Saturday, 13 October 2007

They have some unusual animals in Regent's Park at the moment...

...and some of them are even more rare than buyers in the ABCP market. That however, may be about to change.

The proposal apparently (the details are sketchy) is for a group of banks to set up a mega-SIV. This new vehicle will acquire the mortgage assets now held by some existing SIVs and conduits. The range of participants is unclear - Citi, with over $100B in conduits, is apparently leading the deal structuring, with JPMorgan interested in selling the new paper. The basic idea is that having a vehicle with a more diverse range of assets will avert the need for many banks to sell their existing conduit assets causing a crash in the RMBS market. Things are not exactly going well there as it is, as you can see from the recent price action on the ABX Home Equity BBBs (this graph is for the 07-2s):

(Graph from Markit via Calculated Risk. This is pretty good on the ABX if you need some background.)

The credit enhancement for the new vehicle hasn't been made public thus far: one structure might be for all the contributing banks be jointly and severally liable for some bottom tranche, followed by a layer of seller-specific credit enhancement. The proposal is apparently to be dubbed M-LEC, for master liquidity enhancement conduit.

In this context it occurs to me to wonder why holding assets off balance sheet in conduits have such a preferential capital treatment compared with on balance sheet credit enhancement. To see this, consider the following two trades: 1. A bank sells a diverse $500M portfolio of assets into a conduit, retains a $10M seller's interest, funds by issueing three month ABCP, and writes a back-up liquidity line; 2. A bank holds the assets on balance sheet and buys a three month credit derivative on losses in excess of $10M, rolling it as it expires.

In both cases the bank is exposed to losses between 0 and $10M but not above. In 1., it has to fund the assets if the ABCP market is disrupted, whereas in 2. it knows that it has to fund the assets in all conditions and hence can lock in term funding. Therefore arguably 2. is less risky than 1., and certainly not riskier. But you can guess which situation has the higher regulatory capital, can't you?

Update. The plan is now out. Or, at least, the intention to come up with a plan that may lead to the MLEC is out. I wonder how they are going to value the assets the MLEC will wave in...

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