Yesterday a controversy broke out about whether or not Citigroup chief financial officer Gary Crittenden should back up his contention that the perceived risk of owning certain mortgage bonds, as measured by the ABX, was overstating the actual risk. Crittenden’s critics say that if Citi really believes what it is telling worried investors—that things aren’t as bad as they look—then Citi should start employing strategies to capitalize on this. His defenders reply that Citi already is doing something—holding the bonds instead of selling them at steep discounts—and, more importantly, that there is no way to short the ABX.

It’s a bit of an obscure debate but in an age when the prices of obscure credit products are leading to the ouster of chief executives on Wall Street and huge declines in stock prices, it may be a debate worth having. And so we have it after the jump.

For Crittenden’s critics, his defense of Citi’s positions ring hollow because the firm isn’t taking on even more risk by getting even deeper into the positions they have already taken.

“When Crittenden says that ‘if you look at what the ABX would imply in terms of real estate price reduction, it starts to imply very, very high numbers... it’s unlikely that those... will take place’ the sentence should not come to an end,” writes Brad Delong. “There should be a comma, and after the comma the sentence should continue ‘therefore Citigroup is sponsoring and investing in a new hedge fund to take advantage of the undervaluation of the ABX and similar market opportunities, and we are now raising capital.’”

Felix Salmon, who writes for Portfolio’s Market Mover blog, thinks this is “a cheap shot.” Critics like Delong are asking too much.

“You could try going long the ABX, but the ABX doesn't have anything to do with cashflows: it has everything to do with the cost of insuring against default. And it's entirely possible that a jittery world will pay more for default protection for some time, even if the cashflows themselves are rock-solid,” Salmon writes. “In fact, the only way you can really benefit from the (implied) mispricing is to mark your assets down today, in line with what the ABX is implying, and then collect your cashflows as per schedule. And that, it turns out, is exactly what Citigroup is doing.”

You know what? We don’t think these guys are anywhere near innovative enough. There are plenty of creative ways to go long on the ABX that we can think of. We’re not advising that Citi—or anyone else—adopt these strategies. For one thing, Citi might well be happy with the risk-reward ratio from simply holding the bonds but not taking on further risks involved in these strategies. For another, all these strategies are completely unhedged. But they are not really so complex or difficult to structure. And they are entirely possible even in a relatively illiquid credit market.

The first four strategies are completely straightforward.
• Buy or Hold: The most obvious step, as Salmon points out, is to buy or hold bonds and other mortgage backed securities.
• Go long Bond Insurers: Another easy step is to go long the equity of bond insurers.
• Sell insurance: You can also become a seller of credit default swaps yourself.
• Short Bond insurance: If you really think bond insurance is over-priced, short bond insurance by borrowing insurance contracts from dealers and selling them. When the price of bond insurance drops back down to reasonable levels, pocket the profit.

The next steps are a bit more complex. You’d probably have to at least get your lawyers on the phone.

• Submarines: Create a structured investment vehicle that employs the riskiest strategies above, especially the short bond insurance move. Fund it with equity from your fellow “ABX mispricing” bulls. Make the equity tradeable. The next step is crucial: sell under-water put options on the equity of the SIV. This will give all those ABX bears the right to make you buy back the equity in the SIV if its long bets turn out wrong. Because the first letters in ‘short SIV’ have a nautical flavor—S.S.—and they are underwater, they are called Submarines.

• Naked Submarines: Create another SIV that only sells under water put options on the bonds and equity of the Submarine but doesn’t actually hold the underlying positions. They are naked underwater put bets on the short siv, or Naked Submarines. Warning: very risky because there are no underlying investment assets—such as bonds—that might retain some residual value if the bet is wrong.

Of course, all of these positions could be made riskier—and potentially more rewarding—by adding leverage. The last two strategies, when highly levered, are called Nuclear Submarines and Nuclear Naked Submarines.

As we said, we’re not in the business of recommending investment strategies. But the next time someone tells us that the ABX is mispricing risk in asset backed securities, we’d like to see them really put their money where their mouth is. Get on Submarine, baby!