Last updated: March 4, 2008 6:17 pm
Banks working on injecting up to $3bn into Ambac, the bond insurer, in the hope of staving off ratings downgrades and preventing the need for writedowns, might face further losses indirectly related to bond insurers, analysts have warned.
The latest source of concern is variable interest entities (VIEs), another three-letter acronym that now holds toxic properties. This follows the failure of municipal auctions, known as auction rate securities (ARS) in recent weeks, while collateralised debt obligations and (CDOs) collateralised loan obligations (CLOs) continue to loom over the balance sheets of banks and investors.
VIE is an accounting term that covers a multitude of activities in almost any kind of special purpose vehicle - from conduits and structured investment vehicles (SIVs) to individual CDOs themselves. The term VIE refers to the way in which a bank's economic exposure to a vehicle can change, which is key to whether it can be kept off-balance sheet.
Accounting for VIEs has been increasingly in the spotlight since US banks began to reveal more details about their exposure to various vehicles, such as the asset-backed commercial paper conduits used to fund investment in mortgage-backed bonds and other structured debt.
For example, Citigroup shocked investors when it took $11bn writedowns, much of which was on $25bn of previously off-balance sheet exposures.
According to analysts at CreditSights, banks could still face $88bn in extra losses linked to writing down the value of their VIEs, excluding any provisions already in place against monoline exposures.
"Some see VIEs as a new source of potential losses from the banks," says William O'Donnell, strategist at UBS.
"Indeed, as the auction rate market begins to sort itself out, we now apparently have a new worry."
The potential for losses and an escalation of selling pressure across already stressed markets stems from the fact that some VIEs hold assets that were insured by the likes of MBIA, Ambac and other bond insurers.
This week, MBIA had its triple-A rating affirmed by Moodys, although it is ratings watch negative, while S&P affirmed both MBIA and Ambac on Monday, although it said the latter was still in danger of a downgrade.
In recent years, bond insurers moved away from just wrapping municipal debt issued by local government authorities and started lending their triple-A credit rating to a host of structured credit vehicles. These vehicles have been hit by the troubled US mortgage market, which shows no sign of abating as home prices keep falling, while foreclosure rates are rising sharply.
Now the bond insurers, under pressure from regulators such as Eric Dinallo, the New York State insurance superintendent, want to split themselves in two. One part will insure municipal debt while the other will focus on structured credit exposure.
"This 'good bank, bad bank' scenario carries with it a host of implications for US bank/broker policyholders that have utilised the monolines to help hedge various exposures to higher risk structured credit products," says CreditSights. The figure of $88bn in potential writedowns for the banks "assumes that the banks and brokers would not receive any protection or payments from the monoline insurers".
Of the major Wall Street brokerages, Goldman Sachs lists $62.1bn in total exposure in unconsolidated VIEs, Morgan Stanley sits on $37.7bn, Bear Stearns clocks in at $11.5bn, while Merrill Lynch has $6.5bn, says CreditSights. The data is drawn from the most recent company reports says CreditSights.
Disclosure by the banks of maximum exposure to loss from their VIEs is much lower with Goldman around $26bn, $16bn at Morgan Stanley, $9bn at Merrill and $100m at Bear, said CreditSights.
However, the firm says “we continue to question whether maximum exposure numbers accurately capture the entire risk associated with VIE assets.”
Based on recent filings, Creditsights says Citigroup has roughly $84bn in total CDOs in its unconsolidated VIEs, while Bank of America has disclosed $13.6bn in VIE exposure.
However, complicating the issue for analysts and investors is the paucity of detailed disclosure by brokers and banks in relation to off-balance sheet holdings.
Additional reporting Paul J Davies in London
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