Curing SIV

A bail-out fund raises more questions than answers.

You know a market has seen better days when some of its leading actors are compared to a deadly virus. With many traditional buyers of commercial paper (short-term corporate debt) still on strike, Wall Streeters with more wit than taste have branded the sickliest of the structured investment vehicles (SIVs) that issue such paper to punt on longer-term assets “SIV-positive.”

As the feeble struggle to roll over their debt, the banks with the most to lose from their demise are reaching for a palliative. Citigroup, JPMorgan Chase and Bank of America plan to set up a fund, expected to be worth up to $100 billion, that would buy assets from troubled SIVs. Though no government money will be available, the Treasury played a key role in its creation.

As demand for the asset-backed securities that SIVs buy has evaporated, some have had to sell holdings at fire-sale prices to repay investors. Since SIVs hold paper nominally worth $325 billion, further dumping could have a chilling effect on prices in other credit markets.

The new entity — clumsily labeled the Master-Liquidity Enhancement Conduit, or M-LEC — will essentially be a buyer of last resort, using the proceeds of its own debt issues to purchase assets from troubled SIVs. It will take only highly rated paper. By splitting this off from dodgy subprime assets, the hope is to tempt investors back and avoid an avalanche of forced selling. “Most commercial-paper buyers will touch only top-quality assets. A few are still happy to punt on rough stuff. But no one wants a murky mix of the two, which is what you have in many SIVs now,” says a person close to the fund.

There is a whiff of self-rescue about the enterprise, especially with regard to Citigroup, which is more exposed to the asset-backed commercial-paper market than any other bank. However, rumors have been circulating that British banks were also keen to see a rescue fund established, as they hold a large share of the SIVs’ most toxic tranches.

Nevertheless, it is too early to say whether the scheme will work, or even happen. Much is still to be thrashed out. The banks may struggle to reach agreement on a host of issues, not least the price at which to buy assets. Nor is it clear that other banks, investors or even SIVs will participate. European banks are conspicuously absent, so far, as are investment banks. Commercial-paper investors may find the M-LEC’s complexity a turn-off. And it will not be lost on them that the bankers peddling the scheme are the same whose misvaluation of debt securities caused the problems in the first place.

Participating SIVs will have a stake in the enterprise, but taking part may prove expensive. Some 4% of the payment will be not in cash but in junior notes, which will end up worthless if the assets don’t perform. The fund will also charge them a fee for taking on their assets. It is structured to keep most of the credit risk in the SIVs it helps. The banks that provide credit lines to it will incur losses only after lower tranches held by the SIVs and outside investors have been wiped out, which seems unlikely even in current conditions.

Joseph Mason, a finance professor at Drexel University, sees bigger problems. He argues that voluntary co-guarantee schemes like this are doomed to failure because only the weakest institutions want to participate. Like Groucho Marx, the SIVs that most easily qualify for membership of the club will be the least likely to want to join, since they will have cheaper funding alternatives. He also worries that the fund’s creation suggests “we now have an entire market that’s deemed too big to fail.”

Even those who support the fund admit that it is, at best, a temporary solution, buying time so SIVs can find other sources of finance or wind down gracefully. It may also provide breathing space in which to sort out deeper problems facing the market, such as the unstable structure and opacity of SIVs. “The market has to move to a new business model,” says a senior Treasury official.

That means wrenching change, which may explain why stockmarkets fell on the day of the announcement. To some, the Treasury’s participation signalled that things were worse than feared. Much of the week’s other news seemed to bear this out: Nomura, Japan’s largest securities house, said it would take a $620m write-down on mortgage-backed securities; and Citigroup posted a 57% drop in quarterly profits and said parts of the debt market might not recover soon.

The consolation for banks is that they, too, have buyers of last resort. Citic, a Chinese bank, this week said it had considered bidding for a stake in Bear Stearns, a Wall Street firm whose share price has slumped thanks to hefty mortgage exposure, though no deal was imminent. If M-LEC fails to take off, the bottom-fishers will soon have others to nibble at.

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