Introduction
Over the weekend of October 13, 2007, the U.S. Treasury hosted talks with some of the largest U.S. banks with the aim of creating a "superfund" that would be used to provide stability to the shaky credit markets.[1] The meeting included some of the biggest banking institutions such as Citigroup, Bank of America, and J.P. Morgan Chase.[2] This summer brought turmoil in the credit markets as the subprime mortgage fiasco began to bear fruit, and the goal of the proposed superfund is to hedge off fears of future bank defaults as well as invigorate demand for commercial paper, which has since this summer frozen up.[3] This article will review the details of the proposed superfund, its aims, and address some criticism leveled at it as well as the government's role in the process.
Details
As expected on October 15, 2007, the triumvirate of aforesaid banks announced the creation of a superfund entitled the Master-Liquidity Enhancement Conduit (M-LEC).[4] The twofold goal of the superfund is to: 1) protect banks and financial institutions from shaky investments held by SIVs; 2) reinvigorate the demand for commercial paper.[5] Structured Investment Vehicles (SIVs) were first created in the 80's by two London bankers, Nicholas Sossidis and Stephen Partridge-Hicks, then at Citibank.[6]
At the time, the securitization of assets, such as securities backed by mortgages or credit card debt, was developing, and the two bankers wanted to find a better way for Citigroup clients to profit from this nascent market.[7] What they developed is known as a SIV, which is essentially a fund established by a financial institution that issues short-term debt to investors and uses the proceeds to invest in higher-yielding assets usually over a longer term.[8] Oftentimes these high-yielding assets would consist of asset-backed securities or the like.[9] Banks would collect fees for operating the oftentimes complicated SIVs; however, the principle benefit to the bank is that the SIV fund is owned by the investors, not the bank, so the fund stays off the balance sheet.[10] The two banks launched the first SIVs, Alpha Finance Corp. and Beta Finance Corp., in 1988 and 1989 respectively.[11] Soon thereafter, Messers. Sossidis and Partridge-Hicks left Citigroup to form their own SIV management firm, Gordian Knot.[12] Gordian Knot, located in the ritzy Mayfair district in London, is the world's largest SIV, valued at $57 billion.[13] Since those beginning years, the industry in SIVs has grown to thirty[14] such funds valued at $400 billion.[15]
The current problem concerning SIVs stems both from the growth of the industry and the investments chosen by the funds. As the attractive features of SIV's disseminated into the greater financial sector, many inexperienced investors enter the market, "many of the new players didn't fully recognize the perils involved in borrowing money short-term and investing it long-term."[16] Moreover, many of the chosen long-term assets were in securitized mortgage debt, which of late has come past due. The problem became self-perpetuating during the summer as the credit markets were roiled causing a sharp drop in confidence, which consequently dried up much of the supply of commercial paper, which the SIV funds principally rely on for short-term debt.[17] Treasury officials, including Secretary Henry Paulson, watched this perilous situation with the credit markets develop and convened a meeting in mid-September with executives from the largest financial institutions in Mr. Paulson's office.[18]
The fear was that the banks would either be forced to transfer the funds onto their balance sheets or the funds themselves "would engage in a fire sale of assets, a move that could exacerbate the credit crunch and damp the broader economy."[19] Over the weeks subsequent to the meeting with Mr. Paulson, Citigroup officials drafted the details of M-LEC. The M-LEC superfund hopes to raise nearly $100 billion with the aim of restoring investors' confidence in the commercial paper market; this $100 billion represents "roughly one-third of the $350 billion in debt issued by SIVs [that] would be coming due in the next six to nine months."[20] This $100 billion goal is to be raised by the participating banks and financial institutions, and they have given themselves a 90-day timetable to do so.[21]
The M-LEC superfund will operate as a "superconduit" to act as a "buyer of last resort" by paying near market prices for SIV assets.[22] First, the superfund would issue short-term debts to investors, and in turn would use these proceeds to purchase securities from ailing SIVs.[23] By purchasing these assets from the SIVs, which currently have little demand because of excessive risk, this could prevent the SIV funds from selling their assets at "fire-sale prices."[24] There would be restrictions placed on the types of SIV securities that the superfund would purchase (only assets rated AA or higher), the superfund likely would not purchase any CDO debt, and the SIVs must offer the securities at discount.[25] The life of M-LEC is expected to be one year, and participating banks will receive fees for their work in arranging it.[26] Broad participation in the superfund is important, and so far the only other big player it has enlisted since the original announcement is Wachovia Corp, with many European institutions so far cautiously hanging back.[27] However, other financial institutions that either manage SIVs or are affected by its market, are watching from a distance, and if the credit squeeze continues, they too could join.[28] This seems nearly certain if the asset-backed commercial paper markets continue to contract, as the Federal Reserve recently projected is the case.[29]
Criticism
Criticism of the M-LEC superfund is on two fronts. First, some contend that CItigroup stands with the most to gain from the superfund, and therefore its wooing of other investors is slyly deceptive.[30] Citigroup's holdings account for 25%, or $100 billion, of the SIV market, so Citigroup "was facing the prospect of either having to unload them in a disorderly fire-sale fashion or moving them onto its books."[31] As the world's largest bank by market value, such a prospect caught the attention of Treasury out of fears of such a scenario occurring and having secondary effects of damping the economy.[32] The critics are correct in concluding that CItigroup is directly exposed to the most risk from the SIV market. For instance, neither Bank of America nor J.P. Morgan have SIVs, but both decided to participate in forming M-LEC out of fears of how the market seizing up would harm them, and both are expected to gain from collecting fees for their participation in the superfund.[33]
Second, critics accuse the government of helping to prop up banks that should ultimately bear the loss of bad investments by moving the SIV funds to their balance sheets.[34] To be clear, the federal government is not providing capital or bailing out the SIV-laden banks, but critics contend "[the government's] role could be crucial in persuading investors to buy debt issued by the rescue fund as part of the plan."[35] Further, critics doubt the perilous claims made by Citigroup and Treasury that the SIV market is crucial to "world economic health" and likewise that the failure of SIVs would in turn lead to broader turmoil in other capital markets.[36] Rather, the banks and the SIV industry should bear their risk: "Hasty rescue plans amount to an amnesty for sloppy banking and an invitation for it to continue."[37] In response to apologists of the superfund, see infra, who argue that the fund does nothing more than establish a price basis for the SIV assets, superfund critics argue that its efforts could distort the market by "throwing good money after bad."[38]
In response to these critics, Peter J. Wallison, a senior fellow at the American Enterprise Institute, contends that the principle objective of the superfund is "price discovery."[39] He contends that there currently exists great uncertainty about the value of some of the SIVs' assets: "buyers back off because they can't assess the risks, and would-be sellers fear unnecessary losses if they sell at too low a price."[40] As applied, the value of the securitized assets is unknown, so the market is "moribund."[41] The presence of the superfund, he contends, will act similar to an auction with low bidding on the securities at first, but as the bids rise, the securities will begin to flow when "a substantial number of holders think their mortgage of other asset-backed securities are worth at least that much.""[42] Through this process the market may be reignited and confidence restored to both buyers and sellers.[43] Moreover, Mr. Wallison argues that Treasury support is different than support from the Fed: "Treasury has no funds with which to effect a bailout or to make good on a guarantee."[44] By contrast, he offers that Treasury's involvement is necessary because this deal requires a "good broker"; to close, he offers this analogy: "Banks are like cats; they aren't easily herded…Their culture is aggressive competition."[45] With no other meaningful players, he contends, Treasury's refusal would have smacked of irresponsibility.[46]
Conclusion
A triumvirate of the nation's largest banks, at the behest of the Treasury, recently announced the proposed formation of a superfund to provide support to the ailing SIV market. The aim of this superfund would be to stave off the possibility of institutions holding SIVs from either emptying these funds in a fire-sale or moving the debts back to their respective balance sheets. Ultimately, the fear is that without prompt action, either scenario could cause broader economic distress. In the weeks to come with both the commercial paper market continuing to tighten and SIV assets hemorrhaging further, the M-LEC superfund's effect on the markets is eagerly anticipated.
[1] Carrick Mollenkamp et al., Rescue Readied by Banks is Bet to Spur Market, WALL ST. J., Oct. 15, 2007, at A1, available at http://online.wsj.com/public/article/SB119240580162658678.html.
[2] Id.
[3] Id.
[4] Carrick Mollenkamp et al., Call to Brave for $100 Billion Rescue, WALL ST. J., Oct. 16, 2007, at C1, available at http://online.wsj.com/public/article/SB119245287618859154.html.
[5] Id. at C1.
[6] Carrick Mollenkamp et al., How London Created a Snarl in Global Markets, WALL ST. J., Oct. 18, 2007, at A1, available at http://online.wsj.com/public/article/SB119266856453862839.html.
[7] Id. at A12.
[8] Id.
[9] Randall Smith et al., Behind Banks' Credit Rescue Fund, WALL ST. J., Oct. 17, 2007, at C1, available at http://online.wsj.com/public/article/SB119257807388261274.html.
[10] Mollenkamp, supra note 6, at A12.
[11] Id.
[12] Id.
[13] Id. at A1.
[14] Mollenkamp, supra note 4, at C1.
[15] Mollenkamp, supra note 6, at A1.
[16] Id. at A12.
[17] Id.
[18] Id.
[19] Id.
[20] Id.
[21] Mollenkamp, supra note 1, at A1.
[22] Id. at A16.
[23] Smith, supra note 9, at C1.
[24] Id.
[25] Mollenkamp, supra note 4, at C2.
[26] Mollenkamp, supra note 1, at A16.
[27] Smith, supra note 9, at C1.
[28] Id. at C2.
[29] Anusha Shrivastava, Asset-Backed Paper Market Continues Its Contraction, WALL ST. J., Oct. 19, 2007, at C2, available at http://online.wsj.com/public/article/SB119271344512963433.html.
[30] Mollenkamp, supra note 1, at A16.
[31] Id.
[32] Id.
[33] Id.
[34] Id.
[35] George Anders, SIV Fund Gives Banks an Unnecessary Break, WALL ST. J., Oct. 24, 2007, at A2, available at http://onliine.wsj.com/public/article/SB119319190211669418.html.
[36] Id.
[37] Id.
[38] Id.
[39] Peter J. Wallison, Subprime Superfund, WALL ST. J., Oct. 18, 2007, at A16, available at http://online.wsj.com/public/article/SB119267191281762976.html.
[40] Id.
[41] Id.
[42] Id.
[43] Id.
[44] Id.
[45] Id.
[46] Id.