Pathology of Debt

By
Henry C.K. Liu


Part I: Commercial Paper Market Seizure turns Banks into their own Vulture Investors
Part II: The Commercial Paper Market and Special Investment Vehicles
Part III: The Credit Guns of August heard around the world


Part IV: Lessons Unlearned

This article appeared on AToL on November 30, 2007


Moody’s Bullish 2005 Report on Structured Financial Operating Companies

Moody’s has developed a rating methodology for Structured Financial Operating Companies (SFOCs). Moody’s has recognized the similarities in which various forms of vehicle operate and has developed a new classification and ratings process for this group of structured finance entities. SFOCs are operating companies that apply detailed, pre-determined parameters to define and restrict their business activities and operations. The SFOC designation applies to a number of different structures including:

Derivative Product Companies (DPCs)
Collateralised Swap Programs (CSPs)
Credit Derivative Vehicles (CDVs)
Structured Investment Vehicles (SIVs)
Structured Lending Vehicles (SLVs)
Interest Rate Arbitrage Vehicles (IRAVs)
Issuers of Guaranteed Investment Contracts (GIC Issuers).

Moody’s Special Report, issued on April 14, 2005 states: “Under this classification Moody's has assigned ratings to more than 50 of these vehicles. To date, there have been no rating downgrades on any of their publicly-rated issued debt, which testifies to the resilience and strength of the structures of these vehicles and how robust they are to market disruptions. This view on the unification of the general rating approach for these vehicle types provides a basis for the continual growth within this market as the markets evolve and converge as well as providing a basis for the introduction of new or hybrid vehicle types.”

Optimism Turned to Panic

By August 2007, this optimistic statement was rendered inoperative by events. Fed data show that the $1.1 trillion market for commercial paper used to buy mortgages on homes, aircraft, and cars seized up in August just as more than half of that amount comes due in the next 90 days. Unless new buyers could be fund to buy new debts to replace the old ones, hundreds of hedge funds and companies will be forced to sell $75 billion of asset at prices that reflect sharp losses.  Such distressed sales would further drive down prices in a market where investors have already lost $57 billion as estimated by the Merrill Lynch broadest index of floating-rate securities backed by home- equity loans. That will adversely affect the position held by 38.4 million individual and institutional investors in money market funds, the biggest holder class of commercial paper. Top-rated commercial paper is one of the safest assets in normal times. But these are not normal times.

The major players in the SIV market by the end of 2005 were:
Beta Finance Corp was sponsored by Citibank International Plc (Commercial bank) in 1989 with asset under management (AUM) of $15.3 billion;
Sigma Finance Corp was sponsored by Gordion Knot Ltd (Investment manager) in 1995 with $34 billion of AUM;
Centauri Corp was sponsored by Citibank International Plc (Commercial bank) in 1996 with $16.1 billion of AUM;
Dorada Corp was sponsored by Citibank International Plc (Commercial bank) in 1998 with $10.5 billion of AUM;
K2 Corp was sponsored by Dresdner Kleinwort Wasserstein (Investment bank) in1999 with $20.6 billion of AUM;
Links Finance Corp was sponsored by Bank of Montreal (Commercial bank) in 1999 with $13.5 billion in AUM;
Cheyne Finance was sponsored by Cheyne Capital Management Ltd (Investment manager) in 2005 with $7 billion in AUM;
Cullinan Finance Corp sponsored by HSBC Bank Ltd (Commercial bank) in 2005 with $27 billion in AUM.

As of March 2007, every one of the above SIVs was in distress, plus a few more:
Eiger Capital (Orion Finance)
III Offshore Advisors (Abacas Investments)
West LB (Harrier Finance Funding Ltd., Kestrel Funding
Standard Chartered Bank (White Pine, Whistlejacket Capital)
Societe Generale (Premier Asset Collateralized Entity)
Stanfield Global Strategies (Stanfield Victoria Finance)
Rabobank International (Tango Finance)
Eaton Vance (EV Variable Leveraged Fund)
HSH Nordbank (Carrera Capital Finance)
MBIA (Hudson-Thames Capital)
IXIS/Ontario Teachers (Cortland Capital)
Axon Financial (Axon)
IKB KG (Rhinebridge)

Worldwide Investors with Complex Holdings

By any measure, this is a small number of issuers. But the problem is that the ABCP they issued are bought by large number of investors worldwide in patterns that are difficult to sort out because of the complexity of the CDO tranches and the variety of hedges employed by investors.

On the liability side, some SIVs experimented with the capital structure in order to meet the risk/reward requirements for a broader scope of new and traditional capital note investors. This has been mainly through the adoption of a three-tier structure similar to that of collateralized debt obligations (CDOs) – with senior, mezzanine and equity levels of issuance – and some of the established SIVs have been restructured to take advantage of this new market trend. The issuance of junior tranches by SIVs is not a new practice, but it has not been widely adopted until recently. Asset Backed Capital (ABC), one of the oldest SIVs, has long achieved a Moody’s A1 rating for its senior subordinated notes, with a tranching ratio of approximately 60 junior notes to 40 mezzanine capital.

One new SIV trend has been the rapidly growing demand for rated capital notes. As the first loss piece of the SIV capital structure (subordinate to MTNs and CP), capital notes typically expose holders to first gains and losses in the asset portfolio. According to Standard & Poor’s, over US$11 billion in capital notes have been rated to date, pointing to the transparency and disclosure required by investors as well as the expected impact of Basel II on institutions holding unrated notes.

Shrinking spreads had led to innovations to the traditional SIV structure. On the asset side, some SIVs trended away from the absolute practice of investing in high grade and liquid ABS. They explored less liquid products such as CDOs and mezzanine ABS (these are usually harder to get marked-to-market prices and have larger bid/offer spreads). Several existing and new SIVs received approval from rating agencies to synthetically purchase assets (in lieu of highly-rated ABS/MBS) by selling credit default swap (CDS) protection on corporate assets. As with conventional SIV portfolio management, the vehicle would profit from the credit arbitrage between long-maturity assets on a leveraged basis and short-maturity liabilities. Additionally, the ability to use repurchase agreements (repos) as alternative asset-purchase funding was incorporated into SIV mandates, as they were within other structured finance operations.

In 2004, Citigroup introduced a new vehicle that takes this to a whole new level. Sedna Finance incorporates a three-tier liability structure, with AAA-rated first priority senior notes (FPS), A-rated second priority senior notes (SPS) and an unrated first loss piece. Citibank raised 90% of the US$1 billion capital through its SPS notes with 150 times leverage, exponentially greater than the 15 times industry average leverage. In addition to funding the purchase of various assets, proceeds from the issuance of bonds and paper may also be used for single-name CDS as either protection buyer or seller. Sedna was approved to take up to 20% of its total portfolio risk in synthetic instruments.

As the industry grew more adept with the application of single-name corporate CDS, credit-linked notes (CLNs) took on a more significant role on the funding side as they could be used to achieve lower funding costs. For example, an SIV can issue a euro-denominated CLN synthetically linked to the credit risk of a BBB-rated entity, swap the euro to US dollarand use the proceeds to acquire AAA-rated securities. In effect, it has hedged out currency risks while potentially improving net yield, at least in theory.

The Impact of the New Basel Capital Accord

The New Basel Capital Accord will make the back-up liquidity structures for many ABCP conduits very expensive. What had been a zero capital charge will become a capital charge of up to 8% of the outstanding exposure. In the US, the Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and Office of Thrift Supervision all also has specified new sets of capital requirements for ABCP.

In Europe, various national regulators and the EU will be specifying capital levels for European banks. One major impact is that US ABCP program bank sponsors are required to hold risk based capital against liquidity facilities that have maturities of less than one year. A 10% credit conversion was applied to all of these liquidity facilities until 30 September 2005. Further to this date, conduits are required to pass certain asset quality tests in order to maintain the 10% credit conversion; otherwise they will be subject to 100% credit conversion. This is one reason why partially enhanced, market value securities arbitrage program have grown in leaps and bounds in recent years. Basel II will potentially change this and result in similar capital requirements for liquidity facilities within Europe. As of yearend 2004, securities arbitrage and SIVs accounted for approximately 25% of the total ABCP market.

The impact of these regulatory changes will be far-reaching, further increasing the cost of liquidity provisions. However, the proposed Basel Accord is also expected to provide additional downward pressure on the spreads of high-rated assets, removing the arbitrage opportunities for these conduits as their funding costs move closer to the spreads on the assets. It is not expected to drive these vehicles out of the market, but rather enforce the need to restructure and adopt many alternative funding and liquidity management techniques.

On 26 June 2004 the Basel Committee on Banking Supervision released its revised framework for the capital adequacy of banks. International Convergence of Capital Measurement and Capital Standards (Basel II) substantially revises the 1988 Basel Capital Accord.

Under Basel I: A $100,000 commercial loan with AAA credit rating would require $8,000 capital charge while the same loan with a B credit rating would require the same $8,000 capital charge.

Under Basel II: A $100,000 commercial loan with AAA credit rating would require $370 while the same loan with a B credit rating would require up to $42,000 capital charge.

The logic is that capital requirements should increase for banks that hold risky assets and decrease significantly for banks that hold safer portfolios. Basel II creates incentives for banks to move risky assets to unregulated parts of the holding company, and to transfer risk to investors through securitization. Banks have strong incentive to undertake regulatory capital arbitrage to structure the risk position of a group of loans in a manner that allows it to be reclassified into a lower regulatory risk category compared with the Basle 8% standard. Securitization is the key tool used by large banks to engage in such arbitrage.

Credit derivative vehicles (CDVs)

Credit derivatives have been responsible for a sea-change in global investment management practices. A number of SIVs have been approved to engage in synthetic trading. Other firms are also focusing on synthetic trading adopting the ways of the SIV.

Similar to an SIV, a CDV has its assets reviewed by the agencies on a regular basis to ensure economic capital levels are capable of supporting their business volumes. The high rating provides the firm with an extraordinary competitive advantage in terms of counterparty creditworthiness. Qualification requires intensive monitoring of market and credit risks integrated into their asset and liability management process. These firms must also report risk exposures and limits on a very frequent basis to the rating agencies.

One such vehicle is Primus, which is an AAA-rated structured credit vehicle established as a dedicated seller of single-name CDS protection. Recently, Primus has moved into portfolio credit derivative trades, namely tranched CDS.

Hybrid vehicles

With the ongoing convergence in the market, more hybrid-type vehicles entered the market. In August 2005 BSN Holdings Ltd launched an innovative ABCP program that engaged in securities arbitrage and lend in the repo market. The US$20 billion ceiling program, Chesham Finance, resembled conventional securities arbitrage conduits and structured investment vehicles in that it could buy a wide variety of short- or long-term securities rated at least AAA or AA. However, the vehicle would not be required to maintain a bank liquidity support or a capital base. Asset-liability maturities would be managed to an exact science through a system of repaying maturing CP by issuing paper exactly matched to its assets and monitoring this using SIV-like cumulative net cumulative outflow (NCO) tests. Additionally, this may include using extendible CP and call and put options on the CP to ensure perfect matching. In addition, Chesham was approved to lend to highly rated counterparties under reverse repos.

Structured lending vehicles (SLVs)

Bear Stearns’ Liquid Funding Ltd, a US$1.7 billion (MTN) ceiling program, was among the first vehicles to use reverse repos and total return swaps as collateral. Although it has been referred to as SIV-like, its motivations are very different. Whereas SIVs look to arbitrage the spread between long-dated assets and short-term liabilities, Liquid Funding seeks to provide borrowers with a secured source of long-term funds as an alternative to the unsecured and repo markets.

Due to prohibitively costly regulatory capital charges, many repo desks are reluctant to provide deals with maturities exceeding one year. Liquid Funding seeks to bridge this gap with its innovative program of rated notes. It most resembles an SIV in that it achieves a high rating for its notes through a battery of tests, including NCO analysis and a capital adequacy test incorporating market value risk. In addition, its collateral portfolio is marked to market on a daily basis. Liquid Funding is labelled a structured lending vehicle (SLV) under Moody’s SFOC rating classification.

Another SLV entrant was $10 billion ceiling Atlas Capital, launched by Wachovia Capital Markets that leveraged SIV and market-value CDO technologies to provide a flexible funding and warehousing platform for its clients’ investments. On the asset side, Atlas engaged in reverse repo and total return swap activity as part of its charter. It issued MTNs, CP and repos to fund pools of investments that could either be leveraged for asset managers or hedge funds, or warehoused for asset managers who have plans for a CDO launch, but were waiting for more favorable market conditions. In an interesting twist, Atlas’s clients selected the assets that were purchased with the proceeds from the debt issued.

The Importance of the Commercial Paper Market

A crisis in the commercial paper market which normally is an arena of high safety spooks investors of all levels of risk appetite. The average yield on overnight asset-backed paper rated A1+, the highest short-term credit rating by Standard & Poor's, rose another 4 basis points, or 0.04 percentage point, to 6.09 percent on Friday, August 24, rising 59 basis points since August 9.

Fed data show outstanding U.S. commercial paper fell 4.2% in the second week of August, the biggest weekly drop in at least seven years, as investors fled asset-backed debt and opted for the safety of Treasuries. Short-term debt maturing in 270 days or less fell $90.2 billion to a seasonally adjusted $2.04 trillion in the week ended August 24. Commercial paper outstanding has fallen by $181.3 billion in two weeks.  The retreat tells market participants that the Fed’s discount rate cut last week failed to instill enough calm to draw back investors.

On April 10, 2006, the Federal Reserve Board made major changes to its CP outstanding calculations. New outstanding categories were added, some existing category definitions were modified, and current and historical CP issuer information was updated. The historical data for the new outstanding structure contains data for January 2001 through the most recently completed month. The historical data for the old outstanding structure contains data for January 1991 through March 2006. Prior to April 10, asset-backed was considered to be a subcategory of financial and other (unknown) was not included in total outstanding. Asset-backed outstanding is no longer a subcategory of financial outstanding. Financial outstanding and all its subcategories no longer include asset-backed outstanding.

Rule 2a-7 of the Investment Company Act of 1940 limits the credit risk that money market mutual funds may bear by restricting their investments to "eligible" securities. An eligible security must carry one of the two highest ratings (1 or 2) for short-term obligations from at least two of the nationally recognized statistical ratings agencies. A tier-1 security is an eligible security rated “1” by at least two of the rating agencies; a tier-2 security is an eligible security that is not a tier-1 security. The sum of tier-1 and tier-2 securities will not add up to the total due to ineligible securities.

Money funds may hold no more than five percent of their assets in the tier-1 securities of any individual issuer and no more than one percent of their assets in the tier-2 securities of any individual issuer; moreover, a money fund's holdings of tier-2 securities may constitute no more than five percent of the fund's assets.

The one day rate for AA financial commercial paper peaked at 6.62% on January 2, 2001.   It bottomed at 1.64 on January 18, 2002. As of the week of August 22, 2007, there were $2.042 trillion of outstanding CP in the US credit markets of which about half were asset backed or $1.057 trillion, falling from $1.083 of the week of August 1. The non-financial CP volume peaked around $350 billion in January 2001 and was $204 billion in the week of August 22, 2007.  The non-financials had difficulties accessing the CP market in 2001.  Reports to that effect concerning Ford, DB/Chrysler and GM were in the news.

The CP Crisis of 2001

The European communication sector that fell into deep crisis in 2001 began rather innocently. Nokia signed a $500 million US-Commercial Paper Program on March 12, 1997. The dealers of the Program were Credit Suisse First Boston (CSFB) and Merrill Lynch, and the issuing and paying agent was Citibank N.A. The issuer in the Program was Nokia Capital, Inc. guaranteed by Nokia Corporation. Nokia’s Program has A-1 rating by Standard & Poor´s and a P-1 rating by Moody´s Investors Service. Nokia said it was re-entering the US commercial paper market to further diversify its funding sources. The success of the Nokia CP program started a wave of communication issues that led to the communication debt bubble in Europe.

When CP rates are at historical lows, the net effect is to keep the walking-dead companies alive, a situation well recognized in Japan in recent decades, or to launch new white elephants. British Telecom, privatized in 1984, having spent extravagantly on 3G technology crumbled under a debt of ₤28 billion in 2001, losing ₤1.8 billion in the first quarter.  When companies cannot roll over their CP because of a drop of credit rating, they generally have to resort to drawing down their revolving bank credit line at much higher cost which in turn puts further stress on their already falling credit ratings.  In a high leverage situation, the downward spiral can undo a major corporation is days. For financial companies, the impact can be catastrophic.

Growing concern about access to short-term capital sent tremors through Wall Street in February 2002 amid signs that more companies were about to be frozen out of the commercial paper market, the main source of day-to-day corporate funding. Investors dumped stocks of telecommunications companies after Qwest Communications was forced to turn to its banks for $4 billion after it was squeezed out of the commercial paper market. It had failed to find buyers for an issue of new short-term funding.

Concern that other companies would suffer the same fate rose after JP Morgan Chase said Sprint, another US carrier, was overextended in the commercial paper market and would have to look elsewhere for financing, such as the bond markets or bank loans at higher cost. Sprint had $3 billion of commercial paper outstanding at the end of the year. It needed to raise an extra $1.7 billion to meet its funding needs for the next year as current paper matured. It sought to cut $60m in costs by laying off 3,000 staff to meet the cash short fall.

On February 15, 2002, New Hampshire conglomerate Tyco International Ltd got clipped by up to $3 billion in its sale of CIT Group, the commercial financing firm it bought in June for $10 billion. The company, which was grappling with a heavy debt load and trying to soothe skittish investors, was negotiating from a position of weakness as it sought a quick sale of CIT, one of the nation's leading specialty and commercial finance companies. It specialized in lending, leasing, and financing for small- to mid-sized companies. CIT was an expert in some of the more arcane aspects of corporate borrowing, using intimate knowledge of its client companies to arrange successful deals for equipment leasing, factoring, lending for acquisitions and expansion, and credit management. The company’s clients included more than 700,000 companies, with specializations in the transportation industry, the apparel industry and the construction equipment industry. CIT operated across North and South America, in Europe and the Pacific Rim. The company was a subsidiary of RCA and then Manufacturers Hanover Bank in the 1980s, after being a freestanding public company for many years. CIT went public again in 1997. It was briefly owned by Tyco International Ltd. in 2001 and then was spun off to the public again in 2002.

CIT's business suffered when it lost access to the short-term commercial paper market, the cheapest source of financing for big companies, because of questions raised about Tyco's accounting practices. Lenders like CIT depend heavily on inexpensive financing for the loans they make. Being shut out of the commercial-paper market left CIT at a big competitive disadvantage.

An industrial company known for its ADT brand security systems and for its electronics component business, Tyco had begun growing quickly through acquisitions with easy credit, making four major purchases in the four months before it announced the CIT deal. Tyco apparently thought it was getting CIT for a bargain price, given its low recent performance.

CIT Group was under Tyco’s umbrella only for about a year. By early 2002, Tyco's stock price was in a steep slide as rumors hit Wall Street about accounting regularities and suspicious payments to its director, Dennis Koslowski. Tyco's declining reputation had damaged CIT Group’s ability to borrow, and in February 2002 Tyco announced that it would sell the financial company within the next few weeks. When it failed to find an immediate buyer, Tyco spun CIT Group off to the public. Tyco had hoped to sell CIT for $10 billion, but spun it off for about $4.6 billion. The public offering took place in July 2002, and CIT Group was once again a stand-alone public company. At almost the same time, the Securities and Exchange Commission announced that it was investigating Tyco. Dennis Kozlowski was sentenced to jail in September 2005 and ordered to pay fines of $167 million for his part in financial wrongdoing at his company.

Tyco and CIT were dealt serious blows when they were shut out of the commercial paper market and rating agencies downgraded their debt on concerns about Tyco’s finances. Commercial paper represents a critical source of borrowing for firms like CIT, which was forced to turn to $8.5 billion in more expensive bank loans when it lost access to commercial paper. CIT cannot effectively compete in the market place if it cannot play in the commercial paper markets. Their inability to sell commercial paper, and their having to take down short-term debt to cover obligations, has forced CIT into the position of having to sell right away. Tyco International was forced to draw down $14.5 billion of bank funding to repay all its commercial paper debt outstanding.

The problem was global. A new procedure was implemented on November 13, 2001 by Euroclear group enabling GE Capital, the largest issuer of Billets de Trésorerie, to deliver on a same-day basis an EONIA Index linked BT not only to Euroclear France clients but also to Euroclear Bank participants. This new procedure explains the operating process between the Issuer, its Issuing and Paying Agent (i.e. domiciliataire) Euroclear France and Euroclear Bank. The development was driven by GE Capital, the largest issuer of commercial paper in Europe. GE Capital actively sought to offer its floating rate commercial paper to institutional investors across Europe. Euroclear extended the deadlines for index communications between Euroclear France and Euroclear Bank to provide to BT issuers a same day issuance for one day securities. The new procedure confirms that the Billets de Trésorerie are not domestic instruments any more and can circulate all across Europe. This also confirms that any financial product under French law can be provided to all international investors.

In October 1999, GE Capital Aviation Services (GECAS), a wholly owned subsidiary of GE Capital, completed the financing of four A330-200 aircraft for Flightlease, a wholly-owned subsidiary of SAir Group of Switzerland. The aircraft have been sub-leased to Swiss Air under a long-term operating lease. The four aircraft were part of a 10 aircraft order by Flightlease and were purchased in September and October 1999 by GECAS. This cross-border financing involved a US leveraged lease. GE Capital arranged 100% of the financing through a combination of a GE Capital equity investment and non-recourse debt provided by an off balance sheet asset backed commercial paper conduit. This structure enabled Flightlease to achieve 100% financing of the equipment cost and off-balance sheet treatment for the aircraft lease at an attractive lease rate.

But in 2002 the impact of the squeeze in the commercial paper market has been limited to the bottom end of the market, among companies with short-term ratings of A2/P2. The spreads between rates on individual issues has widened to between 50 and 75 basis points, up from 15 to 25 basis points. More highly rated companies were not affected and sector related.

GE, the world's largest non-bank financial conglomerate that incidentally also manufactures, issues credit at the retail level through vendor financing, to capture sales for GE products. It gets its funds wholesale from the commercial paper market, which GE dominates because it has a good credit rating. When GE credit rating was downgraded recently, it faced being frozen out of the commercial paper market in the Fall of 2002, and had to revert back to costly bank credit lines that adversely affected its interest rate spread and profitability.

More than 20 companies, including San Francisco-based Luminent Mortgage Capital Inc. and Thornburg Mortgage Co. in Santa Fe, New Mexico, have been unable to roll over asset-backed commercial paper. Thornburg said sold $20.5 billion of securities at about 95 cents on the dollar to pay down commercial paper it couldn't refinance.

GMAC Commercial Paper (CP)

GMAC Financial Services is a global, diversified financial services company. GMAC maintains a diversified portfolio of business operations, including automotive finance, dealer and personal line insurance, real estate finance and other commercial businesses. At December 31, 2006, GMAC held more than $287 billion in assets and earned net income for 2006 of $2.1 billion on net revenue of $18.2 billion.

GMAC was established as a wholly owned subsidiary by General Motors Corporation (GM) in 1919, and currently operates in approximately 40 countries. GMAC offers its Commercial Paper directly to institutional and commercial investors in the United States. These short-term promissory notes are obligations of GMAC and are generally available for 1 to 270 days. GMAC CP is issued on a discount or interest-bearing basis at identical yields and is payable upon maturity at a designated bank. Settlement is made via Depository Trust Company (DTC).

In November 2006, GM sold a 51 percent controlling interest in GMAC to a consortium of investors led by Cerberus Capital Management, L.P. to insulate itself from potential credit downgrade of General Motors, its parent. By the end of 1991, money market funds were shying away from GMAC commercial paper. As the nation's second-largest issuer of these short-term debt securities, G.M.A.C. had more than $23 billion in commercial paper outstanding, about $5 billion more than the value of GM common stock. The Cerberus deal was worth $14 billion payable over 3 years. In 2005, GMAC made a net profit of $3 billion while GM overall lost $10.6 billion, reducing GM bonds to junk status in 2005. Financial plight of GM depressed GMAC value against the Cerberus transaction, which required GM to make good the difference in value to Cerberus.

General Motors announced it will take a $39 billion charge against third-quarter 2007 earnings as a result of writedowns in the ­carrying value of deferred tax valuation allowances. The charges stem from difficult business conditions in GM’s US and German operations and hefty losses at the real-estate arm of GMAC in which GM has a 49% stake.

GM said in early November that it was writing down deferred-tax benefits by $39bn as a result of difficult business conditions in North America and Germany, and heavy losses at ResCap, the mortgage-lending arm of GMAC. ResCap reported a third-quarter loss of $2.3bn, pushing GMAC’s income down by $630m compared to a year earlier.

The third-quarter results include various other special items, including a $3.5bn after-tax gain from the sale of Allison Transmission, a maker of heavy-duty transmissions, and charges of $1.6bn in pension service costs.

On August 15, 2007, Fitch Ratings said Kohlberg Kravis Roberts & Co. affiliates KKR Atlantic Funding Trust and KKR Pacific Funding Trust might have to sell securities because of losses. There were about $385 billion outstanding in SIVs and 23% of their assets were MBS or CDOs. SIVs often are not backed by credit lines from banks like ABCP programs, of which there are $1.05 trillion outstanding.

At the same time, Barclays Capital had to provide rescue financing to $1.6 billion Cairn High Grade Funding I, a so-called SIV-lite that it had structured for hedge fund Cairn Capital that could not raise short-term funding due to the ABCP market seizure related to the US subprime mortgage crisis. Barclays would provide US$1.6 billion in fresh funding to pay off all maturing short-term asset-backed commercial paper. Barclays said it had fully hedged its credit exposure to the vehicle.

The US subprime mortgage crisis has dealt structures like SIV-lites a double blow. Theses SIV-lites have been having difficulty in raising short-term funding as investors grew more risk averse, forcing ABCP yields to six-year highs, and have seen the value of their longer-term investments, mostly in asset-backed securities, fall sharply.

Bank holding companies, including Citigroup, are not simply limited to the risks on the balance sheets of their banks. Little known affiliated investment vehicles that issue billions in commercial paper are partially owned by large banks and create a whole new source of risk. These vehicles, known as “conduits” and SIVs, are run separately and because of US accounting standards, do not have to appear on the holding company’s balance sheet. Citigroup controls 25% of the SIV market, totaling nearly $100 billion under management. Citigroup-own Centauri Corporation holds $21 billion in debt, which however is not mentioned in the holding company’s 2006 annual filing.

Citigroup said it has given its SIVs, $10 billion of available financing, and the funds had drawn $7.6 billion of that financing as of October 31. The move, disclosed in a quarterly filing with regulators, may add to investor concern about Citi’s $83 billion of structured investment vehicles, which issue short- and medium-term debt to finance their acquisition of bank bonds, repackaged debt, and other securities. Citi said in its filing that its credit lines to the SIVs were done on “arms-length commercial terms,” and that the bank has no plans to list the SIVs' assets on its own balance sheet.

The funding problems are likely to get worse if Moody’s cuts the ratings on some of Citibank’s SIVs. Citigroup and HSBC Holdings Plc received warning of possible downgrades to their structured investment vehicles as Moody’s reviewed its ratings on $33 billion of debt. SIV “debt ratings continue to be vulnerable to the unprecedented large and sustained declines in portfolio value combined with a prolonged inability to refinance maturing debt,'” Moody’s said in a statement.

At this late date, when dead bodies of the credit market crisis are floating to the surface and the carnage no longer deniable, there are still public voices trying to calm market sentiment by presenting the raging crisis “in perspective”, pointing to the low percentage of distress mortgages in relation to the entire mortgage market. Yet in a top-heavy structure precariously balanced on complex mechanics, a few small bricks removed at critical points can bring the whole structure crashing down. It is irresponsible for public figures to label the tip of a massive credit iceberg as merely a fly in the ointment so as to persuade a trusting public to view the escalating crumbling of the financial sector as a buying opportunity.

Next: Off-Balance-Sheet Debt