Dangerous Waters for a Bailout

Why the big banks' plan to help rescue the credit markets is off to a shaky start

by David Henry

The megafund that the nation's three biggest banks are hoping will resuscitate a chunk of the credit markets was initially greeted with enthusiasm. But it isn't clear how the plan, hashed out in six weeks, will work—a weakness that could undercut its original intent.

When the credit markets seized up this summer, it became clear that so-called structured investment vehicles (SIVs) simply wouldn't survive. Those entities, which the banks can keep off their balance sheets if they follow certain accounting rules, are investment pools that use short-term commercial paper to buy higher-yielding securities, including collateralized debt obligations (CDOs) backed by risky subprime mortgages. Now those SIVs can't refinance their short-term commercial paper. With $325 billion in assets, SIVs could cause widespread damage across the credit markets. "The last thing anyone needs is the assets being sold at fire-sale prices," says Sylvie A. Durham, a structured finance lawyer in New York with Greenberg Traurig.

But there's plenty of uncertainty surrounding the $80 billion rescue plan. The proposal, which is being aggressively pushed by the Treasury, hasn't been fully developed, in part by design to test the degree of interest from potential investors who might want to weigh in on the specifics. And some elements of the plan that have been worked out seem to be at cross purposes with what Citigroup (C), JPMorgan Chase (JPM), and Bank of America (BAC), the main sponsors of the megafund, are hoping to achieve. With so much still unresolved, there's no way of knowing how effective it might be.

Internally Inconsistent

Part of the problem is the inherent contradictions in the proposal. For one thing, the superfund plans to buy only the best-rated securities from the SIVs, mainly those that haven't been tainted by subprime. So the SIVs still won't be able to unload the most troubled investments in their portfolio. It's a bit like trying to keep a mortally wounded patient alive while harvesting the good organs for transplant. Although selling securities to the superfund would allow the SIVs to scrounge up cash to pay off their debts, a growing percentage of their portfolios would be toxic. And if the credit ratings on their remaining investments sink too low, some of the entities may have to liquidate their assets as required by their charters. That could potentially trigger the fire sales the rescue plan was designed to prevent. "SIVs will be even more exposed to erosion of credit quality in the remaining assets," says Christian Stracke, an analyst at CreditSights.

There's also a real likelihood that those already bruised assets will continue to rot on the vine. Some are CDOs contaminated with securities backed by subprime mortgages. On Oct. 11 rating agency Moody's Investors Service (MCO) cut the grades on a raft of mortgage securities worth some $33.4 billion. Downgrades on CDOs that own those investments will follow. Standard & Poor's downgraded $4.6 billion of mortgage-related investments on Oct. 15. "The banks are hoping the more questionable stuff becomes more attractive to the market in time," says Stracke.

It's also not clear how the superfund will value the assets it does pick up from the structured vehicles. It will certainly buy them at a discount to their original prices. But there are no reliable market prices now. Paying too much will threaten the superfund's returns and its ability to raise money from investors. On the flip side, if prices are too low, that could further damage the SIVs that the rescue fund was supposed to help.