Citigroup Lands in Drudge's Doghouse
An Arcane Investment Product Hits the Front Pages
By blackhedd Posted in Citigroup | Economy | finance | Paulson | SIV | subprime mortgage — Comments (20) / Email this page » / Leave a comment »
I was nonplussed to see a big scare headline on the Drudge Report, linking this wire story, under an ugly three-month chart of Citigroup's stock price.
I was even more weirded out to see that the story was about Structured Investment Vehicles (SIVs), a form of engineered financial product that is abstruse enough to confuse professionals, let alone the average Drudge Report reader.
Actually, there was important news from the land of SIVs today, but it came from the London-based Hong Kong-Shanghai Banking Corporation (HSBC), one of the world's largest retail banks. Our intrepid wire reporter (and others) have been spinning Citigroup as bad guys and HSBC as good guys, but as usual there's more to the story.
Read on...
SIVs are not new, having been around in one form or another for about 20 years. A SIV usually has a sponsor who kicks in a small amount of equity capital, and then purchases large amounts of debt securities with medium to long maturities. Shares in the SIV are then marketed to investors, such as banks and hedge funds.
What makes a SIV "structured"? Two key aspects. First, the funding mechanism. The SIV borrows in the short-term corporate debt ("commercial paper") market, to get the money to buy the longer-term debt. Since short-term interest rates are normally lower than longer-term rates, that gives you the rationale for doing the SIV in the first place. It's basically a yield-curve play.
The second aspect is what is usually called "credit enhancement." There is a large variety of ways that SIV sponsors increase the effective creditworthiness of the resulting investment product. For example, the SIV sponsor can obtain a cash line-of-credit, an insurance policy, or an interest-rate swap from some third party to guarantee the assets of the fund.
SIV sponsors are generally large commercial banks rather than Wall Street firms, because they have the ability to vertically integrate the risk-management, commercial-paper issuance, and credit-enhancement functions of the SIV. (After all, the whole business of a commercial bank is to borrow short and lend long.) Accordingly, Citigroup and HSBC have been big players in this game, as have Bank of America, Wachovia, and JP Morgan Chase.
Now you have to bear with me here, because this is a very complicated story. I'll go slow.
The sponsor of a SIV does not put its own capital at risk, except for the small amount of equity it uses to start up the fund. And, crucially, it does not lend its own credit rating to the commercial paper it issues to fund its purchases of longer-term debt.
For these and other reasons, the assets of a SIV are carried off the balance sheet of the sponsoring institution. This is a standard and approved accounting practice. Keep this in mind, because it's going to come back later, at the crux of the story.
Mortgages, Of Course
Now SIVs got really big over the last three years or so, primarily as a vehicle for investing in asset-backed securities, especially (wait for it...) securities backed by mortgages, including subprime mortgages. (You knew there was no way to get through a big finance story without hearing the "S" word, right?)
By the back of my envelope, there were something like $400 billion worth of mortgage-backed securities owned by SIVs out there in the world at the beginning of the summer. And the commercial paper market as a whole, which funded those purchases, topped out well over a trillion dollars in August, when the financial world as we know it came to an end. It's now smaller than $900 billion.
(For comparison, the total amount of US mortgages in force is well over ten trillion dollars, with subprime mortgages making up about one tenth of that total.)
Now you're probably asking yourself what happens if you use money that you borrowed for 270 days ("commercial paper") to buy securities with maturities measured in years. That's right, you have to go back into the market to re-fund your short-term borrowings as they run off.
So far, so good. But what happens when the funding window slams shut? Now we've finally come to the nut of the SIV situation, and why such an arcane subject is front-page news.
It is indeed the case that the money markets are no longer willing to fund purchases by SIVs of mortgage-backed assets. This happened as a natural result of the liquidity crisis that roared through the credit markets this past summer.
Under these conditions, the SIVs come under extreme stress, and may be forced to declare insolvency. They may even be forced to liquidate, which means selling the medium and long-term assets they can no longer fund with short-term borrowings.
And that's something that very few people want to see happen, because there's no secondary market for these securities to start with, even under ideal conditions. Dumping up to $400 billion worth (face value) of them onto already distressed credit markets is, very simply, a recipe for a global meltdown.
Finding a Solution
So what's the answer to the dilemma? Well, someone is going to have to step up and lend the short-term money to the SIVs, that the money markets are unwilling to lend.
And who might that be? Well, the obvious victims would be the large banks that sponsored the SIVs in the first place, like Citigroup, JP Morgan Chase, and HSBC.
Ok, what's good about that idea? Well, it undoes one of the key aspects of SIV engineering, which is the limitation on the sponsor's credit exposure. If a sponsor was to guarantee commercial paper issued by its own SIVs, that would automatically stamp the sponsor's (very high) credit rating onto the SIV securities, which would solve the whole problem. The SIVs would become "on balance-sheet" liabilities of the sponsors, rather than "off balance-sheet," so they would also be much more visible to regulators and investors.
And why would a sponsor resist doing such a thing? At least two reasons. First, Citigroup et al have much better uses for their capital than committing it to a non-growing market in a distressed asset class. And second, they don't want the potentially large hit to their own earnings that would result from moving the SIVs onto their balance sheets.
Phew. Are you still with me? We're finally getting to the newsworthy part of the story.
As it turns out, Citigroup and the others have the legal right to simply do nothing, and let their SIVs twist in the wind. Of course they were careful to write the SIV covenants so that they would have this out.
But markets have long memories. You can't just burn investors like that, because it'll be a cold day in Hell before they buy anything from you again. Even though Citibank and the others face no legal obligation to stand behind their SIVs, they do face a far stronger obligation: the need to protect their reputations and their sterling credit ratings.
The M-LEC
At this point, the US Treasury Department steps into the picture. Undersecretary Steel and Secretary Paulson have thrown their weight and credibility behind a complex plan to provide SIV funding without moving SIVs onto sponsors' balance sheets. I wrote about this plan, called an "M-LEC," here and here.
The M-LEC is a very complicated structure, but in essence it's a "Super-SIV," extending the basic credit-enhancement techniques of ordinary SIVs to a larger pool of SIVs. (And no, it's not a government bailout in any way, shape, or form.)
The jury is still out on the M-LEC, which is scheduled to be in full operation by the end of 2007. But seven weeks into the plan, much of the market is unconvinced, with some very authoritative voices (including Bill Gross, Alan Greenspan, and Warren Buffett) coming out against it.
And that's why Citigroup's stock price keeps falling. The markets are anticipating that the M-LEC will fail, and Citigroup will indeed need to take up to $80 billion worth of SIV liabilities onto their balance sheet.
What did HSBC do to make news? HSBC has notably held out of the M-LEC. And they just announced that they would move $45 billion worth of SIV liabilities onto their balance sheet, effectively bailing out investors in the SIVs they sponsored. They're polishing their reputation nicely, but they're also going to take a big hit to earnings. In fact Goldman Sachs came out yesterday with the opinion that another $12 billion would be needed on top of the 45.
The Bottom Line
Global investors are cheering HSBC's move, even as they criticize the M-LEC plans of Citigroup, JP Morgan Chase, Bank of America, and Wachovia. I could write another whole long post about the pros and cons of this. Rather than do that, I'm going to leave unanswered the question of which is ultimately the better approach for investors and for the markets.
But this strange, complex situation in the financial world does have an impact on the real world. And this point is your key takeaway from the whole story:
Whether or not it's ultimately the right thing to do, the fact that major financial institutions are being called upon to commit their capital to stand behind the SIV market, means that capital will be locked up and unavailable for normal credit formation.
And that puts downward pressure on the global economy.
Citigroup Lands in Drudge's Doghouse 20 Comments (0 topical, 20 editorial, 0 hidden) Post a comment »
Remarkably good, in fact. It gave Asian markets quite a lift overnight.
The arguments about letting the SIVs fail and come onto sponsor balance sheets are actually complex, which is why I avoided them.
It's obviously a good thing to get greater transparency and faster marks to market.
What gives me the creeps is when people like Bill Gross and Warren Buffett, who are in a position to profit from extreme financial distress, start saying we should just rip the band-aid off the wound all at once.
The funding is certainly a vote of confidence - haven't followed the market today because of nightmarish travel so I don't know what their reaction was. I'm still bearish on the nearterm prospects for this sector.
I was shocked today to read a WSJ editorial scaremongering on the Abu Dhabi investment. Apparantly Citi is now a shill for terrorists and other bank fraud and we should be suspicious anytime an ivestor conviniently picks a number, say 4.9%, which aovids additional regulatory scrutiny (cause you wouldnt want to avoid scrutiny unless you have something to hide, right?).
I know the editorial board is dintinct from the reporters but this can't help credibility for the Nation's business paper of record.
So how much is the Drudge Effect on most companies? Do they tank specifically because it is on Drudge, or do most of the illuminati already know what's happening and have already made their calls back to Davos and Bildenberg?
“The path of the righteous man is beset on all sides by the inequities of the selfish and the tyranny of evil men."
The Abu Dhabi news is very very big, which I heard right after I finished writing this story last night.
I don't think Drudge moves markets any more than he moves politics or anything else.
While I think Greenspan enjoyed it too much - his actions as fed chairman actually did impact the economy, so parsing his words to decipher what those actions might be made sense. Drudge does not enjoy such power, nor does he have any particularl insight that I have ever seen which makes him a good predictor of the market.
They've sold $7.5 billion in "Equity Units" to Abu Dhabi which can convert to up to 4.9% of Citi's equity. If I understood the deal correctly, these Equity Units appear to be convertable bonds with a mandatory conversion provision.
Maybe they intend to use the proceeds to shore up their SIVs?
Socialism doesn't work. It looks nice on paper, but it's been tried and it's failed miserably every time (usually accompanied by widespread death and suffering).
Proud member of the V.R.W.C.
I'm with Fred!
...but it looks like some kind of convertible preferred. At any rate, the numbers tie out nicely. C's marcap last night was about $150 billion, so $7.5B for just under 5% of the company is about right.
4.9% is also about right. The 5% ownership level is one of those "magic numbers" that trigger additional reporting requirements and attention from the SEC.
Keep in mind that Citigroup's largest shareholder is a Saudi prince. The investment vehicle that just did this funding is the sovereign wealth fund of Abu Dhabi. I don't know, but I'd bet there's a family relationship in there somewhere.
I am just glad you didn't try to fully cover the complexities of CDS's and trigger events such as restructuring. This stuff is confusing enough.
I would only suggest that HSBC has it's own parochial reasons for taking some of this "on balance sheet". That includes both the SIV structure (Swan, Cullinan, Solitaire) and global accounting "magic".
Conceptually, "C" could also yield to that path since they share some of that structure, but I doubt they will. It appears the Abu Dhabi and overall investor diversity will help take some of that pressure off.
"Dulce et decorum est pro patria mori"
Contributor to The Minority Report
Great post. Thanks for this.
How will the Wall Street firms be affected? Do you think GS, LEH, and MS will still have sufficient capital and profitability to maintain their current level of operations? It seems that these firms are being unfairly hit by traders for something that primarily plagues the commercial banks.
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And statesmen at her council met
Who knew the seasons when to take
Occasion by the hand, and make
The bounds of freedom wider yet
- Tennyson, _To the Queen_
Thank you, Blackhedd, for the excellent description of SIV's and of the M-LEC which is proposed for resolution of the liquidity runoff being experienced by several large banks at their captive SIV's.
Yesterday, I pointed out that Citigroup is paying 11 percent plus convertibility for the $7.5 billion preferred equity investment by Abu Dhabi. Yet at the same time, it is reducing to 6% the cost to subprime borrowers whose loans it services.
In a way, my comment was 'snarky.' But in a sense, I was perfectly serious.
If the cost of equity capital (at the margin) to the nation's largest bank is double digit coupon plus equity conversion, then something is very wrong. Your comment last night was to the effect that C's return on equity is over 15%, and the infusion may well be accretive to earnings. It certainly is, if the alternative is damage to the bank's capital levels.
Earnings, however, are reported in arrears. We don't really know whether the earnings at the Citigroup organization monolith represent 15% returns on equity. That is because we don't yet know to what extent the earnings were lifted by such things as profits from $80 billion of off-balance sheet assets which (when things worked right) added to profits.
Imagine, for example, that I have a business with $1 million of shareholder equity. I do a transaction with another business, putting up very litte, entitling me to a good portion of that firm's profits, but not putting me at risk for its liabilities.
Depending on the numbers, my profits share from that business may sharply lift my own return on equity. It may not be possible to tell how much my own returns have been maginified by that investment.
And, if that business were to hit troubled times, it would in all likelihood look to me for additional funding. It won't be possible to see with clarity what my true returns would have been in its absence. I may know, but my creditors and investors may not.
My point is that banking, investment banking and brokerage all are businesses which are sensitive to the creditworthiness of the underlying firm. That Citigroup just paid more than 11 percent for capital is a symptom of where banking in America lies at the moment.
It wasn't a bad investment by the Abu Dhabi's; it was a brilliant investment on their part, difficult to do with that much investable capital. But it was a symptom that something is very wrong in America in 2007.
I am not sure which way I feel about the alternatives re SIV's as judgement days approach in several of them. To the extent that the M-LEC isn't funded, chances are that several money market funds now holding SIV commercial paper will either break the $1 a share level their sponsors try to maintain, or the sponsors will need to write checks to the funds making up the difference.
It may be that at day's end, the participating banks may simply go to a quasi governmental window, like that at the Federal Home Loan Banks, borrowing enough at modest cost to cover their commitments to the M-LEC. It appears from recent news reports that Countrywide Credit has drawn down FHLB funds to the extent of $51 billion to cover its funding needs. As the late Everett Dirksen used to say, 'a billion here, a billion there; pretty soon you're talking about real money.'
It is true that Buffett, Gross and others would shed no tears for breakdowns of the SIV markets for the opportunities such breakdowns would provide.
It is not at all clear whether (as you point out), as a nation, as an economy, we are better off with our larger banks tying up so much capital in the M-LEC, making it unavailable to corporate and personal loans but preventing the inexorable dislocations to themselves and others, or whether we are better off taking the damages now.
Nor is it clear whether the evolution of Citigroup into the far-flung group of operations it has become is the highest and best use of its shareholders' capital. It may be that at some point the investment bank, the credit card operations, and other activities may be spun out into separate companies, perhaps for the betterment of C shareholders and the nation at large.
However, we are better off for your exposition of the SIV and M-LEC situations
And therein lines the problem. If the SIV is truly an arms-length vehicle, you have to let it go down. But, since you put most of the investors into the vehicle, you can't let it go down, lest your reputation and business suffer. Thus, it really isn't arms-length. If it is, off-the-books is ok. If it really isn't, it should be on the books.
The difference between how HSBC and Citi handle this may come down to how aggressively they marketed the SIV as an investment, who bought, and how willing they are to let those customers go. HSBC obviously felt they couldn't afford the hit.
My guess is that with the cool reception to the alternative approach to protect the investors, Citi will have to step in, support it on its own, and put it on the books. Only my guess. If one US based bank does it, they will all do it. Blackhedd noted the consequences.
Also watch for Citi to start divesting 'non-core' businesses as HSBC already has. Citi will emerge smaller but more profitable. The question is how long does it take to make this transition? HSBC obviously thinks the quicker the better.
The timing and terms of the Abu Dhabi investment are of interest. My read is that Citi isn't ready to give up on the M-LEC approach and they need more time to try to make it work. Bringing the SIV's 'on-sheet' may be more devastating for Citi than HSBC. The Abu Dhabi deal keeps "C" from free-fall in that light. The high rate of return and relatively low conversion price were likely concessions to make the Abu Dhabi deal happen now, before "C" hits bottom. I wouldn't be surprised to see another deal like this. Citi is a great franchise and it has some valuable and marketable assets. Its stock is cheap and the dollar makes it even cheaper.
We do live in interesting times...
Citigroup and the other participants won't throw in the towel on the M-LEC until we all see how the money markets respond to it. We won't know for a few more weeks yet. And don't forget the politics: Secretary Paulson's entire reputation is invested in this deal.
One interesting thing about SIV investments is that they actually may be good investments, if held to term. Supposedly intelligent people were convinced to buy them in the first place, after all.
Mortgage-backed securities still are probably very, very safe. Yes, the default-rate on them has ticked up this year, impairing their value. But the resultant hysteria far outstripped the actual value-impairment, for the simple reason that the securities are illiquid.
No well-run bank makes irrational investment decisions. Taking a portfolio of mortgage-backed securities on-balance-sheet sounds like a very inefficient way to use capital. But HSBC may have calculated that they weren't any worse off doing that, given the outlook for yields elsewhere.
Give that some thought. If true, it portends at least somewhat slower global growth.
As far as letting SIV investors hang out to dry, that's not even a possibility. Look at what the Wall Street firms with mortgage-back exposure had to do back in the summer. Both Bear and Goldman recapitalized their exposed hedge funds with billions of dollars each.
The word is that Goldman (who always land on their feet) have made a bloody fortune on this trade. I have no skinny on how Bear did.
The fact that Hank Paulson has had to put his entire reputation on the line should speak to the gravity of the situation. The key is restoring confidence. But part of restoring confidence is transparency. HSBC dealt with that and it's done.
The M-LEC doesn't seem to solve the transparency issue. And, as I understand it, it only solves part of the SIV issue. It's sort of the big "Oops! Never mind. We solved it ourselves" solution. Good if they can pull it off, but, if this drags out a while in implementation, HSBC is going to be looking good.
Implications of the HSBC move to global growth - noted. But, the M-LEC only accomplishes its goal if it keeps confidence (and evaluations) high. Otherwise, you end up buying your own debt anyway, even if its spread across 5 or 6 players. Also not an efficient use of capital. HSBC, in their view, has chosen the quicker and more efficient poor use of capital as opposed to the longer, drawn out, less efficient poor use of capital.
If Citi and group are successful (and I hope they are), they may avoid the pain. But if they try and don't succeed, the longer it's drawn out, the more it's gonna sting.
These actors, for those paying close attention, have been advertising some nasty philosophy.
Personally, I hope they get gutted.
Blackhedd, that was a great article. I would love to see, even in summary (actually, only in summary!) , the more complex arguments for and against M-LEC.
My personal opinion on the matter, not that I expect anyone to listen, is that Citigroup, JP Morgan Chase and Bank of America have been specifically interested in undermining American sovereignty. Furthermore, I haven't enjoyed the level to which the Bush adminstration has appeared to cater to their needs above the market in general. Let creative destruction reign.
When I saw your headline I thought he was complaining about Citi selling out to Arabs - instead he is getting in a huff about finance that I'm sure he doesn't understand.
The bet here HSBC is making is that the short-term damage of the bailout will pale to the long term consequences of drawing out judgement day and hoping that funding comes back. Personally, I think it's the right bet but it will be a while before we can definitively know.