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October 15, 2007

Super SIVs - A Fraudulent Attempt at Concealment
by Mike Shedlock

The Wall Street Journal is reporting Citigroup Rescue Plan Redied.

Over the weekend, the Treasury hosted talks to help a group of banks set up a $100 billion fund to buy troubled assets in exchange for new short-term debt. The banks hope to have the fund up and running within 90 days.

The problems stem from affiliated funds called structured investment vehicles, or SIVs, which Citigroup and others set up as a way to make money without taking the risk involved onto their balance sheets. Such vehicles are formally independent of the banks that create them. They issue their own short-term debt, usually at relatively low rates that reflects their high credit rating. Then, they use the proceeds to buy higher-yielding assets such as securities tied to mortgages or receivables from midsize businesses seeking to raise cash.

[Mish comment. This is classic borrow short lend long madness. When done with leverage it eventually blows up. Citigroup is an enormous player in SIVs and the assets on which it has lent (mortgage backed securities), have plunged in value]

Behind Treasury's concern were banks like Citigroup, whose affiliates owned $80 billion in assets backed by mortgages and other securities. The world's biggest bank, by market value, held the assets off its balance sheet and was facing the prospect of either having to unload them in a disorderly fire-sale fashion or moving them onto its books.

[Mish comment: One problem here is that Citigroup should never have been allowed to hold those assets off its books in the first place]

Under the proposed rescue package Citigroup, J.P. Morgan Chase & Co. and Bank of America Corp. will set up a fund, or "superconduit," to act as a buyer of last resort. It will pay market prices for SIV assets in an effort to prevent dumping.

[Mish comment: In other words, Citigroup is setting up a fund to buy assets from itself. How convenient. By the way, when you are buying something from yourself, who determines market price?]

Details are still being worked out but the oversight committee of the three banks will set criteria for what the new fund, to be called the Master-Liquidity Enhancement Conduit, will buy.

[Mish Comment: It will be interesting to see if there are "price guarantees"]

Banks would face huge losses if their affiliated funds were forced to unload billions of dollars in mortgage-backed securities and other assets because it would drive down prices and lead to big write-offs at the new, lower market prices. Indeed, in the past several months, Citigroup's own affiliates have sold some $20 billion in assets.

Some bankers objected to the plan, calling it an escape hatch for Citigroup, which has more SIVs than any other bank, according to people familiar with the situation. The bank has accounted for about 25% of the global SIV market. As of August, assets held by SIVs totaled $400 billion.

[Mish comment: $400 billion in off balance sheet assets is preposterous. Chuck Prince and his entire team should be fired. More to the point why should Citigroup be bailed out? They were incredibly greedy and they should pay the price]

Citigroup has drawn special scrutiny. The bank and its London office run seven affiliates, or SIVs, that would be able to sell assets to the superconduit.

Bringing assets onto its balance sheet would be a big problem for Citigroup because it would be required to set aside reserves to cover the assets. The banking titan operates with a capital ratio that is thinner than peers.

[Mish comment: So what? Citigroup deserves to have a problem for acting stupidly]

If the WSJ is remotely close to accurate on the plan details, this Super-SIV bailout is nothing but a fraudulent attempt to allow banks and financial institutions to keep questionable assets off their balance sheets.

Mandatory Auction Calls

On October 12 naked capitalism was talking about another fraudulent way of keeping assets off balance sheets:

Some financial firms have sought in recent weeks to avoid write-downs by selling mortgage positions to hedge funds, with an agreement that allows the hedge fund to sell them back after a set period. A hedge-fund trader says his firm recently bought $1 billion of risky subprime mortgage loans from Bear Stearns with a one-year pact, known as a "mandatory auction call," under which Bear agrees to participate in an auction for the loans that will provide the hedge fund with a minimum rate of return, according to a person familiar with the situation. "They didn't want the mortgages on their books," the hedge-fund manager says.

Such financial arrangements typically are considered proper if there's an economic purpose to the trade and if risk is taken on by both parties. Legal problems could arise if such trades are part of an attempt to conceal a company's financial picture, regulators say.

When it comes to Bear Stearns, there is absolutely no economic purpose to the trade. The only purpose was to conceal the current value of the asset. This makes it fraudulent. The SEC should investigate but it likely won't.

Super SIV Doomed To Fail

On Saturday I commented Super SIV Bailout Plan Doomed To Fail. As details emerge I have seen nothing to change that opinion. The WSJ article has filled in a lot of blanks and the remaining blanks will be filled in on Monday. But as of now this still looks to me like a game of Don't Ask - Don't Sell.

Don't Ask - Don't Sell

• Don't Ask what the asset is worth.
• Don't Sell or you will find out and not like the result.

Of course you can sell to the Master-Liquidity Enhancement Conduit at market prices, but market prices are not set by selling assets to yourself or by agreements to buy assets a back at a guaranteed price as Bear Stearns is doing.

Let's go back to the beginning. This problem was caused by loose monetary policy in conjunction with rules that allowed garbage to be kept off bank balance sheets. The proposed solution is another scheme to keep garbage off bank balance sheets. Logically the solution and the problem cannot be the same.

All indications are the Super-SIV bailout is nothing but a delay tactic that simply cannot work. Furthermore, there is another crisis waiting in the wings: commercial real estate. There is also a looming consumer led recession that is coming no matter what the Fed does. For those reasons, attempts to delay will only exacerbate the problem.

I do not know what the market will do on Monday. Perhaps this bailout will sent the market to new highs. Bulls certainly have been stomping as if the economic problems we face are temporary. Unfortunately the problems we face are not temporary. Structural economic problems run long and deep. Whatever final shape this bailout plan takes, it is doomed to fail over the long haul. A collapse in consumer spending and commercial real estate will seal the fate. Both are going to happen.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Michael "Mish" Shedlock is a registered investment advisor representative for SitkaPacific Capital Management. Visit http://www.sitkapacific.com/ to learn more about wealth management for investors seeking strong performance with low volatility.

Copyright © 2005-2008 Mike Shedlock

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