The Negative Basis Trade

While the media is abuzz with its coverage of Lehman’s (LEHMQ.PK) repo 105 and Citigroup’s (C) super senior CDO tranche losses, one has to wonder if their surprise (and dismay) is somewhat akin to that of Captain Renault at the activities at Rick’s gin joint in the movie Casablanca. (“Captain Renault: I'm shocked, shocked to find that gambling is going on in here!”)

It has, after all, been two years since UBS (UBS) openly confessed that their super senior CDO positions - hedged, partially hedged, and unhedged - accounted for approximately 50% of UBS’s total losses as of year-end 2007. (See Shareholder Report on UBS's Write-Downs, April 18, 2008.)

Similar to Citigroup, UBS notes that their strategy was recommended to them, or at least ratified by their hired external consultant:

The external consultant compared the gap between UBS and the composite leader … and concluded that the [UBS Investment Bank] had gaps in the Credit, Securitized Products and Commodities businesses, with smaller gaps in Rates and Emerging Markets….and recommended that UBS selectively invest in developing certain areas of its business to close key product gaps, including in Credit, Rates, MBS Subprime and Adjustable Rate Mortgage products ("ARMs"), Commodities and Emerging Markets. ABS, MBS, and ARMs (in each case including underlying assets of Subprime nature) were specifically identified as significant revenue growth opportunities. The consultant's review did not consider the risk capacity (e.g. stress risk and market risk) associated with the recommended product expansion.

In structuring ABS CDO deals, the sell-side banks would often hold on to a large portion of the super senior triple A tranche, as UBS confesses:

The CDO business model involved structuring a CDO for a manager and retaining as much as 60% of the capital structure on UBS's own books. The deal size would frequently be in excess of USD 1 bn.

So why the feigned shock and dismay at Citigroup’s super senior positions?

The banks would often then “hedge” these positions by entering a positive carry trade with the monoline insurers. This trade became known as the “negative basis trade” as the senior tranche paid a higher coupon to the banks than the insurance premium required – that is the credit default swap spread – by the monolines to wrap the bond (and enable the banks to conveniently remove the bond from their balance sheets). Banks would then present value the future expected profits from this long-term carry trade and consider them as realized profits, distributable as bonuses to the brilliant bankers.

From UBS’s report:

Day1 P&L treatment of many of the transactions meant that employee remuneration (including bonuses) was not directly impacted by the longer term development of positions created.

… and

Employee incentivisation arrangements did not differentiate between return generated by skill in creating additional returns versus returns made from exploiting UBS's comparatively low cost of funding in what were essentially carry trades… the UBS funding framework amplified the incentives to pursue compensation through profitable carry trades.

What shocks me, rather, is how little we have done in these past two years to buffer against the key pitfalls that brought UBS to their knees: the ineffective internal and external auditing processes; the misalignment of incentives for risk managers and traders; the inadequacy of resources provided to risk managers to monitor complex portfolios and their liquidity; and the fact that an accounting construction was ever allowed to exist that would enable (and encourage) banks to consider partially hedged super senior as completely risk-free and off-balance-sheet items (see UBS’s Amplified Mortgage Portfolio “AMPS” super senior positions). Loopholes such as these led to the downfall of the major banks.

When will the scrutiny of the “negative basis trade” begin?

Disclosure: No positions