The Next Market Shock Meltdown on Wall Street: a Tale of M-LECs and SIVs

Two related news items rocked Wall Street last week. The first was mounting losses in the financial sector tied to the sub-prime credit crunch. The second was a hail-Mary play drawn up by the U.S. Treasury and Wall Street banks, to create a “super-fund” to help jump-start gridlocked credit markets.

It’s clear to me that Wall Street is desperate and it’s time to hit the panic-button.

Third quarter profit reports took a turn for the worst last week. Of the S&P 500 financial firms that have reported so far, earnings are plunging 17% from a year ago. That’s the largest decline in Wall Street profitability since Bloomberg began tracking the numbers in 1997!

Wall Street is writing-off tens of billons in sub-prime and other loan losses as a result of the credit crunch. So they’ve asked the Treasury Department for what amounts to a bail out. The solution is to set up a new and suitably cryptic Wall Street acronym know as an M-LEC (Master Liquidity Enhancement Conduit) to help bail out another obscure Wall Street acronym known as an SIV (Structured Investment Vehicle).

Just what are SIVs, you may ask, and why do they need to be rescued by an M-LEC?

That’s a good question; but have no fear -- Wall Street and Washington are diligently working on the answer, which is akin to a high-finance version of the old shell-game... let me explain.

The SIV Shell-Game

SIVs were created by Wall Street’s big banks and brokers for the sole purpose of hiding assets... legally of course. Although some economists, including NYUs Nouriel Roubini have said that SIVs should be “forbidden”, these special purpose vehicles are allowed by accounting regulations, and have become big business in recent years.

Typically set up by banks and investment firms, SIVs issue short-term commercial paper (backed by the parent firm) and use the money to purchase long term asset-backed debt securities.  In recent years, this has included lots of sub-prime mortgage loans, many of which are now defaulting at alarming rates, and that’s the problem now impacting credit markets.

Here’s how the operation usually works. A big bank, say Citigroup, sets up an SIV for the sole purpose of buying, let’s say, mortgage-backed securities. The SIV is considered a separate operating company apart from Citigroup, therefore the assets, and more important the liabilities, are NOT consolidated on Citigroup’s own balance sheet.

And that's the key to SIVs. Banks and brokers are subject to strict reserve and net capital requirements that limits their ability to leverage up their balance sheet. Too much debt appearing on the balance sheet after all might lead to a credit-rating downgrade. And financial firms are very sensitive to their sterling credit ratings.

Banks like Citigroup are still ultimately on the hook for the SIV’s debts, but these are considered “contingent liabilities” that aren’t typically counted in the credit-rating equation.

Commercial Paper Market Plunges, Cutting Off SIV Funding

So the SIVs come in handy as a short of shell-company, keeping mountains of risky debt off the parent firm's balance sheet. The SIVs typically issue short-term commercial paper to raise capital. Then they turn around and leverage up the cash – typically 10-15 times – but sometimes as high as 20 times! With this highly leveraged capital base, the SIV can buy even more mortgages and other debt.

Citigroup is in fact is the King of SIVs, with no less than $100 billion in assets outstanding as of July. At the peak, the total market size for SIVs was about $425 billion as of mid-July, but according to data from Moody’s, the industry has shrunk rapidly by more than 10% since the credit crunch shock began to roil markets.

The reason is that SIV funding depends upon constant issuance (or rolling over) of short-term commercial paper at favorable interest rates.

But when the credit crunch struck this summer, investors soon discovered that too much defaulting sub-prime debt was lurking in these portfolios, and they quickly backed away from buying commercial paper issued by SIVs. Interest rates on commercial paper soared as a result, reaching a peak of nearly one-full percentage point above the fed funds rate in August.

Since then, rates have come back down, but are still quite a bit higher than normal. So now the $300 billion SIV market – leveraged up as much as 10- to 20-times that amount in asset-backed securities – is teetering on the brink of collapse, no longer able to access cheap financing.

Could a Sub-Prime Fire Sale be Just Around the Corner?

Without funding, the SIVs have little choice but to start selling leveraged assets at fire-sale prices to raise cash. Some of these assets include exotic and illiquid collateralized mortgage obligations that can’t even be accurately priced in the current environment, much less in a panic sale.

Mass liquidation would create a downward spiral in asset values that would end in the outright collapse of many SIV. Such a scenario is Wall Street’s worst nightmare, because the big banks and brokers would then be forced to take these troubled securities back onto their own books – resulting in potential losses in the hundreds of billions.

It’s no wonder that Wall Street’s biggest firms are busy lobbying the Treasury Department to create this super (bailout) fund: they are desperate to avoid a fire-sale of $320 billion is troubled assets, that would end up coming home to roost on their balance sheets.

It’s no coincidence that investors in the Treasury bailout fund so far include Citigroup, Bank of America, and JP Morgan, who collectively have agreed to kick-in as much as $80 billion to rescue the SIVs. These three firms reported multi-billion dollar losses and charge-offs in recent weeks (see table above), and now they’re staring down the gun-barrel of a much bigger hit if they don’t do something fast to bail out these SIVs.

Desperate times call for desperate measures, and the Treasury sponsored super-fund is just such a measure

Cleaning up the Commercial Paper Market Crash

There are already plenty of skeptics to the super-fund idea. According to a story in Bloomberg, former Fed Chairman Alan Greenspan indicated last week that the fund could do more harm than good saying: “It's not clear to me that the benefits exceed the risks.”

The asset-backed commercial paper market – the life-blood of cheap SIV financing – declined again last week for the 10th straight week, extending the worst slump in seven years that has caused the total value of the outstanding commercial paper market to contract 25% since July.

Imagine investors’ reaction to a stock market crash of 25% – such as occurred on Wall Street 20-years ago – and you get an idea of what SIVs are now facing. But in the aftermath of this crash, it may not be so easy to clean up the mess.

The credit crunch correction is far from over... and the next market shock to hit Wall Street looks even nastier!