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.
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