Banks Bet With Employee Insurance Premiums, Lose.

This post first appeared on Minyanville.

Citigroup (C) can't catch a break, as another bizarre type of structured investment has gone awry. The latest troubled fund, however, has nothing to do with subprime mortgages.

According to The Wall Street Journal, nearly 700 banks hold a total of $117.5 billion in what are known as bank-owned life insurance programs, or BOLIs. Banks take out policies on their employees and collect if the workers die. The income is tax free, leading critics to call the practice a tax shelter.

Banks park the insurance premiums in fixed income investments like Citigroup's Falcon Strategies fund. The fund was marketed to banks and sophisticated retail investors, who claim the opportunity was called a "haven."

Now, the fund having lost nearly 75% of its value, Citi may have to pony up millions to pacify angry investors. The two biggest, Wachovia (WB) and Fifth Third Bank (FITB), have a combined $1.6 billion in exposure - much of which came from the banks' BOLI proceeds. Fifth Third is already suing a broker and insurance company that helped facilitate the investment.

Citi has agreed to reimburse private investors for any losses stemming from Falcon's demise. The bank may end up doing the same for its institutional investors.

Financial markets have become adept at absorbing such news - a potential loss of $1.6 billion just isn't what it used to be. Investors seem convinced government bailouts will soften the blow of the endless parade of imploding investment schemes.

Risk management wasn't just lax for the PhDs and traders dreaming up CDO squareds and credit default swaps. Mispriced risk was endemic, a system-wide malaise caused by the exploitation of nearly limitless easy credit.

While these latest losses may not sink the offending banks, they're a few more hacks at a tree that's not getting any sturdier.


Position in WB