Another Off-Balance Sheet Time Bomb: VIEs

Despite the sudden flurry of worry in the press, triggered by the release of Citigroup’s 10K, VIEs, or variable interest entities, have been around for some time. They were a favorite device of Enron’s. SIVs are a subset of VIEs.

With such an illustrious history. it’s a wonder they haven’t gotten more inquiring coverage until now. Indeed, it’s a bit odd that Bloomberg is reporting the story today, in “Goldman, Lehman May Not Have Dodged Credit Crisis,” when the most immediate trigger for possible VIE problems, namely a downgrade of the big monolines, is now off the front burner. It is also noteworthy that the headline and early part of the story focuses on the two heretofore largely unscathed Wall Street firms, when the rope-a-dope Citigroup has $320 billion in unconsolidated VIEs. This is nearly as large as the entire SIV market at its height.

Moreover, recall SIVs in the end took small losses relative to their outstandings (roughly 3%, from what I can infer; note the NAVs reported were NOT a measure of loss on the total, merely losses to capital note holders). That’s why the much ballyhooed MLEC program never saw the light of day; the industry could absorb the damage on its own. By contrast, due to the opaqueness and likely significant differences among these VIEs, the loss potential is harder to assess. CreditSights puts it at $88 billion, Moody’s at $30 billion. That variance alone says this is a murky and not well understood problem.

From Bloomberg:

Goldman, which hasn’t had any of the industry’s $163 billion in writedowns, said last month it may incur as much as $11.1 billion of losses from the instruments.

The potential for a fire-sale of the assets that would bring another round of charges has “always been our greatest fear,” said Gregory Peters, head of credit strategy at New York-based Morgan Stanley…

VIEs, known as special purpose vehicles before Enron Corp.’s collapse in 2001, finance themselves by selling short-term debt backed by securities, some of which are insured against default….

Wall Street’s writedowns stem from a surge in mortgage delinquencies among homeowners with the riskiest subprime-credit histories. The industry’s VIEs, also known as conduits, had $784 billion in commercial paper outstanding as of last week, according to Moody’s Investors Service and the Federal Reserve.

“There’s a big number at work here and it will have significant consequences,” said J. Paul Forrester, the Chicago- based head of the CDO practice at law firm Mayer Brown. “The great fear is that a combination of subprime CDOs, SIVs and conduits result in a flood of assets into an already-stressed market and there’s a price collapse.”…

“The lightning rod of the monoline fix is so important to so many banks,” said Thomas Priore, chief executive officer of New York-based Institutional Credit Partners LLC, which manages $12 billion in CDOs.

Accounting rules allow financial firms to keep VIEs off their balance sheets as long as they’re not the ones that stand to gain or lose the most from the entity’s activities. A bank would also have to account for its portion of a VIE if prices for the debt owned by the fund fall too far or if the bank is forced to provide financing…..

Goldman, which earned a record $11.6 billion in the year ended in November 2007, said it avoided writedowns by setting up trades that would profit from a weaker housing market. Now the threat is $18.9 billion of CDOs in VIEs, the firm said in a regulatory filing on Jan. 29. Goldman spokesman Michael DuVally declined to comment….

Lehman, which wrote down the net value of subprime securities by $1.5 billion, guaranteed $6.1 billion of investors’ money in VIEs and $1.4 billion of clients’ secured financing as of Nov. 30, according to a filing also made on Jan. 29….

Citigroup, which has incurred $22.1 billion in losses from the subprime crisis, has $320 billion in “significant unconsolidated VIEs,” according to a Feb. 22 filing by the New York-based bank. New York-based Merrill Lynch, which recorded $24.5 billion in subprime writedowns, has $22.6 billion in VIEs, according to CreditSights….

The securities in the VIEs may be worth as little as 27 cents on the dollar once they’re put back on balance sheets, according to David Hendler, an analyst at New York-based CreditSights. Hendler based his estimate on the recent sale of $800 million of bonds by E*Trade Financial Corp.

Predictions for losses vary widely because banks aren’t required to specify the type of assets being held in the VIEs or how much they are worth, said Tanya Azarchs, managing director for financial institutions at S&P.

“The disclosure on VIEs is hopeless,” Azarchs said. “You have no idea of the structure or how that structure works. Until you know that you don’t know anything. It’s like every day you come into the office and another alphabet soup has run off the rails.”