By Eric Ben-Artzi, a former risk manager at Deustche Bank and Goldman, and SEC whistleblower
We are all still paying the price for the stream of ever more leveraged credit derivatives that fueled the world’s greatest credit bubble. It appears that some of these are attempting a comeback. Last week, the Financial Times reported that Citi is offering a new version of the now-infamous Leveraged Super Senior CDO (“LSS”). If it succeeds, the Bank could claim the benefit of insurance on a portfolio of corporate bonds, while the client (aka “counterparty”) only deposits a small fraction of the insured amount.
The purpose of the first synthetic CDO, created by JPMorgan in the ‘90s, was to relieve the bank of risky debt it actually owned. The riskier LSS deals arrived circa 2005, and were mostly arranged by trading desks which did not own the referenced bond portfolio. Rather, they simply turned around and sold insurance on the full amount of corporate debt, using regular CDS. The profit – the difference between the fees on the insurance sold and the cost of the insurance bought – was then claimed upfront and handed out in bonuses to the traders and salespeople at the end of the year.
On a large scale, such transactions have the effect of lowering risk premiums (aka “spreads”). Ultimately, the borrowing costs of the corporations referenced in the portfolio go down, encouraging still more leverage. With bond yields decreasing, bond investors chase ever more leveraged instruments. These were some of the dynamics behind the last credit-fueled asset bubble, where borrowed money found its way to real estate and the stock market. In a recent interview with Der Spiegel, Nobel winning economist Robert Shiller warned: “… stock exchanges are at a high level and prices have risen sharply in some property markets… That could end badly”. A few days ago, the Financial Times reported that CMBS issuance has nearly doubled since last year to reach a post-crisis peak, as have CLO and CDO issuance. “US regulators have warned that banks are making riskier loans to companies in an effort to boost flat-lining profits and fight off competition from other types of lender” wrote the newspaper. As early as last February, in an article titled “Credit Super Nova!” Pimco’s Bill Gross warned: “our credit-based financial markets and the economy it supports are levered, fragile and increasingly entropic – it is running out of energy and time.”
The leverage in previous LSS trades created a potential time-bomb, commonly known as “gap risk”. It amounted to a “walk-away from the trade and cut your losses” option for the bank’s counterparties. Such options must be valued as part of the trade, and increase in value dramatically in times of market distress. Now it appears that Citi’s clever “structurers” have neutralized this bomb, by taking away the client’s option to walk away when losses mount. Based on a description in Euromoney, if realized losses reach a very high threshold, the counterparty would now be contractually obligated to post additional collateral and cover Citi’s losses. Market risk has now been transformed into credit risk. Compared to the old LSS structure, this is an improvement – but only if the credit risk is treated properly.
The problem is that this is “wrong-way” tail-risk, which is hard to properly capture using common risk-measures such as VaR. The counterparty will need to pay Citi in an extreme scenario, when a large number of previously healthy companies default. Odds are the counterparty won’t be in great shape either.
Even in a less extreme scenario, Citi faces liquidity risk: the standard insurance contracts it can sell against these LSS trades typically require margin to be posted daily. It is precisely margin calls on such derivatives that hastened the collapse of Lehman Brothers (in fact, a margin call by a certain Bruno Iksil, who went on to become the London Whale). Since the LSS counterparty is not required to post simply because markets are stressed, Citi would have cash flying out one door, and none coming in the other.
In the extreme scenario where losses do materialize, Citi’s salesmen and their clients can tell themselves: “YBGIBG – You’ll be gone I’ll be gone”. Those left to foot the bill will be Citi’s stakeholders. Since Citi is still too big to fail, this means taxpayers.
In the summer of 2007, LSS trades that had been sold to many Canadian investors blew up spectacularly. The Canadian government eventually stepped in and bailed out Deutsche Bank, the largest LSS dealer at the time. Let’s hope that Tim Geithner’s successors at the New York Fed are protecting us from a repeat performance.