Understanding Risk in Structured Deals

NEW YORK, Dec 19 (Reuters) - For the Wall Street dealers promoting the wonders of structured credit derivative deals, the advice given by Janet Tavakoli to investors is often not music to their ears.

Tavakoli is an old hand in the $3 trillion credit derivatives market, and only more recently has become a bit of a gadfly because of a book she wrote arguing, among other things, that credit derivative dealers sometimes fail to fully communicate risks to investors.

She has worked for a variety of banks in the United States and Europe, most recently at WestLB before leaving and criticizing the risk management of the troubled German bank. Now she is running her own consulting business in Chicago.

Tavakoli is by no means an enemy of credit derivatives, which were dubbed "financial weapons of mass destruction" by billionaire investor Warren Buffett earlier this year. She praises the wonders of structured transactions and credit derivatives when in the right hands.

But Tavakoli has argued that many big dealers have let down investors when it comes informing them of the real risks involved with such baskets of credit default swaps. Dealers themselves deny this.

Structured deals with credit derivatives make up more than 75 percent of the booming CDO (collateralized debt obligation) market for spreading credit risk globally. The market is estimated to have reached a size of $650 billion this year and has attracted growing legions of investors.

Now that the harsh credit cycle has come full circle following the explosion of spreads during the past few years as record-sized defaults and bankruptcies hit a peak, a few hard lessons have been learned.

Some sophisticated players, like hedge funds and specialized offshore insurance company subsidiaries, tend to understand the nuances involved in the credit derivatives market. But other investors like European insurance companies and bank portfolios have sometimes been taken by surprise, Tavakoli says. So she tells investors to make sure they are being fully compensated for the risks they assume.

" Investors are gradually educating themselves," said Tavakoli, who recently wrote about the market's evolution and little-discussed risks in "Collateralized Debt Obligations and Structured Finance" (Wiley, 2003). "If investors are not on their toes, they may not understand the value of what they're buying."

TWO TROUBLING TRENDS

Tavakoli complains about two trends in the market.

One is the slicing of what's known as "super-senior" tranches in a synthetic CDO, a basket with varying tranches of fixed-return based on the value of credit default swaps of companies. The biggest threat to that fixed return, though, are defaults of companies that make up the basket's assets.

At the very top, low-risk level is what's called the super-senior tranche, which itself is typically divided, with the top, bigger chunk kept by the desk putting together the new deal and the smaller, bottom piece going to an investor.

Those super-senior tranches are rated triple-AAA by ratings agencies because it is typically devised in a way that it is highly unlikely -- but still possible -- a default will impact the return. But that rating is assigned is before the tranche is sliced, meaning that the bottom investor may not be receiving a truly triple-A investment.

" A larger percentage of that bottom piece will no longer be triple-A with a default. In my view, that's not a triple-A," Tavakoli said.

Another target of Tavakoli's is the ever-popular single-trance synthetic CDO.

Unlike the synthetic CDO, which is a large deal usually involving several investors taking various degrees of risk, single-tranche deals target specific tranches to just a single investor and then the dealer hedges the rest of the risk in the default swaps market.

Single-tranche synthetic CDOs are popular for many reasons. They are easier for dealers to launch and execute because only one investor is involved, meaning more volume for trading desks. Investors like them as well for quickly getting a basket of credit exposure.

But even some on Wall Street have likened single-tranche synthetic CDOs to portfolio insurance for stocks due to the way dealers "dynamically hedge" the rest of the risk within the deal.

Portfolio insurance on stocks was partly blamed for exacerbating the 1987 crash, and selling begat more selling, and some fear it could do the same in the credit derivatives market in the case of a severe shock.

Tavakoli says that investors with single-tranche synthetic CDOs may be in the dark about the cash flows related to them and the potential volatility of the transactions, which are not rated by the major ratings agencies because they are private deals and the target investors often do not require an explicit rating.

" I would say the single-tranche business is going to be ripe for a shake out," she said.

Reprinted with permission from Reuters.

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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