Bank-backed SIV bailout shows rules don't work
Bank-backed SIV bailout shows rules don't work
Wall Street Journal columnist David Reilly says investors did not not see credit-market problems coming and argues that a bailout plan announced by big Wall Street banks Monday shows post-Enron rules haven't done enough to protect investors when companies bury risks in off-balance-sheet vehicles. "This is the Enron disease, we have not killed it," said Christopher Whalen, managing director of Institutional Risk Analytics.
Risks Sparking Bailout Were Still in Shadows By Post-Enron Rules
By DAVID REILLY
October 16, 2007; Page C1
The bailout plan that is supposed to revitalize credit markets and prevent some major banks from straining their balance sheets raises two crucial questions: Why didn't investors see the problems coming? And how could they have happened in the first place?
Changes enacted after Enron Corp.'s collapse were supposed to prevent companies from burying risks in off-balance-sheet vehicles. One lesson of Enron was that the idea that companies could make profits without taking any risk proved to be as ridiculous as it sounds.
Regulators made a great show of slamming closed that loophole. But as the current situation makes clear, they not only didn't close it all the way, but the new rules in some ways made it even harder for investors to figure out what was going on.
That is causing headaches for investors in banks, especially the biggest institutions such as Citigroup, Bank of America and J.P. Morgan Chase. All three, along with assistance from the Treasury Department, joined to craft the rescue package for what are known as structured investment vehicles, or SIVs.
These SIVs, along with vehicles called conduits, don't get recorded on banks' books because regulators and accounting-rule makers gave banks a pass when crafting post-Enron rule changes meant to curtail off-balance-sheet activity.
All the banks had to do was structure the vehicles so that the risk of loss associated with them was ostensibly transferred to other parties. Then the vehicles could stay off a bank's balance sheet. That allowed banks to make bigger profits without having to tie up capital on their balance sheet. Never mind that the banks created, ran and garnered fees from the vehicles.
But the bailout of some of these vehicles shows that banks, and in turn their shareholders, did shoulder a lot of the risk connected to some of these vehicles and essentially controlled them.
This belies the "whole legal fiction of separateness" as allowed by accounting rules, said Christopher Whalen, managing director of Institutional Risk Analytics, a Los Angeles research and risk-management systems firm.
"This is the Enron disease, we have not killed it," he added. Enron structured transactions to be within the letter, if not the spirit, of accounting rules in a bid to keep the deals off its books and out of view of investors. No one is saying, of course, that the big banks are literally shams like Enron.
A spokesman for the Financial Accounting Standards Board, which drafted the current rules, declined to comment.
Banks use SIVs and conduits to issue short-dated commercial paper and medium-term notes, investing the proceeds in assets such as credit-card debt and mortgage securities. The vehicles profit by capturing the difference, or spread, between the notes they sell and their investments. Their sponsor banks then garner these profits in the form of fees they charge the vehicles.
The lack of disclosure to investors about SIVs and conduits, along with the risks they pose, is "significant enough that getting a real feel for what the potential impact could be is difficult," said Craig Emrick, senior accounting analyst with Moody's Corp.
Even if the exposure turns out to be minimal, the profits banks generated from the SIVs and conduits are, at best, going to be smaller in the future, cutting into the earnings of banks such as Citigroup that had significant amounts of these assets.
Citigroup, for example, has nearly $160 billion in SIVs and conduits, but its shareholders wouldn't get a clear view of this from reading the bank's balance sheet. Instead, footnotes only disclose that the bank provides "liquidity facilities" to conduits that had, as of June 30, $77 billion in assets and liabilities.
"Generally, the company has no ownership interest in the conduits," the bank's second-quarter filing, the latest available, states. The Citigroup filing makes no mention of SIVs. In a letter to investors in August, Citigroup disclosed that it had about $100 billion in SIV assets, although that has since declined to about $80 billion.
A Citigroup spokeswoman declined to comment.
Banks typically agree to acquire the assets of their affiliated conduits if they can't roll over their IOUs. But they only backstop a portion of SIV assets. That might make it seem like the banks have some liability, and indeed some have had to step in. But backstops aren't a sign of ownership under accounting rules, though.
In fact, most off-balance-sheet vehicles, conduits and SIVs included, don't have "owners" in the traditional sense. Rather they are like corporate zombies and are typically set up in offshore tax havens.
Because of this, accounting-rule makers trying to clamp down on off-balance-sheet vehicles decided to look at who shares in the risks and rewards of a structure, rather than who owns it, when assessing control.
But banks found they could structure vehicles so that other parties would have to shoulder losses. That allowed them to pass the risks test and keep the vehicles off their books.
FASB, when crafting the new rules, considered weighing the fees banks generate from running these vehicles as an indication of a reward that could also show control. But the board didn't include that test, fearing it would be too difficult to measure and that it could lead to over-consolidation of assets that would weigh down banks' balance sheets.
Although the recent debt-market turmoil and its effect on these vehicles have concerned accounting-standard setters, there is no plan at the moment to reconsider current rules.
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posted by Victor Lloyd Smith @ 1:33 PM
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