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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

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 (, 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. "There's a good chance some SIV-related debt will end up on the balance sheets of the banks (, 8/13/07)," he said.

'Freaked Out' Fed

Consequences of the SIV mess could be felt outside the banking sector. If SIVs start to tie up banks' capital, bankers will have less money to lend for other purposes, extending the breadth of the credit crunch. Another possibility is that SIVs—which can afford to lend money at lower rates than banks because they're exempt from the capital requirements that apply to banks—will shut off capital for all but the most creditworthy mortgages and loans. That would force consumers and businesses to shop elsewhere, paying higher rates.

Economist and market strategist Ed Yardeni of Yardeni Research says SIVs helped influence the Fed, which monitors the SIV market closely, to cut the discount rate in August. "The concept makes money when the SIV can borrow in the liquid commercial paper market at a lower interest rate than is earned from the bonds and loans.…The concept doesn't work when funding dries up in the money markets," Yardeni wrote in an Aug. 28 note. "This is what has been happening over the past two weeks. That really freaked out the folks at the Fed, causing them to cut the discount rate and dramatically to liberalize discount window borrowing terms."

Kestrel Funding, a Dublin-based SIV, illustrates the new freeze. Moody's said it has placed Kestrel debt on review for possible downgrade because Kestrel, managed by a unit of German bank West LB, has "breached a trigger which caused it to enter into a restricted operations mode." Among other consequences, Moody's said, Kestrel is unable to purchase additional assets. That could put West LB's Brightwater Capital Management unit in the position of buying Kestrel debt and carrying it on its books. There's also a chance Kestrel itself will have to sell assets and take losses.

Part of the shock stems from the conventional investor wisdom that SIVs were safe havens to park cash. They have traditionally been viewed as prime vehicles, and rated as such, and differ from other blind investment pools such as collateralized loan obligations or collateralized debt obligations because SIV investors are first in line to be paid if the loans in the pool declared bankruptcy. That made SIV investors feel even more comfortable.

The hunt for subprime mortgages buried in vast blind investment pools turned the light on all sorts of investment products, including SIVs. Now it may just be a matter of time before the concern spreads from SIVs to the banks that created them.

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