leveraged super senior tranches

Every financial contract is subject to a bunch of risks, and in some sense each of those risks affects its value. There’s some chance that an asteroid will crash into the earth next year, rendering your 30-year interest rate swap considerably less valuable, and if you’re so inclined you can discount its value for that possibility.

One nice thing to imagine is that your financial contract is, like, one contract, and all the risks are spelled out in that contract, and you can figure out the value of the contract based on real or market-implied probabilities of all the risks happening etc., and you add them all up and you conclude “the market value of this contract today is 12!” or whatever and you go on your merry way. But that doesn’t need to be true. Some of your risks live in the contract and are part of the contract; some live in the counterparty and have to do with the counterparty’s riskiness; some live in whatever collateral arrangements you have with the counterparty and have to do with the mechanics of your collateral; some are asteroids.1

Anyway, remember the Deutsche Bank whistleblower story? I said last week that the question of whether DB’s actions constituted accounting fraud was not a particularly interesting question, but that is all relative and you’d be surprised what I find interesting. One thing I find interesting: those Deutsche Bank trades! And umm their accounting.

So, some background. As far as I can tell, DB sold a bunch of credit protection in sort of normal ways, CDX and stuff. And it bought a bunch of protection in leveraged super senior tranches. A super senior tranche, classically, is:

  • You have a pool of reference assets,
  • You pay some spread to a protection writer,
  • If defaults wipe out more than some unlikely-seeming percentage – 15%, say – of those assets, then the protection writer gives you money, more or less 1% of notional for every 1% of losses over that threshold,
  • So for instance if there are 40% losses you get paid 25%.
  • The protection writer is like a big bank or monoline or whatever and, in 2005, is either AAA/AA or is posting mark-to-market collateral or both.

So there’s your trade. A leveraged super senior is the same thing, except replace that last bullet point with:

  • The protection writer posts a bunch of collateral – 10% of max exposure, say – day one.
  • The protection writer is a Canadian asset-backed commercial paper conduit or some other non-credit party.2
  • If certain bad things happen that make you worry that you don’t have enough collateral, you can ask the protection writer to post more collateral, but (1) they don’t have to, (2) they don’t want to, and (3) they can’t.3

Read more »

Oh man, what is going on in this FT article? Here is the bottom line:

In a series of complaints to US regulators, two risk managers and one trader have told officials that Deutsche had in effect hidden billions of dollars of losses.

“By doing so, the bank was able to maintain its carefully crafted image that it was weathering the crisis better than its competitors, many of which required government bailouts and experienced significant deterioration in their stock prices,” says Jordan Thomas, a former US Securities and Exchange Commission enforcement lawyer, who represents Eric Ben-Artzi, one of the complainants.

The “in effect” does a lot of work there; Deutsche Bank “in effect” hid billions of dollars of losses because there were no losses. Other than that!

Here’s a synopsis of what seems to have been going on:

  • Starting in 2005, Deutsche did some credit trades where they bought protection from some Canadian pension funds and sold protection to hedge funds, etc.
  • The bought and sold protection were not identical, with various technical bits of non-overlap that you can read about at your leisure down below.1
  • A credit crisis occurred, changing the risks involved in those non-overlapping bits from silly, abstract, purely theoretical risks into significantly more alarming and more-likely-to-occur but still purely theoretical risks.2
  • Deutsche’s people sort of ran around dopily trying to figure out what to do about it. Here’s a condensed version of the running around they did about the main risk, the “gap option” that DB was short in its leveraged super senior trades:

Read more »