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Nye Lavalle
Making a Loan Only After It Goes Bad

Published: October 19, 2007
“The banking system is healthy.”

Ben S. Bernanke, Federal Reserve chairman, Oct. 15

“Our bank regulators must evaluate regulatory capital requirements applicable to bank exposures to off-balance-sheet vehicles.”

Treasury Secretary Henry M. Paulson Jr., Oct. 16

Out of sight, out of mind.

As America’s big banks reported poor quarterly results this week, it was hard to know what was more distressing: the news, or the fact many bankers were clearly surprised.

They were surprised because banking has evolved to the point where a large part of the revenue comes from things invisible to readers of financial statements, either commitments to make loans, or through vehicles carefully engineered to stay off the balance sheet.

A notable illustration came from Citigroup. Its write-offs were half a billion dollars more than the bank had forecast only two weeks earlier, and its optimism about the fourth quarter was toned down considerably.

But the most impressive fact was the bank’s explanation of why its nonperforming corporate loan total had doubled, to $1.2 billion, in just three months.

Citi explained that the bulk of that came from just one loan — and it was a loan that had not even been made a few months earlier. Citi had taken a fee to provide a backup line of credit to a structured investment vehicle — a line that would be called on only if the S.I.V. could not borrow and a German bank could not meet its promise to make the loan.

That happened, so Citi forked over the cash and immediately put the loan on nonperforming status.

That’s a neat trick. You don’t make the loan until you know it will be a bad loan.

Henry M. Paulson Jr., the Treasury secretary and former chief executive of Goldman Sachs, says many banks “appear not to have fully appreciated all of the risks associated with the securitized assets on their balance sheets or the many risks associated with commitments to provide liquidity to off-balance-sheet vehicles, such as conduits and structured investment vehicles.”

What you don’t know really can hurt you.

Mr. Paulson mobilized the big banks to find a way to rescue S.I.V.’s by purchasing assets from them. The idea is that the new super-S.I.V., called a Master Liquidity Enhancement Conduit, would be able to borrow in the commercial paper market — something the S.I.V.’s cannot now do — because the banks would provide backup lines of credit to reassure investors.

The convoluted structure speaks volumes about how banking has changed. The banks considered and rejected a suggestion that they just lend money to the S.I.V.’s directly. Nor did they want to buy the S.I.V.’s assets — supposedly safe securitization products — for their own balance sheets.

Even if it works, the new conduit — promptly dubbed a FrankenFund by some — just buys time. The securitization model, in which risky loans were largely financed by investors who thought they were making safe investments, has not recovered from the shock of learning that financial alchemy had not turned junk into gold.

Until — or unless — it recovers, the majority of new mortgage loans will be made only because the government, or an enterprise with government backing, is willing to guarantee them. Investors will still buy securities backed by those loans.

But if a loan does not meet the government’s standards — perhaps because it is too large — most borrowers must find a bank willing to make the loan and keep it on its balance sheet.

How old-fashioned is that? Banks do not want to tie up their capital for 30 years. They long for the go-go years when they got fees without having to actually put out the cash for very long.

Mr. Bernanke, the Fed’s chairman, voiced the conventional wisdom when he said the banks were in good shape. He is in a better position than the rest of us to know that is true, but so were the bank managements who were surprised.

Gary L. Crittenden, Citigroup’s chief financial officer, told my colleague, Eric Dash, that Citi, in manufacturing products to sell into the securitization market, had focused on the wrong thing. “We had a market risk lens looking at those products, not the credit risk lens,” he said.

Now Citi, and its competitors, are learning just how much credit risk they took on. Mr. Paulson wants to make sure that regulators force them to have adequate capital for those risks, and that accounting standards force disclosure of the risks.

Those are good ideas, although they may be a little late.

With the securitization market in trouble, we need the banks to be able, and willing, to revive their traditional roles as financial intermediaries. Their decision to avoid that in setting up the complicated “Master Liquidity Enhancement Conduit” is not an encouraging development.

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