Tuesday, December 25, 2007

Alphabet Soup and the Subprime Crisis

(Information Arbitrage) M-LEC. Super SIV. SWF. Kind of reminds me of banking "reform" in the late 1980's - SAIF, BIF and other ridiculous acronyms representing entities that ultimately did little to help the underpinnings of the S&L crisis. The story of the day is the abandonment of the M-LEC structure, supported in spirit by the US Treasury but ultimately driven by the realities of the private sector. Some are saying "what a dumb idea - of course it was going to die." From my perspective those voices don't really understand what is going on here. And of course I do.

As I said from the beginning, the M-LEC proposal was never conceived of or structured as a "bailout" in the conventional sense, implying that Government funds were going to be used to prop up an ailing market. The Treasury Department certainly served as a catalyst to get the discussion going, but it was only going to work if the private sector bought in - both metaphorically and with hard dollars. And this type of buy-in was required of both the SIV issuers and the potential M-LEC investors, two constituencies with their own agendas and stresses. The metaphor I used to conceptualize the M-LEC structure was akin to the "good bank/bad bank" model of yesteryear, where the best assets could be pooled and liquidity raised against them, bridging the gap between either the sale or recovery of the worst assets that remained on-balance sheet. Bottom line, the Treasury's catalytic actions got issuers and investors the world over to focus on the magnitude of the problems facing the SIV vehicles and their sponsors, and it is this that represents the true value of Mr. Paulson's initiative. Was this his endgame? Who knows. But in any event, it worked.

But as the M-LEC moved closer to reality another path towards resolution presented itself - the injection of capital by SWFs directly into the ailing institutions, enabling SIV assets to written down and something approaching economic reality to be reflected on financial institutions' balance sheets. Citigroup. Morgan Stanley. Merrill Lynch. UBS. And this list will get longer, believe me. The confluence of massive sovereign liquidity in Asia, the marquee names of the institutions willing to receive investment, the ability of the SWFs to actually help the financial institutions' with the exploding business opportunities in the region, Saudi Prince Bin Talal's high-profile success with his Citi investment back in the early 1990s - all of these contributed to the development of the on-balance sheet SWF alternative to the off-balance sheet M-LEC alternative. The private market has spoken, and this is the solution that was deemed best. Congratulations to Mr. Paulson, the financial institutions' receiving investment, the SWFs and investors in these institutions' and their SIV vehicles. This was a pretty good answer to a really difficult problem.

But before anybody claims victory, let's keep a few key things in mind. The problem is far from solved. Liquidity has not yet returned to the market. There is still not a clear bottom to where these mortgage and associated derivatives portfolios will ultimately realize value. And it is this uncertainty that makes the SWFs investments so brave and so bold. Will Merrill need an additional $5 billion? Will Citigroup need another $10-$15 billion? UBS? $5-$10 billion more? Who knows. Maybe so. And where is that money coming from? Will political realities enable Asian SWFs to buy 20-25% of these damaged firms without causing a huge backlash? I'm not so sure about that, and it's not a question I'd really like to be compelled to answer. I think we are maybe in the second inning of a game going into extra innings, with a lot of excitement, angst, fear, conflict and greed lying ahead.

If there is one thing we can take away from this SWF for M-LEC trade is that the Government really has limited tools at its disposal to deal with crisis once it has happened in such a massive, interconnected world. The real answer lies in prevention. And is it here that the US Government, the Federal Reserve and the SEC have failed so miserably. They should take a good, hard look in the mirror when doing a post-mortem of the sub-prime crisis. If they have any self-awareness at all they certainly won't like what they see.

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