Commercial paper risks are lurking behind Citigroup

Conduit Risks
Are Hovering
Over Citigroup

If the Vehicles Go Sour,
Rescues Could Be Costly;
Bank Has 'No Concerns'

By David Reilly, Carrick Mollenkamp,
and Robin Sidel
The Wall Street Journal
Wednesday, September 5, 2007

http://online.wsj.com/article/SB118895110892617533.html?mod=yahoo_hs&ru=...

Though few investors realize it, banks such as Citigroup Inc. could find themselves burdened by affiliated investment vehicles that issue tens of billions of dollars in short-term debt known as commercial paper.

The investment vehicles, known as "conduits" and SIVs, are designed to operate separately from the banks and off their balance sheets.

Citigroup, for example, owns about 25% of the market for SIVs, representing nearly $100 billion of assets under management. The largest Citigroup SIV is Centauri Corp., which had $21 billion in outstanding debt as of February 2007, according to a Citigroup research report. There is no mention of Centauri in its 2006 annual filing with the Securities and Exchange Commission.

Yet some investors worry that if vehicles such as Centauri stumble, either failing to sell commercial paper or suffering severe losses in the assets it holds, Citibank could wind up having to help by lending funds to keep the vehicle operating or even taking on some losses.

Citigroup has told investors in its SIVs (which stands for Structured Investment Vehicles) that they are sound and pose no problems.

"Quite simply, portfolio quality is extremely high and we have no credit concerns about any of the constituent assets," said a recent letter from Paul Stephens and Richard Burrows, directors in Citigroup's London-based group that oversees the bank's SIVs. "Citi's SIVs remain robust and their asset portfolios are performing well."

A Citigroup spokesman declined to comment on the bank's SIV disclosures or potential exposure that it might face from them.

So far, there hasn't been any suggestion of problems with Citigroup's SIV or conduit vehicles. Yet recent turmoil in the commercial-paper market, in which some issuers were unable to find buyers for new paper, raised concerns that SIVs and conduits could face problems that would force the banks affiliated with them to step in.

This has left bank investors grasping at straws as they try to piece together the risks facing individual banks. 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.

"Any off-balance-sheet issues are traditionally poorly disclosed, so to some extent, you're dependent on the insight that management is willing to provide you and that, frankly, is very limited," says Mark Fitzgibbon, director of research at Sandler O'Neill & Partners, which focuses on the financial-services industry.

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' debt.

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.

Citigroup is also affiliated with structured investment vehicles, or SIVs, that have "nearly $100 billion" in assets, according to a letter Citigroup wrote to some investors in these vehicles last month.

Whether conduits and SIVs should be allowed to remain outside banks' main balance sheets has been debated in accounting circles. In the wake of Enron Corp.'s implosion -- in which off-balance sheet vehicles played a major role -- accounting rule makers sought to require companies to move most off-balance-sheet vehicles back onto their books.

But conduits and SIVs presented some unique issues because even though banks set the vehicles up they usually don't own a majority of their shares. The vehicles are often established in a tax haven and are run solely for investment purposes as opposed to typical corporate activities.

Banks wanted to avoid consolidating these vehicles because doing so would balloon their balance sheets and force them to restrain lending.

Accounting rule makers in the U.S. then looked at who controls the vehicles based on who shares the majority of risks and rewards associated with them. Banks found that by selling to a third party any first loss associated with the vehicles, they could transfer the risks associated with them. That helped to keep the vehicles off their books.

The current market turmoil has rekindled debate over whether the vehicles should be consolidated. Some also suggest banks should have to account for the liquidity backstops they offer these vehicles, since they resemble guarantees and could even force banks to take conduit or SIV assets onto their own books.

To many observers, the off-the-books treatment flies in the face of the banks' extensive involvement with SIVs and conduits. A 2005 Moody's Investors Service report said that Citibank International PLC, Centauri's investment manager, handles tasks such as evaluating investment opportunities, arranging funding and hedging.

Several conduits and several SIV-type structures in Europe have run into troubles. Some bankers fear there could be more due to losses related to exposure to soured mortgage loans. That raises the question of whether banks should rescue a SIV if it teeters, said a banker involved with the vehicles.

Allowing a SIV to fail could sully the reputation of a bank that created it and even cause financial-system risks because investors might suddenly refrain from buying commercial paper from other conduits and SIVs.

But if a bank mounted a rescue, it also would likely raise questions over why the bank didn't consolidate the vehicle in the first place, since it would be agreeing to bear losses associated with it.

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