Toomre Capital Markets LLC

Real-Time Capital Markets -- Analytics, Visualization, Event Processing, and Intelligence

Banks Looking to Set Up ABS CP Assets Rescue Fund

Late Friday October 12th 2007, The Wall Street Journal was reporting that a number of very large commercial banks, including Citicorp, were looking to set up as much as a $100 billion dollar fund to purchase "shaky" mortgage securities and other suspect investments from their collective non-affiliated Asset-Backed Commercial Paper ("ABCP") conduits, also known as a Structured Investment Vehicles ("SIVs"). In their story entitled Big Banks Push $100 Billion Plan To Avert Crunch, reporters Carrick Mollenkamp, Ian McDonald and Deborah Solomon explain that

The new fund is designed to stave off what Citigroup and others see as a threat to the financial markets world-wide: the danger that dozens of huge bank-affiliated funds will be forced to unload billions of dollars in mortgage-backed securities and other assets, driving down their prices in a fire sale. That could force big write-offs by banks, brokerages and hedge funds that own similar investments and would have to mark them down to the new, lower market prices.

The ultimate fear: If banks need to write down more assets or are forced to take assets onto their books, that could set off a broader credit crunch and hurt the economy. It could make it tough for homeowners and businesses to get loans. Efforts so far by central banks to alleviate the credit crunch that has been roiling markets since the summer haven't fully calmed investors, leading to the extraordinary move to bring together the banks.

Conversations about creating such a fund have been coordinated by U.S. Treasury department with the Federal Reserve being kept informed. Apparently Treasury's undersecretary for domestic finance, Robert Steel, a former Goldman Sachs Group Inc. official and the top domestic finance adviser to Treasury Secretary Henry Paulson, is the point person at Treasury. The WSJ article goes on to explain why the commercial banks have been so worried about this asset valuation issue:

In recent weeks, investors have grown concerned about the size of bank-affiliated funds that have invested huge sums in securities tied to shaky U.S. subprime mortgages and other assets. Citigroup, the world's biggest bank by market value, has drawn special scrutiny because it is the largest player in this [SIV] market.

Citigroup has nearly $100 billion in seven affiliated structured investment vehicles, or SIVs. Globally, SIVs had $400 billion in assets as of Aug. 28, according to Moody's. Such vehicles are formally independent of the banks that create them. They issue their own short-term debt, usually at relatively low interest rates reflecting their high credit rating. The vehicles use the money to buy higher-yielding longer-term assets such as securities tied to mortgages or receivables from midsize businesses seeking to raise cash.

Many SIVs had trouble rolling over their short-term debt in August because of concerns about the quality of their assets. That contributed to the broader seizing up of credit markets.

The Financial Services Authority, the United Kingdom's markets regulator, has suggested that U.K. banks consider participating in the plan, a person familiar with the situation said. HSBC Holdings PLC, the largest U.K. bank, has an affiliate SIV called Cullinan Finance Ltd. with $35 billion in senior debt. An HSBC representative wasn't immediately available to comment.

Toomre Capital Markets LLC ("TCM") applauds the various parties for trying to create a ready buyer for the securities and assets held by the various SIVs. However, much like in the movie Apollo 13, TCM feels the urge to yell "Houston, we have a problem!" regarding the ABCP market. The quality of the assets being financed by SIVs varies considerably. Some of the underlying assets are truly of the highest and most pristine quality; others are of lower quality and had to be "structured" to a considerable extent to pass the rating agency acceptance tests for quality and timeliness of cash flow from the underlying assets.

Now recall the environment from which the capital markets have just come. As TCM wrote on February 5th 2007 in the post It's All Fun and Games Until Someone Gets Hurt, late in 2006 and at the start of 2007, the fixed income markets were irrational. Investors of all types were irrationally reaching for yield. Heck, for the first time in history, the current coupon MBS coupon (FNMA and FHLMC-back pass-throughs) traded at prices with negative option adjusted spreads ("OAS") -- meaning that once an investor theoretically paid for the hedges to buy back the collective homeowner's option to prepay the mortgage at any time, the current MBS coupon had a lower yield than comparable Treasury securities. MBS were trading through Treasuries and corporate credits were at all-time tights.

In such an environment, does one really think that the money market sector was immune to the reach for yield? Does one really think that limits were not stretched to get yet more assets financed through the SIV conduits? If you are like TCM, you might suspect that maybe one or two asset deals that stretched the rules, and hence there is some reason to suspect just what is the true credit quality backing the SIVs. In short, there really might be some fire behind the smoldering smoke from the ABCP market.

The problem with SIVs is not so much that a few of the underlying asset deals (which collateralize the commercial paper issuance) stretch the credit and structured finance rules. The worst offenders no doubt can be weeded out in due course and practically even the worst credits are not likely to significantly impact the available funds for the next roll of the commercial paper (i.e. in next 30 to 90 days). What is the problem is that the buyers of SIV commercial paper do not know enough or trust the information they are receiving about what composes the dynamic asset pool backing each SIV. In short, they are right to ask, 'Why take the risk of buying into a blind pool of assets with declining asset values where at least some are likely to be suspect credits?"

The SIV implications for the banks are truly horrendous. The ABCP market is larger than for the traditional corporate credit commercial paper. If the SIVs cannot roll over their maturing commercial paper, the affiliated SIVs will need to secure liquidity to repay the commercial paper either by borrowing from commercial banks or by liquidating the collateralizing assets. The banks might have to buy many of these relatively low yield assets and the extension of such credits will reduce the funds that might be available to commercial interests and consumers, perhaps even cutting off commercial and consumer loans altogether if the bank's capital ratios are ever threatened by having so many more assets on the balance sheet.

With so many assets potentially for sale, is it any wonder that there are concerns about what each piece of collateral might be worth when the "market" turns to be all sellers? Toomre Capital Markets LLC is quite fearful that the resolution of the questionable collateral backing ABCP will not be solved by a big self-interested liquidity purchaser. Hence, TCM has been advising that the fixed-income markets are not yet done unwinding the excesses of the past decade and another (likely potentially even more painful) down leg from the housing market asset correction is likely to come. Reader's comments and thoughts are most welcome.