Bespoke Tranche Opportunities: Is the Big Short 2.0 looming?

September 11, 2016
Editor(s): Heath Gilham
Writer(s): Quoc Anh Nguyen, Daniel Pederick, Kevin Kingsley, Max Yang

Collateralized Debt Obligations (CDOs) were one of the main catalysts of the GFC, amplifying a 2% GDP hit on the housing market to a global crisis. CDOs were junior securities to mortgage based instruments, paid out only after the first claims to returns. During the housing crisis, the lack of clarity on the values of these secondary assets lead to a stagnant and confused market for CDOs, the instrument was branded with a tainted reputation and rarely traded since.

Recently, CDOs have gone through a rebranding making a comeback as Bespoke Tranche Opportunities (BTOs). They are essentially bespoke junior mortgage based instruments proposed by the investor themselves. If the investor wants a specific BTO, all they need to do is to agree with the suppliers and make a deal. Tranche means that the security is a proportion of a larger securitised bundle of mortgages and as for opportunity part of the name, the highly leveraged nature of a BTO suggests significant risk and reward.

CDO issues

Before the GFC, a major issue facing ratings agencies was the lack of clarity to the secondary assets contained within the CDOs. Building off the idea that placing several risky investments together made the portfolio diversified, and the notion that the housing market was infallible, investors overlooked the cultural and practical flaws in the system. In order to persuade low to moderate income earners to apply for mortgages, common formalities such as down payments and income checks were often ignored. Interest and principal payments were even deferred upon request in many cases. As more and more people began defaulting on these loans, the content of the CDOs quickly lost value. First the mezzanine tranches collapsed, and this slowly worked its way up to the AAA tranches.

Due to the disproportionately high ratings denoting them as safer investments than they really were, major CDO arrangers lost. Merrill Lynch, for example, recorded billions of dollars in losses, and was purchased by the Bank of America during the crisis for approximately US$50 billion, despite once holding US$93 billion worth of CDOs. The collapse led to banks needing to lay off large portions of their workforce, and resulted in heavier regulation of the contents of such securities.

Bespoke tranche opportunities are essentially a rebranding of CDOs. Due to the negative perception of CDOs after the financial crash, this was essential to ensure their survival. Similar to a CDO, a bespoke tranche opportunity allows investors to essentially place bets on the outcome of securities, bonds, and loans that they are not directly invested in. There are however a few defining differences between the two. Firstly, a bespoke tranche opportunity is effectively a CDO supported with credit default swaps, ostensibly lessening the risk involved in the investment. Moreover, whilst it was challenging to tell what was in the tranches of a CDO, here an investor informs a bank what combination of derivatives bets they wish to make, and the bank constructs a customized product in one tranche that meets the demands of the investor.

Credit Rating Agencies

Credit rating agencies (CRA) are tasked with the responsibility of checking whether lenders and fixed-income securities would be able to meet their obligations by providing investors with information. This information would be given through a type of rating depending on the CRA. Currently, 95% of the credit ratings in the world are operated via three companies: Fitch Ratings, Moody’s Investors Service and Standard & Poor’s. Through the use of analytical methods and statistical measurements, the three companies provide information which investors will depend on when making financial decisions.

During the Global Financial Crisis, to an extent, these CRA were not always providing very accurate information. Leading up towards the crisis, the CRA overstated the rating of many financial instruments. In terms of the CDOs which was the main catalyst for the GFC, the CRA rated the tranches separately depending on whether it was a “senior”, “mezzanine” or “junior”. Therefore, to maximise the rating and the profit, the tranche structure was adjusted by mixing safe and risk-free assets with risky pieces of Mortgage-backed securities (MBS) allowing the CRA to rate these CDOs with a AAA rating.

As seen during the GFC, the CRAs activities stained their creditability to the extent many investors and other firms were forced to file for bankruptcy, a classic example being Lehman Brothers. Due to the oligopoly of CRAs and their strong market influence, the activities of the BTOs are very similar to the CDOs which might bring about the possibility of another GFC.

Current Economic Climate

The market for BTO quadrupled from $5 billion in transactions in 2013 to $20 billion in 2014. Is this a sign that BTO is fast gaining converts as a premier destination for investment?

One of the attractions of BTO is, of course, the prevalence of low interest rates across major markets globally. Interest rate in the US reached 0.25% in December 2008, the lowest level in 30 years. Though it has risen to 0.5% in December 2015, the Federal Reserve is content as of July 2016 to leave the target rate range unchanged between 0.25% and 0.5%. The Japanese and EU central banks both hold their rate at 0% for the moment, and across the developed world the situation is similar (Australia keeps it at 1.5%). In this situation, it would not be a surprise if investors all jump on board new devices such as the BTOs to get any positive real returns.

If the clock could be turned back to pre-2008 time, where uncertainty seems moderated and there is no GFC to remember, undoubtedly many would have. Robert R. Johnson, president and CEO of the American College of Financial Services in the Philadelphia area believed that there is now a much higher level of risk awareness among investors. Unsophisticated investors are now greatly wary of financial instruments that they cannot understand, and BTOs sellers have a much harder job convincing the average investors than their pre-GFC CDOs counterparts had.

Moreover, global economic condition is not yet settled. The aforementioned low rates across the developed world are signs that central banks are still struggling to fire up growth. Look in the opposite direction to some abnormally high rates in the developing world (14.25% for Brazil, 10.5% for Russia, and 7% for South Africa), and it is the same story told differently – governments there are struggling to retain investors’ trust in the face of weak growths. The State Street Investor Confidence Index in July registered a drop in sentiment among investors in Europe, North America and Asia. A poll by Morning Consult among US stock market investors suggest that between 25% to 50% will shift their portfolios to safer assets regardless of who wins the US presidential election later this year.

The great economist John Maynard Keynes observed that high economic uncertainty generates high liquidity preference, with people going for the “money-under-the-mattress” strategy. Given these conditions, BTOs may not find willing customers outside of the highly risk-loving club – at least for now.

The Future of BTOs

BTOs are in fact not dangerous solely by their nature, is it the underlying credit reliability of both the mortgage holders and credit default swappers that affect the nature of BTOs. Looking prospectively, it is incredibly difficult to predict a collapse in the junior security market. BTOs are of course currently traded less frequently than their previous counterparts and the current regulatory environment has become much more sensitive to risk. However, recent credibility issues and the increase of sub-prime loans in the auto sector have caused concern than the default swappers backing the BTOs may not be able to handle the downside risk of highly leveraged investments. BTOs are not an immediate looming threat, but the space is worth watching.













The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.

Meet our authors:

Heath Gilham
Quoc Anh Nguyen
Daniel Pederick
Kevin Kingsley
Max Yang