Big banks ponder creating fund to rescue mortgage-backed securities

Big Banks Push
$100 Billion Plan
To Avert Crunch

Fund Seeks to Prevent
Mortgage-Debt Selloff;
Advice From Treasury

By Carrick Mollenkamp, Ian McDonald,
and Deborah Solomon

The Wall Street Journal
Saturday, October 13, 2007

In a far-reaching response to the global credit crisis, Citigroup Inc. and other big banks are discussing a plan to pool together and financially back as much as $100 billion in shaky mortgage securities and other investments.

The banks met three weeks ago in Washington at the Treasury Department, which convened the talks and is playing a central advisory role, people familiar with the situation said. The meeting was hosted by Treasury's undersecretary for domestic finance, Robert Steel, a former Goldman Sachs Group Inc. official and the top domestic finance adviser to Treasury Secretary Henry Paulson. The Federal Reserve has been kept informed but has left the active role to the Treasury.

The new fund is designed to stave off what Citigroup and others see as a threat to the financial markets worldwide: the danger that dozens of huge bank-affiliated funds will be forced to unload billions of dollars in mortgage-backed securities and other assets, driving down their prices in a fire sale. That could force big write-offs by banks, brokerages, and hedge funds that own similar investments and would have to mark them down to the new, lower market prices.

The ultimate fear: If banks need to write down more assets or are forced to take assets onto their books, that could set off a broader credit crunch and hurt the economy. It could make it tough for homeowners and businesses to get loans. Efforts so far by central banks to alleviate the credit crunch that has been roiling markets since the summer haven't fully calmed investors, leading to the extraordinary move to bring together the banks.

In recent weeks, investors have grown concerned about the size of bank-affiliated funds that have invested huge sums in securities tied to shaky U.S. subprime mortgages and other assets. Citigroup, the world's biggest bank by market value, has drawn special scrutiny because it is the largest player in this market.

Citigroup has nearly $100 billion in seven affiliated structured investment vehicles, or SIVs. Globally, SIVs had $400 billion in assets as of Aug. 28, according to Moody's.

Such vehicles are formally independent of the banks that create them. They issue their own short-term debt, usually at relatively low interest rates reflecting their high credit rating. The vehicles use the money to buy higher-yielding longer-term assets such as securities tied to mortgages or receivables from midsize businesses seeking to raise cash.

Many SIVs had trouble rolling over their short-term debt in August because of concerns about the quality of their assets. That contributed to the broader seizing up of credit markets.

The Financial Services Authority, the United Kingdom's markets regulator, has suggested that U.K. banks consider participating in the plan, a person familiar with the situation said. HSBC Holdings PLC, the largest U.K. bank, has an affiliate SIV called Cullinan Finance Ltd. with $35 billion in senior debt. An HSBC representative wasn't immediately available to comment.

If the banks agree, the plan could be announced as early as Monday, people familiar with the matter said. Citigroup announces third-quarter earnings Monday. The tentative name for the fund is Master-Liquidity Enhancement Conduit, or M-LEC.

The plan is encountering resistance from some big banks. They argue that Citigroup is asking others to help bail out its affiliates and an industry-wide bailout isn't needed. Citigroup bankers created the first SIV in the late 1980s in London.

The new fund represents a way for Citigroup and other banks to "outlast the current market conditions that are so dry right now," says Jaime Peters, an analyst at Morningstar Inc.

Traditional buyers of debt issued by SIVs include money-market mutual funds, municipalities, and other risk-averse investors attracted by the high credit rating of the vehicles.

By providing a receptacle for assets backed by subprime mortgages and other creations of Wall Street, the SIVs contributed to the big expansion of credit in recent years whose aftereffects are now roiling the economy.

The Citigroup plan would create a "superconduit," a fund backed by some of the world's biggest banks that would issue short-term debt and serve as a buyer of assets currently held by SIVs affiliated with the participating banks.

According to the people familiar with the plan, these assets include securities tied to U.S. mortgages as well as debt pools called collateralized debt obligations.

Because the superconduit would be backed by the big banks themselves, it's expected this would reassure investors and make them more willing to buy its short-term debt, or commercial paper.

The Citigroup proposal recalls the 1998 bailout of huge hedge fund Long Term Capital Management, which was reeling from bad bets on currencies and other investments. Seven big banks and investment banks, prodded by the Fed, banded together and prevented LTCM from collapsing.

Two banks in the discussions with Citigroup, Bank of America Corp., and J.P. Morgan Chase & Co., would participate not because they have SIVs -- they don't -- but because they would earn fees for helping arrange the superconduit, according to people briefed on the discussions. The superconduit's debt would be fully backed by participating banks, they said.

One supporter of the effort is Treasury Secretary Henry Paulson, who decided to assemble the banks after conversations with businesspeople who expressed concern about SIVs and their impact on the economy, said a person familiar with the matter.

It's the second time in two months that U.S. authorities helped arrange for financial institutions to discuss steps to avert a credit crisis. In mid-August, at the request of the New York Fed, financial leaders met with Fed officials who explained the Fed's steps to open up the supply of cash to the nation's banks.

The new plan would be challenging to pull off. Bank-affiliated SIVs selling assets into the superconduit will have to agree on how to price those assets. Some SIVs may value the securities differently. There have been several meetings since the initial Sunday meeting, both at Treasury and in New York.

For Citigroup Chief Executive Charles Prince, solving the bank's SIV is the latest fire that he needs to put out. Mr. Prince, under pressure to raise the bank's lagging performance, recently said third-quarter earnings would fall 60% from year-earlier levels owing to the August meltdown in global credit markets. Some investors and analysts have called for Mr. Prince's ouster.

SIVs are purposely kept off the balance sheets of the banks to which they are affiliated. One reason for this is that banks want to keep down the amount of assets on their balance sheets to reduce the amount of capital that regulations require them to keep.

Because SIVs are off the balance sheet, it is difficult for investors to size up the financial risks they pose. Off-balance-sheet liabilities played a major role in the 2001 collapse of Enron Corp., and the makers of accounting rules have generally sought to get affiliated entities back on the balance sheets of the companies creating them.

---

Robin Sidel and David Reilly contributed to this article.

* * *

GATA is grateful for financial contributions, which are federally tax-deductible in the United States.