Monday, October 15, 2007



Over the weekend, a consortium of banks, at the prodding of Treasury Secretary Hank Paulson, finalized plans for the Master-Liquidity Enhancement Conduit, a “super conduit” set up to buy troubled assets, primarily assets backed by sub-prime mortgages and other less than stellar credits, from bank affiliates known as structured investment vehicles, or SIVs. (This is separate from the “Hope Fund” discussed in the previous post.) This Rube Goldberg contraption was put together out of fear that, with the commercial paper of the SIVs rolling and unlikely to find buyers for paper issued to refinance it, the SIVs will be forced to unload their risky assets at, to quote the Wall Street Journal “new, lower market prices.” This would lead to big losses at the SIVs and, indirectly, at their bank sponsors and the distinct possibility that their bank affiliates would have to put the SIVs on their own books, forcing the banks to set aside the sizable reserves that the SIVs were set up to avoid. In other words, banks (horrors!) would have to face the downside of making bad financial bets.

Several things are malodorous about this arrangement:

--Hank Paulson and the others who knocked heads to get this arrangement done insist that there will be no government money involved in the bailout. Let’s suspend disbelief here and take Mr. Paulson, and the government for which he works, at his word; after all, there is precedent here: no government money was involved in the LTCM bailout. But even if we assume that there will be no taxpayer money involved here, there had to be an element of government coercion in forming the superconduit. Citibank needed no persuasion to enter into the superconduit arrangement; it is by far the most heavily exposed to SIVs, accounting for 25% of the global SIV market. However, other participants in the Master-Liquidity Enhancement Conduit, such as JP Morgan and Bank of America, have no SIVs. They are saying that the lure for them is the fees they will generate for setting up the conduit and the business their broker-dealer arms will generate from it. So the managements of these institutions are putting the banks’ credit, and profitability, on the line to back risky securities at above market prices (See the next bullet point.) in order to save a competitor that they both would like to displace as the largest bank in the world. “Yeah, that’s the way it was. Honest.”

--The superconduit is supposed to pay market prices for the securities it will buy. But the whole arrangement is designed to allow the SIVs to avoid selling the securities at, as the Wall Street Journal put it, “new, lower market prices” that would result from a panic sale. So the conduit will pay market prices in order to save the SIVs from having to sell at market prices. Uh huh. In the absence of the supposedly market price bid from the conduit, put together for the very purpose of making that bid, the market price of the securities in question would be far lower. Sounds logical…to the Mad Hatter.

--Besides the SIVs who hold this dicey paper, and Citicorp, who benefits here? Of course: hedge funds and other holders of this funny paper, who eschew government interference in the market place until the market place begins to make them feel uncomfortable. And who invests in hedge funds? Could it possibly be Hank Paulson’s Wall Street friends, or George Bush’s Wall Street friends, or the mucky-mucks, pooh-bahs, and suzerains of the banks that will become contributors to the superconduit, along with their pals at the yacht and country clubs in Greenwich? Hmm…Perhaps healthy dollops of government coercion were not all that necessary to get these captains of finance to use their shareholders’ money to effectively bail out some of their investments. Is that too cynical?

--Shareholders ought to start asking questions, but from different perspectives. Citi shareholders ought to be delighted by the bailout, but ought to be asking Mr. Prince and his minions why in the world the bank got so heavily involved in SIVs in the first place. What, besides seeming gross incompetence, was the bank trying to hide? Shareholders of JP Morgan and Bank of America ought to ask why their banks’ credit, and profitability and hence the investments of the holders, should be put on the line to bail out a careless competitor and, perhaps, the investments of the people who run their banks. Can the fees involved be that good? Or is this a case of these banks’ not being able to say no the federal government, perhaps for fear that, because of some idiotic adventure on the part of their managements, they will be next in line, hat in hand, to see Mr. Paulson.

--Taxpayers ought to keep a close eye on these developments. The government is already deeply involved in this. Why? When will government money have to be employed? Why? Should taxpayers be forced to bail people, usually people with a lot more money than they, out of the consequences of their own financial folly?

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