In an amusing expose on the negative basis trade, Bloomberg has identified AllianceBernstein and TIAA-CREF as the winners in the trade where Deustche Bank and Citadel crashed and burned. In a nutshell, a negative basis is where you buy CDS and a bond at the same time while picking up carry, or a positive coupon, due to a dislocation of the prices. This is normally a "riskless" trade as you are technically protected from bankruptcy of the underlying asset for the period of time until the maturity of the CDS, usually 5 years. Problems arise when everyone and their grandmother is also involved, which is exactly what caused Volkswagen stock to hit a 1000 euros last year. When the stampede of other participants tries to unwind, the original basis which would have been as tight as 20-30 bps can explode all the way to 1000 bps, dooming all people who are still involved to some very brutal margin calls, potentially leading to fund shutdowns. This is exactly what happened with Boaz Weinstein's "SABA" group at Deutsche, and is the main reason why Citadel was down over 50% in 2008.
In 2007 every hedge fund would snap up even 5-10 bps of negative carry and lever it up 20-50x... Ah those were the times.
While in "theory" the trade is, as we said, riskless, if in the time between now and the end of the protection contract there is another episode of "deleveraging flaring", investors, who get involved now chasing the carrot of 4-6% in risk free return/year, may very well find themselves on the street once the negative basis goes from 400 to 4000, at least hypothetically. With the all too vivid example of Volkswagen still fresh in everyone's memory, very few brave souls will actually put the basis trade on now, for fear of what may happen tomorrow. So opportunities of risk free 5% will likely persist for quite some time. And if any further damnation is needed, Citigroup "strategist" Mikhail Foux is quoted as saying, “For those situations where there’s a risk of some sort, you should probably be putting on basis trades.” Well done Mikhail.
Sphere: Related Content
Print this post