Citibank is saying that it will only put AAA and AA paper in its super-SIV, the M-LEC (Master Liquidity Enhancement Conduit). AAA is the highest available rating in Standard & Poors rating system, and AA is next lowest. Historically, this rating has meant no defaults between 1970 and 2001 as it was given to issuers of the highest quality.

More recently, with the slicing and dicing of MBSs, CDOs and CLOs, it has been given to the most protected tranche of a security. The idea is that although all of the mortgages in a bundle may be of poor quality, surely only a few will default. So if we slice it up so that some slices bear the risk of default ahead of other slices, then the last slices to see defaults will be safe and can be given the prized AAA and sold to widows and orphans (Do I hear “Pirates?”).

But that all depends on statistical assumptions about default rates, which are now appearing to be badly wrong. The Black Swan has swum by. The ABX indices are saying that most of the lower quality tranches are wiped out and AAAs are trading at prices which indicate significant losses are expected. Once the lower grade tranches are wiped out, the defaults hit the “high quality” tranches. The AAAs. But they’re still rated AAA because the rating agencies can’t or won’t re-rate them on a timely basis. So I suspect Citi has to rush to get these dead fish into the M-LEC and assigned to a new set of bagholders before they go bad. Our compassionate Treasury Secretary is helping them. He is apparently also lobbying for the mortgage companies to be compensated by the taxpayer for the cost any loan modifications they may make to avoid foreclosures. He certainly is right there, looking out for Wall Street. Is that actually his job?

This chart shows what is happening to AAA tranches of home equity loans, which are typically the 20 part of 80/20 financing. Res ipsa loquitur :