Behind the Citigroup rescue

(Fortune) -- Banks are expected to clean up their own messes. So it was a troubling sign on Monday when Citigroup - the nation's largest bank - announced it had to embrace what looks like a private sector bailout.

Worse yet: The bailout might not even work.

At issue are structured investment vehicles (SIVs), which are large investment funds that were set up to make money by issuing short-term debt to buy higher-yielding longer-term bonds. SIVs have about $400 billion of assets. Citigroup (Charts, Fortune 500) accounts for a large share of that, with potential exposure to SIVs with assets of $83 billion.

Accounting rules have allowed Citigroup to account for these SIVs off its balance sheet. The real danger now is that certain events could occur to change that, which would mean higher losses for Citigroup and a strain on capital that could crimp lending by the bank.

One scenario that could cause an SIV to move onto Citigroup's balance sheet - which doesn't seem to have occurred yet - is if losses at the SIV rise above a pre-determined level. Other institutions typically agree to take the losses up to a point, and that third-party commitment allows banks to keep the SIV off their balance sheets. One big unanswered mystery in the SIV mess is the identity of these third parties and their ability to actually take SIV losses.

Another scenario that could force Citigroup to bring SIVs onto its balance sheet: Reputation. Citigroup would not want to be held responsible for letting one of its SIVs collapse.

Keeping its SIVs from collapsing and keeping them off its balance sheet is what's behind Monday's announcement that it is working with Bank of America (Charts, Fortune 500) and JPMorgan Chase (Charts, Fortune 500) to set up what's known as a "master liquidity enhancement conduit," or M-LEC. In effect, the three banks want to set up a new fund that will buy assets from the SIVs and thereby give them the liquidity they badly need.

Bank of America and J.P. Morgan don't have any SIV exposure. But they may see a need to support Citigroup's fund because it stops the SIVs from dumping their assets at firesale prices, as that could result in them having to mark down bonds on their own books by large amounts. They also stand to earn hefty fees.

But can the bailout plan work, especially since the banks expect investors to provide most of the necessary funds by purchasing M-LEC debt?

One view is that it may actually worsen the SIV liquidity problem because M-LEC would be effectively competing against other SIVs for investors' cash, making it harder for them to sell their debt.

The M-LEC organizers are going out of their way to make its debt look attractive. Monday's press release strives to reassure investors that investors would be protected by a strong capital structure and commitments to provide liquidity.

The release also stresses that the M-LEC would only buy top-quality assets, theoretically assuaging fears that the SIVs would use this as an opportunity to offload their trash.

But monumental questions remain. Will Citigroup be forced to provide the most equity to M-LEC? If so, how much is that capital contribution in dollar terms, and how will that be reflected on its balance sheet?

Second, is Citigroup really prepared to disclose details about its SIVs and the quality of its assets if investors demand them before they buying the M-LEC's debt? A person familiar with Citigroup's SIVs says they hold no subprime assets.

Fine, but what is the real price of nonsubprime assets? Since the SIVs have been holding off from making big sales, and since trading is light in the markets for mortgage-backed bonds, it may be that nobody knows what the SIV assets are really worth - and they may not want to find out.

In a sense, the M-LEC is a massive bet that SIV assets can be sold several months from now at prices above what they could be sold for now. The M-LEC is therefore trying to act as a parking place for assets till the storm is over.

But what if SIV assets were always substantially overpriced - because of the systemic mispricing of risk that took place during the credit bubble? If that's the case, their assets will drop sharply, even if liquidity returns.

In that scenario, the M-LEC will take the losses on anything it has bought from the SIVs at inflated prices. If that happened, Citigroup would presumably have to take a large chunk of the loss.

In markets, if there's a loss, someone has to take it. In its SIV bailout, Citigroup is gambling big that it never comes to that. If it does, expect a new CEO at Citigroup and a massive reorganization of the bank's business.