The Carry Trade from Off-Balance-Sheet Heaven

The Citigroup-structured CDO, Adams Square Funding II, Ltd., closed in March 2007 with the $600mm Class A1 Floating Rate Notes (Due 2047) not being offered by Citi; rather the A1 notes were being insured by a swap counterparty by way of the then-convenient-and-now-infamous negative basis trade.

By insuring this A1 tranche trade (Ambac Assurance was reportedly the ultimate swap counterparty), Citi was able to lock in substantial up-front “profits” on the trade in addition to their significant underwriting fee. FASB’s accounting regime (1) enabled the so-called profits on the trade to be recognized immediately, by way of “sale accounting,” and (2) allowed the trade to disappear into off-balance-sheet oblivion, away from Citigroup shareholder verification.

The negative basis trade was perpetuated by several banks for many reasons, as described more comprehensively here. The forthcoming chart provides what we believe to be a thorough breakdown of the minimum estimated up-front profit -- of approximately $9.8mm -- Citigroup would have been able to achieve in having the A1 wrapped by a monoline guarantor.



Indeed UBS’s shareholder report explains that

[UBS’s] CDO desk viewed retaining the Super Senior tranche of CDOs as an attractive source of profit, with the funded positions yielding a positive carry (i.e. return) above the internal UBS funding rate …

and…

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…

UBS may have made larger sums on the deals they had wrapped: UBS’s cost of credit default swap (CDS) protection was on average as low as 11 bps, or 0.11%.

The ability to lock in such enormous, fictitious, gains (and potentially distribute some of these gains immediately in the form of bonuses to investment bankers) proved to be a major contributor to the financial crisis. With the under-capitalized monolines – such as ACA, AIG, Ambac, CIFG, FGIC, FSA, MBIA, Radian and XL -- struggling or failing to support the credit protection contracts they had over-sold, several of the TBTF banks were forced to rely on the government’s (and taxpayers’) aid to fund the ultimate return to their balance sheets of what we estimate to be $300 billion of off-balance-sheet negative basis trade securities.

Other resources: a diagram describing the trade more generally, in its context relative to the CDO, can be found here.