I remember wondering why some banks and especially Citibank, after things started to go very wrong during the summer of 2007, were so stupid as to take back on their books all sorts of toxic CDOs they had sold to other entities. Well, last week's Economist gave me the answer to that conundrum (emphasis mine):
"Citigroup came a cropper when it sold "liquidity puts" along with its CDOs. These gave the buyers the right to hand the CDO back at the original price if the market collapsed. They looked like a tweak that would enable the bank to extract a slightly higher return, and Citi's most senior managers knew nothing about them. The liquidity puts ended up costing the bank a king's ransom when $25 billion-worth of CDOs came back on the balance sheet."
Citibank didn't take back those CDOs out of a misplaced and almost suicidal attempt at safeguarding its reputation as I thought back then but simply because it was contractually obliged to do so. The stupidity had occurred a long time before, when some genius designed, mispriced and marketed those protective puts.
Speaking of genius quants, how about this modelling gem (emphasis mine):
"A BBB tranche in a CDO might pay out in full if the defaults remained below 6%, and not at all once they went above 6.5%. That is an all-or-nothing sort of return, quite different from a BBB corporate bond, say. And yet because both shared the same BBB rating, they would be modelled in the same way."
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