Friday, 5 October 2007

Monetising prejudice premia

Over at Calculated Risk, Tanta takes issue with this report from JPMorganChase (via Creditflux):
In a new research report entitled "Leveraging CLO illiquidity premia", JP Morgan says that the combination of historically wide CLO liability spreads and near-zero default rates makes this an optimal time for buy-and-hold investors to consider investing in CLOs-squared. It says this is a way to efficiently monetise the current illiquidity created in the "spread rout of 2007".

The report concludes that CLOs-squared offer reasonably low risk relative to the underlying CLOs. Junior tranches in particular offer higher spreads than triple B and double B tranches of regular CLOs with similar or lower risk.
Normally I have a high regard for Calculated Risk, but Tanta's sarcasm is rather disheartening. She says:
[...] because this whole problem, you see, was just a matter of the underlying collateral and had nothing whatsoever to do with levering up complex derivatives or having to unwind some goofy structured deal.
Leverage and complexity aren't good or evil. Particular deals might be, or perhaps even more specifically particular deals sold a certain way to particular investors might be, but that's it. You can't conclude that all structured trades are necessarily bad. After all, buying stocks on margin has been common for U.S. retail investors for many years, but no one is suggesting that this form of leverage doesn't meet some legitimate investment objectives. So JP's investment idea should not be dispensed with by waving a magic wand of disapproval at it: you actually have to analyse it. Still with people talking this way, it might be a good way to go long some cheap complexity.

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