Behind 'The Iksil Trade' - IG9 Tranches Explained

Via Peter Tchir of TF Market Advisors,

There is a lot of talk about IG9 these days.  I think the story has a lot more to do with tranches than with outright selling of the index.

IG9 10 year is a 125 name, equally weighted CDS index that matures on December 20, 2017.

The index has had 4 defaults, Fannie Mae, Freddie Mac, Wamu, and CIT.  The recoveries were high for all 4 of them.  I am told the total cumulative loss from these 4 Credit Events was 0.6%.  We will use that number for simplicity.

IG9 is the last CDX index that had an active tranche market.  It was the “on the run” index at the time of Lehman, and since then, the synthetic CDO business has never truly recovered and IG9 has remained the benchmark for synthetic CDO’s and tranches. [largely legacy positions, but probably a warning sign to regulators, that although the real market has moved on to IG1a, the model driven market remains stuck managing massive books of trades and hedges, based on an index that was created 5 years ago]

So what was once a 3%-7% tranche is now roughly a 2.4% - 6.4% tranche.

So if you sell protection on this tranche, you need further cumulative defaults of 2.4% before you make any payments, and then you make payments until 6.4% of the notional has had losses.  If there is a 0% recovery on each default, you could have 3 defaults before having to make any payment (each name is 1/125 or 0.8%).  If recovery was 40% then you have no payments until the 6th default.

We will come back to look at the names and assess how likely that is.

The big question is, what do you get paid on this tranche?  20 points up-front and 500 bps running.  So if you sell $1 billion of this tranche, you receive $200 million up front and $50 million per annum.  In a relatively tight credit spread environment, this is a lot of money.  If you use the upfront payment to “defease” losses, the $1 billion of exposure has a maximum loss of $800 million, and would require  4 defaults at 0% recovery before actually having a loss, and more realistically, would only take a loss on the 8th default with a 40% recovery.  Suddenly the trade seems less scary, as least to me.

But how do people come up with a number of a “100 billion”?  That comes down to “deltas”.  The delta on this tranche is about 7.5 times.  So if someone wanted to take this risk, without delta (just sell the tranche and not have a “correlation” bet), every $1 billion would create $7.5 billion of index trading.

You could sell this “no delta” and the buyer would pay you for the tranche, but then have to go and sell 7.5 times that amount of index out to the market so they could manage their “correlation” risk – a giant model based book.  Some dealers are very good at tranches, but are weak at trading the underlying index.  In those cases, you might sell the tranche “with delta” and sell the index position yourself because you can get better execution that way.  So you sell the tranche and buy 7.5 times the index from the correlation desk (the with delta trade).  Then you sell the straight index into the market.  It would explain why you are seen as a seller of index when the real trade is actually being a seller of the tranche.

So who knows what exactly is going on, but I think selling tranches without delta explains far more than just selling the index.

The risk/reward of selling the tranches is very interesting and fits a bank potentially well

  • No payments until several more defaults – so you are senior
  • The big up-front payment covers at least one more default
  • The spread is the same as you earn on CDS that references junk bonds
  • Your exposure is capped, your tranche may model up as “7.5 times” that amount of index, but you have a capped exposure, much smaller than that

So what names or companies are you exposed to.

Of the 121 names, there are two “weird” ones that no longer have any debt.  Countrywide, and IAC/InterActiveCorp.   Countrywide, for all its problems, has no debt and was fully guaranteed by BAC.

The most dangerous names are:  Radian, MBIA, Spint, I-Star, and RR Donnelley.  These are the only names that trade with a spread above 500 running.  So of the 121 names, only 5 names trade wider than the 500 running that is earned on the tranche.  These are the prime default candidates.  If you had a 40% recovery on average, and all 5 names defaulted, the seller of the tranche would not yet have lost money.  Radian and MBIA are the most likely to default, based on spread, and even those don’t trade at levels of imminent default.

After these 5 names, you wind up with ILFC, Jones, Liz Clairborne, JC Penney, as the only names trading about 400 bps in CDS.  Levels that are a far cry from default.

Look at the names, but this risk in tranche format is far more interesting, in my opinion, rather than just selling the index.  Selling the index outright in $75 billion would expose you to each and every name, have losses on day 1.

Why might the trade make sense? or what could it be hedging?

  • Loan demand is down as corporations rely on the bond markets and this may be a more attractive way for JPM to maintain net interest margins in their corporate business, rather than buying bonds in the secondary market
  • Jamie Dimon is very public that he thinks we are near the bottom of the housing market and “all signs are green” so putting on investment grade corporate risk makes perfect sense
  • They may be short high yield, they are starting to dominate the new issue market, so they may have shorts on that, and it may not be co-incidental that they are going long a product that pays 500 bps running, which would cover the cost of HY shorts, which also pay 500 running in CDS, and may even explain why HY CDS spreads have been “decompressing” in what has generally been a good environment for credit
  • Choosing tranches and derivatives as a way to take exposure may be a direct result of the latest stress tests from the Fed, it is possible that those stress tests force banks to take risk in non-traditional formats to minimize the impact of stress tests

In the end, it is all speculation, what, if any trade they have on, but I think this explanation is far less scary, and in fact should encourage holders of JPM that their bank is well positioned to take advantage of opportunities they see in the market and potentially remain a step ahead of the competition.