Transparency Is Key To Super SIV

By Steven Pearlstein
Wednesday, October 17, 2007

Only on Wall Street -- and in its political annex, the U.S. Treasury -- could someone think that the way to prevent a meltdown in structured investment vehicles is to create a giant structured investment vehicle.

While we're at it, why not locate it, with all the other SIVs, in some offshore financial haven like the island of Guernsey or the Cayman Islands, where we can shield it from lawsuits and regulatory scrutiny and make sure nobody has to pay taxes until the profits are repatriated.

Like the SIVs it is hoping to rescue, let's make sure it is highly leveraged, to get the best return on the relatively modest amount of real cash anyone puts into it.

And let's ensure none of the banks setting up this Super SIV will have majority control or assume too much of the risk, so they won't have to put any of it on their balance sheets or set aside their own money -- "regulatory capital" -- in case something goes wrong.

Best of all, let's use it as another chance to earn big fees!

It's a sweet deal for the banks, but for the rest of us, it is probably more a mixed blessing.

The problem this was meant to solve is that the "independent" SIVs set up by the banks to buy asset-based securities -- IOUs backed by mortgage loans, car loans, credit card loans and the like -- can't renew, or roll over, the short-term loans they took out to buy the securities. Their lenders, mostly money market funds, are suspicious that some of those assets aren't really of the AAA quality that was advertised. Because the good assets are mixed in with the bad, the lenders don't want to risk lending any more.

The Super SIV is meant to get the market unstuck by buying up some of that commercial paper or some of the "good" assets behind it. It is the classic solution to a liquidity problem, creating a buyer of last resort.

Some conservative noses are out of joint because this is, in their eyes, a government intrusion into the workings of the free market. That's true to a degree, but there is also nothing new about that. It also applies to the role that government-sponsored enterprises like Fannie Mae and Freddie Mac are now playing in the mortgage market. It applies to the role the Federal Reserve played when it lowered the discount rate back in August and announced it would accept a wide range of securities as collateral. And it applies here in the case of the Bush Treasury, which served as honest broker in the creation of a private-sector buyer of last resort for asset-backed commercial paper.

This isn't a bailout, exactly. It is more like organizing a rescue without actually spending money. And it is a classic role for government, persuading parties to do something in collaboration that is in their collective best interest, but that none of them would be willing or able to do alone. It's right there in the economics textbooks, under "collective-action problem."

Some have argued that, because of the Treasury's involvement, these new SIVs have the implied backing of the federal government and set a lousy precedent, encouraging banks and other lenders to take similar risks in the future with the knowledge that if things get rough, the government will save their bacon. There is no denying this "moral hazard," as economists like to call it. But in truth, investors have long assumed the government would never allow any of the big banks to fail because of the chance that could trigger a wider meltdown in the financial markets. Treasury's involvement as midwife to the Super SIV reaffirms that assumption. It doesn't expand it.

One question still hanging over this plan is what the new entity will pay to roll over the commercial paper, or buy the assets of one of the bank SIVs. As is their habit, the Wall Street sharpies have come up with some clever ideas for slicing, dicing and repackaging the risk that allows them put off the day of reckoning. But there is no doubt that the final price will be higher than the banks would have gotten if they had all been forced to sell on the open market.

How do I know that? Because if the prices weren't higher, then there would be no need for the Super SIV. The premise, however, is that once the market returns to normal and the bad assets can be separated from the good, the higher prices will prove to be justified. If that's not the case -- if this turns out to be a problem of bad loans rather than a temporary shortage of liquidity -- then a reckoning will occur, and the banks and their lenders will be forced to take their losses.

To me, all that makes pretty good sense. What doesn't make sense is for the Treasury to compound its past failures by allowing the banks to set up new Super SIVs without including them on their balance sheets. By doing so, the banks will not only be allowed to keep investors and lenders in the dark about the true extent of their obligations, but allow them to avoid setting aside some of their own equity as a financial cushion in case they have to make good on those promises.

In a speech at Georgetown University yesterday, Hank Paulson said the administration would be studying the recent experience with bank SIVs to determine changes in accounting and regulatory regimes. It's not clear, however, what more there is to study. Given the amount of outstanding commercial paper tied to bank SIVs -- an estimated $400 billion -- and given the belated acknowledgments by the banks of the serious risk to their reputations they take on when they set up these supposedly independent vehicles, it's time to require banks to account for these vehicles on their own books, where they belonged all along.

Steven Pearlstein can be reached atpearlsteins@washpost.com.


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