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STRUCTURED INVESTMENT VEHICLES
The Great New Idea of twenty-first-century banks was known as “originate and distribute.” The notion was that by packaging loans into securities that were sold to investors all over the world, the banks wouldn't get stuck if loans went bad.
Citigroup had pioneered entities called “structured investment vehicles,” or SIVs. In essence, mortgage loans were sliced into pieces, with some sold and others kept in these stand-alone units. The SIVs borrowed money by selling short-term IOUs on the market, making them vulnerable to a change in investor appetite for short-term lending. And SIV loans frequently were not shown on the banks' books.
A bank has to set aside capital – a cushion to absorb losses – for every loan it makes and every bond it buys. By parking the loans and securities in SIVs off the banks' balance sheets, Citibank and other banks that used SIVs didn't have to set aside capital to absorb any losses. That made the potential profits far greater than if the loans had been on the banks' books. But it also meant there was no capital cushion to absorb losses if the banks ended up taking back the losses, either because they had legal promises to the SIVs or felt maintaining reputations required them to bail out the SIVs.
In 2006, Citibank's off-balance sheet assets amounted to $2.1 trillion; its on-balance sheet assets were $1.8 trillion. Not only were these enormous loans hidden, but several top Fed staffers confessed later that they hadn't even heard the term “SIV” until the end of July. Neither had some senior Fed officials - even though they were charged with being guardians of the financial system. In fact, that was typical. An astounding array of derivative products had exploded across the marketplace over the past few years. Even market sophisticates faced a steep learning curve to keep up with what was happening, and that included Citigroup's own chief executive, Chuck Prince.
Dubbed “Prince of the Citi” by the financial press when his bank was flying high, Prince was a lawyer who had taken over the big bank in 2003 when Sandy Weill, the financial entrepreneur, retired. Prince famously dismissed worries that his bank and others were counting unwisely on cheap and plentiful credit to make ever bigger and riskier loans.
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing,” he told the Financial Times in early July 2007.
It was, actually, a profound observation: a banker who didn't dance, who didn't make ever more risky loans, would find his bank's market share falling and near-term profits less impressive than his competitors'. Prince was one of several Wall Street chief executives who, it turned out, didn't understand the risks their own institutions were taking or who were powerless to stop them. Citi, it would become clear, was not only too big to fail, it was too big to manage.
Ben Bernanke soon would discover what happens when the music stops.
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