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Citigroup's `Last Roman' CDO Shows Enron Accounting (Update3) - Blo...

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Citigroup's `Last Roman' CDO Shows Enron Accounting (Update3) - Blo...

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Citigroup's `Last Roman' CDO Shows Enron Accounting (Update3)

By Mark Pittman - May 22, 2008 16:40 EDT May 22 (Bloomberg) -- Citigroup Inc. created a $2.5 billion mortgage-backed security called Bonifacius Ltd. in August as capital markets seized up and panic swept Wall Street. The issue took the name of a general, called by historian Edward Gibbon the ``last of the Romans,'' who fought and died for a fading empire. The bonds were created from subprime home loans as demand evaporated. Within six months, Bonifacius collapsed as homeowners fell behind on their payments in record numbers. Citigroup, Merrill Lynch & Co., UBS AG and other banks created more than $1.5 trillion of collateralized debt obligations like Bonifacius, keeping an undisclosed amount in off-balance-sheet funds called variable interest entities. Bonifacius and $190 billion of similar securities have gone bust since October, spotlighting loopholes the Financial Accounting Standards Board failed to close when Enron Corp. went bankrupt in 2001 after disclosing investments that weren't on its books. ``They never got the real problem fixed after Enron,'' said Lynn Turner, the chief accountant for the Securities and Exchange Commission when the Enron scandal was exposed. ``When people find out how little FASB did, they're going to be shocked. FASB needs to be taken out behind the woodshed and given a good whoopin'.'' Variable interest entities, or VIEs, are a post- Enron version of special-purpose vehicles, the term for the investments Citigroup created that led to the demise of the energy-trading company. The lack of disclosure about VIEs is adding to concern among investors after financial institutions reported $382.6 billion of writedowns and losses from subprimecontaminated debt since the start of 2007. VIE Rules A bank can set up a VIE as long as its partners stand to gain or lose the most from projected changes in the value of the underlying securities. Banks aren't required to disclose the assets they sell to their own VIEs, what price was paid, or whether they have lost value, making it harder for investors to determine when the subprime crisis will end. Citigroup spokeswoman Danielle Romero-Apsilos declined to say whether Bonifacius was put in a VIE. The New York-based bank also didn't say if any losses from the security were included in the $7.4 billion it wrote down from the ventures since September. ``We have provided extensive disclosures on our VIE and subprime CDO exposures and suggestions to the contrary are false,'' Romero-Apsilos said in an e-mailed statement today. Citigroup shares, rising 66 cents, or 3.1 percent, to $21.72 in composite trading on the New York Stock Exchange, had fallen 61 percent from last year's high. The drop eliminated about $154 billion of market value as investors struggled to figure out the amount of the company's losses from subprime-linked securities. The company's losses and writedowns total $42.9 billion, more than any other bank, according to data compiled by Bloomberg. Bank Losses The combination of the 7.7 percent decline in existing U.S. home prices, the highest level of mortgage delinquencies since 1984 and lack of disclosure about what banks may be liable for is stoking concern that banks will be required to take assets from VIEs back on their financial statements, resulting in new losses. Treasury Secretary Henry Paulson pointed to the dangers posed by off-balance-sheet entities in a speech May 13 at the National Press Club in Washington, D.C. ``Existing capital rules may have also failed to mitigate, or even amplified, the stress associated with these vehicles,'' said Paulson, the former chief executive officer of Goldman Sachs Group Inc., Wall Street's most profitable securities firm. Paul V olcker, who was chairman of the Federal Reserve from 1979 to 1987, said in testimony to the Joint Economic Committee of Congress the next day that regulators should have stopped banks. ``Why were they permitted to set up those off-balance- sheet entities that may or may not have had some formal relationship with the banks?'' he said. FASB Changes The SEC and state attorneys general in New York, Connecticut and Ohio have said they are investigating how banks and dealers created and sold investments linked to subprime mortgages. FASB, the group that sets U.S. accounting rules, is drafting changes that would prevent banks from using off-balance-sheet treatment for VIEs if they retain the power to buy or sell assets for the venture, said Russell Golden, the group's director of technical application and implementation. ``Do the investment banks have the power to decide what assets go into the entity? Or who they sell it to?'' Golden said in an interview from his office in Norwalk, Connecticut. ``That additional step is going to put more of the assets and liabilities on their balance sheets.'' FASB's staff wants to present its board with the recommendations on June 4 and seek comments from banks, brokers and other market participants, Golden said. The board may approve the new rules by the end of the year, he said. `They're the Same'

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Citigroup's `Last Roman' CDO Shows Enron Accounting (Update3) - Blo...

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Moving assets off balance sheets allows banks to make investments in loans and securities without requiring them to increase reserves or capital levels to protect depositors against losses. ``When the dealers set these things up, they're usually a vehicle of convenience,'' said Christopher Whalen, managing director of Hawthorne, California-based Institutional Risk Analytics, which assesses credit for banks. ``They're supposed to be separate from the bank, but the economic reality is that they're the same.'' VIEs are under increasing scrutiny because they contain CDOs, or bonds largely backed by subprime debt that are repackaged into new securities with credit ratings as high as AAA, according to S&P. More than 180 CDOs with $192 billion of assets have failed since October, data compiled by S&P and Bloomberg show. Only $5.1 billion of CDOs collapsed between 2003 and mid-2006, S&P said. JEDI, Chewie The biggest underwriters of defaulted CDOs are New York- based Merrill, with $39 billion, followed by Citigroup at $35.1 billion and UBS in Zurich with $20.1 billion, according to S&P and Bloomberg data. They sold almost half the CDOs that were either in default or in so-called acceleration mode as of May 12, the data show. Merrill spokesman Mark Herr and UBS spokesman Doug Morris declined to comment. When a securities firm sells an investment to its own VIE, there's no incentive to ensure that the bond is priced for its risk because the bank will always take it back if there's a default, said Joseph Mason, a professor at Louisiana State University and co-author of a study last year that said the danger of default for subprime mortgage bonds was understated. Bernoulli, Diogenes ``There's no reason to go through the credit rigamarole when this is really the same as making an equity investment in the bank itself,'' Mason said. ``The only structured finance transaction you don't support is the last one you'll ever do.'' Acceleration occurs after a default when CDO managers are required to pay out the most senior debt first, leaving investors in lower-rated pieces with losses. Trustees in 30 CDOs created by Citigroup filed events of default or acceleration notices, one of which is Bonifacius, according to S&P and Bloomberg data. Almost all of the collateral backing Bonifacius was rated A or above by S&P. Enron used SPVs with names like ``JEDI'' and ``Chewie,'' based on ``Star Wars'' characters, to book loans as trading revenue, according to a report by Enron Bankruptcy Court examiner Neal Batson. Like the SPVs, the securities going into VIEs have colorful names. One CDO created by Merrill was named Bernoulli, after the physicist who founded fluid mechanics. A Deutsche Bank AG CDO was called Diogenes for the Greek beggar-philosopher who carried a lamp to look for an honest man. UBS Writedowns FASB restricted the use of off-balance-sheet accounting in the wake of Enron, once the seventh-biggest U.S. company by sales. More than 5,000 jobs and $1 billion in employee retirement funds were wiped out when Enron plunged into bankruptcy after widespread accounting fraud was revealed. Investors sued to recover more than $40 billion in losses. Before, companies needed only to sell 3 percent of the equity in a unit to take it off the books. After, FASB wrote rules that permitted such transactions only if banks had minimal discretion over the activities of the ventures and brought them back on their books if they were obligated to absorb a majority of expected losses. One way banks comply with the rules is by placing the AAA, or ``super-senior,'' pieces of CDOs into VIEs and selling the riskiest portions to investors. The AAA portions are typically the largest part of a CDO. Good Fate The strategy is backfiring because mortgage defaults are rising so fast -- home foreclosure rates in the U.S. increased 65 percent in April from a year earlier, according to RealtyTrac Inc. --that banks can no longer argue they have the least at stake, forcing them to bring failing assets of VIEs back on their books. Half the $38 billion in writedowns taken by UBS, the biggest European bank, came from its holdings of super-senior pieces of CDOs, the firm said in an April 18 report to shareholders. The bank began holding the pieces in 2005 because it viewed them ``as an attractive source of profit,'' UBS said in the report. The securities behind Bonifacius consist of 288 prime and subprime mortgage bonds, other CDOs and Alt/A debt, which is based on mortgages that straddle prime and subprime. Bonifacius, which means ``good fate'' in Latin, is divided into nine pieces. The largest, which was originally rated AAA, has since been cut to Baa3 at Moody's and to BBB- by S&P, the lowest levels of investment grade. Banks are betting that markets will improve enough to allow the securities to be sold at a higher price, according to Stanley Sporkin, a former federal judge who helped write the federal 1977 Foreign Corrupt Practices Act when he was the head of the enforcement division at the SEC. ``Not every off-balance-sheet activity is wrong,'' Sporkin said. ``But there could be pockets of activity to hide things that later explode.'' To contact the reporter on this story: Mark Pittman in New York at mpittman@bloomberg.net To contact the editor responsible for this story Emma Moody at emoody@bloomberg.net Want to save this for later? Add it to your Queue!
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