CDOs: Super senior is super bad

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By:
Louise Bowman
Published on:

‘Riskless’ exposure comes back to haunt banks

Banks are facing far bigger write-downs on their ABS CDO business than first thought because they took on super-senior exposure that was supposed to be virtually riskless

There has been only one game in town in recent weeks as far as the structured finance market is concerned – and that is trying to put accurate numbers on just how big the final hit taken by banks from their ABS CDO businesses will be. The realization that early numbers put out by some banks could be wildly off has dawned in recent weeks – primarily since Merrill Lynch and Citi put out write-down figures that seemed an order of magnitude greater than anything that had been suggested before. Although Merrill and Citi were at the top of the league tables for underwriting CDOs, when they revealed potential billion dollar write-downs in the double digits it became clear that something else was afoot.

Comparing the hits that each bank is expecting is a frustrating business because of the inconsistency in their approaches. But the mere fact that the ABX indices have tanked during October (see chart) would suggest that any bank putting out figures in November rather than September would be expected to mark exposure down far more sharply than before. This fact was largely ignored in the sensational coverage of, particularly, Merrill’s write-down (and subsequent departure of Stan O’Neal) – but was not the real reason for the sudden ballooning of these figures.

As has been so often the case in this credit crunch, it is seemingly risk-free triple-A exposure that is causing the new problems for the banks. Super-senior tranches of ABS CDOs sit above the triple-A tranche in the structure and as such had been assumed to be practically risk-free. As a result, many banks and monoline guarantors had piled into the business. But during October it became very apparent that these tranches are actually very far from this, and now account for the bulk of the write-down forecasts that the banks are revealing.

Misjudgement

It is truly shocking that the risk implicit in these tranches could have been so badly misjudged – even given all the problems that have been exposed in the RMBS market so far. "Prior to recent weeks super-senior tranches of CDOs were considered virtually risk-free, and the idea of write-downs was unimaginable," says CreditSights analyst Simon Adamson in a report. But the reason for the development is depressingly familiar: originators and rating agencies completely underestimating the correlation risk implicit in CDOs with insufficiently diversified collateral pools.

"Super-senior ABS CDO tranches are now vulnerable for two reasons," Matt King, managing director and global head of credit products strategy at Citi, tells Euromoney. "Because securitizing securitizations involves two layers of tranching and because in many cases CDOs were built almost entirely from triple-B ABS tranches."

A moving target                                                                                                            .

On-the-run ABX index prices, 2007

Source: Markit


This double layer of tranching makes the valuations of ABS CDOs highly sensitive to movements in the underlying markets – in this case the critically damaged sub-prime mortgage market. So losses are not confined to the equity level and will hit tranches higher up the capital structure. If almost all the collateral backing a CDO is triple-B, the impact can be sufficient to hit even the super-senior level. But even if the collateral is not entirely composed of triple-B ABS, the CDO is not immune from trouble.

ABS CDOs fall into two categories: high-grade, which are backed by assets rated single-A or above, or mezzanine (those backed by triple-B assets). High-grade deals will clearly suffer less severe losses than mezzanine deals, but could still trip up because of the presence of CDO buckets – many of which can reach 20% to 25% of the pool. Because these buckets can be so large, the super-senior tranche may well attach at a level that is inside the size of the CDO bucket – and thus be quickly under pressure when the CDOs in the bucket under perform. Citi estimates that super-senior attachment points for high-grade ABS CDOs were 17.5% and mezz 40% for 2006/07 deals. Recovery rates on HG super seniors are now just 55% and for mezz a mere 32%.

Raters under fire

Much criticism has already been levelled at the rating agencies that their models failed to take into account the correlation implications of the collateral backing the ABS CDO market becoming almost entirely composed of sub-prime RMBS (see RMBS: The true meaning of true saleEuromoney  November 2007). Just how seriously these implications were misjudged is nowhere more apparent than a super-senior tranche of a securitization being hit.

Several analyses of bank exposure to super-senior CDOS were published over the past month. According to Citi, Merrill and UBS are facing potential write-downs of $10 billion and $7 billion respectively, with Citi itself looking at around $6 billion. CreditSights published figures for European banks which indicated that UBS has $12.4 billion potential exposure to super-senior ABS CDOs, Credit Suisse $6.1 billion and Deutsche Bank $6.7 billion. The monoline insurance companies have wrapped significant volumes of this exposure for the banks but it seems that in recent years the banks were more willing to keep the exposure themselves. A recent comment from MBIA stated that its involvement in mezzanine ABS CDOs has been "selective" since 2004. But as the risk involved in wrapping super-senior tranches was deemed to be so low they were very attractive to the monolines, and their exposure to potential write-downs will be significant. Their combined gross par exposure to the entire CDO business was estimated to be around $105 billion in August this year.

Super scary

Estimate of potential super-senior ABS CDO exposure write-downs

Source: Creditflux, Citi


Analysts freely admit that their estimates of exposure can only be a rough guide. "Ultimately it will depend on how active banks have been in selling, closing or hedging their positions," CreditSights points out. But the numbers make interesting reading as to the discrepancies between what the banks have actually written down and what the analysts think that their exposure actually is. For example, by modelling write-downs required by using the ABX and TABX indices as a guide for CDO values, CreditSights concludes that the $1.6 billion write-down reported by UBS before the end of September should be more in the region of $8.1 billion. And the $819 million write-down by Barclays before October should have been closer to $2.6 billion.

The positions of two banks in Europe starkly illustrate how these risks should and should not have been managed. UBS has super-senior CDO exposure of $20.2 billion, about two-thirds of which ($13.2 billion) is in mezzanine ABS CDOs. As such, it should be facing a potential write-down of $7.17 billion according to Citi and $9.28 billion according to CreditSights. "While we do not expect it to make the additional $9 billion write-downs estimated by our model, we do not see how it can avoid further substantial losses," say the analysts at CreditSights. In contrast, Deutsche Bank seems to have reduced its CDO correlation book at the end of the second quarter to less than $1 billion by the end of the third quarter and as such will make no further write-downs in the fourth quarter of this year.