Friday, October 31, 2008

Systemic Risk in the Sovereign Air

Larger-than-life market-perceptions of systemic risk have blown sovereign debt wider and their credit default swap (CDS) levels to epic proportions.

With the US Treasury's 10-year CDS as wide as 40 bps (i.e., 0.4%) -- a 40-fold since early 2007 -- we're being forced to re-evaluate just what is meant by the "risk-free" rate of return (which is traditionally the UST, in fixed-income world).

According to the following chart (click on it to enlarge), perhaps 27 bps should be the minimum credit-related risk-adjustment used in conjunction with discounting by by the "new" risk free rate...
(1 basis point (bp) = 0.01%. In other words, the seller of protection earns a 0.4% annual premium on US debt, versus a 39.5% annual premium on Argentina; but beware that shorting the CDS will require you to post wicked amounts of margin given the volatility.)

Remember: A country's default probability is a measure of both its ability and its willingness to pay its debt.

Wednesday, October 29, 2008

Jack of All Trades?

We are brought up with the mantra that, while substantially limiting the upside, diversification saves us on the downside. Being by nature (partly subconsciously) risk-averse we tend to diversify endlessly, protecting against losing our dinner, even if it means a lesser chance of a royal dinner with the Queen.

Possibly true for the individual - not necessarily for the managed funds. Let's dig deeper...

Our investigations into recent hedge fund performance bring us back to our deliberations on whether diversification really is always such a good thing. (Remember, the monolines, in an attempt to diversify their portfolios, moved away from being purely muni-bond insurers, and were stung by their participation in the structured finance market. See Muni Bond Insurance (for the short term) for more on this.)

This chart (click on it to enlarge) shows us that multi-strategy hedge funds are among the worst performing in the down cycle.

Some thoughts and possible explanations/justifications:
(1) Multi-strategy funds tend to be more highly leveraged on the back of this diversification (just like certain ABS, CDOs)
(2) As you have more strategies under management, you may tend to lose asset-specific expertise
(3) Perhaps better managers like to keep it clean and simple...

Summary opinion: perhaps diversification is truly a good thing if it's not mis-used or mis-applied. If the diversified fund or portfolio is able to be more aggressively managed purely due to the benefits of diversification, the plain vanilla option, often cheaper, may just become more enticing.

Friday, October 24, 2008

Overnight Madness

Aside from the well-publicized widening and volatility in both the issuer-based and asset-backed commercial paper markets -- which until recently moved in tandem with the Fed Funds rate -- we're noticing an increased market interest in the short-term rating of the issuance. And this "tiering" is not limited to term-funding, but has infiltrated the overnight lending market. As always, a picture says a thousand words:

(Click on the graph to enlarge)

Volvo's Slowing Demand

From Bloomberg News: Volvo Cuts Truck Market Outlook After Demand Slumps

Kind of a random post for this blog but these numbers are just insane...
The Gothenburg, Sweden-based company won just 115 European orders in the third quarter, down from 41,970 a year earlier
Volvo has cut production at two European factories and is eliminating 1,400 jobs at its truck division in response to slowing demand.

That's a 99.73% drop folks (and this number is likely to go up as cancellations line up) - Not sure I would refer to this as "slowing demand" at this point...

Thursday, October 23, 2008

The Luxuries of a Covenant Light Lifestyle

Blackstone president and COO Tony James wrote a piece for the Financial Times this morning touting covenant light loans as a "positive development," allowing companies "the flexibility to work through their problems and, thus, help maximise total enterprise value."

When a business hits a downturn, because of either poor management or external forces, you want the business to continue. An ongoing business has a far greater total enterprise value than one liquidating. Loans with strict covenants can destabilise an otherwise healthy company, when even a short recession over a few quarters might trigger defaults. The holders of the senior debt take action; cash flow stops to the junior debt, suppliers stop shipping, customers flee and employees lose jobs. The equity holders with little or no remaining stake in the business not only find it difficult to restore health to the business, but they have no economic incentive to do so.

Equally important is the value destruction that ensues when a company defaults. Creditors squabble and courts hold interminable hearings. In the meantime, the company drifts. The very worst time for a boat to lose its pilot is during a storm. But this is exactly what results from the traditional hair-trigger covenants that many see as the healthy formulation of leveraged capital structures.

All valid points, perhaps. But let's dig a little deeper...

Typically, the two pertinent loan covenants are incurrence and maintenance covenants. Incurrence covenants restrict the company's ability to issue debt (typically, senior to this loan - which makes sense, especially if you're the lender and wish to retain your level of seniority). Maintenance covenants describe (minimum) collateralization levels (think coverage ratios) that must be maintained to avoid the loan from being in default. When you speak of covenant light loans, you're primarily talking about loans who lack the maintenance covenant(s). The fewer the covenants, the lower the likelihood of default, and hence Mr. James' rosy article.

Now let's consider covenant light loans as a microcosm for today's environment. Everybody's long regulation. Regulation is king. The market has seen what happens without it, and decided that it prefers regulation. Let's examine the lack of restriction (as a metaphor for regulation) on covenant light loans. The covenants act as a means for the lender to involve itself (think govern or regulate) in the performance of the company if/when it fails to comply with its covenants. Among other things, the lender can extract additional spread from the failing company (as an alternative to enforcing default) or, upon default, the lender at least has a strong position at the negotiation table, as a senior secured lender, and since the only-recently-failing maintenance coverage ratio describes the company's ability to "cover" the loan, the lender often walks away whole, or at least close to whole.

In the absence of such a covenant, the lender has limited recourse until default. Granted that defaults are less likely, but once they occur, who is to say what the recovery rate may be?

In summary, if I'm borrowing, I'm long the additional flexibility (unless it costs much more); but as a lender, one has to expect that the severity of any defaults will be sharply higher than those having quality/coverage controls in place. This is the real downside that should be guarded against: lenders with large exposure to low-recourse, low-recovery loans which are or may defer interest or "pay-in-kind."

Wednesday, October 22, 2008

Pension Paradise

Here's a story from Professional Pensions we thought we'd relay without commenting on. We'll leave any judgments up to our readers (who may or may not be happy holders of pensions).

USS plans five-fold increase in alternative investments
Mark Selby

THE Universities Superannuation Scheme is set to increase its allocation to alternative investments.

The £29bn fund’s annual report revealed it is in the process of increasing its alternatives portfolio from 4% to 20% – investing in a mix of private equity, hedge funds and commodities.

USS saw its funding levels drop to 77% in March after rising to 98% in June 2007 using a gilts valuation measure.

USS head of alternatives Mike Powell said the aim of the alternatives portfolio was to deliver equity type returns but with lower risk.

He said: "In our view the recent turbulence in the hedge fund industry has provided USS with a great opportunity as a new entrant and will make USS a very attractive partner for hedge funds given our long term investment horizon.

"The fallout in the industry will also prove to be a great arbitrator of quality and skill amongst the huge number of hedge funds. The size of the allocation is not fixed and we allocate capital to where we see the best risk adjusted opportunities."

Wednesday, October 15, 2008

JPMorgan vs. Morgan Stanley

As an update to yesterday's piece, just to be fair to all parties involved, JPMorgan today stated they're newly bearish on AAA CLOs. Morgan Stanley yesterday described their bullish stance, saying that AAA CLOs could survive 10% CADR at 50% recovery rates. JPMorgan contend that widening is likely given the deep repressionary risk which will take its toll.

We'll keep you posted, but just a note that from an analytical perspective, unless (and this is a key "unless") the AAA tranches attaches (i.e., suffers any principal writedown), the value of the tranche will likely be higher for more severe default rate environments, as O/C trips will speed up payments to the AAAs. The shortened duration, then, improves the value when discount rates (DMs) -- as they are -- are higher than the promised coupon/spread on the tranche.

Tuesday, October 14, 2008

Are AAA CLOs "Safe?"

There's been a fair bit of structured finance research this month discussing, and mostly touting, the merits of investing in AAA CLO paper, which has been caught up in the generally widening market trend (currently trading around LIBOR + 475 bps).

For the most part, we expect the better cash CLO AAAs to avoid principal writedowns; generally, the underwriting standards for CLOs have improved over time, unlike their ABS CDO counterparts. Of course, the synthetic (LCDS) CDOs backed by senior secured loans (note: reference obligation is borrowed money) were not as fortunate. Many of these deals entered into an Event of Default upon Lehman's bankruptcy filing. See our prior pieces on Investigating the GIC and Eligible Investments for more on this.

For the leveraged/mark-to-market investor, we show a graph of the DM movement over the last 10 weeks -- based on just over 300 bid, offer and transactional data points since 07/31/08 -- and let you decide for yourself whether we're at the bottom:

(Click on it to enlarge the picture)

Tuesday, October 7, 2008

IOSCO's Call for Comments

The International Organization of Securities Commissions (IOSCO) put out this Consultation Report this morning -- with a request for comments -- on Best Practices for Funds of Hedge Funds. The comment period ends January 5, 2009.

This report develops their prior piece with respect to guidelines relating to (a) a fund of hedge funds' management of liquidity risk, and (b) their due diligence processes performed before and during the investment.

Thursday, October 2, 2008

A Parachute from the Past

With the troubled assets relief program (TARP) being omnipresent in the news these days, we thought we'd take you back to 1996 (based on CCA of 1990) Press Release.


PR-8-96 (2-6-96)

The FDIC Board of Directors today issued a final rule that, with certain exceptions, prohibits troubled holding companies, banks and thrifts from making "golden parachute" payments. These are typically large cash payments to executives who resign just before an institution is closed or sold. The regulation was issued under authority granted by the Crime Control Act of 1990.

The new rule also limits the ability of any holding company or FDIC-insured institution to pay the liabilities or legal expenses of an employee or director who is subject to an enforcement proceeding.

The statute permits the FDIC to prohibit or limit golden parachute and indemnification payments, but provides several exceptions, such as for qualified pension and retirement plans. Other exceptions have been added by the FDIC with the recognition that such payments have reasonable business purposes. The rule provides guidance to the industry on which payments are considered legitimate and which are considered abusive or improper.

The agency first proposed rules in this area in 1990, and then issued a second proposal for additional comment in March of last year. The final rule, which is similar to the 1995 proposal, becomes effective on April 1, 1996.

# # #

Congress created the Federal Deposit Insurance Corporation in 1933 to maintain public confidence in the nation's banking system. The FDIC insures deposits at the nation's 12,000 banks and savings associations and it promotes the safety and soundness of these institutions by identifying, monitoring and addressing risks to which they are exposed.