Returning from New York this past weekend I opened the Wall Street Journal on Monday to discover yet one more chapter in the structured finance shell game. Evidently Treasury Secretary Henry Paulson picked up the bat phone to several of the largest US banks, begging them to work together in order to facilitate an orderly unwind of numerous off balance sheet structured investment vehicles (SIVs). The proposed Super SIV will try to float one year capital notes with proceeds earmarked for the purchase of SIV assets originally created by Citigroup. Thus Citi avoids two problems, an increase in reserve requirements from assets returning to their balance sheet and ongoing reputational risk.
At this point, the rational investor is throwing up his hands, and why not?
“I have never seen Treasury play this kind of role,” said John Makin, a visiting scholar with the conservative American Enterprise Institute in Washington and a principal with hedge fund Caxton Associates LLC. The banks made “riskier investments that didn’t work out. They should now put it back on their balance sheet.”
Paulson and Co have their hands full lately as trust and confidence in structured finance have been waning. Apprehension and/or the inability to mark securities to market have sent a shock wave through the credit markets. More recently we witnessed the following acts of desperation:
- Increased injections of liquidity by the Fed
- Broadening the collateral accepted (to include asset-backed commercial paper) and terms (from 7 to 30 days) of the repo market
- 100 basis point cut (two separate actions) in the discount rate and 50 basis points to fed funds
- Encouraging use of the discount window (formerly stigmatized) because banks no longer trust collateral being posted when lending to each other
- Proposed Super SIV whereby roughly 20% of the total SIV market is re-tranched
Clearly the credit markets are faced with unprecedented circumstances due to countless players and massive leverage. Unlike LTCM which required a NY Fed bailout, the credit markets today have grown incredibly opaque while derivative exposure has gone parabolic.
It’s obvious the SIV assets won’t be priced at market rates because there’s not much of a market to begin with (and why the super SIV exists in the first place). But where exactly do they get priced? To whose benefit? And by which standard?
Unlike the Bernanke induced rally two months ago, Paulson seems to be striking out in spades. The banking index is probing 52 week lows while Citigroup has dropped over 6% in 3 days.
This latest scheme, to which the ex-Goldman Treasury Secretary gives his blessing, attempts to put off the structured finance day of reckoning even further. Could the Super-duper SIV create the inevitable mark-to-market across most aspects of the securitization world leading to a run on the bank? Note to Hank: Beware the law of unintended consequences.
Exhale…. The worst is behind us according to Chuck Prince and the Citigroup enterprise he presides over. Citigroup released quarterly earnings this week as Wall Street embraced Prince and the banking sector with higher share prices. Consensus on the Street is “the worst is behind us” so let’s take a closer look. Here are a few of the items referenced by the people at Minyanville.com:
-Citigroup stated that forecast earnings for the quarter will be down 60% from the third quarter of 2006 so Citi should earn roughly $2.2 bln. Therefore, Citi’s earnings this quarter will not cover the dividend of $2.7 bln resulting in a lower shareholder equity number. One time event? Not if you read the following: “[Citi] will have additional assets as some portion of our leveraged loan commitments, and drawn liquidity facilities that we have for CP conduits, will remain on our balance sheet.”
-Over the past four quarters, Citigroup’s balance sheet has grown by 36% (roughly $600 bln) while capital has grown by only 11% ($12.4 bln). Further, a significant part of the build in Citigroup’s equity base came through the issuance of trust preferreds. In fact, total trust preferred rose from $6.2 bln to just over $10 bln. Based on
Citigroup’s forecast, Tier 1 capital will likely be less than the 7.9% reported at the end of the second quarter, and well below the 8.6% reported a year ago.
-The bulk of the funding for the $600 bln in asset growth over the past year came not through deposit growth (up $127 bln), but through short term borrowings (up $92 bln from $72 bln to $167 bln) and long term debt (up $100 bln to $340 bln).
Finally, Citi references signs of stress with their mortgage customers…
“First, our reserve increase reflects a change in our estimate of losses inherent in our portfolios, but not yet visible. For example, if a mortgage customer is making payments a few days later than normal or even into the grace period, this behavioral pattern can be correlated with future delinquency and future losses. Our reserve build this quarter reflects such behavioral patterns that we are observing in our portfolio as well as an enhancement to our loss estimation process.”
My comments: Leveraging the balance sheet has become commonplace within the banking world thanks to conduits, CDOs, SIVs (structured investment vehicles) and a plethora of other off and on balance sheet activities. Without question the world has become more precarious for both borrowers and lenders. Of course at present the Bernanke put has provided a short reprieve.
Returning from the long holiday weekend bulls continue to bank on several rate cuts by Mr. Bernanke while George Bush relieves a segment of subprime borrowers. More and more we witness “portfolio managers” recommending banks based on above average earnings or low price to book. Like the housing bulls several years ago we believe the ‘analysis” is flawed on several fronts:
1) Banks hold over $1.27 trillion in asset backed securities on their balance sheet, mostly mortgage related. Recent collateral repricings caused by tighter lending standards and ongoing foreclosures will create mark to market problems intermediate term. For example, due to national house price declines thus far and 2008 projections one could make the case for a 15% haircut to present valuations.
2) LBO debt exposure is roughly $300 billion, most of which has already declined by 10-12% due to the recent credit crunch. As deals get restructured and or cancelled write downs could approach $40-50 billion.
3) Banks are potentially on the hook for several hundred billion in asset backed commercial paper conduits which remain “off balance sheet” until something breaks. Accounting rules don’t require banks to separately record anything related to the risk that they will have to loan the entities money to keep them functioning during a markets crisis. Several bailouts both here and abroad have already been announced over the past few weeks. Today in the WSJ Citigroup reluctantly disclosed some of these off balance sheet conduits known as SIVs:
Conduits and SIVs are entities that banks use to issue commercial paper, which are usually highly rated, short-term notes that offer investors a safe-haven investment with a yield slightly above certificates of deposit or government debt. Banks use the money to purchase longer-term investments such as corporate receivables, auto loans, credit-card debt or mortgages. The two kinds of vehicles are closely related, although SIVs can also issue longer-dated notes, can use leverage and have tended to have greater exposure to mortgage debt.
Banks affiliated with the vehicles typically agree to provide a so-called liquidity backstop — an assurance the vehicles’ IOUs will be repaid when they come due even if they can’t be resold, or rolled over — for all the paper in a conduit. For SIVs, three to five banks typically offer a liquidity backstop, but only for a portion of the vehicles’ assets.
Those liquidity backstops have become important because gun-shy investors are in some cases refusing to buy commercial paper. That could force banks to ride to the rescue if it happened to one of their affiliated conduits or SIVs.
These conduits are substantial in some cases. Take Citigroup, the nation’s largest bank as measured by market value and assets. Its latest financial results showed that it administers off-balance-sheet, conduit vehicles used to issue commercial paper that have assets of about $77 billion.
My comments: In a U.S. banking industry with $857 billion in equity, roughly $1.75 trillion dollars of securitized real estate loans, LBO debt and off (soon to be on) balance sheet ABS commercial paper exist, certainly not an insignificant number. The threat to the banking system might not present itself in the amount of questionable loans it currently holds, rather in the number of good loans that might later prove vulnerable as weak holders of loan obligations in other sectors of the economy liquidate these loans. Even in a highly leveraged society in which the risk is widely dispersed, the unwinding process can quickly escalate. Housing bulls learned a lesson; will the bank buyers take notice?