Tuesday, February 13, 2007

Excellent analysis of collateralized debt obligations

can be found at Will the CDO Machine Destroy Public Equity? by Christopher Whalen at seekingalpha.com. The key to this analysis is the author's statement that the "credit derivative markets are telling you that the risk premium for many issuers is zero or even negative.." Whalen backs up this assertion with a couple of examples including this one:

"F (Ford Motor) five-year credit default insurance is trading inside the yield on five-year F unsecured debt. This means that you can buy the F debt, purchase CDS coverage, and lock in a risk-free spread of almost a point on the trade -- even if the automaker were to eventually file bankruptcy."

Of course it is absurd to consider that any public company debt is less risky than US Treasuries. Whalen elaborates on how this state of affairs has come to pass by quoting a source thus:

"One senior risk manager told us months ago that the existence of negative basis trades in the CDS market is attributable to sheer avarice on the Sell Side and stupidity on the Buy Side. That is, too many CDO deals using too much leverage to fund too many going private transactions bought by too many hedge funds."

That sounds about right to me. The basis for Whalen's title is the idea that a lot more public companies could be taken private because debt is cheaper than equity right now. Eventually, a bunch of these highly leveraged entities are not going to be able to meet their debt obligations and that is when we'll see the "macro market risk event" that Whalen refers to. In other words, a lot of hedge funds and others will take it in the shorts.

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