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Tuesday, May 10, 2005

Yo! Junk Bond My Ride

$453 billion of debt ($292 billion for GM, $161 billion for Ford) are in question in a very large, short equity, long credit capital structure arbitrage trade.

Even Linda Lovelace would have said, that's a mouthful...rim pun intended.


When GM shares bounced on Kerkorian's tender, the hedges funds sold, keeping the bonds. But that position was subsequently hit by the S&P downgrade to junk level.

Sources discount two of the hedge funds rumored to be in trouble. Industry sources say GLG "has no long exposure to GM and is of sound financial state." Another discounts Bailey Coates' involvement.

Deutsche Bank shares have been hurt by the talk but speculation of its involvement is fading too, given its record of sound risk management.

Deutsche Bank said it will not comment on rumors that it is exposed to US hedge funds which made big losses after buying GM bonds. 'We do not comment on speculation in the market,' a spokesman said.

Dealers said earlier that both Deutsche Bank and JP Morgan are rumored to be most exposed to the funds 'which are in trouble after getting their fingers burned with GM bonds'.

Potential Exposure

Anticipating a downgrade later in the summer, we commented on this potential back on 04/28, in High Yield Bond Market Time Bomb

A review follows. GM, Ford and their financing arms fall off the Lehman Brothers index of investment grade bonds.

Investors that can only hold investment grade paper because their agreements with clients stipulate this, or because they track the index or even just benchmark it, have to sell the fallen securities.

These include banks, insurance companies and large pension funds. Swamped by large volume, high yield prices collapse.

This hurts investors and increases the cost to companies of raising money in this market. Rumblings of large deals in jeopardy have already been heard as noted in The Games Afoot Series.

Meanwhile, in the credit derivatives markets hundreds of billions of dollars of credit default swaps and collateralized debt obligations (CDO's) linked to GM and Ford begin to come unglued. Everybody hedges like mad and a meltdown more or less occurs.

Market Reaction

So far, cash markets are taking it in stride, as most players have had ample time to unwind their Ford and GM positions. However, the credit derivatives markets are under some strain.

After the GM downgrade, Investment banks stocks slipped and Treasury bonds rose as investors shifted into safe haven assets.

Growing concern about the credit worthiness of GM and Ford has sent the value of the lowest, least secured tranche the so-called "equity" tranche tumbling.

As a result, equity tranche holders (many of them hedge funds) have been scrambling for cover, hedging their exposure. Rumor has it that some funds may be struggling to meet margin calls.

The complex trades made by many hedge funds mean that any troubles, risk drawing in the counter parties, particularly banks, with which they conducted the trades.

Mechanics of the Trade

In a credit default swap, the buyer pays an annual fee and gets paid the full amount insured if the borrower defaults. In return, the swap seller gets the defaulted loans or bonds.

Swap prices typically decline when credit worthiness improves, and rise when it worsens.

The credit default rates are higher than lending rates because banks do not take a short term trading view. They look at the company's credit worthiness, such as its free cash flow.

Hedge funds invest in CDO's to get a better return than in the regular bond market because they offer higher interest rates.

Ford and GM debt have been included in a lot of CDO structures because they trade at wider spreads than similarly rated credits.

Many company's credit default swaps have suffered from the contagion effect of GM as hedge funds buy protection to cover their positions.

Driving on the Wrong Side of The Road

Hedge funds use arbitrage bets, where they bet on several outcomes to increase the chance of being right.

For example, one popular GM deal has been to sell the parent company's bonds, betting on a fall, and buy the debt of GMAC, the financing arm, betting on a rise, because the fortunes of these entities are expected to diverge.

Most arbitrage bets are positioned for a widening or divergence of GM and GMAC. In May 4ths Market Soapbox we noted "if Kerkorian is successful, GM is getting parted out."

Why? Kerkorian will sell the only thing GM and GMAC are good for, GMAC's non core assets. Such as the mortgage business, raising around $28 Billion, then GM will draw the finance unit in closer.

Therefore, we believe that GM and GMAC spreads would converge, rather than diverge.

What will the hedgsters, insurer's and banks involved do then? Can you say major trouble in the financial markets?

You can't say you have not been duly warned. All those ostriches out there, please keep your head firmly in the sand and ignore at your own risk.


At Wed May 11, 02:50:00 AM PDT, Blogger Barry Ritholtz said...

I suspect that a lot of the wrong way arbs (long bonds, short common) have covered already.

Score another point for the Black Swan event!


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