Arbitraging the client
30th November 2010
Plenty of practices once considered normal are now beyond the pale. Depending on the outcome of a High Court trial involving Barclays, credit rating arbitrage may soon join drink-driving and smoking in the office as behaviour no longer considered acceptable.
The case, brought by Cassa di Risparmio della Repubblica di San Marino (CRSM), an Italian bank, focuses on products discredited in the wake of the financial crisis. Nevertheless, the stakes are high. If CRSM wins, the legal floodgates could open to allow investors to extract compensation on the trillion-plus dollars of products sold during the bubble. But the practices being examined in court also underpin the huge market for structured products still being created today.
Credit ratings arbitrage hinges on two very different approaches to measuring default risk. Rating agencies look at historical default rates to assess future risks. Meanwhile, credit derivatives traders use market spreads to estimate the probability that companies will go bust in the future.
The arbitrage appears when traders bundle debt and slice it in the form of collateralised debt obligations (CDOs). Conservative investors bought these products on the basis of triple-A credit ratings, accepting a low return in exchange for safety. But bankers designing CDOs could profit from the difference between the ratings of the assets and their market price.
Barclays is accused of perfecting the arbitrage by bundling together existing CDOs in so-called CDO-squared products. According to analysis presented by CRSM, the triple-A credit rating of its investments implied a probability of default of less than one percent. Meanwhile, the market-based approach used internally by Barclays suggested a default probability of more than 25 percent.
An exchange of emails disclosed in court appears to show the arbitrage in action. “Matteo wants to make more points than before in a lower spread environment”, wrote one Barclays CDO banker, referring to a salesman’s profit on the deal with CRSM. “The more we arb this the more likely it is that we have downgrades/defaults before next year”, a colleague responded.
Barclays argues that it is impossible to compare the two approaches to measuring default risk. It is also depending on a battery of contractual arguments, case law and expert witnesses to derail CRSM’s case. If Barclays prevails, it will help warn other clients off making similar claims.
But whatever of the outcome of the trial, the idea of using structured products to profit from investors’ misunderstanding of risk probably won’t survive.