Have You Talked To Your Family About Bespoke Tranche Opportunities Lately?

There's a specter haunting Wall Street.
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In the final credits of the Selena Gomez vehicle The Big Short, viewers are served up a startling reminder of the risks that still stalk the American financial system:

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Never mind the actual scale of risk involved, the note rang all the right alarm bells: a suspiciously esoteric name, an intimation of financial shenanigans, a whiff of hubris. The post-script spurred a whole genre of “What are bespoke tranche opportunity” stories in non-financial media. The millennial-focused style and entertainment site Bustle ran not onebut threestories on the topic.

So the average reader likely felt a sense of latent dread in perusing Thursday's Financial Times story, “Investors pour back into crisis-era credit product.” From the article:

Hedge funds are embracing an esoteric credit product widely blamed for exacerbating the financial crisis a decade ago, as low volatility and near record prices for corporate debt tempt them into riskier areas to seek higher returns.
The market for “bespoke tranches” — bundles of credit default swaps that are tied to the risk of corporate defaults — has more than doubled in the first seven months of 2017.

All the old bad guys are back in the mix. Citi, BNP Paribas and Goldman Sachs are marketing the stuff. Hedge funds are piling in. And there must be a lot of money sloshing around, if we're sounding crisis overtones, right? How much are we talking here? Hundreds of billions? Trillions?

Traders in this opaque, over-the-counter market estimate there has been issuance of $20bn to $30bn this year, compared to $15bn in the whole of 2016 and $10bn in 2015.

Oh. So what we have here is a rapidly growing though still niche market in a product that might be shaped like truly bad crisis-era stuff but is derived from something different entirely, corporate debts rather than mortgages. It's safe to say that the biggest crisis bespoke tranche opportunities are likely to cause in the near future would be relegated to a few hedge funders' bonus checks.

But the story's still interesting. If the trend holds, corporate debt BTO issuance will double or even triple year-over-year. Why the sudden yield-seeking? The junk bonds underlying BTOs most sought-after by hedge funds have gotten too rich, and now credit investors have to look elsewhere for a similar risk-return. For some that means plunging into structured credit. For the more risk-averse, though, it means mortgages. From Bloomberg:

Pacific Investment Management Co., Goldman Sachs Asset Management, Columbia Threadneedle and others are snatching up bonds tied to subprime mortgages and other home loans made before the housing crisis, while selling speculative-grade company debt. They say junk yields are too low for the risk investors are taking, and securities backed by mortgages -- which have already gained as much as 6.9 percent this year.

The same underlying high-yield credit boom is responsible for both of these divergent trends, each of which has what the Bloomberg story calls “crisis-era taint.” But neither structured credit nor an appetite for non-agency mortgage debt does a crisis make. You gotta mix the two to get something interesting.

Goldman and Pimco Are Loading Up on Mortgage Bonds [BBG]
Investors pour back into crisis-era credit product [FT]

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Let's Talk About: Basel III

The Fed last night unleashed eight zillion pages of Basel III implementation on the universe and I'm tempted to be like "open thread, tell us about your hopes and fears for capital regulation." So do that! Or don't because it is super boring, that is also a valid approach. Still I guess we should discuss. Starting slow though. Banks have to have capital, meaning that they have to fund some of their assets with things that are long-lived and loss-absorbing, like common equity, rather than with things that have to be paid back soon and at face value. The reason for this is that the rest of banks' assets are funded with things that we really do want to be paid back soon and at face value, like deposits, and if the value of those assets declines you don't want those deposits to be wiped out. The rules say that you need capital equal to a percentage of your assets. The game is deciding (1) what that percentage is, (2) what is capital (proceeds from selling common stock, and actual earnings, yes, but, like, deferred tax assets?), and (3) how you count assets (you might want more capital to shield you from losses in, say, social media stocks than you would to shield you from losses in Treasury bonds, so regulators use "risk-weighted assets," so that $1 of corporate bonds counts as $1 of assets, $1 of Treasuries counts as $0 of assets, and $1 of Facebook stock counts as $3 of assets*). Anyway, here are the required capital levels: