Of scorpions and Starfighters Are exotic credit derivatives achieving much more than pushing the envelope to its limits?
The Economist Global Agenda Jan 31st 2006 | FRANKFURT http://www.economist.com/agenda/PrinterFriendly.cfm?story_id=T63265 IN "JARHEAD", Sam Mendes's recent film about the 1991 Gulf war, some bored American marines arrange a fight between two scorpions. The money wagered and the attendant pandemonium, indexed to the fortunes of one protagonist or the other, are hugely disproportionate to the contest. Something similar happened when Delphi, a supplier of car parts, went bankrupt in October. It wasn't just lenders and bondholders who suffered. Their exposure was a mere $5.2 billion. Market participants had another $28 billion of notional exposure to Delphi embedded in scores of credit derivatives. That triggered pandemonium too, as the market tried to assess the residual value of those derivatives. Delphi was a popular name among the corporate entities bundled together in securities known as collateralised debt obligations (CDOs). Some CDOs are synthetic: that is, they don't contain actual loans or bonds but are simply indexed to the fortunes of around 100 selected companies. If most of them stay solvent, the CDO pays good money. If more than a handful default, then investors begin to take a hit on the coupon payments and sometimes their capital too. The precise mixture of risks and payouts depends on how the CDO is constructed. Moreover, the value of a CDO depends not just on expected rates of default, but also on what might be recovered from defaulting companies' assets. Some pools are static: that is, their composition does not change during the life of the security (usually five or seven years). Others are dynamic: they are in the hands of a manager who can weed out the exposure to companies before they default, or trade credit risk with the aim of improving the portfolio. CDOs can contain a single "tranche" of credit risk; or the exposure is sliced into tranches of differing risk. Thus in theory investors can pick the collection of risks that suits them. They are helped by the existence of credit ratings, at least for the safer tranches (the riskiest "equity" tranches, which bear the first loss in the event of default, usually have no rating). But they must also consider the likely market price of the tranche they invest in, both for accounting reasons and in case they want to sell before maturity. CDOs are not that actively traded, and riskier tranches hardly at all. So it is often near impossible to establish a "market" price for them. Accountants have a horrible time when auditing books of illiquid CDOs, being forced to use numbers that they know are nearly meaningless. Risk controllers have a hard task too. They rely heavily on the integrity of their traders, who are closest to the market, to price their own exposures conservatively. Anshul Rustagi, a CDO trader at Deutsche Bank, was fired in January after being found to have overstated the value of his trading book by around £30m ($50m). Which just goes to show how uncertain pricing becomes at the frontiers of finance. Investors are seeking to exploit areas where return might outweigh the perceived risk; arrangers are looking for ways to skew that return, trying to ensure that they won't be on the losing side; while the rating agencies are hired as referees, to ensure that the investors at least start with a fair chance. All three groups of actors are sophisticated. Yet the market is constantly learning from its own mistakes to produce better documentation, clearer definitions of default and loss, and better analysis of riskiness and of other factors that affect prices. Many of the Delphi claims, for example, are being settled for cash, since there are so few debt instruments available for delivery. Rocket science squared Developments in the CDO business often stretch the limits of understanding. They certainly seem to breach the limits of usefulness to actual borrowers and lenders. After the synthetic CDO, came the CDO-squared, a CDO comprised of other CDOs, which increases the likelihood of its value being impaired. In practice, though, rating agencies argue, CDO-squareds have suffered no more ratings downgrades than normal CDOs, perhaps because they carry a bigger cushion of collateral in the first place. Products in this market become fashionable in waves. In the middle of last year the "leveraged super-senior tranche" was all the rage. Imagine a slice of exposure to 100 or so names well above triple-A, ie "super-senior", because there is a very high loss threshold before it takes a hit. The likelihood of loss is minimal, but not zero. If you think the risk sufficiently remote, why not leverage your investment by, say, 15 times? That was the bet last summer, though like Mr Mendes's scorpions, it has a sting in the tail: a sufficient move in credit spreads can trigger a wind-up of the CDO at market prices and eat into the investor's capital. What's next? Investors, notably hedge funds, have an appetite for highly risky single tranches of exposure, linked for example to the performance of funds of hedge funds, or private-equity funds. Meanwhile, there is little attempt to relate this frenetic activity to the economy as a whole. Corporate borrowing spreads are thin; stockmarkets are buoyant. This means there should not be much margin left for intermediaries between borrowers and lenders. The intermediaries, in the arena of structured finance, have responded by creating debt instruments with equity-like characteristics. You might wonder whether this is really necessary, when private-equity funds have full coffers and plenty of targets in the corporate world. In closing, Buttonwood is drawn to another military analogy. Who remembers the Lockheed F-104 "Starfighter"? Introduced in the late 1950s as NATO's most advanced jet plane, with stubby wings and a huge single engine, it was a triumph of "rocket science" but difficult to control. The Starfighter shot to fame as a flying deathbed. Of the 916 bought in 1960 by the West German armed forces, 269 crashed over the next quarter-century; 110 pilots died. Surely, at some stage during those 25 years it would have been sensible to shelve the programme. But no: huge investments were involved, and the pilots who might have led a protest loved the challenge. It is too soon to tell whether some strands of CDO may turn out to be financial Starfighters (although with merely pecuniary consequences). Meanwhile, a word of praise for Swiss Re, which last month used CDO technology to securitise 252m of credit-insurance risk on trade receivables. That seems a little closer to oiling the wheels of commerce than, say, synthetic CDO-squareds. «¤»¥«¤»§«¤»¥«¤»§«¤»¥«¤»§«¤»¥«¤»§«¤»¥«¤»§«¤»¥««¤»¥«¤»§«¤» This is ZESTEconomics. Post economics-related articles and event info to [email protected] If you got this mail as a forward, subscribe to ZESTEconomics by sending a blank mail to [EMAIL PROTECTED] OR, if you have a Yahoo! ID, visit http://groups.yahoo.com/group/ZESTEconomics/join ==theZESTcommunity====================================== [1] ZESTCurrent: http://groups.yahoo.com/group/ZESTCurrent/ [2] ZESTEconomics: http://groups.yahoo.com/group/ZESTEconomics/ [3] ZESTGlobal: http://groups.yahoo.com/group/ZESTGlobal/ [4] ZESTMedia: http://groups.yahoo.com/group/ZESTMedia/ [5] ZESTPoets: http://groups.yahoo.com/group/ZESTPoets/ [6] ZESTCaste: http://groups.yahoo.com/group/ZESTCaste/ [7] ZESTAlternative: http://groups.yahoo.com/group/ZESTAlternative/ [8] TalkZEST: http://groups.yahoo.com/group/TalkZEST/ Yahoo! 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