On Wednesday, UK insurer L&G’s preliminary annual results revealed the following clarification:
We have separately identified our CDO investments, which have previously been classified within ABS. Of the total £1,004m of CDO investments, £844m relate to internally managed CDOs which are super-senior tranches of bespoke structures constructed and managed by Legal & General to provide enhanced yield with significant protection against default. The bespoke CDOs were previously classified under an internal rating basis. We believe it is appropriate to identify these internally managed assets separately, and they are now reported within the not rated category. The underlying credit exposures within our CDOs are investment grade. We estimate that, given normal levels of recoveries, it would take on average more than 40% of the underlying portfolio to default over a ten year period for any loss to accrue.
We’ve had a few quiet questions about L&G’s CDO holdings for some time now, but as the above makes clear, the real issue is not simply whether L&G is invested in CDOs – a troubling, though not crippling £1bn of them at that.
The real issue concerns the fact that L&G is far more intimate with world’s favourite financial structured vehicles than might at first seem to be the case.
Emphasis ours:
The balance of £844m relates to a further four CDOs that were constructed in 2007 and 2008 in accordance with terms specified by Legal & General.
Typically, insurers, pension funds and the like invested in CDOs as yield enhancers for their otherwise boring portfolios. Not L&G.
L&G was actually building CDOs.
Why? We hazard an educated guess: what we appear to be talking about here are four synthetic CDOs which have been created for the purpose of a balance sheet arbitrage.
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The notion of balance sheet arbitrage was, in fact, sine qua non for the genesis of the CDO.
It all started back in 1997, with something called BISTRO, created for JP Morgan. BISTRO, or Broad Index Structured Trust Offering, was a massive scheme that allowed JP Morgan to offload $9.7bn of credit risk from its balance sheet – a supreme accomplishment that allowed JPM to bounce quickly out of the funk it found itself in in the wake of the Asian financial crisis.
The structure was ingenious: BISTRO sold tranched bonds, promising attractive yields, to investors. The proceeds of the bond sales were kept in a cash reserve which in turn collateralised BISTRO’s party trick: writing credit default swaps against bonds and other assets on JPM’s own balance sheet.
This effectively allowed JPM to magic away – from a regulatory perspective – troubled assets that it did not wish to tie up capital holding to maturity. JPM had created a structure that simultaneously allowed it to offer attractive – supposedly safe – bonds to its clients, and yet in the very same fell swoop, hedge its own balance sheet.
It was a securitisation, but better: nothing had really been sold. It was a synthetic securitisation.
Synthetic securitisation has a number of advantages over regular securitisation- namely, that it’s quicker and cheaper to set up. Its main blessing though, is also its principal curse: synthetic securitisations can also easily be structured to contain a great deal of apparently “free” leverage.
A CDS contract – as AIG now knows only too well – can be written to cover a huge notional amount; a risk taken on because the perceived chance of that huge payout ever occurring might be perceived to be so small.
If a CDO was thus writing multiple CDS contracts then, just like AIG, the CDO might write contracts the notional value of which far exceeds the cash collateral available to it as raised through the sale of tranched bonds.
Such a CDO might have been structured on the assumptions of a model that says it would be stochastically impossible for all the CDS contracts issued to ever be called.
Combine, then, both the notion of balance sheet arbitrage and the opportunity for inherent “free” leverage in a CDS contract and you have a potentially heady mix in synthetic CDOs.
For JPM it meant that they could rapidly de-risk a huge chunk of their bond and loan portfolio through a relatively small – and attractive – offering on the debt capital markets.
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Back though, to L&G. Some questions:
- Is L&G using these four synthetic CDOs to perform its own balance sheet arbitrage?
- If so, what is the total notional size of the assets that CDS contracts written by the CDOs are hedging?
- Is there a knock out trigger in any of these CDOs that may cause them to be unwound (causing the CDS to be dissolved, and a lot of credit risk returning to the counterparty’s – potentially L&G’s – balance sheet)?
No reply to any of those as of Friday afternoon. A spokesman simply pointed to this week’s year-end results announcement.