naked capitalism

The negative reactions on the proposed SIV rescue plan (officially known as the Master Liquidity Enhancement Conduit) have become so widespread that I haven’t been reporting as closely on this topic as I did earlier. However, some of the recent coverage has finally surfaced at least one reason for the plan that at least makes sense (whether readers regard it as legitimate is another matter entirely).

Recall that one of the ongoing mysteries about this program is that it involves a great deal of fuss and expense for what appears to be little or no gain.

The new MLEC will buy high-quality assets from exiting SIVs (which begs the question of what happens to the crappy assets left behind). The old SIVs get cash and some securities from the MLEC. The MLEC has some credit enhancement and issues commercial paper and medium term notes.

The problem is that the MLEC is not going to be fully guaranteed by the banks providing credit enhancement, so the investors will want the assets in the MLEC to be price within hailing distance of current values. That, of course, is what the SIV sponsors want to avoid, or at least minimize, since selling assets into the MLEC at realistic prices will require them to take losses.

In addition, there has been no discussion as to the end game for the MLEC. There have been some comments that indicate that it will sell the assets it holds, but over a long-ish period of time, thus reducing market impact.

But if any bank sponsor is not stressed financially, it too could simply fund its SIV and simply liquidate more gradually. So then the question becomes whether the benefit exceeds the fees the MLEC will charge. For banks that aren’t in duress, the answer would appear to be no.

But a new piece of the puzzle emerged yesterday in the Wall Street Journal:

Supporting these off-balance-sheet funds, known as structured investment vehicles or SIVs, is the heart of the rescue effort led by Citigroup, J.P. Morgan Chase & Co. and Bank of America Corp. Accounting groups have raised the question of whether Citigroup and other managers of the SIVs should account for the funds, many of which face potential losses, on their own balance sheets.

A spokeswoman for Citigroup said, “Citi is confident that it has accounted for the SIVs it sponsors on behalf of investor-clients properly and in thorough accordance with all applicable rules and regulations.”…

If it doesn’t work, Citigroup and other SIV managers could find themselves in a bind that could force them to take financial hits.

If the rescue plan failed and buyers continued to stay away from the commercial-paper market, the bank might feel pressure to pony up cash to backstop the SIVs to preserve its reputation with the vehicles’ investors, who would otherwise incur the bulk of the losses. But that prospect has raised the issue among accounting professionals about whether the bank shares in potential losses to such an extent that it should consolidate the SIVs onto its own books..

So the MLEC keeps the losses from being consolidated. That now appears to be a clear benefit, and perhaps the only benefit, of this scheme.

The New York Times today, in two different stories, indicated that the pressure, generally and on Citi, the biggest SIV sponsor, is increasing. From “$75 Billion Fund Is Seen as Stopgap“:

Nearly three weeks after the country’s biggest banks announced a $75 billion fund to help stabilize the credit markets, the reality is sinking in that the plan will provide hospice care to troubled investment funds, not resuscitate them….

The proposed bank fund “is more a towline to get them to the scrapyard,” Lou Crandall, chief economist at Wrightson ICAP, a financial research firm, said….

Citigroup’s seven SIVs are under pressure to repay investors. Several less robust funds could face downgrading. Over all, the 30 or so SIVs have been forced to sell assets at an alarming pace — shedding roughly $75 billion since July and shrinking the industry by a fifth. Market participants expect SIVs to unload even more, as much as $15 billion a week….

“People get the idea that this is a total solution or a complete rescue,” a person involved in the plan said. “But the goal is actually much less ambitious: it is really to provide an orderly unwind or promote a restructuring.”

According to people briefed on the fund, the plan will encourage SIV investors to extend their short-term notes by at least six months…

Analysts say the fund will not benefit all SIVs equally, with those sponsored by big banks gaining the most. All this has turned the spotlight on Citigroup — which, skeptics suggest, shaped the plan specifically to ease its troubles….

At least 10 other foreign banks — including Dresdner Kleinwort of Germany, HSBC and Standard Chartered of Britain, the Bank of Montreal and Rabobank of the Netherlands — manage SIVs.

Market players say they are under just as much, if not more, strain than Citigroup. To delay the day of reckoning, they have been buying commercial paper and riskier notes from the SIVs they sponsor. Some are also looking to restructure, too.

A second New York Times article, “Analyst Raises Doubts About Citigroup Dividend,,” focuses on the fact that even before the SIV crisis, Citigroup was more thinly capitalized than other large banks. The “$30 billion capital shortfall” is thus the analyst’s estimate of what it will take, between increasing reserves and equity, to bring the bank in line with industry norms:

A long-time banking analyst said late last night that Citigroup may be forced to cut its dividend or sell assets to stave off what she said was a $30 billion capital shortfall, moves that could pull down its shareholder returns for several years.

The analyst, Meredith A. Whitney of CIBC World Markets, downgraded Citigroup’s stock to sector underperform, from sector perform, and called for the bank to bring precariously low capital levels more in line with its peers.

“We believe the stock will be under significant pressure and could trade in the low $30s,” she wrote. That would be as much as a 28 percent decline from yesterday’s $41.90 closing price for Citigroup shares.

If correct, the findings could be yet another blow to Citigroup’s chairman and chief executive, Charles O. Prince III, who has endured a barrage of criticism in the last few years for his failure to control costs and improve results. A 57 percent earnings drop in the third quarter, when both its big investment banking and consumer operations suffered heavy losses, raised doubts about his attention to risk management and his ability to lead the company….

In the third quarter, Citigroup said it lost $1.3 billion from mortgage-related securities amid the credit market downturn. Executives conceded they did not pay enough attention to credit risk or adequately hedge their positions.

But Ms. Whitney’s report turned the spotlight on other potential miscues, including Mr. Prince’s growth strategy. The report points out that Citigroup’s capital levels have declined to their lowest levels in decades after a recent spate of acquisitions. Citigroup’s tangible capital ratio stands at 2.8 percent, nearly half of the level of its peers.

While Mr. Prince has long promoted internal and international growth, Ms. Whitney’s report points out that Citigroup has spent more than $26 billion on acquisitions since spring 2006. That, on top of the $5.9 billion in losses and a 10 percent dividend increase in January, has strained its capital position.

Citigroup’s management has said that it expects capital to return to its target levels in early 2008. It plans to use stock in its Nikko Cordial purchase, improving its balance sheet management, and not repurchasing stock until it bolsters its capital cushion.

Other banking and risk experts agree with Ms. Whitney’s analysis, however, and some suggest that it may even be conservative. Citigroup’s capital position “is too low based on the risks on the trading side but the kicker is that Citigroup is going to have a lot more losses” on the consumer side, said Christopher Whalen, the managing director of Institutional Risk Analytics. “It is going to be a one-two punch.”

The more news that comes out, the more it looks like the MLEC is all about Citi.

Update: 11/1, 12:00 PM: More coverage from Bloomberg on the analyst earnings downgrades for Citi:

Citigroup Inc., the largest U.S. bank, fell to the lowest in four years in New York trading after three analysts cut their ratings and CIBC World Markets said the company may have to reduce its dividend to shore up capital.

CIBC and Morgan Stanley recommended investors sell the shares, while Credit Suisse analyst Susan Roth Katzke reduced her rating to the equivalent of hold from buy. Citigroup may have to sell assets, shrinking opportunities for growth, CIBC said.

Analysts are souring on Citigroup after the company reported $6.5 billion in writedowns and losses from credit markets, jeopardizing Chief Executive Officer Charles Prince’s promise to increase earnings faster than costs. The combination of $25 billion of acquisitions in the past 19 months and the lowest cushion for losses “in decades” increases the risk of owning the stock, CIBC’s Meredith Whitney said.

“The Citigroup news is a wake-up call for those who think these issues will go away with the Fed cutting rates,” said Michael Metz, the New York-based chief investment strategist at Oppenheimer Holdings Inc., which manages $60 billion. “We’re not going to get resolution on these credit issues for months.”….

Citigroup fell $2.19, or 5.3 percent, to $39.17 in composite trading on the New York Stock Exchange at 10:55 a.m., after falling as low as $38.13…..

Prince began making acquisitions after the Fed lifted a ban on deals by the company in March 2006. The “buying binge” increased assets while earnings stagnated, Whitney said.

Profit fell to the lowest in three years as the company reported writedowns from credit and trading losses. The ratio of Citigroup’s tangible equity to tangible assets fell to 2.8 percent, half the average of its peer group, Whitney said. She cut her estimate of Citigroup’s earnings per share for this year to $3.68 from $3.75, and reduced her outlook for next year to $4.20 from $4.55.

Citigroup’s tier 1 capital ratio, a measure used by regulators to make sure banks have enough cash to cover losses, fell to 7.4 percent at the end of the third quarter from 8.64 percent at the same time last year..