The Hindu Business Line : The US Treasury plan that failed

The plan was plagued by uncertainties from the day it was announced and there was little clarity about who would participate and how much money would be subscribed. The basic infirmity was that it was led by three banks that were known to be involved deeply in creating the structured investment vehicles or in benefiting from them, says K. SUBRAMANIAN.

Christmas season brings cheer to all. But sadly for the US Treasury, it could not leave one gift for distressed banks. It was working on a salvage plan for banks from end-August when the sub-prime crisis erupted. It collapsed two days before Christmas.

It was clumsily called a Master Liquidity Enhancement Conduit, or M-LEC, and had the support of three major groups: Citigroup, Bank of America and JP Morgan Chase. The idea was to pool around $75-100 billion to buy risky mortgage securities and other assets to ease pressure on credit markets and flows. It was to be a super-SIV (structured investment vehicle) to save SIVs.

There were reports of intense backstage discussions, conference calls, etc., between the US Treasury and leading bankers and public persons over a bailout plan for banks a la LTCM (Long-Term Capital Management) in 1998. For weeks, the discussions were in camera. Too many persons were involved and it became difficult to keep them under wraps. Information about M-LEC was made public in mid-October. The Treasury, it was explained, coordinated the efforts of private bankers. It was more than eager to avoid giving any impression that it was a government directed effort to bail out banks.

The lead was taken by Mr Hank Paulson, who was chief of Goldman Sachs for eight years prior to his joining the Treasury as Secretary in May 2006. He was assisted by two of his deputies — Mr Robert Steel and Mr Anthony Ryan — who had their stints with Wall Street.

Treasury’s symbiosis with the financial community is neither new nor unknown. Mr Robert Rubin personified the syndrome at its best. When Mr Paulson took over, there were hopes that he would continue the tradition. The collapse of M-LEC belies that hope.

Collapse no surprise

The plan to set up M-LEC collapsed on December 22 when the three banks that promoted the idea said in a joint statement, “The vehicle is not needed at this time.” Financial papers uniformly proclaimed its collapse – not many lamented it. Some commented how it was “embarrassing” to the Treasury, while many said that its demise was no surprise.

There had been misgivings about the plan from the day it was announced. It was plagued by uncertainties and there was no clarity about how it will work, who will participate and how much money would be subscribed. The basic infirmity was that it was led by three banks that were known to be involved deeply in creating the SIVs or in benefiting from them.

Citigroup was the pioneer that created the creature way back in 1988 and set a model for others. It was known to hold assets valued around $100 billion in them. The other two were deeply involved as money market managers. As Financial Times analysed in an edit, “Even some of the banks involved wonder whether Citigroup, which could contribute a quarter of its assets to in the new fund, is being bailed out of its lending errors with a murky form of innovative off-balance sheet financing.” (Cleaning up after credit innovation, October 15, 2007.)

Dwindling corpus

There was no clarity about the corpus of the fund and how much each member would contribute. When M-LEC was announced, it was estimated at around $75-100 billion. It had only three members and they went on declaring that others would join. In due course, even by mid-December, no new member joined. The corpus also got emasculated to $20 even as banks lost interest in the fund.

As some commentators had explained, the fear of the Treasury was “fire sale” of assets depressing the market overall and having its fallout on the economy. The endeavour in the short term was to restore stability and confidence in the vital sector of commercial paper market. It was buttressed in part by infusion of liquidity by the Federal Reserve. But more remained to be done in clearing the CDO (collateralised debt obligation) mess.

The plan failed to address the CDO issue. There were around 30 SIVs, which held assets valued at $320-400 billion. Citi, as mentioned earlier, held a quarter of that. It was the fear of the magnitude of this sale that spurred the Treasury to act.

Under the rules disclosed, the fund was not allowed to buy ‘tainted’ bonds tied to sub-prime loans, etc. It could buy only debt with the highest ratings. The problem of the SIVs was not with the rated assets but the toxic. They could sell those assets outside of the fund.

As for other assets, the rules provided that BlackRock, as the manager, would take a commission upfront and discount the bonds. It was supposed to pay market prices for them. It was unclear how those prices would be priced. The problem with the CDO was that it was priced to model and not to market. The reduced prices for the assets seem to have distanced many banks (and SIVs) form the fund. The banks could manage to shift those assets back to their balance sheets or internalise them and pricing would have become an accounting issue.

Parallel bailouts

In retrospect, it seems that this exercise about M-LEC was a side show or rather a public relations manoeuvre to calm the markets. The three banks promoting the plan had other ideas under their hat. They began to clean up the mess through other means.

For instance, Citigroup bailed out its own SIVs to the tune of $49 billion. Others like HSBC followed similar moves. CreditSights, an independent research group, reported that SIVs had reduced their holdings by more than 25 per cent since August and banks had taken on their balance sheets more than $80 billion. Along side, many of them had also started writing down bad debts.

The advantages of such reworking and rebalancing balance sheets are that banks are not subject to humiliating treatment by external agencies. They may continue to retain their toxic assets in their vaults. One consequence of this process was that M-LEC was becoming increasingly irrelevant for most banks.

Even by November, within a month after the announcement of the plan, a senior Wall Street banker said, “As far as we can see, it appears dead in the water right now.” However, the Treasury officials continued to maintain that the plan was “on course.”

Sovereign Wealth Funds

Another tide that lifts these banks is recourse to Sovereign Wealth Funds (SWFs). There seems to be a change in perception. Gone is the earlier acrimony or suspicion over their role. Now asset managers are seeking them and are eager to render technical services.

“Sovereign wealth funds are certainly here to stay,” says Mr Edwin Truman of Peterson Institute of International Economics, Washington DC. “As the world grows, the scale of their financial wealth is just going to get bigger and bigger.”

During this year alone, SWFs have invested around $45 billion in a range of companies and assets. The banking sector has attracted their attention most. Reports indicate that till date SWFs have invested $33 billion for minority stakes in a handful of banks. The list of banks is a veritable Easter Parade and includes Citigroup, UBS, Barclays, Merrill, Morgan Stanley, etc. As Portfolio.com suggested, “Wall Street, its capital eroded by the sub-prime crisis, is getting a bailout – only it’s is not from the Treasury Department or the Federal Reserve. It’s from Asian governments” (December 21, 2007).

The US Treasury, which had in the past expressed deep reservations over the secretive role of SWFs and their investment strategies, seems to view them benignly.

What differentiates SWFs from other Wall Street investors is that they are willing to wait for longer turn return and will not jump the gun on sighting market volatility. In a way they gamble. But it suits the US authorities and bolsters their banks to operational levels. Surely it has made its M-LEC irrelevant. Treasury will have no regrets.

(The author is a former Finance Ministry official with extensive experience in international, trade and finance matters.)

More Stories on : Financial Markets | Financial Policy | Mortgage

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page