The hope is that the new super-fund will be able to regain investor confidence and market all but te most dodgy paper in a way the SIVs no longer can. Treasury secretary Hank Paulson is closely connected to Wall Street, and stands to take the heat for orchestrating the bailout - particularly from vulture funds poised to scoop up the debt at bargain basement prices. The arrangement is being defended, as the LTCM bailout was a decade ago, on grounds that plummeting prices and rising yields in this part of the short-term credit market would have much wider systemic consequences. Confidence in the stability of the financial system is still shaken by August's turmoil, but it's still not certain that other banks, themselves holding lots of junk, will participate or leave Citigroup twisting in the wind. =========================================== Rescue Readied By Banks Is Bet To Spur Market By CARRICK MOLLENKAMP, DEBORAH SOLOMON and ROBIN SIDEL Wall Street Journal October 15, 2007; Page A1
The high-stakes plan to rescue banks from losses on mortgage securities amounts to a big bet that a consortium of financial giants -- at the prodding of the U.S. government -- can persuade investors to pour more money into the troubled credit market.
Over the weekend, the Treasury hosted talks to help a group of banks set up a $100 billion fund to buy troubled assets in exchange for new short-term debt. The banks hope to have the fund up and running within 90 days.
According to people familiar with the matter, the Treasury hopes the plan, which could be announced as early as this morning, will jump-start demand for commercial paper, which froze up this summer amid the credit crunch that roiled global financial markets.
Companies depend on commercial paper to finance day-to-day expenses like payroll and rent. Some financial commercial paper -- known as asset-backed paper -- has been able to find buyers in recent weeks. But investors have remained skeptical of other types, including paper issued by certain bank-affiliated investment funds
The lack of buying signaled that the markets weren't working properly, despite the efforts of central banks, and that investor confidence was low, since commercial paper typically is considered a safe investment.
Some influential investors think the Treasury-backed strategy might work. Other object to the Treasury's role in seeking to help banks avoid a big financial hit for making bad bets.
The coordinated effort is a good way to help restart stalled debt markets, said Mohamed El-Erian, who runs Harvard University's $35 billion endowment and is set to become co-chief executive and co-chief investment officer of money-management firm Pacific Investment Management Co. in January. "No bank would do this on its own."
"The proposal has the potential to restore liquidity to a market," he added.
Four weeks ago, in an unusual move, Treasury officials convened a meeting of some 10 banks, including Citigroup Inc., to discuss a private-sector solution to the problems and sounded out other market participants about their views on a rescue package. The problems stem from affiliated funds called structured investment vehicles, or SIVs, which Citigroup and others set up as a way to make money without taking the risk involved onto their balance sheets. Such vehicles are formally independent of the banks that create them. They issue their own short-term debt, usually at relatively low rates that reflects their high credit rating. Then, they use the proceeds to buy higher-yielding assets such as securities tied to mortgages or receivables from midsize businesses seeking to raise cash.
The government isn't putting money into the plan but its role could be crucial in luring investors to buy debt issued by the rescue fund as part of the plan.
Even that's too much for some big investors. "I have never seen Treasury play this kind of role," said John Makin, a visiting scholar with the conservative American Enterprise Institute in Washington and a principal with hedge fund Caxton Associates LLC. The banks made "riskier investments that didn't work out. They should now put it back on their balance sheet."
The popularity of SIVs has boomed since two Citigroup bankers, Nicholas J. Sossidis and Stephen Partridge-Hicks, invented the strategy in London in the late 1980s. (They later left to form their own company, London-based Gordian Knot, which operates the world's largest SIV.)
Behind Treasury's concern were banks like Citigroup, whose affiliates owned $80 billion in assets backed by mortgages and other securities. The world's biggest bank, by market value, held the assets off its balance sheet and was facing the prospect of either having to unload them in a disorderly fire-sale fashion or moving them onto its books.
Either scenario would have hurt financial markets and could have damped the economy by curtailing banks' ability to make new loans to consumers and corporations. Treasury envisioned a potentially "disorderly" unwinding of assets that could worsen the credit crunch, said a person familiar with the matter.
When it began discussions with the banks last month, Treasury made clear that a government-backed bailout or any publicly financed rescue effort was "not on the table," and that it wanted to facilitate a private-sector response, this person said.
Under the proposed rescue package Citigroup, J.P. Morgan Chase & Co. and Bank of America Corp. will set up a fund, or "superconduit," to act as a buyer of last resort. It will pay market prices for SIV assets in an effort to prevent dumping.
J.P. Morgan and Bank of America don't have SIVs, but they plan to participate because they would earn fees for helping arrange the superconduit, whose lifespan, according to people briefed on the plan, is expected to be about a year. The superconduit can buy assets from any bank or fund around the world.
Details are still being worked out but the oversight committee of the three banks will set criteria for what the new fund, to be called the Master-Liquidity Enhancement Conduit, will buy. For now, it is unlikely the fund will buy assets underpinned by subprime mortgages due to concern that they would constrain it, people familiar with the matter said. Subprime mortgages are those aimed at borrowers with shaky credit.
The plan means that some banks now stand to profit from the problems their industry helped create. Citigroup, J.P. Morgan and Bank of America, for example, will be paid fees for providing the financial backstop to the fund. In addition, the broker-dealer arms of the banks could be paid for helping the new structure raise capital. Bank of America highlighted the opportunity to generate fees in discussions leading up to the final plans, people familiar with the matter said.
Citigroup took the lead in pushing for the rescue plan. Large sums of SIV debt were coming due in November. And increasingly debt analysts were forecasting a tough future for SIVs. A Citigroup research report, issued two days before the banks and Treasury met for the first time, noted, "SIVs now find themselves in the eye of the storm."
The banks and Treasury consulted the Federal Reserve early on. The Fed was available to answer technical questions but left it to Treasury to oversee the talks. At a critical meeting convened by Treasury on Sunday, Sept. 16, Anthony Ryan, Treasury's assistant secretary for financial markets, asked the bankers about their outlook. The response was that assets could be sold, but in a process that would bring disorder to the markets.
Banks would face huge losses if their affiliated funds were forced to unload billions of dollars in mortgage-backed securities and other assets because it would drive down prices and lead to big write-offs at the new, lower market prices. Indeed, in the past several months, Citigroup's own affiliates have sold some $20 billion in assets.
Some bankers objected to the plan, calling it an escape hatch for Citigroup, which has more SIVs than any other bank, according to people familiar with the situation. The bank has accounted for about 25% of the global SIV market. As of August, assets held by SIVs totaled $400 billion.
In coming weeks, there could be challenges in getting other banks to join because they may be concerned their investors could view it as a signal that their books are weak.
In recent weeks, investors have grown worried about the size of bank-affiliated funds that have invested huge sums in securities tied to shaky U.S. subprime mortgages and other assets. Citigroup has drawn special scrutiny. The bank and its London office run seven affiliates, or SIVs, that would be able to sell assets to the superconduit.
Bringing assets onto its balance sheet would be a big problem for Citigroup because it would be required to set aside reserves to cover the assets. The banking titan operates with a capital ratio that is thinner than peers.
Auditors in recent weeks also had taken a hard-line when it came to assessing losses within SIVs. As the credit crunch worsened in August, many financial institutions argued that losses due to market volatility didn't reflect the assets' long-term value.
But on Oct. 3, the Center for Audit Quality, backed by the Big Four accounting firms, issued analysis that said market prices were real and couldn't be ignored. One paper argued that banks must periodically reassess the condition of off-balance-sheet funding vehicles and take account of market prices and any resulting losses, even if these were seen as an anomaly. If the losses become so great that a bank sponsoring one of these vehicles may have to shoulder some of their cost, "the sponsor would be required to consolidate" the vehicle, the paper said.
The Center for Audit Quality drafted the papers after consulting with the Securities and Exchange Commission. As a result, this put companies on notice that the Big Four accounting firms, along with the SEC, had taken a common stand on these complex accounting questions.