Structured credit: They’re back! Leveraged super seniors return
Citi markets new deal; CDS at post-2007 tights.
Synthetic 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 collateral.
Citi’s move 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.
Leveraged 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 credit portfolio.
The 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.
Citi lost $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 bank’s highest-rated CDOs would lose so much money. Citi’s faith in CDOs “looks pretty unwise today”, Prince said in 2010.
“This 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. “It’s a bit of a test case, and it will be interesting to see how investors react.”
Some experts are, however, sceptical.
“I am 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 again.”
The reason 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.
Citi’s 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.
However, 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.
Alongside 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 away.
Many banks 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 the crisis.
Citi in 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 risk.
The deal 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.
Whether 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 senior.
Citi’s 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.
Still, while some structural issues with leveraged super senior tranches might have been addressed, investors still need to find the deal attractive, and some have raised questions over the pricing.
“We looked at the deal but according to our calculations it should be paying around 5.5%, rather than the 3.5% they are offering,” says one fund manager. “For me it’s a bit too expensive, and it seems that Citi are looking to get a cheap hedge and hoping some investors go for it.”