Credit Suisse's CDO headache
The bank's $2.85 billion charge traces back to highly-rated CDOs traded in London whose valuation was questioned by auditors, sources say.
New York (Fortune) -- Credit Suisse's stunning announcement that it is taking a $2.85 billion charge because it failed to properly value some bonds is a major black eye for a firm that has not been shy in touting its success in avoiding the pitfalls that have befallen its competitors.
According to sources inside and outside the firm, Credit Suisse's pricing errors centered on a portfolio of collateralized debt obligations owned by the firm's London securitized product trading desk.
In discussing the debacle, Credit Suisse (CS) used the word "mismark," and has suspended (with pay) the traders it claims are responsible, but the difference in valuations on asset-backed securities CDOs appears at this point not to have been intentional, according to sources inside the bank.
Sources told Fortune that the losses were taken in a proprietary trading account - a so-called back-book in trader parlance - where Credit Suisse was betting its own funds, as opposed to a regular trading account, which would be used to hold bonds prior to sale to customers.
The pending close of a $2 billion bond offering may have helped push Credit Suisse to disclose the loss.
The securities in question are said by bank sources and clients to be in the so-called super-senior tranches of ABS CDOs, where price declines of upwards of 50 cents on the dollar or more in the past quarter have become standard. Fortune could not find out the size of the CDO portfolio.
Apparently, according to sources at Credit Suisse, in an otherwise routine post-quarter review, Credit Suisse's auditors at KPMG questioned the trading desk's valuation methodology. One aspect of the current CDO market that almost certainly hurt CS are the wide bid-offer spreads of the CDO tranches in question, often more than 20 or 30 points. This is taken as a clear indication of not only poor liquidity in the market, but a sharp difference in opinion over valuation. It also invites the opportunity for a sharply favorable, if unwarranted, valuation.
For example: A trader owns a (hypothetical) CDO tranche whose market is quoted by rival investment banks at between $40 and $80. Many pricing models would allow that bond to be valued anywhere around the $80 level, despite the fact that it is almost certainly trading around $40.
The revaluation will forced Credit Suisse to cut its profit by $1 billion. Last week, the bank reported earnings of $7.8 billion from continuing operations for the year, a modest decline of only 3% from last year given the calamities in the global credit markets. In fact, there has been no shortage of ink spilled touting the bank's remarkable transformation into a nimble, risk-managing focused operation from its legacy of being at the center of most every financial crisis in recent financial history.
Indeed, unlike the end of the 1980s, when a busted leveraged buy-out almost forced the collapse of the then-First Boston Corp., to the 1998 debt crisis, which saw Credit Suisse First Boston lose billions of dollars, the bank's writedowns this year have paled in comparison with those of UBS, Citigroup (C, Fortune 500) and Merril (MER, Fortune 500)l. UBS (UBS) alone has taken over $19 billion in writedowns for its mortgage exposure.
Combining the $2.85 billion charge with the announcement of $1.89 billion in writedowns last week, Credit Suisse has now reduced the value of its fixed-income holdings by $4.74 billion.
A Credit Suisse spokesman in New York declined to comment. In a conference call, bank chief executive Brady Dougan refused to disclose how much of the $2.85 billion was related to "adverse market conditions" and how much was the traders' "lateness in marking."