Mindset Arbitrage

One interesting observation about the securitization process is that many of the securitized products are meant to aggregate a risk so it can be distributed to capital market participants (hedge funds, opportunity funds, insurance companies that buy securities, and money managers and banks).

For example, Commercial Mortgage Backed Securities are used to source risk from real estate investors that own and operate real estate assets. This is a cash flow based market where people that manage buildings have a well defined plan for extracting more dollars to the bottom line (raise rents, lower expenses, re-capitalize the entity that owns the building, etc.). When your day-to-day business is servicing tenants, collecting rents, staffing a building, and maintaining the property you aren’t use to thinking about duration or what rating the rating agencies have assigned your loan. Things like day count conventions and their effect on the yield vs. the coupon isn’t your expertise. These are all esoteric things that some traders and bankers spend years not understanding in any rigorous way.

Residential Mortgage Backed Securities source risk from homeowners and mortgage originators. Here people’s assets secure loans and allow risk to be quantified by analyzing statistical data which, in aggregate, should hold closely to some historical trends. One can view how high LTV loans made to borrowers with a FICO score between 600 and 620 have performed in a given state over the past five years and extrapolate the performance of other loans with the same characteristics (recent problems arose when people didn’t care about the loan characteristics, just that they could get bonds or what rating the bonds had).  I don’t think I have to explain that, given all the examples in the media trying to explain CDOs (but really securitized products in general), it should be Q.E.D. that people taking out mortgages didn’t fully understand how the risk was being laid off nor how it would affect them (even the banks got sloppy).

Even corporate CDOs took instruments from a market where securities are valued based on the fundamental credit quality and technical factors and sold instruments that were valued using correlation trading models.  Obviously this is a bit different since these are all sophisticated (theoretically) institutional accounts. However, no one was prepared for, nor did they understand fully, the implications of things like the Ford and G.M. downgrades to junk or how the price movement in CDO tranches was going to show a disconnect because of the types of accounts that held them. (What this means is that the lowest tranches, which take losses first, become the worst risk in the pool. Essentially, then, these “equity tranches” became proxies for Ford and G.M. Since these equity tranches were held by accounts that have to mark to market, they dropped in price to reflect liquidity concerns. The tranches above them were generally held by insurance companies, or non–mark to market accounts. Dealers, proprietary trading desks, and hedge funds had all put on trades that went long equity tranches and short the tranches above them assuming the relative spread would move predictably. Unfortunately, for them, there was no price movement in the tranches they were short, since those accounts didn’t have to mark to market, and thus didn’t need to sell to prevent further losses while the equity tranches dropped in value.)

Even starting a fund is an exercise in mindset arbitrage. Some manager looks to buy assets, like mezzanine debt, which generally trades on price or as a spread to a benchmark interest rate, by raising equity for a fund. All they are doing is taking the returns they know are out in the capital markets, adding leverage, and going to investors that are very focused on R.O.E. (return on equity). This is probably the worst example here, despite being quite valid, because the level of sophistication can be quite high. However, with lots of money chasing high returns, sometimes due diligence and other metrics of reliability and quality fall by the wayside.

It should become apparent, now why there is money to be made re-packaging risk–essentially you are outsourcing the placement and structuring of that risk so that the person who is willing to get paid the least for taking a particular risk gets it. This is why it is possible for one to sell securitized products at a net interest rate less than the underlying assets.

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3 Comments on “Mindset Arbitrage”


  1. […] to pocket 2.7% of the loan amount. On $10 million dollars that’s $270,000 I made just for arbitraging various conventions and the difference in how bond investors think and how lenders gener…. Would you have been better off to take the 10.05% loan from the insurance company, quoted on a […]

  2. quantum probability Says:

    -A cash flow business as opposed to what?

    -What is the efficiency gain from mastering all the bond math anyway?

    -Like how you use the media as proof.

    – Why did those who went long/short relative tranche bets think the secure parts would mark a price change?

  3. quantum probability Says:

    “This is why it is possible for one to sell securitized products at a net interest rate less than the underlying assets. ”

    Still not crystal clear.


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