October 16, 2007
A Fiendishly Ingenious Confidence Scheme
Posted by Lawrence Cunningham

            A quick abstract review of the factual background of the crisis in credit markets: Big Bank (say Citigroup) creates Little Bank (called a structured investment vehcile of SIV).  Little Bank issues short term asset-backed commercial paper that must be redeemed each month and uses the proceeds to buy long term asset-backed securities, including sub-prime mortgage pools. Large defaults on sub-prime mortgage assets shrink the value of Little Bank’s long-term investments and skittishness among investors in the commercial paper market dampens their willingness to fund rollovers. 

            Little Bank is stuck.  It cannot generate financing to pay its maturing commercial paper and cannot sell its long-term securities except at very low prices—if at all.  A crisis appears.  The solution? 

            Big Bank, with the aid and blessing of the US Treasury Secretary, a former Wall Street man, creates Special Bank (called a Master Liquidity Enhancement Conduit or M-LEC). Special Bank will issue senior securities and commercial paper to the public for cash and use the proceeds to buy from Little Bank portions of its long-term securities investments that are deemed to be high quality.  Little Bank uses the proceeds to repay its maturing commercial paper.

            Little Bank doesn’t get all its sale proceeds in cash, instead taking junior securities in Special Bank so that, if the investments continue to sour, Little Bank will absorb losses before the new public investors in its senior securities do. 

            Also, Big Bank takes a share: all securities that Special Bank buys from Little Bank include a fee that is transferred to Big Bank. All Big Bank does to earn the new profit stream is promise to buy Special Bank’s commercial paper if no one else will.

            The point of all this?  To try to get investors to believe that all is well with Big Bank and Little Bank—to “increase investor confidence.”  Some questions:

            (1) Why should investors have confidence that buying commercial paper from Special Bank is any different than buying commercial paper from Little Bank? 

            (2) Why, if Big Bank thinks investors should have confidence, doesn’t Big Bank just buy the commercial paper itself?

            (3) If Big Bank is Citigroup, why should anyone have confidence in its opinion on all of this, given its admission yesterday that its own “risk management” system has been failing amid this crisis?

            (4) What is the Secretary of the Treasury doing engineering a scheme like this?

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Comments (18)

1. Posted by Joan of Argghh! on October 17, 2007 @ 5:45 | Permalink

Sooner or later, the degrees of separation will lead back to Kevin Bacon, right?


2. Posted by bill perkins on October 17, 2007 @ 6:41 | Permalink

!ENRON!--it's a verb, right? To ENRON, I've been ENRONED, we are ENRONING.


3. Posted by M. Simon on October 17, 2007 @ 6:54 | Permalink

Al Gore is Enron's secret banker.

Enron was hoping to get out of hot water by selling carbon credits.

That deal did not mature in time.


4. Posted by y81 on October 17, 2007 @ 6:54 | Permalink

Answers:

(1)--The Special Bank securities are backed by higher quality assets than the Little Bank securities were and they have more credit enhancement in the form of first loss positions held by Little Bank. Also, Special Bank has a larger pool of assets so there is more diversification.

(2)--Because then the underlying assets would be on Big Bank's balance sheet and the point of the enterprise is to shift the risk of these assets from Big Bank's depositors to high-yield investors who have an appetite for risk. That was also the point of the Little Bank scheme.

(3)--There you have me.

(4)--Because the only thing we have to fear is fear itself and history and the chattering classes who write history have decided that preventing or ameliorating financial panics is an appropriate role for the government. Just as soon as you can get all the history professors and all the history books to say that FDR was an idiot who inappropriately socialized risk (not what I believe, by the way), then Paulsen and Bush will drop the prevention of financial panics from their list of responsibilities.


5. Posted by MoMan on October 17, 2007 @ 7:36 | Permalink

Nah, it aint Enron...Enron was fraud, pure & simple. It's more like Orange County 1994. Borrowed short to buy long, then leveraged that up 3x. Value of long assets decreases causing (in effect) a margin call & bingo- bankruptcy. Of course it wasn't the fault of the knucklehead investment officer at Orange County- it was mean old Wall Street taking advantage...whatever, I say let them go belly-up, its good for the system.


6. Posted by y81 on October 17, 2007 @ 8:08 | Permalink

MoMan, someone has to borrower short and lend long, or the market won't clear. Once upon a time, banks used their federally insured depositors' money for this purpose, but now they don't.

As for "letting them go belly-up," I can only say that you sound like Andrew Mellon and history has not been kind to those who follow that advice. Just as soon as you have gotten the history books rewritten to make Hoover the hero and Roosevelt the villain, people will listen to your advice.


7. Posted by 8 on October 17, 2007 @ 8:26 | Permalink

It's like when a parent co-signs a car loan for their teenager.


8. Posted by John Blake on October 17, 2007 @ 9:07 | Permalink

Always the same, like Long-term Capital with its Nobelists at the switch: Borrow short-term securities,buy long-term with proceeds, pocket the interest-rate difference until yield curves invert. When ploy becomes unsustainable, lay off default risk on a third party intermediate, preferably tax-funded (think S&L crisis in 1980s). Save the U.S. economy!-- meantime, we'll stash our gains in vehicles beyond mere mortals' ken. It's only money, after all.



9. Posted by sharinlite on October 17, 2007 @ 9:40 | Permalink

This a shill game played, as usual by those that have and will make the most money at the expense of the rest of Americans!! They created the mess, will get paid to fix it...hehe...and in the meantime our economy is in serious hurt.


10. Posted by Kenneth Bennight on October 17, 2007 @ 9:54 | Permalink

Little Bank borrows short and lends long. That is the business plan that gave us the savings and loan meltdown. And this is regarded as a solution to a problem? Oh joy. Have these people no memories?

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