October 23, 2007 / 7:01 AM / 12 years ago

Champions of U.S. superfund seen losing argument

ZURICH (Reuters) - Whether a $75 billion (37 billion pound) fund to rescue the battered mortgage-backed securities market takes off or not, its sponsor U.S. Treasury Secretary Henry Paulson seems to be losing the argument over its merits, strategists and economists said.

U.S. Treasury Secretary Henry Paulson answers questions after delivering a speech to the Georgetown University Law Center on "Homeownership, Mortgage Markets and the U.S. Economy" in Washington October 16, 2007. REUTERS/Hyungwon Kang (UNITED STATES)

The fund, announced last week by Citigroup (C.N), Bank of America (BAC.N) and JP Morgan (JPM.N) with Paulson’s support, aims to prevent structured investment vehicles (SIVs) from making panic sales of bonds linked to U.S. subprime mortgages.

Many of the SIVs — off-balance sheet vehicles holding some $370 billion in assets that rely on short-term financing to make a return — are struggling to stay afloat as investors shy away from buying their commercial paper.

The plan has faced a rising tide of criticism, not least from former Federal Reserve Chairman Alan Greenspan, who said last Friday the superfund may do more harm than good.

Financial strategists contacted by Reuters said time is running out for the plan’s champions to regain the initiative and the fund risks being still-born.

“I think they are losing the intellectual argument,” Ian Harnett, a Director at financial consultancy Absolute Strategy in London said on Monday.

The fund was nevertheless more likely than not to go ahead because of the potential embarrassment for the three U.S. banks and for Paulson himself if the idea is scrapped, said Harnett.

“I would still put it at 70 to 30 that it does happen because of the reputational risk,” he said.

A global credit crunch, originating from huge losses in U.S. subprime mortgage lending, has put acute pressure on SIVs, as demand dried up among investors for the short-term paper SIVs issue to fund investments in high-yielding asset-backed securities with longer maturities.

A fire-sale of assets by the SIVs, set up mainly by banks, would force banks into a fresh round of writedowns of securities held on their balance sheets and result in them granting fewer of the loans that are the life-blood of the global economy.

SMOKE AND MIRRORS

The fund would buy high-quality securities from SIVs which are forced to sell assets as their short-term funding runs out.

Much criticism has focused on whether the fund, called a master liquidity enhancement conduit, would help shed more light on the shadowy world of structured finance.

U.S. economist Paul Krugman, writing in the New York Times on Monday said it looked “like an attempt to solve the problem with smoke and mirrors.”

“This rescue scheme could be seen as an attempt to hide the bad debts everyone knows are out there, and as a result could delay any return of trust to the markets,” he added.

European credit markets initially gave a cautious thumbs-up to the plan, with spreads tightening early last Monday. But as the week went on, analysts said there were more questions than answers raised by the fund, and spreads ballooned again.

Even analysts who are broadly sympathetic to the fund’s objectives say its sponsors have much more explaining to do.

“The idea is theoretically sound but you have to have the financial world buy into it otherwise it won’t take off,” said Andrea Cicione, a credit strategist at BNP Paribas (BNPP.PA) in London.

“It’s very important to understand the details and very important they explain how they arrive at pricing. It’s going to be about transparency,” he added.

Some commentators say if the fund does not take off, in some form, the alternative would be forced asset sales, setting off a descending spiral in financial markets.

In a sign of the worsening crisis, the ratings on two SIVs — Cheyne Finance and Rhinebridge — were cut on Friday to D, or default, as payments were missed on senior debt.

“Dithering about how it (the fund) is constructed will raise the risk that the moment is lost,” said Avinash Persaud, who heads London-based financial advisory firm Intelligence Capital. “The longer liquidity crises last, the deeper they go.”

Persaud said banks taking part in the fund should be forced by regulators to treat their involvement as provisioning, and set aside capital accordingly, rather than a new investment.

“The regulator should treat the fund for what it is. It is a direct consequence of previous activity and if it is treated like that it can only be a good thing,” said Persaud.

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