It’s the middle of 2007. Executives at RBS are joining the dots about how even super senior tranches of CDOs offer scant protection in the face of a tsunami of subprime defaults.
A structure which would become commonly understood by many, had some that should have been in the know scratching their heads. Given that CDO structures seem to be the answer to everything these days, it beggars belief that the captains of the industry had trouble grasping the problem.
And yet as the FSA report into the collapse of RBS to remind us, one at least did have trouble:
For example, on 14 May 2007, Mr Cameron asked Mr Crowe for an explanation of why the daily profit and loss summary for debt capital markets was worse than asset-backed securities and in particular ‘how much leakage of sub-prime into CDO business? … I’d like to be clear in the truth circle before thinking what to say to others who currently think our issue is all abs’. Mr Crowe responded stating ‘CDO is all sub prime related’. In interview, while Mr Cameron could not recollect when he became aware that the value of super senior CDOs was threatened by developments in the sub-prime market, he explained that:
‘I don’t think, even at that point, I fully, I had enough information. Brian may have thought I understood more than I did… And it’s around this time that I became clearer on what CDOs were, but it’s probably later.’
Introducing, Johnny Cameron – chief of the RBS investment bank in 2007.
The bank’s super senior CDOs are a fascinating part of the FSA’s report and Johnny Cameron’s role in the sorry tale will always now be seen as bumbling, as Matt Levine says.
Concerning RBS’s continued issuance of the securities in early 2007, despite signs of trouble in the market, the bank mostly suffered from a “bias towards optimism” (but not “outside the bounds of reasonableness”) about the products, the FSA judges. This at the same time that other squids banks were primarily remaining active in order to get rid of inventory and pile on downside hedges. Those that were not would ultimately find themselves in marriages of necessity, on the receiving end of taxpayer money, or in bankruptcy. Back in 2007 though…
“GBM [RBS Global Banking and Markets] also shared a widely held view that it was inconceivable that super senior CDOs would suffer any loss as the tranching process had rendered them almost risk free,” the regulator adds. Which maybe puts Cameron’s lack of knowledge into context.
In addition to the retention of super senior tranches in the first place, this optimism affected (afflicted?) RBS’s decision not to hedge the exposures in the middle of 2007, because it would have locked in losses that were not supposed to happen in housing markets. Hedging had suddenly become more expensive and, in any case, monoline insurers were themselves starting to wobble:
Johnny Cameron was not alone in his optimism. It permeated down from the upper echelons. Cameron in a “compelled interview” with the FSA in 2009:
He [then-chief executive of RBS, Fred Goodwin] is and was an optimist and he tended to take an optimistic view of what was likely to happen and had often in his life been proved right… He genuinely did not believe that house prices could possibly decline as much as other people thought and held that view strongly.
Ultimately the FSA declined to take enforcement action against Sir Fred Goodwin for delegation to Johnny Cameron because of the “overall mix” present in GBM staff. But arguably the overall mix was the problem — CDO groupthink. What’s more is that the optimism was challenged from outside RBS at the time, hence the criticisms levelled at RBS’s valuations of its super senior positions. As it turned out, optimism shaded into opacity of disclosure.
In time, opacity would shade into RBS’s illiquidity — and then it became part of the bank’s legacy (complete with its own unit, mind you):
Write-downs on credit trading assets were first taken at end-2007, although (as noted in paragraph 296) at this point RBS had recognised fewer losses than were seen at some other firms. 372 However, when announcing its rights issue in April 2008, RBS announced significant increases to its expected losses on these asset classes. From that point on, RBS managed a group of CDOs, monoline exposures, leveraged loans and certain other US MBSs within a separate ‘strategic assets unit’ (SAU). These assets were classed as legacy business and continued to be tracked and reported separately until the firm was restructured into ‘Core’ and ‘Non-Core’ divisions in 2009.
Good that they decided to get “strategic” about it. Finally.
By Joseph Cotterill and Lisa Pollack
Related links:
“Finance, like air safety, is epistemic” – Deus Ex Macchiato
Wisest is he who knows he does not know – FT Alphaville (2009)
Synthetic CDOs: not saving anything – FT Alphaville (2008)