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Today In Swiss Banks With Creepy But Defensible Structured Products

I don’t really understand it but the TVIX thing is creepy fun. If you haven’t followed it, Credit Suisse issued this exchange-traded note called TVIX that was a 2x levered bet on the VIX. They suspended new issuance about a month ago due to position limits, and people were just so damn excited to own the thing that its price crept up to 189% of its fair value, where “fair value” is a reasonably easily measurable thing based on the formula in the TVIX prospectus. Then last week Credit Suisse announced that they would be creating more units, and the price plummeted to and then through fair value, which is what you’d expect to happen. Except that it started plummeting a few hours before that announcement, which is Suspicious.

So of course people are sad and there’s a Bloomberg Brief with sort of sad-funny quotes like:

“When it started to fall, I bought more because I couldn’t believe how low it was going. I didn’t realize I was playing with a hand grenade.”
– Michael Gamble [heh! – ed.], 67, who doubled down on his TVIX investment before the price collapsed.

Investors “all think: ‘Oh, I’ll just buy these things, I’ll be hedged against volatility and everything will be wonderful.’ And now they’ve seen the market goes down and their volatility protection goes down too, and they’re going ‘Hmm, what happened here?’ These people are going to have to pay a really expensive lesson.”
– Larry McMillan, who manages $30 million as president of McMillan Analysis Corp.

So, yes, Larry, they are going to pay a really expensive lesson. But what is it? Stephen Lubben has a little thing in DealBook today where he frets:

The reason I’ve been concern[ed] with E.T.N.’s is that they amount to entering into a total return swap with the financial institution. I have my doubts about the wisdom of selling total return swaps to retail investors.

And he makes some good points but with respect to TVIX this is kind of totally wrong in the sense that the one problem with TVIX is that it was not like entering into a total return swap with Credit Suisse. In the specific sense that, if you entered into a VIX swap with Credit Suisse,* and then the fair value of that swap was $100 and you were like “I would like more of that please,” you would go to Credit Suisse and they would either say “no you have enough already” or they would say “okay you can have it at $101,” and if you were instead like “I would like somewhat less of that please,” you would go to Credit Suisse and they would either say “no haha you’re stuck here forever,” which no, they wouldn’t do that, or they would say “okay you can take it off at $99.” Or whatever. What would not happen ever is that Credit Suisse would offer to take it off your hands at $40 or (more relevantly) sell you more at $189. (Or take it off your hands at $187 but that’s sort of overdetermined.) And because it is a bilateral contract, it probably would not exactly occur to you to go to someone else and ask them to take it off your hands at $189, and if it did they wouldn’t do it. And so basically you’d be anchored at around fair value, because broker-dealers have obligations not to charge excessive markups and 89% seems excessive.

With TVIX, on the other hand, your counterparty was Credit Suisse and it wasn’t – CS owed you the return on the note, but if you wanted that return before maturity you’d pretty much just sell into the market. And if the market price was $189 then that’s what you’d get – and what someone would pay, which, weird for them. Even cooler is that I guess if Credit Suisse wanted to sell more, and was able to do so without crashing the thing back down to fair value, it would have no qualms about doing so at the market price for the thing rather than the fair value of the underlying assets.** Of course it shouldn’t ever really be able to do that – the possibility of that arbitrage should preclude it – but then, in theory no one should have been able to sell at 189% of fair value and someone apparently did.

For the ETN issuer that arbitrage doesn’t really exist – the mispricing existed only as long as CS was not issuing more notes, and collapsed as soon as / slightly before they reopened it. Bloomberg has the top ETNs by premium to net asset value and basically it’s one anomaly and the rest are more or less fine:


But ignore the reality! Just focus on the conceptual distinction where:
(1) Credit Suisse does an OTC swap with a client; it will generally put that on and unwind it at something that somewhat approximates a plausible fair value plus a reasonable spread, but
(2) Credit Suisse packages the same payoffs into a security (ETN, whatever) and sells it so that there is a market in that security; it will be able to trade in that market at the prices that obtain in that market, whatever the relationship of those prices to the underlying fair value.

Normally those two things collapse into one because the security will trade at its fair market value and there is no arbitrage. But … well, obviously there are a couple of ETNs where the arbitrage existed, though maybe not so much for the note’s sponsor.

But there are probably some other cases of arbitrage – like, for instance, does/should this inform how you think about CDOs? Yesterday we talked about this court case where UBS sold a CDO to a German landesbank where UBS got to stick garbage in the CDO and the landesbank got to take it. And eventually the landesbank sued and was all “the stuff you stuck in the CDO was waaaaaaay riskier than its ratings suggested, as evidenced by the fact that it was trading waaaaaay wide of everything else with that rating,” and, true!, but the court didn’t care because that was kind of the deal. So the question is: is this (one-on-one, intensively negotiated, no-real-liquid-market, partly OTC-documented) deal an swap deal where UBS can’t stuff you with crap at excessive markups, or is it like a security where the price the market will bear is the price the market will bear? Judging by UBS’s win this week I guess the latter.

The Trouble With Exchange Traded Notes [DealBook]
SEC Said to Review Credit Suisse VIX Note [Bloomberg]
Chaos Over a Plunging Note [WSJ]

* By which I mean a horrible daily-accrual 2x-levered VIX swap with the structure of TVIX which, I dunno, maybe you’d do if you weren’t a retail investor? But probably not? Shrug.

** On, I guess, the same theory where Warren Buffett can sell stock when his stock trades above “intrinsic” value and buy it back when it trades below.

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7 Responses to “Today In Swiss Banks With Creepy But Defensible Structured Products”

  1. Guest says:

    UBS rocks!

  2. iLuvMatt says:

    I read through this only because I love Matt.

  3. Beerio says:

    I am slightly troubled by mom and pop investors (and me) buying these levered daily accrual ETNs and the like – it's not trivial to work out fair value and how they're going to trade, especially given the tools at hand for your average retail investor. Much as I hate the SEC or whomever telling people what they can and can't buy, it's pretty clear that the majority of the people buying these sorts of notes have no idea what they're doing.
    At least, that's my excuse for getting burned by them in the past….

  4. Mmj says:

    Wow, Matt, where did you get that strain?!

  5. sohbet says:

    Relative game comment sounds like pr straight from ir talking points to me written by an underpaid res associate rather than an honest opinion of what matters: will financing costs for banks rise and will corporates that have stronger ratings than the banks wake up and disintermediation