by Calculated Risk on 11/05/2007 12:23:00 AM

From Vikas Bajaj at the NY Times: Bankers’ Lesson From Mortgage Mess: Sell, Don’t Hold

Bankers on Wall Street frequently describe themselves as being in the moving and not the storage business. They make money by trading stocks and bonds, not by owning them.

In the last week, top executives at two of the world’s largest banks, Citigroup and Merrill Lynch, have come under scrutiny for ignoring that fundamental principle.

Bajaj goes on to describe how Merrill and Citigroup kept many CDOs on their balance sheets, waiting for better prices.

“A lot of us were scratching our heads wondering ‘Where did these bonds go,’” said a banker at a rival institution who was not authorized to speak publicly.

“They just sat on them, putting them here or there on the balance sheet. They thought they were going to be O.K.”

The banks didn't realize there was a systemic problem not captured by their historical models - falling house prices - and diversification doesn't reduce this risk.

C.D.O.’s were created on the premise that managers could lower the risks of default by investing in loans made by different companies and dispersed across the country. The notion that one could lower risk by diversifying, and including a small reserve of cash, was supported by historical patterns and allowed the bonds issued by C.D.O.’s to earn higher ratings than the bonds they owned, said Mark Adelson, an independent analyst and consultant.
...
“The notion that you could be really diversified because some of your production had an Option One name and some had the New Century name and some had the Ameriquest name seems absurd,” he said referring to mortgage companies that specialized in risky home loans.

This brings us back to the key sentence in Citi's Press Release: Citi's Sub-Prime Related Exposure in Securities and Banking

... fair value of these super senior exposures is based on estimates about, among other things, future housing prices ...

Perhaps Citi should release their forecast for house prices so we can see if the $8B to $11B writedown is sufficient.

Also note that many of the IBs (especially Citi) might be making a similar mistake - being in the "storage business" - by keeping the LBO related pier loans on their balance sheets while waiting for better prices.