November 26 2007: 10:15 AM EST
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The next credit scandal

The real outrage of the credit crunch has been in the way major banks disclosed potential losses. Now, there are billions more in undisclosed risk.

By Peter Eavis, senior writer

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NEW YORK (Fortune) -- The major banks have already reported billions in unexpected losses from complex investment vehicles known as CDOs. Now they face big risks from other corners of the debt markets -- but don't expect them to warn investors anytime soon.

The failure by banks to properly inform shareholders of their potential losses is perhaps the biggest scandal so far of the credit crunch that began this summer.

Earlier this year, for example, Merrill Lynch, Citigroup and Bank of America gave almost no indication that one particularly toxic debt product -- CDOs, or collateralized debt obligations -- could be the source of billions of dollars in losses.

Those losses came to light this fall, blindsiding shareholders and pummeling banks' stock prices.

The lack of disclosure not only has unsettled investors, but also has raised the prospect that large losses are lurking in other parts of the banks' businesses.

One likely new trouble spot: Conduits, the opaque structures banks set up to provide debt funding to borrowers. Often, the debt issued by the conduits is collateralized with assets, like mortgages.

Conduits typically aren't consolidated on a bank's balance sheet. But banks are often on the hook to fund them if investors stop buying the debt they've issued. When that happens, a lot of risk can get moved onto the balance sheet.

In a similar way, a good chunk of Citigroup's CDO losses occurred because it had to honor prior commitments to fund a large amount of debt previously issued by CDO structures. The financial services giant was ultimately forced to bring onto its balance sheet $25 billion of short-term CDO-debt backed with risky mortgages. (CDOs explained)

Now, conduits could trigger a similar process at many big banks. Since demand for certain types of conduit debt has shrunk dramatically and bad loan numbers on subprime debt are soaring, banks could well end up absorbing large amounts of conduit debt.

Citigroup (Charts, Fortune 500) had off-balance sheet conduits with assets totaling $73 billion as of Sept. 30. And Merrill bought $5 billion of assets from its conduits in the third quarter, a move that led to pre-tax losses of over $500 million in the same quarter.

Almost every major banks has significant conduit exposure. But if conduits are becoming a problem, banks are not saying much about it in their financial statements.

A close look at what happened with CDOs at Citigroup and Merrill shows just how little investors are told -- and should make investors wary about how little they know about banks' exposure to conduits.

So why was CDO exposure so secret?

Banks typically arranged and sold CDOs to investors, so the sold ones would not appear on their balance sheets.

In fact, there was one place in financial statements where numbers were given on CDOs. The disclosure was inadequate, but still worth looking at now.

In quarterly financial statements, companies disclose their "variable interest entities," or VIEs. These are entities to which a company has actual or potential economic exposure.

When it comes to inadequate CDO disclosures, the VIEs that matter are those that are not consolidated on a company's balance sheet.

A word search for CDO in a public financial statement may have taken an investor to the VIE tables. But once there, there would be no way of gauging just what the true exposure was to CDO losses.

This is partly the fault of the accounting rule -- something called FIN 46-R -- that governs off-balance sheet VIEs. The big problem is that it doesn't force companies to disclose realistic estimates for losses.

Under FIN46-R, companies must disclose their maximum loss exposure. That sounds like a conservative approach, but in practice it isn't. That's because banks often add comments in financial statements that effectively tell investors not to take these maximum loss numbers seriously.

Take a look at Citigroup's second quarter filing, posted Aug. 3, which was well into the summer credit meltdown. In it, the bank said actual losses from its unconsolidated VIEs, which included $75 billion of CDOs, were "not expected to be material." It has since estimated losses could be between $8 billion and $11 billion (which is most definitely material).

So the question becomes: Did banks have a good idea of what off-balance-sheet CDO losses would be before they were disclosed? The answer to that is: Almost certainly.

Even if FIN 46-R doesn't demand that banks disclose their estimates for actual losses, if such losses are material, other accounting guidelines demand they be made public.

And recent financial statements clearly indicate that banks have closely and continuously estimated the value of their financial commitments -- even those to off-balance sheet entities, like CDO structures.

If a change in the estimated value of a financial commitment to an off-balance-sheet entity produces a loss, that also generates a loss on the income statement. Both Merrill (Charts, Fortune 500) and Bank of America (Charts, Fortune 500) say in recent financial statements that their income statements have already been recognizing value changes in commitments to provide funding to CDOs.

For Citigroup, it was these sorts of CDO funding commitments that led the bank to take $25 billion of CDO debt onto its balance sheet.

If Citigroup were valuing that commitment in the same way as Merrill and Bank of America, then it would presumably have taken at least some losses on it before the CDO debt came on its balance sheet.

And those loss estimates should have been rigorous and sophisticated. That's because FIN 46-R guides companies to give probabilities to different loss scenarios for its unconsolidated entities.

In other words, if FIN 46-R were being followed, all the banks concerned should have been able to produce internal estimates for a range loss scenario -- and they would have been doing so as the credit crunch started this summer.

"We are confident that our financial statements fully comply with all applicable rules and regulations," said Citigroup spokeswoman Christina Pretto.

Just think how much better warned investors would have been if those actual loss estimates had been made public.

And just think how useful it would be to know those loss estimates for distressed conduits the banks must deal with now. To top of page

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