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The Super Conduit Proposal


It is difficult to see how the banks can avoid the inevitable.

This article is being brought to you by Minyan Satyajit Das, a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

Hair of the dog refers to ingestion of alcohol as a hangover cure. The fresh intake of alcohol blunts some of the symptoms but ultimately only aggravates the conditions.

Financial markets are trying their version of the same cure for the current credit crisis.

Citigroup (C), Bank of America (BAC) and JP MorganChase (JPM), in conjunction with the US Treasury, have proposed a super conduit to save the day. The Master Liquidity Enhancement Conduit ("MLEC") is an $80 bln fund to buy AAA and AA rated securities from SIVs and conduits. This would be the largest conduit vehicle ever. Given that these vehicles are the cause of current problems, Wall Street believes that if something does not work the first time, you should just do it again in a larger size.

The scheme has parallels in the re-capitalization of Long Term Capital Management (LTCM) in 1998. The stated reasons for the super conduit are fundamentally different from the real reasons that the proposal has been concocted. Unfortunately, like the folk hangover remedy, the super conduit is unlikely to work. Here's why.

Collateralized debt obligations (CDOs) – a souped-up securitization which one veteran commentator Ian Kerr has christened Chernobyl Death Obligations – have been one of the primary lines of transmission of risk and losses in the current credit problems. CDOs are based on a variety of assets – corporate loans, bonds and (more recently) securitized debt in the form of securitized mortgages (including sub-prime debt) as well as CDO securities themselves (known as re-securitizations). CDOs can be used to transfer risk but they create their own risks.

CDO securities use significant leverage to enhance returns. The leverage is further increased where structured finance vehicles have bought CDO pieces. CDOs invest in AAA and AA rated CDO securities (CDO2 or CDO3). Other investors include special purpose vehicles that then issue debt against the value of the purchased securities. Conduits issue top-rated Asset Backed Commercial Paper (ABS CP).

Structured investment vehicles (SIVs) issue mainly high-rated long-term debt. In a dizzying process that multiplies leverage, the debt issued by conduits and SIVs is then used as collateral for further borrowing. As credit losses occur the daisy chain of risk magnifies the losses rapidly.

"AAA" ratings of a CDO security only means that it is designed to be rated "AAA" using a financial engineering trick – inserting junior (subordinated) tranches to absorb the expected losses. In this way, low quality loans can be turned, at the touch of a magician's wand, into AAA and AA bonds. However, if losses occur in the underlying loans then the layers available to absorb loss are eaten up. This can lead to a downgrading of the AAA rated securities triggering mark-to-market (MtM) losses. High quality CDO securities are unlikely to default and suffer actual cash losses but the current market value of these securities can fall, reflecting the downgrading or changes in credit spread.

Where investors such as SIVs and conduits have borrowed against these securities, the falling MtM value means finding money to top up the collateral or selling the securities, thus realizing the loss. For SIVs, the MtM losses may trigger breaches of tests that require selling securities to liquidate the structure. This is what is currently happening, exacerbating demands on market liquidity. Around US$80-100 billion of such sales have been undertaken or are in process. The super conduit is meant to mop up these securities.

A big problem with the super conduit solution is agreeing on price of these securities. There is currently no meaningful market - price indications range from 70 cents to around 95 cents in the dollar. Given the differences in structure and disagreement on key pricing variables how will the securities be priced? Who will price the securities?

Then there are practical issues. What securities will be eligible for purchase? Will MLEC be an "equal opportunity buyer" or will it only buy from the banks creating the super conduit? What happens if the securities rating change after purchase? Must the buyer be a distressed seller? How do you define distressed sellers? These problems were not present in LTCM as it was a single hedge fund and the instruments were relatively standardized with reasonable agreement on prices.

As banks need to inject liquidity into the vehicles or the assets may have to be bought by them anyway, the proposal has no significant effect on overall market liquidity. In effect, no new money is available for investment in these securities. At best, the whole scheme creates an orderly market for the inevitable sale of these bonds.

The real reasons for the super conduit are different. The banks share one objective – they need to prevent forced selling of the complex and illiquid securities at a discount pushing down traded prices. If the securities actually trade at low market prices then these prices would have to be used to calculate the MtM value on positions rather than the mark-to-model and fair values currently being used. This would increase the already significant losses on existing securities. It would also require major prime brokers to revalue collateral held against loans. This may trigger margin calls on already cash strapped investors. The net result would be more selling and ever more of these securities ending up in the hands of the major banks and dealers.

The super conduit may allow banks to move securities from a MtM portfolio into non-MtM portfolios allowing valuation at book value or using more flexible "fair value" techniques. The structure also benefits from low capital charges for high quality securities under the Basel 2 credit capital regime, making it cheaper for banks to hold these investments on balance sheet.

The banks appear to be attempting to act in concert to influence the market price through the super conduit. Is this how free and transparent markets should work? Is this process allowed under securities and banking regulations? As details are sketchy, no one can be sure of what really is going on.

As it stands, the super conduit cleverly packages the banks' need to salvage reputations and their clients' money as a systemic rescue. The banks and other "invited" participants coincidentally happen to operate large conduits and SIVs. Citigroup alone manages around US$100 bln through such structures. The involvement of the US Treasury brings the odd scoop of moral hazard.

In the final analysis, it is difficult to see how the banks can avoid the inevitable. These securities will end up on bank balance sheets using up now scarce liquidity, requiring the banks to post capital against the holding and (the worst of all) take the MtM losses. It will need stronger medicine than a traditional folk remedy to deal with the current problem.
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