10/16/2007

A Primer on Co-guarantee Systems

JOSEPH R. MASON†

We all knew something was up when the Federal Open Market Committee
voted unanimously for a 50 basis point cut in the Fed funds rate September 18;
we just didn’t know what. We found out at least part of it recently. It appears
now that the Treasury was in negotiations with banks accounting for a large
portion of the SIV market to work out a means of co-guaranteeing a large
investment vehicle that could buy pieces of SIVs that were due to roll over this
fall and help maintain bank funding. Ultimately, the plan will benefit Citigroup,
which accounts for about 25% of the SIV market. Ultimately, the plan will fail –
perhaps spectacularly.
The reasons for my views are threefold. First, co-guaranteeing risk that never
leaves the banking system is a form of regulatory arbitrage that will create
greater opacity. Second, voluntary co-guarantee systems are doomed to failure
since only the weakest institutions want to participate. Third, the system will
again provide explicit recourse to purportedly “off-balance sheet” funding
arrangements whose risk never left the bank in the first place.

CO-GUARANTEES FURTHER MASK RISK

The basic problem is that risk does not go away just because it is held
elsewhere or in different structures. Suppose you and I agree to exchange risks. I
take on your risk, you take on mine. Risk does not leave the system and, in fact,
if our risks are equal neither one of us has reduced the risk we hold.
The problem is just another classic regulatory arbitrage. Although risk does
not leave the system, capital does. Somehow, regulators have been duped over
the years into thinking that guaranteeing the underlying risk is somehow different
than holding the risk yourself and should therefore be rewarded through a risk-
based capital charge reduction.
Regulators have been repeatedly confused by (pardon the pun) results of
repeated games. In a repeated market-funded world with a relatively small
number of investors, banks will strive to keep investors happy so that the next
funding will be obtained on favorable terms. How do you keep investors happy?
Make sure they do not take a loss. Hence, no matter what the contract says, the
guarantee is merely a shell masking the incidence of risk, and thereby potential
(or, more recently, realized) loss. Hence, the proposed plan merely created an
additional layer of opacity that will leave investors more confused about who
holds the risk, and will therefore result in greater market volatility. Bad idea.

† Associate Professor of Finance and LeBow Research Fellow, Drexel University

LeBow College of Business, Senior Fellow at the Wharton School, and Financial
Industry Consultant, Criterion Economics, LLC. Contact information:
joseph.r.mason@gmail.com; (215) 895-2944 of; (610) 805-9083 cell.
2 Joseph R. Mason

ADVERSE SELECTION IN VOLUNTARY GUARANTEE ARRANGEMENTS

Who wants to participate in a voluntary co-guarantee plan? Two principal

parties. First, banks that cannot fund themselves in the present financial
environment. Second, banks that want to buy those banks as principal creditors in
liquidation when the plan fails.
Banks that cannot fund themselves in the present financial environment
cannot really fund one another, but they can create the illusion of doing so while
hoping the crisis will pass quickly. S&P recently revised its forecast of the
market difficulties in light of recently revealed information about the
performance of the fourth-quarter 2006 and first-quarter 2007 subprime loan
vintages by extending the effects through 2009 although Bernanke only extended
his forecast through 2008. You can choose which one to believe, but the crisis
will not be over this fall.
Since the crisis will remain ongoing, so will the funding stresses in SIVs.
That means the probability that one of the banks involved will try to exercise on
the co-guarantee system is large. Historically, such exercise is associated with the
demise of the voluntary plan because none of the parties associated with the plan
have the capital to absorb the loss. Take, for instance, the attempts at state-level
voluntary deposit insurance systems in the US. Those state-level systems grew in
three broad historical periods, just prior to the Civil War, in the later 1800s, and
in the 1920s. Failed deposit insurance (which were, in those days, co-guarantee
arrangements) shared certain characteristics. When safe banks banded together
during calm periods to create a co-guarantee system that was based on
monitoring one another and promoting safe and sound banking practices, the
systems lasted longer than otherwise. When risky banks participated in the
schemes and were not monitored adequately (or when there was little incentive to
do so), the rapid failure of the risky institutions brought the system down quickly.
The adverse selection problem can be summed up simply in the words of
Groucho Marx: none of the risky banks wants to be the member of any club that
will allow them to join. The banks involved in the present co-guarantee scheme
are institutions with high liquidity and solvency risk. They have neither the
capital to absorb unexpected losses nor the incentive to do so, since the
commercial paper investments are purportedly sold. (Recall from above, the
repeated funding game.)

THE TREASURY SEEMS TO BE ACTING ON THE OCC’S BEHALF IN A TOO-BIG-

TO-FAIL SCENARIO

Some have maintained that the Bank of America’s participation in the

scheme provided capital depth that could better ensure safety. Setting aside, for a
moment, uncertainty about the underlying financial condition of Bank of
America and assuming they have adequate capital, is Bank of America really that
generous?
Promoters of the plan maintain that Citigroup and other parties in need of
liquidity will pay others (principally Bank of America) to bear the risk in the co-
guarantee arrangement. Bank of America, indeed, has pointed to the fees it will
generate in the deal. At the same time, however, the participants maintain that the
plan is necessary because the risk is difficult to measure and value.
September 2007 Quartet Market Crisis Update 3

Citigroup makes up about 25% of the SIV market and admittedly cannot
absorb $100 billion on its balance sheet without being rendered critically
undercapitalized. Citigroup is also exposed to much broader risks in the market,
that led them to announce a 57% year-to-year decline in quarterly earnings and
that they expect to write off billions of dollars due to heavy mortgage-related
losses. Hence, two distinct scenarios arise involving Citigroup’s success or
failure in riding out the storm. Let’s look at each in turn.

1. Citigroup Fails

Previously, I did not discuss the second participants in the voluntary co-
guarantee scheme: banks that want to buy troubled banks as principal creditors in
liquidation when the plan fails, above. Those participants include, both
historically and currently, Bank of America. Bank of America became Bank of
America through A.P. Giannini’s practice of buying failed banks in California in
the Great Depression. More recently, Bank of America purchased a large stake in
Countrywide, which is not yet out of financial distress.
So suppose that Citigroup is rendered critically undercapitalized. Citigroup,
as before, is too-big-to-fail, so the principal regulators, the Office of the
Comptroller of the Currency (for the banks) and the Federal Reserve (for the
bank holding company), in tandem with the Federal Deposit Insurance
Corporation, will have to arrange a marriage. Bank of America, having
previously been willing to play ball and holding a material stake in the enterprise
already, will be a likely candidate for a significant stake.

2. Citigroup Survives

In the event that Citigroup survives, the arrangement would stand as another
example of explicit recourse in off-balance sheet structured finance. (See, for
instance, “What is the Value of Recourse to Asset Backed Securities? A Study of
Credit Card Bank ABS Rescues.” (with Eric Higgins). Journal of Banking and
Finance, April 2004 (28:4), pp. 857-874. This paper is a revised version of
Federal Reserve Bank of Philadelphia Working Paper no. 03-6, April 2003.) In
that event, Bank of America’s investment would have been one in government
recourse and they would therefore have shrewdly profited from an investment
with de facto full faith and credit backing from the US Treasury (and arranged by
the Treasury, as well).

SUMMARY

In summary, we are witnessing the Treasury acting on the OCC’s behalf in

dealing with another episode of Citigroup’s too-big-to-fail status, which remains
firmly intact since the thrift crisis. The arrangements further entrench implicit
recourse as a means of bailing out structured finance arrangements, essentially
replacing credit card asset-backed security revolving collateral periods discussed
in my work with Eric Higgins with longer-term collateral revolving funding
periods.
Nonetheless, we cannot escape the question of, “if roll-back, or reversion to
the balance sheet in the event that the deal goes sour, is never allowed, how can
4 Joseph R. Mason

we continue to believe in the fundamental fallacy of true sale?” If regulators are

repeatedly misled by the necessity for repeated sales the regulatory
undercapitalization of such arrangements will continue to necessitate bailouts.
The US, like the UK, should roll back “true sale” under FAS140 to require banks
to hold some (even miniscule) capital against securitized funding arrangements.
Then, when banks needed to bail out investors (who they need to sell to again,
next month) they will have already reserved for the risk of having to do so.