“People of the same trade seldom meet together, even for a merriment and diversion, but the conversation ends in a conspiracy against the public, or is some contrivance to raise prices”—Adam Smith 1776 Wealth of Nations

 

Therefore, for Mr. Paulson, the Secretary of the Treasury, to put his prestige behind the three largest banks in the United States and leading institutions to form an alliance in order to shore up the Structured Investment Vehicle (SIV) market is a “slap in the face” of the famous Scottish professor who is the Father of Economics.

 

The Opinion of the Wall Street Journal

 

In today’s Wall Street Journal, Wall Street Reckoning, the editorial writers pointed out their frustration at not being able to ferret out all the facts involved in the Citicorp problem involving some $80 Billion Dollars of Structured Investment Vehicles. The Wall Street Journal pointed out that Citicorp and the Secretary of the Treasury are doing everything possible to help Citicorp avoid monumental losses from their off balance sheet exposure to this monumental conduit. The Wall Street Journal asked the obvious question “Why would anyone not involved in subprime straits” want to invest in any bailout of Citicorp irrespective of Mr. Paulson’s arm twisting. Stated differently, if the Wall Street Journal with the best financial sleuths in the business unable to get to the bottom of the problem, I can assure you that my efforts will also be feeble. However, I do have some “painful” suspicions as to the reasons for the “veil of secrecy” and some concerns that the truth could hurt Citicorp tremendously. 

 

In a nutshell, I think that Citicorp lent many of the investors money to purchase the debt obligations of the SIVs and that the only collateral that Citicorp received was the investors “equity” in the SIVs. Alternatively, Citicorp could have invested in let us say another issuer’s SIVs with the quid pro quo that the other issuer invests in Citicorp’s SIVs. If my suspicions turn out to be facts, then 1) Citicorp could be financially responsible for the $80 Billion of SIVs because the investors will default on their loans to Citicorp and 2) Citicorp could have violated regulatory limitations on the amount of exposure that they can have to any given class of investments. To put it bluntly, we are discussing a potentially major financial problem.

 

The Wall Street Journal goes on the say that it is vital to the larger financial system that the big banks (Citibank is the largest bank in the United States) are honest about their mistakes, and clean up their balance sheets, and generally police themselves. The short phrase for this is “Marking to Market.” In essence, the Wall Street Journal believes that Paulson and Citicorp’s desire for the creation of a $100 Billion dollar superfund will not solve the problem, and this cover up could actually hurt the credibility of the financial system. In essence, the Wall Street Journal believes that the system is best served by Citicorp being responsible on its own for cleaning up this mess rather than have a political solution, which could hurt in the long run the capitalistic system.

 

Mr. Paulson has taken these unprecedented steps because he is deeply concerned about a meltdown of the $400 billion-dollar SIV market. The meltdown could have catastrophic implications for Citicorp, a commercial bank that controls about ten percent of all deposits in the United States. Furthermore, what is bad for Citibank is bad for the financial marketplace.

 

If Citicorp’s Fathering of $80 billion-dollar SIVs is off balance sheet, why are both Citicorp and the Secretary of the Treasury concerned?

 

1. First of all, let me say, that the details are still too sketchy for anybody to conclusively state why a problem exists.

2. However, let me give you some of the reasons for the concern

1. Investors stand to loose billions of dollars if the collateral backing the SIVs sells at a substantial discount.

2. Some people have speculated that Citicorp could have lent the SIV investors the money to purchase the SIVs. If the only collateral Citicorp received was SIVs, then Citibank could risk losing billions on bad loans.

3. The total size of the SIV market is $400 billion. Thus, the magnitude of losses could be significant especially on the lower quality tranches. 

 

Introduction:

 

Over the past few weeks, there has been tremendous publicity about the efforts of the Secretary of the Treasury Henry Paulson to form a consortium, led by the Bank of America, Citicorp, and J.P. Morgan to bail out investors in Structured Investment Vehicles (SIV). Mr. Paulson’s concern is that the meltdown of the $400 billion-dollar SIV market through the distressed sale of the lower quality assets held by SIVs will destabilize the credit markets and ruin the reputation of some of its corporate sponsors such as Citicorp. My rejoinder is that A Fool and His Money are Quickly Parted. That is, while I do not know Chuck Prince, I have been told for forty years, that Robert Rubin, the Vice Chairman of Citicorp, could give Einstein a run for his money. Is it possible that Mr. Rubin was playing Mr. Einstein’s violin while “Citi” was “burning”? 

 

We are told that the credit squeeze on some $400 Billion dollars of these SIVs stems from their mismatch of the maturity of the assets in these pools and their funding sources. That is, supposedly the assets are long term investment grade quality and the funding sources are short term commercial paper. Given that an elementary lesson in finance highlights the fallacy of using short term funds to invest in long term assets, it is surprising that $400 billion of this vehicle was created and that Citicorp set up seven affiliated funds that invested about $80 Billion in SIVs. Of course, the answer is also as old as the history of mankind—reckless greed. Citicorp threw the dice to make possibly as little as an extra $300 million per annum. This role of the dice was based upon their assumption that a meltdown of the SIV market would not explicitly impact their balance sheet or their reputation.

 

Given the veil of secrecy that surround the asset make up of SIVs and the nature of the beneficial ownership of the SIV, it is premature to speculate how damaging a SIV meltdown would undermine Citicorp’s image and prestige, the most important asset of any financial fiduciary. 

 

Frankly, I have read reports that indicate that over 99% of the assets of the SIVs were rated “A” or higher. Frankly, I am mystified that the SIVs would be trading so low, if the assets were of such a high investment grade. Certainly, over time, investigators will uncover the credit quality backing the SIVs.

 

What is a SIV?

 

A SIV is legal husk. That is, SIV are off balance sheet special purpose entities that are controlled by the banks that create them. Interesting enough, they are not owned by the bank, and are technically independent of the bank. However, they could never exist without the full support of a bank. The Wall Street Journal recently referred to them as “corporate zombies.”

 

Before we go too far in this essay, let us define Structure Investment Vehicles or “SIV.” SIV is an investment company which generates returns through yield curve arbitrage by purchasing medium- and long-term high grade (AAA, AA, A) and some junk bonds and funds itself with low-cost short-term senior debt instruments such as commercial paper. Interestingly enough most SIVs do not have conventional owners; that is, the profit beneficiaries of this vehicle are the subordinated debt holders. According to the Moody Investor Service, the average SIV has an asset breakdown of 62.4% AAA, 27.9% AA, and 8.9% A. This adds up to 99.2% investment grade. Needless to say, if Moody’s is correct, then “There is something Rotten in the State of Denmark.”  SIVs currently do not provide transparency. Obviously, these securities could not be trading at below $.70 to the dollar if in fact the SIVs literally have 99% of their investments in high grade securities.

 

My First Recommendation

 

I think for the sake of the world’s financial system, we should hire some third-party fiduciaries to inspect the books of the SIVs to corroborate the credit worthiness of their holdings. The specter of a financial meltdown requires third party verification so that financial engineers can fix this Mr. Hyde invention.

 

Is Citicorp guilt of something beyond Stupidity?

 

The short answer is that it is premature to judge Citicorp and its executives. As a friend of mine reminded me recently, we are all innocent to proven guilty.

 

While we certainly can accuse Citicorp of stupidity in creating the SIV credit crisis, we have not proven that Citicorp breached the legal walls in creating $80 billion of SIVs associated with the bank. I do not want to make the same mistake as the prosecutor of O.J. Simpson and make Mr. Prince try on the “plastic gloves.” Instead, I will simply say that Mr. Prince irresponsibly risked Citicorp’s reputation to make a few extra bucks. In essence, I am old dog who was trained in an era when you were subject to criminal punishment for making disparaging comments about commercial banks. At this stage in my dog life, I just cannot learn new tricks and scream out loud my incredulity about the unsavory role played by the Federal Reserve and Citicorp in allowing these corporate zombies to exist. In essence, off balance sheet financing is a ticking time financial time bomb.”

 

Possible Current Citicorp Transgression

 

The potential scandal involving Citicorp involves some $80 billion dollars in Structured Investment Vehicles (SIV) that were held by seven off balance sheet subsidiaries of Citicorp. Citicorp set up these off balance sheet entities under a loophole established by the Federal Reserve. However, this ability to keep the SIV off the balance sheet depends upon the ability of the creditors of the SIV to take losses. That is, if the creditors are shells or affiliates of Citicorp then the “independence” status is compromised. Since Citicorp only has $65 Billion of book value, this creates a major problem.

 

Why would a bank want to be associated with a SIV?

 

The banks profit from the creation of SIVs by earning fees from their transactions with the SIVs, and earning an interest differential between their short-term borrowings to fund their long-term assets. In the case of Citicorp they borrowed in the commercial paper market, and invested in a hodgepodge of illiquid, low quality assets such as junk bonds, and sub prime mortgages.

 

Bank of America and J.P. Morgan are willing to work with Citicorp to extradite the later from its dilemma because they expect to earn large fees.

 

How can a company profit from an off-balance sheet entity when companies are not allowed to control of the book partnerships while still claiming they were independent?

 

Alas! The regulators made an exception for the commercial banks. The sad truth is that American companies end up controlling their regulators. This fact of life which has been documented repeatedly at the Interstate Commerce Commission, the Interior Department, the Pentagon, the State Department, etc. is imbedded in the American business fabric. 

 

However, Citicorp could have crossed the line! There is a regulation under the Federal Reserve Act known as Section 23 A.  This prohibits “covered transactions” with any one affiliate of a Fed member bank in excess of 10% of the bank’s capital and surplus, and 20% in aggregate for all bank affiliates. That is, if it discovered that the creditors of the SIVs cannot take losses or invested because of an implicit guarantee by Citicorp than Citicorp must put the SIVs on their balance sheet. Alternatively, if Citicorp invested in another issuer’s SIVs with the quid pro quo that this other issuer would invest in Citicorp’s SIVs this certainly would violate the spirit of the law.  

 

Has the Federal Reserve failed to Impose Strict Standards for Citicorp?

 

The Federal Reserve has in essence closed its eyes to the Citicorp transgression. That is, the Federal Reserve has encouraged the banks to exceed their legal lending limits to affiliates and then the Federal Reserve has allowed the banks to use the shady assets found in the SIVs to borrow at the Federal Reserve Discount window. Historically, the Federal Reserve only lent against U.S. government guaranteed paper. Allowing SIV assets to be margined by the commercial banks is certain letting Citicorp get outside the Pale.

 

Will the Creation of a Super-Conduit save the mess?

 

Increasingly market savvy participants question both the motive and the effectiveness of the efforts by the Treasury to save Citicorp’s credibility by getting a consortium of financial institutions to provide guarantees on the SIVs.  Market participants point out that the holdings of the SIVs are toxic; that is, they are low-quality long-term assets and not mostly investment grade securities. In order to solve the SIV induced crises, the bail out has to include all $400 billion of SIVs outstanding.

 

What Transgressions has Citicorp Made in Recent Years?

 

1. Citicorp has paid significant sums ($2.65 billion) to creditors of Enron under a class action settlement. This payment was for their part in hiding losses by loaning money to those companies in a special way that would reduce liabilities visible on the balance sheet.

2. Citicorp’s three top executives in Japan had to resign because of their role in helping Japanese citizens launder money. Citicorp used deceptive sales tactics and helped its clients commit fraud.

3. Citicorp was involved in trying to disrupt the European bond market by rapidly selling about $18 billion dollars of bonds and then profiting when they repurchased these securities after causing a panic.

4. Citicorp paid enormous fines for providing false and misleading stock research during the dot.com frenzy. Their dishonest research cost investors billions of dollars. Citicorp was required to bring in a new Director of Research from outside the commercial bank who would be totally independent of their investment banking department.