from Follow the Money

It seems like both the People’s Bank of China and W

May 14, 2005

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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hold lots of worthless IOUs in their portfolios (link via Dan Gross/ Moneyblog).

There seems to be a lot to talk about this weekend, whether the Fed’s various views on the risks associated with the US current account deficit, Argentina’s debt exchange (which now looks set to go forward after a legal challenge was dismissed) or how Kerkorian’s bid for GM wrong-footed a few hedge funds.

Worthless IOUs have done rather well recently -- much better than going "long equity/ short mezz." Apparently, holding the equity tranche of a collateralized debt obligation (the equity tranche has the most default risk) while selling the mezzanine tranche (the next most risky portion) short was another hedge fund trade that hasn’t done so well recently.

``The trade is supposed to make money if spreads move either wider or tighter in a parallel fashion,’’ wrote analysts at Merrill Lynch & Co. in a May 10 research note. Yet the rating cuts for General Motors and Ford ``caused spreads to move in a non- parallel fashion and these trades to underperform significantly,’’ Merrill said. ``We expect a rush to the door to be painful.’’

The comments thread on my previous post was getting a bit crowded, so feel free to chat away while I try to read up on collateralized debt obligations.


The best explanation of the underlying logic of the long equity short mezz trade that I have seem comes from Rohan Doctor of Citi (no link available)

Structured credit is the way to seperate default risk from spread risk. ... by buying an equity tranche (which is exposed to the first few defaults in a portfolio and has proportionally more default risk than spread risk) and sell a certain (delta) amount of the mezz tranch (which has proportionally more spread risk than default risk) you are essentially getting paid to for taking the view that there will be a low level of defaults and, at the same time, you are neutral (this is delta hedged) to any parallel move in market spreads should they widen.

As I understand it, so long as the spreads on both move in a parallel fashion, this trade works. Supposedly it made sense if you thought high levels of cash on corp. balance sheets would limit the number of defaults (making the "equity tranche" attractive, but were worried about a market selloff leading to a widening of all credit spreads. However, recently, the spread on "equity" tranches widened (their price fell) while the spreads on "mezz" tranches tightened (their price rose) ...

UPDATE 2. For those trying to understand CDOs a bit better, I recommend the comment from kr pasted in below the fold, so to speak.

From kr, with additional emphasis from Brad: I’ll try to offer a different perspective on these ’credit tranche trades’ which are now headline news. I think the easiest intuition comes from thinking about it a bit like an equity option. The key principle there ("Black-Scholes") is that you can offset your option exposure with the underlying shares, where the proportionality is the "delta". Hedging this way means that you are not exposed to _small_ moves in the market, in _either_ direction. That’s not to say that there is no exposure though; the residual P/L has the same sign in either direction (i.e. you win when the stock moves up significantly, or if it moves down significantly). This effect is called "convexity" (because your P/L is U-shaped). Of course you pay for this benefit, and the benefit increases if the stock is more volatile. Anyhow, that’s the qualitative basis of options pricing.

For credit tranche products ("CTP" below), there is an option, there is a ’delta’, and there is ’convexity’... you just have to understand what the parallel is.

First, the ’underlying’: A stock option is the option to buy shares at a given price. For CTP, the underlying is a portfolio of credit risks. As an example, you might pick 10 bonds issued by your least favorite corporate borrowers. If you bought those bonds at par, let’s say it costs you $10MM. At the end of the exercise, maybe you chose GM paper and GM staggered into Ch. 11. Those bonds are now trading at maybe $15, so after all the other bonds return their principal, you might only have $1 x 9 + 0.15 * 1 = $9.15MM. To be concise, the ’underlying’ is the amount of principal expected to be returned on a portfolio of credit risks.

Second: The ’option’ reflects what part of that portfolio you choose to be exposed to. Back in the familiar world, a stock option lets you buy at say $35. If the stock is lower, you buy at that price; if it’s higher you exercise your option and buy at $35. Thus there is a limit to what you’d pay. CTP gives you an option on the credit risks of the portfolio. It may be that you don’t want to insure the bottom $8MM of credit risk. You put up $2MM, take exposure to $10MM of credit, and in the above scenario you lose $850,000 of your $2MM. If there are many more defaults, you can’t lose more than $2MM. That’s the key idea. Now, just as in equity options, you can form combinations to achieve fancy exposures - for example, you don’t want to take the first dollar of risk and you don’t want to lose more than $3MM. This is just long one tranche "option" and short another - i.e. a equity vs. mezz type trade like people are discussing.

Thirdly - the ’delta’: Most market operators don’t believe they can make good directional bets, so they set up a hedge - taking only the volatility-type risk. In our CTP context, if you have a large enough pool of credit risks, you can be sure to see some defaults. Any portfolio will have a determinable ’expected loss rate’, which captures both the default likelihood and the loss (i.e. the $0.85 we lost on GM above). Now, without any fancy trading, one can hedge this with ordinary credit derivatives. This hedge position does not have the convexity feature - i.e. if the market improves and default expectations fall, the position will make money, and if things go the other way, it will lose money. However, the hedge plus the CTP should be neutral to small shifts in the market.

Finally: The ’convexity’. Just because there is an expected credit loss rate does not mean that the exact amount of losses will be realized. Things could be better or worse. The more diverse the pool of credits, the closer one expects to be to the expected loss rate. Trading the CTP against the hedge is basically betting on this uncertainty. This is what hedge funds are trying to trade. Essentially they take two CTPs - one long, one short, with the same ’delta’. That is, the overall position is supposed to be insensitive to shifts in the market’s overall default expectations. But, their convexity is different and HF’s may have some view on the relative pricing (i.e. how much they are paying / receiving to be long / short the default uncertainty).

The underlying problem with this strategy is that the price of credit convexity is not as determined by the fundamentals as one might hope. Almost all players are HFs, driven by the liquidity constraints of their capital call provisions. If a fund has to sell out, they may force other funds to take a certain P/L, and the domino effect begins. There is very little anchor in terms of ’real money’ which would take their positions without liquidity-based trading.

One other thing - in the ordinary options context, it is not easy to understand the volatility (i.e. uncertainty of the stock price vs. the option strike). It sounds easy, but real life is not like they say in the textbooks. For credit, it is even tougher because you are trying to guess at the uncertainty of credit defaults. This involves several different borrowers instead of just a single stock issuer, and those different borrowers may not be easy ’comparables’ in the financial-analyst sense. GM / F would be classic cases - are they really like other high-yield issuers? Is there a specific ’fear premium’ built into them that is not like other borrowers?

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