Friday, April 18, 2008

Misplaced bets on the [super-senior] carry trade

(Gillian Tett in the FT) Earlier this week, I asked a senior executive of one of the world’s most troubled investment banks when he had first grasped the meaning of the phrase “super-senior.” Sheepishly, he admitted that the moment was last August.

It is a telling admission. As the credit turmoil rumbles on, the largest investment banks are continuing to make writedowns on an ever more eye-popping scale. One example is UBS, which has admitted it is now likely to have incurred more than $35bn losses from the credit crunch – in a matter of months.

But as the zeros mount up, what is still baffling – at least to anyone who is not a banker – is how these institutions could lose quite so much quite so fast. Sure, we know that subprime is at the heart of these woes. But how exactly does a bank, such as UBS, conjure up losses larger than the gross domestic product of many countries – especially when, last summer, it seemed to be on track for another strong year of profits?

Hopefully, a full answer will emerge soon, since the largest investment banks are engaged in their own forensic research (and UBS is poised to submit detailed reports to its regulators). But even before this verdict emerges, it is clear that a key culprit was the issue of super-senior – and more specifically, what senior management did (or did not) know about this asset before last August.

First, a brief note of explanation. 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 AAA 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 AAA 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. And 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.

But, last August it became clear why this 10bp spread existed: namely, because these assets are not as liquid as government bonds in a crisis. Indeed, the prices of some tranches of debt have fallen by 30 per cent in recent months, to the shock of senior managers. Hence these sudden, gobsmacking writedowns at places such as UBS, where the CDO desk alone produced over $15bn of losses, mostly super-senior linked.

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.

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