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| Latest winner, source: Zero Hedge |
A look at the “Death Star” and why the Germans don’t like it.
Quest post by Macronomy:
Surf's up ! Much ado about nothing and CPDO redux in European Style
“No one loves the messenger who brings bad news” - Sophocles in Antigone
So what?
We have an epic rally in the equity space because of some news of a possible plan to leverage up the EFSF, CDO-SIV style? What has materially change today? Not much.
And my good credit friend to comment:
"Another volatile day in the equity market …. On rumors, rumors and more rumors of EFSF, ESM, EIB, ECB …. And overall leveraging of the existing system …. It may make the trick for a while, but I tend to think it will not be long before Mr Market rejects that “too complicated to work” puzzle."
The plan so far is sketchy at least and fraught with danger.
Why? Because it eerily reminds me of the halcyon days of the structured credit space, namely CPDO structures. A CPDO (Constant Proportion Debt Obligations) structure was a fixed income instrument with cashflows that had a high and rated likelihood of payment, in theory. At least that was the plan, when ABN AMRO launched its 1 billion euro CPDO called SURF in January 2007. Trouble was that the widening wave got too big to surf and SURF 100 got wiped out.
Its death came in October 2008:
"Requiem for the CPDO" - FT Alphaville - Sam Jones
October 13, 2008 (Bloomberg):
"ABN Amro Holding NV had the ratings on three constant proportion debt obligation funds totaling $305 million cut to D by Standard & Poor’s as the transactions were forced to unwind."
So much for the "Deal of the Year" awarded in February 2007 by Risk Magazine...
Sam Jones commented at the time:
"The CPDOs, funds that use credit-default swaps to bet on company creditworthiness, were downgraded because of “spread widening and increasing volatility” in the credit derivatives market."
"CPDOs, a structured finance post-mortem" - FT Alphaville - Tracy Alloway - Februrary 5 2010:
"Remember that these things, which basically used credit-default swaps (CDS) to bet on company creditworthiness, began popping up in the summer of 2006. ABN Amro’s Surf was the first to be issued, with an AAA rating."
Why did I chose to dicuss the CPDO example in relation to the proposal of the leverage EFSF proposal and not a Credit CPPI note?
Here is why:
The Credit CPPI note is an investment whose principal is protected by a low-risk portfolio (zero-coupon bonds or cash deposits) where the return is increased by leveraging the exposure to a risky portfolio of CDS names, when losses are incurred in the CPPI, the SPV (Special Purpose Vehicle) must decrease leverage to protect the principal.
But, when losses are incurred in our CPDO, the SPV must increase leverage in order to make up the increased shortfall in NAV (Net Asset Value), and by the way principal is not protected.
So, in the CPPI you have limited downside and unlimited upside, in the CPDO, you have limited upside and unlimited downside, kind of.
So in our leveraged EFSF play, the lower volatility in interest rates, the lower likelihood of default. But in a CPDO/Leveraged EFSF, there is a risk of failure of repayment of full principal at maturity.
Could it be the explanation for the apparent reluctance of our German friends to leverage/increase the EFSF given their first hand experience with structured credit?
In a CPDO/leveraged EFSF, when multiple downgrades happen, creating significant widening in spreads/higher interest rates, the loss in NAV can be significant.
So what?
We have an epic rally in the equity space because of some news of a possible plan to leverage up the EFSF, CDO-SIV style? What has materially change today? Not much.
And my good credit friend to comment:
"Another volatile day in the equity market …. On rumors, rumors and more rumors of EFSF, ESM, EIB, ECB …. And overall leveraging of the existing system …. It may make the trick for a while, but I tend to think it will not be long before Mr Market rejects that “too complicated to work” puzzle."
The plan so far is sketchy at least and fraught with danger.
Why? Because it eerily reminds me of the halcyon days of the structured credit space, namely CPDO structures. A CPDO (Constant Proportion Debt Obligations) structure was a fixed income instrument with cashflows that had a high and rated likelihood of payment, in theory. At least that was the plan, when ABN AMRO launched its 1 billion euro CPDO called SURF in January 2007. Trouble was that the widening wave got too big to surf and SURF 100 got wiped out.
Its death came in October 2008:
"Requiem for the CPDO" - FT Alphaville - Sam Jones
October 13, 2008 (Bloomberg):
"ABN Amro Holding NV had the ratings on three constant proportion debt obligation funds totaling $305 million cut to D by Standard & Poor’s as the transactions were forced to unwind."
So much for the "Deal of the Year" awarded in February 2007 by Risk Magazine...
Sam Jones commented at the time:
"The CPDOs, funds that use credit-default swaps to bet on company creditworthiness, were downgraded because of “spread widening and increasing volatility” in the credit derivatives market."
"CPDOs, a structured finance post-mortem" - FT Alphaville - Tracy Alloway - Februrary 5 2010:
"Remember that these things, which basically used credit-default swaps (CDS) to bet on company creditworthiness, began popping up in the summer of 2006. ABN Amro’s Surf was the first to be issued, with an AAA rating."
Why did I chose to dicuss the CPDO example in relation to the proposal of the leverage EFSF proposal and not a Credit CPPI note?
Here is why:
The Credit CPPI note is an investment whose principal is protected by a low-risk portfolio (zero-coupon bonds or cash deposits) where the return is increased by leveraging the exposure to a risky portfolio of CDS names, when losses are incurred in the CPPI, the SPV (Special Purpose Vehicle) must decrease leverage to protect the principal.
But, when losses are incurred in our CPDO, the SPV must increase leverage in order to make up the increased shortfall in NAV (Net Asset Value), and by the way principal is not protected.
So, in the CPPI you have limited downside and unlimited upside, in the CPDO, you have limited upside and unlimited downside, kind of.
So in our leveraged EFSF play, the lower volatility in interest rates, the lower likelihood of default. But in a CPDO/Leveraged EFSF, there is a risk of failure of repayment of full principal at maturity.
Could it be the explanation for the apparent reluctance of our German friends to leverage/increase the EFSF given their first hand experience with structured credit?
In a CPDO/leveraged EFSF, when multiple downgrades happen, creating significant widening in spreads/higher interest rates, the loss in NAV can be significant.
Read the rest here
Check Saturday’s massive post or yesterday's "Death Star" special in case you missed it. I updated the UBS rogue trader and the Calendar. Feedback is always appreciated: leave a comment, follow me on Twitter or email me. The MoreLiver's Daily is also now on Facebook.
Quote of the Day: “In America, it’s just 400 people who own as much as most of the rest of us put together – and that when we decide we really want to change the rules of the game, those 400 people won't be able to do squat about it.” – Michael Moore at Occupy Wall Street event (video)
News: Tuesday Watch – Between The Hedges
News: Today's Headlines – Between The Hedges
FX options: Vols, Risk Reversals & Pin Risk – tradingfloor
** Credit Markets – Macronomics
EURO CRISIS
** UBS' Euro Doom And Gloom Team Releases Sequel: "The Eurozone Sovereign Crisis Has Entered A More Dangerous Phase" – ZH
Politicians must do more, but likelihood is crisis intensifies before policy can deliver what is required. Risk scenarios: Disorderly default, EZ exit, Recession. Scribd link to the full report.
** Causes of the Eurozone Crisis (Part 2): Policy Implications – The Street Light
No to being judgmental or austerity, yes to shared responsibility. After the crisis, reduce capital flows, change policy to either support periphery or restrict EZ to core.
“Attacking one of the challenges will not suffice. Each and all must be overcome. And that’s why the challenge seems so overwhelming.”
Monetary policy: Which region needs QE? – Buttonwood’s / The Economist
M2 growth in the euro area is low, compared to U.S. after the Fed’s QE rounds. Europeans thus get lower inflation, lower growth and lower employment.
Dilemma: markets demanding comprehensive and credible plans, but politically such a plan is difficult.
FT Report That Greek Bailout Package On The Verge Of Collapse After Surge In Greek Funding Needs Sends Stocks, Euro Plunging From Highs – ZH
Greek funding hole 109bn two month ago, now 172bn, difference of 63bn, or 360 bn annualized. Zero Hedge: HA HA HA HA.
Misplacing Trust in the ECB – The Source / WSJ
“Death Star” / EFSF
** Leverage: Yesterday's Problems, Today's Solution – ZH
Peter Tchir: “Why is EFSF just not being expanded? Wouldn’t it be easier to just increase the size of the EFSF? It would be, but there is no support to get that done.”
Is it legal, could it fly?
** Analysing the latest battle plan – Macro Man
The plan falls down because it would depend on EIB recapitalization. Good text, clear diagrams. Must-read.
More details on the euro TARP… – Pragmatic Capitalism
“this looks like a start, but not a fix. Like the original EFSF, this plan will have teeth. But let’s not sugarcoat it. This is a kick of the can even if it’s a swift kick”
German turmoil over EU bail-outs as top judge calls for referendum – The Telegraph
Judge: without new constitution & referendum, EFSF cannot be Death Starred.
FDP does not want to hear another word on the Death Star.
"Solidarity Has Its Limits" As German FinMin Snubs Geithner And Downplays Levered EFSF – ZH
Another no to Death Star.
EU Super-Bailout Option Slips Away – The Source / WSJ
EFSF is a Failure for the World – HistorySquared
“The litmus test. Does this solution take power away from the looters, and capital away from the moochers, so that the producers can create something to raise the standard of living of the world? No. It empowers the looters. It enables moochers. It transfers capital away from the producers.”
OTHER
Thinking About Sovereign Bankruptcy – DealBook / NYT
There are no sovereign bankruptcies, only defaults, but should there be?
“Basel III doesn’t go far enough”
.
Unamerican and far beyond – Deus Ex Macchiato
Commentary to the above article