Spread: The fixed fee on those swaps is called the spread. In the same way that a bond price rises when its yield falls, when the spread falls, the value of a credit default swap to someone who has previously sold protection becomes more valuable.
Indexed: A third party puts together a seemingly diversified (or focused) list of companies so that investors can invest in a liquid pool of similar companies that they want exposure to, whether that's on a debt, synthetic or equity basis.
Setting the Stage
The Indexed Synthetic CDO market rallied until March 2005. In most cases, the more risk an investor took, the better that investor did. The indices were rallying, and those willing to offer protection against the default of a wide number of corporations were willing to do so at smaller and smaller spreads. As I have said previously, those spreads were too small to compensate for the possibility and severity of losses.
Also, until March of 2005, the decline in spreads was fairly uniform. There weren't many credits within each index that were not moving in tune with the rally. This was significant, because it meant that results were particularly good for the "first loss" investors. What hurts "first loss" investors are credits going into default. If the spread on the index as a whole improves (goes lower), but a small minority of credits diverge (get wider) and then default, the "first loss" investor can get hurt, while investors with greater loss protection can still do well.
What Happened Last Week
Last week, not only did spreads rise in general, but some credits related to the auto and auto-parts industries widened disproportionately. This wouldn't have been such a problem, except that a large number of hedge funds participated in the Indexed Synthetic CDO market doing an esoteric arbitrage trade, where the hedge funds went long the "first loss" piece and short 2 to 2.5 times the "second loss" piece. This trade was sometimes called the "correlation trade."
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 david.merkel@thestreet.com.
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.
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