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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