Here They Go Again—–Hedge Funds Picking-up CDS Nickels In Front Of The EM Steamroller

Are you looking to make a terrible investment decision?

Well sure you are, isn’t everyone?

And thanks to the fact that it appears we may now be testing the limits of the market’s collective patience with the notion of central bank omnipotence, there are plenty of bad investment opportunities out there to choose from.

That said, you always want to go big or go home, which is why what you might want to do is go out and ask a struggling emerging markets lender what its worst “assets” are and then offer to insure those assets against default so that said lender can then go out and invariably make more terrible decisions on the way to hopefully creating a non-negligible amount of systemic risk.

If that sounds crazy to you, that’s because it most certainly is, but don’t tell the buysiders who inexplicably decided to go long EM credit risk at the worst possible time in decades via their participation in a synthetic CLO from none other than Standard Chartered. Here’s Bloomberg:

Imagine this pitch: Buy a complicated, derivatives-based deal tied to emerging-markets debt. Right now. In a shaky credit market.


The expected response might be laughter — or speechlessness. But Standard Chartered pulled off just such a deal in the past few weeks, selling a $236.3 million piece of a synthetic collateralized loan obligation to a group of hedge funds in a risk-transfer maneuver.


Did I mention this is Standard Chartered? The London-based bank has been accused of breaching U.S. sanctions against Iran, shook up its upper management a few months ago and does a lot of business in China. Its shares have lost more than 20 percent so far this year.


Standard Chartered’s deal was aimed at lowering the amount of money it must hold to offset riskier holdings. The bank reduced its capital charges by millions of dollars on a $3.5 billion pool of debt by paying hedge funds to insure against potential losses.


The bank had a ready-made audience,and other big banks have completed billions of dollars of similar deals in recent years.


But this one took an extra leap of faith. About 17 percent of the reference loans were domiciled in China, some 17 percent in Hong Kong and 7 percent in India, according to the prospectus dated Sept. 23. Also, this deal came after Standard Chartered shook up its upper management and as China’s slowest growth in more than two decades roils Southeast Asia.

Now look, there’s never really a “good” time to start moving credit risk from imperiled banks onto your own balance sheet, and apparently, the hedge funds that got into the mezz tranches here are getting something like an 11% yield which looks great in a world dominated by ZIRP, but one can’t help but wonder if this isn’t going to be a disaster.

Bloomberg characterizes this as “a complicated, derivatives-based deal,” which is a typical characterization for synthetic CDOs. Not to take anything away from that description (because bless their hearts, it’s probably just a well meaning attempt to warn readers that they’re about to be subjected to some financial alphabet soup), but these deals aren’t really all that complicated conceptually. Here’s how this works: I have some loans I made that I think are probably bad and it’s keeping me from making more bad loans because the regulators don’t like the amount of risk I’m taking, so what I’ll do is I’ll periodically pay you some spread over a benchmark rate I probably manipulated and then you’ll agree to pay up when these loans go bad. Because they aren’t my problem anymore, I get to go to my regulators and say “see, these guys are on the hook, not me, so now please let me go out and make more of these bad loans” and of course because the cost of capital is zero, it’s a sweet deal for me, even if I fooled you into believing that the CDS premium I’m paying you is attractive.

In case that’s not clear enough, allow us to simplify further: metaphorically speaking, the hedge funds that participated in this deal just knowingly issued a whole bunch of flood insurance on a bevy of homes in New Orleans knowing that hurricane Katrina is coming.

Of course there are no certainties in the world and if EM doesn’t suffer a complete meltdown, then anyone who agreed to provide doomsday insurance in return for a thousand basis points of yield is going to look very, very smart and we certainly won’t begrudge them their (fiat) profits, but just note that you heard it here first – this is picking up nickels in front of a steamroller.

Source: Nickels, Meet Steamroller: Embattled Bank Suckers Hedge Funds Into EM Insurance Bet | Zero Hedge