Uneasiness in the Credit Markets

The credit markets are pricing in the uncertainty caused by fear of a European debt crisis which will cascade into banking failures.  Some of the market reactions are:

Spreads Up/Prices Down

• In the credit default swaps (CDS) market, the bid-ask spread has risen to 5.4% from 3.0% of the annual cost of the contracts on the 15 most traded CDSs on US investment grade companies.  The 3.0% figure is from August 1, 2011.
• The Bank of America Merrill Lynch Global Broad Market Index has reported that spreads on bonds have increased from 170 basis points at the end of July to 231 basis points.
• The Barclays Capital Global Aggregate Corporate Index has an absolute yield of 3.82%, up from 3.67% on August 19th.
• The Markit CDX North America Investment Grade Index has risen to 122 basis points from 96.3 basis points in August.  This index increases as investor confidence improves.
• The Barcap CMBS Super Duper Index has a relative yield of 3.03% compared to 2.13% on July 25th.
• The Standard & Poor's/LSTA US Leveraged Loan 100 index is down 4.7% in 2011.

Investors have de-risked their portfolios by moving out of the leveraged loans and distressed debt.  Banks are continuing to close down their proprietary trading desks and lowering their exposure to corporate debt.  They are not committing capital to facilitate trades or acting as a principal.  There is less liquidity in the market because of these factors.

The source for this article can be accessed here.

CDO: Alternative Assets Being Used as Underlying Assets

CDOs were created to use bonds, mortgages and commercial loans as the underlying collateral.  In the last ten years, they have begun to use alternative assets such as distressed debt, hedge funds, commodities and private equity as the underlying.  They have also created CDOs with one tranche.

Distressed debt is defined as securities of companies in default or that are trading below investment grade.  They have a yield of the Treasury rate plus 10%.  The portfolio of the CDO may include both distressed and not distressed debt.  By the structure of the CDO, the rating of the senior tranche is higher than the underlying portfolio.  Investors can gain access to distressed debt and limit their risk.  Banks are the main sellers of distressed debt to CDOs.  It cuts their losses on the debt, offloads their liabilities to the CDOs and frees up reserve capital by reducing their nonperforming assets ratio.

Collateralized fund obligations (CFOs) have multiple hedge funds as the underlying assets.  The institutional investors interested in this vehicle are pension funds, insurance companies, mutual funds and high net worth clients.  The hedge funds are aggregated under a fund of fund manager.  The manager has restrictions on the total number of hedge funds, number of investment strategies and percentage invested in each fund.  The restrictions are set by the rating agency.  When the payments are due to the investors of the CFOs, the fund of fund manager has to notify the hedge fund managers to redeem the investments.

Commodities can be the underlying assets for collateralized commodity obligations (CCOs).  More accurately, the assets are Commodities Trigger Swaps (CTSs).  These transactions trigger a payment when a condition is met.  An example would be when the price of the commodity hits a price target.  The CTSs would be based on a basket of commodities.  They would avoid extremely volatile assets.  The trigger events would have to be substantially spread out to avoid multiple payouts at the same time.

Unlike normal CDOs, single tranche CDOs (STCDOs), also known as bespoke CDOs or CDOs on demand, only create one tranche.  They are structured as synthetic CDOs, using CDSs to receive premiums to pay the interest rate on the CDOs' securities.  In this security, the investors have more control over the terms than in a CDO with multiple tranches and receive all cash flows.  The advantage for the sellers is that they are cheaper and quicker to issue.  In a normal CDO, the entire risk of the portfolio is transferred to the investors.  In a STCDOs, only a specific portion of the portfolio risk is transferred to the investors.  The seller is still exposed to the underlying assets in this case.

CDO squared invests in other CDOs.  This allows for more diversification and higher spread returns for the investor.  Losses are incurred based on where (the tranche) bond defaults occur.  In a normal CDO, losses are incurred based on the number of bond defaults.  CDO squared may be cash backed or synthetically created and may invest in different tranches or specialize in one tranche across multiple CDOs.  There is a danger that the CDO squared may invest in assets that are in multiple CDOs.  Rather than diversifying the portfolio, these overlapping assets cause the portfolio to be concentrated in them.  This would cause greater losses than expected if the underlying assets default.

Lastly, there also was a CDO created with private equity investments as the underlying assets.  As with CFOs, there were restrictions on the total number of private equity managers.

Synthetic CDO Structure: One More Wrinkle

Synthetic CDOs can be structured as funded or unfunded.  In a funded CDO, the investors buy securities from the manager who buys Treasury notes.  The manager receives swap payments from selling credit default swaps (CDS) and the interest on the notes.  These are passed on to the investors as interest on the CDO securities.  If a credit event happens on the CDS position, the CDO has to pay out based on the terms of the contract.  The notes are sold to cover this cost.  In an unfunded CDO, investors become the seller of the CDS position.  They receive payments from the CDS position and are liable for any payouts in case of a credit event.  The CDO is paid a management fee.

Introduction to Arbitrage CDOs

Arbitrage Collateralized Debt Obligations (CDOs) buy bonds, mortgages, commercial loans and other CDOs and sell securities to investors.  Their main creators are money managers that earn fees on the assets under management.  The CDOs make money on the spread in interest between the assets in the CDOs and the interest that the CDOs pay to their investors.  Like the balance sheet CDO, arbitrage CDOs may be cash-funded or synthetic.

Cash-funded arbitrage CDOs can be structured as cash flow or market value.  The cash flow CDO holds a portfolio of assets and receives interest and principal payments.  It issues securities that have the same payment schedule and maturity dates as the portfolio.  The CDO uses its receivables to pay its investors.  The cash flows of the CDO are dependent on the default and recovery rates of the assets.  Most of the time, the CDO manager can trade the assets of the portfolio to increase the return and to reduce the risk of loss due to defaults of the underlying assets.

The market value CDO also holds a portfolio of assets and issues securities to investors.  It is used when the payment schedule and maturity dates of the assets and securities are not the same.  The cash flows of the CDO are dependent on the interest payments and the selling of bonds to make principal payments.  They are also affected by the default and recovery rates of the assets.

Synthetic arbitrage CDOs use a swap (credit default or total return credit) to transfer the risk of an asset without owning it.  The CDO will receive swap payments every quarter.  It will pay the money manager LIBOR + spread and receive the total return on the CDO's assets.  From the total return, it will pay out to its investors.

US Debt is Downgraded and Investors Buy...US Debt

In one of the more ironic turn of events, the Standard & Poor's downgrade of US debt on August 5th caused the S&P 500 Index to fall 6.7% and the 10 year Treasury bill rose 2% (as of August 25th).  Some strategists such as Liz Ann Sonders of Charles Schwab and Kevin Rendino of BlackRock are saying equities are oversold.  Many people are saying that the downgrade was not based on the economic situation in the world but on the political gamesmanship in Congress.  The fall in stocks was led by financials but also encompassed aerospace & defense, technology and energy sectors.  If a recession can be avoided, then equities are looking cheap.

The source for this post is here.

Introduction to Balance Sheet CDOs

There are two types of Collateralized Debt Obligations(CDOs):  balance sheet and arbitrage.  We will go over the balance sheet CDOs here.  They are used to manage risk by offloading the loans on the bank's or insurance company's balance sheet to the CDO, freeing up regulatory capital used to reserve against the loans and get capital.  They are used primarily for Collateralized Loan Obligations (CLOs).

The balance sheet CDO can be set up as cash-funded or synthetic.  Cash-funded CDOs buy the underlying securities of the portfolio from issuing securities to the investors.  The synthetic CDO is more complicated.  This CDO does not own any securities.  It sells credit default swaps.  Then the regular premiums are used to pay the interest on the securities of the CDO.  Instead, it issues securities to the investors and the cash received is invested in US Treasuries.  The interest earned on them is used to fund any swap payments to the counterparties.

Absolute Return Funds: Shelter from the Storm?

Absolute return fixed income strategies have a goal of a positive return in all market environments.  It may be a real return over cash or a nominal return.  Since the downgrade of US debt by Standard & Poor's, all markets have suffered as investors are rushing to the safest investments such as gold and, ironically enough, US Treasuries.  There is a general de-risking across the board.

Absolute return funds do not have to be hedge funds.  They may be separately managed accounts.  Investors buy into this strategy to manage interest rate risk, increase diversification and enhance their returns.  There are many ways an absolute return fund may be run.  The manager's positions must be liquid.  The fund must follow a disciplined investment process across all its exposures (alphas).  The manager must be experienced in shorting assets.

The source for this article can be accessed here.

BRIC: Underperformance Leading to Fund Outflows

Funds investing in Brazil, Russia, India and China (BRIC) have seen net outflows since March 2010.  Assets invested in funds have retreated to $28 billion from a high of $38 billion in 2007.  Other fund investing in gold and Non-Japan Asia have added about $4 billion in assets each.  BRIC funds have become standard investments.  Investors are always looking for a new thesis.  There are 350 funds, 2,000 offshore funds, local funds, and thousands of diversified funds that are allowed to invest in the area.  Performance has lagged as well.  India and China have experienced inflation.  Russia has underperformed due to the US debt crisis.  Brazil has tax issues and foreign investor outflows leading to capital controls.

The source for this article is here.

An Interview with IndexIQ: Hedge Fund Replicator

Finalternatives.com published an interview with Adam Patti, CEO of IndexIQ.  His firm runs mutual funds, such as the five star IQ Alpha Hedge Strategy, that replicates hedge funds.  He says that most funds' returns are composed of multi-asset beta (the market return across different asset classes).

Index IQ runs six indices that replicate hedge fund strategies such as global macro, equity market neutral and long/short.  The indices are composed of ETFs that represent the asset classes in each strategy.  The goal here is to add value for the investor, improve transparency and liquidity, reduce fees and be tax efficient.

The interview may be accessed here.

Basics of Collateralized Debt Obligations

Collateralized debt obligations (CDOs) are backed by a portfolio of bonds or loans.  They can be split into collateralized bond obligations (CBOs) and collateralized loan obligations (CLOs).  A CDO deal is structured with a special purpose vehicle (SPV) that is legally domiciled in Delaware or Massachusetts.  The SPV is isolated financially from the sponsor through "bankruptcy remote".  If the sponsor goes bankrupt, the SPV is unaffected.  The SPV buys bonds and loans from banks, insurance companies, etc. and issues new securities against the collateral.  The payment flows of the original bonds and loans are used to pay the interest and dividends on the new securities.  The principal is paid at the end of the SPV's life by selling the bonds and loans.  The new securities of the CDO have different classes called tranches - senior, mezzanine and equity.  Cash flows from the collateral are used to pay of the obligations of the senior tranche first, then mezzanine and equity.  The securities are issued privately to institutional investors.

Banks receive six main benefits from CDOs:

• Reducing regulatory capital - This is based on the amount of outstanding loans of a bank.  By selling the loans to an SPV removed it from the regulatory capital calculation.
• Increasing loan capacity - If the bank sells its loans to an SPV, it may take the proceeds to make new loans
• Improving ROE/ROA - The bank can take the proceeds of loan sales to pay down its debt, reduce its capital base and increase the amount of high yield assets
• Reducing capital concentration - By selling loans to an SPV, the bank can increase its loan capacity to sell to a particular industry when it has reached its credit exposure limit.  It also can help manage their exposure to leveraged loans.
• Preserving customer relationships - A bank may own too much debt from a client.  It may be sold to a SPV.  Since the bank is running the portfolio for the SPV, the client does not know that the loan has been sold.  The client does not get upset with the bank.
• Competitive positioning - CDOs with high yields attract institutional investors

CDOs usually have credit enhancement to receive an investment grade credit rating from Standard & Poor's, Moody's or Fitch's.  However, the interest rate on these CDOs are lower and less attractive to investors.  They are:

• Subordination - When lower level tranches provide credit support to more senior tranches
• Overcollaterization - When lower level tranches proved additional collateral to a senior tranche
• Spread enhancement - Funds used to cover losses in a CDO.  If there are no losses, the funds go to the equity (lowest) tranche.
• Reserve account / cash collateral - Excess cash in US Treasuries or commercial paper used to support credit
• External credit enhancement - CDO manager may purchase credit default swaps, put options or an insurance contract to protect against defaults in the loan portfolio

We will look at the different types of CDOs in later articles.

Credit Derivatives: Some Basic Information

In prior posts, we have looked at credit default swaps.  Let's take step back and look at credit derivatives as a whole.  They are financial contracts such as options, forwards, futures, swaps and credit linked notes that are used used by fixed income managers to hedge positions (credit protection) or to enhance portfolio returns (credit exposure).  Through credit derivatives, portfolio managers are able to isolate and transfer credit risk, get liquidity in the market and have transparent pricing by trading the underlying credit.  Previously, they would have to hold the underlying assets in their portfolio which is capital intensive.  To manage risk using this method, the manager would have to look at each company's financial statement and balance sheet to rate their soundness.  He would also look at the industries of the portfolio companies and diversify loans to companies in different industries or sectors.

What is credit risk?  There are three components:  default, downgrade and credit spread.  Default risk is the risk that the bond issuer or loan borrower will not pay the bond or loan in full.  A loan is in default if a scheduled payment is not made.  Downgrade risk is when a rating agency such as Standard & Poor's, Moody's or Fitch's lowers the credit rating of the debt.  Credit spread risk is when the market spread between the underlying bond or loan increases for the remaining debt.  Credit risk is usually measured by rating agencies or using the credit spread.

What are the underlying / reference assets that credit derivatives are used for?  They are high yield bonds, leveraged loans, distressed debt and emerging markets bonds.  These assets have low to medium correlation with US equities and low or negative correlation with US Treasuries.  They have a high exposure to large declines in prices.  High yield bonds a.k.a. junk bonds are rated below investment grade by the agencies (either below BBB by Standard & Poor's or Baa by Moody's).  Leveraged loans are bank loans made to companies of credit ratings below investment grade or with a spread of 150 basis points over LIBOR (London Interbank Offer Rate).  LIBOR is the interest rate at which banks borrow from other banks in London.  In addition to the three credit risks listed above, the borrower can pre-pay the loan by re-financing or pre-paying the balance.  This is call risk.  There are to types of loans - revolvers and term loans.  Revolvers are committed lines of credit that also back commercial paper loans of companies with high credit ratings.  Term loans are given to companies with lower credit ratings, are funded commitments with fixed amortization schedules and are based on floating interest rates.  In addition to credit risk, emerging markets debt is exposed to political risk.  Distressed debt is composed of bonds of companies that are in default because of a missed payment, bonds going through Chapter 11 re-organization, the company having cash flow problems or have low credit ratings.

Options, futures and forwards are known as binary options.  They are similar to equity options.  If an event occurs as dictated by the terms of the contract, then the option seller pays money to the holder.  A credit-linked note is a bond with an embedded credit option.  These notes have a higher interest rate than regular bonds but the holder of the note provides the issuer with some credit hedge.  The referenced asset is either a corporation or a basket of credit risks.

A total return credit swap allows an investor to rent a balance sheet.  The investor trades the return of an asset for a guaranteed rate of return, usually LIBOR plus a spread.    The seller of the swap retains ownership of the asset.  For example, an investor could be positive on Apple bonds.  A swap can be bought on the returns of Apple bonds.  The buyer would receive that return and pay the seller LIBOR plus a spread.  The seller has hedged his position in Apple bonds and is now receiving payments of LIBOR plus a spread.

Short Sellers of Chinese Reverse Merger Companies

Some Chinese companies have managed to become listed on American and Canadian stock exchanges by performing a reverse merger.  In this transaction, a US company is bought by the Chinese company that then uses the US company's public listing.  A number of research analysts have exposed accounting fraud at a series of these companies or accused the companies of fraud.  Either way, the result is a precipitous drop in the stock price.  These analysts have erased $21 billion of market capitalization from them.  Many of the companies have been delisted by the exchanges.  Auditors have quit.  The SEC is investigating them and class action lawsuits are being prepared.  Some people say that they have gone overboard and are accusing legitimate companies of fraud.  Others say that they are co-conspirators with hedge fund managers and are front-running with their research.  Here are some of these analysts:

The most well-known research firm is Muddy Waters.  Carson Block has published research that has brought down the prices of Sino-Forest Corp, Orient Paper, RINO International, China Media Express and Duoyuan Global Water.  He and hired experts visit China to confirm company's claims about their offices and factories.  They include legal experts, accountants and private investigators.

John Hempton of Bronte Capital is another investor that has publicized fraud in these companies.  He is formerly of Platinum Asset Management where he managed $21 billion.  Bronte Capital has around fifty short positions globally.  In China, he has exposed Universal Travel Group, China Agritech, Longtop Financial Technologies and China Media Express.  The most recent one is Hollysys Automation Technologies.  He is an accounting expert.

John Bird has about thirty short positions including China Sky One Medical, Harbin Electric Inc, China-Biotics Inc and Deer Consumer Products Inc.  He is long some oil, gas and pipeline stocks.  He advocates comparing the SEC filings of Chinese companies to their local filings with the State Administration for Industry and Commerce in China.

Andrew Left of Citron Research has published reports on China-Biotics Inc, China Media Express, Deer Consumer Products Inc, Longtop Financial Technologies and Harbin Electric.  He hires private investigators in China to help him in his research and has someone translating Chinese documents and filings.

Rick Pearson is a writer from theStreet.com that is also an investor.  His pedigree is from Deutsche Bank where he was in convertible bonds.  He does research on the ground in China by counting employees and cars in company parking lots, checking factories and factory equipment, confirming SEC filings with local Chinese employees and old-fashioned networking.  He has short positions in China-Biotics, China ShenZhou Mining, Gulf Resources, Harbin Electric and Longtop Financial Technologies.

The source for this article can be accessed here.

A Look Back at the Quantitative Equity Hedge Fund Crisis in 2007

With all the talk about the debt ceiling crisis and possible repercussions on the markets, I was reminded of another, more limited crisis in August 2007.  There was a paper written by Amir Khandani and Andrew Lo the following month.  From August 7th to the 9th, several quantitative long/short equity hedge funds experienced declines of 27%.  On the 10th, these same strategies rose 23.67%.

There are eight theories created to explain the whipsaw nature of the markets.  They are:

• A multi-strategy hedge fund or proprietary trading desk was forced to sell its most liquid assets, equities, to raise capital to meet margin calls, investor redemptions or to reduce portfolio risk
• The first round of selling caused other funds that were long/short hedge, long only or 130/30 to cut their leverage by selling off their portfolios
• After reducing their portfolios' leverage, there was a complete reversal on August 10th
• The losses were short term and suggests that hedge funds were crowded into the same trades or strategies
• Some factors that caused the magnitude of losses:  rapid growth of long/short and 130/30 funds, high levels of leverage used by funds, quantitative models did not account for crowded strategies and panic because of the subprime problems in the credit markets
• Losses incurred by quantitative funds were the result of the sudden liquidation of market neutral fund(s)
• Systemic risk in hedge funds have increased because of number of funds and assets under management, increased correlation among hedge fund indices and the growth of credit-related strategies
• Credit issues could cause new liquidity problems in long/short, global macro and managed futures

The crowded strategies of hedge funds magnified the losses.  Quantitative funds use the same factors such as January effect, reversion to the mean and price momentum for their investment models.  They use the same risk models.  The fund managers are educated in the same academic institutions and have similar thought processes.  When a large number of leveraged funds have the same holdings, there is often a race to sell at the best prices to limit losses.  The manager holding the position at the end would have the largest losses.

In The Quants:  How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It, Scott Patterson writes that the turning point was when Goldman Sachs Group decided to infuse their quantitative funds with capital.