My concerns with Citigroup’s derivatives exposure was communicated to FDIC senior management in 2007. I doubt I could have been any more clear in my warnings that Citigroup and its accountants were “hiding” the risk exposure the banking company presented to the FDIC insurance fund.

My supervisors buried my warnings and pretended they were unaware of such risk exposure right up until mid-2008. Why weren’t senior regulatory officials and accountants held accountable? Why did the Financial Crisis Inquiry Commission ignore reports of these regulatory lapses?

From: Haskins, Dwight J.
Sent: Thursday, October 18, 2007 11:12 AM
To: Corston, John H.; Hirsch, Pete D.
Subject: Long and Short of Citigroup SIV exposure, insurance implications?

John/Pete,

FYI — looks like we will want to consider how best to track some of these unique, off- balance sheet, complex bank risks and how they are aligned with deposit insurance premium considerations. The SIV (structured investment vehicle) presents a particularly challenging policy and accounting issue I suspect, for us, and the National Risk Committee, and Policy staff.

There has been lots of press this week regarding potential exposure to the banks regarding their Structured Investment Vehicles (SIVs). I was trying to explain the situation to others earlier and thought it worthwhile to consider the unfolidng risks. Considering the Citigroup exposure, here’s the important issues as I see it.

Citi sets up the SIV but since the SIV has no credit history, Citi had to guaranty any loan provided by the investors that the SIV transacts. The loan by the SIV is also secured by the mortgage- backed securities, commercial paper, or CDOs purchased by the SIV. The loan proceeds were used by the SIV to purchase MBS/CDOs that pay 7.5% interest, while borrowing at 4.5% interest.

The SIV borrows short term at 4.5%, lends long term at 7.5%, and remits the spread to the investors and pays a fee to the bank for administering the SIV. What promotes investor interest is the guaranty by the bank and the fact that the rating agencies opined that there was very little risk in lending to the SIV in part because there was “over-collateralization” (initially, that is) to support the loan.

Everything is fine until now when it turns out that the investments the SIV purchased are not performing as planned. The mortgages aren’t getting paid, so the value of the mortgage-backed securities purchased for say $100 are only worth $80. The lender/investors gets word and ask the SIV to pay back the loan.

The SIV can’t really pay the loan back because it used the cash to buy the MBS. Citi doesn’t necessarily have the cash reserves to make good on its guaranty without having to sell some of its investments to get cash — and that most likely would require having to unload under-water assets, causing loss recognition. The SIV can’t sell the MBS because the marketplace knows they are bad investments and nobody wants them.

But Citi guaranteed the loans, so if push comes to shove, Citi is on the hook. Citi would have to buy the investments for the amount the SIV owes even though they are not worth that much, or sell the underlying investments and pony up the rest. This could cause the bank major losses. By the way, I saw no mention of any of this in Citigroup’s latest 10-Q so it could be interesting to see if the SEC embarks upon some inquiry since I would think some discussion was warranted in the Management and Discussion Analysis.

There is a lot of commercial paper issued by the SIV apparently due in November and Citigroup doesn’t apparently think investors are going to be interested in rolling over new commercial paper for old commercial paper knowing the collateral value is suspect. Solution? Create the M-LEC as super SIV. The major banks will put some cash into this super SIV account, and that pool of cash, together with new commercial paper issued byM-LEC, will be used to purchase the bad investments that the SIV is unable to finance.

While the underlying investments haven’t changed or gotten any better, the transactionestablishes a new carrying value and prevents mark-to-market impairment from being realized. So, instead of accepting that the investments are worth $80 and recognizing the loss, they are sold to the M-LEC who is willing to pay $95 instead of $80. M-LEC gets $15 from the banks (the cash they invested in the M-LEC) and $80 by issuing new commercial paper. The commercial paper lenders (investors) are fine with this apparently since the banks will take the first loss if the investments end up not paying off.

The only thing not mentioned is the accounting rules. How does the investment get valued when it is sold to the M-LEC? It may be worth $80 which looks to be the market value. But if the new investors are willing to pay $95 the accountants may go along with that value. Lets say at $95.

The “loss” to the bank (Citi in this case) that guaranteed the selling SIV is only $5, and not $20 — all because of the newly created super-SIV was constructed. The theory, I suppose, is that in time investors will be less worried about the value of the investments and the investments may rise in value again as the market returns to normalcy. Lets say the value goes back to $100. Everyone gets their money back with no losses reflected. One could see this as a “win-win” situation, perhaps giving the banks a chance to fund reserves for any future losses.

But, one could take the argument that this unique arrangement is to prevent any equity capital impairment to Citigroup.

Shouldn’t there be some “additional” or implicitdeposit insurance premium charged to Citigroup to reflect the scenario that the bank’s capital was at least temporarily impaired until the M-LEC could save the day? 

One could argue that Citi should be exacted a charge for being a guarantor to the SIV which puts their capital position at risk.

In addition, charging Citigroup for this additional risk could counter the argument by some that moral hazard is being encouraged by the Treasury for encouraging this workout scheme.