Credit Derivatives played by Hedge Funds

There have been some big changes in market environment after LTCM collapse as more hedge funds have been entering credit derivatives market. From the above facts, it can be noted some failures on credit derivatives, such as LTCM with total return swaps, Aman Capital with leveraged credit derivatives and Marin Capital with synthetic CDO. It seems LTCM has been the pioneer of hedge funds involvement in credit derivatives market and some hedge may have seen the opportunity to gain big returns assuming that their bet would never go wrong like LTCM’s bet.

In spite of Warren Buffet’s opinion in 2003 that credit derivatives are “financial weapons of mass destruction”, players in capital market continue to use credit derivatives for speculating and hedging purposes. The general argument is that credit derivatives provide more liquidity for credit markets other than from financial institution’s funding and also provide higher returns than the original securities or assets. Hedge funds with their investors’ funds can be seen as the sources of credit liquidity. Here it can be seen that even in a nature of retail funding a hedge fund may access the wholesale credit market due to the advantage of high leverage.


Figure-1. Players of Credit Derivatives [4]

In has previously been mentioned that total assets under management of hedge funds is estimated more than US$2 trillion in 2006. If the involvement of hedge funds is about 30% average between buyers and sellers (see figure-1) and the total market volume of credit derivatives is estimated US$20 trillion in 2006 (see figure-2), it can be projected that US$6 trillion of credit derivatives market is managed by hedge funds. If say 20% of hedge funds or US$400 billion assets played in credit derivatives, this may suggest that there is a 1:15 leverage applied by hedge funds with assumption that the 30% average hedge funds consists of offsetting long and short strategy. If it is assumed that hedge funds overall may have stand-alone strategies as buyers and sellers and the involvement becomes 60%, then it can be projected about US$12 trillion of credit derivatives market is managed by hedge funds with 1:30 leverage in trading. For example, a hedge fund selling a credit default swap (CDS) of a US$15 million loan value for US$1 million premium would have to face maximum US$15 million claim. If selling US$2 million mezzanine notes of a synthetic collateralised debt obligation (CDO) of two CDSs above, a hedge fund would have to face maximum US$30 million claim.

The market volume of credit derivatives have shown a figure of exponential growth from 1996 to estimated 2008. From just US$0.2 trillion in 1996, it has been growing gradually to US$2 trillion in 2002 until rapidly jumping to US$5 million in 2004 and estimated to grow exponentially to US$20.2 trillion in 2006 and further to US$33.1 trillion until 2008. The size in 2006 is around 1.5 times annual nominal US GDP. However, this cannot be compared explicitly as there are factors of leverage and multiplier in credit derivatives that may bias the perception of the real volume of credit market and money circulation in the context of macro and monetary economy. The main driving factor of credit derivatives is in fact governments who sponsor the development in the countries that use alternatives of liquid funds available other than those in financial institutions and can be explored outside the countries. Hedge funds all over the world are one of the liquidity providers for credit derivatives market even though some tend to deal with a lot of speculations.


Figure-2. Market volumes credit derivatives (US$ trillion) [source]


(Synthetic) Collateralised Debt Obligation (CDO)

A CDO is a derivative resulted from a securitisation process of a portfolio of loans or bonds which is being sold by a lender or issuer to a Special Purpose Entity (SPE) who then issues securities in the form of notes collateralised by the portfolio of bonds or loans. A synthetic CDO refers to a portfolio of CDSs.

The notes issued by an SPE are structured with different payoffs and prices based on the credit qualities of the underlying portfolio to give investors choices to invest in different risk profiles. By structuring a CDO, SPE can enhance the quality of a portfolio with mainly speculated grade loans or bonds by issuing notes with higher credit qualities. In an arbitrage CDO, the notes are usually priced over the yield of the underlying bonds or loans for SPE to gain. For example if the average yield of the bonds portfolio is LIBOR+5%, the CDO may be priced on average at LIBOR+6%, thus the PV of bonds portfolio is higher than the CDO. By purchasing CDO notes, investors may enjoy the advantage of higher expected return even without having the original assets. Despite there are complicated mathematical techniques for structuring and pricing CDO notes, a simple hypothetical example of an arbitrage CDO can be described as follows.

Structuring an arbitrage CDO and hedge funds’ play

The underlying portfolio of $100 bonds matured in 2 years with $10 expected default consists of:
- $10 rating C bonds with expected return LIBOR+4%.
- $10 rating B bonds with expected return LIBOR+2%.
- $30 rating A bonds with expected return LIBOR+1%.
- $50 rating A+ bonds with expected return LIBOR+0.5%.

The notes issued in different tranches:
- Equity tranche: $10 note unrated at LIBOR+5% p.a.
- Mezzanine tranche: $10 note for rating B at LIBOR+3% p.a.
- Mezzanine tranche: $30 note for rating A at LIBOR+2% p.a.
- Senior tranche: $50 note rating A+ LIBOR+1% p.a.

With this simple structure assuming LIBOR is 4%, SPE may expect the net present value between the bonds portfolio and the CDO’s tranches are still positive as the average rate of return of the bonds portfolio is lower the average cost of capital of the CDO tranches.

Buyers of the equity tranche may enjoy the highest return of 9% followed by mezzanine and senior tranches. However in default event of $10, equity tranche buyers may not receive back the $10 investment but senior and mezzanine tranches are still repaid. In default of $4, equity notes receive only $6 of $10 investment. Equity tranche buyers expose to default risk.

Sellers of equity tranche pay 9% or $0.9 but the $10 investment received from buyers would not be repaid if the portfolio defaults by $10. It means that only with $0.9 sellers can generate $10. Meanwhile, by selling mezzanine and senior tranches at the existing notes’ rate, sellers expect the rate will drop so that they can buy back and profit. But they may lose if the rate rises.

The most popular position played by hedge funds is long equity tranche and short mezzanine or senior tranche. The advantage of this position is that hedge funds can enjoy the high return from buying equity tranche by selling mezzanine or senior tranche with smaller cost. For example at LIBOR equal to 4%, a hedge fund receives $0.9 (9%) from long equity and pays $0.6 (6%) for short mezzanine rating B note, earning $0.3. If LIBOR rises to 6%, a hedge fund closes it positions and pays $1.2 for equity and receives $0.8 from mezzanine, costing $0.3. If the proportion of mezzanine tranche is bigger the equity, a hedge fund can profit if LIBOR increases. If the proportion of mezzanine tranche is smaller the equity, a hedge fund can enjoy the spread assuming LIBOR decreases or at least does not move. However, this position is still risky. Marin Capital in June 2005 held $500 million long equity position and $1 billion short mezzanine position betting on General Motors (GM) outlook. When GM was rated down to speculative grade, the equity and mezzanine tranches were repriced downward and Marin ended up with an enormous loss.

How CDO helps private equity’s LBO and attracts hedge funds investment can be seen in figure-3 regarding the tranches financing structure of a target company’s debt. By investing in equity tranche, private equity funds may enjoy the highest returns while banks and CLO may enjoy higher returns rather from investing directly to the company. In CLO is the portfolio of CDOs from several private equity’s LBO. Hedge funds and mezzanine funds are the way to hedge position in the equity tranche.


Figure-3. Tranches financing structure of private equity’s LBO [1]

The first CDO hedge fund was launched by Ferrell Capital Management in 2001 when issued US$50 million of unrated junior notes which were based on the performance of a group of hedge funds. Then JPMorgan structured out hedge fund-of-funds CDOs for Grosvenor Capital Management and Ivy Asset Management. In Europe, Deutsche Bank financed CDO for Prime Edge private equity funds transactions. Credit Suisse First Boston structured out deal for US$500 million hedge fund-of-fund CDO deal for the Bahrain-based Invest Corp. Seemingly, the CDO is structured out of hedge funds of funds, which are normally held by major investment banks. [2]

In May 2007 Merrill Lynch and Credit Agricole Asset Management launched a new type of CDO called the collateralised foreign exchange obligation (CFXO).[3] If the product is successful in market it would be the first CFXO that may be followed naturally by other CFXOs. The underlying portfolio is made up of about 10 foreign exchange pairs combining the currencies of the Group of 10 developed countries with a number of emerging market currencies. The AAA-rated tranche is to pay 80 bps - 100 bps in coupons while the riskiest equity tranche is expected to return about 20 per cent.


Credit Default Swap (CDS) and Total Return Swap (TRS)

CDS

CDS is basically a derivative showing an agreement as one counterpart agrees to pay some regular protection premium as a percentage of the notional debt held as its asset to the other counterpart who promises to pay any defaulted part of the debt so that its assets are protected from losses. Figures-4 shows Acme Inc. agrees to pay premium to CDS dealer or seller to buy protection of Giant Corp’s debt held as its asset. If Giant Corp. suffers a default, Acme Inc. is safe and CDS dealer suffers a loss. If Giant Corp. is fine, Acme Inc. still costs a protection and CDS dealer enjoys a protection payment.


Figure-4. Basic CDS cash flows[4]

Hedge funds as CDS buyers usually purchase CDS to hedge portfolios of the bonds they currently own. Hedge funds also purchase CDS on corporate bonds designed to profit from a widening corporate credit spreads as CDS is cheap when the spread is narrow and expensive when widen. Some buy CDS on sub prime, mortgage backed, fixed-income securities and indexes as a way to profit when borrowers’ credit quality falls. Some hedge fund managers also buy CDS on emerging debt to bet on a decline in a country's credit quality.

Hedge funds as CDS sellers like to receive protection income and expect no default in the bonds or loans. With that intention, they bet on a good hope of bonds or loans to fulfil the obligation. Notwithstanding this intention, the bonds or loans default hedge funds may end up owning the bonds or loans and think the next strategy to recover the defaulted part.

Trading CDS on Sallie Mae’s LBO[5] can be related to the process tranche financing in CDO as to protect the tranches portfolio in three ways. First, hedge funds buy CDS before Sallie Mae’s LBO at say 40 bps and sell it at say 60 bps after the LBO as the credit quality and risk of Sallie Mae increase. Second, hedge funds buying CDS on Sallie Mae debts expect students’ debt would default as receiving default payment. They may be predicted not so many jobs for students and not so many bright students. Third, hedge funds selling CDS on Sallie Mae debts expect otherwise and receive protection income.

TRS


TRS is basically a derivative of a netting position between the bonds’ fixed payment and the bonds’ referenced floating payment. Any yield decrease may increase the bonds value and the receivers or buyers may profit whereas the payers or sellers may lose. Any yield increase may decrease the bonds value and benefit the sellers whereas the buyers may lose.


Figure-5. Basic TRS cash flows[6]

Hedge fund buyers of course expect yield decreases, price increases and spread narrows. For example, a hedge fund pays at LIBOR+2%+$90 and if price increases and spread narrows it would receive at increasing LIBOR+2%+$95. On the other hand, hedge fund sellers should expect yield increases, price decreases and spread widens. Moreover, with small collateral hedge funds can trade for a huge value of bonds. For example, only with $1 million capital hedge funds can trade TRS for a face value of $100 million bond. Using 1:10 leverage hedge funds can upsize the TRS profit to 10 times. The collapse of LTCM may be regarded with TRS transaction. LTCM bet on narrowing spread after the Asian Crisis and then bought TRSs on emerging countries bonds. Unfortunately, Russian bonds then defaulted. Spread widened, yield increased and bond price decreased. Because of too much leverage LTCM lost US$2.3 billion with US$1.6 billion TRSs in the portfolio.


References
[1] Banque de France. “Are risk transfer mechanisms sufficiently robust?” Financial Stability Review, No. 9, December 2006. http://www.banque-france.fr/gb/publications/telechar/rsf/2006/chroni3_1206.pdf

[2] O'Leary, Christopher. “The CDO Revolution Continues as Market Awaits Issue Backed by Hedge Fund Debt.” Investment Dealers' Digest, 3/5/2001, Vol. 67, Issue 9, p15.

[3] Davies, Paul J, “Merrill, Credit Agricole bring credit derivatives to FX.” http://www.ft.com/cms/s/0ed8c664-f80e-11db-baa1-000b5df10621.html

[4] Smithson, Charles and David Mengle, 2006, p56. The promise of credit derivatives in nonfinancial corporations (and why it's failed to materialize). Journal of Applied Corporate Finance, Fall 2006, Vol. 18 Issue 4 p54-60.

[5] The Economist, “Sallie Mae’s big day.” 21 Apr 2007, p79-80.

[6] Smithson, Charles and David Mengle, 2006, p55.