2 Popular Minimum Volatility ETF Strategies

Tuesday, August 21st, 2012

by Del Stafford, iShares

By now, you’ve probably heard about the benefits of a minimum volatility (or, “min vol”) strategy and the ETFs that seek to deliver it, but you might still be wondering how to use these funds in a portfolio. One common misconception is that min vol ETFs are a tool designed for volatile markets specifically, but this simply isn’t the case. In fact, the two minimum volatility ETF strategies we see our clients using most often are both strategic, long-term plays that have nothing to do with current market volatility. These two strategies are: 1) lowering overall portfolio risk or 2) increasing allocation to equities without increasing overall portfolio risk.

Lower overall portfolio risk
Investors who are trying lower their overall portfolio risk can simply replace their existing market capitalization based equity investment with the corresponding minimum volatility ETF. For example, let’s say a client’s portfolio consists of 60% equity and 40% fixed income. Let’s use the MSCI USA Index to represent “equity” and the Barclays US Aggregate Bond Index to represent “fixed income”. The client would replace the 60% allocation to the MSCI USA Index with a 60% allocation to the MSCI USA Minimum Volatility Index.

This strategy would result in a ~20% reduction in portfolio risk since inception of the analysis (June 2008) and an even greater reduction in risk in the nearer term (see below).

Increase allocation to equities without increasing overall portfolio risk
Like the example above, an investor looking to employ this strategy would start by replacing their existing market capitalization based equity investment with the corresponding minimum volatility ETF, but then they would also increase their allocation to the minimum volatility ETF while decreasing their allocation to fixed income. After replacing the MSCI USA Index with the MSCI USA Minimum Volatility Index, the investor would increase their allocation to the MSCI USA Minimum Volatility Index and decrease their allocation to the Barclays US Agg Bond Index until the total portfolio risk reaches the level they desire. For example, they may seek a level of portfolio risk that is just below the since inception risk of the Original Portfolio, which is 12.15%.

This strategy allows the investor to increase their allocation to equity by 17% while obtaining a consistently lower level of risk than the Original Portfolio (see below).

While there are certainly other ways to employ minimum volatility ETFs in a portfolio, our team has found that these two strategies are the most commonly used among our clients.

Source: Markov Processes International (MPI)

Del Stafford, CFA is the iShares Head of Product & Investment Consulting and a regular contributor to the iShares Blog. You can find more of his posts here.

The iShares Minimum Volatility Funds may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful.

Copyright © iShares

Tags: Barclays, Bond Index, Case In Fact, Common Misconception, Current Market, Equity Investment, ETF, ETFs, Fixed Income, Inception, Investor, Investors, Ishares, Market Capitalization, Market Volatility, Msci, Portfolio Risk, Risk 2, Usa Index, Volatile Markets, Volatility Index
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Pocket of Strength: Employment in the Mining Industry

Wednesday, July 11th, 2012

Did you know that one of the industries that has seen the best job growth in the U.S. is mining? As you can see below, from the end of December 2007 through May 2012, U.S. employment in the mining sector has increased 16 percent. This percentage change is far better than any other sector, according to data from the Bureau of Labor Statistics.

The number released on July 6 showed that unemployment remains stubbornly stuck above 8 percent and Business Insider shared once again its “SCARIEST JOBS CHART EVER”. However, global investors should keep in mind that there are always pockets of strength. If you break out the June unemployment rate by industry, you can see that mining, quarrying and oil and gas extraction remains the lowest.

This trend is set to continue, according to Citi GPS. Citi believes as many as 3.6 million new jobs may be created by 2020, with 600,000 jobs in the oil and gas extraction sector and 1.1 million jobs in the related industrial and manufacturing activity. The firm says this could drive national unemployment to fall by as much as 1.1 percent.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. By clicking the link(s) above, you will be directed to a third-party website(s). U.S. Global Investors does not endorse all information supplied by this/these website(s) and is not responsible for its/their content.

Tags: 6 Million, Break, Bureau Of Labor, Bureau Of Labor Statistics, Business Insider, Employment, Gas Extraction, Investor, Job, Mining Industry, New Jobs, Oil and Gas, Oil and Gas, Percentage Change, Pockets, Third Party, Trend, U S Global Investors, Unemployment Rate
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Viewing Global Markets – What Happened in 2012?

Monday, June 4th, 2012

by Andrew Horowitz, The Disciplined Investor

Looking at the table below, it seems that the year has been one big waste of effort for most equity markets. Closing in on the lows in the EuroZone and just above the weekly lows in the U.S. markets.

But, Asia has been remarkably strong. In fact, China (up until very recently) has not wanted to budge from its high perch. Even with much of the bad news that is being thrown at it, Chinese stocks have been relatively resilient.

If you were thinking that they were just too cheap after the shellacking they took last year – consider the the continuing downtrend for Spanish and Indian shares.

Information on the table below looks at year-to-date trends for 2012 through June 1st.

The continuing prompts, promises and pledges from the Chinese government on additional stimulus measure has clearly been well engrained (brainwashing anyone?) into the investor’s psyche.  So, either the economy is going to get better without stimulus, or additional provisions will need to come in a rapid manner as markets have a short memory.

Which is it?

Copyright © The Disciplined Investor

Tags: Bad News, Brainwashing, Chinese Government, Chinese Stocks, Eurozone, Global Markets, Horowitz, India, Indian Shares, Investor, Lows, Nbsp, Pledges, Promises, Provisions, Psyche, Rapid Manner, Shellacking, Short Memory, Stimulus, Waste Of Effort
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The Gold Miners are on Fire – The List

Friday, June 1st, 2012

by Andrew Horowitz. The Disciplined Investor

Gold miners are flying. With gold moving up as investors are looking for alternatives to the high priced fixed income and the drooping prices of stocks, there is some serious shine to the gold mining names.

In fact, the overall GDX is up 5.5% and the juniors (GDXJ) is up 5.7%.

But, take a look at the massive performance today of the individual names.

Tags: Andrew Gold, Fixed Income, Gdx, Gold Miners, Gold Mining, Horowitz, Investor, Investors, Juniors, Moving, Names, Nbsp, Resistance, Stocks, Subscribers
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From High to Low – A Look at World Markets (Horowitz)

Wednesday, May 23rd, 2012

by Andrew Horowitz, The Disciplined Investor

It has been a wild ride over the past 52 weeks and some markets came out looking good, some not so good.

Clearly the U.S. has the best overall return in 2011 and that shows through on the peak to trough range – and still holding up well.

Europe (ex-Germany) has not had as good as a run. Even with the big uptick due to the LTRO, the markets have been punished.

Asia speaks for itself – Japan is still a mess though…

Copyright © The Disciplined Investor

Tags: Asia, Europe, Germany, Horowitz, Investor, Japan, Nbsp, Trough, Uptick, Wild Ride, World Markets
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Whitney George: Capturing Results from “Absolute Value” in Small Caps

Wednesday, May 9th, 2012

A rare interview with a Great Investor who specializes in small company stocks. The Royce Funds’ Whitney George (co-Chief Investment Officer and co-manager with Chuck Royce) will discuss where he is finding value in some of the world’s fastest growing companies. He discusses his and his firm’s “Absolute Value” approach.

One of the interesting nuggets in this interview (Mack covers this in her prefacing remarks) is that of thought-leading economist, John Maynard Keynes, who was a great investor in his own right, dramatically improved his investing strategy by adopting a long term bottom-up small cap value approach after many years of top down investing. This is notable as a historical precedent because the change-up in philosophy was timely, co-inciding with the turmoil of the great depression.

Copyright © Wealthtrack.com

Tags: Absolute Value, Cap Value, Chief Investment Officer, Company Stocks, Economist John Maynard, Fastest Growing Companies, George Co, Great Depression, Investor, John Maynard Keynes, Mack, Nuggets, philosophy, Rare Interview, Royce Funds, Small Cap, Small Caps, Turmoil, Value Approach
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Kathleen Gaffney: Bond Investor says Dividends Best Source of Income

Monday, April 30th, 2012

A bond investor who says stocks are the next best thing! Great Investor Kathleen Gaffney, co-manager of the legendary Loomis Sayles Bond Fund explains why the great generational bull market in bonds is coming to a close and why dividends are becoming the best source of income.

Tags: Bonds, Dividends, Investor, Kathleen Gaffney, Loomis Sayles Bond, Loomis Sayles Bond Fund, Stocks
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The Put Spread Collar

Thursday, April 26th, 2012

by Randy Frederick, Managing Director of Trading and Derivatives, Schwab Center for Financial Research

Key points

• Collars combine a covered call and a protective put.
• Collars help you cost effectively protect a position that you’re not ready to sell—but they limit your upside potential.
• A put spread collar is a sophisticated strategy for experienced option traders that can allow for more upside profit potential if you’re willing to take a little more risk on the downside.

A collar is a risk-management strategy that combines a covered call and a protective put. An investor who establishes a collar is usually concerned with protecting a position in a cost effective way. While a collar can provide short-term protection against a downturn in the stock, it also limits upside return.

But what if you only need some downside protection—for example, if you think a potential downturn will be limited and not catastrophic in scope. Or, what if you want more upside potential, but without spending any additional money?

If either of these scenarios applies to you, consider a put spread collar.

What is a put spread collar?

As with a traditional collar, a put spread collar is usually set up so that both the long (protective) puts and the short (covered) calls are out of the money, but with the same expiration date. However, with the put spread collar, the long put position can be purchased much closer to the money than the short call position and the difference in price is offset by the sale of a farther out-of-the-money put position.

This structure allows for greater upside potential, with less downside risk when there is only a small decline in the price of the stock. However, if there is a big decline, downside losses could be significant. A put spread collar is essentially a covered call combined with a bearish put spread.

An example of a put spread collar

To illustrate this strategy, let’s assume that a couple of months ago, you purchased 1,000 shares of XYZ at a price of $26 and since then the stock price has risen to $28.30. You are optimistic about the long-term prospects of XYZ, so you don’t want to sell it, but in the short term you’re concerned about a possible small pullback. No matter what happens though, you believe there will not be a large decline.

You only have a 2.30 unrealized gain in this stock so you would like to limit your immediate downside risk as much as possible without spending a lot of money. However, because you’re bullish you’d like to leave a fair amount of room for the upside too.

The solution may be to establish a put spread collar as follows:

This position ensures that you won’t lose more than 0.80 unless XYZ drops more than 3.30 points. However, you can make 6.70 points if XYZ rallies. Your only out-of-pocket expense would be the commission charges. Let’s take a look at this strategy (as of expiration date) on a profit and loss graph.

Profit and Loss for a Put Spread Collar

Source: Schwab Center for Financial Research.

As you can see in the chart above, based on the starting price of 28.30, your profit, loss and breakeven thresholds at expiration are:

• Below $25 there is downside risk to zero. The maximum loss is 25.80 or -$25,800 if XYZ drops all the way to zero.
• From $25 to $27.50, the loss is limited to .80 points or -$800.
• From $27.50 to $28.30, the loss will range somewhere between -$800 and $0.
• From $28.30 to $35, the gain will range from $0 to $6,700.
• At $35 or above, the gain is capped at a maximum of $6,700.

Like a traditional collar, with a put spread collar you can specify how long you need the protection. One nice feature is that the costs should not change materially based on the length of time holding this strategy, because time value affects all the options similarly and the option premiums essentially cancel each other out.

Depending upon the price of XYZ at expiration, some of the options could expire worthless, get assigned, or be exercised, so in order to reach the profit and loss scenarios described above, let’s compare the put spread collar to a similarly structured (zero cost) traditional collar.

The table below identifies exactly what takes place at each price point. For comparison purposes, let’s assume all positions are purchased when XYZ is at the current market price of $28.30.

How Do They Stack Up? A Traditional Collar vs. a Put Spread Collar

Source: Schwab Center for Financial Research.

In the table, you can see that the traditional collar and the put spread collar have essentially the same initial cash outlay (not including commissions) and gains and losses at prices between $25 and $29.

However, at prices below $25, losses will not exceed $800 on the traditional collar but will continue to get worse as the stock drops on the put spread collar. Because the put spread collar is short 25 puts, they will need to be closed out in the market, and the farther the stock drops the more expensive this will be. The maximum loss on the put spread collar is -$25,800. Essentially the downside protection on the put spread collar ends if XYZ drops below $25.

At prices above $29, gains will not exceed $700 on the traditional collar but will continue to grow on the put spread collar until a price of $35. At all prices above $35, the maximum gain on the put spread collar is $6,700. This additional $6,000 of potential upside opportunity is the trade-off for the extra risk taken below 25.

The bottom line is that a put spread collar is only appropriate when you are trying to protect against a modest decline in price—not a severe decline.

What to keep in mind

A put spread collar is a unique strategy, suited for specific situations so I’d like to conclude with a summary of its benefits and risks:

Benefits

• Provides limited downside protection at very low or potentially zero cost.
• Allows for greater upside profit potential versus a traditional collar.
• If the stock stays within the range of the call option and the higher strike put, the cost is zero or very low and all options expire worthless.

Risks

• While this strategy does limit risk somewhat, if the stock declines below 25 your losses could be quite significant.
• Anytime you sell a call, you have established a maximum selling price for your stock. While this strategy does allow for greater upside potential, if the underlying stock moves substantially above the short call strike price, your profit potential will still be limited.
• If your short calls go in-the-money, you could be assigned at any time.
• All options eventually expire, and the benefit of this strategy ends at expiration.
• Because a put spread collar is a spread, you have to be approved for spread trading in order to utilize this strategy.

For additional information on this strategy or for assistance with other options strategies, please contact a Schwab Trading Specialist at 800-435-9050.

Important Disclosures

Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. With long options, investors may lose 100% of funds invested. Please read the options disclosure document titled Characteristics and Risks of Standardized Options before considering any option transaction. Call Schwab at 800-435-4000 for a current copy.

With long options, investors may lose 100% of funds invested. Multiple-leg options strategies will involve multiple commissions. Spread trading must be done in a margin account. Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received. Writing uncovered options involves potentially unlimited risk.

Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.

Past performance is no indication (or “guarantee”) of future results. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Examples are not intended to be reflective of results you can expect to achieve.

Tags: Covered Calls, Decline, Derivatives, Downside Protection, Downside Risk, Downturn, Expiration Date, Investor, Losses, Managing Director, Nbsp, Option Traders, Puts, Risk Management Strategy, Scenarios, Schwab, Scope, Sophisticated Strategy, Spread Collar, Xyz
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Positioning a Portfolio for Rising Rates (Morillo)

Monday, April 9th, 2012

With the recent selloff in the US Treasury market we have received numerous questions on how to position a portfolio in the face of rising interest rates. To answer that question, it’s important to first look at what factors are causing rates to rise.

In a typical economic cycle, rates rise as economic activity improves, raising demand for credit as well as increasing expectations for future inflation. The Fed then attempts to keep the economy from overheating by raising short-term rates to match the improved economic prospects. In this scenario fixed income instruments generally perform poorly as the higher rates paid for newly issued debt makes existing debt less attractive particularly at longer maturities. Simultaneously, the improved economic conditions will generally result in equities performing well as they reflect expectations for earnings growth and increased pricing power across the economy.

I believe this scenario is, by far, the most likely to play out in the medium term, and it is certainly the scenario that has the most extensive historical precedent. With that in mind, how could an investor reposition a portfolio to navigate this scenario? I would advocate some reallocation from fixed income to equities. Looking at data since 1975[1], a reallocation in the 10-20% range appears to be a reasonable compromise between the increased risk to the portfolio from a larger holding of equities and the goal of protecting against the potential for raising rates.

Within the fixed income component of the portfolio the improving economic conditions will generally result in diminishing concerns of credit default. That provides some boost to returns of credit instruments, which can potentially make up some of the negative effects of rising rates.

There are, however, two additional potential “tail risk” scenarios that can also cause rates to rise:

1: In the “policy error” scenario, the Fed allows improving economic conditions to significantly overheat the economy. This results in a material increase in inflation expectations as well as long-term rates, which may eventually require a painful inflation-fighting contraction. There is only one period in the last 100 years of US history that plays out this way — during the 1970s “stagflation”. Given the significant attention that policymakers have placed on the risks of associated with this scenario, I believe it has a low probability of taking place.

2: In a “loss of confidence” scenario, rates rise in the absence of improving economic conditions simply as a result of creditors pulling away from the market due to concerns about the US government and/or the economy’s ability to meet its obligations. There is no precedent for this scenario in US history, and I believe it to be highly unlikely in the medium term.

For investors who are concerned with these “tail risk” scenarios, a shift to equities may no longer make sense. Instead, a shift to TIPS or other inflation-hedging instruments in the case of scenario 1 or to cash in the case of scenario 2 could be warranted.

Investors should discuss their own portfolio allocation with their advisors.

Past performance does not guarantee future results.

TIPS can provide investors a hedge against inflation, as the inflation adjustment feature helps preserve the purchasing power of the investment. Because of this inflation adjustment feature, inflation protected bonds typically have lower yields than conventional fixed rate bonds and will likely decline in price during periods of deflation, which could result in losses.

Tags: Compromise, Credit Default, Credit Instruments, Earnings Growth, Economic Activity, Economic Conditions, Economic Cycle, Economic Prospects, Fixed Income Instruments, Income Component, inflation, Investor, Maturities, Medium Term, Reallocation, Rising Interest Rates, Risk Scenarios, Selloff, Treasury Market, Us Treasury
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Synthetic CDO’s – When Risky Isn’t Risky – Or Free Equity

Wednesday, April 4th, 2012

by Peter Tchir, TF Market Advisors

Synthetic CDO ‘First Loss’ tranche safer than ‘Second Loss’ Tranche

In the past few weeks there has been some more noise from regulators and the rumor mill related to synthetic CDO’s.  It hasn’t hit the frenzy surrounding the Abacus deal last year, but the questions are starting to pop up again.  Who was long what?  Who was short what?  Who picked the portfolio?  Etc.

While all that is important, I figured now is a good time to trot out one of my favorite pieces.  In many cases the ‘first loss’ or ‘equity’ or ‘unrated’ tranche was actually safer than the ‘second loss’ or ‘mezz’ or ‘rated’ tranche above it.  Does this make any sense?  On the surface, NO!  An investor would expect the more senior tranche to underperform the ‘equity’ in good scenarios and outperform in bad scenarios.  That makes sense, yet many of the synthetic CDO’s were created in such a way that there was almost no scenario where the second loss tranche outperformed the equity tranche.  Bizarre, but true.

It’s important to understand this phenomenon as it helps explain a lot of the strategies that were employed and also why the defense of ‘I owned the equity’ is not a very strong defense.  I will now try and walk you through how this paradox is possible.

Cash CDO vs Synthetic CDO

The best way to demonstrate ‘safe’ or ‘free’ equity is to show how we got there and why its unique to the synthetic CDO’s.  Free equity does not exist in the cash CDO world (maybe that’s why that market was a fraction of the synthetic one?).

I will walk through 2 hypothetical examples that illustrate the point.  The example is more similar to a corporate CDO than a mortgage backed one, but the principals remain the same, and in reality, the trade first appeared in the credit referenced world and then moved to the mortgage world as that market developed.

For a cash CDO, let’s assume we have 100 bonds each paying T+150, each with a maturity of 5 years.  Let’s assume that the 5 year treasury yields 4.5% (reasonable at the time most of these deals were created).  So we have a portfolio of 100 bonds paying 6% each.

For a comparable synthetic CDO, let’s assume we have 5 year CDS on the same 100 bonds (issuers) and each CDS pays 100 bps.  That’s a reasonable ‘basis’ where the 5 year bond pays T+150 and the CDS to the same maturity is 100 bps.  Its simplified for our purposes, but realistic.

If each position is $10 million, then the $1 billion bond portfolio generates annual income of $60 million.  The $1 billion CDS portfolio generates $10 million of annual income.

Now let’s assume a simple capital structure.  A 3% ‘first loss’ tranche, a 10% ‘mezz’ tranche and a 87% ‘super senior’ tranche.  Again, this is simplified, but not out of line on a 5 year corporate structure to have the mezz as BBB and the Super Senior as AAA.

Let’s assume that the senior tranche of the cash deal gets T+60 or 5.1%.  They get less than the average since there is so much subordination.  Assuming a ‘basis’ of 50 bps, the synthetic deal would pay 10 bps on this tranche.  Lets assume the mezz tranche earns T+300 or 7.5%.  They are receiving a premium to the average because although they have second loss, they do have leverage once losses start hitting that tranche.  That mezz tranche for the synthetic would pay 2.5% keeping the 50 bps basis.

So here is what we have:

So in a no default case, the returns look reasonable for the risk.  The funded returns are higher, but that does reflect the use of cash.

The key element here, the driver of the free equity, is the income versus cost of the senior tranches.  In a cash deal, 86% of the income is used pay the interest due on senior tranches.  For a synthetic deal, only 34% of the income is needed to pay the senior tranches.  This excess income, and how little of an impact any individual default has on the income stream of a synthetic deal, is what creates free equity.

Now let’s take what might be an extreme case, but is great at illustrating the difference between the cash deals and synthetic deals.  Let’s assume 20 defaults occur, all with 0 recovery.  This would generate $200 million of losses.  It should wipe out the equity, the mezz, and eat into the super senior.  Where it gets interesting, is when you look at the residual income.

With $200 million of assets gone, the cash deal would only generate $48 million of income.  This would be enough to pay the full interest due on the senior tranche, but not enough to cover the ‘mezz’ tranche and nothing left for the equity.  That makes sense to me.  It’s on the synthetic side that you get a very interesting dynamic.  The residual income would be $8 million.  Not only is that enough to continue to paying the interest on the senior and mezz tranches, but it leaves $4.6 million for the ‘first loss’ tranche which is 15% per annum on the notional!

It all comes down to the ‘waterfall’ of how the interest is distributed.  On the cash deal, its easy to see that with 20% default, on day 1, with 0 recovery, that the equity would be wiped out, the mezz would be wiped out, and even if there were no waterfall/cashflow restrictions, there would be no distributions to the first loss holder.

On the synthetic side, the story is very different.  The equity would be wiped out, but receive $23 million over the 5 year deal in residual interest flows if there were no more defaults.  The mezz tranche would be wiped out but receive $7.5 million in interest over 5 years.  So the mezz loss would be 92.5/100, or 92.5%.  The first loss piece would lose 6.9/30 or only 23%.  It seems amazing, but the first loss loses less than the second loss in a synthetic cdo with a straight waterfall.

To make matters worse, the mezz tranches were often structured so that they stopped receiving their interest payments on any portion of their tranche that had been used to cover a default.  In the above example, that $2.5 million per annum would have then gone straight to the first loss holder.  The second loss would have received 0 in income and had to pay for the $100 they lost.  The so-called first loss piece would actually receive 7.1 millon per annum (24%) and over the life receive 35.7, so even after paying away $30 in losses, they would have received a positive return, while the tranche above them, the more senior tranche, the IG rated tranche, would have lost 100% and even the super senior would have had a negative return!

Scary but true.  And yes you could argue over the time value of money, and you can argue over capital structure, and you can argue that individual spreads were be different and in all likelihood higher spread names would default first, all of which make the ‘free’ equity less free, but its almost impossible to argue that the equity is as risky as you would think.  The risk/reward that exists does not match what you would expect.

If there are no defaults, it’s clear that the first loss portion will outperform the mezz tranche.  Its now also clear that under extremely adverse conditions, the first loss outperforms the tranche above it, which is truly bizarre.  At least, maybe, there is something in the middle ground, that salvages the mezz tranche?

How about there are 10 defaults on day 1, each with a 70% recovery.  This is fairly unrealistic, but should be an example skewed against the first loss tranche.  The 10 defaults each losing 30% means a total loss on the portfolio of 3% so the first loss would have to pay out that amount.  The mezz tranche would have no losses.  The mezz tranche would receive the $2.5 million a year its entitled to.  Even with 10 defaults, the residual income to the first loss tranche would be 5.63 million.  A total of 28.2 million over 5 years.  So a slight net loss of $1.8 million or an annualized loss of just over 1%, compared to a gain of 2.5% for the mezz tranche.  Yes, in this case the mezz moderately outperformed, but any additional defaults would primarily impact the mezz so the outperformance would disappear quickly.  And this is the most harmful case I can think of where mezz receives all that it is entitled to and the equity receives the bare minimum.

There were deals where the equity was getting large ‘guaranteed’ interest payments, sometimes in excess of 20%, so more than the amount at risk over the life of the trade.  Guaranteed coupons this high were a sign of how unrisky the risky tranche was.

One European dealer created a structure, where, by using a reserve account to build up excess cash flow, they got the rating agencies to rate the ‘first loss’ tranche HIHGER than the tranche above it!  Boggles the mind that the rating agencies did it, but more proof that the concept is real.

How could this happen?

One of Wall Street’s biggest flaws seems to be complacency when something is working.  The CDO structure had worked with bonds and loans and other cash instruments as the underlying.  The flows made sense.  The first loss did very well in good times, but underperformed the more senior tranches in times of high default rates.  There really was no reason to suspect that the dynamics of a synthetic CDO changed all that.  On the surface it seemed the same.  Heck, it even got a similar ratings profile to the cash deals.  The relative value paid to senior investors in synthetics seemed in line with what investors demanded on the cash side.  People had Guassian Copula models attributing the spread to various tranches ‘fairly’.  Though I remain convinced that the quants just liked the word copula because it reminded them of copulation.

Another reason it happened, is because have you ever tried to explain to risk management that the first loss tranche is safer than the second loss tranche?  How the unrated tranche is less risky than the BBB rated tranche?  It’s so counterintuitive it’s not an easy argument.  The first time someone told me it existed, I shook my heading thinking they were missing something.  It just doesn’t seem right, but it is.

This happened primarily for the early deals.  As people became more aware of the issue, bells and whistles were added to protect the senior investors (at their request).  After defaults, cash flows to the first loss would stop, or at least some portion would stop, to build up a reserve or cushion against future defaults.  It helped and seemed fair.  Over time the product evolved and in the later credit deals, the risk/rewards had gone back to being more in line with expectations.

As a market developed for single name CDS on the mortgage side, synthetic CDO’s backed by them were also created.  For better or worse, mainly for worse, most Wall Street firms seemed to have a mortgage department that was in direct competition with their credit department.  In chasing P&L and accolades, the amount of communication between the desks was often minimal.  Investors, who probably understood the concept of ‘free’ equity less than the street, also tended to run their investments in credit cdo’s separately from their mortgage backed cdo investments.  I believe that this allowed many of the early mortgage deals to create the same sort of free or low risk equity that had existed in the early days.  There is nothing wrong with it, it just skews the risk reward and means that you have to be careful when making the claim that the equity holder was taking the real risk.

Have you ever wondered why so many bears were either long the ‘equity’ tranche or seemed willing to be long?

Well, wonder no more.  You now know that depending on structure, the first loss, or equity, was actually very well protected.  Deals could be structured in such a way that by owning the first loss and shorting more senior tranches, the base case was high teens returns, the best case were massive gains as big losses hit the super senior, and the scenarios that caused a loss were minimal (if not non-existent).  These are complex deals.  I have simplified the analysis to make a point, but the math works, and it does help explain why there are few stories about how hard it was to place the equity of synthetic cdo’s and why many of the people most bearish the underlying markets were long them and were short higher up the ‘capital’ structure.

So, if we get another round of discussion about the CDO market, like we did surrounding Abacus, at the very least I hope this makes you question what the parties are saying and spend more time figuring who had what risk, based on the documentation and the math, rather than just the name of the investment.

Copyright © TF Market Advisors

Tags: Bizarre, Fraction, Frenzy, Good Time, Hypothetical Examples, Investor, Mezz, Mortgage World, Nbsp, Paradox, Phenomenon, Principals, Regulators, Rumor Mill, Scenarios, Synthetic Cdo, Tf, Tranche, Unrated, World Market
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