The credit crunch has introduced terms such as CDO - collateral debt obligation – and SIV – structured investment vehicle. Now, meet another potential troublemaker: variable interest entities, or VIEs
Even Goldman Sachs and Lehman Brothers may find they haven't dodged the credit crisis.
The new source of potential losses: so-called variable interest entities that allow financial firms to keep assets such as subprime-mortgage securities off their balance sheets. VIEs may contribute to another $88 billion in losses for banks roiled by the collapse of the housing market, according to bond research firm CreditSights.
Goldman, which hasn't had any of the industry's $163 billion in writedowns, said last month it may incur as much as $11.1 billion of losses from the instruments.
The potential for a fire-sale of the assets that would bring another round of charges has “always been our greatest fear,” said Gregory Peters, head of credit strategy at New York-based Morgan Stanley, the second-biggest securities firm behind Goldman in terms of market value.
VIEs, known as special purpose vehicles before Enron's collapse in 2001, finance themselves by selling short-term debt backed by securities, some of which are insured against default.
Insurers lose strength:
Now that Ambac Financial Group and other guarantors have started to lose their AAA financial strength ratings, Wall Street firms may be forced to return those assets to their books, recording the declining value as losses. MBIA, the biggest insurer, said on Monday it plans to separate its municipal and asset-backed businesses, a move Peters said would likely result in a lower credit rating for the types of assets owned by VIEs.
Wall Street's writedowns stem from a surge in mortgage delinquencies among homeowners with the riskiest subprime credit histories. The industry's VIEs, also known as conduits, had $784 billion in commercial paper outstanding as of last week, according to the Federal Reserve.
“There's a big number at work here and it will have significant consequences,” said J. Paul Forrester, the Chicago-based head of the CDO practice at law firm Mayer Brown. “The great fear is that a combination of subprime CDOs, SIVs and conduits result in a flood of assets into an already-stressed market and there's a price collapse.”
Waiting to unwind:
CreditSights has one of the highest projections for additional losses. Moody's says the fallout from VIEs, collateralized debt obligations, and other deteriorating assets may run $30 billion. CDOS are packages of debt sliced into pieces with varying ratings.
One type of VIE that's already been forced to unwind or seek bank financing is the structured investment vehicle, or SIV. Like SIVs, VIEs often issue commercial paper to finance themselves and may have multiple outside owners that share in the profits and losses. Because banks agree to back VIEs with lines of credit, they have to buy commercial paper or notes when no one else will.
Ambac, the world's second-biggest bond insurer, and two smaller competitors lost a AAA rating from at least one of the three major ratings companies in recent months. Standard & Poor's on Monday affirmed the AAA of MBIA, the largest “monoline” in the industry, though said the outlook is “negative.”
The more widespread the downgrades, the more likely the assets in the VIEs will be cut. Some buyers of the debt demand the highest ratings, giving banks a vested interest in helping the insurers salvage their ratings.
Capital injection:
New York-based Ambac may get $3 billion in new capital with the help of Citigroup and Dresdner Bank as early as this week, the Wall Street Journal reported Monday.
“The lightning rod of the monoline fix is so important to so many banks,” said Thomas Priore, chief executive officer of New York-based Institutional Credit Partners LLC, which manages $12 billion in CDOs.
Accounting rules allow financial firms to keep VIEs off their balance sheets as long as they're not the ones that stand to gain or lose the most from the entity's activities. A bank would also have to account for its portion of a VIE if prices for the debt owned by the fund fall too far or if the banks is forced to provide financing.
Goldman, the most profitable Wall Street firm, and Lehman, biggest commercial paper dealer, have avoided much of the pain so far.
Goldman, which earned a record $11.6 billion in the year ended in November 2007, said it avoided writedowns by setting up trades that would profit from a weaker housing market. Now the threat is $18.9 billion of CDOs in VIEs, the firm said in a regulatory filing on Jan. 29.
Lehman, which wrote down the net value of subprime securities by $1.5 billion, guaranteed $7.5 billion of VIE assets as of Nov. 30, according to a filing also made on Jan. 29. “We believe our actual risk to be limited because our obligations are collateralized by the VIE's assets and contain significant constraints,” Lehman said in the filing.
Citigroup, which has incurred $22.1 billion in losses from the subprime crisis, has $320 billion in “significant unconsolidated VIEs,” according to a Feb. 22 filing by the bank. Merrill Lynch, which recorded $24.5 billion in subprime writedowns, has $22.6 billion in VIEs, according to CreditSig
Even Goldman Sachs and Lehman Brothers may find they haven't dodged the credit crisis.
The new source of potential losses: so-called variable interest entities that allow financial firms to keep assets such as subprime-mortgage securities off their balance sheets. VIEs may contribute to another $88 billion in losses for banks roiled by the collapse of the housing market, according to bond research firm CreditSights.
Goldman, which hasn't had any of the industry's $163 billion in writedowns, said last month it may incur as much as $11.1 billion of losses from the instruments.
The potential for a fire-sale of the assets that would bring another round of charges has “always been our greatest fear,” said Gregory Peters, head of credit strategy at New York-based Morgan Stanley, the second-biggest securities firm behind Goldman in terms of market value.
VIEs, known as special purpose vehicles before Enron's collapse in 2001, finance themselves by selling short-term debt backed by securities, some of which are insured against default.
Insurers lose strength:
Now that Ambac Financial Group and other guarantors have started to lose their AAA financial strength ratings, Wall Street firms may be forced to return those assets to their books, recording the declining value as losses. MBIA, the biggest insurer, said on Monday it plans to separate its municipal and asset-backed businesses, a move Peters said would likely result in a lower credit rating for the types of assets owned by VIEs.
Wall Street's writedowns stem from a surge in mortgage delinquencies among homeowners with the riskiest subprime credit histories. The industry's VIEs, also known as conduits, had $784 billion in commercial paper outstanding as of last week, according to the Federal Reserve.
“There's a big number at work here and it will have significant consequences,” said J. Paul Forrester, the Chicago-based head of the CDO practice at law firm Mayer Brown. “The great fear is that a combination of subprime CDOs, SIVs and conduits result in a flood of assets into an already-stressed market and there's a price collapse.”
Waiting to unwind:
CreditSights has one of the highest projections for additional losses. Moody's says the fallout from VIEs, collateralized debt obligations, and other deteriorating assets may run $30 billion. CDOS are packages of debt sliced into pieces with varying ratings.
One type of VIE that's already been forced to unwind or seek bank financing is the structured investment vehicle, or SIV. Like SIVs, VIEs often issue commercial paper to finance themselves and may have multiple outside owners that share in the profits and losses. Because banks agree to back VIEs with lines of credit, they have to buy commercial paper or notes when no one else will.
Ambac, the world's second-biggest bond insurer, and two smaller competitors lost a AAA rating from at least one of the three major ratings companies in recent months. Standard & Poor's on Monday affirmed the AAA of MBIA, the largest “monoline” in the industry, though said the outlook is “negative.”
The more widespread the downgrades, the more likely the assets in the VIEs will be cut. Some buyers of the debt demand the highest ratings, giving banks a vested interest in helping the insurers salvage their ratings.
Capital injection:
New York-based Ambac may get $3 billion in new capital with the help of Citigroup and Dresdner Bank as early as this week, the Wall Street Journal reported Monday.
“The lightning rod of the monoline fix is so important to so many banks,” said Thomas Priore, chief executive officer of New York-based Institutional Credit Partners LLC, which manages $12 billion in CDOs.
Accounting rules allow financial firms to keep VIEs off their balance sheets as long as they're not the ones that stand to gain or lose the most from the entity's activities. A bank would also have to account for its portion of a VIE if prices for the debt owned by the fund fall too far or if the banks is forced to provide financing.
Goldman, the most profitable Wall Street firm, and Lehman, biggest commercial paper dealer, have avoided much of the pain so far.
Goldman, which earned a record $11.6 billion in the year ended in November 2007, said it avoided writedowns by setting up trades that would profit from a weaker housing market. Now the threat is $18.9 billion of CDOs in VIEs, the firm said in a regulatory filing on Jan. 29.
Lehman, which wrote down the net value of subprime securities by $1.5 billion, guaranteed $7.5 billion of VIE assets as of Nov. 30, according to a filing also made on Jan. 29. “We believe our actual risk to be limited because our obligations are collateralized by the VIE's assets and contain significant constraints,” Lehman said in the filing.
Citigroup, which has incurred $22.1 billion in losses from the subprime crisis, has $320 billion in “significant unconsolidated VIEs,” according to a Feb. 22 filing by the bank. Merrill Lynch, which recorded $24.5 billion in subprime writedowns, has $22.6 billion in VIEs, according to CreditSig
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