Saturday, March 7, 2009

The Bank Nationalization Arbitrage Play

When the hotdog vendor you buy lunch from talks about the impending nationalization of Citigroup, it is fair to say that nationalization risk is "priced in" Citi's (and all other financials') securities. And while the risk that the government will take over Citi, BofA and the other major banks is palpable, the upside in shorting bank stocks is very limited (BAC can only go down another $3.14 while Citi is a frequent visitor to the 99c club), especially considering the downside risk in the form of a squeeze, which can be easily observed by looking at the market action in the last 30 minutes of trading on Friday (for retail investors who bought into this short covering wave thinking this could be the indicator of a market bottom, our condolences).

Nonetheless, a unique way to play the nationalization threat, with limited downside and potentially substantial upside, does exist in the form of a Parent (HoldCo) - Bank bond basis trade.

The dramatic widening in financial CDS over the past several weeks is the result of bank CDS referencing the bank Parent (aka HoldCo), level, or the most comprehensive and risky layer of a bank.

In several instances a financial Senior - Sub relationship can be exploited via CDS, however in the case of a default event both are likely to converge to comparable recovery levels as there not yet been a case of split preferential treatment of Sr/Sub debt classes in a bank nationalization. A potentially more lucrative and less risky way to play the creeping nationalization threat is via a Bank-Parent arbitrage. Nowhere is this more evident than in the Lehman brothers bankruptcy case: Barclays, which balked at the prospect of purchasing Lehman HoldCo which contained that toxic dump of all of Lehman's worthless CMBS "assets", jumped at the opportunity of buying Lehman's Bank assets (and associated debt), even more so that it ended up being a transaction in which bank assets were purchased for nanocents on the dollar (golf clap for Lehman creditors' legal advisor Milbank Tweed for allowing this daylight robbery to occur). Lehman HoldCo debt is now trading around 13 cents while FSB/bank debt was in the 80s and virtually doesn't trade. The reason why the government may be interested in a Parent-Bank bifurcation is that roughly 70% of bank debt outstanding is at the parent level according to Bank of America, which suggests that if the government finally does come around to a dramatic recapitalization of the zombie banks, it is likely that the Bank level would be supported while the Parent would be wiped out.

The arbitrage in this case would be purchasing bonds guaranteed by the Banks while shorting bonds not guaranteed by the Bank/only by the Parent. This relationships can be seen by comparing the relative spreads of JPM's 6% bonds due 10/1/2017 (Bank guarantee, A+ rating) versus JPM's 6.125% bonds due 6/27/2017 (Parent guarantee, A rating).

As can be seen from recent market action, the bond spread has started to diverge as traders being to exploit this relationship. Nonetheless, the current spread is still only 100 bps. A Lehman-like resolution would result in the spread exploding, as Parent bonds hit cash prices in the teens, while Bank bonds drop only marginally. Also, as the worst case scenario is pari passu treatment, the spread can at most converge to 0. On a $10 million basis this implies the maximum downside is $100,000, while the upside could be well over $5 million: this should be a much more acceptable risk/return scenario to any trader who is betting on a sweeping bank nationalization, but is unwilling to take on the common stock short squeeze or creeping nationalization risk. Additionally, the trade could double up as nationalization insurance, since bank CDS are trading at levels at which it makes no sense to actually use them for "protection" purposes due to exorbitant carry costs (absent a pair trade with matched bonds, which is in fact a trade that has been aggressively implemented over the past 2 weeks, and which the administration should be very concerned about due to the perverted inherent incentives of basis holders to see the eventual bankruptcy of the underlying security). Sphere: Related Content
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Anonymous said...

if truly was going to nationalize BOFA or JPM and allowed the parentco to wipe out - that would trigger cross default language that would cause the same sort of CDS explosion as witnessed after lehman ... ie. defeating at least one purpose of nationalization.

Tyler Durden said...

Cross defaults would not apply to the Bank issued bonds which (at first blush) seem to also have FDIC guarantees. Ultimately this trade falls into the "end of the world" category (long US CDS) and who knows if you get paid anything (nationalization will likely be the beginning of the end) but in the form of a self-fulfilling prophecy it likely will lead to spread divergence.

Anonymous said...

just saying doubtful u will get the ultimate parent/sub payout as the pre-requisite for that would be for parent co to file or left so badly treated that there would be a downgrade which would then cause the cds mess and more rapid delevering.

still not a bad trade tho as they most likely should trade differently.

now once clearinghouse for CDS is setup this could be a moot point but doubtful everything will be transfered day1.

Anonymous said...

Just wondering, what bank do you guys put your cash in?

Anonymous said...

IIRC, when Barings went under, the creditors of the bank were fine, but the creditors of the holding company got nothing,

The purchaser of the bank (ABN AMRO?) made sure it wasn't responsible for the holding company's debts.

Anonymous said...

Another good reason to eliminate all credit default swaps.The world did fine before JPM invented these

Unknown said...

actually worse case scenario would be WAMU - after they were seized and then filed chapter 11. because of cash owned by holdco, the opco bonds went to 25 and holdco bonds went to 65...

Anonymous said...

This trade fails many times b/c the HoldCo has left over subs or cash that is not seized. WaMu is the most recent example, but others from past include First City, Bank East, etc where Sr at HoldCo got either par+ or close to it. Have to look at the Bank HoldCo Reports (Y-9c) to determine what assets are actually held at HoldCo (only available for Bank HoldCos not Thrift HoldCos).

Unknown said...

it only fails, if as you point out, one hasn't done their homework on the asset side. but obviously your downside risk is limited to the spread at inception. from a liability standpoint it is much more likely to success than fail as a generalized trade

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