What is behind the Single Master Liquidity Enhancement Conduit (M-LEC) aka ‘Superfund’ proposed by Citigroup, JPMorgan Chase and Bank of America, with the active verbal encouragement of the US Treasury?
Exploding amounts of opaque financial instruments held by growing numbers of opaque financial institutions made a significant contribution to the perfect storm that resulted in massive disruption of interbank markets, the drying up of many collateralised debt obligations (CDO) markets, collateralised loan obligations (CLO) markets and asset-backed commercial paper (ABCP) markets and the continuing upheaval throughout the OECD wholesale financial markets. Prominent among the opaque financial instruments are a wide range of complex structured finance products based on the securitisation, bundling, slicing and dicing, tranching, enhancement and recombination of securitised illiquid assets and cash flows like mortgages, car loans and credit card receivables. Leading examples of opaque financial institutions are the Structured Investment Vehicles (SIVs) and Conduits (SIVs closely associated with a particular bank) whose assets M-LEC is supposed to purchase. All these SIVs, Conduits and similar constructions are off-balance-sheet vehicles created mostly by commercial banks (some by investment banks), mainly to avoid regulatory burdens, including capital adequacy requirements, reporting requirements, governance requirements and other restrictions on the asset and liability sides of banks’ balance sheets.
This raises the obvious question as to whether the proposed sale by a number of opaque off-balance-sheet vehicles of between $75 bn and $200 bn of illiquid opaque asset-backed securities (ABSs) to a single huge opaque off-balance-sheet vehicle, M-LEC, funded by the three above-mentioned American banks (and any other institutions willing to join the venture) represents a move towards better functioning ABS and ABCP markets and towards fair-value or fundamental-value pricing of these securities? It is possible, but not likely.
Clearly, if SIVs and Conduits have to unload large quantities of illiquid opaque financial instruments on an unwilling market because these SIVs and Conduits can no longer refinance their short-maturity liabilities in the defunct ABCP markets, the ‘fire sale’ prices realised by such distress sales would indeed be distressing to the sellers. These same prices would, however, be exhilarating to the buyers – the vulture funds and other deep pockets/smart money investors that are always on the look-out for just such opportunities. Since these SIVs and Conduits have no systemic financial stability significance, their losses (which are mirrored by profits earned by their counterparties) are of no policy relevance, and even their bankruptcy (which would inevitably involve some net real resource cost) would be a second-order issue.
The ‘fire-sale’ prices that might be realised if these SIVs and Conduits had to dump their illiquid assets on a reluctant market could also impact adversely on holders of similar illiquid assets, even if these assets had not been traded at the same time and the same prices. ‘Fair value’ accounting may require marking to market of these assets using the distressed valuations achieved in the sales by SIVs and Conduits. Any institution holding such assets, including banks, could take a serious hit on their balance sheets as a result.
An obvious alternative to a fire-sale of illiquid structured finance instruments by the SIVs and Conduits to the market, would be for the banks either to purchase the instruments directly from these off-balance-sheet vehicles (at generous prices), that is to take the securities ‘on balance sheet’, or to purchase the SIVs and Conduits themselves, that is, to take the off-balance-sheet vehicles ‘on balance sheet’. The argument against that, from the perspective of the banks, is the same as the argument for creating the off-balance-sheet vehicles in the first place: it would use up capital and impose commercial banking standards of reporting, transparency and governance on the securities/former off-balance-sheet vehicles.
If Citigroup, JPMorgan Chase, Bank of America and any other banks are exposed to such vulnerable SIVs and Conduits, whether as shareholders, as creditors or providers of (as yet) undrawn lines of credit, for reputational reasons or simply because they would not like to value their own holdings of opaque structured finance vehicles at bargain-basement prices, it is their right to try and limit the damage to their bottom lines through any set of actions that does not violate laws and regulations. It is possible that in doing so (especially if a wide cross-section of US and international banks were to participate in the venture) they would restore liquidity to a currently illiquid set of markets and do some social good as well.
Even if we grant this argument, is this the best that could be achieved from the perspective of the efficient functioning of the financial system? Hardly. If I am correct in my belief that the proliferation of regulation-avoiding off-balance-sheet vehicles has indeed been a major contributor to our current problems, scant progress would be made by the creation of M-LEC – yet another gigantic off-balance-sheet vehicle. If banks are going to bid for the opaque securities held by opaque SIVs and Conduits, they should do so directly, taking the illiquid securities onto their own balance sheets, rather than stuffing them into M-LEC at prices unlikely to be the result of arms-length transactions. With a bit of luck, the three (or more) M-LEC sponsoring banks will in any case have to consolidate their shares in M-LEC with their own accounts, but this issue is still unresolved.
In view of the widespread lack of enthusiasm among the rest of the US and international banking community for signing up for M-LEC, it seems likely that the three institutions that proposed the creation of this Mother of All Liquidity Enhancement Conduits are the institutions most exposed, directly or indirectly, either to the SIVs and Conduits targeted by M-LEC – those holding large portfolios of the most opaque and illiquid structured financial instruments – or to the fallout from any forced, rushed liquidation of these investments. The deafening silence of the Fed about the merits of M-LEC reinforces this impression.