International Investing

This clearly written FT article discusses why banks loved this tranche of CDO debt and why it is now such an issue:

Sometimes they did this simply to keep the CDO machine running. But there was another, far more important, incentive: regulatory arbitrage.

Most notably, because super-senior debt carried the AAA tag, banks were only required to post a wafer-thin sliver of capital against these assets - even though this debt has typically offered a spread of about 10 basis points over risk-free funds. Thus, banks such as UBS and Merrill have been cramming their books with tens of billions of super-senior debt - and then booking the spread as a seemingly never-ending source of easy profit. And it is not just the CDO desks that have been playing this game; treasury departments have been playing along. So have many hedge funds, including those financed by . . . er . . . the major investment banks.

But, last August it became clear why this 10bp spread existed: namely, because these assets are not as liquid as government bonds in a crisis. Indeed, the prices of some tranches of debt have fallen by 30 per cent in recent months, to the shock of senior managers. Hence these sudden, gobsmacking writedowns at places such as UBS, where the CDO desk alone produced over $15bn of losses, mostly super-senior linked.