The FT's Sam Jones put two and two together this week and finally explained what the notorious liquidity put is. You might recall that a couple of weeks ago he told us about CDOs which issued commercial paper. I noted at the time that given the problems with CDOs, and given the problems with asset-backed commercial paper, the intersection of the two – call it CDO-backed ABCP – would have to be particularly toxic.
Well, it turns out that the snark was a boojum. Or, rather, the liquidity put is that CDO-backed ABCP, and it's making billions of dollars of Citigroup's (NYSE:C) capital softly and silently vanish away.
A liquidity put is really nothing more than a CP backstop. But let's back up for a second, here. A CDO is at heart just a collection of bonds, be they mortgage-backed or otherwise. In order to buy those bonds, it needs to raise money. Historically, it has raised that money from long-term investors who in return get the income from the bonds which the CDO owns. But in 2005, Citi started to create CDOs which raised their money not only from investors but also by issuing ABCP. Explains Jones:
To mitigate any CP rollover risk, Citi entered into a series of “agreements” which forced it to buy the CDO CP if no one else would. As Mr Rubin calls them, “liquidity puts”.
The problem with these CDOs is exactly the same as the problem with SIVs (or, for that matter, with banks in general): that the structure's assets have a much longer duration than its liabilities. If the CDO or the SIV can't roll over its ABCP, then the sponsoring bank is in trouble, since it invariably has agreed to buy that CP if no one else will do so. Of course, there's normally a very good reason why no one else will buy that CP, and the bank ends up having to take enormous mark-to-market losses on the CP it's forced to buy at par.
And according to Jones this is not just a Citigroup problem.
The Corporation is obligated under the written put options to provide funding to the CDOs by purchasing the commercial paper at predetermined contractual yields…
And as we understand things, those obligations forced BofA to buy $12bn of CDO CP from off balance sheet CDOs.
Stay tuned: I think this story is going to develop even further on Monday.