Firewall Strategy

15 October 2007



US Banks Form $75 Billion Subprime Rescue Fund

It’s only a matter of time before someone holding short-term subprime mortgage-backed securities in the US panics. When that happens, it could touch off a race to the bottom on prices. Such a mark down would be bad for the financial sector in particular, but it would damage the US economy as well. To prevent this, some of America’s largest banks, including Citi, Bank of America and JP Morgan, have set up a $75 billion rescue fund.

The idea is for these banks to purchase through the so-called “Master Liquidity Enhancement Conduit” [MLEC] highly rated assets from various structured investment vehicles [SIVs]. SIVs are specially created entities that sell asset-back commercial paper (that is, short-term debt, usually under 1 year) to make long-term investments. Recently, these SIVs have had trouble selling their paper because many investors are simple afraid of the risks to the entire asset class.

The fund’s backers have stated, “Recently, refinancing in the asset-backed commercial paper markets has been difficult despite the high quality collateral underlying many of these securities. The objective of MLEC is to facilitate these refinancings and to complement other market-based solutions in supporting an orderly and efficient market environment.”

The rescue fund is, in effect, the big banks trying to pump their own liquidity into the short-term debt market. The truth is there are some short-term commercial paper investments that are as good as gold (or perhaps oil is the better comparison these days), while others are toilet paper waiting to be used. The big boys will buy the good stuff, giving a needed shot in the arm to SIVs with decent, low-risk assets.

The MLEC is similar in concept to the package banks put together in 1998 to save Long-Term Capital Management, a quant fund that imploded as all quant funds eventually do if the use too much leverage. The banks will probably be able to turn a profit on these investments, but even if they don’t, their overall financial health rests on markets free of panic. This is, in some respects, an investment in their own well-being.

© Copyright 2007 by The Kensington Review, Jeff Myhre, PhD, Editor. No part of this publication may be reproduced without written consent. Produced using Fedora Linux.

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