Credit lifeboat comes with moral hazards

Credit lifeboat comes with moral hazards

What’s the best way to rescue stricken credit vehicles? The answer, it seems, is to create an even bigger one. Under plans encouraged by the US treasury, three leading investment banks will launch a $75 billion (Rs2.95 trillion) conduit which will buy the assets of those structured investment vehicles (SIVs) currently struggling to find financing.

Conceptually, the move makes sense. SIVs are typically off-balance sheet funds that invest in asset-backed securities, including mortgages, and are financed through the short-term commercial paper market.

Unlike conduits, which have a full bank guarantee, SIVs tend to have only a partial bank guarantee. That means if they run into financing difficulties as commercial paper programmes roll over, they will be forced to dump assets at firesale prices.

That can have knock-on effects for the entire banking industry, forcing other holders of similar assets to mark their positions to the new lower market price, which may in turn trigger further firesales.

It’s not yet clear how the unpromisingly-titled Single-Master Liquidity Enhancing Conduit (SMLEC) will work in practice—that is likely to be revealed later on Monday. But the likely total credit guarantee of around $75 billion is enough to absorb about one-third of the estimated $250 billion of industry-wide SIV assets.

Assuming that is enough to roll over all forthcoming financing programmes for the immediate future, that should remove a major element of uncertainty from both the commercial paper market and the asset-backed securities market. If the commercial paper market reopens, banks will be under less pressure to hoard cash to honour guarantees.

In this sense, the SMLEC is, therefore, a welcome attempt to ease the credit squeeze, which is already taking its toll on the world economy.

Still, as with all central bank-orchestrated lifeboats, the SMLEC presents the usual array of moral hazards; prudent banks with minimal exposure to SIVs that hoped to profit from distressed sales will lose out; while banks that piled into SIVS, and which stand to lose most if market prices fall further, will find their recklessness goes unpunished.