Felix Salmon

Citi’s Abacus

By Felix Salmon
October 20, 2011

It’s worth reading the full SEC complaint in the case which was settled by Citigroup yesterday for $285 million. For anybody familiar with Goldman’s Abacus deal, it all rings very familiar; in fact, the wording on the Abacus sign can be applied perfectly accurately to Class V Funding III. It’s worth rehearsing in full:

It’s wrong to create a mortgage-backed security filled with loans you know are going to fail so that you can sell it to a client who isn’t aware that you sabotaged it by intentionally picking the misleadingly rated loans most likely to be defaulted upon.

The loans in this case — just like in the Abacus case — were “synthetic”, or made up of credit default swaps rather than actual loans. Wall Street, at the time this deal was done, had run out of actual loans to securitize, and so was forced to create such things by inventing ever more complex transactions. This one, for instance, is a hybrid CDO-squared: it’s a CDO made up mostly of CDSs written on the mezzanine tranches of other CDOs.

Citigroup had two aims when it structured this transaction; one was fully disclosed to its client-investors, and the other was not. The first was to make millions of dollars — $34 million, to be precise — in fees. The second was to put on a $500 million short position in the CDO market. Citi was a big trader in CDSs on CDOs, and therefore could simply have acquired that short position directly, in the open market. But when Class V Funding III was put together, such protection was already very expensive. And the CDOs that Citi wanted to buy protection on were known in the market to be particularly horrible. Probably, it couldn’t buy protection on those particular names at all. And if it could, the price would be prohibitive.

So Citi created Class V Funding III instead. It gave Credit Suisse Alternative Capital a list of the CDOs it wanted to buy protection on, and CSAC did what it was expected to do — it persuaded itself that it could live with having a large number of them in its deal. After all, CSAC wasn’t investing its own money in this dog — it was just managing it for others. And hey, it was AAA-rated! What could possibly go wrong?

Citi, with CSAC on board, then went out to investors and told them that the portfolio had been selected by CSAC — professional! experienced! expert! — and that they could have confidence in CSAC’s selection of securities. Citi did not tell investors, of course, that Citi itself had actually picked most of the CDOs in Class V Funding III, and they certainly didn’t mention that Citi would be holding a $500 million short position in those securities on its own books indefinitely, as a naked-short prop trade. Here’s how the complaint puts it:

The pitch book and offering circular were materially misleading because they failed to disclose that:

a. Citigroup had played a substantial role in selecting assets for Class V III;

b. Citigroup had taken a $500 million short position on the Class V III collateral for its own account, including a $490 million naked short position; and

c. Citigroup’s short position was comprised of names it had been allowed to select, while Citigroup did not short names that it had no role in selecting.

The fine, in this case, is richly deserved, and the money’s going to the right place — the investors who bought into this dreadful deal. I do wonder how many more of these late-vintage CDOs there are, sitting out there and as yet unprosecuted. (I have to admit that I didn’t think of Citi as being particularly evil in this regard; I thought they were more at the incompetent end of the spectrum.) And I certainly hope that if and when there’s some big mortgage settlement with the banks, that the banks don’t receive in return immunity from prosecution on this kind of deal.

7 comments so far | RSS Comments RSS

The CDO managers who were long this deal knew that SOMEONE was on the other side of this deal. The positions were synthetic, there wasn’t a natural demand for long investors like bonds. The product is a pure bet. Whether the person betting against the longs was Citi or someone else shouldn’t matter.

Many of the the longs didn’t bother to look at the underlying “bonds” in the deal. Those that did bother to look at the underlyings still bought into it. Why such gross incompetence should be rewarded with a refund is beyond me.

Posted by pessimist2 | Report as abusive

pessimist2, this is the one way bet world of the buy side. Make a bet like this, if it pays off good if it blows up run to the courts. Hands up who thinks investors are going to be motivated to do proper due diligence in the next bubble.

In this case we don’t even have a company that made a ton going short the Market a la Paulson.

Posted by Danny_Black | Report as abusive

pessimist2, this is the one way bet world of the buy side. Make a bet like this, if it pays off good if it blows up run to the courts. Hands up who thinks investors are going to be motivated to do proper due diligence in the next bubble.

In this case we don’t even have a company that made a ton going short the Market a la Paulson.

Also if, as you claim, the underlings were “known in the Market to be particularly awful” did csac make a leveraged bet on them? Don’t you think the sec should be going after lazy, incompetent buysiders who DO have a fiduciary responsibility to their investors.

Posted by Danny_Black | Report as abusive

Danny, you know enough to know that on net, even after the lawsuits and arbitrations, the buy-side got slaughtered in the structured products marketplace. You can call them idiots for it (I would agree), but it was hardly a one-way bet in their favor.

Posted by najdorf | Report as abusive

Pessimist 2 – You have it exactly right.

There would be no deal at all without someone who was betting that the underlying would default. The identity of who is short the underlying and who proposed the underlying was irrelevant. “Investors” were writing mortgage insurance.

There was no doubt that both the buyers and sellers got an underlying portfolio with the characteristics they wanted. There was no confusion or misrepresentation about what went into the reference portfolio.

Did anyone for a minute think the selection agent was charged with a duty to select a portfolio that wouldn’t collapse?

It is possible that the buyers did a competent credit analysis and, as it happened, got it wrong. More likely, they simply checked a ratings box and perhaps had some (conscious?) faith in correlation models. They choose not to step in front of their own management groupthink trains. This was (pick one or more of the following) – stupid, ignorant, wilfully blind, indifferent, or incompetent.

Where’s the indignation over the conduct of the buy side? Why not flow any recovery through to buy-side shareholders?

Posted by simplemind1 | Report as abusive

“It’s wrong to create a mortgage-backed security filled with loans you know are going to fail ”
Nobody knew the loans were going to fail. Mostly, people thought enough of them would NOT fail that they were assigned a AAA rating. It is strange to see contrarian guesswork portrayed here as clairvoyance, but hey it’s your jingle.

As to ‘naked short prop trade’ — thisis also what buyers of synthetic securities are also assuming when they buy this stuff. If it were not a prop trade, the interest rate would be the risk free rate of return. Moreover *there is no derivative product traded* where the seller has not been involved in some way in selecting the underlier. A short is required for all zero sum products of this kind, or the product cannot be constructed at all.
maybe it’s fun to watch rich bankers hauled into court for the crime of calling the market correctly. But it isn’t going to make anyone’s house worth more. Synthetic CDOs didn’t cause any bubbles. No synthetic houses were repossessed in their wake. Apart from Ambac shareholders or creditors , the non-gambling public lost no money through this product. Nor did any syth-CDO make default of the underliying bonds more likely, any more than weather derivatives make rain appear or the sun shine.

Posted by AEinCH | Report as abusive

simplemind1, also remember buy side are investment advisors. As such they have a legal fiduciary responsibility to the clients. Market makers do not.

Posted by Danny_Black | Report as abusive

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