Wednesday, October 24, 2007

Another Good Summary of the SIV Market – Now the Concern is Timing

Excerpts below from a WSJ article discuss some of the basics of the SIV market and whether or not the bank bail-out (MLEC) will arrive in time. Stay tuned, this is a good one to be a spectator at, especially if you really want to see how things are handled under stress. Text in bold is my emphasis.

As three of the world's biggest banks try to finalize a rescue plan for some shaky investment funds, the funds themselves face mounting problems.

The outlines of a new superfund -- an effort led by Citigroup Inc., Bank of America Corp. and J.P. Morgan Chase & Co. that may include at least seven other banks -- are still being hashed out, according to a person familiar with the situation. The three banks could present a formal structure to potential bank partners and funds as soon as next week.

Meanwhile, the funds at the heart of the situation -- known as structured investment vehicles, or SIVs -- need to find investors for $100 billion in debt coming due in the next six to nine months, even as ratings firms continue to come out with reports that lower the ratings of securities in moves that could further depress the value of SIV holdings.

SIVs sell short-term debt and then use the proceeds to buy longer-term, higher-yielding securities. But SIVs have had trouble in recent months selling debt, and some of their roughly $350 billion in assets are backed by U.S. mortgages -- a market that has seized up amid the housing slump and subprime-lending shakeout. Typically, money-market funds, municipalities and other risk-averse investors buy SIV debt.

The bank consortium would provide much-needed cash to the funds by setting up a superfund to buy highly rated securities from them. The superfund plan would aim to buy assets from the SIVs to prevent them from selling those assets en masse at today's depressed prices, something the banks and some regulators say could roil markets and the economy.

The plan, which the banks aim to finalize by month's end, could still fail or arrive too late to be of help. Besides tapping the superfund, SIVs are likely to restructure their debt, wind down or, in a worst-case scenario, become a dead SIV that can't pay debt investors.

Still, as the superfund negotiations continue, problems for SIV operators have worsened. Some SIV operators, such as Citigroup and Rabobank of the Netherlands, have been selling assets. In the United Kingdom, the Whistlejacket Capital Ltd. fund operated by Standard Chartered PLC is considering alternative funding plans, a Standard Chartered spokesman said.

Meanwhile, the types of assets held by some SIVs continue to come into question. Moody's Investors Service Inc. recently downgraded $33.4 billion of securities issued in 2006 and backed by subprime mortgages in moves that could make it more difficult for SIVs to unload assets.

Holders of SIV capital notes are bearing the brunt of the SIV fallout. Investors in capital notes typically supply an SIV with as much as 5% of its money. In return, these noteholders -- often European banks and insurers -- receive a share of the SIV's profits or losses. They are ranked lower than the other debtholders and thus could be the first to bear losses if SIVs sell assets to the banks' rescue fund.

Capital-notes holders face two options: risk losing money if the SIV sells assets to the banks' fund at a loss, or try to keep the SIV going by buying more of its debt. In recent days, SIVs have been trying to persuade capital-notes holders to buy medium-term notes to fund the SIVs and protect their investments, people familiar with the matter say. Some capital-notes holders -- and SIVs -- say they are skeptical about the banks' plan, because selling assets at today's prices will require the SIV and the notes holders to recognize a loss on those investments.

Capital-notes holders "profit if the SIV does well, but they lose their investment if there is a shortfall," says Geoff Fuller, an attorney at London firm Allen & Overy LLP, who advises clients including Citigroup on SIVs and other securitization projects.

U.K. mortgage lender Nationwide Building Society, for instance, recently invested a fraction of its assets in capital notes of several older, bank-sponsored SIVs, and says its holdings haven't been downgraded by ratings firms. Indeed, holders of notes in the shakier SIVs launched over the past two to three years, not those in older SIVs, are taking the worst lumps.

"We saw it as a potentially attractive risk-reward proposition," says Mark Hedges, Nationwide's head of structured finance. "We are monitoring the situation because it needs to be monitored, but we have a very modest portfolio."

Mr. Hedges, like other notes holders, says he is concerned the rescue fund could dilute the value of his investment. He adds he doesn't have enough information to make up his mind on the fund.

The lead banks have provided little public guidance on their plans for the fund, leaving themselves open to criticism. Executives working on the fund see it not as a silver bullet but as one of several options open to SIV operators, according to a person familiar with the effort. The plan would benefit a lead participant, Citigroup, because it is a large operator of SIVs. The SIV industry has become a key part of the U.S. economy, because the funds buy securities backed by mortgage loans to U.S. home buyers. The industry, at its peak earlier this year, totaled about 30 funds with $400 billion in assets.

The three banks have many issues to work out, according to people familiar with the situation. They need to figure out how participating banks would divide any profits or shoulder losses when the rescue fund is wound down, according to people familiar with the plan. They need to decide if participating banks will be ranked based on how much funding they provide, just as banks take lead and supporting roles in stock offerings.

In recent days, the group has tried to bring in other banks. Wachovia Corp. plans to participate -- at a level likely below the three lead banks -- pending approval of a governance plan for the fund, said a person familiar with the situation. Germany's Dresdner Kleinwort, a unit of Allianz SE and operator of the K2 Corp. SIV, and Britain's HSBC Holdings PLC, the affiliate of the Cullinan Finance Ltd. SIV, are considering joining. Both are large SIV operators.

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