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Citi Puts Lipstick on Asset-Backed Pig

Can a huge bailout plan save banks from big writedowns?

Updated from 1:38 p.m. EDT

The big banks might like to bundle all their crummy debt and shoot the whole package into outer space. But fixing this mess won't be quite that simple, and the markets finally agree.

Three institutions rolled out a plan Monday to ease a credit crunch afflicting the market for asset-backed commercial paper.


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JPMorgan Chase

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Bank of America

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are creating an investment fund in a bid to lure money market funds back into the commercial paper market.

So far the banks' plan is lacking in specifics. Even the size of the new investment fund is unspecified as yet -- though reports put it at between $80 billion and $100 billion. But, the impact of the poorly detailed plan is clear. After making record highs last week, the Dow Jones Industrial Average slid over 100 points while the Nasdaq Composite dropped 0.9% on the day.

"When I read this story, I said, 'Things are not over. ... We are not out of the woods,'" says Christopher Vincent, head of fixed income at William Blair & Co. "This means more news, more noise, and more Fed rate cuts." Vincent believes there will be three more 25 basis point rate cuts before the Fed contemplates ending this easing cycle.

Shares of financial companies, which had been pressing the message that the worst is over in their earnings warnings this month, fell sharply on news of the super-fund. Citigroup, which announced a 57% drop in profits this year fell over 3%, as did

Lehman Brothers


, while

Goldman Sachs

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Morgan Stanley

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, BofA, and JPMorgan all slid over 1% on the day.

What is certain is that the banks need to find someone to buy securities held by their so-called structured investment vehicles, or SIVs. Otherwise they will have to bring the collateral onto their own balance sheets, which would be costly because of the need to raise capital as well. Alternatively, the issuers could try selling the securities, but deals at fire-sale prices could start another spiral of asset writedowns.

So it's clear why Citi, which reportedly backs SIVs with some $80 billion in debt outstanding, and its peers need to do something. Whether Monday's plan is the right move is already being questioned, though.

"The solution they came to in Canada was more direct," says David Merkel, an investment consultant and contributor at,'s investment-ideas site.

He says the problem with the SIVs is about matching up the risk of assets and liabilities. The SIV's had been using short term funding to buy longer-term assets. Early on in the summer's credit crunch, Canadian institutions facing similar short-term funding problems were able to swap out their commercial paper for floating rate paper that matched in maturity with the investments they were buying. Merkel says this makes things a bit more expensive, but "it is the proper solution."

James Bianco, president of Bianco Research questions how "this removes the risk of investing in this type of paper for the big money market funds."

Investors have kept their distance from asset-backed paper, even as other kinds of debt have started to find buyers again. That's because anxiety remains over the value of the collateral backing the asset-backed securities. It remains impossible for outsiders to judge how much of any given commercial paper issue may be connected to fraudulent or poorly documented mortgages.

Commercial paper investors seek highly rated, liquid assets for funds that many investors consider nearly equivalent to cash -- money market funds. But recent downgrades have only made this sort of paper more perilous.

Moody's Investors Service last Thursday downgraded another $33.4 billion in mortgage-backed securities, noting that it now assumes losses tied to currently delinquent loans will be 40% to 50%. The ratings agency also said in a press release that it believes significant loan modifications "that might mitigate future losses are not likely to occur in the near term."

The Moody's move was the latest in the ratings arena, but its rivals S&P and Fitch have been active on the downgrade front as well.

"The downgrades are coming so fast that you could go to the bathroom, come back to your desk and find you're a junk bond manager," says Bianco.

Christian Stracke, analyst at CreditSights, says he believes the move will help the banks avoid a nightmare scenario -- a forced liquidation of SIV assets.

But Stracke says he's not convinced there will be many other buyers of the other than the banks involved in the consortium. The new fund could buy good assets from the banks' SIVs, he says, thereby giving the SIVs enough liquidity to weather the current storm without liquidating whatever they have left in inventory.

This approach would save the banks from a big writedown but could increase their exposure to the asset-backed commercial paper market, whose health remains questionable. Stracke says this is more capital-efficient because holding commercial paper requires less capital reserve than buying SIV assets outright.

But he says the whole plan rests on the idea that the SIV collateral won't further deteriorate -- a notion he questions.

"If the assets really were so good," he says of the asset-backed commercial paper market, "it would be liquid."

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click


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