Monday, July 22, 2013

Leveraged Super Seniors – the valuation question

By Jasvin Josen
This article appeared in The Edge, Malaysia on Feb 11, 2013
In the last article, I explained what a Leveraged Super Senior trade is and the accompanying trigger points. It is important to note that Deutsche Banks’ alleged miss reporting of the losses from these products, stems from a valuation stand point. There were no cases of actual defaults or unwinding of the trades. The main issue was how these trades were priced in the books at the height of the crisis.
In this article I describe the main principles in valuing the trade and what can go wrong.

Chart 1 : Bank as the protection buyer of a Super Senior CDO tranche

Cash flows from the Leveraged Super Senior Tranche
When the bank becomes the issuer of a CDO tranche, he is a protection buyer of that tranche. The bank pays a fixed spread every year (or half yearly) until the end of the CDO tenor (usually around 5, 7 or 10 years). During that time, if there are defaults in the CDO pool and the defaults hit the tranche, the bank receives a loss payment from the investor.

Exposure to CDO tranches is sold to the investors as Credit Link Notes, which mirrors bonds. The investor would pay the principal notional amount (for example, $850m for the Super Senior tranche) at the beginning and receive the premiums at regular intervals. These premiums are just like the bonds’ coupons. At the maturity of the note, if there were no defaults, the investor gets back his principal. But if there were defaults and the losses reached the investor’s tranche, the investor only gets back part of his principal after deducting the losses payable to the bank.

Readers will recall from the previous article, that for a super senior tranche, both parties do not expect any losses to creep up into that tranche. Thus, they agree that there is no need for the investor to pay the full principal at the beginning. The investor only pays about one tenth of the principal and now has a “leveraged” super senior tranche.

The mark to market value for the leveraged super senior
When the bank records the value of this trade, he present-values the cash flows. The upfront principal paid by the investor is recorded like a collateral, to be paid back at the end. The Super Senior Tranche is valued as follows:

Present Value of
 [+ potential cash flow from any defaults during the tenor of the CDO
 – fixed premiums (spreads) paid every year]

The potential cash flow from defaults in the CDO is estimated using the bank’s own model. Readers can refer to my previous article (Pricing of a CDO, June 7, 2010) for a step-by-step process of pricing a CDO tranche.

Now as the credit crisis loomed, the CDS spreads in the reference portfolio were getting higher. This should cause the bank’s model to estimate higher defaults in the portfolio. This means that the potential cash flow received from defaults (a positive figure) could be higher than the fixed premiums payable (a negative figure). This results in a positive mark-to-market value for the bank, which is an unrealisable profit. What this actually indicates is that if the investor chooses to unwind the trade, the investor pays the bank the amount of the mark-to-market profit computed by the bank.

The Issue
In the Leveraged Super Senior case, we know that if certain triggers are breached, the investor can choose to put in more collateral or unwind and walk away from the trade.
At the height of the crisis, it was believed that there were cases when the mark-to-market profits were higher than the amount of collateral received from the investor. For example the mark-to-market value of a trade could be recorded as $14m but only $10m collateral was received from the investor. Hence, the collateral was not enough to cover the mark-to-market profits of the bank.

Rightfully, this shortfall (or “gap”) should be addressed by the gap risk reserve, which essentially represents the losses the bank would suffer should the investors decide not to top up the collateral. However, in Deutsche Bank’s case it was reported that the gap risk reserve did not adequately cover the purported huge gap of $12billion.  

There are also questions around the loss model that the bank used to give rise to the mark-to-market profit and the computation of the gap risk as an option vs. a reserve.
The bottom line, in my view is that the more complicated a trade gets, the more challenging the valuation becomes and this is where the integrity and professional ethics of those involved is the most questionable.

1 comment:

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