When is a Hedge Not a Hedge?


Pyburn has some numbers on just how much the notorious "super-senior"

tranches of subprime-backed CDOs are actually worth in the market. It’s probably

no surprise that the junior tranches are changing hands in "the high single

digits," but more to the point the super-senior tranches, she says, are

fetching no more than 60 cents on the dollar, which of course corresponds to

a 40% write-down. By contrast, she says, Merrill’s latest write-down was just

19% on its super-senior CDO holdings.

These numbers are scary enough that there’s a serious chance of a domino effect.

Banks for instance were able to hedge their CDO holdings by insuring them against

loss – but now the insurers are at risk of going bust. The titles of two

blog entries on this subject say it all: "So

Much For Being Hedged" and "Another

word for hedged… leveraged".

We’ve already seen something along these lines at Morgan

Stanley, where the "hedge" on its bearish mortgage-bond bet seems

to have been much riskier than the original bet itself. But I have to say that

the Morgan Stanley losses don’t make a lot of sense to me. For all the talk

of "negative convexity", the trade looks as though it was after

all a simple long-senior, short-junior play. If you really wanted to make a

bearish bet on mortgage bonds, why on earth would you fund it with a long position

in mortgage bonds, of all things? Why not use emerging-market debt,

or Treasury bonds, or something – anything – which wouldn’t go down

when mortgage debt fell in value?

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