CDOs, the securities that probably contributed most to losses
during the financial crisis, appear to be back, with Citi
marketing the first leveraged super senior tranche to be seen
since 2007. The deal is backed by corporate
comes as corporate bonds hover near five-year tights, dampening
liquidity and increasing demand for synthetic exposure through
the credit default swap market. Now, with CDS spreads trading
near their tightest level since 2007, the bank is looking to
reduce risk and offer investors a leg-up in returns.
super senior tranches were the securities that attracted
triple-A ratings before the financial crisis in the belief that
it was almost impossible to lose money selling default
protection against the most senior tranche of a
perceived extreme unlikelihood of losses meant banks built up
huge super senior positions, with Deutsche Bank, for example,
accumulating $130 billion of leveraged super senior trades,
according to documents filed with the SEC.
$30 billion from a combination of leveraged super senior
positions and senior tranches of CDOs over six quarters during
the crisis and was eventually bailed out by the US Treasury,
however those losses were predominantly on deals backed by
mortgage-related collateral. At the subsequent inquest, chief
executive Chuck Prince told investigators that nobody could
have predicted the banks highest-rated CDOs would lose so
much money. Citis
faith in CDOs looks pretty unwise today, Prince
said in 2010.
is the first deal of this kind for a very long time and a brave
move by Citi because not that long ago nobody would have even
considered looking at something like this, says Jochen
Felsenheimer, a partner at Munich-based hedge fund Xaia
Investment. Its a bit of a test case, and it will
be interesting to see how investors react.
experts are, however, sceptical.
highly surprised that anybody would attempt to do this,
says Jon Gregory, a partner at London-based capital markets
consultancy Solum Financial. Out of all the products that
were around before the financial crisis this is the one
structure you would think would never be seen
Citi appears to be comfortable floating a new LSS deal is that
the structure is different to pre-crisis vintages, with the
bank building in protections that will prevent it being exposed
in the way it was six years ago.
Citis clever twist on the old model revolves around
the way in which the investments are unwound. In pre-2007 deals
the safety of the LSS investment, and its triple-A-credit
rating, was predicated on the fact that a high number of credit
events was required before the investor suffered any loss. For
example, the 22% to 100% tranche of a 125-name portfolio would
require 40 credit events before getting hit.
the reason banks lost so much money was not defaults, but the
leverage on the deals. For example, a $10 million investment
was leveraged 10 or 20 times into a tranche with a notional of
$100 million or $200 million.
the leverage was a trigger, usually the market value of the
tranche or the spread of the underlying portfolio, at which the
investor must pay more collateral. A crucial aspect of this
set-up, and the Achilles heel of the structure, was that if the
trigger was hit, the investor had the option to walk
did not price that gap risk into the structure, and when the
investor backed out they were left holding the losses, or
relying on hedges that were worth not very much at all during
its latest deal has introduced a feature that gives it full
recourse to the investor, removing the option to back out. That
means whatever the market does, Citi can still collect on its
insurance, effectively swapping gap risk for counterparty
is currently in the marketing phase, with Citi looking to find
common ground with investors, and the payoff structure has yet
to be finalized. However, the average spread on the underlying
portfolio is around 150 basis points, and fund managers report
Citi is offering 350bp to take the risk at 10 times leverage.
The attachment point is 15%, meaning investors are protected
against the first 15% of losses in the portfolio.
this level of return will be sufficient to attract investors
back into the market is debatable. The auguries earlier this
year were not great, with JPMorgan and Morgan Stanley failing
to raise interest in new full capital structure CDOs. Citi has
had some success marketing single tranches in the past two
years, sources say, though not in leveraged super
innovative structure also acts as a sweetener for investors, in
that there is no mark-to-market trigger on the deal. That means
that the bank can claim against the investor only in the event
of default, a much more attractive proposition than being
caught by spread movements in the underlying.