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Shorting Bank Debt Proves Too Tough In Illiquid Mart

21 Jun 2003

Despite attempts over the last 18 months by trading desks to develop a market for shorting bank debt, the idea is now on the backburner, according to bankers and investors. Goldman Sachs is the only bank that put together a detailed proposal for shorting bank debt, though Wall Street rivals are said to have looked at the concept. But the illiquidity in the bank market and questions over the economics proved too much of a burden, sources said. Bankers at Goldman referred questions to a spokeswoman, who declined comment, and traders at rival desks including J.P. Morgan and Credit Suisse First Boston also declined to comment on whether they have offered a short-sell product.

A manager at one of the largest distressed debt funds stated that now the debt market is in bull mode there is not the same need for shorting as there was a couple of years ago. "The ability to find a product to do this is immaterial for us," he said. But almost every other investor and dealer contacted agreed it would go far to enhance liquidity in the market. "It only adds to the liquidity in the marketplace. If you can short, then at least there is a stop-out bid. You can take a view on the credit and get protection," one distressed debt player said. Another CLO manager who talked to Goldman said it would have been a great product for his firm as the provider of the loans. "We would love to earn an incremental spread by lending loans to them," he said.

But there are a myriad of obstacles. One investor who looked at the Goldman proposal stated that it is simply not economic. "[They] structured a product that would be the easiest one to get short with institutional leveraged loans," he said. Goldman would borrow the loans from a bank or CLO, paying an admin fee and the coupon on the loan, and lend the security out to a client. "But the deals that people wanted to short were the fallen angels where the cost of going short was much less," the source said. "The leveraged loan short was going to be a product that you don't want to pay for." One major snag though is trying to borrow investment grade loans from a bank. "You could only do it for three or six months, not a year or two," said a manager of a multi-billion dollar distressed fund. "We would like it, but it's a technical problem."

Goldman was said to be unable to obtain the required repo agreements from banks for the loan product, as banks were unwilling to lend out the loans for the required period of time. "The illiquidity of the market makes it too much of a credit risk," said the manager. Also, if a hedge fund wanted to short an investment-grade name, it is much easier through credit protection or shorting the bonds, another manager said.

But the concept of shorting is not impossible mechanistically, stated another distressed debt investor, who said on three occasions he has pitched an idea to banks using swaps with levered funds, but each time he has found dealers unwilling. "You ought to be able to do this. Swap departments understand how to do this, but they cannot find takers," he complained. Several dealers also commented that the shorting of debt will become achievable, but only when the market is liquid enough and has a more efficient infrastructure.

21 Jun 2003