Missing the Boat on the M-LEC Issue

We have witnessed a tremendous backlash against the M-LEC, Super SIV or whatever other name you choose to call the pooled securitization vehicle proposed by several banks and supported by Mr. Paulson and the US Treasury. While articles in the New York Times, Financial Times and the Wall Street Journal have all raised concerns over its likelihood of success, the motivations behind its creation and concerns over "moral hazard," two particularly snarky pieces showed up this weekend penned by Mr. Ben Stein (NYT) and Mr. Alan Abelson (Barron's) that warrant comment.

Let me be clear: I see neither a moral hazard nor a pending bailout in the form of the M-LEC; what I see is something more akin to the "Good Bank/Bad Bank" restructurings of the 1980s, where discrete pools of good loans were hived off of the bad to protect the good from being subject to perverse behaviors arising from the bad. This doesn't mean that the bad somehow get wiped away, forgiven, eliminated or anything of the sort. What it does mean is pools that, in aggregate, are being penalized for the credit features of a portion of its assets are able to access cost-effective financing for those assets that warrant it. The others, well, they need to be worked out. This isn't crazy stuff. It's just sound finance. Not voodoo financial engineering. Not some super complex derivative strategy. At its core it is pretty basic stuff.

One can use either the Good Bank/Bad Bank analogy or even the tracking stock/spin-off analogy, where the value of a mis-priced component of a group of assets is allowed to trade at its own level, bolstering the value of the combined group. Either way, Messrs. Paulson and Steel are not out to try and pull the wool over investors eyes, bail out Wall Street or anything like that. They are merely helping to problem-solve at a time when, let's face it, the problems are both large and stark. And they happen to be two very seasoned market participants who get it, and can certainly add to the collective gray matter required to address the pain that we'll all inevitably incur.

Now, the first cynic at the table is Mr. Stein from today's NYT:

Now, the ultimate Wall Street player and insider, Henry M. Paulson Jr., the Treasury secretary, has bestirred himself to take serious notice of the credit problems faced by some very big lenders. He wants to create a bailout fund in which banks that still appear sound buy some of the debt of the troubled players like Citigroup.

THE deal, as far as I can tell, is that they buy the most secure levels of debt that Citigroup and others own, get large fees and allow Citigroup and the others to keep the debts off their balance sheets. But there are at least two giant issues here.

One is that it’s a bit too predictable that Mr. Paulson would basically pooh-pooh the subprime problems until major Wall Street powers got in trouble and then — presto! — swing into action. It might have been inspiring had he stepped up to the plate when smaller players like home buyers were getting burned, but that’s not really his style.

The other is that it’s hard to see what good the maneuver would do. Suppose Citigroup or some other lender has a perfectly good loan to sell. Why does Citigroup need a big Treasury-sponsored organization to sell it? They can sell it to anyone right now. The problem is with the questionable loans. And they seemingly are not part of the plan from the Treasury.

I don't know if Ben is running for office, but it sure sounds like it. I think his characterization of Mr. Paulson's motivations make for good copy but are too inane for words. Right, he is bailing out his Wall Street buddies. Mr. Stein, while you don't make much of this subprime mess most of us do, and the credit markets are gradually waking up to the longer-term risks posed by the credit crunch, and the amount it effects Wall Street relative to Main Street is trifling. So if Mr. Paulson really wants to help his Wall Street pals there are easier ways to do it (like to whisper in the ear of Mr. Bernanke - if someone wants to see a possible moral hazard in action look at Fed policy). And as it relates to the argument that Citi and others could just sell the well-performing loans, this structure provides a single, ready buyer, a buyer who is only going to buy if the price makes sense. No firm planning to be involved with the M-LEC structure is charitable by nature, and unless the deal makes sense they won't participate. So I'm not really sure what to make of your argument except to say that it is expedient if not entirely possessing teeth. So your entire bailout line of discussion to me is, in fact, a red herring, and a convenient vehicle for you to vent your spleen about what really irks you: that the Government should stay out of all this stuff, period. Now if that is what you had written I'd have taken you more seriously, but as you didn't, well, I don't.

And now, from Mr. Stein's bosom buddy, Mr. Abelson from this weekend's Barron's:

Happily, we have in the person of Henry Paulson a Treasury Secretary who has a keen grasp of how the financial world works, who understands how crucial bankers and brokers are to the comfort and well-being of this rich nation. He is able to make that judgment because so many of them are his bosom buddies, one of his treasured legacies from the many years he spent laboring in the vineyards of Wall Street.

Carpers and cynics who never met a payroll and, indeed, likely never did an honest day's work (you know the types as well as we do: politicians, journalists, that sort of lowlife) may snarl all they like about crony capitalism and worse. But decent, compassionate folk can only cheer the speed with which Mr. Paulson whistled up a $100 billion bail-out for a posse of banks that found themselves stuck on a sandbar when the sea of liquidity they have been so happily splashing about in suddenly went bone dry.

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Enter Mr. Paulson, who put the arm on a number of major banks, even some that had no exposure to SIVs, to set up a fund with the real catchy name of the Master Liquidity Enhancement Conduit to help out the needy banks by buying securities from them, presumably at a discount. The obvious intention is to reassure the world that everything's hunky-dory and keep the banks, poor sensitive creatures, from having to show those squishy assets on their balance sheets.

Our considered view is that the supposed bail-out is a typical bit of Washington flash: all show and no substance. For a second, more tempered, opinion we turned to Punk Ziegel's savvy bank analyst, Richard Bove. He calls it "a horrible idea" that "would do nothing to solve any subprime-debt questions, mortgage issues, bad bank-loan problems etc... It would not bail out any bad loans from anyone, anywhere...It will not solve the liquidity problems where the SIVs need the most help and it will not reduce the debt problems facing the economy."

Again with the snarky sarcasm? Ben and Alan must have gone bowling late last week and decided to pile on Mr. Paulson this weekend. Again, reference to a bail-out. Where? The M-LEC is a market-based vehicle being assembled by financially motivated participants, none of whom is the US Treasury. So this jargon is simply inaccurate and muckraking, at best. And as for the balance sheet argument, if analysts are too dumb to take into account the impact of off-balance sheet assets, be they SIVs, asset defeasance transactions, operating leases, etc., then they deserved to fired. Balance sheet footnotes, my friends. Sure, one can argue over the accounting rules, but any bank analyst worth their weight in dog-sh@t knows of these deals and their true economic effects. That said, I think Mr. Bove's questions are more to the point. There is no question that the M-LEC solves no bad loan issues on day 1. If anything, it provides some financing to buy time, but how much value this really conveys is a mystery to all. And he is also correct that the detritus is incredibly hard to finance, and will weigh on balance sheets likely for quite some time. Some may well have to be sold at huge losses, others will be worked out, while some others may recover as market conditions improve. That said, it is a big unknown.

I think the real question is if the M-LEC has enough positives to make it worthwhile relative to the unknowns. As it introduces friction, it costs money to assemble for participating firms, especially those selling assets into the vehicle. And as noted above, it doesn't directly solve any fundamental credit problems. But it does create a ready market for high-quality SIV assets, in size, that streamlines the operational process of generating liquidity relative to selling discrete assets to many, many buyers. And it does provide an opportunity for market conditions to improve, possibly enabling some of the currently distressed paper to recover. And the part that doesn't, the banks will take some lumps. Lumps that they deserve to take. So net net, it might be worth a go. And it certainly doesn't have all of the negative connotations or motivations put forth by Messrs. Stein and Abelson. I don't know what someone put in their Wheaties this weekend, but keep it out of my bowl, ok?

 

Comments

[Roger]

To my friends at Alacra, you need to take a pill. We are not saying materially dissimilar things, except for your little rant at the beginning. Clearly transparency is necessary. This is one of the tickets to play the game. Another is that the M-LEC pays true market prices, which I am assuming it will, or else there won't be too many non-SIV bank participants. They are greedy, too, and won't do something which does not directly benefit them. As to your RTC argument, we'll see what happens, but neither you nor I know what will happen over the next 3 months, 6 months, 1 year. Will M-LEC free up a measure of liquidity against a pool of higher-rated SIV assets? Yes. Will it buy time for the market to stablize in order to provide a better forum for liquidating lower-quality assets? Yes. Is the M-LEC a panacea? No. You are drawing conclusions in the absence of data, data which will be accumulated over the ensuing months. Then let's have a revisit, ok?

[alacrablog]

Snarky or not, this reeks. Let the market determine prices. You're advocating re-engineered financial engineering with no guarantee of transparency. From the FT:
The financiers behind the clumsily named scheme like to present this as a clever way to rebuild confidence in parts of the financial markets currently gripped by paralysis, most notably in the area of structured credit and commercial paper.

More specifically, what the M-LEC will apparently do is purchase assets from bank-affiliated structured investment vehicles (SIVs) that cannot fund themselves in the commercial paper market. It will restructure these assets into a form that will be more appealing to investors, thus hopefully enabling the M-LEC to do what SIVs cannot - namely issue commercial paper. However, precise details of what kinds of assets will be bought - such as mortgage assets - are yet to be revealed.

In itself, this is not a bad concept. After all, some SIVs do need to be restructured or refinanced, given their current funding woes. This is difficult to achieve on a unilateral basis and in a timely manner, given the complexity of assets that SIVs typically hold.

However, it is possible that the M-LEC could provide one neutral forum for doing this without needing to place these assets on the banks' balance sheet. It is even conceivable that future historians will come to regard the M-LEC as the 2007 equivalent of America's Resolution Trust Corporation - the state-owned body that helped resolve the S&L mess by buying up bad assets.

But there is a crucial catch. The RTC helped to solve the S&L mess because it auctioned off the assets it acquired - initially at ultra-low prices - believing that the US needed to create a true "clearing price" of S&L assets in order to rebuild market confidence. It is far from clear that those running the M-LEC will have the courage to repeat this trick. On the contrary, one raison d'etre of the fund - if not the crucial imperative - is that some banks apparently want to avoid asset sales because they fear they would depress prices and hurt balance sheets.

Moreover, many banks also appear to think that the recent price fall in structured credit is simply a "temporary" affair that will be corrected soon (or at least during the life of the M-LEC). This seems odd, given that the fundamentals for mortgage securities are continuing to deteriorate. It also means that when the M-LEC organisers say they will purchase assets at "market" prices, this could potentially cover a multitude of sins.

Thus, if the M-LEC is to produce a genuine solution to the current financial woes, it is imperative that it buy assets at genuine, clearing prices - not artificial prices created by banks. If not, investors will retain nagging fears that prices have further to fall.

To see just how damaging it can be when there are not genuine clearing prices for assets, just look at Japan in the 1990s, when banks refused to recognise their losses and were rightly criticised by the Americans. The consequences can be debilitating. History may not repeat itself precisely but in the financial sector it often rhymes.

[lb]

M-LEC equates to treasury sponsored round tripping. They will create a market that looks sound. Once they unwind everything, goodbye bank 'funded bailout', welcome back RTC.

All the toxic sludge is going to be transfered to smaller less knowing banks, pension funds, and deceptively named bond funds.

That's right, if you think you or your 401k were safe from this by investing in a bond fund, guess again. Check out your funds top 10 holdings, you'd be amazed at the amount of structured credit that has been stuffed into them. M-LEC isn't going to help you, if anything it will help them stuff more overpriced toxic waste into your portfolio.

[rk]

Good comment on Mr. Abelson's column. As a long time subscriber to Barron's, I always skip his column as I found his snarky tone to be wearing and tiring week after week. As for Mr. Stein, I know he writes a lot in many places. But I can't say he made much impression. This article of his proves that my inattention wise. Thank you for reading these articles so that the rest of us do not need to.