Meme of the Day: Liquidity Puts and CDOs

Are you sick of the liquidity put yet? You shouldn't be, because it's only getting more and more interesting. There are three articles worth reading on the subject today, starting with David Reilly's WSJ column on whether Citigroup should move its $41 billion of CDO exposure onto its balance sheet. The answer is that yes, of course it should, since Citi's exposure to these vehicles is significant. But there also seems to be a very good chance that it won't take all this nuclear waste onto its balance sheet, since there's a colorable case to be made that accounting laws don't require it.

Reilly also moves forward the question of who owns the equity in all these trades: the answer, it seems, is no one. If you recall the chart I published on Friday, it shows that the equity investor puts in no money at all, which essentially means that the bank sponsor has at least as much exposure to the structure as anybody else. I thought that maybe this extreme structure was just a Canadian thing, but apparently not:

Like other banks, Citigroup structured these vehicles so they wouldn't be included on its books. The vehicles are created as corporate zombies that ostensibly aren't owned or controlled by anyone.

But is this just a Citi issue? According to Peter Eavis, writing on the newly-relaunched fortune.com, no. He says that Merrill Lynch and Bank of America have similar exposure, although they might have accounted for it slightly differently. And there might be more banks we don't even know about, too:

Almost every major banks has significant conduit exposure. But if conduits are becoming a problem, banks are not saying much about it in their financial statements.

I like the way that Eavis lumps in CDO vehicles and SIVs as just different types of conduit, with much the same kind of balance-sheet risk – I think that's exactly right. In other words, a bank's SIV exposure is always no more than a lower bound for its overall conduit exposure. And now that HSBC is taking its SIVs onto its balance sheet, banking-industry best practice clearly shows that all such conduit exposure belongs on the balance sheet and not off it.

Finally, Antony Currie explains how this situation came about in the first place, in an excellent backgrounder on CDOs in general:

As the market boomed, greed set in. By 2006, investors buying the riskiest slices of ABS CDOs, called the equity, could virtually dictate their own terms. And investment banks were willing to bend over backward if it helped win the business of arranging a deal. One example: Rather than funding the highest-rated portion of a CDO with long-term debt, banks often used much cheaper short-term commercial-paper programs.
That saved the CDO money, meaning more interest could be paid to the equity investors. Some banks even agreed to step in if lenders suddenly snubbed the short-term debt. That is exactly what happened, and this "liquidity put" has landed Citigroup with $25 billion, and Bank of America with $15 billion, of exposure to commercial paper backing CDOs.

Were liquidity puts confined to Citi and BofA? For the time being, it seems as though yes, they were. But no one knows for sure.