Forgive us if you’ve seen this, but we missed it.
Goldman Sachs published a note last week - on Boxing day - by analyst William Tanona estimating an additional Q4 writedown for Citi of $18.7bn. Staggering.
Here’s the most interesting part of Tanona’s analysis:
The last column in particular: over three short months, GS is saying that Citi’s super senior CDO exposures - supposedly safer than AAA - have declined in value by 50 per cent in the case of high grade and 75 per cent in the case of mezz CDOs. CDO squared? Worthless, say GS.
The biggest single Q4 writedown however, to the tune of $7.5bn, predicts Tanona, will be taken on commercial paper of ABS CDOs. And it’s probably this analysis that should bear the most scrutiny.
Again, that commercial paper of ABS CDO is a super senior exposure. The CP Goldman refers to is actually a series of liquidity backstop facilities provided to specially designed super-senior CDO conduits: Leveraged Super Seniors (LSS). Gird your brains…
Leveraged Super Senior conduits are, in fact, the only reason Citi has any of this super-senior CDO exposure at all. They are financial spivvery par excellence.
Super-senior exposure to CDOs was once the preserve of monoline bond insurers. Being so senior, super senior yields peanuts - typically 5-6bp. But by leveraging it - sticking super senior swaps into a conduit and issuing commercial paper against them banks could get higher yields. Citi, in particular, became massively involved as a super-senior counterparty and a leading LSS conduit sponsor.
Of course, with such a complex and ultra-leveraged product there was always a very high liquidity risk. Thus banks who designed, sponsored and underwrote leveraged super senior conduits - Citi chief among them - sweetened the pill they offered to investors by writing liquidity backstops: promising to buy up LSS commercial paper if buyers for it couldn’t be found.
In the event - as FT Alphaville reported in November - Citi was forced to buy $25bn of such super-senior-backed commercial paper: a big increase in exposure that was shocking in its own right.
But what’s really shocking now is that Goldman have slapped a $7.5bn writedown onto it. Because that confirms a disturbing trend Felix Salmon alerted us to when he wrote about LSS trades back in November too:
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 structure, the liquidity put was funding not the 90 cents at the base of the pyramid, but rather the 10 cents at the top.
In other words, the commercial paper investors in an LSS conduit bear the downside risk. Unlike in a normal conduit, in an LSS conduit, it was the commercial paper investors who bore the first risk. They were the “equity” tranche in all but name. The mechanics of this courtesy of Alea here.
Now Citi holds that CP, it bears the downside risk. In a typical LSS notes Salmon…
… a 10-cent drop in the value of the super-senior tranches would wipe out the provider of the liquidity put entirely.
Back now to the real world.
Citi’s own estimate - which it pinned hope on - was for a Q4 writedown of around $8-11bn. Such was the cautious expectation in early November on which Citi assured a return to normal trading by the second quarter of 2008:
While significant uncertainty continues to prevail in financial markets, it expects, taking into account maintaining its current dividend level, that its capital ratios will return within the range of targeted levels by the end of the second quarter of 2008. Accordingly, Citi has no plans to reduce its current dividend level.
Goldman Sachs clearly see things differently. And it’s that LSS commercial paper that is to blame. Whether Citi writedown their LSS CP remains to be seen, but for now, it seems unlikely that they’ll have an easy ride back to a normal Q2. Both Goldman and - on Thursday Sanford Bernstein - expect Citi to go looking for another capital injection in the not too distant. Anywhere between $5-10bn. Step up, you Sovereign Wealth Funds.
