Ever since Ben Bernanke and the Federal Reserve juiced the stock market with their 50-point rate cut on Sept. 18, Wall Street has been radiating a surreal warm glow. The housing bust, so obviously the catalyst for the economic dislocations of the summer -- the subprime mortgage meltdown, the credit crunch, the terrible August trials of the quant funds -- was only getting worse, but investors just didn't seem to care.
Then came the news on Monday that three of Wall Street's biggest banks are ganging up together, backed by the express encouragement of the Treasury Department, to create a "Master Liquidity Enhancement Vehicle" -- a so-called super conduit. The MLEC is designed to address the still lingering problem that there are an awful lot -- maybe around $400 billion worth -- of investment securities on the market that no one wants to buy. Such a state of affairs is known as "illiquidity." The great fear is that if the owners of these securities started unloading their holdings at rock-bottom prices that could attract buyers, a severe market crash would soon be forthcoming.
Way to spoil the party! The Dow Jones industrial average immediately dropped by 108 points on Monday and another 71 on Tuesday. Why? Because the announcement of a rescue plan is tantamount to shouting, in capital letters: WALL STREET, WE STILL HAVE A PROBLEM.
When combined with Treasury Secretary Hank Paulson's somber speech Tuesday morning warning that the housing crisis is set to drag on indeterminately, one can only conclude that the stresses that have flowed from real estate into the financial markets are going to ramp up. The purpose of the super conduit may not be to clean up the mess that already exists, but prevent matters from getting considerably worse.
Reviewing the attempts by financial journalists across the globe to explain what exactly the Master Liquidity Enhancement Vehicle entails, one is struck by how every article includes a version of the same basic paragraph, as if working from a common template.
It goes something like this:
Banks such as Citigroup set up special entities, so-called structural investment vehicles (SIVs) or conduits, whose purpose was to generate profits by making long-term investments in highly complex financial instruments -- such as the now infamous collateralized debt obligations (CDOs) that repackaged subprime mortgage securities -- and paying for their purchases by selling short-term debt, known as "asset-backed commercial paper." The SIV would reap the high yields of the relatively risky long-term securities, but pay relatively low interest rates on the short-term paper.
A classic strategy, with one big catch. The short-term debt had to be constantly rolled over, sometimes in time frames lasting just a few days, but more often a few months. As long as the SIVs could sell new short-term debt to pay off the expiring paper, there was no problem: just roll it on over and everything's hunky dory. But then came the housing bust, and the subsequent revelation that complex financial instruments whose value was tied to the likelihood that people with bad credit and no documented income would regularly make their mortgage payments might be, hmm, bad investments. Suddenly, market players lost their appetite to provide short-term funding to the owners of such "toxic waste." The market for asset-backed commercial paper collapsed, in turn presenting the SIVs with the dreary prospect of making good on their debts by selling actual assets at everything-must-go prices.
Again, that previous paragraph or variations thereof, is now standard conventional wisdom explaining what has been going in the financial markets in the last few months. The new rescue scheme is supposed to solve the illiquidity crunch by creating a super SIV that will restore confidence in all concerned by selling new debt that will fund purchases of highly-rated securities that can't currently find buyers. Theoretically, the fact that the biggest blue chips in the business are backing this new fund, with the moral support of the Treasury Department, will encourage skittish institutions to dip their feet back in the water.
Will it work? Nobody knows, and analysts are all over the map on the question of whether to call the plan a bail-out, a shell game, or just a highly ironic attempt to solve a problem by engaging in the exact same behavior that caused it. The only thing we know for sure is that the Master Liquidity Enhancement Vehicle will be featured in the center ring of the Wall Street circus for a while to come.
What we can say, however, is that before August, outside of the relatively small group of people who were actually involved in operating SIVs and conduits, hardly anyone knew any of this was happening. Then, on Aug. 12, the Financial Times' Gillian Tett dropped a bombshell into the world of finance journalists and econobloggers with an extraordinary article that detailed the whole sorry saga.
Tett's entire story holds up amazingly well, two months later, but let's just pick out one sentence:
[SIVs] are typically quite opaque, invest in complex securities and often do not need to be displayed on a bank's balance sheet.
Let me repeat that: The banks, such as Citigroup, that created these entities, did not have to report them on their own balance sheets -- at most, their existence was only revealed by obscure, virtually unintelligible footnotes.
Does this behavior ring any bells? Does anyone recall a certain Houston-based energy company that dabbled in derivatives trading and tried to make its books look good by moving dodgy operations into off-balance sheet special entities whose true nature was hidden from the outside world?
Back in the day, defenders of unregulated markets were wont to call Enron a "bad apple" that was properly punished for its sins, and to lecture all and sundry on how its misbehavior should not be interpreted as a sign of larger systemic problems. But it's hard to look at the current mess and see anything besides Enron economics redux. When the words "opaque" and "complex" are combined with "off the balance sheet," the red carpet is being rolled out for abuses of all kinds. Why didn't anyone know that this $400 billion business was going on? Because no one was supposed to. The less scrutiny, the fewer questions, the less chance that anyone would be able to accurately gauge the true risk inherent in a prospective investment.
Hank Paulson went into considerable detail on Tuesday morning discussing potential strategies for helping struggling homeowners and bringing more regulatory scrutiny to the mortgage broker industry. He was less forthcoming about structural changes that would rein in the Wall Street behavior patterns that provided the incentive for all that reckless mortgage origination, and that thrives on disguising what it is up to in clouds of impenetrable complexity. There is an obvious mandate for government intervention here -- not to bail out the bad actors, but to rewrite the rules of engagement. Financial accounts should be clear and transparent, off-balance sheet entities should be beyond the pale. Investors and regulators have a right and responsibility to know exactly what is going on.
It's a never-ending game. Wall Street's bright minds are always inventing new "vehicles" -- each more convoluted and difficult to understand than the last, because the more you can obscure, the better your chances are to game the system. There's already plenty of suspicion that the current super conduit is just another variant on the same old strategy, an attempt to paper over the widening sinkholes in the system with the tried-and-true methods of the past. Should we not be suspicious that Citigroup, the very institution that seems to be suffering the worst from its dabbling with SIVs and conduits, is leading the rescue charge?
Nothing is so complicated that it can't be explained in clear English, without footnotes. It's called "transparency" and it should be the law.