Citigroup Inc. , our taxpayer-funded national bank, is readying a new credit derivative, the CLX. Basically, the CLX is systemic risk insurance that will pay out in the event of a financial crisis. The basic premise is to allow investors to hedge against a spike in funding costs.
ReutersAccording to Risk Magazine "the CLX is constructed as a sum of the Sharpe ratio -- deviations from the mean divided by volatility -- of various market factors, such as equity volatilities, Treasury rates, swap spreads, corporate bond swaption-implied volatilities, and structured credit spreads. Citi will make the CLX tradable by using fixed historical values for the mean and volatility parameters, eliminating the need for costly recomputation from lengthy time series." Read Risk Magazine story on the CLX.
If you understood the last paragraph, please take two bailouts, a bonus and call your Treasury Secretary in the morning.
Citigroup says CLX is based on six indexes. It's still in the planning stages, but it won't put the firm at risk. Citi's considering building it at the request of customers it considers sophisticated enough to use CLX wisely. Citi just wants to make a market in CLX. It will buy when there are no buyers, sell when there are no sellers. Citi says its role will be neutral. They may even bring other brokerages in to spread the risk.
Sorry, but the CLX sounds a lot like what got Wall Street into trouble in the first place. Complicated derivatives, including collateralized debt obligations, synthetic CDOs and credit default swaps, ripped apart balance sheets and drove financial institutions such as Citigroup into the arms of taxpayers.
Investors, swayed by Wall Street sales pitches touting the safety of these securities, had little understanding of the risks these securities held. And who can blame them? When you look at the CLX, it's not exactly clear on what it's based and who's really carrying the risk.
But the complexity is only part of the problem.
Barry Ritholtz, the well known blogger and investor, points out on his Big Picture blog that "Any insurance product, CDS, any contract is only as a good as the financial condition of the contraparties. Any insurance product designed to pay off in the event of a financial crisis becomes increasingly unlikely to do just that...We already have systemic risk insurance. Only, it's not from Citi, it's from Uncle Sam." See blog post by Ritholtz.
The point is, when push comes to shove, will there be a market for the CLX? Won't most of the institutions buying them be in trouble if they need to cash out? And who cashes them out, Citi? How much is Citi going to set aside to cover potential losses?
Citigroup, denies that it's putting taxpayers at risk. Rather, it might have the opposite effect: for example strengthening an insurer when borrowing costs soar.
But a lot of finance pros have looked at this and they say the way CLX is laid out, there doesn't seem to be any specific party responsible for paying on the contracts. If it's Citi, what happens if Citi can't pay? Under proposed reforms, Citi would be too big to fail and get a bailout if it ran into CLX trouble.
You, dear taxpayer, may be the ultimate counterparty to this "innovation."
CLX raises a lot of questions, but let's add one more. Where are the regulators?
For months, we've been hearing how there's been a regulatory crackdown on Wall Street. Agents from the Securities and Exchange Commission, the Commodities Futures Trading Commission and Federal Reserve allegedly are swarming institutions such as Citigroup. They're pushing banks to build up capital, reduce leverage and cut the risk-taking.
ReutersTestifying before the Financial Inquiry Commission, Lloyd Blankfein, chief executive of Goldman Sachs Group Inc., told lawmakers that his firm was under more scrutiny than ever, especially from the Fed.
More regulation was the tradeoff made in the fall of 2008 when the Fed offered cheap money and protection to institutions such as Goldman and Morgan Stanley by giving them a banking charter.
Citigroup CEO Vikram Pandit reportedly nearly lost his job because of one dissatisfied regulator, Sheila Bair, the chairman of the Federal Deposit Insurance Corp. She might want to revisit the subject, given how CLX could impact the bank's $303 billion in U.S. deposits. Read WSJ report on Bair and Citigroup.
Citi says regulators have been given CLX for consideration. So far, they haven't passed judgment.
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