Liquidity puts

It seems from FT alphaville that liquidity puts are not that well known. Here's the gig. In any structure where a vehicle issues paper backed only by collateral (such as a SIV, conduit or securitisation) but where the paper has a shorter duration than the collateral, there is liquidity risk: if no one buys the paper, the issuer can have a problem regardless of solvency. To protect against this liquidity risk, many sponsors have bought liquidity lines, aka liquidity puts. Typically the issued liabilities are ABCP, and the liquidity put is an undertaking from a large well-rated and liquid bank that if the CP market does not want the issuer's paper then (providing it is solvent) the bank will either buy the paper or lend the issuer money. This loan is often contingent on a general disruption in the CP market, and this type is also known as a backup CP line.

This structure was commonplace and many SIVs, conduits and other securitisation SPVs enjoy some form of liquidity support from a major bank. The problem is, as I noted earlier, many of these backup lines have been or will soon be triggered. You wrote it liquidity, you own it.

Between a rock and an accounting rule

Naked Capitalism makes two interesting points about Citi:

• Reading the Wall Street Journal we find:

  Citigroup's subprime exposure -- and source of its problems -- are two big buckets that together total $55 billion, the bank said. The first bucket totals $11.7 billion, including securities tied to subprime loans that were being held, or warehoused, until they could be added to debt pools for investors. The second, totaling $43 billion, covers so-called super-senior securities.

  This position is larger than Merrill's and so we can expect further very chunky write-downs from C at some point.
  
• Moreover unlike mother M., Citi does not appear to have done much to reduce its position. Why might that be? One possibility is that if Citi had sold, they would have had a mark, and that mark in turn would have had to have been used for the same assets in their conduits. Those conduits would then have missed the OC tests, forcing Citi into the unpalatable decision between providing them with implicit support or suffering the reputational damage of not doing so. If this really is the case, Citi is going to have its work cut out staying afloat as these securities decline further in value.

It is worth thinking about what would have happened before securitisation. Had Citi had the same assets then, they would all have been on balance sheet in the banking book, and hence not marked at all. They would have had considerable discretion about the size and timing of loan loss provisions, and the only write-downs would have been from actual experienced losses. In short we would not have had any real idea of how bad the problem was. I rather prefer it this way round.

Snow down on the MLEC

John Snow - Hank Paulson's predecessor as Treasury secretary - isn't that keen on the MLEC either. According to Reuters:

We've got all this paper out in the system, and my inclination is to say, let's accelerate the price discovery process on this paper [...]

We know that when you prop things up artificially -- Japan -- we know when you prop things up artificially -- the (savings and loans) in the United States -- you get bigger adverse consequences

He has a good point. Warren Buffett is not keen either:

I think there should be a requirement that before the securities are put into the new super-SIV, 10 per cent of the holdings should be sold into the market to people who are not associated [with the subprime problem]

Certainly the history of intervention to prop up prices in the markets is not encouraging, and suspicions remain that the MLEC will not use the right mark. Perhaps it falls foul of the Market Abuse Directive? Oh, and the ABX is on the way down again. Here are the 07-02 BBBs:

Conduits and Consolidation

Bloomberg has an interesting article Citigroup SIV Accounting Looks Tough to Defend. The author, Jonathan Weil, makes the point that Citi is caught between the devil and the deep blue sea:

• If it supports its SIVs, accounting consolidation kicks in since the firm is deemed to be providing implicit support and under FASB Interpretation No. 46(R) that brings them back on balance sheet.
  
• If it doesn't support its SIVs, the reputational damage will be severe.

Weil argues this is one of the reasons for the MLEC plan: it would allow Citi to dig some of SIVs out of the mud without forcing it to consolidate. This is a good point and it might well be true. But there is another dimension, too: regulatory consolidation. It is a little known (if deeply, deeply boring) point that regulatory consolidation is not the same as accounting consolidation.

Regulatory consolidation very roughly works by identifying which parts of the group are financial, putting all of their risk on the top company balance sheet, subtracting the equity invested in non-financial subsidiaries, and calculating regulatory capital on the result. Accounting consolidation again very roughly seeks to identify whether an entity which a firm has a relationship with is controlled by, owned by or gives the results of its activity to the firm. If so, that entity is consolidated. In detail the topic is complex, particularly in the context of firms which have both banks, insurance companies and other activities in a single group - financial conglomerates - or where careful structuring has been used to try to dodge the consolidation provisions of IAS 27, SIC 12 or whatever for a given securitisation SPV, SIV or conduit. For now, though, note that in principle at least an entity can be consolidation for accounting purposes but not regulatory purposes and vice versa. And that's fairly odd. I can see that it makes sense to deconsolidate non-financial subsidaries of a financial holding company for regulatory capital purposes. I can even see how you might want to treat the same risk in different operating companies differently - for instance if a holding company owns both a bank and an insurance company. But the idea that an entity such as a conduit is consolidated for accounting purposes but not for regulatory capital seems deeply imprudent. And of course many conduits have been structured to ensure that provided no implicit support is given they will not consolidate for either purpose.

It is worth noting that for FAS accounters, FIN 46(R) on the Consolidation of Variable Interest Entities includes provisions for the recognition of an implicit variable interest, aka implicit support. This occurs amongst other things when a bank provides a conduit with credit or liquidity support that it is not contractually obliged to provide.

That brings us to the heart of the dilemma. Implicit support is poison. Regulators and auditors can only spot it after it has happened. But if conduit paper has been sold with a nod and a wink, so that the buyers expect implicit support and will exact reputational damage if it is not provided, then there is something rotten in the state of finance.

The brotherhood of the MLEC

Strangely enough, some bankers are not happy with the idea of Citi et al. manipulating the ABS market by waving assets into the MLEC at the wrong mark. From the FT:

A committee of top international bankers on Sunday warned that the proposed $75bn mortgage securities superfund must be transparent in its pricing of assets if it is to help restore market confidence.

The statement by the Institute of International Finance reflected concern that the superfund, which is backed by Citigroup, JPMorgan Chase and Bank of America, is proposing to buy assets from troubled investment vehicles at higher than true market prices. Josef Ackermann, chief executive of Deutsche Bank and chairman of the IIF, stressed the importance of “proper valuations” and the need for financial institutions to “take the hits”.

One does wonder if the 'one conduit to rule them all' plan is going anywhere...

Where's the mark, Chuck?

The importance of my earlier question about how the MLEC will price the assets it is going to purchase is highlighted by an article in the FT today:

[It has emerged that] Axon Financial, a SIV linked with the US hedge fund TPG-Axon, had taken losses of $110m on sales of $3bn of its investments.

Very crudely scaling from $110m on $3b to Citi's $100b in conduit assets gives us a loss of $3b. So we know a real mark to liquidation would really really hurt. The market is so illiquid at the moment that it's hard to be sure until you try to sell of course. So it should be no surprise to learn that many banks have not yet marked their conduit assets down:

One banker said last week: “The banks have varied enormously in terms of how much they have marked down their books – of course there are some that want to avoid the big write-downs.”

The MLEC then looks like an attempt at creating a new vehicle the banks can claim is arms length and which they can use to justify valuations which might not really be liquidation levels. That helps in turn helps the banks other conduits and the value of their on-balance sheet ABS. If you tell people it's worth par often enough, loudly enough, maybe it will be...