If something looks like a duck and acts like a duck, especially if it quacks like a duck, then it is almost certainly a duck. If something looks like an asset and acts like an asset, than it should be treated as an asset and put on the balance sheet of the company that owns it. What is ownership of an asset? Ownership implies control and the ability to profit from an asset. In terms of consolidated subsidiaries on audited balance sheets, ownership implies the ability to suffer losses from the asset.

Recent credit market problems have revealed hundreds of billions of owned assets and related liabilities that banks such as Citigroup (C) [$30.70 -1.00%, market cap: $152.9B], and insurance companies such as AIG (AIG) [$55.65 -2.45%, market cap: $141.1B] kept off their balance sheets. This was in clear violation of the spirit (if not the letter) of GAAP. Simply put, these companies committed accounting fraud that was nonetheless legal because they conformed to the letter of a badly-outdated GAAP rule on consolidation of special purpose entitities. One clear result: Citigroup finally consolidated $49 billion of SIVs that supposedly it never owned, and did not deign to put on its balance sheet.

Anatomy of a Structured Investment Vehicle (SIV)

A SIV has one purpose: interest rate arbitrage. Via financial voodoo and certain guarantees that a SIV usually obtains from its sponsoring institution (the owner), SIVs can borrow money at extremely low rates, such as LIBOR. After borrowing a ton of money at or near LIBOR, a SIV will then buy various securities that yield more than LIBOR. The interest rate spread is split between the nominal owner of the SIV and the sponsor or real owner (such as Citigroup). SIVs usually have very little equity and are levered greater than 10x and up to 14x. That means that for every $1 of equity in the SIV (provided partially by the sponsoring institution and partially by various investors), the SIV can have $10 of assets, and $10 of debt. This leverage is in itself dangerous, but is not much different from the leverage inherent in all banks.

However, SIVs are structurally insolvent, as it owes short-term debt but own long-term debt assets. It relies upon the short-term commercial paper market to sell its debt. The company's assets are long-term debt such as CMBS, RMBS, CDOs, along with plain-vanilla corporate debt. For more information on SIVs, I suggest the excellent article on them by Randy Kirk on SeekingAlpha.

The problem with the SIVs is that to get their high credit ratings, without which they would have been unprofitable, they required backstop funding agreements from their bank sponsors. So Citigroup, for example, agreed to provide up to $10 billion in backup funding to its $49 billion worth of SIVs if they could not sell their debt. This meant that if trouble came, Citigroup would be on the hook for $10 billion (most of which it lent to its SIVs a couple months ago). If times got really bad, the SIV could become completely insolvent and it is theoretically possible that Citigroup could have lost the entire $10 billion. Yet despite this risk (which I will admit was remote), Citigroup did not consolidate the SIV on its balance sheet as it should have done. Its Tier 1 capital ratio was artificially inflated (duping banking regulators), its investors were left in the dark, and it earned what was essentially free money from the SIV that artificially pumped up its ROA and ROE.

This is one case where GAAP fails and IFRS did a much better job. GAAP consolidation rules need to be quickly amended to prevent future shenanigans of this sort.

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Michael Goode

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