The Big Bank Bail-Out Plan or MLEC – What Are They Really Trying to Accomplish?

The excerpts below from an article in the WSJ, discusses the SIV bail out being put together by three big banks. This is an excellent summary of what the banks are trying to accomplish, the risks involved. One point I would like to add to this post that the article did not include is that in the conduit business in which the banks partook, the banks would often agree to cover the corporations commercial paper if the commercial paper could not be rolled-over. There in lies the real rub. If they can't roll-over the commercial paper then the bank has to cover it. But, who said the large banks were altruistic. See a previous post on conduits, this provides good background information. Text in bold is my emphasis.

When Lee Iacocca ran Chrysler in the 1980s, he complained about a double standard for enterprises in trouble.

Ailing industrial companies got no sympathy, he said. Economic Darwinists urged them to make drastic cutbacks or even perish, in the name of market discipline. And it took many months of struggle before Chrysler got U.S. loan guarantees. When banks stumbled, it was a different story -- no matter how foolish their mistakes. They were rescued in the name of protecting the global financial system.

Several of the world's biggest banks are going through strange gyrations to avoid owning up to missteps in the London market for structured investment vehicles. SIVs are funds the banks set up as a way to make money without taking the risks involved onto their balance sheets.

The banks have dropped hints that if they don't succeed in raising a $75 billion rescue fund, dangerous ripples could spread into the broader commercial-paper market and beyond.
Such talk roused the U.S. Treasury earlier this month to help Citigroup Inc., B of A, and JP Morgan Chase draft the rescue plan. The big banks are proposing a fund that would buy troubled SIV assets, helping liquidate mortgage-related investments that otherwise might be dumped on the market at a loss. The government isn't putting money into the plan, but its role could be crucial in persuading investors to buy debt issued by the rescue fund as part of the plan.

For all the drama of late-night rescue talks, though, the banks have danced around two crucial questions. First, is the SIV market so important to world economic health that it should be saved in its own right? Second, are global markets in such perilous shape that a shakeout in SIVs could trigger collapses in other capital markets?

It's hard to say "yes" to either question. SIVs exist mostly as a way for banks to do business without putting up their own capital. The market hardly existed 15 years ago; today, its total assets amount to $350 billion.

There's nothing special about how SIVs invest their money. They own the usual assortment of bank debt, mortgages and other asset-backed instruments. What's striking is how they are set up, with huge amounts of leverage on a slim capital base; with bank sponsors that don't own them but instead collect management fees for running them; and with their funding derived mostly from short-term commercial paper.

Put those three factors together, and it's clear that SIVs can make tidy profits for banks when things go well. But they are vulnerable to a liquidity squeeze if the commercial-paper market dries up. That's what happened this summer.

Even Citigroup, one of the most active SIV sponsors, isn't portraying these conduits as the bankers' equivalent of the eight essential amino acids, without which we can't live. In a research report last month, Citigroup analyst Birgit Specht wrote that it's too early to tell whether all such conduits will survive. Regulatory changes are dimming the appeal of conduits, to the point that banks may revert to traditional balance-sheet placement for many such holdings.

So if SIVs aren't vital per se, do we still risk Armageddon if they fade away too quickly? Anyone familiar with the Depression-era wave of bank failures has to be mindful of the risks that panics can spread, crippling sound institutions.

But this time around, banks world-wide are in remarkably robust health. For the first few years after the September 2001 terrorist attacks, interest-rate trends made almost any lending profitable. Their trading desks have done just fine in recent years. And most corporate clients have been models of good behavior.

If banks ever could absorb a few hits, now is the time. Current conditions differ sharply from 1982, when the Latin American debt crisis hit as major U.S. banks were struggling with a recession and the aftermath of lofty short-term rates that squeezed lending margins. In 1982, regulators had good reason to worry about a domino chain of defaults. There's more padding in the system today.

Hasty rescue plans amount to an amnesty for sloppy banking and an invitation for it to continue. Japan's experience in the 1990s is a case in point. Rather than owning up to banks' poor judgment in real-estate lending, Japanese authorities tried for years to shore up shaky loan portfolios. That produced economic stagnation.

Even worse, painless rescues protect the careers of bankers who ought to pay the price for their poor judgment. So far, no CEO of a major U.S. bank has been held accountable for the SIV mess. There haven't even been any widespread purges of their lieutenants.

People involved in the SIV rescue fund say it will buy troubled funds' holdings at prices that both shore up the market and are economically rational. Hmmn. It was fascinating to hear Alan Greenspan, former Federal Reserve chairman, weigh in last Friday with doubts about how investors would feel if "some form of artificial non-market force is propping up the market." But if the SIV rescue fund tries too hard to make prices levitate, that's just throwing good money after bad.