On the Edge of Efficient Markets

The Epicurean Dealmaker

is on a roll. The anonymous banker (you can tell he’s a banker, because he copyrights

his blog entries), had a great

piece up yesterday on Bob Merton, derivatives, and risk.

All the wonderful risk transfer instruments that have been developed over

the past several years—credit derivatives, total return swaps, collateralized

debt and loan obligations, etc., etc.—have not eliminated one iota of

risk in the global financial system. They have merely spread it around, presumably

more efficiently, to the investors who want to hold it.

Some people argue that this broad-based, system-wide transfer of risk has

indeed made the world’s financial markets safer and better able to withstand


But can we say that systemwide risk has indeed been reduced? To say that convincingly,

you would have to argue that the hedge funds and others buying credit risk

are somehow "better owners" of such risks; that in fact traditional

balance sheet lenders were inefficient holders of credit risk, and hedge funds

know how to price credit risk better than commercial banks. But is this true?

I for one find it hard to believe that a collection of ex-Wall Street bond

traders and fixed income quants—who are the guys buying this stuff for

hedge funds nowadays—actually have superior credit skills than the green

eyeshaded legions at JP Morgan, Citibank, and Bank of America who used to

originate and hold corporate debt.

This is especially germane in light of a rather scary article by David

Wigan of Reuters on the correlation trade. The riskiest parts of the CDO

and CDS markets are trading at ridiculous levels, it would seem:

Much of the focus is on so-called equity risk, in which investors offer

to insure the first 3 percent of defaults on a portfolio of 100 to 150 companies.

Such is the level of demand that the upfront cost of five-year equity RISK

on the iTraxx index of credit default swaps has fallen in 18 months from around

26 percent of the value of the insurance to 8.6 percent.

The market is basically making two bets, here: firstly, that if most companies

stay out of trouble, then any given individual company is going to stay out

of trouble. That’s the "correlation trade". And secondly, there’s

the bet that most companies are going to stay out of trouble.

The problem is the private equity boom, where buyouts invariably come with

massive new leverage. One or two of those buyouts are bound to go sour — and

when that happens, in the best case scenario, the people making these correlation

trades are going to lose a lot of money. In the worst-case scenario, a couple

of big defaults trigger a credit crunch which leads to a lot of defaults,

and everybody loses a lot of money.

The Epicurean Dealmaker has also managed to unearth

a gem of an SEC filing today, from Houston-based air freight forwarder EGL,

Inc. The founder, Jim Crane, tried to take the company public

at $36 per share, but was outbid by a rival private-equity shop willing to pay

$47.50, and is now blaming one of his lieutenants, accusing him of, essentially,

being a spy for the opposition. Rather than celebrate the fact that he’s getting

a much better deal for his shareholders, he’s threatening all manner of "legal

action for damages and other relief" instead. Concludes our blogger:

The EGL take private is a nifty example of how private equity can indeed

do the right thing by existing public shareholders in a situation where entrenched

management can potentially deter competing bids.

But what if doing the right thing involves hiring a mole in the target company?

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