November 27 2007: 8:38 AM EST
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Why Citi can't take the high road over credit mess

The banking giant should follow HSBC's lead, and take its troubled debt funds onto its balance sheet. But Citi might not have the financial strength to do it.

By Peter Eavis, senior writer

Citi may not have enough capital to absorb its SIVs as HSBC did.

NEW YORK (Fortune) -- Is Citigroup simply not strong enough to do what HSBC has done with its sick-looking SIVs?

SIVs are structured investment vehicles, the huge, heavily-leveraged bond funds that several large banks set up off of their balance sheets when credit markets were buoyant. Many SIVs are now facing a liquidity squeeze that threatens their survival, forcing their sponsoring banks to make tough choices about their future.

Monday, HSBC (Charts) said it was taking two SIVs - named Cullinan and Asscher - onto its own balance sheet. That will mean consolidating the SIVs' $45 billion of assets, and it could lead the bank to supply up to $35 billion of funding to its SIVs.

As soon as the SIVs got into trouble in the summer, the most obvious solution was for the banks affiliated with the SIVs to take them onto their balance sheets. The fact that none of them did so straight away raised a red flag over the SIV mess, because banks, always eager to protect their reputations, tend to move quickly to shore up any affiliated entities that run into trouble.

Instead, the U.S. Treasury sponsored a move driven by Citigroup (Charts, Fortune 500), J.P. Morgan Chase (Charts, Fortune 500) and Bank of America (Charts, Fortune 500) to set up a new, larger Super SIV that would buy up assets from the SIVs that came under pressure. Since Citigroup has by far the largest exposure to SIVs - its seven SIVs held $83 billion of assets as of Sept. 30 - the Treasury's Super-SIV looked very much like a way of supporting Citigroup.

Citigroup could have simultaneously banished any notion that it wasn't strong enough to deal with its SIV mess by taking the SIVs onto its own balance sheet. HSBC's readiness to consolidate exposure to its SIVs will only reignite questions about Citigroup's ability to deal with its own SIV mess.

"Not everybody can do this," said HSBC spokesman Patrick McGuiness, referring to HSBC's SIV consolidation. McGuiness also describes the bank's SIV plan as proactive, because its two SIVs have existing funding in place that extends into next year.

In other words, the SIVs are shielded from being forced to sell assets to pay off debt that's coming due -- at least for now. Typically, if a SIV has to sell assets to pay off debt, it triggers downgrades in a SIV's ratings, an event that could prompt a rapid selling of more assets in the SIV.

By using its own balance sheet to sort out its SIVs, HSBC has effectively snubbed the Treasury-sponsored Super-SIV. When asked why HSBC wouldn't prefer to use the Super-SIV instead, McGuinness said: "Because it's not comprehensive. It will only take certain assets from certain SIVs."

If other large banks share HSBC's reservations, the Super-SIV's ability to get off the ground becomes questionable. And the Super-SIV still has to raise the fresh money from investors that it needs to fund the purchase of assets from other SIVs.

Reports about the Super SIV so far suggest that it can be set up, but what would happen to Citigroup if it doesn't materialize? Now that HSBC, a large SIV player, has snubbed the Super-SIV, investors have to ponder the implications for Citigroup -- and particularly consider what would happen if it too consolidated its SIVs.

Citigroup spokesman Jon Diat says that the bank, "will not consolidate the assets of the SIVs," and adds that they have a range of liquidity sources that they can continue to access. The $7.5 billion capital injection from the emirate of Abu Dhabi should help Citi, but it's only a start.

So what would happen if Citigroup does take its $83 billion of assets in its SIVs onto its balance sheet? The HSBC case provides something of a roadmap.

Intriguingly, HSBC says that it doesn't expect any "material impact to earnings" from moving the SIVs' $45 billion of assets and associated funding onto its balance sheet.

How can that be? Because of the big drop in bond prices caused by the credit crisis, those $45 billion of assets will be worth far less than when they were purchased by the SIV. Why wouldn't those losses have a material impact on HSBC's earnings?

Standard and Poor's analyst Richard Barnes says this is because the assets will be classified by HSBC as a type of asset whose temporary changes in value don't get reflected in the income statement.

However, changes in the values of those assets will get reflected in shareholders' equity, which is the measure of a company's net worth. And since Citigroup is already facing doubts about the strength of its equity, a movement to bring SIVs onto its balance sheet would, of course, deepen such doubts.

Citigroup is also exposed to potential losses from off-balance sheet debt vehicles called CDOs and conduits (see this story about those two types of exposure), so it's no surprise that Citigroup has so far not taken its SIVs on balance sheet.

The bank may not have the strength to do so. But it may end up having no choice. To top of page