MLEC: ‘initial’ thoughts

The big investment banks (led by Citigroup) have clubbed together to create a colossal $75bn SIV (Structured Investment Vehicle), which the banks hope will help solve many of their problems. The fund has been set up so that banks can pool and price bank debt, as well as CDOs, CLOs, residential mortgage backed securities (and anything else they can chuck in) that they’ve had problems selling and pricing recently. MLEC is supposed to stand for Master Liquidity Enhancement Conduit; cynics might call it the Market Level Evading Conduit.

Banks sponsor or invest in SIVs, because they provide leveraged returns from a diversified and high quality portfolio of assets. SIVs buy (or to be more precise ‘used to buy’) bank capital notes.

Banks like the high returns that SIVs provide, and they definitely like the fact that SIVs remain off balance sheets. The off-balance sheet financing means SIVs require no regulatory capital, whilst providing a nice and predictable income stream for the bank.

As SIVs have grown, more and more have been created, thus creating more capacity. The huge demand for bank paper (amongst other things) from SIVs (and other forms of structured credit like CDOs) has until recently been a huge compressor of corporate bond spreads. And so, in a nicely self-perpetuating (or incestual?) manner, the tight spreads have resulted in banks’ cost of capital falling. And the more SIVs they create, or the more capital the banks give them, the cheaper the banks’ cost of capital becomes.

The credit crunch has meant that SIVs have been struck by their perfect storm. They cannot issue any more debt because nobody’s buying it, so the SIVs cannot buy bank capital securities. Indeed, some of them have to look to sell their assets to pay their debts. And, thus, the value of these assets falls. Then banks’ capital notes cost a lot more to issue, and their capital efficiency is impaired, and their returns fall.

So, what do the banks do? They bend over backwards to avoid a fire-sale of their capital notes by the SIVs, and agree to set up MLEC, an opaque, anti-free-market vehicle that enables SIVs to avoid marking their assets to market, with the ultimate aim of avoiding the re-pricing of risk of their capital notes. We’ll give it a miss, thanks.