Call them super-sophisticated or call them super-reckless, buyers of structured credit equity tranches are a relatively rare breed. This is not, however, the only problem: they are also all alike. This riskiest part of the capital structure still lies largely in the hands of fast-money hedge funds and it isn’t hard to figure out what that means: any market shock is likely to turn them all into sellers overnight. These aren’t the kind of buyers that will ride out sustained mark-to-market volatility since they cannot take a lot of pain before getting hit with margin calls.
This became all too evident in May 2005 during the correlation crisis precipitated by the downgrade of Ford and GM. Mezzanine tranches of structured credit should have widened out the most but they didn’t – the equity did. This was because the hedge funds were all long equity and short the tranche above it: there was only one type of investor in this part of the capital structure and they were all trying to do the same thing.
In order to avoid a repeat of this situation on a larger scale, the market needs to find more buyers for equity. The problem is that although there are natural structural buyers for mezzanine, there aren’t the equivalent for equity – the hedge funds themselves are only buying it opportunistically. These funds have worked hard to develop sources of permanent capital for their equity investments [see Asset-backed securities: Funds list to ease first-loss sales, Euromoney May 2006] which will probably mean that their allocations to equity grow – only exacerbating the impact if they all decide to get out at the same time.
Equity is structurally cheaper than mezzanine as there are far fewer buyers for it. What the market needs is a way for other investors with more of a capacity to mark tranches down in a stressed situation rather than swiftly crystallizing a loss to be drawn in. There is a need for the market to come up with new structures that will enable buyers such as insurance and pension funds to take this risk. Combo notes can achieve this but have attracted too much attention from the regulators.
The structured credit market is trading in an extremely technical way: everyone is long simply because it is too expensive to go short. But liquidity in the market is extremely fragile: if there is a reverse and trading moves more towards fundamentals then the high likelihood that hedge funds will sell off en masse could trigger other adverse events elsewhere. Investors should no longer be looking to exogenous factors for directional movement: the biggest risk that the structured credit market faces is the market itself.
