Some Straight Talk on "Liquidity Puts"

"Liquidity puts" - yet another new and ominous sounding term for something that has been in existence for a long, long time. The term is defined in an 11/13/3007 article in Fortune as follows:

What Citi did a couple of years ago was insert a put type of option into otherwise conventional CDOs that were backed by subprime mortgages and sold to such entities as funds set up by Wall Street firms. The put allowed any buyer of these CDOs who ran into financing problems to sell them back - at original value - to Citi. The likelihood of the put being exercised, however, was regarded as extremely remote because the CDOs were structured to be high-grade entities called "super-senior."

Have you ever heard the term "recourse?" It is a fairly simple concept that has been around over six centuries, and is directly related to the aforementioned liquidity puts. The Merriam-Webster definition of recourse is as follows: 

Main Entry:

re·course

Pronunciation:

      \ˈrē-ˌkȯrs, ri-ˈ\    

Function:

noun

Etymology:

Middle English recours, from Anglo-French recurs, from Late Latin recursus, from Latin, act of running back, from recurrere to run back — more at recur

Date:

14th century 

1 a: a turning to someone or something for help or protection <settled the matter without recourse to law> b: a source of help or strength : resort <had no recourse left>2: the right to demand payment from the maker or endorser of a negotiable instrument (as a check)

Turning to someone for help or protection? A source of help or strength? Sure sounds like a liquidity put to me. The interesting thing about recourse, however, is that it is generally believed that assets need to remain on-balance sheet if they are subject to its occurrence. Because, as a matter of fact, one does not know if and when those assets may be coming back to you, and should be accounted for in a conservative manner. This then raises the issue of securitization in general, and whether or not many of these vehicles should be off-balance sheet at all. A little blurb on securitization from Wikipedia raises the issue as well (the bolding is my own):

Securitization occurs when a company groups together assets or receivables and sells them in units to the market through a trust. Any asset with a cashflow can be securitized. The cash flows from these receivables are used to pay the holders of these units. Companies often do this in order to remove these assets from their balance sheets and monetize an asset. Although these assets are "removed" from the balance sheet and are supposed to be the responsibility of the trust, that does not end the company's involvement. Often the company maintains a special interest in the trust which is called an "interest only strip" or "first loss piece". Any payments from the trust must be made to regular investors in precedence to this interest. This protects investors from a degree of risk, making the securitization more attractive. The aforementioned brings into question whether the assets are truly off balance sheet given the company's exposure to losses on this interest.

This is the issue in a nutshell. Liquidity puts and its variants are strewn across the entire securitization landscape and have been for a few decades, and any investor that buys and sells the shares of financial institutions without understanding this concept is in for a lot of pain. The likelihood of incurring this pain has always been there, it is only that today's markets being as they are that the fat tail of the distribution has finally come along to swat ignorant investors (and their unfortunate clients) in their pocketbooks. But don't sit there and tell me that these risks are new, special and different. They're not. It is only that certain investors have been awakened from their heavenly slumbers by a heaping dose of reality. And whose fault is that? If you want to play in the world of complex instruments read the documents. Very. Carefully. Don't rely on the rating agencies - they won't save you. And don't count on clear and useful accounting rules or detailed company disclosures to bail you out. You've got only your own brains, perspective and diligence to count on. And if any of these three are lacking - look out.

 

Comments

[Paul Denlinger]

There has been a systemic failure up and down the chain which has led the US to the present crisis. It all started when the Fed lowered interest rates in 2000, and instead of starting businesses and creating jobs, Americans decided to go shopping for big ticket items. Then the lenders started making no-interest loans on home purchases, and instead of having alarm bells go off in the Fed, and in the heads of individual Americans, people actually took out these loans to "buy" homes. And it went all the way up the ladder, including it seems, to the office of the CEO in Citibank.

However, at the time, no one spoke out fearing that they would have been been branded as "out of date".

This is why I get more than a little upset when Americans say that things will be OK. People should be optimistic, but optimism needs to be grounded in reality. There always should be a plan. If there isn't one, it simply sounds like irresponsibility.