Credit derivatives house of the year: Citi

Citi has become a provider of risk-recycling services to the Street’s bad banks, while leading the market in the creation of new – and more robust – structured credit assets

Paco Ybarra, Citi

Of the big US banks that survived the financial crisis, Citi was in the worst shape, but went on to make some of the best decisions – not least among them, keeping structured credit trading within the core part of the bank.

"Everyone had to make strategic decisions around what businesses they wanted to be in after the crisis," says Paco Ybarra, global head of markets and securities services at Citi. "We made the early decision to stay committed to structured credit and emerging markets. We have a long history of running risk in emerging markets. It's part of our genetic make-up."

That choice is now paying off in spades, with Citi's credit business representing around a third of the bank's total global markets revenues of $13.6 billion during the first nine months of the year.

Structured credit in particular saw a major revival in 2014, as near-zero interest rates spurred investors to seek out higher-yielding assets. One place they found them was in collateralised loan and debt obligations (CLOs and CDOs), resulting in a record-breaking year for CLO issuance in the US – volumes reached $97.11 billion in October, topping the $97.01 billion sold in 2006.

In total, Citi arranged 31 CLO and CDO deals during the first three quarters of the year, according to data from SCI – well ahead of its nearest competitors, Bank of America Merrill Lynch and Credit Suisse, which were tied for second place with 19 deals each. 

We can unwind and distribute derivatives risk more efficiently than most other firms, and we're offering that as a service to bad banks

Opportunity

The demand for high-yielding assets also created an opportunity for Citi to re-open the synthetic securitisation market, which had been dormant since the crisis. In the first half of 2014, the bank closed the first synthetic CDO transaction since 2008, and followed this with another nine deals, with a combined market value of $10 billion – more than any other dealer.

The product will always be associated with the financial crisis, but the market has learned its lessons, says Vikram Prasad, head of correlation and exotics trading at Citi. For one, the deals done last year were fully distributed deals, meaning every part of the capital structure was sold to investors. For another, the transactions are unrated – a good thing, Prasad insists, because it forces investors to commit capital on the basis of fundamental credit analysis.

Third, hedge funds are not shorting the deals. "Currently, there are no hedge funds shorting the equity and mezzanine tranches, so we essentially have some of the most sophisticated credit investors picking the names in the portfolios with a long perspective," says Prasad. Here, the bank was able to draw on relationships it developed while managing its ‘bad bank', Citi Holdings, in the post-crisis years.

Finally, the super-senior tranches are – in theory – much safer investments. Investment-grade CDOs experienced losses of less than 3% in the crisis, while high-yield portfolios lost about 10%. The super seniors in the new deals attach at 15%.

Despite this last point, the big challenge in getting full-capital structure deals away was in finding buyers for the most senior tranches. Citi found nine willing investors, but the relative pricing of the structure had to be adjusted to draw them in, says Carey Lathrop, Citi's head of global credit markets. "The investors at the bottom of the capital structure had to leave something on the table to give the super-senior investors an adequate return."

Pre-crisis, a typical five-year super-senior tranche was trading at 5–10 basis points. This compares with 30–50bp for 2014 deals, which generally have a three-year life.

Ybarra says the new market is much more robust. "The big difference is that we're not so dependent on models to price these deals because we are placing the entire capital structure. One of the reasons CDOs lost connection with reality in the past is because firms were pricing small tranches without placing the rest of the capital structure. The pricing was based on complicated models that made lots of assumptions that proved to be wrong, particularly with mortgage products. The discipline of placing the entire capital structure forces you to correctly price and distribute all the risk," he says.

He believes the market is here to stay, at least as long as interest rates remain low. "We speak with regulators and investors about our structured credit business all the time. There is a renewed awareness of the merits of securitisation. The pendulum is starting to swing back," Ybarra says.

Tricky proposition

Elsewhere, Citi has combined its credit trading skills with its global footprint to support the growing demand for exchange-traded funds (ETFs) of emerging market bonds – a tricky proposition because they are equity products offering credit exposure, and leave market-makers with liquidity risk.

In early 2014, the firm established a joint venture between the credit and equity divisions to make markets in the products. "We wanted the equity traders to face the Street, but for the risk to actually be managed within the credit business," says Marc Pagano, head of emerging markets credit trading at Citi.

On the face of it, the risk is considerable. As a market-maker, it's Citi's job to create and redeem shares for investors in the ETFs – redemptions could leave the bank holding the underlying securities, which might be difficult to sell on if investors are in flight.

And Citi's business is growing. The firm is now a leading market-maker for ETFs issued by the likes of BlackRock, State Street and WisdomTree. It also claims a 50% market share of create-and-redeem trades in emerging market bond ETFs in the US primary market, and a 40% share in secondaries. The operation was expanded to Europe in the third quarter, where it has grabbed similar market shares.

In part, the market is expanding precisely because of the liquidity risks Citi will have to manage – investors are attracted because it's easier to sell an ETF than a basket of bonds, says Lathrop, who estimates ETFs could account for 30% of emerging market bond flows within three years. Viewed that way, Citi and other market-makers are providing a valuable service both to investors and sovereign issuers. But what about the exposure?

Pagano insists the firm has the expertise to manage any liquidity risk. It can apply a haircut to the securities when redeeming shares, for example, and is free to stop trading at any time. "We're not short a liquidity option. If there is a dislocation, the value of liquidity is high, and we can charge a premium. We're not sitting on any basis risk – the ‘create and redeem' mechanism allows us to get in and out of risk very efficiently," he says.

Ybarra says Citi is well aware of the risks associated with emerging market bond ETFs. "The issue with ETFs, as with any index product, is that investors may be making assumptions about liquidity that will not hold true in a crisis. ETFs are very efficient instruments, but they're not magical. They will be limited by the liquidity of the underlying. We understand that. We are not going to provide liquidity at all costs at all times. We will be in the market and responsibly provide liquidity, subject to our risk appetite."

A third major strand of Citi's business last year was the acquisition and liquidation of unwanted assets from other banks, a field in which the firm was able to deploy all the expertise it gained running Citi Holdings. In many cases, the leverage ratio – which is driven primarily by gross notionals, rather than risk – was the driver for selling banks.

"We can unwind and distribute derivatives risk more efficiently than most other firms, and we're offering that as a service to bad banks," says Prasad.

The demand has been overwhelming. Citi acquired and wound down around $450 billion worth of credit derivatives portfolios from other banks in 2014, primarily comprising single-name CDSs. In the single largest deal, a European bank novated a portfolio of credit derivatives with a gross notional of more than $200 billion to Citi at the end of the third quarter. To put those figures in perspective, a big dealer's CDS book might contain a notional total of $2 trillion.

Risk independently confirmed the seller in that deal was Deutsche Bank.

"The portfolio had an average life of three years, but we felt we could collapse the capital increase and the notional within six months," says Prasad. "Because we had the team in place, we felt very comfortable with it." Three months after the acquisition, Prasad says the project is on track.

The portfolio was notable because it contained no open market risk, only counterparty exposure. "There was no market risk or Basel III capital implications to manage. It was a pure leverage ratio issue – an exercise in collapsing gross notional and managing counterparty risk," he says.

Complex transaction

Other purchases involved portfolios valued at $20 billion to $30 billion. In the most complex transaction, Citi acquired a portfolio of exotic emerging markets risk, including relative-value and curve trades as well as first-to-default baskets. The firm was expecting to have neutralised the market risk and unwound most of the counterparty exposure by the end of last year, with a few tall poppies left to address.

"We're doing these trades with eyes wide open," says Lathrop. "The sellers are looking for capital relief. We're looking at how long it will take us to distribute or defease the risk and what return we're earning on capital. We will take that risk on our books only if it makes sense."

Impressively, while Citi's credit businesses took on $450 billion of gross notional, its leverage ratio-related capital charges fell about 10% for the year, without any methodology changes.

"We view the purchase of credit portfolios as another aspect of market-making and providing liquidity. We are not investors in these assets; we are in the business of recycling. When we look at a deal, we are thinking about how long it will take to digest, hedge and sell the risk. It only makes sense if we can do that very quickly. We don't have infinite amounts of capital – we have to get rid of the risk one way or another, and over time, we have found ways to do that very efficiently," says Ybarra.