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November 27, 2008 7:07 pm
The linchpin of this financial crisis has been “super-senior” investments backed by subprime mortgage securities and derivatives. These securities were labelled “super-senior” because they were viewed as ultra-safe and secure, protected by so much extra collateral that it would be an understatement to call them merely “senior”.
With the latest bail-out of Citigroup this week, the US government has embraced the “super-senior” methodology for its own balance sheet. It will now proudly hold a “super-senior” position in Citigroup’s most troubled assets. Commentators have praised the government’s new approach and financial stocks rallied along with expectations of similar deals from other banks.
The details of the new arrangement are straightforward. Citigroup has $306bn (€236bn, £199bn) of troubled assets. Before the deal, the bank was at risk of losing that entire amount, which was one reason why market participants were skittish about the bank’s future. After the deal, Citigroup will be at risk of losing the first $29bn. If the assets fall by more than $29bn, the government will bear 90 per cent of any additional loss.
Thus, Citigroup has a subordinate claim to the government’s senior position. Citigroup’s more junior claim provides a 10 per cent cushion to protect the government from losses, much as other junior claims – now largely worthless – once protected Citigroup from declines in the value of underlying subprime mortgages. Indeed, the government’s seniority is not as “super” as Citigroup’s initially was. Back then, subordinated claims gave Citigroup a cushion of more than 50 per cent. That was not enough.
The government’s maximum potential exposure on its new “super-senior” position is a quarter of a trillion dollars. But unless Citigroup’s assets fall by 10 per cent, the government will not lose any money and the bail-out will be free. “Super-senior” positions were toxic to major banks, but regulators hope they will be anodyne for the government. Can anyone imagine Citigroup’s troubled assets declining by $29bn?
Citigroup in effect has paid the government an insurance premium, in the form of dividends on newly issued preferred stock, in exchange for an agreement that the government will cover the losses on its troubled assets if they fall by more than 10 per cent.
Option selling strategies are not new and are profitable most of the time. Many well-known investors and traders have sold options, often cloaked with complex financial engineering, to generate large positive returns. One recent proponent is Warren Buffett, whose holding company, Berkshire Hathaway, sold $37bn of long-term put options on stocks. Now, the government has entered the option-selling fray and most experts believe its new short put position in Citigroup’s assets will perform better than those of Mr Buffett and certainly better than Citigroup’s own “super-senior” trades. Citigroup’s earlier option sales ultimately lost billions and Berkshire Hathaway is nursing a multi-billion-dollar mark-to-market loss.
There are strong arguments that the government is following a smart strategy and that it should act as “asset purchaser of last resort” during times of market crisis. Yet it is important to recognise the risks and realities of the government’s new “super-senior” position. The government’s and Berkshire Hathaway’s positions will perform well only if markets eventually recover. The US Treasury Department, Federal Reserve and Federal Deposit Insurance Corporation are taking on risk associated with $306bn of Citigroup’s assets. On Wall Street, this bail-out would be described as a $306bn deal. It is unclear whether Congress authorised a deal of that size. Instead, administration officials characterise the deal as smaller and without significant liabilities, just as banks initially characterised their “super-senior” deals as off-balance sheet and low risk.
If the latest Citigroup deal is a template for bank bail-outs to come, the government might soon become involved in the mother of all “super-senior” transactions and the largest option sales in history. Super-senior deals, including both Citigroup’s initial mortgage trades and this week’s bail-out, appear to be prudent ways to earn incremental income with zero risk. Until they aren’t.
The writer is a law professor at the University of San Diego and is the author, most recently, of The Match King: The Financial Genius Behind a Century of Wall Street Scandals, to be published in early 2009 from Profile Books/PublicAffairs
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