Sneaky structured strategies(4)

The debt markets are in a malaise, but structured product specialists within large bulge bracket banks have been feverishly busy. Why? According to debt market insiders, it’s part of a balance sheet risk management game that has the effect of making all that LBO debt look not so lousy.

The game includes this rule: there are two ways to increase the price of a debt offering – injecting more liquidity into the market and enhancing the credit of the issuer.

The Federal Reserve Bank recently took care of the liquidity issue by lowering rates. But even given this boost, private equity market observers have been pleasantly surprised to see some of the “hung bridge” loans trading at discounts that aren’t as drastic as originally feared – more in the range of 95 cents on the dollar range, as opposed to 90 cents on the dollar.

What forces are at play here? Weren’t the markets experiencing a massive case of indigestion?

The answer lies partially in the way banks have enhanced the credit of all the paper they now hold, say debt market insiders. Credit gets enhanced through additional equity, and we know private equity firms are not writing bigger equity cheques. Where is the additional equity coming from?

Enter the structured product wizards. By turning a single-rating loan into a structured product, a bank can hold on to the unrated tranche – the equity tranche – which is not marked to market. This has a beneficial effect on the rest of the higher tranches, starting with the top tranche – often a triple A or double A. As if by magic, a warehouse full of debt that would have received a dismal mark down is priced at a more acceptable discount.

It’s going to take a long, long time to unload all the commercial paper created over the past year, but in the meantime the banks are doing their best to avoid the crushing consequences that illiquidity has on the value of securities for which there are no bids.

Market observers have been adamant that the credit crunch has been related to liquidity, not credit fundamentals. The banks now holding significant “first-loss” equity tranches should certainly hope so.