For Bankers, Yet Another Credit Migraine

Citigroup leads the banks at risk as demand dries up for a $400 billion market for off-balance-sheet investments

by Steve Rosenbush

The credit crunch has big banks in a bind. Not only are they holding billions of dollars in buyout-related debt they may be unable to sell, but large hedge funds run by players such as Goldman Sachs (GS) and Bear Stearns (BSC) have been burned by bad bets on subprime mortgages. But wait, there's more bad news: Fears are mounting the banks may next be whacked by their Structured Investment Vehicles (SIVs), a relatively obscure market that has ceased functioning in recent weeks. Few outside the financial community know about it, but that could change quickly.

Citigroup (C) created the SIV market 19 years ago, and other banks quickly followed. Typically, a bank will set up a SIV as a separate company with its own address and officers. The SIV will borrow money at low interest rates from money-market funds, and invest the funds in mortgages and other asset-backed securities, which pay a higher yield, creating a spread that generates profits for the bank. But the bank doesn't have to list the borrowed funds on its own balance sheet—the SIV carries the loans, and the bank gets to skirt capital-reserve obligations governing its own debts. As a result, the off-balance-sheet arrangement frees up capital for other purposes. Today, there are about 30 SIVs with a combined value of $400 billion, according to Moody's Investors Service (MCO).

But the subprime mortgage meltdown has terrified money-market funds and other investors and decimated demand for SIVs, regardless of their quality or credit worthiness. It's hard to know how much subprime debt a particular SIV may hold or whether today's prime-rated SIV will be tomorrow's junk—leading many investors to avoid the entire market.

Citi at Risk?

On Sept. 5, Moody's announced a downgrade of stunning magnitude, lowering its ratings or outlook on $14 billion worth of SIVs, in some cases to an astonishing extent. "The rapid spread-widening and decline in the market value of assets across the board…is unprecedented in structured finance," Paul Mazataud, group managing director at Moody's, said during a conference call with investors that day. Moody's, for example, dropped its ratings on some longer-term notes issued by London-based Cheyne Finance from prime A3 to Caa2, deep within the well of junk.

The SIV meltdown already has hurt hedge funds such as Cheyne Capital , which manages Cheyne Finance. Cheyne, a London-based hedge fund manager, invests in a range of markets, from convertible and credit and asset-backed bonds to equities. But now there's fear the SIV crisis could spread more broadly into the economy. Those at immediate risk include the banks that manage SIVs, the vehicles' lenders of last resort. Citi alone has $100 billion of exposure with seven SIVs, including its $21 billion Centauri Corp. Citi said on Sept. 6 its SIVs were high-quality and it was comfortable with them. Other major lenders with exposure to the market include Barclays (BCS) and Deutsche Bank (DB).

The market for SIVs has ceased to function during this summer's credit crisis (BusinessWeek.com, 7/27/07). SIVs hold a wide range of mortgages, credit-card receivables, and other kinds of asset-backed debt, some of it subprime.

If money-market funds and other buyers stay out of the market, commercial banks could be required to lend money to SIVs and carry those loans, says Chip MacDonald, a partner and corporate finance expert with global law firm Jones Day.