2. 2007-2008 financial crisis Lowest Interest rate in forty years Many home loans were sold to major investment banks Investment banks – Securitized into CDO’s and sold to investors.
4. CDO Securities backed by a pool of fixed income assets Consists of CLO’s, CBO’s and RMBS Provide liquidity as traded daily on secondary market Pay slightly higher interest rate than corporate bonds
5. CDO is complex and costly process Enables a bank to design loans to homeowners to make more loans as bank can sell loan to third party Bank can originate more loans and fees Many CDO’s became liquid due to size, investor breadth and rating agency coverage
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8. Waterfall Portfolio of 300 mn (BBB) 240 mn of AAA, paying LIBOR +54bp {5.7 mn} After deduction of expenses & hedging cost 7.3 mn Annual Cash flow of 12.7 mn @ 4.25 26 mn of AA, paying LIBOR +79 bp {1 mn} 14 mn tranche of equity {return of 40%} In case of 3 mn loss 20 mn of BBB, paying LIBOR +275 bp{0.6 mn} 5.4 mn 2.4 mn If reinvested Reserve Account If not Equity holders
9. LBO (Leveraged Buyout) The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital
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11. Junk Bond A bond rated 'BB' or lower because of its high default risk. These are usually purchased for speculative purposes. Junk bonds typically offer interest rates three to four percentage points higher than safer government issues.
13. Rating Agencies Help bringing liquidity to CDO market as per following reasons : Analyzed each tranche of a CDO and assign ratings accordingly Used historical models to predict risk Limited Manpower Had to allocate risk to appropriate tranche and understand correlation of loans
17. Magnetar Founded in 2005 Magnetar Capital-Return 25% in 2007 Considered its return as one brilliant strategy Strategy-certain tranches of CDO(collaterlized debt obligations) were unsystematically mispriced Unaffected with the subprime market held up or collapsed
18. Magnetar Structured Finance Arbitrage Trade Made profit –By equity tranche of CDO’s and derivative CDO instrument relatively mispriced Bought less risky CDO equity and credit default swaps(CDS) protection on tranches Performed its own calculation of Risk for each tranche and compared that with the return that the tranche offered
19. Magnetar Structured Finance Arbitrage Trade Results showed –Two classes of securities had very similar risks but significantly different yields Bought CDS on mezzanine tranche and long position on Equity
20. Peloton Founded in 2005 Top performer in hedge funds in 2007 Became bankrupt after one month of getting two prestigious awards-at Black tie euro hedge ceremony
21. Peloton Fall Strategy Shorted the US housing market before subprime crisis and was profited Misunderstood the subprime crisis Went long for AAA-rated securities backed by Alt-A mortgage loans UBS downgraded its Alt-A backed securities Market went down leading to margin calls No support from investors and banks due to conflicts in views
23. Leveraged Profit The investors purchased the senior tranche of CDO yielding LIBOR +50 bps By leveraging by 25x earned a return commensurate with equity tranche or LIBOR +1250bps.
24. Bank Debt & Cov-lite Loans Fueled by leveraged buyout boom Corporate bank debt allowed companies to operate with no maintained or interest coverage ratio LBO firms demanded loose terms Lenders passed on the weak cov-lite loans Investors analyzed at summary level
25. Bank Debt & Cov-lite Loans Rating agencies gave false sense of security Bank loan and leveraged securities prices fell Investors believed that the default rates would hit higher level that in 1930s and would stay there till maturity
26. Covenant - lite Loans The current cov-lite loans were traded heavily Was thought to have limited near term default as companies ran until cashless The Cov-Lite were traded heavily as compared to Cov-heavy loans The nominal coupons were less on cov-lite as compared to cov-heavy loans
27. Default Rate and Recovery Rate Discount Rate to justify Cov-Lite Valuations
28. Arbitrage – Bank loans and Bonds Yield on secured cov-lit bank loans and compare it with unsecured bonds of same company If yields are close, trading opportunity exist More risk the company wider spread gets
29. Arbitrage – Bank loans and Bonds Difference of recovery rate on various securities Default rates were identical because issued by same company Bank debt had pressure of selling as held in large by investors. Whereas, bonds did not