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November 18, 2007

Some Straight Talk on “Liquidity Puts”

"Liquidity puts" - yet another new and ominous sounding term for something that has been in existence for a long, long time. The term is defined in an 11/13/3007 article in Fortune as follows:

What Citi did a couple of years ago was insert a put type of option
into otherwise conventional CDOs that were backed by subprime mortgages
and sold to such entities as funds set up by Wall Street firms. The put
allowed any buyer of these CDOs who ran into financing problems to sell
them back - at original value - to Citi. The likelihood of the put
being exercised, however, was regarded as extremely remote because the
CDOs were structured to be high-grade entities called “super-senior.”

Have you ever heard the term “recourse?” It is a fairly simple concept that has been around over six centuries,
and is directly related to the aforementioned liquidity puts. The Merriam-Webster definition of recourse is as follows: 

Main Entry:

      \ˈrē-ˌkȯrs, ri-ˈ\
Middle English recours, from Anglo-French recurs, from Late Latin recursus, from Latin, act of running back, from recurrere to run back — more at recur
14th century 

1 a: a turning to someone or something for help or protection <settled the matter without recourse to law> b: a source of help or strength : resort <had no recourse left>2: the right to demand payment from the maker or endorser of a negotiable instrument (as a check)

 Turning to someone for help or protection? A source of help or strength? Sure sounds like a liquidity put to me. The interesting thing about recourse, however, is that it is generally believed that assets need to remain on-balance sheet if they are subject to its occurrence. Because, as a matter of fact, one does not know if and when those assets may be coming back to you, and should be accounted for in a conservative manner. This then raises the issue of securitization in general, and whether or not many of these vehicles should be off-balance sheet at all. A little blurb on securitization from Wikipedia raises the issue as well (the bolding is my own):

Securitization occurs when a company groups together assets or
receivables and sells them in units to the market through a trust. Any
asset with a cashflow can be securitized. The cash flows from these
receivables are used to pay the holders of these units. Companies often
do this in order to remove these assets from their balance sheets and
monetize an asset. Although these assets are “removed” from the balance
sheet and are supposed to be the responsibility of the trust, that does
not end the company’s involvement. Often the company maintains a
special interest in the trust which is called an “interest only strip”
or “first loss piece”. Any payments from the trust must be made to
regular investors in precedence to this interest. This protects
investors from a degree of risk, making the securitization more
attractive. The aforementioned brings into question whether the assets
are truly off balance sheet given the company’s exposure to losses on
this interest

This is the issue in a nutshell. Liquidity puts and its variants are strewn across the entire securitization landscape and have been for a few decades, and any investor that buys and sells the shares of financial institutions without understanding this concept is in for a lot of pain. The likelihood of incurring this pain has always been there, it is only that today’s markets being as they are that the fat tail of the distribution has finally come along to swat ignorant investors (and their unfortunate clients) in their pocketbooks. But don’t sit there and tell me that these risks are new, special and different. They’re not. It is only that certain investors have been awakened from their heavenly slumbers by a heaping dose of reality. And whose fault is that? If you want to play in the world of complex instruments read the documents. Very. Carefully. Don’t rely on the rating agencies - they won’t save you. And don’t count on clear and useful accounting rules or detailed company disclosures to bail you out. You’ve got only your own brains, perspective and diligence to count on. And if any of these three are lacking - look out.

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