Epicurean Dealmaker explains why I’m a bit too sanguine about the prospects
for the CDO market: it all comes down to margin calls. All it takes is one CDO
getting liquidated at prices substantially below market, he says, and "all
hell breaks loose":
First, the prime brokers reset their hedge fund clients’ margin requirements
to match the current lower market prices. Bang! First margin call. Second
(or simultaneously), the bank resets the input expected volatility in its
VAR model to reflect the new, more volatile behavior of the securities. Bang!
Second margin call. All of a sudden, a hedge fund that was sitting fat and
happy with a portfolio of nicely behaved CDOs on its books is looking at a
huge margin call and usually no way to meet it without liquidating securities.
Oops. Fire sale, look out below.
All this is a definite possibility, and I’d never say that this kind of vicious
cycle can’t happen. It can, and it might. But then again, it might not.
Why am I not convinced? Four reasons. Firstly, I’ve seen what’s
happened in practice with Bear Stearns’ High-Grade Structured Credit Enhanced
Leverage Fund. We still don’t know the endgame to that story, but we do know
that $7 billion of leverage got brought down pretty painlessly to $1.2 billion
in leverage without any fire sales and without any bailout from Bear itself.
Clearly, there are non-fire-sale solutions to these kind of problems.
Secondly, there are two very different types of leverage employed by hedge
funds and other owners of CDOs. One is the kind of prime-broker leverage that
our anonymous dealmaking blogger is referring to. And then there’s the kind
of leverage that hedge funds and other investors find in the wonderful world
of credit derivatives. Many CDOs and hedge funds are loaded up with CDSs: credit
default swaps which bring in a certain income unless and until underlying credits
start defaulting. And when hedge funds write credit protection, they don’t have
to put up margin in the same way they do when they borrow cash money. For that
reason, CDSs are a popular way of leveraging your exposure to a certain credit,
and they also don’t suffer from the same margin-meltdown risk that normal loans
carry.
Thirdly, I think that the move from public and transparent markets to private
and opaque markets is more than a blip. CDOs are in the middle: they’re public
and opaque. Where do they move from here? One possibility is that they snap
chaotically back to being public and transparent. But the other possibility
is that they move in the other direction, and become private and opaque: that
would involve being snapped up by pools of private capital which don’t mark
to market and which can invest with a long time horizon. Those pools are already
being formed, and they could prove to be very popular.
Finally, I wonder whether banks are quite as rule-bound as the epicurean dealmaker
imagines. Take another look at the attempted liquidations of Bear Stearns’ funds’
assets. Prime brokers seized, them, put them out to bid – and then, in
the end, didn’t sell them. Why not? If the market price is ever and always superior
to the model price, then the prime brokers should just accept the best bid,
and sell as much as they can at that level. But mark-to-market is not always
the best way of valuing something as complex and illiquid as a CDO. If trillions
of dollars of CDOs have been sold in the primary market, does it really make
sense to revalue them all on the basis of two or three small trades in the secondary
market? Besides, all CDOs are different, and the vast majority of them don’t
trade at all, which means that there’s literally no market for them to mark
to. I suspect that if marking CDOs to market becomes a real problem in the prime
brokerage community, then they might end up not marking CDOs to market.
In the 1980s, banks around the world sat on hundreds of billions of dollars’
worth of defaulted sovereign debt, while carefully making sure never to mark
it to market. Banks are good like that: they know when to recognise reality
and when not to. If the A-rated tranches of CDOs start defaulting unexpectedly,
then at that point it makes sense to mark down their prices. But at the moment
default rates are still incredibly low, which should give banks and investors
the ability to muddle through, somehow.