Structured credit's fastest growing sectors, credit indices and synthetic CDOs, were the victims of a painful dislocation in May in the wake of the downgrades of General Motors and Ford [see this month's cover story, The worm of doubt]. Correlation model price driven trades, which have been highly popular of late, went wrong for dealers and many players in the leveraged community.
"All credit tranche products (like CDOs) have option-like elements in them," says Hyun Shin, professor of finance at London School of Economics (LSE). "As options, their prices move as the price of the underlying asset moves. Being long an option gives you the gains while limiting your loss – but, of course, you pay up-front for the privilege.
"Hedge funds were going long some tranches and short other tranches with the net effect that they were being paid up-front for writing these options. However, writing options can be a mug's game. As the rather crude City saying goes, with such a strategy, 'you eat like sparrows, but shit like elephants'," Shin says.
Investors, instead of creating a credit portfolio consisting of cash bonds, have for some time been able to take positions by using credit derivatives, such as credit default swaps.