Pathology of Debt

Henry C.K. Liu

Part I: Commercial Paper Market Seizure turns Banks into their own Vulture Investors
Part II: The Commercial Paper Market and Special Investment Vehicles
Part III: The Credit Guns of August heard around the world
Part IV: Lessons Unlearned

Part V: Off-Balance-Sheet Debt

This article appeared in AToL on December 1, 2007

Conduits and SIVs allow companies and banks to take on off-balance-sheet debt. These vehicles usually hold highly rated, short-term debt that offers a higher yielding alternative to ultra-safe Treasury debt. Banks use the low-cost proceeds to buy longer-term debt like auto-loans, credit card, or mortgages to profit from their high cash flow. Banks that have stakes in conduits have provided “liquidity back-stops”, promises that the vehicles’ debts will be paid by the banks when the debts come due even if the vehicles are not able to pay them. Banks are reluctant to consolidate the distressed vehicles because it would have to put the liabilities on bank balance sheets thus restricting lending. Also, allowing conduits or SIVs to fail could damage a bank’s reputation and might even create financial systemic risk if investors should lose faith and stop purchasing commercial paper altogether. This creates possible scenarios where banks must lend the distress vehicles money in hope of riding out the storm or take substantial immediate losses. 

The trillion dollar commercial paper market that raises funds for the purchase of assets from home mortgages to car loans seized up in August 2007 just as more than half of that amount comes due. Unless the issuers continue to find new buyers to roll over the maturing debt, hundreds of hedge funds and home-loan companies will be forced to draw on bank loans or sell some $75 billion of debt at fire sale prices every 90 days which would drive further down prices in a market where investors have already lost $44 billion. That will hurt the 40 million individual and institutional investors in money market funds, the biggest owners of commercial paper. The money comes predominantly from retirement funds.  Let that be a warning to those who advocate the privatization of social security.

Ottimo Funding Ltd., whose name is “excellent” in Italian, started selling its $2.8 billion of mortgage bonds at the end of October after failing to raise roll over financing in the commercial paper market. Many of Ottimo’s securities were backed by option adjustable-rate mortgages (ARMs). Borrowers with option ARMs are permitted to make low initial interest payments for the first few years, causing loan balances to grow. Monthly payments can later more than double.

The securities auctioned were rated AAA and backed by Alt-A mortgages, a credit class above subprime, made to borrowers with good credit scores who opt for unusual terms, such as reduced income documentation or delayed principal repayment, without enough visible assets to offset the risk, such as sufficient cash in the bank. The sale of Ottimo securities did not generate enough cash to fully repay investors who bought short-term debt from the fund that were now maturing.

Ottimo, created six months earlier by Stamford, Connecticut-based $20 billion hedge fund manager Aladdin Capital Management, extended the maturity of its asset-backed commercial paper in August after being unable to roll over the debt. Investors in short-term commercial paper issued by Ottimo and similar funds fled to safety in US government bonds after losses linked to subprime home loans began to spread. S&P in August cut Ottimo credit rating to C, the second-lowest ranking, from AAA.

The threat of a fire sale of assets by investors that also rely on the shrinking market for asset-backed commercial paper prompted U.S. Treasury Secretary Henry Paulson to broker talks that may lead to the creation of an $80-100 billion super fund by Citigroup Inc., JP Morgan Chase & Co. and Bank of America Corp.

The super fund would buy securities from structured investment vehicles, or SIVs, to prevent them from dumping their $320 billion of holdings and further roiling credit markets.

But Ottimo is not considered a SIV. Ottimo’s bonds are backed by mortgages to people with credit scores of 708 and higher, compared with scores for subprime loans that average less than 620. The company's commercial paper has an A1+ rating from Standard & Poor's and P1 from Moody's Investors Service, the highest available.

Aladdin was not forced to immediately shutter Ottimo because the company exercised an option to extend the maturities on its commercial paper, providing 30 to 45 more days to find buyers. No issuer had extended maturities in the 12-year history of the asset-backed market until Ottimo. Two other issuers, Luminent and a unit of Melville, New York-based American Home Mortgage Investment Corporation did so within the last two weeks of October. More than $100 billion of extendible commercial paper is still outstanding.

The laws of finance may be bent but cannot be denied by obscuring the unwinding of obligations through manipulation to postpone the day of reckoning by adding more obligations. Ponzi schemes of paying early creditors with money from new creditor eventually will fail, with the final bill increasing in size as time goes on. The reckoning of the debt cancer faces a choice of facing the music honestly by excising the invasive malignancy now or let it metastasize over the entire financial system over the painful course of several quarters and even years and decades. Until October, investors were willing to buy extendible commercial paper because it offered higher interest rates than standard asset-backed commercial paper. Since then, as Wall Street carnival barkers continue to urge investor to take advantage of buying opportunities, it is time to sell.

Financial Panic

Short-term corporate debt yielded 5.75% to 5.95% on average on August 8, compared with 5.45% for non-extendable asset-backed commercial paper and 5.25% to 5.30% for corporate commercial paper. Since then, asset-backed commercial paper with a maturity of 30 days or less are yielding above 6% on average if buyer could be found, and corporate borrowers pay about 5.2% while three-month LIBOR hovers around 4.89%. Extendible commercial paper has no market.

Wall Street is gripped by financial panic and has stopped funding mortgage bonds, even AAA rated bonds backed by prime home loans. Even the Fed’s decision on August 17 to cut discount rate 50 basis points to 5.75% and the September 18 decision to cut the discount rate another 50 basis points to 5.25% and the Fed Funds rate target 50 basis points to 4.5% and the October 31 decision to cut the discount rate another 25 basis points to 5% and the Fed Funds rate target another 25 basis points to 4.5% failed to revive demand for ABCP. The rate for overnight borrowing in the asset-backed commercial paper market soared 0.39 percentage points, the biggest rise since the September 11 terrorist attacks. Overnight yields fell 2 basis points to 6.01% while 30-day paper widened 9 basis points to 6.09 percent. A basis point is 0.01 percentage point.

The distinction between asset-backed securities and asset-backed commercial paper is primarily one of the tenure of the paper - commercial paper by definition is short-term funding, and is therefore mostly used for short-term assets such as trade receivables.

Asset backed commercial paper (ABCP) is a device used by banks to get operating assets such as trade receivables funded by issuance of securities. Traditionally, banks devised ABCP conduits as a device to put their current asset credits off their balance sheets and yet provide liquidity support to their clients whose working capital needs are funded by the bank. If the bank wants to release the regulatory capital that is locked in this credit asset, the bank can set up a conduit, essentially an SPV that issues commercial paper. The conduit will buy the receivables of the client and get the same funded by issuance of commercial paper. The bank will be required to provide some liquidity support to the conduit, as it is practically impossible to match the maturities of the commercial paper to the realization of trade receivables. Thus, the credit asset is moved off the balance sheet giving the bank a regulatory relief.

So depending upon whether the bank provides full or partial liquidity support to the conduit, ABCP can be either fully supported or partly supported. ABCP conduits are virtual subsets of the parent bank. If the bank provides full liquidity support to the conduit, for regulatory purposes, the liquidity support given by the bank may be treated as a direct credit substitute in which case the assets held by the conduit are aggregated with those of the bank.

Non-bank entities also set up ABCP conduits. ABCP conduits can be single originator or  muliple originator conduits. In the latter case, the credit enhancements (and/or liquidity enhancements) are found both at the level of transfer by each originator (originator-level enhancement) and at the program level.

The ABCP market

Bank-sponsored ABCP conduits are the oldest and largest segment of the asset-backed commercial paper market. As of June 30, 2007, there were over 200 such conduits worldwide, with approximately US$900 billion of ABCP outstanding, comprising two-thirds of the outstanding ABCP rated by Moody’s. On June 30, 2000, ABCP outstanding was $570 billion. By the end of year 2001, it had reached USD 745 billion, up from USD 641 billion year-end 2000.

Unlike the bank-sponsored conduits in the US and Europe, bank-sponsored ABCP market in Japan had been reported by Moody’s as largely unaffected by recent market turmoil. But the Tokyo stock market suffered its sixth straight loss on Friday November 9 amid persisting nervousness about the impact of the subprime mortgage crisis. Selling accelerated late in the day on November 9 following a news report that Mizuho Securities might have lost as much as ¥100 billion ($8.7 billion) due to the turmoil stemming from problems in the subprime mortgage market. Moody’s also rates 20 bank-sponsored ABCP conduits in Australia and Asia with outstanding of US$39 billion.

Some notable administrators of ABCP in the US market are:
Citigroup N.A, ABN-AMRO Bank N.V.: Banc One, N.A., JP Morgan Chase; General Electric Capital; Westdeutsche Landesbank Girozentrale; Rabobank Nederland; Liberty Hampshire Co. LLC; Societe Generale; Bank of America National Trust & Savings Association; Canadian Imperial Bank of Commerce; Barclay's Bank PLC; Credit Suisse First Boston; First Union National Bank, Charlotte; Bayerische Landesbank Girozentrale; General Motors Acceptance Corporation; Firstar Bank, N.A. and Dresdner Bank AG.

Back in unusually heavily attended 2002 annual Bond Market Association meeting in New York featuring then Treasury Secretary Paul O'Neill, Securities and Exchange Committee chairman Harvey Pitt, and former Fed chairman Paul Volcker, a swarm of reporters, looking for the next Enron, turned up to ask questions about special-purpose entities (SPEs) and other means of moving risk off corporate balance sheets. One association member asked Pitt how the market could distinguish between how SPEs now were different from those used by Enron which had been deemed legally fraudulent. Pitt had no ready answer. The off-balance-sheet genie had been let out of the bottle, and there was no easy way to put it back in.

New Accounting Rules on Off-Balance-Sheet Obligations

The Financial Accounting Standards Board (FASB) adopted new rules for consolidating SPEs and disclosing off-balance-sheet activities. SPEs can no longer be all-purpose entities, especially not the kind of debt-hiding entities that Enron used and abused to puff up its profits. Interpretation No. 46, “Consolidation of Variable Interest Entities”, expands on existing rules to more precisely specify under what conditions a parent company must consolidate an off-balance-sheet SPE. Now, the question of consolidation is a matter of who takes the risks and who reaps the rewards of the enterprise.

Hundreds of US companies keep trillions of dollars in debt in off-balance-sheet subsidiaries and partnerships, skirting the consolidation rules of FASB 94, FASB 125 and FASB 140. If a company creates a legal structure, called a special-purpose entity (SPE) with a 3% minimal equity infusion, they do not have to consolidate the transaction under SEC and FASB rules. Banks arrange many of the devices and are big users themselves. JP Morgan revealed in the Enron bankruptcy that it had nearly $1 billion in potential liabilities stemming from a single 49%-owned
Channel Islands entity called Mahonia that traded with Enron. Dell Computer had a joint venture with Tyco called Dell Financial Services (DFS) that originated $2.5 billion in customer financing, mentioned only as a footnote to Dell’s accounts. Dell owned 70% of DFS, but did not control it and therefore could keep DFS debts off its own balance sheet.

To move assets off its books, a company typically sells them to an SPE, funding the purchase by borrowing cash from institutional investors. As a sweetener to protect investors, many SPEs incorporate triggers that require the parent to repay loans or give them new securities if its stock falls below a certain price or credit-rating agencies downgrade its debt or other triggering events. However, the International Accounting Standards Board (IASB) resisted this type of treatment. Under pending European Union legislation, all listed companies in the EU had to report under IASB by 2005, except those that report under US GAAP, which would have to move to IASB by 2007

Moving debt off the balance sheet is more difficult in
Europe than in the US under IASB rules which use the standard of whether a company participates in the risks and rewards attached to that debt in deciding whether debt can be off-balance-sheet. By contrast, US GAAP uses the standard of what legal form such an entity takes. In the post-Enron world, the rules on off-balance-sheet debt have tightened up, but new loopholes have been exploited.  Under existing accounting rules, the assets of SPEs must be consolidated when outside investors’ stakes are protected in that fashion. Yet Some 42% of off-balance-sheet debt provide guarantee for outside investors in indirect ways to get around the rules.

Synthetic Leases

Synthetic leases allow a company to own financial instruments that would give it the tax benefits of ownership without the accounting burdens of ownership. Synthetic leases are designed under current accounting rules to achieve off-balance sheet treatment of both assets and liabilities by classifying lease payments as operating expenses. Return on assets (ROA), return on equity (ROE), interest-coverage ratios and leveraging ratios (debt to equity) are improved relative to standard on-balance sheet treatment.
Synthetic transactions qualify for off-balance sheet status if the lease does not: (1) transfers ownership of the property at the end of the lease term; (2) does not contain an option to purchase at a bargain price; (3) the non-cancelable lease term is not equal to or greater than 75% of the estimated economic life of the property; and (4) the present value of rents and other minimum lease payments does not equal or exceed 90% of the fair market value of the property.

Generally, the ownership transfer and bargain purchase criteria are structured to provide a fixed, market-rate purchase price at the end of the lease term. The non-cancelable lease term is structured so that the non-cancelable portion of the lease term is short-term.

Under a synthetic lease, the lessee retains the tax advantages of ownership since the transaction places significant benefits, burdens and control of ownership with the corporate user who is regarded as the tax owner of the property and is eligible for the accelerated depreciation and interest deductions contained in the lease payments.

Several factors determine if synthetic leases are beneficial to a company: (1) the value of the asset is expected to appreciate over time; (2) the cash tied up in the asset can be  better utilized and (3) 100% financing allows the company faster more cost-effectively growth. In most cases, 100% financing is available, thus creating a structure with “all in” cost that may be substantially lower than traditional financing programs.

Synthetic leases are used for financing equipment integrated into industrial buildings, corporate headquarters, hospitals, single-tenant offices, movie theaters, hotels, retail branches, call centers, and data centers. Under a synthetic transaction, a capital source provides funding for the construction or acquisition of equipment to be utilized by and leased to a corporate user. If the equipment is purchased by the user upon the expiration of the lease, a predetermined purchase price is paid to the lessor. Funding sources for synthetic leases are commercial paper on a floating-rate or fixed-rate basis through interest-rate swaps, private placement, bank debt or other sources.

Leases can be structured such that funds are provided on a drawn basis usually with spreads over Bankers’ Acceptances, or an undrawn basis where funds are raised in the commercial paper market by a major funding source using a funding conduit.

In a typical synthetic transaction, the borrower would have two options at the expiration of the lease term: One is to purchase the property from the lessor (or owner) for the balance due. Because this amount cannot be a bargain purchase, an appraisal is required at the lease inception stating that the amount is not a bargain price. The other option is to sell the property on the last day of the lease term to a buyer unaffiliated with the borrower and guarantee the lessor any deficiency in the sale proceeds up to a specified amount with any excess payable to the lessee. Through a fixed price purchase option available at any time, lessees may benefit from any appreciation in the underlying value of the leased asset(s) even though such assets are not owned for GAAP accounting purposes. Alternately, lessees have the right to “return” such leased assets at the lease maturity upon making a residual payment, assuming there is no event of default and certain return provisions have been satisfied.

Implementing synthetic leases has led to unique and bleeding-edge structures (beta testing), which are highly influenced by accounting and tax rules.  FASB new rules regarding SPEs, including those involving synthetic leases, would make it much harder, if not impossible, to make use of such arrangements when they involve SPEs. Some companies such as Symantec continued to use synthetic leases to keep real estate financing off their balance sheets. Symantec defended its practices by pointing out that the arrangements meet new accounting rules because its synthetic leases do not involve SPEs. But most lenders have to get a regulatory exemption to offer such leases without the use of SPEs, and only a handful have done so.

While the debt reflected by Symantec’s synthetic leases is kept off the balance sheet, the amounts involved are footnoted on the balance sheet under “restricted cash.” Krispy Kreme unwound a non-SPE synthetic lease that was slated to finance a new mixing plant in
Illinois, and instead carried some $33 million to $35 million of the debt on its balance sheet. Cisco also decided to abandon its use of synthetic leases announcing last March that it would unwind all the leases it has used to finance its San Jose, California, headquarters and several manufacturing facilities in California and New England. Cisco consolidated roughly $1.6 billion in real estate assets by the end of the last fiscal year, betting that it was better to have investors see a bigger balance sheet than suspect that it was hiding debt.

When Sears returned $8 billion in credit card receivables from an SPE to its balance sheet, in early 2001, the company's ROA dropped from 3.6% in 2000 to 1.6% in 2001. Even so, Sears's stock soared by almost 70% as a result of the change toward more transparency.

Skepticism about GE lingers. Toronto-based credit-rating agency Dominion Bond Rating Service figured that if all of GE Capital’s off-balance-sheet securitizations were added back to the debt it consolidated as of year-end 2001, the finance subsidiary’s leverage ratio would rise from 13.5 times tangible assets to closer to 16 times.

The activities conducted through SPEs in the asset-backed securities market now raise the same issues of disclosure and hidden risk as did in the Enron disaster.  More than a trillion dollars of assets were taken off corporate balance sheets in 2006 and put into SPEs and vehicles known as commercial-paper conduits. That amount makes Enron look small time.

Commercial banks use SPEs to securitize their own assets, and also sponsor asset-backed commercial-paper conduits, which purchase and securitize assets from third parties. New accounting rules for these activities will cost both banks and their corporate borrowers. After FASB rule 157 goes into effect on November 15, 2007, banks were supposed to be required to consolidate their SPEs to add a lot more assets on their balance sheets, requiring banks to raise capital to meet regulatory reserve requirements. Banks and near-banks may then be compelled to rein in their SPEs and conduit programs, and the terms for both loans and asset-backed commercial paper would tighten. Moreover, without the liquidity guarantees provided in bank-sponsored conduits, many companies might lose their access to the asset-backed market altogether. One day before the deadline, the FASB announced that Rule 157 would be postponed for one year, allowing the off-balance-sheet liability issue to remain obscure and the malignancy of opacity to fester for another twelve months. The crash of 2007 will be prolonged through the end of 2008.

On Monday, November 12, a rumor was circulating that FASB Rule 157 was going to be delayed. This helped to power markets higher. The accounting change requires is that all of the paper on the balance sheets of various funds, banks and brokers -- RMBS, CDOs, CDS, etc. -- must be "carried at fair value on a recurring basis in financial statements."

The FASB announced in a news release at 12.05 am: “At its Board meeting today, the Financial Accounting Standards Board (FASB) reaffirmed its vote against a blanket deferral of Statement 157, Fair Value Measurements. For fiscal years beginning after November 15, 2007, companies will be required to implement the standard for financial assets and liabilities, as well as for any other assets and liabilities that are carried at fair value on a recurring basis in financial statements. As a result, Statement 157 becomes effective as originally scheduled in accounting for the financial assets and liabilities of financial institutions. The Board did, however, provide a one year deferral for the implementation of Statement 157 for other nonfinancial assets and liabilities. An exposure draft will be issued for comment in the near future on this partial deferral.”

In other words, no more mark-to-model or other accounting fantasies are permitted. Still the implementation of the full FASB 157 being partially delayed suggests that banks’ balance sheets are not sufficiently strong to cope with that shock at the moment. Whilst this undoubtedly gives banks more time to work out their problems, that is actually bad news as it will mean the financial markets remain in a state of closure for longer, and the process of removing capacity will take longer to materialize. A total deferral for a full year nearly passed, the seven-member FASB rejected such a proposal only by a four-to-three vote.

Creating Liquidity out of Illiquid Assets

The ability to create liquidity out of illiquid assets by packaging them into securities has been the most significant innovation in the capital markets in the past two decades. Since Fannie Mae and Freddie Mac started the trend in the mortgage market as part of their official mandate from Congress to foster more home ownership, securitization has expanded into a variety of credit markets. This was not a problem when the relationship between asset value and debt was kept within normal bounds.

At some point, asset securitization shifted into debt securitization as the debt bubble expanded from the Fed’s loose monetary policy coupled with the Treasury abusive use of dollar hegemony, using the capital account surplus to finance an expanding trade deficit.   Asset-backed securities were eventually overwhelmed by collateralized debt obligations, backed by payment streams from credit-card debt, auto and home-equity loans, commercial mortgages, and trade receivables beyond consumer ability to carry once the temporary wealth effect of astronomical asset appreciation fueled by massive debt ends. The debt bubble was being serviced of new debts.

Asset-backed securitization allows originators to monetize illiquid assets and remove them from their balance sheets to devote the proceeds as new capital to finance growth. The macro-economic benefit of securitization is that it has enables the extension of credit to far more individuals and businesses in the US. The macro-economic cost of securitization is vastly expanded systemic risk of default in a debt bubble, especially when the debts proceeds come largely from taking on new debt and are largely devoted to financing more debt, rather than real investment for expansion.

Securitization of Debt Fed the Debt Bubble

As the debt bubble expanded, industrial companies began to look for profit from financial engineering, a respectable euphemism for manipulation. The problem was exacerbated by outdated financial-reporting practices that failed to keep pace with securitization innovation, thus allowing debt proceeds to be swapped with counterparties as current income and payment of principle counted as long-term capital investment. Debt liabilities then magically disappear from corporation annual reports. Programs executed in SPEs off-balance-sheet kept investors in the dark about the risks involved in their high-yield investments.

As early as 2002, Pacific Investment Management Co. (PIMCO) bond fund manager Bill Gross accused General Electric of using off-balance-sheet activities to manipulate its reported earnings, and also suggested that the company’s heavy dependence on the short-term commercial paper market was becoming precarious. See my AToL series on central banking: BANKING BUNKUM - Part 3d: The Lessons of the US Experience

Paying for Bad Loans Made in Good Times

As the biggest players in the structured-finance market, commercial banks in the US and Europe may have to face up to the real liabilities of their SPEs. Several studies of securitization programs by Standard & Poor's showed that all the major banks, and many minor ones, conducted significant off-balance-sheet securitizations through their own SPEs and through commercial paper conduits. Conduit programs alone financed approximately $500 billion in assets in 2006, none of which appeared on corporate or bank balance sheets, except as minor footnotes. 

Securitization has enabled banks to finance assets through the capital markets, but the process has not eliminated associated risks for banks. In fact, in most cases, banks and asset-sellers have retained the majority of the risk of assets transferred off-balance-sheet. The process works profitably when the economy is strong and expanding and credit losses are small as easy and low-cost credit can bail out trouble loans, as was the case through most of the 1990s. But as Greenspan was fond of rationalizing: “Bad loan are made in good times.” He never bothered to finish the second half of the truism: “No loans are made in bad times,” a fatal fact when the economy depends on the roll over of existing debt. 

Under current rules regarding SPE accounting, neither financial-services firms nor other types of businesses need disclose much about their off-balance-sheet activities. Even the rating agencies have to essentially take banks at their word about the performance of the assets in their SPEs and conduits. But that happy state of affairs will end in one week’s time. 

FASB Rule 157

Financial Accounting Standards Board (FASB) rule 157, effective November 15, 2007 will make it harder for companies to avoid putting market prices on securities considered hardest to value, known as Level 3 assets. Level 1 asets are mark-to-market, based on liquid real prices. Level 2 assets are mark-to-model, an estimate based on observable inputs and used when no quoted prices are readily available. Level 3 assets those the value of which are based on “unobservable” inputs reflecting companies’ “own assumptions'” about the way assets would be priced.

At stake is the value of the assets on bank balance sheets, i.e. liabilities of increasingly complex and esoteric instruments, such as ABS (asset backed securities), MBS (mortgage backed securities), CDS (credit default swaps), CDO (Collateralized Debt obligations) and similar instruments.

Level 3 assets are those that are so complex, or so remote from the initial underlying assets because they have been sliced, repackaged, re-sliced, repackaged, and combined with other bits that there simply is no way to reliably calculate what they are worth in changing market conditions, because there is no ready market for them, and no market for the easily identifiable bits, and their value can only be derived from the changing value of other instrument through a complex network of hedging. Banks are still allowed to assign to Level 3 assets the value they can rationalize, but they are now obliged to tell regulators and the markets how of the holdings are in that category. 

US banks and brokers reportedly face as much as $100 billion of writedowns because of Level 3 accounting rules, in addition to the losses caused by the subprime credit slump. Estimates of final losses from the credit crisis have suggested a range of  $250 billion to $500 billion. More institutions are expected to revalue their currently mark-to-market value downward.

Big Wall Street firms to date have written down at least $40 billion as prices of mortgage-related assets dwindle because of record foreclosures. Morgan Stanley, the second-biggest U.S. securities firm, is said to have 251% of its equity in Level 3 assets, making it the most vulnerable to writedowns, followed by Goldman Sachs at 185%. Citigroup, which already wrote down $11 billion, has 105% of its equity in Level 3 assets. As market capitalization shrinks from falling share prices, the ratio of Level 3 assets to equity will rise.

Beside Citigroup, other banks may be forced to write down as much as $64 billion on collateralized debt obligations of securities backed by subprime assets, up from about $15 billion so far.

ABX Indexes and Level 3 assets

ABX indexes, which investors use to track the subprime-bond market, are showing “observable levels” that would wipe out institution capital if ABX prices were used to value their Level 3 assets.  ABX value reflects a percentage of the instrument face value. Ultra-safe AAA paper has lost 30% of their face value, more than half of that in the last two days of the second week in November. AA paper (Japan is rated AA, as are the best banks) has lost more than half its value. Lower rated indices dropped earlier, now hovering around 20 cents on the dollar.

Adding to the banks’ problems is the amount of Level 3 paper private equity or hedge funds bought with highly leverage financed by banks. Many clients who purchased Level 3 paper from banks are protected by “guaranteed sell back” clauses in their initial purchase agreements. Bank financing provided to real estate and construction firms and private equity funds whose business model was underpinned by cheap and easy credit is destined to become non-performing loans.

No matter how finance engineers slice and dice it, risk cannot be extinguished, it can only be transferred or redistributed. In the asset securitization process, companies un-bundle the securities into a hierarchy of different tranches by assigning varying degrees of credit risk out of general pool of assets. The tranches produced in a typical asset-backed deal range from AAA credits down to BB.

With the number of corporations still holding a AAA credit rating dwindling, and with growth of money rising at a faster rate than US sovereign debt, highly rated, asset-backed paper is an easy sell with institutional investors bulging with cash they must invest. Securitization can lower the cost of capital for companies than bank loans.

But in most cases, the originator of the asset, such as a manufacturing company financing trade receivables or a specialty finance lender securitizing loans, retains a residual interest in the performance of the assets. This interest obligates the issuer to cover losses in the asset pool up to a certain percentage. If losses exceed that percentage, other low-rated, subordinate tranches of the issuance begin to absorb them, with the loss climbing up the rating scale. The post-Enron fear taught the market that there are all sorts of toxic sludge out there hidden below the surface. Lack of specific transparency coupled with certain macro danger is an explosive mixture in a jittery market.

The risks for banks go beyond CDO exposure. The banks are also obligated to provide liquidity support if cash flow from the conduits the structured is not enough to pay off the paper as it matures. If enough loans in conduits go bad, the sponsor banks could be liable beyond their capital can sustain. The US economy is strong and resilient and can be expected with weather each and every one of these financial problems separately. But the US economy is now predominantly a finance economy and a confluence of interrelated financial market failures can put a mighty economy in intensive care for a long time.

Even a Triple-A-rated company like General Electric could be vulnerable if it were unable to securitize assets easily. Through GE Capital, its finance subsidiary, GE uses sponsored special-purpose entities (SPEs) and conduits to securitize loans and receivables fro itself and for clients. In its latest annual reports, GE asserts that if required in the event of an accounting change regarding the consolidation of SPEs, GE could use “alternative securitization an insignificant incremental cost.” Still, skeptics say that GE’s statement in its annual report about SPEs is misleading, because such an accounting change would likely affect all off-balance-sheet financing alternatives. And if GE has to finance the assets on the balance sheet, the impact on its financial statements will be more than incremental.

What has compounded the problem is that nobody yet knows who holds the commercial paper that is exposed to the US sub-prime mortgage market and has been dubbed as toxic. Commercial paper is typically bought by pension and insurance funds. But until these funds can work out their exposure, they are refusing to buy more. It is this buying strike that has created the liquidity freeze.

Skepticism over SMELEC

The Treasury constantly monitors financial markets. By mid year key market participants were telling Anthony Ryan, Treasury's assistant secretary for financial markets, their rising anxiety over the asset-backed commercial paper market from which SIVs roll over the short-term debt. The market saw a massive restructuring approaching with a potential for a disorderly unwind of many SIVs. The Treasury became actively engaged in the seeking a resolution by playing a lead role in facilitating discussions among competing banks.

Critics charged that the Treasury is essentially helping big banks escape from the financial pain of risky bets that turned sour, banks that in earlier years has given banks huge profits. Ryan countered that the government's role was merely to “facilitate market participants” and that no public sector money was involved. At any rate, the super SIV being created is “voluntary” and that no bank is required or forced to take part. Still, a big promoter of the arrangement is Citigroup which has the largest risk exposure from SIVs.

Citigroup, which is the largest sponsor of SIVs with seven such affiliates, has been criticized that its own SIVs would benefit most from the plan. Bank of America will also benefit; . The Charlotte, N.C., bank's mutual funds are big investors of commercial paper, including debt sold by the SIVs. Bank of America said its concern wasn't whether the commercial paper would be paid off but rather the unnecessary seizing up of the market. Reportedly, the price of admission for SIVs will be high. SIVs will only be allowed to sell assets rated AA or better and likely will be unable to sell collateralized debt obligations: pools of debt repackaged into slices with different levels of risk and return, backed by subprime assets. In addition, the SIVs will have to pay a fee to the super conduit and accept a discount in the price of the securities they are selling. In return for that discount, the SIVs will receive notes in the “junior” layer in the conduit which will take the first hit if losses are incurred.

The restructuring of SIVs also raises the specter that certain SIV note holders may find themselves stuck with unexpected losses. Many fixed-income managers are intrigued by the idea of investing in a "Super SIV" fund. But some also say they are wary of the complexity of the proposed fund.  The banks will essentially sell all of their currently off balance sheet Structured Investment Vehicles (SIVs) to the SMELEC, and use their own balance sheets to buy the commercial paper issued by the SMELEC to finance these purchases. Participating banks will “insure” investors against some portion of future losses within the SMELEC.

In November 2005, Merrill Lynch chief executive E. Stanley O’Neal told investors that the brokerage firm would shift its strategy and would become more aggressive investing its own money to increase profitability.  Two years later, asked how Merrill Lynch could lose so much money, O’Neal said: “We made a mistake,” as he resigned from the company with an option and retirement package of $161.5 million.