Error in Meissner text?

[afterworkguinness]

Hi, I think there is an error in the Meissner text and can't find an errata for this text to verify. On page 19 the foot note reads "10. Shorting the equity tranche means being short credit protection or selling credit protection, which means receiving the (high) equity tranche contract spread"

In the context, he is talking about CDOs, which makes me think this is incorrect. In a CDO, doesn't being short a tranche buy credit protection and investing in the tranche (long) is to sell credit protection?

When you invest in one of the tranches of a CDO, you are exposed to credit risk which is why you are compensated by a spread right ?

 

[brian.field]

This is a bit confusing to me too.

A CDO manager buys, for example, bond A to put in the CDO's collateral pool. The CDO is taking the credit risk in this asset. The CDO could also sell protection on the asset to achieve the same risk profile but in the former, the CDO would receive interest cashflows whereas in the latter, the CDO would receive the fixed spread payments.

The CDO investor buys an amount of a CDO tranche, so the investor is long the CDO tranche and in so doing, is long the credit risk of the underlying....or the investor has sold protection on the asset underlying CDO if the CDO engaged in selling protection on the underlying asset.

If an investor shorted a CDO tranche, then this would be the same as buying protection on the CDO tranche, so based on this logic, I agree with @afterworkguinness.

It is also interesting to note that during the subprime CDO crisis, funds like Magnetar did the opposite of what Meissner describes in that they went long equity and shorted mezzanine tranches, if I am not mistaken.

 

[brian.field]

It is also unfortunate that Meissner uses the following language:

"...the correlation of the bonds in CDOs that referenced investment grade bonds decreased..."

I think he should have stated this more clearly as follows (assuming I am interpreting it correctly, which is open to question):

The correlation decreased between the tranches of the CDO (the CDO tranches naturally referenced investment grade bonds in the CDOs underlying portfolio).

 

[brian.field]

This is really bothering me now.

Meissner says, "Shorting the equity tranche means being short credit protection or selling credit protection which means receiving the equity tranche contract spread."

Assume a CDO manager buys asset A. Then the CDO is long asset A since the CDO benefits from an increasing asset A value and the CDO's position worsens with a worsening asset A value. Since the CDO is long asset A, I would say also say that the CDO is long the credit risk of asset A since the CDO's position improves when the credit risk of asset A improves. Similarly, the CDO's position worsens when the credit risk as asset A worsens. The same can be said when the CDO sells protection on an asset, i.e., if the CDO sells protection on asset A, it is long the credit risk of asset A.

Now, if an investor goes long a CDO tranche, his position will be the same as that of the CDO, i.e, if the CDO is long an asset, then the investor that is long a CDO tranche would also be long the asset, i.e., the investor would be selling protection, i.e., short protection, i.e, the CDS sellerthat receives the CDS spread.

If an investor shorts a CDO tranche, then the investor's position would be opposite that of the CDO, i.e., the investor would be short the asset, i.e., buying protection or long protection, i.e, the CDS buyer that pays the CDS spread.

If an investor shorts a CDO equity, then the investor is buying protection on the equity and paying the CDS spread.

Perhaps if Meissner said "Short a CDS on the equity means being being short credit protection or selling credit protection which means receiving the equity tranche contract spread" because then your position would improve when CDS spread decline.....like a typical "short" position would imply.

 

[NNath]

Hi @David Harper CFA FRM , @brian.field @afterworkguinness , I think meissner says conflicting things in between chapter 1 and chapter 3. Which one is correct ? Is there a difference between the "correlation of the assets of the CDO" and "negative correlation between equity and senior tranche". Did the correlation increase or decrease. See comparison between text as below.

 

[brian.field]

I would also like to hear David's thoughts on this.

 

[bpdulog]

There are a lot of past threads on this but I haven't seen any final conclusion given.

Equity tranche value is positively correlated to PD

If PD goes down, equity tranche value goes down

It is opposite for a short position, yet int the text the hedge fund is losing money? Doesn't make sense

 

[bpdulog]

After reading this old WSJ article http://web.stanford.edu/class/msande247s/2008/first week/WSJ 0912 2005 How a Formula Ignited Market That Burned Some Big Investors.pdf


I think the author is wrong - hedge funds were purchasing the equity tranche which implies selling credit protection. I don't see how you can collect a spread on something you've sold

Also mentioned here in this Credit Derivatives book by Vinod Kothari: https://books.google.com/books?id=f...U#v=onepage&q=2005 tranche trade ford&f=false

"Under this strategy, hedge funds by the riskiest equity tranches and sell the safer mezzanine slices and make money on the difference between the two..."