Hank Paulson's got an Enron-like crisis that could swamp Citigroup (C) and JPMorgan (JPM)

Banks lent their solid credit ratings to SIVs so they could issue supposedly risk free commercial paper (CP) -- a short-term corporate IOU -- with higher yields. SIVs, which issue short-term notes to invest in longer-term securities with higher yields, are often organized by banks but are not actually owned or held by them. They are supposed to be financed through the issuance of CP backed by pools of home loans and credit card debt, but the loss of confidence in the quality of subprime mortgage bonds has also tainted these securities.

But nobody is buying SIV-affiliated CP because they now realize that it's backed by subprime mortgage bonds -- which investors now consider to be the financial equivalent of toxic waste. In order to revive the CP market, the banks affiliated with these SIVs have to dump the toxic waste. But if nobody buys it, then the Wall Street firms that sponsored these SIVs will be forced to take huge hits to their capital.

How so? Analysts say that investors have all but stopped buying SIV-affiliated CP, and the worry is that the 30 or so SIVs will unload billions of dollars of mortgage-related assets all at once. That would put intense pressure on prices. As Wall Street firms and hedge funds mark value of similar investments they held to their new lower values, they face potentially huge hits to their profits.

Like the partnerships that sunk Enron, these banks don't have to account for the SIVs until a time of crisis -- at which point they're required -- legally or to preserve their reputations -- to step in and buy them. (As a brief reminder, Enron had created off-balance sheet partnerships backed by huge borrowing which enriched its executives while hiding Enron's money-losing operations).

In the case of the SIVs, nobody wants to discuss just how big the problem could be. My hunch is that the problem is so big that the banks and Treasury department are worried that an accurate accounting would deeply spook the financial markets -- leading people to withdraw their money from the stock markets and the banks that are on the hook for these SIVs. That's why they're working on a semi-secret government-arranged bail out. (Incidentally, I think the fear of how big the write off of this toxic waste would be is the real reason behind the Fed's September 19th 50 basis point rate cut.)

The Treasury Department proposal calls for the creation of a "Super-SIV," or a SIV-like fund fully backed by several of the world's biggest banks to provide emergency financing. The Super-SIV would issue short-term notes to finance the purchase of assets held by the SIVs affiliated with the banks, with the hope of reassuring investors.

It sounds to me like a non-starter. First, the interests of different banks are at odds with each other and this plan will only work if they can all agree. For instance, big banks will argue over the amount of capital each bank would need to contribute, how it would be administrated, and the fee structures and cost burdens.

Secondly, the basic problem is that the Super SIV -- which sounds like some kind of viral epidemic -- appears to me to be putting lipstick on a pig while giving the banks a huge fee payday. It doesn't solve the underlying problem which is that investors borrowed huge amounts of money to buy toxic waste -- they need to pay the price for their mistakes.

If I borrowed money to buy shares in a company that went out of business, I would need to pay back that loan out of my own pocket. Why shouldn't the same principal apply to the banks behind these SIVs and the investors who fell for their sales pitch?

Update One: A Bloomberg News reporter who interviewed me yesterday said that this morning at 9, the Treasury Department would make an announcement but it has not happened yet. Meanwhile, Bloomberg News reports that the Super SIV will total $80 billion and that the total value of SIVs is $325 billion. In the view of one debt strategist, $80 billion is enough to pay off senior debt holders -- but it still leaves $240 billion to pay off everyone else.

Update Two: Well it's official: The Associated Press reported at 9:09 this morning that Bank of America Corp. (NYSE: BAC), Citigroup, and JP Morgan Chase will be establishing a Master Liquidity Enhancement Conduit (M-LEC) -- the official name for the Super SIV -- which could be operating within 90 days. The article called it a Superfund -- I don't know if the pun was intended -- but it just reinforced in my mind the M-LEC's purpose -- to clean up financial toxic waste.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He owns Citigroup shares.