By Paul J Davies and Michael Mackenzie
February 14 2008
SourceThe world of synthetic collateralised debt obligations is suffering as the cost of protecting corporate debt against default via credit derivatives – from which these CDOs are created – continues to be pushed higher.
But there is another problem building, and some fear it could lead to a repeat of the correlation crisis of 2005, which saw hedge funds and investment banks suffer hundreds of millions of dollars worth of losses.
The problem then was that investment banks and hedge funds had built up large exposures to the riskiest equity tranches of synthetic CDOs, which pay the highest returns but bear the first losses from any defaults in an underlying pool of credit derivatives.
When sentiment changed suddenly after the shock downgrades of US carmakers GM and Ford, these investors found that there was no market for the risk they held.
Now a similar correlation pattern has emerged as hedge funds have loaded up on the same risk by selling protection on equity tranches.
However, this time the patterns of pricing in the CDO market, or the movements in correlation, have also been fuelled by what is occurring at the other end of the risk spectrum.
Here, large banks worried about systemic risk and the potential collapse of the monoline industry have been busily trying to buy as much protection as possible on the safest senior tranches.
The danger is that if a single company suddenly appears more likely to default, it would provoke a sudden shift from a perception of systemic risk to a realisation of idiosyncratic risk.
Those with exposure to equity tranches are suddenly far more likely to lose money from a default than they previously thought. This was what happened in spring 2005, when events at GM and Ford caused such a jolt.
“Correlation now is even more unbalanced than it was in 2005,” says Alberto Gallo, credit derivatives strategist at Bear Stearns.
“Most of the money in the long correlation trade [for example selling protection on equity tranches] is from hedge funds.
“These investors are most exposed to losses if there is a sudden change.”
He adds that the small number of real money investors, such as traditional asset managers, that have been selling protection on senior tranches to banks stand to make the biggest gains, as they did in 2005.
However, the biggest losers of all could be the supposedly most sophisticated investors – the investment banks.
If they are allowing their traders to bet in line with hedge funds, while risk managers in other areas are buying protection on senior tranches, they would lose twice over in the event of a sudden switch.
”Correlation models are being tested as we have low levels of idiosyncratic risk - corporate defaults are currently low - while systemic risk - illustrated by the wide level of spreads - is high,” says Sivan Mahadevan, head of credit derivative strategy at Morgan Stanley.
Copyright The Financial Times Limited 2008