Big U.S. banks try to restore confidence in credit markets
The biggest banks in the United States, with active encouragement from the Treasury Department, unveiled a plan Monday to keep the housing-related debt crisis from worsening.
The plan calls for the banks to create a new financing vehicle to try to restore confidence and reduce the risk of a market meltdown by propping up an important part of the debt markets. But the banks hope to take minimal risk and avoid actually investing any of their own money.
Although credit markets have calmed in recent weeks, and the stock market remains near record highs, some securities are almost impossible to sell anywhere near their previous prices. There is fear that allowing those securities to plunge in price could disrupt credit markets, alarm investors in everything from hedge funds to money market funds, and perhaps make it harder to borrow money, making a recession more likely.
If the banks' initiative works as planned, many investors that helped to finance risky loans — including supposedly safe money market funds — will be spared distress. And the banks will collect fees for little more than promising to make loans if no one else will.
"The idea is to avoid a fire sale of assets," said one banker involved in the initiative, who asked not to be identified because negotiations on its terms are continuing.
The new entity, called a Master Liquidity Enhancement Conduit, or M-LEC, could raise as much as $200 billion or more through the issuance of its own securities, and use the money to buy securities that otherwise might be dumped on the market.
The announcement by Citigroup, JPMorgan Chase and Bank of America came on the same day that Citigroup reported a sharp fall in third-quarter profits, with write-offs on troubled securities that were substantially larger than it had forecast just two weeks ago. Other financial institutions, including Merrill Lynch, have also had to take substantial write-offs.
Though Monday's move was meant to reassure the markets, investors reacted with doubt. The Dow Jones industrial average fell 108 points, and financial stocks were among the worst hit.
"I don't really see that this is going to make a significant difference," said Jan Hatzius, chief United States economist at Goldman Sachs. "It seems a little more like a PR move, frankly."
Hatzius said he wondered "why this is going on when previously the official word was that things were getting better."
The market upheaval that took hold in July arose from securities that were supposed to be safe — and were certified as such by bond rating agencies — even though they financed risky mortgages. Those securities would not default unless a large portion of the underlying loans went bad, and that was deemed unlikely. But in the wake of the subprime mortgage crisis, questions have arisen about whether the rating agencies were too optimistic.
The conduit could work brilliantly if it turns out that the collapse in the market value of the securities represents market panic rather than an accurate assessment of the likelihood of eventual default. If this is the case, then prices will eventually return to normal and this new creation will have bought time for that to happen.
In the meantime, it is hoped that what amount to bank guarantees of some debt — coupled with the fact the Federal Reserve is the lender of last resort for banks — will persuade investors like money market funds to buy securities issued by the new conduit.
If they will not buy, or if the securities really do not prove to be worth face value, however, little will have been changed.
Details remained in flux Monday, but some were not persuaded that the new structure would really do much. Josh Rosner, an expert in mortgage-backed securities at Graham Fisher, an independent research firm in New York, questioned why the banks needed to establish such a vehicle.
"If they really believe these are good assets being mispriced in the market," he said, the banks could just buy them and wait for the asset values to recover. "This raises the question of whether the banks are doing this just to avoid taking their losses."
But some hailed the move as a way of preventing a crisis without directly involving the government, and said it reduced the so-called moral hazard that comes when the government bails out those who made risky bets, thus encouraging more foolish bets in the future. In this case, the Treasury encouraged the talks, but neither offered to put up money nor dictated the agreement.
"I don't see this as a bailout," said James Paulsen, chief investment officer at Wells Capital Management. "There is no public money involved in this. The government's role here is facilitating discussion among private players to take care of this themselves. If the private players can find a way to help alleviate this, then why shouldn't they?"
At issue is a borrowing crisis facing a group of institutions known as structured investment vehicles, or SIVs, that were little known even to many on Wall Street until the credit crisis erupted this year. These vehicles essentially are private banks, albeit ones without the benefits of deposit insurance or the right to borrow from the Federal Reserve. They lend long term, and borrow short term. If they cannot borrow money, they are in trouble.
The vehicles, often started by banks like Citigroup, were financed by issuing commercial paper, a form of short-term credit, for 90 percent or more of the value of their securities. The expectation was that the cushion of 10 percent or less would be enough so that the commercial paper could readily be sold at low interest rates, often to money market funds. Because commercial paper usually matures within months, not years, it is necessary to sell new commercial paper as the old paper is paid off.
Now, however, it is practically impossible to sell such paper, and the SIVs are faced with the threat of having to sell many of their securities into a market with few buyers. "It is in nobody's interest to see a disorderly sale of assets by the SIVs," said Nazareth Festekjian, a Citigroup managing director who was involved in planning the conduit.
The proposal came about from discussions among the banks and the Treasury Department, in which one idea considered was for the banks to just purchase the commercial paper issued by the SIVs. But that was rejected by some bankers, a person involved in the talks said, and the conduit idea was developed.
The new conduit will offer to buy many of the securities owned by SIVs, but at a cost to those vehicles. First they will have to pay a fee for the right to sell anything to the conduit, and part of that fee will be passed on to the banks, increasing their profits.
Most of the proceeds will be paid to the conduits in cash, which they can use to redeem commercial paper. But a part of the payment, perhaps 5 percent of it, will instead be in junior securities issued by the conduit.
Because those securities would bear the first losses suffered by the conduit, it is the SIVs, as a group, that will take the first risk that the securities turn out to be worth less than the conduit pays.
"The same folks who brought you the SIV in the first place are now repackaging them in yet another conduit," said Ed Yardeni, president of Yardeni Research. "I guess they figured there's strength in numbers."
The conduit would raise money by selling what it calls senior securities to investors who would be assured of payment unless losses grew so large that the junior securities were wiped out. The rest of the money would come from selling commercial paper, with the banks promising to buy that paper if no one else would.