Banking: This Disaster Was Guaranteed

Money-back assurances on subprime-linked securities are costing some leading banks billions

Although refund policies have long been standard practice for retailers, they've rarely been given for financial investments--and for good reason.

A closer look at the mortgage meltdown reveals Citigroup (C) and other big banks offered a type of money-back guarantee to buyers of nearly $100 billion of subprime mortgage-linked securities, according to a BusinessWeek analysis. Incredibly risky in retrospect, the refund policies were critical in the banks' push to keep a steady stream of money coming in during the peak years of the housing market from 2004 to 2006. But the myopic decision has been a central cause of the billions in losses that some banks are now reporting. Citi, which declined to comment, announced on Nov. 5 that it was on the hook for $25 billion worth of such deals.

The refunds are emblematic of the "What, me worry?" attitude that permeated the housing market. Everyone involved, from banks to borrowers to investors, convinced themselves they were taking little, if any, risk.

For the investors, at least, it was free money. In an effort to attract money-market funds--a new group of buyers for subprime-related securities--banks started putting guarantees on some products a few years ago. The deal appealed to the target audience, a conservative group seeking higher yields at low risk. After all, it was a no-lose situation. The funds didn't have to worry if the underlying mortgages started to look shaky since the banks agreed to pay back the investment plus interest, with few exceptions.

At the same time, the banks convinced themselves that it was a low-risk proposition. They figured the securities would at least maintain their value. And even if the investments did stumble modestly, the losses would be minimal and affect only the lowest tier of investments. So the banks never figured they'd have to make good on the refunds. "It sounds like there was so much hubris that they thought something bad couldn't happen," says Jack T. Ciesielski, publisher of The Analysts' Accounting Observer.

The refund policies came at a pivotal juncture in the housing market--the point at which the boom turned into a bubble. They allowed the banks to tap into a new pool of money, which in turn attracted more money from players already in the game, such as hedge funds.


Here's how it happened. Money-market funds eagerly bought up the short-term debt associated with the subprime-linked securities known as collateralized debt obligations (CDOs). The refund policies, technically known as "liquidity puts," were crucial. For instance, they allowed the credit rating agencies to bestow on the investments the same grade they gave the banks that backed them. That reassured the funds.

The CDO managers then used the borrowed money to fund their purchases; it was a cheap way to leverage the portfolio. Hedge funds salivated over that strategy, pouring billions more into CDOs. For example, two Bear Stearns (BSC) hedge funds now in bankruptcy relied on guarantees from Citi to raise $10 billion from money-market investors for three CDOs brand-named Klio, according to documents reviewed by BusinessWeek. It was all part of the massive machine that pumped more than $1 trillion into the housing market.

In the aftermath, analysts are increasingly worried about banks' hidden commitments on everything from credit-card debt to corporate loans. Warned Goldman Sachs (GS) analyst William F. Tanona in his Nov. 19 report on Citi, which rated the stock a sell: "Other off-balance-sheet items could be lurking."

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