Saturday, 15 March 2008

Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – (7)

For arbitrage to be possible, there must be a difference in rates; the larger the difference the bigger the arbitrage profit. Differences in rates are due to either the variation in tenor (time to maturity) or credit quality. To maximize its profit, speculative capital sets to borrow at the lowest short term rate and use it to buy highest-yielding, longest term asset.

The superlatives "lowest" and "longest", nota bene, do not pertain to a logical or mathematical extreme; speculative capital is too pragmatic to chase abstractions. Rather, they connote a practical consideration: speculative capital strives to create and exploit the widest borrowing-lending rate differential doable.

The lowest short term rates are available in the commercial paper (CP) market. The rates are low precisely because the CP market is accessible only to highest rated corporations. Speculative capital is, alas, nomadic, with no corporate lineage and a short engagement horizon. Like a mule, it has neither the pride of ancestry nor the hope of future to offer to lenders. Consequently, it seems to be hopelessly shut out of the CP market.

Then, mustering its will in the form of everything structured finance wizardry could offer, it finds a way and calls it Special Investment Vehicle—notice “vehicle,” as in a means of “getting there”. In an SIV, all the necessary requirements for arbitraging CP-CDO rates are brought together:

1. The first and foremost is the concern of CP investors—the lenders—about the creditworthiness of the SIV. Without satisfying them, there would be no money. The concern is addressed, in consultation with the rating agencies that will rate the vehicle, through multiple provisions:

  • i) Pledged assets: CDO asset is pledged to lenders as collateral;

    ii) Marking-to-market and price triggers: Collateral is marked-to-market and automatic triggers are put in place to force sell the asset should the price drop below a comfort level.

    iii) Bank liquidity lines: As the final line of defense a bank provides a guaranteed liquidity line to compensate for any short fall in the securities price.

2. The asset to be purchased is CDO because:

  • i) It has familiar form, similar to a mortgage-based security (MBS), with an established origination and distribution network;

    ii) it offers the highest rates and is at the same time acceptable as collateral to CP investors.

We are familiar with this structure. It is the option that Arbitrageur pitched to Lender. Here, the relatively small sum that the “qualified investors” put into the SIV is the option price—the $5 in our example—which gives them the right to default should something go wrong with the asset. The asset is the CDO, CP buyers are the lender and the SIV manager is the arbitrageur.

The SIV is a legal structure, so it include hundreds of details, from loan covenants to bank obligations. These details, while critical in their own right, do not concern us. The most critical component of SIV is its CDO asset.

A CDO is a security created by combining a pool of cash flows, typically mortgages. The pool is divided into various tranches, from the most highly-rated “super senior” to the riskiest “equity piece.” This structure is very similar to collateralized mortgage obligation (CMO) which has been around since the early 1980s. So, why CDO and not CDO? What is the difference between these securities?

This point is critical to understanding the modus operandi of speculative capital which lies in the root of current crisis. We need to take a short break to get ready for it.