Friday, August 24, 2007

Will conduits sink banks? No. Will they (help) sink the economy? Yes.

Today's FT has an nice article on the conduit, ABCP situation, as it relates to banks. I especially like the opening about the large UK bank, HBOS:

HBOS’s annual report for 2006 covers almost 200 pages. But the document does not carry a single reference to Grampian Funding, the vehicle the bank uses to help lower its financing costs. So investors could be forgiven for expressing some surprise on Tuesday when HBOS announced that it would take direct responsibility for financing Grampian.

Grampian, which has assets of about $37bn, is one of Europe’s largest bank conduits. These are funding vehicles usually kept off a bank’s balance sheets that have emerged as pivotal players in the current market turmoil. HBOS, the UK’s fourth-largest bank, is the largest financial institution so far to publicly admit the effects of the drought in the market for asset-backed commercial paper, which conduits such as Grampian rely on for funding. But other banks are suffering as well.

The article goes on to discuss the impact on banks generally of putting all the conduit's onto their balance sheets. Analysts - those clever creatures who know all the facts but rarely seem to be able to notice the forest before it crashes on top of them - have used their sharpest pencils to calculate that bank's capital ratios will drop by only a bit (0.4 in the case of HBOS to 7.3%) and yes there is the obligatory reference to the Basel II Framework (zzz). The analysts - many of whom will soon be unemployed - go on to note that the SIVs (special investment vehicles), cousins of the conduits, generally have higher asset quality and less reliance on CP funding.

Oh well that's all right then. But hang on, is it? I think the FT hit upon perhaps the key point in this odd mess when noting that HBOS's annual report of however many pages had nary a mention of this $37 billion beastie called Grampian. So for shareholders or creditors or others where HBOS is a counterparty, the point isn't really that Basil the 2nd is still pretty fit. The point is that one's confidence in the intelligence and skills of the managers of HBOS has taken a hit. Quite a big hit I would say. And though one cannot quantify the effect this has had and will have on HBOS and the other banks and the market in general, it is fair to say based simply on what we see happening, that the hit has been large. It is like the old chesnut that one's good reputation takes a lifetime to build but only a moment to lose. And once lost is recovered slowly and painfully.

Analysts are paid to quantify whatever is laying about that can be quantified. This may or may not have anything to do with the crux of the situation. In the case of ABCP and conduits, I think it does not. Confidence has been lost. At the margin the impact will be more expensive credit and less available credit. Multiplied across the hundreds of banks with - yes it is fair to say - secret conduits, the impact on the real economy will be significantly negative.

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