Losses on the Super Senior positions contributed approximately three quarters of the CDO desk's total losses (or 50% of UBS's total losses) as at 31 December 2007...
Of the total USD 50 bn Super Seniors held by UBS, UBS purchased USD 20.8 bn of these Super Seniors from third parties.
UBS wasn't just holding onto its own super-senior tranches, it bought more than $20 billion from other banks as well! And it had some inventive ideas when it came to hedging the credit risk on these instruments, too. Consider the largest bucket of super-senior tranches:
Amplified Mortgage Portfolio ("AMPS") Super Seniors: these were Super Senior positions where the risk of loss was initially hedged through the purchase of protection on a proportion of the nominal position (typically between 2% and 4% though sometimes more). This level of hedging was based on statistical analyses of historical price movements that indicated that such protection was sufficient to protect UBS from any losses on the position. Much of the AMPS protection has now been exhausted, leaving UBS exposed to write-downs on losses to the extent they exceed the protection purchased. As at the end of 2007, losses on these trades contributed approximately 63% of total Super Senior losses.
I've read this quite a few times, now, and I still don't understand what it means. I think it means that UBS took out insurance against the value of the security falling between 2% and 4%: "the purchase of protection" here refers to protection against market moves, and not to CDS protection against an event of default. But I'm not sure. In any case, it was clearly a license to print money for the mortgage desk:
A hedging methodology enabled the desk to buy relatively low levels of market loss protection (generally 2 to 4% and sometimes more), and the desk considered the position as fully hedged.
It's the arbitrage that wasn't. You buy a security yielding more than your internal cost of funds, and which has a zero risk weighting, you "fully hedge" it, and you get a positive carry. What's not to love? At this point it's easy to see how UBS ended up with $50 billion of these things.
One normally hopes that a human being somewhere in most banks would look at a $50 billion exposure based only on "statistical analyses of historical price movements" and call a halt to what could be a very dangerous venture. Evidently no human at UBS did so.
(Via Campbell)
This article has 6 comments:
CDOs split up the capital into different segments, with the lowest segment taking *ALL* the principal loss, before the next higher segment loses a penny. So if the lowest segment is the bottom 2%, then the CDO has to take a 2% loss before the rest of the 98% is affected.
In UBS case they would have bought the tranche from 0-15%, and bought protection from 0-3%. As long as the losses were less than 3%, they would not have lost a penny.
But then the bottom fell through the Subprime securities market and the losses, as marked to market, were significantly higher than the protection level.
Think of a car insurance as an analogy. You write a policy with a $10,000 total value insured with a $500 deductible. If the loss is less than $500, you do not pay anything but once the loss goes above $500 you bear all the loss. This is what UBS did, sold insurance on a large chunk ($10,000), and bought insurance for the riskiest ($500 deductible) but then ended up with a huge loss since the loss was much more than the deductible.
They are the only one to suffer. Many banks were short the worst sub-prime tranches and long the next level. They made money when the short got wiped out but did not anticipate the higher level tranche also getting wiped out; they underestimated the magnitude of the problem.
seekingalpha.com/artic...
contends that CDS protection for super senior tranches of CDOs don't make sense. These were AAA rated and did not need credit default protection at inception. The collateralization in the structure should have been more than sufficient. In retrospect it wasn't, or maybe the current write down is due to liquidity concerns rather than risk of default. This is certainly possible.
Mr. Tan contends that the primary purpose of CDS protection was to accelerate the earnings recognition process. In negative basis trading, the purchase of the CDS would have allowed UBS to recognize the discounted NPV of the hedged earnings stream for the duration of the bond on Day 1.
If this was the purpose of the protection, then it makes perfect sense to minimize the cost and extent of the protection measure, an this would enlarge the spread that they can book. After the bonus is paid on the earnings booked, the future losses are UBS' shareholders' problem.
Most of the folks at the UBS structured products desk are probably gone, but I betcha they didn't give back any part of bonuses paid to them in their heyday.
rver
ing
UBS owned the last loss tranche in the Super Seniors (w/ the exception of the X tranche created to cover closing fees). They were always rated Aaa and typically had at least one more Aaa tranche below them and sometimes even two Aaa tranches below them in terms of loss priority. Below these were Aa's, Baa2's, and sometimes Ba2's. Below these were the equity tranches, which were first loss.
When UBS says that they bought protection on 2-4% of the "nominal position," I assume they're referring to 2-4% of the entire CDO. UBS seems to have been doing the opposite of what large hedge funds were doing at the time. Large hedge funds were buying equity tranches and shorting the Aaa's meaning they made money on the two extremes, if the CDO performed great and if the CDO performed very poorly.
UBS, on the other hand, was making the most money somewhere in the middle. By selling protection (and yes, they were selling protection using CDS) on the lower-rated tranches, they were making money if those went bad and still earning interest (albeit only 20-30bps) on the entire principal of the super senior tranches. This worked if the losses were between 0-40% of the portfolio. Once losses exceeded this amount however (which is 100% less whatever % the super senior makes up of the deal), they had only a 2-4% cushion, because of the short hedge they had made on the lower tranche. After that, it begins eating into original principal.
As for increasing bonuses from selling protection through CDS contracts, that does not come into play in this case. More than likely, they bought protection at or near the money, which would mean that they didn't receive much if any NPV upfront. Also, in this market, that typically only works if you sell protection. To make money upfront off of buying protection, one would need to write the contract with a spread under the original spread on the bond with that being the market spread, and since spreads have only be widening, that was never possible.
"these were Super Senior positions where the risk of loss was initially hedged through the purchase of protection on a proportion of the nominal position"
I am sure that UBS was in the business of selling CDS protection if they had a willing buyer to fleece, but that is not in the factset of the original article.
Also, by saying: "To make money upfront off of buying protection, one would need to write the contract with a spread under the original spread on the bond with that being the market spread, and since spreads have only be widening, that was never possible."
are you saying that negative basis trading was not possible during the 2002-2006 period when CDO desks were going full throttle? I don't think this is true.