Derivatives houses have started buying protection on first-loss tranches of synthetic collateralized debt obligations they hold to offset risk they retained when issuing the senior tranches. Hedge funds have emerged as the main sellers of this protection. When first loss tranches of CDOs, which typically represent the riskiest 3% of a portfolio, were retained by dealers they were so out-of-the-money they did not have much mark-to-market volatility, noted Frank Iacono, senior v.p. in structured credit products at Lehman Brothers in New York. Record spread tightening in credit-default swaps over the past year, however, has moved the positions in the money and in turn made them vulnerable to spread volatility and changes in correlation, he said.
By retaining the first loss tranche of a CDO, dealers are long the correlation of the portfolio. This means they are vulnerable to losses if the names in the portfolio move in a non-correlated fashion, Iacono explained. This is particularly acute if a single name or handful of credits default. Spread tightening of around 60% over the past year has made the equity positions valuable, thus increasingly encouraging dealers to hedge this correlation risk, he said.
In the trades, which are typically entered into with hedge funds, dealers purchase first loss protection and sell single name swaps, added an official. The number of hedge funds executing these types of trade has jumped to around 15 from a handful a year ago. For hedge funds, the trade offers an alternative to taking directional positions, allowing them instead to take a view on correlation, he noted.
