Recent media reports cite a variety of reasons for the weakness in financial stocks. They blame multi-billion-dollar asset writedowns, the bursting housing bubble, upheaval in credit markets, exposure to shaky mortgage-backed securities, analyst downgrades, and the prospect of lower revenues stemming from a dramatic slowdown in securitization and M&A activity.
If that was all there was to it, it might be worth trying a bit of bottom-fishing, at least for a quick trade. Unfortunately, given the way the bad news has dribbled out so far, the furtive but clearly desperate attempts at trying to cobble together a "rescue" that nobody wants to acknowledge as such, and the unusual involvement of government agencies such as the Treasury Department, it seems far too early for that.
Indeed, the real concern, as Forbes suggests in "Black-Hole Banking," is what we don't know about the situation.
Citi and other big banks are organizing an SIV bailout. But what else is hidden by their murky accounting?
Investors were shocked recently to discover Citigroup and a handful of other banks were on the hook, morally if not legally, for hundreds of billions of dollars' worth of a product so esoteric it had many scrambling for their finance dictionaries.
The product, structured investment vehicles, or SIVs, didn't appear on the banks' balance sheets. Nor did SIVs show up among the liabilities banks scantily disclose as so-called off-balance-sheet items. In other words, they were a black hole. "There are no regulatory reports, no SEC filings. Everyone's in the dark," says Bert Ely, a Cato Institute scholar and banking consultant.
Cassandras have long warned that institutional exposure to huge, poorly disclosed or undisclosed financial exotica poses systemic risk. Occasionally investors listen, as they did after Long-Term Capital Management blew up in 1998.
Since then trading in everything from commercial paper to credit derivatives has soared. Bank accounting has gotten exotic as well. In the old days banks took in deposits, made loans and tallied up the results on their balance sheets. For regulators, it was a simple matter to add up assets and liabilities and declare how much capital banks needed to keep in reserve to cover losses.
In recent years, though, banks have made generous use of accounting rules that permit them to use derivatives to push credit risk off their balance sheets, where disclosure and capital requirements are relatively skimpy and valuations more art than science. As derivative markets have grown, U.S. commercial banks have taken on $934 billion in exposure in them against which they are required to maintain reserves to cover potential losses.
Among other ventures largely unaccounted for on balance sheets are those like Mica Funding. Large banks set it up to hold loans that could have landed on their own books. S&P bestowed an a-1 rating--its highest--for the short-term borrowings of this Channel Islands vehicle. This despite the fact that 63% of Mica's assets are rated either junk or not rated at all, and 42% aren't even identified by type. Investors have become wary of investment vehicles with such shoddy disclosure, however highly they are rated, and that has made it hard for them to continue financing themselves, says Joshua Rosner, an analyst at New York's Graham Fisher.
Mica-like vehicles aren't the murkiest risk knocking around, either. Banks' off-balance-sheet accounts include only items for which they are contractually on the hook. But other items, which aren't disclosed anywhere, can also saddle them with unexpected losses.
The SIVs, with $400 billion or so in assets, didn't show up on their balance sheets, their off-balance-sheet statements or anywhere else. That's because they're categorized as "bankruptcy remote vehicles," which the banks have no fiduciary duty to disclose and no contractual obligation to support.
The problem with SIVs is that contracts are not the only form of binding obligation. Citigroup set up SIVs, with names like Beta, Centauri and Dorada, with $80 billion in assets. When investors began fearing they were packed with doggy paper tied to the subprime market, the financing to fund them dried up. That has left a handful of banks, led by Citigroup and with the support of Henry Paulson's Treasury, scrambling to patch together a bailout fund to buy assets from the SIVs. If Citi exercised its legal right to walk away, it would do damage to its ability to do other deals and to investor confidence generally. Contract or not, Citi is on the hook.
How much risk do banks face from such noncontractual, off-off-balance-sheet activity? Quantifying it is mere speculation, Citi says. Regulators don't require banks to disclose such risks, or set aside money for them, until the banks actually step in to save the day. By then, of course, it may be too late.
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