Explaining the Hedge Fund Rumors

From the FT ($$):

According to Mike Harris, credit derivative strategist at JP Morgan, hedge funds had been putting on a trade which involved buying the equity tranches (the most risky) and going short (gambling on a decline) in less risky mezzanine tranches. They leveraged up this trade by selling protection (options) against the equity portion. That trade gave investors a positive carry since the yields on the riskiest tranche were higher than the yields on lower tranches.

But the emergence of idiosyncratic risk in the form of the downgrades at General Motors and Ford has caused the spread on the equity tranches to widen, causing losses for the hedge funds putting on this trade. As they attempted to unwind their positions, the selling pressure pushed prices down even further.

There is a saying (mostly in currency markets) that goes "the road to hell is paved with positive carry." That people would have this kind of trade on and lose money doesn't really surprise me. That anyone would have it on in big enough size to risk their solvency would.

When considering trades like this it never hurts to just look at being naked long the riskiest portion in much smaller size (targeting an equal return). Usually when the trade goes bad the variance in the bid/offer spread has been grossly underestimated. Its possible that an unhedeged position might get the same yield with about 1/20th the notional value so if things go bad it's easier to dump it rather than hang on waiting for the bid/ask to tighten back to normal.

I have never traded the CDO market and am just assuming that like most derivatives the bid/offer is several times wider than on the underlying. When the underlying is a corporate bond that is a lot of hay just to break even on a spread trade.