Blog surfing a few weeks ago I stumbled on Zero Hedge by Tyer Durden. I have to say that his bog is one of the most addictive I’ve come accross, and I highly recommend it to anyone in finance. It would be more aptly named Fly on the Wall within the hedge fund community.
The most recent post is an interesting look at some technical and fundamental indicators around bank capital structure trading that are being witnessed from the mounting pressure of nationalization. It nicely weaves together a number of the technical factors we’ve been observing such as high CDS pricing, trough equity pricing, and a hyper schizophrenic debt market.
I am reposting from ZeroHedge in its entirety, hopefully not breaking any rules here:
Saturday, March 7, 2009
When the hotdog vendor you buy lunch from talks about the impending nationalization of Citigroup, it is fair to say that nationalization risk is “priced in” Citi’s (and all other financials’) securities. And while the risk that the government will take over Citi, BofA and the other major banks is palpable, the upside in shorting bank stocks is very limited (BAC can only go down another $3.14 while Citi is a frequent visitor to the 99c club), especially considering the downside risk in the form of a squeeze, which can be easily observed by looking at the market action in the last 30 minutes of trading on Friday (for retail investors who bought into this short covering wave thinking this could be the indicator of a market bottom, our condolences).
Nonetheless, a unique way to play the nationalization threat, with limited downside and potentially substantial upside, does exist in the form of a Parent (HoldCo) – Bank bond basis trade.
The dramatic widening in financial CDS over the past several weeks is the result of bank CDS referencing the bank Parent (aka HoldCo), level, or the most comprehensive and risky layer of a bank.
In several instances a financial Senior – Sub relationship can be exploited via CDS, however in the case of a default event both are likely to converge to comparable recovery levels as there not yet been a case of split preferential treatment of Sr/Sub debt classes in a bank nationalization. A potentially more lucrative and less risky way to play the creeping nationalization threat is via a Bank-Parent arbitrage. Nowhere is this more evident than in the Lehman brothers bankruptcy case: Barclays, which balked at the prospect of purchasing Lehman HoldCo which contained that toxic dump of all of Lehman’s worthless CMBS “assets”, jumped at the opportunity of buying Lehman’s Bank assets (and associated debt), even more so that it ended up being a transaction in which bank assets were purchased for nanocents on the dollar (golf clap for Lehman creditors’ legal advisor Milbank Tweed for allowing this daylight robbery to occur). Lehman HoldCo debt is now trading around 13 cents while FSB/bank debt was in the 80s and virtually doesn’t trade. The reason why the government may be interested in a Parent-Bank bifurcation is that roughly 70% of bank debt outstanding is at the parent level according to Bank of America, which suggests that if the government finally does come around to a dramatic recapitalization of the zombie banks, it is likely that the Bank level would be supported while the Parent would be wiped out.
The arbitrage in this case would be purchasing bonds guaranteed by the Banks while shorting bonds not guaranteed by the Bank/only by the Parent. This relationships can be seen by comparing the relative spreads of JPM’s 6% bonds due 10/1/2017 (Bank guarantee, A+ rating) versus JPM’s 6.125% bonds due 6/27/2017 (Parent guarantee, A rating).
As can be seen from recent market action, the bond spread has started to diverge as traders being to exploit this relationship. Nonetheless, the current spread is still only 100 bps. A Lehman-like resolution would result in the spread exploding, as Parent bonds hit cash prices in the teens, while Bank bonds drop only marginally. Also, as the worst case scenario is pari passu treatment, the spread can at most converge to 0. On a $10 million basis this implies the maximum downside is $100,000, while the upside could be well over $5 million: this should be a much more acceptable risk/return scenario to any trader who is betting on a sweeping bank nationalization, but is unwilling to take on the common stock short squeeze or creeping nationalization risk. Additionally, the trade could double up as nationalization insurance, since bank CDS are trading at levels at which it makes no sense to actually use them for “protection” purposes due to exorbitant carry costs (absent a pair trade with matched bonds, which is in fact a trade that has been aggressively implemented over the past 2 weeks, and which the administration should be very concerned about due to the perverted inherent incentives of basis holders to see the eventual bankruptcy of the underlying security).
The Bank Nationalization Arbitrage Play
Tyler Durden, Zero Hedge, March 7, 2009