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THE MADNESS
cause the prices didn’t move much. As a result, Citigroup held little regulatory capital
against the super-senior tranches.
Citibank also held “unfunded” positions in super-senior tranches of some syn-
thetic CDOs; that is, it sold protection to the CDO. If the referenced mortgage collat-
eral underperformed, the short investors would begin to get paid. Money to pay
them would come first from wiping out long investors who had bought tranches that
were below triple-A. Then, if the short investors were still owed money, Citibank
would have to pay. For taking on this risk, Citi typically received about . to
. in annual fees on the super-senior protection; on a billion-dollar transaction, it
would earn an annual fee of million to million.
Citigroup also had exposure to the mortgage-backed and other securities that
went into CDOs during the ramp-up period, which could be as long as six or nine
months, before it packaged and sold the CDO. Typically, Citigroup’s securities unit
would set up a warehouse funding line for the CDO manager. During the ramp-up
period, the collateral securities would pay interest; depending on the terms of the
agreement, that interest would either go exclusively to Citigroup or be split with the
manager. For the CDO desk, this frequently represented a substantial income stream.
The securities sitting in the warehouse facility had relatively attractive yields—often
. to . more than the typical bank borrowing rate—and it was not uncommon
for the CDO desk to earn to million in interest on a single transaction.
Traders on the desk would get credit for those revenues at bonus time. But Citigroup
would also be on the hook for any losses incurred on assets stuck in the warehouse.
When the financial crisis deepened, many CDO transactions could not be com-
pleted; Citigroup and other investment banks were forced to write down the value of
securities held in their warehouses. The result would be substantial losses across Wall
Street. In many cases, to offload assets underwriters placed collateral from CDO
warehouses into other CDOs.
A factor that made firm-wide hedging complicated was that different units of
Citigroup could have various and offsetting exposures to the same CDO. It was pos-
sible, even likely, that the CDO desk would structure a given CDO, a different divi-
sion would buy protection for the underlying collateral, and yet another division
would buy the unfunded super-senior tranche. If the collateral in this CDO ran into
trouble, the CDO immediately would have to pay the division that bought credit pro-
tection on the underlying collateral; if the CDO ran out of money to pay, it would
have to draw on the division that bought the unfunded tranche. In November ,
after Citigroup had reported substantial losses on its CDO portfolio, regulators
would note that the company did not have a good understanding of its firmwide
CDO exposures: “The nature, origin, and size of CDO exposure were surprising to
many in senior management and the board. The liquidity put exposure was not well
known. In particular, management did not consider or effectively manage the credit
risk inherent in CDO positions.”
Citigroup’s willingness to use its balance sheet to support the CDO business had
the desired effect. Its CDO desk created billion in CDOs that included mortgage-
