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This episode aired on BloombergTV on Oct 10, 2012

Structured Credit

Structured Credit is a very broad concept that takes various forms in today’s markets. Generally, it refers to method of pooling debt obligations and then redistributing the associated cashflows, in theory reallocating the associated risks at the same time. This led to more complicated structured credit instruments such as CMOs, CLOs, and most famously, CDS. The trading of these products has created enormous new markets and allowed for new credit arbitrage trading strategies.

Q: So this is an enormous subject and we’ll just touch the tip of the iceberg today, but let’s at least try to define the term.

A. Generally, it refers to methods of slicing and dicing the risks and/or cash flows associated with a debt obligation, and transferring them out to different parties.

Q. Where does the name come from?

A. The first generation of structured credit deals involved pooling of loans. So, instead of selling one mortgage to one buyer, a bank would throw a bunch of mortgages into a trust, and then sell off rights to receive cash flows from the whole trust to different buyers: first cash flows to Tranche A, second set of cash flows to B, etc. In this way nobody was assuming all the risks of a given mortgage… So, the structure changed how credit risks of the underlying loans were allocated. That was the origin of the term.

Q. Well, we all know that this kind of pooling led to an explosion of CMOs, CLOs, CDOs, etc. etc. that really changed the modern financial world, for better or worse. What other sorts of things fit into the “structured credit” world these days?

A. There’s an enormous category of swaps and options that seek to transfer the credit risk, or cash flows, or market risk, or some combination of the above, from one party to another. Most famously today, I suppose, is a credit default swap. I can own a debt instrument that pays, say, 6% from a somewhat risky credit, but by “protection” for, possibly 100 bps per year. Lots and lots of hedge funds play in this world on all sorts of different sides; some just trade the CDS themselves and never own the bonds to which they relate. Some just buy and sell derivates on CDS exchanges. It’s all gotten pretty exotic.

Q. And these are all the basis for various credit arbitrage strategies?

A. Very often, yes, although that also takes into account normal bonds and unstructured credit instruments. Credit arbitrage picks up microscopic differences in rates, and has to use lots of leverage to generate returns. That’s works well until a big move in interest rates comes along, which can really blow things up, like in 2008. That’s why people call it “picking up nickels in front of a steamroller”.