Sep

27

The behavior of total return swap CLO deals over the last few months has been interesting. As the loans have been marked to market with deep discounts, huge stop loss orders have been triggered in the past few months.
 
Did the creators of these fixed-rule systems realize that they would cause forced liquidations at the worst possible moment? In essence, they piled a mountain of stop loss orders simultaneously at the same price levels. It is the old conundrum: If you trade your equity position in a leveraged trade (and not the market), how do you avoid being the weak hand? Buy high, sell low.
 
The indentures of individual portfolios map out coverage tests (margin requirements) that must be followed by the asset manager. If the tests are not met, a part of the portfolio must be liquidated until the portfolio once again passes coverage tests. It is all very sensible, a rational plan easily understood by investors who fear the leverage. They are protected from the possibly aberrant judgment of the asset manager.
 
Yet when masses of such tests are breached on many deals at once, the prices move to hurt the weak hands and pricing no longer seems rational beyond this internal logic.
 
As the weak flounder and unwind, the strong eat the weak. New structures are created with higher equity positions and firmer footing. The rejuvenating spirit of capitalism lives on.


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