One of the most maddening aspects of the current credit-market crisis has been trying to get a handle on the off-balance sheet liabilities at Citigroup (C), which has already disclosed a $1.6 billion hit from exotic debt investments. In this accounting shadowland, nothing is certain. Yet a document analysis by BusinessWeek suggests that Citi may face a fresh billion-dollar exposure because of financial obligations tied to the commercial paper market, a critical source for short-term financing.
At issue are those wretchedly named collateralized debt obligations (CDOs), entities that issue securities often backed by subprime mortgages pooled in tranches and sold to investors based on their risk tolerance. These culprits exploded on Merrill Lynch's (MER) balance sheet and cost Stanley O'Neal his CEO job. However, the critical issue here is Citi's exposure through financing commitments to about a dozen CDOs, including three managed by executives of the Bear Stearns (BSC) hedge funds that cratered this summer amid the subprime meltdown. Citi garnered fees from underwriting these investments, but it also agreed to cover nearly 90% of the financing backing for the CDOs if the commercial paper market seized up—and the asset-backed segment pretty much has.
Just to be clear: This exposure by Citi is a separate matter from other arcane financial products in the news called structured investment vehicles, investment pools that also use short-term funding. Citi has a huge stake in the success of a proposed $80 billion SIV megafund to resuscitate that market. Citi set up many SIVs, yet has no clear legal obligation to cover losses.
However, this dozen or so CDOs in question could cost Citi dearly in the form of writedowns and future earnings hits. An estimate, based on the free fall in asset prices that whacked Merrill's CDOs and the hits some SIVs have taken, suggests Citi could face a $1 billion or so loss. That number assumes that the value of securities backing the $20 billion has fallen 15%. (That's conservative, given the 20% and 30% declines reported by others.) Do the math, and you get a $3 billion loss. Citi's commercial paper obligations cover the most senior tranches of these CDOs. Citi is on the hook for any losses above $2 billion, leaving the potential $1 billion exposure.
Citi declined to discuss its CDO exposure. The bank has yet to file its complete third-quarter earnings statement with the Securities & Exchange Commission, a disclosure that may shed more light. It's possible Citi might have hedged some of the risk.
It's not the only firm that may be vulnerable. A handful of other banks, including Barclays (BCS), WestLB, and Bank of America (BAC), struck similar financing arrangements. WestLB says its deal problems are resolved. Barclays and B of A declined to comment. In all, there are roughly $100 billion worth of CDOs in which banks are on the line for much of the financing, according to JPMorgan Securities (JPM)—with Citi being the biggest player. "All of [this commercial paper] is probably back on someone's balance sheet," says Kedran Garrison Panageas, a JPMorgan CDO analyst. "My guess is there's going to be some train wreck here," adds J. Edward Ketz, a Penn State accounting professor.
Estimating the value of CDOs is tricky, given that they are complex, opaque, and rarely traded. That's why many people judge them by the credit ratings on their assets, which for Citi's deals were almost exclusively AAA and AA. But "just because a CDO portfolio hasn't been hit with a lot of downgrades doesn't mean it won't in the future," says Douglas J. Lucas, head of CDO research at UBS.
A quick survey of the structured finance terrain turns up bad omens for Citi. In mid-October the Rhinebridge SIV—part of the collection that prompted the rescue fund—reported a 20% decline in the value of its assets in three days, yet some 89% of its holdings had a AAA rating, according to S&P. Meanwhile, Merrill cut the value of its AAA-rated stakes in CDOs by an average of 30%. On Oct. 30, Swiss bank UBS (UBS) increased its quarterly writedown by $700 million from what it predicted four weeks prior, citing the dropping prices of CDOs and mortgage securities.
Nonpublic trustee reports reviewed by BusinessWeek for two Citi-backed CDOs also offer a rare glimpse into the underlying assets of such portfolios. A close look at the holdings for KLIO II Funding and KLIO III—two CDOs that were run by Bear Stearns—shows that about 40% of their portfolios were invested in securities backed by subprime mortgages. These assets, and KLIO stakes in other CDOs such as Knollwood, Porter Square I, and Commodore II, could be ripe for downgrades in the future. Complicating matters, the two Bear Stearn hedge funds traded securities with at least one of the KLIO CDOs. Now, Citi may have to fight with creditors of the bankrupt Bear hedge funds over the CDOs' assets—just one more cloud over Citi's holdings.
The CDOs backed by Citi may have a better pedigree than those that hurt Merrill. They were assembled mostly in 2004 and 2005, when mortgage lending standards were stronger. However, delinquencies on mortgages from 2005 are starting to climb. S&P recently cut the ratings on 402 bonds backed by mortgages that were issued in the first nine months of 2005. The CDOs that own those bonds stand to be downgraded next—potentially setting off a chain reaction that could knock down Citi's CDOs. For example, 18% of the investments in Saturn Ventures II (a CDO that Citi underwrote in 2004 and one for which the bank agreed to provide backup financing) have been downgraded, according to UBS Research.
Citi earned substantial fees on these structured-finance products. Those KLIO deals that Citi underwrote brought in $22.3 million in underwriting fees. And the bank also collected fees of an estimated $40 million a year for offering backup funding on the CDOs that are now in doubt. Now it's payback time, and this could mean a world of earnings pain for Citi.