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Minyan Mailbag: Converts & CDOs

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Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next column with that very intent.

Professor Succo,

Thank you for your excellent columns on the the troubles in hedgie world. It's a shame that as soon as anything more, for want of a better word, complicated than bonds or stocks is involved (just about) nobody in the media seems to have a clue what's going on. FWIW the only people I know who have been making money in convert arb have been doing it Chinese. If you want to look at what's been going on lately I think you also have to look at what's happening in CDO (Collateralized Debt Obligation) land, everyone and their momma had on long subordinate/short mezzanine tranche. The correlation skew steepened, the deltas didn't do what they were "supposed" to do, up on the equity tranche when they were supposed to go down, down on the mezzanine tranche when they were supposed to go up. There was lots of talk of a free lunch there, I guess we should know by now that free lunches in the markets usually aren't so free after all.

Anyway, I'm sure you know all that already.

Thanks again,
Minyan Michael

Michael,

The CDO trade described here is a capital structure trade put on by hedge funds.

The trade is an attempt to take advantage of small price discrepancies between corporate bonds of the same company of different capital risk (senior bonds are first in line to receive back their collateral in bankruptcy; subordinated bonds receive what is left over; and then finally equity holders receive the crumbs if any).

The bet here is that the subordinated bonds are too cheap relative to senior bonds. The price discrepancy is likely small, so heavy leverage will be used (picking up nickels in front of a steam-roller?). This trade will likely also benefit from a general improving of credit in the company.

This trade may have not worked as credit spreads have been stable to a little wider lately. This also may have been a crowded trade and suffered the consequences: everyone trying to get out when it was supposed to have worked.

Regards,
Prof. Succo

No positions in stocks mentioned.

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