More Notes On The Super Conduit

| November 13, 2007


I wrote a month ago about the formation of a strange new entity called the M-LEC or “Super Conduit”. At that time the main forces behind this were Citibank, JP Morgan / Chas and Bank of America. Once again obscure, seldom mentioned work behind the scenes is having a profound effect upon all of us, lets see how.

What is unusual about the economic turmoil of the past 5 months has been that it is hitting hardest in the financial world. In the past, recessions and downturns effected consumers or specific manufacturing segments (such as the Defense downturn of the early 90s) before causing any chain reactions in the broader economy.

This time, the impact is first and foremost at the largest, (theoretically) best run companies in the world. Some would say the very pillars of our economy. A crisis that starts in the high end of the financial world was last seen during the 1907 Knickerbocker Panic.

This all comes down to lending money, lots and lots of money. During the past 4 years or so, billions of dollars were lent out that should never have been loaned. Reading the normal news channels, you would think the only problem is in the US Subprime housing loans, but actually the rot is much broader than that.

When the US Federal Reserve wants to pump more money into the economy, they do so by loaning it into existence. These loans are made to the biggest banks, their “tier 1” partners who in turn loan this money out to investors or smaller banks. Both Bruce Webster and I have spent many years working on some of the primary plumbing for this pump, Fannie Mae.

For many forms of big loans, such as mortgages or large private equity buy-outs, the money is raised by creating bonds, which are sold on the open market. For many years early this century, these private bonds were a favored investment vehicle, and like any other hot trend (like .com stocks in the 90s or silver in 1980) everyone and their monkey was piling in.

The biggest names were some of the biggest players in this game, and they made huge windfalls facilitating the tremendous growth in the economy that resulted. They also began to use a new way to package and sell groups of loans, where they would combine many smaller loans of different risk grades into a single large offering. The thought being that the mix in types and grades would act as a hedge to keep the general bond value stable. Most of these were sold on the open market, but many of these large companies would end up holding portfolios of these as investments. These became known as Collateralized Debt Obligations, or CDOs.

Companies like Citi, Merrill Lynch, Goldman-Sachs and others generated, sold and held many billions of dollars in these CDO investments. The ones they chose to hold appeared like any other asset of the company, and helped these same companies post tremendous profit growth and earnings for several years. When the CDOs went on the books, they did so at a declared value, a value that was computed using a complex formula or model. This is called “Mark to Model”, and is a standard industry practice.

Now we face a different situation, and these same companies are now beginning to regret their CDO holdings. In the past year, many of the assets behind these CDOs (like home mortgages) have fallen behind on payments or defaulted. This has caused the credit-worthyness of the pieces assembled into these large CDOs to be called into question. As a result the prices that anyone is willing to pay for new offerings has been falling through the floor.

In a free market economy, the value of anything is precisely what someone else is willing to pay you for it. As the value of the assets in the CDO fell, the companies holding them began to worry. Could the investment of $100 Million end up being worth a lot less than they expected?

If they were forced to re-value them, it would appear as a huge loss on their profit and loss statements required by law. For the big companies they want to avoid them at all costs. For companies like E-Trade, the gap could actually equal more money than they have (they would be bankrupt). While this is bad if a middle tier player like E-Trade gets hit, if one of the Fed’s Tier 1s (or several of them) were to blow up in this manner, it could destroy confidence in the US economy, and cause a lot of trouble for years to come. This is something everyone wants to avoid at all costs.

Well, they don’t have to re-value them if they don’t have to sell, right? Well, enter the credit crunch – brought on because everyone who buys bonds (they way new money is loaned into existence) no longer trusts the value placed on the notes being sold (because of the CDO mess emerging) and things lock up hard. Companies (like the tier 1’s) who survive by moving huge amounts of money around are now cut off from the supply by their own mistakes. They have to raise money to stay alive, do they really want to sell off the CDOs after all?

This is where the super-conduit comes in. What this amounts to is a huge shared investment fund that they will transfer this rotten debt into, cleaning their balance sheets and possibly saving their bacon. Some of you may think this is the same kind of hokus pokus that Enron pulled except on a gigantic scale, and you would not be wrong. But many of the biggest names in finance are betting this could allow them to dodge the possibly fatal trap they have put themselves in.

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Category: Credit Backlash, Economics, Main, Recession Watch

About the Author ()

Bruce Henderson is a former Marine who focuses custom data mining and visualization technologies on the economy and other disasters.

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