LO 53.3: Identify reasons for the failure of the long-equity tranche, short-

LO 53.3: Identify reasons for the failure of the long-equity tranche, short- mezzanine credit trade in 2005 and describe how such modeling errors could have been avoided.
Credit Trade Description and Modeling Issues
Volatility in credit markets in the spring of 2005 caused significant modeling errors from both misinterpretation and incorrect application of models. Trades incurred losses as only certain dimensions of risks were hedged, while others were ignored.
A popular strategy in credit markets for hedge funds, banks, and brokerages was to sell protection on the equity tranche and buy protection on the junior (mezzanine) tranche of the CDX.NA.IG index, the investment-grade CDS index. As a result, the trade was long credit and credit spread risk on the equity tranche and short credit and credit spread risk on the mezzanine tranche. The trade was primarily executed on the IG3 and IG4 index series. The trade was designed to be default-risk neutral at initiation with equal credit spread sensitivities on the two legs. The motivation of the trade was to have a positively convex payoff profile with the two positions benefiting from credit spread volatility, while earning a positive net spread on the positions (positive carry). This allowed trades to have a position similar to delta-hedged, long option portfolios by receiving, rather than paying, time value.
The hedge ratio for the delta-hedged portfolio then determined the dollar amount of the mezzanine to be shorted for every dollar of the long equity. In other words, the hedge ratio was the ratio of the profit and loss impact of a 1 bp widening of the CDX index on the equity and mezzanine tranches. The proper hedge ratio then allowed for the creation of a portfolio based on the CDX index that, at the margin, was default-risk neutral. The CDX trade benefited from a large change in credit spreads and essentially behaved like an option straddle on credit spreads with an option premium paid to the owner of the option. The hedge ratio for the CDX index was around 1.5 to 2 in early 2005, which resulted in a net flow of spread income to the long equity/short mezzanine trade.
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Topic 53 Cross Reference to GARP Assigned Reading – Malz, Chapter 11
The critical error in the trade, however, was that it was set up at a specific value of implied correlation. A static correlation was considered a critical flaw as the deltas that were used in setting up the trade were partial derivatives that ignored any changes in correlation. With changes in credit markets, changing correlations doubled the hedge ratio to close to 4 by the summer of 2005. As a result, traders now needed to sell protection on nearly twice the notional value of the mezzanine tranche to maintain portfolio neutrality. Stated differently, as long as correlations remained static, the trade remained profitable. However, once correlations declined and spreads did not widen sufficiently, the trade became unprofitable.
Therefore, while the model did not ignore correlation, it assumed a static correlation and instead focused on anticipated gains from convexity. The error could have been corrected by stress testing correlation or by employing an overlay hedge of going long, single-name protection in high default-probability names.
Credit Market Example
Problems in credit markets were already evident by the spring of 2005. The problems were largely related to the automobile industry, specifically the original equipment manufacturers (OEMs), including Ford, Chrysler, and General Motors (GM), which had been experiencing troubles for some time. OEMs were particularly important in the U.S. investment-grade bond market, and the emerging threat of a downgrade to junk status rattled markets. Although the OEMs were not directly part of the CDX.NA.IG index, several of their related finance companies were. Outside of OEMs, several auto parts manufacturers were included in two series of the index, the IG3 and IG4 indices.
The immediate priority of the OEMs in early 2005 was to secure a relief from the United Auto Workers (UAW) union of health benefit commitments to retirees. When GM and the UAW were unable to reach an agreement in the spring of 2005, which coincided with the announcement of large losses for GM, GM and Ford were downgraded to junk status by S&P and Moodys. This created a sharp widening of corporate spreads, including the spreads on the automotive finance companies and other industry names. Several auto parts manufacturers filed for Chapter 11 bankruptcy protection. As a result, the market was now anticipating the possibility of defaults in the IG3 and IG4 indices, and the probability of extreme losses became real. In addition, the convertible bond market was also experiencing a sellofif that resulted in widening of spreads. The IG indices widened in line with the credit spread widening of the index constituents. The mark-to-market value and the implied correlation of the equity tranche dropped sharply. The implied correlation fell given that (1) the auto parts supplier bankruptcies were in the IG4 series, which led to close to 10% of the portfolio now close to default, and (2) the widening of the IG4 series was constrained by hedging, which led to a fall in correlation. Participants could hedge short credit positions in the equity tranche by selling credit protection on the mezzanine tranche or the IG4 index series. Concurrently, the mezzanine tranche saw a small widening as market participants were covering their positions by selling protection on the mezzanine tranche (that is, they were taking on credit risk). These events led to the unwinding of the equity/mezzanine tranche trade with the relative value trade experiencing large losses.
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2018 Kaplan, Inc.
Topic 53 Cross Reference to GARP Assigned Reading – Malz, Chapter 11
R i s k U n d e r e s t i m a t i o n i n 2007-2009

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