October 16, 2007 / 12:15 PM / in 12 years

Scooby Doo superfund can't flee subprime mess: James Saft

LONDON (Reuters) - Like a villain in a Scooby Doo cartoon, the banks behind the new $80 billion bailout fund are essentially saying, “We would have gotten away with it, if it wasn’t for those pesky subprime loans.”

Reuters columnist James Saft in an undated file photo. REUTERS/File

Banks led by Citigroup (C.N), JPMorgan Chase (JPM.N) and Bank of America (BAC.N) have said they would create a fund to buy assets from troubled bank-affiliated vehicles called Structured Investment Vehicles (SIVs).

There are few hard details, but the fund, which is to be backed by the banks, is expected to buy only highly-rated assets from the SIVs, the theory being that if they cull the “toxic” subprime loans, investors will have enough confidence in what is left to buy commercial paper and other securities issued by the new fund.

Problem is, the issue was never just subprime loans, it is the far wider and deeper problem of loans made on overly optimistic assumptions secured on U.S. real estate, which is now in a once in a generation slump.

Of the $370 billion of assets held by SIVs, which sought to make money by buying long term debt and borrowing short through the commercial paper market, fully 23 percent are mortgage-related debt, with another 11 percent in CDO structured debt vehicles that can be presumed to hold some mortgage exposure.

Some of those loans, though no doubt “highly rated” by the ratings agencies, will have been made to borrowers in the class above subprime or on houses in areas, such as California and Florida, where values are falling quickly.

The banks, in isolating the better mortgage debt, run the risks that the market either offers them a price that would force damaging writedowns of other mortgage debt held on or off balance sheet, or worse, refuses to fund at all.

“I’m not sure it will be easy to find people to buy this stuff, “ said Jochen Felsenheimer, head of credit strategy at Unicredit (HVB).

“It’s not just a subprime-linked problem. The problem is that we have used securitization instruments to create a bubble.

“We sold a lot of risk just knowing that the CDO or other manager would buy it.”

This begs the question of who or what will hold the subprime debt. It is possible that the banks involved believe that they and the SIVs they are affiliated with can absorb that hit, if it is only on the much smaller amount of assets considered subprime.


All of this is not to say that the logic underlying the plan, what little of it that is known, is not sound. Elements of all asset backed markets are facing liquidity issues that are compounding the insolvency issues they also face, however large or small.

Put simply, a lot of asset-backed paper will be just fine, if investors with deep pockets and long horizons can be found.

And for the banks to simply allow the SIVs to dump paper on the market, or absorb it on their balance sheets, would cause a number of very serious and negative effects.

Beyond the hits to their own reputations, a disorganized forced sale of these assets would not just hit those who are selling, but force many banks themselves to write down similar assets in similar ways.

That, in combination with being forced to take assets back on to bank balance sheets which are already stretched, would harden and deepen the credit crunch.

Banks would have less to lend and be less willing to do it at attractive rates. This in turn would dampen economic demand and prompt more defaults in both the corporate and personal sector.

As you can see, credit cycles are as vicious on the way down as they are self-reinforcing on the way up.

Like so much about the plan, it is unclear who the investors are that are expected to buy the paper issued by the new fund.

It appears unlikely that the prices offered by the new vehicle will be juicy enough to interest hedge funds or other risk seeking investors.

In the end, that may mean the plan will succeed if it is able to get money market funds to buy the paper it issues.

Money market funds have been on strike since the summer, declining to buy asset backed commercial paper amid fears that their net asset values could fall below 100 cents on the dollar.

Simply put, neither money market fund mangers or their clients get paid enough to take on complex ill-understood risk.

So, hands up everyone out there who wants their money market fund to buy the paper issued by the new behemoth.

James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. Email James at saft@reuters.com

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