Credit bail-out in the works to stop fire sale

The stock market is up. The Fed has lowered interest rates. Credit spreads have compressed and LIBOR rates have fallen, but there is a still a rotten credit problem with CDO and other conduit programs. The crux of the matter is the pricing of these securities which is an alternative way of saying that there is no liquidity in these markets.

An important story in the Sunday NYT suggests that leading money center banks are in discussion with the US Treasury to structure an $80+ billion buy-out fund to support the SIV’s which are having trouble financing their portfolios and may be forced to sell at what would be considered fire-sale prices. The fund is named the Single-Master Liquidity Enhancement Conduit (SMLEC). So much for letting markets work.

With a lack of liquidity, there is no reason anyone wants to provide financing in the public commercial paper. This means that banks will have to provide credit facilities for the SIV commercial paper issuers. The size of the SIV market is over #00 billion so having to support the SIV would be a costly proposition Nevertheless, there is still the problem of pricing and liquidity. At what price should the banks mark this paper if it comes onto their balance sheets?

This dynamics of pricing is the reason for the Treasury to help negotiate some form of joint facility of what some have started to call a super-SIV. With the help p the government and agreement among all of the banks, there could be a way for the bad loans to be bundled in some form at prices which will not fully represent the fact that there is no liquidity.

This type of structure is full of difficulties. What are the values for these CDO? Who should get to participate in this deal? What is the impact on shareholders of the participating banks? What about firms that are holding CDO paper that is not participating in this deal. What should be the role of the US government? Most importantly, why is this needed in the first place, shouldn’t the market sort out the problem first. I thought the Treasury secretary stated that there was no liquidity problem?

There are many micro financial issues which are going to have to be discussed, but our focus is on the macro side and the picture does not look good. The effort to contain the problem just highlights the fact there is a problem which should spill over to US growth. At the very least, there will be a continuing story of global growth coming from outside of the US. This has been a change from what we have really seen from the last decade. The growth differential story will play out in all for the major asset classes. Growth differentials not favorable to the US will put more pressure on the dollar. The slow growth in the US will also mean that rates in the front-end of the curve will come down relative to the rest of the world. The global equity markets will also continue to outperform the US.

This credit bail-out will be important to watch and no a story that will disappear.