Sunday, January 25, 2009

Was Merrill Casualty #3 of The Basis Trade After DB Prop and Citadel

By Tyler Durden at Zero Hedge:

In a bet gone very bad, that if true would make Jerome Kerviel's $5 billion loss at Soc Gen seem like amateur hour, the WSJ reports ($$$ link with hat tip to that the main reason for Merrill's massive $15 billion Q4 loss was due to some very large basis trades gone horribly wrong. We wrote briefly about the basis trade here but now with attention turning more firmly to this topic, it is worth revisiting.

Before we get back to what potentially could be the culprit for over $30 billion in prop trading and hedge fund losses last quarter in all of Wall Street, let's reexamine the basics. As we mentioned previously, at its core, a basis trade is a hedged position where an account buys a bond (let's say with a 5 year maturity) and hedges it with a matched-maturity (or comparable duration) Credit Default Swap. In this way, the account is completely insured from default risk on the bond purchased since if the underlying company that issued the bond were to file for bankruptcy, the account would lose the principal value on the bond but would pick up the recovery from the CDS, ending up with a 0 net gain/loss at the time of default event (CDS settlements can be physical or cash as defined by the CDS OTC-clearing authority ISDA, we will write more about this at a later date).

When an account buys the bond, one also receives the cash flows associated with the coupon on the bond; when hedged in a basis trade, as CDS has a "negative coupon", or the quarterly payment associated with paying for the "insurance", the net recurring cash out/inflow to the account is known as the "basis." In the good old days, the basis would be usually positive, meaning that to hedge a position perfectly, there would be some, usually very minor quarterly cash outflow, usually to the tune of 5-10 bps on the entire notional exposure. Again, in the good old days, a "negative basis" was rare to find - these are positions that for whatever technical or fundamental reasons, would be net cash positive. In other words, an account would have no default risk thru the bond's maturity, and would be compensated to have it put on the books. It would be rare to find negative bases of -10 bps, so hedge funds and prop desks would immediately snap these up as they became available in the market and usually lever them up dramatically, sometimes to the tune of 100-to-1, using a gullible Prime Broker or other synthetic instruments, and end up with anywhere from a 5% to 10% risk free annuity for years.

Another basis trade 101: When looking at the basis of a bond and match-maturity CDS, the most relevant bond metric is its Z-spread, or the spread to Libor, not the more traditional spread to comparable treasury. When comping bonds and CDS, one cares mostly about the bond's Z-spread as that gives the most appropriate reference of whether the bond trades rich or cheap vis-a-vis a CDS. This is because a CDS spread is also relative to the appropriate metric on the Libor curve, not relative to Treasuries.

So back to the basis: the problem with the whole "risk free" concept is that it made one major assumption - that liquidity would be essentially infinite. As the Bear Stearns implosion and the Lehman bankruptcy showed, this is one assumption that would be promptly crushed, and would lead to dramatic aberrations in the basis trade. One major issue was the availability of CDS, or rather lack thereof, to hedge cash bond positions. As prime brokers rushed to conserve liquidity, they made it virtually impossible for accounts to take advantage of dropping bond prices, and increasing Z spreads. They did this by exponentially increasing funding costs on CDS: traditionally the margin requirements on CDS would be in the sub 1% range; after Lehman some counterparties raised the margin requirements as high as 20%, and others even asked for the whole margin to be paid up front. On a $10 million CDS position, which traditionally would only have cash outflows every quarter to fund the quarterly insurance payment, all of a sudden accounts would have to pony up to $2 million in margin just to put a trade on (or keep it on, leading to many basis forced unwinds). Of course, this made it prohibitive for many but the largest hedge funds to participate in the heretofore extremely liquid CDS market, thereby creating phenomenal dislocations and the great arbitrage of negative basis trades that would create 5%-10% and on rare occasions even 15% unlevered returns!

As this can be a handful to swallow at first, we have presented this graphically. We chose to demonstrate the negative basis trade currently available in CIT Group's 5.0% Notes due 2/2014, which we match with CIT 5 year CDS due March 20, 2014. On the graphic below, it is evident that the basis had been gravitating around zero for a while, initially starting off as positive around the time JPM was taking over Bear, then was roughly 0 for several months, but then became dramatically negative the day after Lehman filed. In fact the spread went from 0 to almost 1,500 bps (or 15%) almost overnight! And in the subsequent liquidity constrained market, the basis spread has fluctuated all over, and is currently roughly -500 bps.

This is just one example: most high yield and cross over names currently represent negative basis opportunities: some interesting outliers include Marriott Hotels, Home Depot, Temple-Inland and Omnicom, all of which are BBB- (or higher rated) credits yet present negative basis opportunities of 300 bps and wider. We would be very cautious with blindly purchasing these bases, as the liquidity premium in the market will likely be a key concern for along time, and as long as that is the case, there is no reason why the basis trade should collapse. In fact, if there are any more risk flaring episodes and liquidity becomes even more valuable, these spreads are likely to blow out to even wider levels.

So back to our original topic. How could Merrill lose $15 billion on basis trades? And not just Merrill: Boaz Weinstein's group at Deustche Bank lost over $1 billion on this same trade, and basis trades are the main reason why Citadel has lost over 50% in 2008. Anecdotally, basis trades on CDOs are the reason why AIG, and most of the U.S. insurance industry is in its current deplorable state.

How would one go about estimating the P&L impact to these asset managers? It is not difficult: as the basis explosion resulted in a mismatch of DV01, or dollar equivalent change in 1 bps point in both bonds and CDS, or, netted out via the basis trade itself, one can calculate what the adverse MTM impact was on any notional position. If we take the CIT example above, and we assume that Merill had a $10 billion notional basis position in the name (this is an oversimplification but it was probably true for their overall basis portfolio), and the spread blew out from 0 to 1,500 bps around the time of the Lehman events, Merrill would have experienced a roughly $6 billion hit on the position (an average DV01 of $4MM), which implies that a $15 billion loss could have been created as simply as experiencing a blow up on $25 billion on basis trades. And this assumes no leverage which is naive for the prop desk model: if ML had leveraged its prexisting basis trades even 10x, the total basis trade notional needed to create this loss would have been only $2.5 billion. Is it inconceivable that ML had $25 billion in basis trades? Not at all - after all they were a preeminent CDS trading powerhouse and had one of the most active basis trade prop desks.

This is merely another amusing anecdote of what happens when you have a very popular trade in which everyone had piled in, from hedge funds to prop desks to insurance companies, and one of the assumptions that had been taken for granted disappears i.e., liquidity. The outcomes are only now starting to emerge: so far they have cost the jobs of John Thain (while we are amused by his office decoration choices, if he had not lost $15 billion in Q4, we are confident he would still have his job), "prodigy trader" Boaz Weinstein, and soon possibly Ken Griffin. It seems nobody ever learns from the Black Swan parable even though Nasim Taleb has been pounding the table on this for over 2 years now. Just as the Volkswagen short squeeze caused Adolf Merkle his life, and many hedge fund managers their jobs, every time you encounter this type of overhyped, "hedge fund hotel"-type trade, you will inevitably see casualties.

We at Zero Hedge would venture to surmise that the current bubbly purchasing of Treasuries and corporate loans will be the cause for the next 2 black swan events. We do not know in what form yet (by definition), but would caution all investors from getting involved at this point.

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