Saturday, May 09, 2009

Super-senior CDOs

The second instalment of Gillian Tett's look at the banking crisis includes this,
On November 4, however, Citi suddenly warned that it would report additional losses of between $8bn and $11bn. That was such shocking news that chief executive Chuck Prince resigned. It was also baffling to analysts. Citi was supposed to be expert at measuring credit risk, so how had it managed to misjudge its losses so badly? And why was it still so uncertain about the total bill?

Demchak dialled into the conference call eager to find out. “The issue is super-senior,” one of the executives explained. The problem, he added, was that the bank held on its books $43bn of super-senior risk, linked to CDOs backed by mortgage debt. Citi had previously assumed that the value of those assets was 100 per cent of face value. Now the price was falling.

Super-senior? Demchak could hardly believe his ears. Almost a decade had passed since Krishna Varikooty, Demchak and the rest of the JP Morgan group had invented the term to describe the part of a CDO that was supposed never to default – according to the computer models. Back then, super-senior had seemed a geeky in-joke, so quirky and obscure that only a few technical experts knew what it meant. Now the Citi executives had casually tossed the word into a conference call with hundreds of mainstream investors, analysts and financiers. Demchak didn’t know whether to laugh, cry or just shake his head in wonder. In other circumstances, he might have felt almost proud that his team’s once-obscure brainchild had suddenly burst into the limelight. In fact, he was horrified: the way Citi told the story, super-senior had turned into a scourge that had created most of its unexpected losses.

“How could this happen?” Demchak wondered. During his days at JP Morgan, his team had considered super-senior so safe that it was “more than triple-A”. Even though Demchak himself had gone to great lengths to sell JP Morgan’s super-senior risk to AIG and other insurance groups, he had never imagined that it could pose more than a moderate risk. Nor had he guessed that Citi was holding so much super-senior risk on its own balance sheet. Citi had never discussed the issue before on conference calls nor highlighted it in previous results announcements. “How did this happen?” Demchak asked himself again and again. As he listened to the rest of the call, he got the distinct impression that the Citi managers were almost as baffled as he was
This fits well with the idea that it is the safe parts of the CDOs that are the real problem. No one ever thought that they would be worth less than 100%.

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