Deus Ex Macchiato

An interesting observation from Financial Crookery about the Lloyds Cocos:

the 15% ECNs were indicated at 122/123 on minimal volumes, compared to 110/112 for the previous 13% series. Absent the EU-mandated 2 year coupon pass for the 13% security for “burden sharing”, the 13% notes would have been trading around 132/133, so credit markets value the trigger risk at around 10 points higher than the additional 2% coupon. Is this enough? How should the ECNs be valued?

In exchange for protection from regulatory cashflow interference and the coupon hike, investors add a “wander to loss” risk to the pre-existing “jump to default” risk. These two volatile processes are correlated, and can be modelled to value the ECN. It is essentially a 15% bond which knocks-out if either (i) Lloyd’s book value falls around 45% during the 10 years, returning the value of the (correlated but more volatile) stock price at that time or (ii) Lloyds jumps to default in the normal credit way.

I am conscious of the jaundiced reader’s likely view of model-based pricing. Nevertheless my own valuation of the ECN using this framework was in the 115-120 range(1). The cost of the “wander to loss” risk is higher than credit markets are estimating. The current ECN quote is not particularly cheap on this reckoning, particularly as the ECN would usually trade at some discount to theoretical value. In short, I think the stampede to exchange may have been misguided.

The model used could be questioned – in particular using a 2 factor random walk with correlation strikes me as a rather simplistic way of modelling the joint equity/book process, especially for a credit like Lloyds with a lot of different kinds of subordinated debt – but it is still a pretty reasonable start.

The only question remaining is why the market values the Co-Co’s so generously. The answer may be surprisingly straightforward: a hunger for yield, maintenance of current income and resolute belief in the sovereign put.

I suspect the high coupon is also attractive to those playing tax games. High interest income certainly used to be necessary in some tax ’structuring’ (aka defrauding the ordinary tax payer).

Furthermore, some capital structure arbitrage players, assuming there are any left, would be hedging the note with purchased protection on Lloyds sub debt. That would be a classic short credit gamma long carry position. And we know how well those sometimes work out…

Posted in: Capital Structure Arbitrage, Credit by David /
Comments Off

I have written several times before about the equity credit disconnect of the last few years and its implication for capital structure arbitrage models. Recently, the disconnect has reappeared, as this chart of the day from Bloomberg illustrates:

If there are any CSA funds left after the earlier dislocation, this would theoretically be a great time to go short equity long credit. The trouble is we now know that these dislocation can last for considerable periods, and reversion to anything close to the theoretical relationship is not guaranteed. Does this sound the death knell for capital structure models?

Posted in: Capital Structure Arbitrage by David /
2 Comments

I have observed before that the equity markets have not yet reacted as fully as the debt markets to the crisis – and increasingly it looks likely that they will fall further rather than that the debt markets will rise to join them. Goldman is of that mind, and has recently observed that downside vol is cheap so now is an excellent time to buy puts. Bloomberg reports that Goldman:

recommended Dow Jones Euro Stoxx 50 Index puts that expire in December and have a strike price of 3,000, or 11 percent less than the measure’s closing level today.

“High inflation/low growth is an increasing downside tail risk …If that risk crystallizes, we think it means material rather than modest downside.”

The Euro Stoxx 50 plunged 24 percent to 3,354.20 in 2008 and closed at the lowest since November 2005 last week. The December 3,000 puts on the index fell 6.7 percent to 83.50 euros today. They cost as much as 189.30 euros in March.

Posted in: Capital Structure Arbitrage, Markets by David /
Comments Off

Naked Capitalism has a thought provoking article on the current disconnection between the equity markets and the credit markets, which in turn refers to FT articles by John Authers and John Dizard. Authers describes the issue:

If you believe the credit market, things have worsened sharply in the past few weeks. With spreads widening significantly, recession is a certainty in the US and Europe.

If you believe the equity market, there are grounds for optimism. Stocks are still above the low they hit in January, before the Federal Reserve made its emergency rate cut – betting that this huge monetary stimulus would ensure that any recession is shallow.

[...]

But in the past few weeks, as credit spreads have widened, the shares of those companies the credit market sees as most risky have rallied, and outperformed the rest of the market. Equity investors are making a bet that the credit market has got it wrong.

The credit market may be at levels that cannot be justified by the fundamental outlook for defaults: its investors have difficulty raising liquidity; many need to clean their balance sheets; there are unprecedented worries over various structured credit products, many of which did not exist during the last downturn in the credit cycle; and the problems of the monoline bond insurers create further uncertainty.

One has to sympathise with this last: we are in a situation at the moment where most of many instruments credit spread is compensation for factors other than default, prominent amongst them the cost of financing the position, the possible future volatility of the position, and the liquidity risk of the position.

This leaves some serious issues with equity/credit (aka capital structure arbitrage) models though. The vast majority of these models are based on the assumption that the credit spread is (risk neutral) compensation for the probability of default, and that equity is (some kind of) option on the value of a company struck at the face value of the liabilities. Given these assumptions and a few more besides, a connection between equity prices and credit spreads is established. But if there is a systematic component to credit spreads which varies strongly with time then most of these models are some trouble. And certainly their predictions earlier in the year wouldn’t have ensured career success. As Dizard puts it:

Let’s say you decided at the beginning of the year, with what was left of your limited partners’ capital, to bet that the price of risk in both markets will converge. So, you go short a basket of stocks of investment grade companies, and simultaneously buy the CDX.IG, the index of investment grade credits. However, since, historically, stocks in the form of the S&P 500 are seven times as volatile as the CDX.IG, you levered up the CDX at the multiple required to have a hedged position. Unfortunately for you, in the first week of February, the CDX moved (down) one fourth, not one seventh, as much as equity, as dealers stopped providing liquidity. So your position just died and went to money heaven.

Leaving aside Dizard’s hedge ratio calculation – which is far too naive – he is basically right. And remember you need models like these for a range of wacky convertibles, too, so this is not just a matter of interest to the CSA funds. If nothing else this little market episode will result in some improvements to equity/credit models.

Update. There is further comment from the FT, based on a report by Goldman, here. Some of the examples given here are fascinating:

In the first three weeks of February, the shares of Swedish truckmaker Scania rose 11 per cent. But the spread on its credit default swaps (CDSs) rose 60 per cent… Over the period, spreads on the 155 names in the iTraxx main index of European investment-grade companies widened 55 per cent on average. The figure for 103 names not on the index – including, for instance, Scania – was 41 per cent.

I am not brave enough to opine for certain which market is right. But it is clear that one of them is wrong. And if it is the equity market, there is a lot more pain to come.

Posted in: Capital Structure Arbitrage, Markets by David /
Comments Off

There will be a fair amount written about the UBS writedown, so I’ll stick with the other part of the story, the mandatory CB it is issuing. This will pay a 9% coupon. Citi on the other hand, is paying 11% on the mandatory issued to plugs its capital hole. Assuming (which is a big leap) that both of them went for par, how do we explain this difference?

Update.To plug its capital hole, WaMu is issueing a perpetual pref convertible into common stock. This is still being priced, but the word is that it will pay a coupon of between 7.5 and 8%. It would be really interesting to get the details of all 3 of these instruments, their levels of subordination, conversion features and so on and put them in a capital structure model. WaMu’s is optional conversion rather than mandatory so it is not immediately obvious how it compares with the Citi and UBS offerings.

Meanwhile Morgan Stanley is paying 9% on its mandatory CB, issued to plug a $5B capital hole after taking a further $5.7B writedown.

Posted in: Capital Structure Arbitrage, Capital and Contingent Instruments, Writedown by David /
Comments Off

There are, if not falling cubes, then certainly some falling knives out there. Indeed the current market gyrations seem to suggest a dislocation between the equity and credit markets as well as a weakening of sentiment. As the often amusing Naked Capitalism puts it:

[...] fixed income types speak of truly grim conditions, of the markets for riskier credits having shut down completely, and concerns that the market seize-up could extend its reach to better quality credits. By contrast, many of the equity market participants sounded relatively sanguine, believing that the credit markets are working through a repricing of risk, but that earning yields are sufficiently high so as to be able to withstand an increase in yields.

Meanwhile according to the FT:

Fear now rules the credit markets, where the effective cost of ensuring against a default, in both Europe and the US, has increased by more than half in barely a month. A steady drip of bad news has prompted fears that the subprime debacle could trigger a credit crunch, raising the cost of financing worldwide as investors are forced to sell healthy investments to make good their losses.

Most recently, the equity markets have shown only modest falls, but credit rationing is in full swing, and spreads have moved out markedly, to the extent that they are visible, from the ridiculously tight levels of the first half of the year.

Now this would all be merely interesting, were it not for capital structure arbitrage. CSA posits a relationship between the equity and credit markets, and CSA funds use models based on this relationship to put on equity vs. credit positions. The first generation of these models were based on Merton’s work or elaborations of it. What I would really like to know is how models like these, calibrated to the conditions earlier in the year, are performing at the moment. To end with the FT again:

…we may well be in the middle of a regime shift

In fact it could even be that the new regime was the last four years or so, and what we are seeing now is a return to more ‘normal’ conditions, albeit one that is proceeding in jumps.

Posted in: Capital Structure Arbitrage, Financial Models by admin /
Comments Off