The Correlation Trade Gone Wrong

Because of the market dislocations last week, I want to give a primer on the class of derivatives that really jolted the markets this week: Indexed Synthetic CDOs.

Indexed synthetic CDOs gather together the risk of debt default for a group of corporations, and parcel the risk of default out in a concentrated form to those who hold the "first loss" certificates, in exchange for a high yield. Those who hold other certificates in the loss priority get lesser yields commensurate to the risk of taking losses. This is an arcane area of finance, so let's start with key definitions:

Collateralized Debt Obligation (CDO): A trust that owns bonds, loans, or credit default swaps. The ownership in the trust is hierarchical. There are several classes of certificates that have different interests in the trust, which get defined by which class receives losses from defaults first, second, third, etc. The earlier that a class (or tranche) receives losses if they occur, the higher the yield a class of certificates receives.

Synthetic: A term used in opposition to "cash." One who transacts in corporate bonds participates in the cash market. The synthetic market in corporate credit is composed of credit default swaps. It is called "synthetic" because it transacts in corporate credit risk without making loans to corporations.

Credit Default Swaps: A market participant who buys default protection on a given corporation through the credit-default swap market gains the right to deliver a certain amount of defaulted bonds in exchange for the par value of the bonds when an event of default occurs for the class of bonds covered by the agreement. In exchange for this privilege, the buyer of protection pays the seller a fixed fee for the term of the swap, which is usually five years, but can vary.

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David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. At time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to [e-mail].

Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.

Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.