Credit Funds and Hedge Funds in Structured Credit
Book: Structured Finance and Collateralized Debt Obligations | Author: Janet M. Tavakoli | Publisher: John Wiley & Sons (2008) | ISBN: 978-0-470-44344-6
Chapter 16 maps the ecosystem of vehicles that used structured credit to generate returns. Some were well-run and sensible. Most were not.
Credit Hedge Funds
Credit hedge funds came in many flavors: funds that traded correlation, funds that bought rated CDO tranches and levered them up, funds that made directional bets on corporate spreads across sectors.
The common thread was access to fast cash flow and leverage. Tavakoli is not impressed by the skill claims. She writes that what “multistrategy” usually means in practice is making bets wherever leverage and fast income are accessible.
Hedge funds specializing in structured credit were major buyers of equity tranches of subprime CDOs, particularly the long equity/short mezzanine trade. They fueled the bubble and became part of the crunch when things fell apart.
How Hedge Funds Used Structured Credit
At the end of 2005, hedge funds could participate in investment-grade corporate index risk. The first 0 to 3 percent tranche of a 100-name index didn’t pay much up front. But the first 0 to 10 percent tranche on high-yield debt? Up to 90 percent of notional paid up front, for a five-year horizon. Investment-grade names ran 85 to 88 percent.
Getting 85 to 90 cents on the dollar immediately sounds great. It is a massive cash injection. Tavakoli points out that hedge funds often did this “with very little fundamental credit analysis of the underlying names.”
Some banks also created bespoke structures where hedge funds would receive “two times recovery” – meaning if the actual recovery rate was 50 percent or higher, the hedge fund took no loss. Sounds like a free lunch. These structures created obvious incentive problems in how the underlying portfolios were constructed.
IO and PO Tranches: The Inducement Structure
By 2006 and 2007, banks had trouble selling the first-loss risk of CDOs backed by subprime collateral. So they got creative.
They offered hedge funds an IO/PO structure. A hedge fund paid 5 percent of the preferred shares’ value – issued as an original issue discount (OID) – for the right to purchase the interest-only (IO) tranche. The preferred shares would almost certainly be worthless. That was the cost of admission.
The payoff was the IO tranche: the right to excess interest spread from the deal. Deals stuffed with risky collateral generated lots of interest. IO and PO tranches would start receiving principal payments within months of closing, often both of them being largely unfunded.
The result: a hedge fund paid 5 percent of essentially nothing for the right to receive a fast stream of interest and principal payments from the riskiest possible collateral. The other investors in the CDO were left holding the bag.
Limited Purpose Finance Corporations
The well-run version of the offshore credit arbitrage vehicle is called a limited purpose finance corporation (LPFC). As of the book’s writing, only two had that designation: the Sigma and Theta funds managed by Gordian Knot.
These funds had operated since the 1980s under simple principles: invest only in high-grade assets, actually vet the underlying credit quality rather than relying on ratings, avoid market value triggers that could force liquidation during a crisis.
Sigma and Theta had zero subprime exposure. They consistently turned down overrated deals. Their equity investors had never experienced a loss.
Gordian Knot eliminated market value unwind triggers after Long-Term Capital Management collapsed, recognizing that forced sales in a distressed market punish sound assets along with bad ones. This was smart. Fitch tried to put them on negative watch for removing those triggers, before eventually conceding.
Structured Investment Vehicles
SIVs and SIV-lites were the LPFC concept without the discipline.
SIV-lites issued short-term asset-backed commercial paper and invested in longer-dated “triple-A” paper. The problem: much of that triple-A paper consisted of subprime CDO tranches that were overrated from the start.
In July 2007, a Moody’s analyst called SIVs “an oasis of calm” as the CDO market was beginning to panic. He reasoned that SIVs invested in triple-A and double-A rated debt, so their ratings would be stable.
What he missed: the rating agencies were actively downgrading the very assets the SIVs held.
When investors lost faith in the underlying ratings, SIV-lites couldn’t roll their commercial paper at maturity. They drew on their bank liquidity lines. Eventually, banks had to bring SIV assets onto their own balance sheets. This created capital constraints at precisely the worst moment.
Credit Derivative Product Companies
CDPCs were entities that sold credit protection on highly rated underlying credits. They could employ leverage as high as 85 times. Their triple-A ratings depended on their portfolios staying triple-A.
Primus Financial Products and Athilon were among the first, both launched 2004 to 2005. By early 2007, Moody’s had 24 CDPCs awaiting ratings.
Primus initially focused on investment-grade single-name corporate protection. By late 2005, they decided to expand into protection on ABS and subprime-related products, declaring it a “high-growth sector.” Meanwhile, hedge funds like Paulson and Co. were shorting the same market as soon as ABX indexes made it easy to do so in early 2006.
By end of 2007, Primus had $20.4 billion in credit default swaps outstanding, 19 percent of its underlying ABSs had been downgraded to junk, and it was having trouble raising new debt. Further downgrades threatened technical default.
Collateralized Fund Obligations
CFOs use hedge fund interests as the collateral for a CDO structure. A fund-of-funds manager issues notes backed by a diversified portfolio of hedge fund investments.
Rating agencies tried to apply CDO methodology to this asset class. The structural protections needed to be much larger: equity subordination of 30 percent or more, with AAA tranches making up only 40 to 45 percent of the deal. Monthly mark-to-market tests. Volatility triggers. Overcollateralization tests.
The equity tranche was often retained by the manager. Combined with cheap CDO funding versus prime broker rates, the manager effectively had leverage on leverage.
Tavakoli’s summary: “It would be the ideal hedge fund product: leverage upon leverage with financing to create further leverage.”
That sentence is not a compliment.
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