When assessing risk it always pays to assume that whatever risks you identify there are others associated with them that you haven’t. I pointed out the other day a risk that was associated with my negative outlook over the last year and a half that I hadn’t seen ahead of time. Here is another.
These trades were profitable because a bond could pay out more in interest than it cost to buy the insurance available in the derivatives market to protect the holder against default. In the world of structured finance, a bank would buy a bond, get it guaranteed, or wrapped, by a monoline to support the bond’s AAA rating, but then also pay another monoline to write a default swap on the first monoline, to guard against it defaulting on its guarantee.
The difference between what the bank paid for the insurance and what it received in yield from the bond could be pocketed as “risk-free” profit – and in many cases banks took the entire value of that income over the life of the bond upfront.
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Bob McKee, an analyst at Independent Strategy, a London research house, believes that up to $150bn worth of CDO business done by the monolines could be negative basis trades.
Standard & Poor’s, in a note on the potential impact of monolines on banks this week, said it believed some of the CDOs hedged by bond insurers were part of a strategy of “negative basis trades”.
The problem is that if monolines are downgraded and their protection becomes ineffective, profits booked up-front need to be reversed. Restating earnings is a very tricky area for investment banks – not least because the traders involved will have long ago pocketed their bonuses.
There is always more than one cockroach.
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