Warning: financial meltdowns in mirror may be closer than they appear

As we head into what looks to be an...ummm...exciting news week, it seems like a short review of last weeks frantic attempt to salvage US financial markets is in order.

First up:

Kohlberg Kravis Roberts, which had more than $100 billion of buyout financing pending this summer, was theoretically the private equity firm most at risk from a debt market collapse.

But while most firms waited for the debt markets to regain their strength after the credit crunch, KKR pushed through financing for UK chemist group Alliance Boots and US commercial payments processor First Data. Next week, it is scheduled to complete on US power generator TXU.

KKR, which manages more than $53 billion in funds, is hardly out of the woods, a reality it has acknowledged by talking to US bank Citigroup about creating a holding company to buy orphaned leveraged loans.

The bank has been one of KKR's largest arrangers of leveraged finance and, at one point this summer, had underwritten $50 billion of debt that had yet to be syndicated.

Uh oh.

Credit markets are collapsing, and one of the most aggressive leveraged buyout firms in the world is in trouble. And because KKR is in trouble, Citigroup, their cheerful banker, is also in trouble. What to do?

Citigroup is understood to be underwriting $8 billion in debt for the holding company, which will leverage the $2 billion of equity provided by KKR through its Strategic Capital fund. According to a banker familiar with the arrangement, the fund would buy the loans for KKR deals that are struggling to be sold to third parties.

Ummm, excuse me?:

Perhaps the most mind boggling aspect of this deal is that the LBO loans KKR is reportedly interested in buying are the loans Citigroup made to finance KKR acquisitions, including the buyout of First Data. Follow this closely: Citigroup is lending money to a KKR vehicle that will buy up loans Citigroup made to KKR owned companies.

This is a classic maneuver when you are a powerful financial player who is all-in and frantically bluffing. Bogus mark-to-market accounting and transaction laundering through lame shell corporations was at the heart of the Enron financial meltdown five years ago. You would think that we might have learned something from that experience. How does KKR get away with it?

According to bankers and investors, KKR has made more progress than its rivals because it refused at an early stage to back down on deals. Once the banks appreciated the possibility of losing the firm's fees, they softened their stance.

KKR paid $424 million in fees to banks in the first nine months of this year, making it one of the top three fee payers to Wall Street behind Blackstone Group's $496 million and Goldman Sachs Capital Partners' $449 million, according to data provider Dealogic.

The bank most affected by KKR's financing is Citigroup, which has agreed to finance, and often lead, nearly all KKR's deals this year including TXU, with $37.35 billion of loans in the pipeline.

OK, let's review. Big sleazy leveraged buyout firm, check. Greedy and stupid large bank, check. Frantic rearranging of deck chairs on the Titanic, check. But oh, it gets better.

Before exploring the iceberg looming underneath the tip of this bizarre little news item, let's briefly go back to a simpler time, about six months ago, when KKR and Goldman Sachs locked down one of the biggest deals ever - the just completed leveraged buyout of Texas Utilities (TXU), one of the largest, dirtiest, and most corrupt (it is Texas, after all) electric utilities in the country. Consumer and environmental advocates had already soundly thrashed utility plans to build a dozen new, expensive, and environmentally catastrophic coal-fired power plants. The resulting political pressure was making it impossible for the Texas state government to quietly accept KKR's assertion that the state had no authority to put conditions on the sale. KKR was working hard to acquire TXU in one of its largest acquisitions ever, but couldn't line up the financing without some certainty about what the future might hold for the utility.

Their solution? Do an endrun around state consumer and environmental advocates by cutting a backroom deal with two national environmental groups, Natural Resources Defense Council (NRDC) and Environmental Defense Fund (EDF). TXU gets the considerable aura of respectability of NRDC and EDF, NRDC and EDF enhance their reputation as effective players in the big leagues. Except KKR and Goldman Sachs have already reneged on their part of the deal. In point of fact, they gave away nothing to buy the reputation of two of the leading environmental groups in the country for political purposes, and have since announced plans to build two new nuclear plants that were never mentioned in the previous negotiation.

Had NRDC and EDF not lent their active support to the TXU deal, there is a very good chance that the buyout would not have gone through. Had the deal not gone through, KKR Goldman Sachs, and Citigroup would be in a stronger financial position right now. Just as many Democrats continue to enable the Bush administration through meaningless compromises, NRDC and EDF enabled a huge leveraged buyout that is one of the key components of of KKR's, and now Citigroup's, current problems. The moral of the story (applicable to NRDC and triangulating Democratic politicians alike) is that the consequences of dealing with sleazeballs in good faith can be unpredictable, extreme, and not at all what you thought you were getting.

Now, back to the iceberg. How big a problem does the unease about KKR and Citigroup represent? Well, what we are talking about here is a recently popular form of asset laundering known as securitized investment vehicles (SIV), the corporate version of packaged subprime loan portfolios. Here's the problem:

SIVs use short-term funding like asset-backed commercial paper to buy longer-term assets, which include mortgage-backed securities. The debt markets stalled during the summer's credit turmoil, leaving investors reluctant to buy or sell securities like commercial paper. There are some $400 billion worth of SIV investments globally, according to Standard & Poor's. Banks currently are not required to divulge what kind of assets are held in their SIVs, though any losses would have to be reported in quarterly earnings reports.

$400 billion is about how much we've pissed away so far on George's Excellent Adventure in Iraq, about half of the entire annual economy of Texas or New York, roughly the entire annual economy of the Phillipines, slightly less than the entire annual economy of Iran. It's a lot of money, and if it vanishes suddenly for no good reason, financial markets may vanish shortly thereafter. And there's the rub - nobody knows outside of the banks that created the SIV exactly what assets are in those SIV's, or how much they are actually worth if the economy goes south. This is exactly the same problem that is causing the subprime mortgage collapse (in fact, some of tha SIV assets probably are subprime mortgage packages). And, because the whole Ponsi scheme floats on short-term commercial loans, things can get ugly very quickly when the short-term commercial loan market seizes up. In fact, the subprime mortgage collapse has triggered a collapse in investment in short-term commercial paper over the last two months. Investors don't like being told that nobody knows what their investment is worth. Lowering interest rates just makes the problem worse - why would any investor accept a lower return for a riskier investment?

Let's be clear about exactly what SIV's are. Short-term commercial paper is how business prevents timing issues on a scale of weeks to months from getting in the way of financial transactions that are done deals on paper. It provides liquid cash flow, an essential lubricant of business, and has generally been considered a low-risk, low-yield investment market.

Global banks started using their reputation as major players to tap the traditional low-risk, low-cost, and high liquidity of short-term commercial loan markets to get money for cheap. They then rolled that money over into high-risk, high-return, long-term investments, keeping them afloat by continuously rolling over the short-term commercial paper. These banks, and their friends, are making money by borrowing cheap money from low-risk markets, and investing in expensive loans to high-risk markets. The effect is to contaminate short-term commercial credit markets with risky loans to unknown players.

So. the biggest single pusher of SIV's has been - say it with me now - Citigroup. Their beautiful relationship with KKR has left them holding about $100 billion in seven huge SIV's, roughly a quarter of the entire market in these securities. In turn,

KKR is behind nearly 40%, or $28 billion, of buyout financings in what credit rating agency Fitch estimates is a $72 billion high-yield pipeline in the US.

And, just to remind you where we started,

Kohlberg Kravis Roberts, which had more than $100 billion of buyout financing pending this summer, was theoretically the private equity firm most at risk from a debt market collapse.

This is from this context from which we must consider both the recursive perpetual money machine that the $8 billion loan by Citigroup to Citigroup in order to prop up KKR, and the impending bailout of Citigroup:

In a far-reaching response to the global credit crisis, Citigroup Inc. and other big banks are discussing a plan to pool together and financially back as much as $100 billion in shaky mortgage securities and other investments.

The banks met three weeks ago in Washington at the Treasury Department, which convened the talks and is playing a central advisory role, people familiar with the situation said. The meeting was hosted by Treasury's undersecretary for domestic finance, Robert Steel, a former Goldman Sachs Group Inc. official and the top domestic finance adviser to Treasury Secretary Henry Paulson. The Federal Reserve has been kept informed but has left the active role to the Treasury.

The new fund is designed to stave off what Citigroup and others see as a threat to the financial markets world-wide: the danger that dozens of huge bank-affiliated funds will be forced to unload billions of dollars in mortgage-backed securities and other assets, driving down their prices in a fire sale. That could force big write-offs by banks, brokerages and hedge funds that own similar investments and would have to mark them down to the new, lower market prices.

The ultimate fear: If banks need to write down more assets or are forced to take assets onto their books, that could set off a broader credit crunch and hurt the economy. It could make it tough for homeowners and businesses to get loans. Efforts so far by central banks to alleviate the credit crunch that has been roiling markets since the summer haven't fully calmed investors, leading to the extraordinary move to bring together the banks.

In recent weeks, investors have grown concerned about the size of bank-affiliated funds that have invested huge sums in securities tied to shaky U.S. subprime mortgages and other assets. Citigroup, the world's biggest bank by market value, has drawn special scrutiny because it is the largest player in this market.

Known radical Alan Greenspan is skeptical:

"It's not clear to me that the benefits exceed the risks",Greenspan said. "The experiences I've had with that sort of intervention are two-sided."

Greenspan drew a distinction between the bail-out of a single large hedge fund to prevent the widespread sell-off of assets - as happened with Long Term Capital Management (LTCM) in 1998 - and efforts to prop up an entire asset class, as in the case of the proposed superfund.

In the case of LTCM, "a single company" that was "excised out of the market", there had been a potential for "a dangerous firesale of those assets". When shareholders came in and took out LTCM, that "eliminated that aspect of market disruption".

In contrast, "here we're dealing with a much larger market", he said. "They're not talking about going in and absorbing sub-prime mortgage asset backed [securities]. They're talking about essentially increasing the liquidity of those who have the SIVs [structured investment vehicles] and the like."

Greenspan is right to be skeptical. The shiny new Super-SIV is just the KKR-Citigroup do-se-do writ large.

And who are the geniuses who came up with this cunning plan? Well, the negotiator at Treasury who convened the bailout group is Robert Steel, a former Goldman Sachs vice-chair and the top domestic finance adviser to Treasury Secretary Henry Paulson. And Henry Paulson? Well, before George Bush appointed him to replace the ill-starred John Snow, Paulson was the Chairman and CEO of - say it with me now - Goldman Sachs. And while we're on the subject, remember Robert Zoellick, the World Bank chair who was replaced by our good friend Paul Wolfowitz? He left the World Bank so that he could become a managing director at... do I even have to tell you?

And what is Goldman Sachs up to these days?

A Goldman Sachs filing with the US Securities and Exchange Commission has led to allegations that it may have inflated profits in the third quarter to a spectacular $8.23 billion by booking paper gains on mortgage derivatives at too high a value.

Analysts cited by Fortune Magazine claim that almost a third of the bank's revenue came from "short" positions on the lowest tier of mortgage derivatives and other forms of toxic debt.

These assets are extremely hard to price, and were not in fact realised. More than $2.62bn of declared profits were made entirely on house estimates at the underlying value.

Charles Peabody, an analyst at Portales Partners in New York, said there were concerns that Goldman had set optimistic values on instruments for which there was in reality little or no functioning market.

"Common sense tells me that a lot of these losses were real and a lot of their gains were paper, and that's something we'd like to know more about," he said.

Oh yes. These are exactly the guys we want leading the way out of this mess.

It's going to be a very interesting next few months.