Citi: In Defense of Gary Crittenden

Brad DeLong takes a cheap shot at Citigroup's CFO, Gary Crittenden, who on the Citigroup conference call tried to explain where all those extra write-downs were coming from. Crittenden explained that much of Citi's subprime exposure was in so-called super-senior tranches, which were designed to have no default risk. But in October, suddenly the cost of insuring AAA-rated MBS tranches against default started spiking upwards – which means that the implied markt value of those tranches went down, even if Citi still has every confidence that they won't default. Here's how Brad sees it:

When Crittendon says that "if you look at what the ABX would imply in terms of real estate price reduction, it starts to imply very, very high numbers... it’s unlikely that those... will take place" the sentence should not come to an end. There should be a comma, and after the comma the sentence should continue "therefore Citigroup is sponsoring and investing in a new hedge fund to take advantage of the undervaluation of the ABX and similar market opportunities, and we are now raising capital." If you say:

• We're taking a markdown based on the ABX.
• But we believe the ABX is underpriced.

Shouldn't the very next sentence be:

• We are moving to profit from this mispricing?

In fact, it's not nearly as simple or as easy as that.

The problem is that the ABX is a very bad indicator of what CDOs might be worth. What happened was that Citi and other banks issued many billions of dollars' worth of structured securities which were rated AAA by the ratings agencies and which were then sold to highly risk-averse investors, who placed great store in that AAA credit rating. Of late, the ratings agencies have been going on something of a downgrading spree, and few if any investors place much faith in a AAA rating on a structured product any more. Remember, these investors are very risk-averse. But they're also holding a large amount of highly illiquid paper, which they can't sell easily if at all. So the one option open to them, if they're worried about credit risk on that paper, is to buy credit protection on it.

As a result, the cost of insuring AAA-rated paper against default spiked up – and it's that insurance cost which is measured by the ABX indices. The paper itself still doesn't really trade at all. But here's the problem: since the paper isn't trading, the ABX indices give the closest thing that there is to a market price for the underlying paper. If Citi wants to mark to market, then, it has to mark to the ABX market. Crittenden's point is that those marks don't make a lot of sense when it comes to the actual value of the underlying securities, in terms of the net present value of the cashflows associated with them. If you wanted to construct a model which would spit out the ABX-implied valuations, you'd have to assume nationwide housing-price falls which were really enormous. (It would have been nice for Crittenden to quantify those falls, I must admit.)

So what's Citi to do? It constructed these CDOs, and has faith in the cashflows going to the super-senior tranches which it owns a lot of. It'll mark those tranches down, but it's not going to sell them, partly because it can't sell them (there's no market for them right now), and partly because, pace DeLong, it thinks that the (implied) market is mispricing them.

But precisely because there is no market in these things, one can't simply set up a hedge fund to arbitrage the mispricing, since the mispricing is more theoretical than actual. You could try going long the ABX, but the ABX doesn't have anything to do with cashflows: it has everything to do with the cost of insuring against default. And it's entirely possible that a jittery world will pay more for default protection for some time, even if the cashflows themselves are rock-solid.

In fact, the only way you can really benefit from the (implied) mispricing is to mark your assets down today, in line with what the ABX is implying, and then collect your cashflows as per schedule. And that, it turns out, is exactly what Citigroup is doing.