And Now the Ghosts of Enron Past - VIE's

Goldman, Lehman May Not Have Dodged Credit Crisis
By Mark Pittman

Feb. 26 (Bloomberg) -- Even Goldman Sachs Group Inc. and Lehman Brothers Holdings Inc. 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 Inc. 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 Corp.'s collapse in 2001, finance themselves by selling short-term debt backed by securities, some of which are insured against default.

Now that Ambac Financial Group Inc. 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 Inc., the biggest insurer, said yesterday 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.

`Significant Consequences'

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 Moody's Investors Service and 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.''

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 to $30 billion. CDOS are packages of debt sliced into pieces with varying ratings.

`Lightning Rod'

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 yesterday affirmed the AAA ranking of MBIA, the largest ``monoline,'' though it said the outlook is ``negative.'' MBIA yesterday eliminated its quarterly dividend and said it won't write new guarantees on asset-backed securities for six months.

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.

Ambac Financing

New York-based Ambac may get $3 billion in new capital with the help of Citigroup Inc. and Dresdner Bank AG as early as this week, the Wall Street Journal reported yesterday. MBIA raised money by selling common shares and warrants to private-equity firm Warburg Pincus LLC and issuing $1 billion of surplus notes.

``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 bank is forced to provide financing.

Goldman, Lehman

Goldman, the most profitable Wall Street firm, and Lehman, the 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. Goldman spokesman Michael DuVally declined to comment.
Merrill Lynch & Co. analyst Guy Moszkowski today cut his estimate for Goldman's first-quarter earnings for the second time this month, citing growing losses from assets outside residential mortgages.

Lehman, which wrote down the net value of subprime securities by $1.5 billion, guaranteed $6.1 billion of investors' money in VIEs and $1.4 billion of clients' secured financing 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. Spokeswoman Kerrie Cohen wouldn't elaborate.

Citigroup Losses

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 New York-based bank. New York-based Merrill Lynch, which recorded $24.5 billion in subprime writedowns, has $22.6 billion in VIEs, according to CreditSights.

Merrill spokeswoman Jessica Oppenheim declined to comment, as did Citigroup's Danielle Romero-Apsilos.

The securities in the VIEs may be worth as little as 27 cents on the dollar once they're put back on balance sheets, according to David Hendler, an analyst at New York-based CreditSights. Hendler based his estimate on the recent sale of $800 million of bonds by E*Trade Financial Corp.

Predictions for losses vary widely because banks aren't required to specify the type of assets being held in the VIEs or how much they are worth, said Tanya Azarchs, managing director for financial institutions at S&P.

``The disclosure on VIEs is hopeless,'' Azarchs said. ``You have no idea of the structure or how that structure works. Until you know that you don't know anything. It's like every day you come into the office and another alphabet soup has run off the rails.''

To contact the reporter on this story: Mark Pittman in New York at mpittman@bloomberg.net .

Last Updated: February 26, 2008 13:11 EST