The Tipping Point

Late last June, Deutsche Bank trader Boaz Weinstein was growing increasingly troubled by what he was seeing in the debt and equity markets. Spreads had widened on the loan credit default swap index一a sure sign that investors were looking for insurance against the risk of loan defaults一yet there was no corresponding drop in equity prices. It made no sense to Weinstein, Deutsche's New York-based co-head of global credit trading.
Loans are senior to equity in the capital structure; if a company gets into trouble, lenders are paid back before shareholders receive anything. And Weinstein knew that if investors were worried about credit defaults, equity prices should have been suffering too. Yet although the LCDX index fell 8 percent in about a month, there was no corresponding drop in the Standard&Poor's 500 stock index.
"You should not have the most senior part of the capital structure take a giant drubbing and leave the equity market unchanged," Weinstein says.
The prevailing wisdom at the time was that the credit and eqtlity markets had "decoupled”一that is, they had stopped trading in tandem, as they typically do. But Weinstein wasn't buying it. He also had a hunch that the emerging pain in the subprime mortgage market would not remain isolated. He happened to be reading The Tipping Point, Malcolm Gladwell's popular treatise on how little changes suddenly reach a critical mass and the momentum becomes unstoppable. It seemed to Wein stein last June that the markets were at just such an in- flection point.
He was right. Since then global credit and equity markets have been rocked and more than a few hedge funds have suffered serious damage. Write-downs and Liquidity shortages ao banks have been especially severe (witness thc shotgun marriage between Bear Stearns Cos. and ri val JPMorgan Chase & Co.). The idea that the credit and equity markets had decoupled seems blissfully naive now.
Weinstein and his team at Deutsche have been in the thick of things. both as counterparties and as risk-takers, and they seem to have come through remarkably unscathed. Deutsche was one of the few banks to make the right call on mortgages; many hedge funds are grateful to its asset-backed trading desk for recommending that they short the sub-prime index.
"Bose is on the short list of people I call to discuss market opportunities," says Kenneth Grif1n, founder and CEO of $20 billion Chicago-based Citadel Investment Group. "He is both incredibly creative and sensibly pragmatic."
Weinstein, 34, joined Deutsche's credit derivatives group from crosstown rival Donaldson, Lufkin & Jenrette in January 1998, when such investments were just coming into their own. Among the early users of credit derivatives were convertible-arbitrage hedge funds like Citadel (which has since expanded to become a multi- strategy firm). These managers turned to credit default swaps一‘he most common form of fixed-income deriva tive, which allows investors to take out insurance against defaults一to hedge their bond exposure.
Today, Weinstein oversees 700 traders across the debt spectrum. He also runs Saba Capital. a Deutsche proprietary trading group. The 40-person Saba team specializes in a unique type of capital structure arbitrage that Wein stein helped pioneer.
Early this decade， Weinstein began to study the relationship between credit, equity and vol atility and how to profit from inefficiencies among the three. Rather than limit his capita! structure arbitrage research to distressed bonds and equity, he added a wrinkle by includ ing credit default swaps and equity derivatives. The result, an innovation that has drawn accolades from hedge fund managers. was like putting traditional capital structure arbitrage on steroids.
"The financial community is still in the early days of recognizing the value of the relationship between the two markets," says James Delaney.:former head of capital structure arbitrage at credit derivatives broker-dealer GFI Sectiritics in New York who is launching his own hedge fund. "Boas is one oi the pioneers.
It's not surprising to learn that Weinstein is a master chess player一his immigrant parents enrolled him in a chess workshop at the tender age of five. A product of New York City's Stuyvesant High School and a gradsi ate of the University of Michigan, where he majored in philosophy, Weinstein also has a fondness for casino card games.
"Poker and blackjack are good training." he says. "If you look at a professional poker player, maybe 70 per- cent of the hands that they are dealt they immediately fold. With poker, the evening comes down to four or five important hands. And at a hedge fund, or a prop group at a bank, often the year comes down to fottr or five important trades."
Last year the important trade was subprime. How funds played the subprime market proved to be a make- or-break decision for many. But new hands are always being dealt. Now, Weinstein says, many sub-investment- grade corporate bonds have been falsely tainted by the credit crisis, and therein lies opportunity.
Weinstein recently met with Alpha Staff Writer Imogen Rose-Smith at Deutsche Bank's Wall Street offices to dis cuss last year's meltdown and how hedge funds can make money in the credit market now.

Alpha: What triggered the corporate Credit market meltdown?

Weinstein: The starting point was last June and July, because that is when the leveraged-buyout machine shut down over an inability to place high-yield bonds and loans into the market. People were concerned about the $350 billion pipeline of debt that banks were on the hook for aisd the slsuttering of the collateralized loan ob ligatitsns market because of subprime losses. As a result, high-yield spreads, which started the summer too tight, blew out. But what is interesting is it only affected the high-yield and loan markets; the equity market did not fall. And there was this incorrect notion in the markets in July and into August of decoupling.

That was the disconnect that started to concern you last June?

Even within credit there were serious dislocations, as the secured-loan index, the LCDX, fell as many points as the unsecured high-yield bond index. At their low both indexes were implying a default rate more consistent with a severe recession or depression, while stocks had barely budged, which is just mind-boggling.

Why?

I could understand credit falling a few points without a corresponding move in equities, but to have a ten-point drop in thle most secure part of the capital structure made no sense from a medium-term perspective.

Didn't this notion that problems were isolated also occur in the mortgage market with subprime?

Yes. This idea of decoupled markets started in subprime. When subprime first hit, people thought it would be contained.

How were mortgage problems related to the high-yield market?

When high yield fell, it did so for a couple of reasons. One was simply that spreads were too tight beforehand. But the other was it fell because of subprime. The sub- prime CLOs that were doing poorly shut down the rest of the CLO market, and the CLO market was really i m portant for the high-yield market to clear loan and bond risk off bank balance sheets.

Sounds like you're describing a domino effect.

Subprime problems created CLO problems, which Ted to corporate credit problems.

And yet this idea of decoupling continued to prevail?

There was this view that these problems in credit wouldn't affect equity and wouldn't affect the European markets. But what we saw from the fall and winter was the shatter- ing of this myth. From November to March equity and credit fell hard across all markets.

What's theimpact been so far?

It has really affected everything from the shape of the U.S. yield curve to the yen carry trade to Asian equity prices and even gold prices. One of the last places where things remain out of step is Europe, where the European Central Bank has not cut rates. But really everything else has coupled.

Why do you think so many people bought into the decoupling index?

I remember talking Co the people in equities and even the people in emerging markets, and they would all say the same thing: "You don't understand. The fundamentals look great." So emerging-markets fundamentals looked great because of high commodities prices. Or people would say that equity prices were reasonable because the S&P trades at a decent price-to-earnings multiple. And they kept looking at what was happening in high yield as a technical thing that should not affect them. Clearly, since then we have seen the slowdown in the economy and the potential for a recession.

But corporate credit had been overvalued.

Yes, and people could cling to that a bit because spreads had been very narrow. High yield was technically over-valued into June. but it fell to the point of being extremely undervalued compared with other asset classes. There was such risk aversion because of all of the sub-prime losses at banks that spreads on corporate credit widened too much.

But surely default rates are going to rise?

Yes, defaults are going to increase. But credit spreads now are already implying a default rate higher than during the bear market of 2000 to 2002. During that period the S&P tumbled 45 percent. default rates were at an all-time high and recoveries were low due to frauds such as Enron and WorldCom. Today default rates are at histori cal lows, recoveries have been decent and the decline in equities is much more mild, but credit spreads are practically at 2002 levels.

Why are some traditional long-short equity hedge funds now looking at getting into credit and credit derivatives for the first time?

In good times credit has always been viewed as offering a small premium but, if things were really wrong, you could suffer a default. So there was relatively little up- side and the potential for downside. High yield is so de pressed right now that the risk-reward looks much more symmetric, more like equity.

Where do you see opportunities?

We have been going long some high-yield credits and selling the equity as a hedge; it has been a very profit- able enterprise for us. There aren't many hedge funds involved in this type of capital structure arbitrage on a daily basis. The old-style cap structure arbitrage of the 1980s and 1990s focused mainly on distressed companies. But what we are looking for are the largest dislocations across distressed, high-yield and investment-grade companies一not just fundamentally, but also quantira tively. Factors like equity volatility and implied recovery come into play. We are looking for dislocations across hundreds of names. There are groups with experience through different market cycles that are well versed in equity derivatives, credit derivatives, recovery analysis and credit spreads.

Is this a typical trade for Saba Capital?

Actually, from 2005 through early 2007, Saba was short credit and long equities. During that period companies were actively looking for shareholder-friendly transac dons at the expense of bondholders, whether it was an LBO or a share buyhack. That regime was exactly the opposite of what we are experiencing now. It is important to take note of what the companies themselves are doing to change their capital structures

One good capital structure arbitrage trade for Saba and others was with Countrywide Financial. The trade was to buy credit and hedge it with out-of-the- money puts on the stock.

Yes. If you look at recent examples of large companies that have had problems, the bondholders tend to come out fine. In the case of Countrywide, for a while the stock dropped and credit spreads widened. Countrywide credit default swaps went from 320 basis points in mid-October of 2007 to almost 1,700 basis points on January 9. Fol lowing Bank of America's announcement that month of its intent to purchase Countrywide, the equity has languished. but the credit spread has narrowed by 1.400 basis points and the bond price has risen by 40 percent. The exact same thing happened with Bear Stearns after JPMorgan announced its acquisition.

Why is this kind at arbitrage so attractive tight now?

We are at a point in the cycle where stressed financial and insurance sector firms have little choice but to substantially dilute the existing equity investors. They are doing it by issuing equity and preferred stock to save the enterprise. The same thing happened in 2002, and you are seeing it a lot with the banks now, withl all the sovereign wealth funds coming in and diluting the equity.

But It's not always going to be profitable.

If we were to enter a period where a lot of these compa flies started defaulting, it could certainly become more clsalknging. On an individual basis these trades can be volatile and remain dislocated for periods of rinse. Of course. I'm not presenting this as a risk-free trade. But over the years capital structure arbitrage has been very profitable for us.