to become more orderly, for some liquidity to creep back in, and for a near-term crisis to be averted. But it doesn't change the fact that lots of really bad loans were made, and lots of securities were sold backed by these really bad loans, and real investors and real people will incur over $100 billion of real losses when the dust settles, even in the best of circumstances. And it is going to be the magnitude of the losses, where these losses reside and how they are absorbed that will ultimately determine the damage to both Wall Street and Main Street communities.

Bottom line: there is major ugliness out there, and the US Treasury can only do so much. But they are trying. It is only with the passage of time that we'll know the full extent of the damage, but I think we can all say with confidence that this will rank as one of the worst credit meltdowns in history.

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NB: the title is a reference to and in honor of W. Edwards Deming, one of the true geniuses in the fields of process engineering and organizational management. He was all about a very simple yet powerful concept: reducing the variability of outcomes as a measure of quality. He generally applied this in the context of manufacturing businesses, but his genius is applicable to service-oriented businesses - including Wall Street and asset management businesses - as well. If only some of those market participants had internalized his teachings, maybe some of today's problems could have been averted. Just maybe.

Comments

[dave]

No one of this planet has yet to be issued a free pass to use acronyms without defining them clearly. That's a writer's 101 No-No.

[Yaser Anwar]

Of the major banks, Citi needs "MLEC" the most. They had the worst Tier 1 Leverage Ratio of 4.37% vs. JPM's 7.79% and BoA's 5.58%. Not only that, a good portion of their conduit debt is due in November.

Source of #s: Bridgewater Daily