On Wednesday I said
that the notorious "liquidity put", which was allegedly responsible
for tens of billions of dollars in Citigroup losses, was "really nothing
more than a CP backstop". Today we’re learning a lot about something known
as leveraged super senior trades, or LSS. And it’s now becoming clearer exactly
went down with these trades, and what the liquidity put really involved.
Think about it this way. Remember the Bear Stearns hedge funds which imploded?
Their big mistake was to buy highly-rated mortgage-backed paper with borrowed
money. When the paper fell in value, the funds’ leverage meant they were wiped
out. To this day, we still don’t really know what happened to the banks which
lent money to those funds, although I suspect that most of them were paid off
by Bear Stearns. In an LSS trade, however, there was no Bear Stearns to bail
out lenders, and so those lenders ended up taking a massive bath.
In an LSS, investors made a leveraged bet on the super-senior tranches of mortgage-backed
securities. But the leverage wasn’t the kind of leverage that the Bear Stearns
hedge funds used. The Bear Stearns funds simply went to their banks (or "prime
brokers", as they’re known in the hedge-fund world) and borrowed the money
against the value of their portfolios. When those portfolios dropped in value,
the prime brokers started making margin calls, forcing the funds to sell their
paper at a loss.
An LSS, by contrast, made much the same trade, but didn’t have any prime brokers
breathing down its neck. That’s because it borrowed the money to create its
leverage by issuing asset-backed commercial paper, or ABCP. Investors would
lend money at very short maturities – less than 90 days – against
the assets of the LSS. And those investors had two reasons to be sure that they
would get repaid in full. The first was that the assets of the LSS, being super-senior,
were therefore super-safe. (That one didn’t work out so well.) The second was
that the banks which created these structures, like Citigroup, promised that
they would step up and buy the ABCP if no one else would. That is the
famous liquidity put.
After the super-senior tranches of mortgage-backed securities started plunging
in value, the owners of those tranches found themselves having to roll over
their ABCP, repaying their original lenders and finding new lenders to fund
their positions. At that point, there were no takers for that kind of paper
at any price – there was no liquidity in the ABCP market. And so the liquidity
put was triggered, and Citigroup was forced to buy the ABCP itself.
Now the ABCP is asset-backed, so Citi could and presumably did take possession
of the super-senior paper which was held by the LSS vehicle. The original investors
in the LSS will have been wiped out, left with nothing. But the value of that
super-senior paper as now fallen so far that it’s worth much less than Citigroup
paid for the ABCP.
Let’s say that the value of a super-senior tranche falls from 100 to 65. The
tranche was originally bought by an LSS, where investors paid in 10 cents of
their own money and borrowed the other 90 cents by issuing ABCP. That ABCP eventually
gets rolled over to Citigroup, which also pays 90 cents for it. So the original
investors lose their 10 cents, but Citi ends up paying 90 cents for something
which is now worth only 65. In other words, the lender’s losses – 25 cents
– are significantly bigger than the losses of the people who bought the
riskiest equity tranches in the LSS, and who lost all their money.
Now I hasten to add that I’m pretty sure this is an oversimplified explanation
of what went on in reality. Alea has a more
nuanced and complex take on this whole trade, which involves not only credit
default swaps but even Canadians. And here’s how Charlie Calomiris
The CDO problem became magnified by the creation of additional layers of
securitisation involving the leveraging of the “super-senior”
tranches of CDOs (the AAA-rated tranches issued by CDO conduits). These so-called
leveraged super-senior conduits, or “LSS trades,” were financed
in the asset-backed commercial paper (ABCP) market. Some banks structured
securitisations that levered up their holdings of these super-senior tranches
of CDOs by more than 10 times, so that the ABCP issued by the LSS conduits
was based on underlying organiser equity of only one-tenth the amount of the
ABCP borrowings, with additional credit and liquidity enhancements offered
to assure ABCP holders and ratings agencies. When CDO super-senior tranches
turned out not to be of AAA quality, the leveraging of the CDOs multiplied
the consequences of the ratings error, which was a major concern to ABCP holders
of LSS conduits.
I strongly suspect that the "credit and liquidity enhancements" Calomiris
talks about here are exactly the same as the "liquidity puts" which
did in Citigroup. But it would certainly be nice if someone did some more reporting
on this.
Update: Alea points me to a
May piece from Pimco’s Edward Devlin, who explains the LSS and even provides
a helpful diagram. According to this (admittedly Canadian) structure, the liquidity
put was funding not the 90 cents at the base of the pyramid, but rather the
10 cents at the top! Which means that a 10-cent drop in the value of the super-senior
tranches would wipe out the provider of the liquidity put entirely. Meanwhile,
the equity investor only has upside, and makes no investment at all, so has
no real downside whatsoever. You can click on the image for a bigger version,
or just go to the Devlin article for more detail.
