Barclays resignation: Collateral damage

A high-level resignation at Barclays Capital has sent shudders through the market. Barclays vigorously denies any serious losses, but just what was "Mr SIV-lite" up to? By Sean Farrell

Few people outside the arcane world of structured credit had heard of Edward Cahill before last week, but his departure from Barclays has focused attention on the bank's role in setting up complex investment funds that could face severe losses amid the credit meltdown.

Mr Cahill resigned as head of European collateralised debt obligations (CDOs) from the Barclays Capital investment bank last Monday after returning from holiday. Three days later, Standard & Poor's, the credit rating agency, slashed its ratings to junk status on two of the so-called SIV-lite funds his team had set up for clients.

Mr Cahill, who ran a team of about 18 people in London, was not in the very top rank of Barclays Capital bankers, but he had gained an increasingly high profile in the world of credit since joining from JP Morgan in 2004 by leading Barclays Capital's creation of SIV-lites.

The 33-year-old Irishman claimed in 2005 that the SIV-lite could be set up in four months compared with the two years that were required for its more complicated predecessor, the standard structured investment vehicle (SIV).

SIVs and SIV-lites are unregulated funds that are set up by investment banks for other institutions such as banks or hedge funds.

The funds typically sell cheap short-term debt such as asset-backed commercial paper to investors and use the funds to finance investments in longer, higher-yielding assets such as mortgage-backed securities. Sponsoring banks such as Barclays typically agree to provide liquidity support for the funds of up to 25 per cent of the value of the commercial paper outstanding, under certain conditions.

The funds have been hit hard by the ballooning defaults in the US sub-prime mortgage market as borrowers with patchy credit ratings found themselves unable to afford repayments on their homes.

These defaults have rocked the world debt markets because the mortgages were packaged up by investment banks and sold as bonds in which financial institutions round the world were able to invest in the search for high returns. With defaults rising, the value of the bonds plunged as investors rediscovered risk after years of easy credit for high returns.

The structured credit funds have been doubly hit as the value of their assets has plunged and investors have switched from commercial paper to keep their money in cash or invest in government bonds. The blow-up in the credit markets has drawn attention to the previously obscure funds.

With the market in a state of near panic, the departure of Barclays' "Mr SIV-lite" has raised questions about what exposures Barclays might be left with from the complex products. People close to Barclays are playing down the significance of Mr Cahill's abrupt exit, saying the bank is in touch with him. Barclays denies it had agreed to back the funds to the tune of several hundred million dollars.

Earlier this year, Barclays Capital set up a SIV-lite for Landesbank Sachsen Girozentrale, a German public-sector bank whose problems in the credit market contributed towards its takeover on Sunday by LBBW, a German rival.

Barclays says it has not provided any funding for the Sachsen Funding One SIV-Lite.

But even if Barclays does not have to provide backing to the funds, it has experience of how blow-ups at complex structured credit vehicles can cost it money.

In 2005, Barclays settled a legal case with HSH Nordbank, another German lender, over HSH's investment in a CDO in 2000 which it said cost it $150m. Barclays had originally said any loss for HSH was caused by the market and was not its fault, but the UK bank was keen to settle rather than have its derivatives business scrutinised in court.

The Financial Services Authority declined to comment on what actions it might take on structured credit funds, but a partner at a leading City law firm says the regulator would be examining bank sponsors' exposure to the off-balance-sheet funds even if the lenders had no legal obligation to back them.

"The bank sponsors are the ones who took the initiative in launching the vehicles into the market, and the market and the rating agencies would expect them to provide forms of support. The FSA will look very closely at how banks treat vehicles off balance sheet and if they support them in ways that are beyond their legal commitments."

Concerns about Barclays Capital's involvement in these complex products has come at the worst possible time for Barclays. The bank is meant to be on a campaign to push up its share price so that its share-based offer for ABN Amro, the Dutch bank, can compete with the mostly cash offer from Royal Bank of Scotland and its partners.

Bob Diamond, the head of Barclays Capital, tried to soothe investor concerns early this month by saying Barclays Capital had limited exposure to US sub-prime mortgages and that his business was diversified between many revenue streams.

But Mr Cahill's departure and the ratings downgrades for the funds set up by his team have reignited nervousness about potential shocks in Barclays Capital's earnings.

Investors have long been wary of Barclays Capital's place as the main driver of Barclays' profit growth, fearing that Mr Diamond's business was riding the wave of a credit boom that could shudder to a halt. Though fund managers have been impressed by Mr Diamond's expansion of his business, they instinctively prefer earnings from retail and commercial banking that they can more easily predict and understand.

"Because Barclays Capital has had such strong growth and has been at the forefront of all the new financing techniques employed worldwide, the concern is that they will see a disproportionate correction in terms of revenue and profits if these markets continue to be closed," says Simon Maughan, an analyst at MF Global Securities. The effect on Barclays Capital would probably turn out not to be disproportionate, he adds.

Shares in Barclays fell 3.6 per cent to 589p yesterday, the stock's lowest price for more than a year.