Brad Setser

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Not all that sophisticated

by Brad Setser
April 21, 2008

Back in 2005, Ragu Rajan warned that the banks were taking on the hard-to-sell leftovers from the securitization process. As a result, he argued that the banks were becoming less liquid – and that the process of risk transfer was incomplete. I assumed that this meant that the banks were holding small amounts of the most risky tranches that emerged from bundling a lot of different loans and securities together. That assumption seems to have been off. The risky bits carried high yields, and seem to have been easy to move. Instead the banks were holdings large quantities of the safest (and lowest yielding) securities – the “super-senior” tranches.

Gillian Tett:

The concept of super-senior debt was essentially invented by creative bankers about four years ago to refer to the chunk of debt that sits at the very top of the capital structure of a collateralised debt obligation. It is the bit that gets paid off first, before other investors, if the CDO ever defaults. In theory, it makes this debt super-safe; indeed, so secure that rating agencies have been happy to give super-senior CDO debt a triple-A tag, irrespective of what lay inside the CDO.

When I first heard about this asset class a couple of years ago I initially assumed this stuff might appeal to risk-averse institutions such as pension funds. But nothing could be further from the truth. In fact, key buyers for super-senior in recent years have been banks such as Merrill Lynch and UBS. Most notably, as these banks have pumped out CDOs, they have been selling the other tranches of debt to outside investors – while retaining the super-senior piece on their books. Sometimes they did this simply to keep the CDO machine running. But there was another, far more important, incentive: regulatory arbitrage.

Most notably, because super-senior debt carried the triple-A tag, banks were only required to post a wafer-thin sliver of capital against these assets – even though this debt has typically offered a spread of about 10 basis points over risk-free funds. Thus, banks such as UBS and Merrill have been cramming their books with tens of billions of super-senior debt – and then booking the spread as a seemingly never-ending source of easy profit. It is not just the CDO desks that have been playing this game; treasury departments have been playing along. So have many hedge funds, including those financed by . . . er . . . the major investment banks

It turns out that the super-senior tranches carried a lot more risk than many thought – Combing a bunch of CDOs composed of subprime securities into a new security didn’t make the underlying risk go away. Plus these instruments were illiquid and thus hard to sell.

I never thought that (formerly) highly-rated US securities would trade at the same price as Argentine bonds just after Argentina’s default. The ultimate recovery on those bonds may end up being higher as well.

Moreover, as Gillian Tett reports, the banks themselves weren’t only holding these securities to make the securitization process work. They also liked the extra yield that they could get on something that was rated triple-A.

So there you have it: in the last resort, a key reason for these record-beating losses is not a failure of ultra-complex financial strategies or esoteric models; instead it arose from a humongous, misplaced bet on a carry trade that was so simple that even a first-year economics student (or Financial Times journalist) could understand it. It is a shocking failure of common sense and risk management. So the moral, in a sense, is also a simple one: if someone offers you seemingly free money, in seemingly infinite quantities, with a soothing new name, you really ought to smell a rat. Even – or especially – if you are in the position of running a supposedly sophisticated investment bank.

It took a huge amount of sophistication – or at least computing power – to produce a lot of the securities that have caused so much trouble. But sophistication doesn’t explain why so many banks were holding something with risks that they didn’t fully understand to pick up a few basis points.

And it wasn’t just pure regulatory arbitrage either . Unregulated institutions seem to have been doing much the same thing — UBS’s in-house hedge fund for example.

My guess is that a bunch of unsophisticated reserve managers ended up doing a lot better over the past few years than a lot of sophisticated bank treasurers. They didn’t take on as much credit risk, so they didn’t get as much yield during the good times. But they also didn’t take on the risk of large losses for a few extra basis points.

Of course, the bank treasurers who took on too much “holding complex securities that you cannot sell when you need to risk” generally avoided taking on much currency risk. Central banks generally avoided credit risk, but took on a ton of currency risk. The investment banks held the super-senior tranches no one else wanted; central banks have been holding the dollars no one else wants.


The FT on the sources of UBS’s subprime exposure

The Wall Street Journal’s explanation of why Merrill ended up with so much subprime related exposure on its balance sheet (they kept their factory going even as demand for the product faded … ), and a story illustrating how Merrill created a CDO composed largely of credit default swaps on “triple B” mortgage backed securities and bits and bits of other Merrill CDOs. Merrill didn’t confirm that it ended up holding the super-senior tranche, but, well, you can draw your own inferences.

Yves Smith’s examination of Merrill’s initial round of CDO-related losses.

Fortune’s write-up of UBS’s internal report. UBS’s internal hedge fund seems to have loaded up on subprime — and banks’ own desk was adding to its positions even in q2 2007.

Felix’s analysis. UBS wasn’t just holding the unwanted output of its own securitization. It bought a lot of other banks CDOs. And its hedging methodology effectively left it unhedged — and created incentives for its internal fund managers/ prop desks to take advantage of UBS’s low cost of funds to load up on CDOs and pocket the carry.

The actual UBS report.

Internal Citi presentation (lifted from the comments)

Alea’s table showing CDO issuance


  • Posted by DC

    " then we’d need more people in agriculture, and we can have more people employed in manufacturing if we made that more inefficient. " – Twofish

    That is the deceptive BS argument used by both Greenspan and Rubin to justify the deindustrialization agenda. Everyday we consume enormous amounts of energy, food, and manufactured products. And right now, the US is in a deficit position in energy, manufactured products, and believe it or not, even food. A financial service based economy maybe ok for a niche economy like England, but not for any large continental economy like the US.

    "Please explain how destroying people’s wealth and retirement savings will help people who are running a bank make money. " – Twofish

    On my 401K retirement savings of over $300K, I receive a measly 2.6% interest rate that is well below the real inflation rate. If I were permitted to, I would of course dump every last US Dollar into sound money currencies, foreign energy stocks, and precious metals. I am indirectly subsidizing the enormous financial losses by the Wall Street banksters. Is Bernanke or anyone offering me a bailout check to cover my financial losses on my 401K?

  • Posted by DC

    “Financial mercantilism” describes how Washington and Wall Street have collaborated “to minimize certain unwanted marketplace forces.”

    Hence the long, sad history — from the Latin American debt crisis and the S&L bailout to the subprime mortgage meltdown — of the U.S. government and Federal Reserve rescuing our failed financial wizards. He gives a name for what happens when taxpayers rescue profligate bankers: “Wall Street socialism.”

    Like a prosecutor, Phillips speaks with a finely honed indignation and calls expert witnesses to challenge the “myth” that financial markets are “a rational and safe underpinning for public well-being and the stewardship of a leading world economic power.”

  • Posted by RebelEconomist

    Twofish and anonGuest,

    Thanks for your replies…….I thought it would have been reported in the media if there had been defaults on AAA tranches.

    In that case, I have more sympathy for the rating agencies and less for the holders of these instruments. The rating agencies make it clear that they assess default risk, and not market risk, and so far it seems that the ratings do, as we say in Britain, exactly what it says on the tin!

    The trouble is that there have been plan sponsors, fund managers and even investment bankers who ignorantly, lazily or cynically used agency ratings as a measure of general risk. As I wrote here over a year ago, it seemed to me that some of the structures (CPDOs in particular) were deliberately designed to exploit this misunderstanding.

  • Posted by bsetser

    my sense is that there are a small number of AAA tranches that have taken real as opposed to expected losses … but most of the write down is mark to market. that said, i am very far from being on the ground …

  • Posted by Guest

    The fed has only issued one non-recourse loan in all of this…


  • Posted by Twofish

    DC: Is Bernanke or anyone offering me a bailout check to cover my financial losses on my 401K?

    Yup. Go to your nearest bank and take out a home equity loan or line of credit.

  • Posted by SGC

    AnonGuest: I have to differ with you on this " the blame clearly rests with bank regulators who assessed the risk and still allowed capital relief for the banks"

    The regulators are completely hobbled by operating in a rule based environment where their charges demonstrate no interest whatsoever in helping them maintain the stability of the financial system. Post-Enron the regulators made a serious effort to put an end to "liquidity puts" that also served to provide credit enhancement to off balance sheet entities ( and thereby allowed asset backed commercial paper conduits to get AAA ratings while incurring a tiny capital charge. (The credit enhancement required by rating agencies to issue a AAA to off balance sheet entities carries a 100% capital charge and always has.) Citi’s liquidity puts were either a direct violation of this rule or the rating agencies "conspired" with the banks to circumvent the intent of the rule.

  • Posted by anonGuest


    I see your point in part, but the fundamental issue has always been the answer to the question, “Has the credit risk effectively been transferred from the bank to the vehicle?” If the answer is yes, the bank frees up its capital while collecting a fee. Credit enhancement is separate and is charged capital. The liquidity backstop lines were structured in such a way as to create the impression that credit risk had been transferred. The problem is that the liquidity scenario had never been thought through to the point of the total breakdown of the securitization system itself, and the collapse of normal funding availability. When funding reverts to the bank permanently, it effectively assumes the credit risk permanently. This is yet another permutation of the classic bank run. These were ‘normal’ liquidity backstops. This did not require circumvention of rules. It was just a rule that didn’t contemplate the worst case. This points to another very fundamental problem with Basle and risk management in general. In general, there is no capital charge for liquidity risk. The macro categories for capital charges are credit risk, market risk, and operational risk. Liquidity risk is managed under separate guidelines, which are somewhat fluffy in substance. These events hopefully will cause Basle to rethink the approach to liquidity risk.

  • Posted by anonGuest

    Perhaps there’s a loose analogy between the morphing of these liquidity backstop lines into full credit exposure, and the Fed’s decision to move beyond its normal liquidity provision role by assuming longer term credit risk (particularly with the Bear Stearns loan).

  • Posted by SGC

    I think the question is whether the rating agencies deliberately held off on downgrading the super senior CDOs in order to protect the money markets and force the banks to treat the liquidity backstops as credit enhancement. Contractually the loss should have been taken by the commercial paper holders, since liquidity backstops exclude any assets that are impaired — and by the time that Citi, for example, took the assets on it was clear that they were already impaired, whether or not they had a AAA rating.

    While some very short-sighted people might see this protection of the money markets as a good thing because the public would have been frightened, it seems to me that it just allows a fundamentally unstable and contradictory market to continue to operate. (You can’t have investors believing that money market accounts will never break the buck while also requiring them to sign on to the fact that they could lose money. The product is nonsensical on its face.) In short, it seems that the money markets have been protected at the expense of the banking system, when the reverse would have put us on the road to a more stable and sensible investment environment.

  • Posted by SGC

    "force the banks to treat the liquidity backstops …" maybe that should be "enable the banks to treat the liquidity backstops …"

  • Posted by anonGuest

    SGC – interesting point on rating agency strategy. I have no view on it except that it was an incredibly stupid product in terms of the risk gymnastics required for some paltry yield pick up. Probably a lot of brokers at fault for pushing it like some boiler room stock scam.

  • Posted by Twofish

    SGC: Contractually the loss should have been taken by the commercial paper holders, since liquidity backstops exclude any assets that are impaired — and by the time that Citi, for example, took the assets on it was clear that they were already impaired, whether or not they had a AAA rating.

    The trouble was that the AAA rating referred to credit risk not liquidity risk, and even though the values of the securities dropped because they became illiquid the default risk of those assets didn’t markedly increase, thereby giving the credit rating agencies little reason to reevaluate the rating of the security.

    I think the basic problem is that a AAA rating didn’t mean what a lot of people thought it meant. (And to be far, there were some huge financial incentives not to think too hard about this.)

  • Posted by Twofish

    SGC: You can’t have investors believing that money market accounts will never break the buck while also requiring them to sign on to the fact that they could lose money. The product is nonsensical on its face.

    No more nonsensical then having people base their investment decisions on credit ratings given by an agencies that explicitly tell people not to use rely on those ratings to make investment decisions…….

  • Posted by SGC

    Twofish 15:56:02: Most of the CDOs backing Citi’s asset backed commercial paper conduits were ABS CDOs (i.e. securitizations of securitizations, see, page 11). Since it is usually the lower quality ABS that is put into CDOs, it’s hard to believe that the drop in value was due only to illiquidity and not credit risk. Citi took a 17% writedown on these at the end of December (and the write-downs continue).

    In fact I ran into this by a Citi analyst. See page 3 for an estimate of 75% losses for ABS CDOs. If the super senior tranche is 70% of the CDO, this implies over 60% losses on the super senior tranche.

    That there was significant credit risk for securitizations of securitizations must have been obvious in the fall to the credit rating agencies — which afterall understood the structure of these creatures.

    Twofish 16:00:27: Touché.

  • Posted by bsetser

    I appreciated the quality of this discussion, and the various links that were posted. I will archive many of them in the references section of the post over the weekend. Many thanks.

  • Posted by JB

    I’ve got some issues with this commentary. Triple A rated tranches in CDO’s are not as risky an investment as the lower tranches. While I will agree that the risk element was seriously underestimated by the rating agencies. I’m not going to join the banter that Wall Street has zero brains and anyone could have seen this crisis coming. If all of you fellas had seen it, why are you chatting away on an economics discussion forum rather than enjoying your new yacht on the islands. Some elements, were visible, and should have been anticipated by the banks. But, not all of it was visible. The speed and transition of the pension fund investor out of Asset Backed Securities was really quite impressive. Similarly, I think some of the sharpest risk experts will tell you that the triple AAA rated tranches are undervalued. After Wall Street got their liquidity back this tranche has started to rally on some of the recent rolls.

    In regard to whether or not the rating agencies played a conspiratorial role? Ofcourse they did, at the request of Spitzer and the Federal Reserve. They were holding their downgrades on the big banks and monolines until the last minute. How would you like to be the head of a quasi-public agencies that threaded the needle for massive economic recession?