A crucial catch in the banks’ ‘super fund’ Gillian Tett Financial Times October 16 2007
A decade ago, when Asia was facing a financial crisis, American bankers and government officials regularly travelled to the region delivering homilies about the best way to exit a banking mess.
After all – or so the lectures typically went – America had suffered bank crises in the past, such as the Savings and Loan debacle of the late 1980s. This experience had shown that the best route to recovery was to establish realistic prices for distressed assets, by conducting fire sales if necessary, and then write the losses off.
A decade later, however, it seems that some US financiers need to take another hefty swig of the medicine they used to wave at Asia.
In recent weeks, signs have emerged that parts of the debt world are starting to recover from the turmoil of the summer. Trading activity has resumed in risky corporate debt, helped by the fact that some large banks have written down the value of these loans.
However, it remains an open question whether these write-downs have been large enough (not least because some banks have entered into sweetheart deals with hedge funds to flatter the terms at which loans are “sold”). More pernicious still, some banks appear to remain unwilling to face up to the potential scale of losses bubbling in another important sector – namely mortgage-linked securities.
Take the issue of the so-called Master Liquidity Enhancement Conduit, the investment vehicle that is now being created by Citigroup, Bank of America, JPMorgan and others (or so the founding trio desperately hope).
The financiers behind the clumsily named scheme like to present this as a clever way to rebuild confidence in parts of the financial markets currently gripped by paralysis, most notably in the area of structured credit and commercial paper.
More specifically, what the M-LEC will apparently do is purchase assets from bank-affiliated structured investment vehicles (SIVs) that cannot fund themselves in the commercial paper market. It will restructure these assets into a form that will be more appealing to investors, thus hopefully enabling the M-LEC to do what SIVs cannot – namely issue commercial paper. However, precise details of what kinds of assets will be bought – such as mortgage assets – are yet to be revealed.
In itself, this is not a bad concept. After all, some SIVs do need to be restructured or refinanced, given their current funding woes. This is difficult to achieve on a unilateral basis and in a timely manner, given the complexity of assets that SIVs typically hold.
However, it is possible that the M-LEC could provide one neutral forum for doing this without needing to place these assets on the banks’ balance sheet. It is even conceivable that future historians will come to regard the M-LEC as the 2007 equivalent of America’s Resolution Trust Corporation – the state-owned body that helped resolve the S&L mess by buying up bad assets.
But there is a crucial catch. The RTC helped to solve the S&L mess because it auctioned off the assets it acquired – initially at ultra-low prices – believing that the US needed to create a true “clearing price” of S&L assets in order to rebuild market confidence. It is far from clear that those running the M-LEC will have the courage to repeat this trick. On the contrary, one raison d’etre of the fund – if not the crucial imperative – is that some banks apparently want to avoid asset sales because they fear they would depress prices and hurt balance sheets.
Moreover, many banks also appear to think that the recent price fall in structured credit is simply a “temporary” affair that will be corrected soon (or at least during the life of the M-LEC). This seems odd, given that the fundamentals for mortgage securities are continuing to deteriorate. It also means that when the M-LEC organisers say they will purchase assets at “market” prices, this could potentially cover a multitude of sins.
Thus, if the M-LEC is to produce a genuine solution to the current financial woes, it is imperative that it buy assets at genuine, clearing prices – not artificial prices created by banks. If not, investors will retain nagging fears that prices have further to fall.
To see just how damaging it can be when there are not genuine clearing prices for assets, just look at Japan in the 1990s, when banks refused to recognise their losses and were rightly criticised by the Americans. The consequences can be debilitating. History may not repeat itself precisely but in the financial sector it often rhymes.
The writer is the FT’s capital markets editor