2005 After Maths
Financial Engineering News - December 28, 2005
by Rachael Horsewood

Is the delta of individual tranches the best way of estimating this? Is it misleading to look only at delta hedging since it depends on what dealers divulge? Janet Tavakoli, an ex-investment banker who is now a structured credit consultant in Chicago, has been arguing the latter. The data disclosed by banks is usually based on different parameters. But, as she also says, banks have been known to glorify figures so their market share looks greater than it actually is.

Tavakoli who previously worked in financial engineering at Westdeutsche Landesbank (WestLB) in London, insists on knowing the full notional amount when advising on a deal because the notional of a single tranche CDO offers little meaningful information. “Shorting a AA-rated tranche is very different than shorting a BBB rating tranche, which is very different than shorting equity. When I want to run a first-principles calculation of residual risk, I start with the underlying notional, retranche the deal and work from there.” She adds that the risk does not necessarily increase as the reported notional amount increases.

More people admit that delta hedging is imperfect. Tavakoli says she has argued this all along. “Originally, in Europe, trading desks shorted mezzanine and went long the credit risk (by selling credit default swap protection) on all of the names in the portfolio. Managers balked as the positions ballooned, so we came up with the idea of shorting the mezzanine and delta hedging. This is a way of obscuring that one is long credit risk because the trading desk can claim to be hedged. But even if the models were accurate – and they are not – they are a bad retrofit. The hedge is flawed. Every hedge, including a bad hedge, looks good when it is initially put on in a static environment.” She says that “smart” hedge funds would have hedged individual credits by going long credit default swap (CDS) protection on GM, Ford (and others at various times) in November 2004, seven months before the actual downgrades.

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Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting to financial institutions and institutional investors. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. She is a former adjunct professor of derivatives at the University of Chicago's Graduate School of Business. She is the author of: Credit Derivatives & Synthetic Structures (John Wiley & Sons, 1998, 2001), Structured Finance & Collateralized Debt Obligations (John Wiley & Sons, 2008).

Janet Tavakoli's book on the global financial meltdown is Dear Mr. Buffett: What An Investor Learns 1,269 Miles From Wall Street (Wiley 2009).

Clients of Tavakoli Structured Finance have the benefit of proprietary consultation, which is not available in any other paid or public forum. Clients also commission proprietary research and analysis.

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