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The Master Liquidity Enhancement Conduit

Written By Brian Hicks

Posted October 25, 2007

Just in time for Halloween, the corrupt financial industrial complex is up to its old tricks again. Weighed down with enough bad mortgage paper to cause a market crash, the system’s biggest culprits have now put together a plan that they hope will bury it all in the deepest of graves.

Not just content to take their losses and simply move on, the big banks have chosen instead to bury their foolishness at practically any cost. The real story, it seems, is still far too scary for them to tell. In short, it’s a "marked to market" nightmare that they will do anything–and I mean anything–to avoid.

Working together at the behest of the Treasury Department under former Goldman Sachs star Hank Paulson, Citigroup Inc. (NYSE: C ), JPMorgan Chase & Co. (NYSE: JPM ), and Bank of America Corp.(NYSE: BAC ), among others, have all begun to join hands now in the long dark walk into the shadows.

Their latest plan is called the Master Liquidity Enhancement Conduit, and while not finalized by any means, it is nothing more than a giant shell game.

The Master Liquidity Enhancement Conduit to Backstop SIVs and CDOs

Funded with between $80 and $100 billion dollars, the Master Liquidity Ehancement Conduit, dubbed the "Super Conduit," is designed to prevent the very fire sale of mortgage-related assets that the banks fear the most. Because discovering what these debt instruments are really worth in the open market (answer: not much) would rock the balance sheets of all of the institutions that hold them since they will then be forced to write them down.

In practice it will provide a backstop of value for these troubled securities by creating a market of buyers that doesn’t now exist. That will allow the banks involved to set the market on their own toxic paper as they in essence buy it from themselves. Cute, huh?

So much for the free markets.

But while the Master Liquidity Ehancement Conduit plan would provide a bid where now there is none, the ruse will do nothing to solve the fact that all of this paper is dinged beyond repair and near junk. There is, after all, a reason why nobody wants anything to do with it.

Under the Conduit plan, the bag of you-know-what just simply changes addresses, with the banks having rested their hopes on the fuzzy faith that someone will eventually buy it. Good luck with that one–flies is what it will actually attract.

Of course, the only thing scarier than the plan itself is the fact that we may need it in the first place.

Leaking SIVs–pardon the pun.

Behind it all is the continuing collapse of the Structured Investment Vehicles (SIV) created not coincidentally by a few ex-Citigroup geniuses based in London.

Designed to turn a profit by playing the arbitrage spread between the interest rates of two different sets of paper, the SIV’s literally played with fire. They borrowed money short term (270 days or less) with the one hand and they bought long with the other.

They sold short-term commercial paper (CP) at rates near LIBOR, and they bought longer-term assets offering much higher rates of return-mostly CDOs (Collateral Debt Obligations)–with the proceeds. CDOs are part of the mortgage mess that keep turning up everywhere the dead bodies are to be found.

And here’s the kicker: it is all an off-balance-sheet venture for the banks.

Of course it was a great plan while it lasted, but as the CP market dried up and investors decided to run from anything attached to the mortgage mess, it all has come crashing down. Because now that those short term notes have come due there is no fresh source of financing to pay them off.

That’s what has forced the bank involved to sell off the CDOs–which no one wants–to meet their short-term obligations. Those toxic CDOs, after all, were the collateral for all that CP.

That’s where the nightmare comes in for the banks, since the failure of so many SIVs could force them to dump the CDOs into a completely illiquid market, revealing their true value as they get "marked to market."

That, of course, would set off a daisy chain of events as all of the holders of these toxic CDOs would be forced to put their cards on the table and take their own markdowns. And beyond that, it would force all those losses back onto the balance sheets where they belonged in the first place.

The $400 Billion Question: How Big Is the SIV Problem?

So how big is the SIV problem? That’s the $400 billion dollar question, since that is the amount of money estimated to be involved in the SIVs. Citigroup’s share of this mess is $100 billion alone, which is why it literally can’t wait much longer for the Master Liquidity Ehancement Conduit to begin buying up their toxic paper.

Even then, though, that $80-$100 billion set aside by the big banks will likely come up short of what’s really needed. That’s because over the course of the next six to nine months alone $100 billion in short-term CP is coming due. That’s like trying to bury an elephant with a Dixie cup.

Even more troublesome is this latest tidbit: a good portion of the money used to buy all of that short-term paper came from money market accounts.

Fidelity, for instance, has about 4% of its money market funds invested in an SIV called, appropriately enough, Gordian Knot. Gordian has about $58 billion invested in bad paper. It calls into question exactly how safe those money market funds are after all–which is a scary story in itself.

So while the critics of the "Super Conduit" claim that it’s nothing more than a bailout disguised as more financial engineering, here’s hoping that somehow it all works out. Otherwise, the next bag holder in this mess will likely be the taxpayers.

I can hear the arguments now: These guys are too big to fail.

Their failure would likely dwarf the S&L bailout that cost the taxpayers $125 billion, because the losses here could easily be more than double that.

So don’t be surprised when the Bernanke Fed cuts another half point off the Fed funds rate, completely ignoring the fate of the dollar in the process. It’s not about an equities crash, its about a banker’s worst fear–a debt market crash.

The game is rigged, and Main Street doesn’t stand a chance.

By the Way: Merrill Lynch & Co., the world’s biggest brokerage, posted its first loss since 2001 yesterday. Its own mortgage mess triggered a bigger-than-expected $7.9 billion write-down during the third quarter. Merrill Lynch’s quarterly performance was by far the worst of the Wall Street firms.

The biggest trouble spot for the firm was its fixed-income business, which is typically one of the company’s top divisions in terms of earnings. This quarter, however, its revenues went negative as the unit lost some $5.6 billion because of its exposure to CDOs and sub-prime mortgages.

"In light of difficult credit markets and additional analysis by management during our quarter-end closing process, we re-examined our remaining CDO positions with more conservative assumptions," Chairman and Chief Executive Stanley O’Neal said in a statement. "The result is a larger write-down of these assets than initially anticipated." OOPs!

The wave continues build.

Wishing you happiness, health, and wealth,

Steve Christ, Editor