Who Would Buy “Systemic Risk Insurance” from Citi?

An anecdote: Around late 2002, I became aware of a new structured product. It went by various brand names, but the generic “Structured Notes” seemed to be the best description. It guaranteed to pay you most of the upside of the S&P500, but with no downside.

There were huge risks involved in this paper. My old firm was offered to participate in Structured Notes with Lehman Brothers as an Underwriter/counter-party. In reviewing the paper, I raised 2 key issues (ignoring the lack of liquidity if a buyer wanted an early exit, as well as the tax headache of imputed annual income).

My first issue was the market risk: The Psychology of Humans is such that people tend to buy Umbrellas after they have been caught in a rainstorm. After the Nasdaq had collapsed 78%, that is when you want advisors to offer umbrellas to their clients?

It was similar to Morningstar creating the new “Bear Fund” category. Could anyone argue putting money into a Bear fund after the Nasdaq lost 4/5ths of its value timely? I looked at the mere offer of Structured Notes as a contrary indicator suggesting the bottom was at hand.

The second issue was counter-party risk. The lawyer in me actually read the prospectus. There were no reserve requirements, the money wasn’t held in a client’s accounts, there was nothing in the offering that was guaranteed or insured anything. You were buyting a piece fo paper, nothing more. In the event of a collapse similar to what we had just lived through (2000-03), there was no guarantee even of the return of principle.

The first argument carried the day — the consensus was “Yeah, you are probably right, its too late for these products.”

The second argument was laughed off as paranoia. Lehman Brothers? C’mon!

Which brings me to a new article in Risk Magazine:

“Credit specialists at Citi are considering launching the first derivatives intended to pay out in the event of a financial crisis. The firm has drawn up plans for a tradable liquidity index, known as the CLX, on which products could be structured that allow buyers to hedge a spike in funding costs.”

It s hard to avoid the issue of counter-party risk this go around. 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.

Unless, it is written by a Sovereign itself.

Indeed, that is the precise moral hazard of the bailouts — it is increasingly likely that we already have Systemic Risk Insurance. Only its not from Citi, its from Uncle Sam.

Maybe he should consider charging a fee for this service . . .

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Source:
Citi plans crisis derivatives
Laurie Carver
Risk magazine, 08 Feb 2010
http://www.risk.net/risk-magazine/news/1590861/citi-plans-crisis-derivatives

Previously:
Contrary Indicators 2000 – 2003 Bear (September 9th, 2003)
http://www.ritholtz.com/blog/2003/09/contrary-indicators-2000-–-2003-bear/