Banc of America Securities

Situation Room, May 9, 2005

Credit Market Strategy

Repricing in the correlation
market may have caused
the broader market index
to move wider, even as
overall credit risk appeared
to decline as equity
volatility declined.
Correlation Conundrum
As Glen Taksler details below, the credit market found no respite from last week’s volatility, as
correlation products in the credit derivatives market continued to significantly reprice. Concerns
about potential spillover effects from hedge fund exposures to accelerating losses in mezzanine
hedged equity strategies in ITRAXX and CDX indices led to a notable decoupling of the CDS
indices (wider) and equity volatility (lower) as IG4 ended the day 1 bps wider while the VIX
index ended 0.3 points lower. As Figure 6 below illustrates, there are few cases where the HG
CDX index (excluding the impact of the autos and auto parts) and VIX decouple.

Jeff Rosenberg Figure 6. CDS Credit Spreads Decouple from Equity Market on Correlation Risk
212 933 2927 IG2, 3, 4 series indices excluding autos and auto parts vs. VIX index
IG ex Autos/Parts VIX

65 20
VIX and CDX decouple on Correlation Concerns
IG Spread (ex Autos, Series 3 to Sept 20, Series 4 from

19
60
18

55 17

16
March 21 05)

50

VIX %
15
45
14

40 13

12
35
11

30 10
N 4
4
Au 4

Ja 5

Fe 5

M 5
05

M 5

M 5
5
Au 4

Se 4

Se 4

O 4

D 4

D 4

Ja 4

5
O 4
4
-0

-0

0
l-0

r-0

r-0
0
-0

-0
0

0
-0

-0

-0

-0

-0

-0
n-

n-

b-

b-
g-

g-

p-

p-

ov

ov

ar

ar
ec

ec

ec

ay
ct

ct
Ju

Ap

Ap
Fe
N

Source: Banc of America Securities LLC estimates, Bloomberg.

The main reason for the potential spillover effects is the large estimated losses to the mezzanine
Fears of a broader market
selloff from unwinding hedged equity strategies (long risk in the equity tranche hedged with mezzanine tranches detailed
levered positions look below). We estimate that since April 1, this strategy is down 14 points in tranches referencing
unfounded, at least as far CDX 4 and down 6.75 points in tranches referencing iTraxx. Such large losses clearly lead to
as the bulk of adjustment concern about the potential for greater impact across the credit spectrum as levered hedge funds
has occurred within the are forced to unwind the leverage in other credit products. So far at least, these fears remain
correlation market itself,
with equity tranches unfounded as the bulk of the unwind appears to have occurred within the correlation market itself.
significantly wider and 3- Specifically, the equity tranches are significantly wider and 3-7% tranches are significantly tighter.
7% tranches significantly As Figure 7 below shows, the acceleration in losses to the mezzanine hedged equity strategy likely
tighter… reflects the impact of forced unwinds, in contrast to the first leg lower, which was prompted by an
increase in gap risk (i.e., significant individual issuer spread widening risk) to the equity tranche
following the rise in LBO risks and increased gap risk in autos and auto parts issuers.

Michael Cloherty 212 933 2039 David Goldman 212 933 2926
7
Banc of America Securities
Situation Room, May 9, 2005

Figure 7. Mezzanine Hedged vs. Delta Hedged Equity P&L

Delta-Hedged with the Index (Gray Line) or Mezzanine (3%–7%) Tranche (Black Line)

P&L: IG 0-3 (Points Upfront) Hedged w ith IG 3-7 P&L: IG 0-3 (Points Upfront) Hedged w ith Index

-200

-400
P&L ($000)
-600 Initial leg lower reflected fundamental risks of rising
gap risk from LBOs, autos, & autoparts
-800

-1000

-1200 Acceleration in losses to mezz hedged

equity losses likely reflects forced unwind
-1400
1-Apr-05 8-Apr-05 15-Apr-05 22-Apr-05 29-Apr-05 6-May-05

Source: Banc of America Securities LLC estimates, Bloomberg.

…but the prospect of three

While this unwind trade may have further room to fall, the repricing across the tranches makes the
consecutive months of trade (long equity hedged with mezzanine) more attractive to new entrants. The appearance of
credit hedge fund losses new entrants may help limit the extent of further market disruption. Balanced against this more
could spark investor optimistic scenario is the fact that, while the size of losses to this individual trade appear large, it
withdrawals and forced is still not clear how large an impact those losses had on the overall portfolio. Through the end of
selling, broadening the
impact. That is a risk to
April, we estimate a 5-point loss on the trade before accounting for any leverage. Adding those
spread widening in CDS losses to an overall negative month for credit leads to an estimate of an average credit hedge fund
and the indices even as loss of 1-2%, though certainly higher in cases where this strategy had a larger concentration. The
overall credit risk trends 9 points of losses in the trade in May could lead to a negative overall return for credit hedge funds
lower, a risk that bears in May as well. When added to the estimated 1-3% average credit hedge fund loss in March, the
watching over the next
few days
prospect of three consecutive negative-return months from credit hedge funds could spark investor
withdrawals. That scenario suggests the potential for forced selling from hedge funds whose
investors have a shorter-term horizon and, consequently, a significantly broader market impact. If
that occurs, there is a risk of spread widening in CDS and the indices even as overall credit risk
trends lower.

Getting Out of Delta-Hedged Equity

Correlation Books Repricing

Investors who sold equity
tranche protection, hedged
with the mezzanine, have
lost 5 points since May
6and 9 points since the
beginning of the month
Glen Taksler
212 933-2559
We are seeing a significant repricing in equity and mezzanine tranche protection. Investors who
sold equity tranche protection, hedged with the mezzanine, have lost five points since Friday, May
6:
♦ The investor lost 3.125 points on the equity tranche, which widened from 46.875 points to 50
points upfront mid-market (plus a 5% running coupon).
♦ The hedge portfolio, which in principle should offset equity tranche losses, instead cost the
investor an additional 1.6 points.1

1The mezzanine tranche tightened from 228 bps to 212 bps, or 16 bps. The DV01 of the mezzanine tranche is about 4.6
($4,600 per $10 million tranche notional), and investors typically leverage 2.2 times the equity tranche (for every $10 million in
Michael Cloherty 212 933 2039 David Goldman 212 933 2926
8
Banc of America Securities
Situation Room, May 9, 2005

We first noted this theme in our April 5, 2005, Situation Room article, “With Demand for Yield
Still Strong, Watch How You Hedge.” On days when the overall market moved wider, senior
tranches were widening less than expected, causing hedge mismatches on correlation books. We
are now seeing a similar pattern in the mezzanine: as the market moves wider, mezzanine tranches
are tightening (not widening).

When Theory Diverges From Reality

To increase carry,
investors often hedge with
other tranches, rather
than the index
Provided the market
moves in line with
correlation model
expectations, this hedge
strategy works fine
In theory, an investor who sells tranche protection delta hedges against overall market changes
with the index. For example, an investor who sells $10 million in equity tranche protection buys
roughly $150 million in index protection. But in practice, investors often delta hedge with another
tranche. For example, an investor who sells $10 million in equity tranche protection buys roughly
$22 million of mezzanine tranche protection, instead of the underlying index.
The reason that investors delta hedge with other tranches, rather than the index, is to increase
carry. The investor adds premium by hedging with a leveraged product, in exchange for the risk
that the market may perform differently from model expectations. For example, consider Figure 8,
which shows the annual carry for an investor who sells $10 million notional of the five-year
investment grade equity tranche. The gray line shows that an investor who hedges with the index
currently earns about $900,000 carry per annum.2 By contrast, the black line shows that an
investor who hedges with the mezzanine tranche earns nearly $1.4 million carry per annum. The
difference, shown by the thick blue line (right scale), is about $500,000.
As long as the mezzanine tranche moves in line with model expectations—that is, as long as
correlation remains constant—this hedge works fine, and the investor keeps the extra carry. But if
the mezzanine tranche moves differently than assumed leverage, the investor can lose both on the
original equity tranche and on the hedge (mezzanine) portfolio.
Figure 8. Annual Carry From a Delta-Hedged Equity (0%–3%) Tranche Strategy
Delta-Hedged with the Index (Gray Line) or Mezzanine (3%–7%) Tranche (Black Line)
Investors Hedged Equity With the Mezzanine Tranche Because of Higher Carry

1390 -330

1290 -350

1190 -370
Carry ($000)

1090 -390

Difference
990 -410

890 -430

790 -450

690 -470

590 -490
1-Apr-05 12-Apr-05 23-Apr-05 4-May-05
Carry: IG 0-3 (Points Upfront) Hedged with IG 3-7
Carry: IG 0-3 (Points Upfront) Hedged with Index
Diff (right)

Note: Based on $10 million equity tranche notional. Five-year sector.

Source: Banc of America Securities LLC estimates.

equity tranche notional sold, the investor buys $22 million in mezzanine tranche notional). This results in a loss of –16 bps x
4.6 DV01 x 2.2 leverage, or 1.6 points.
2 At 50 points upfront plus a 5% running coupon, the equity tranche premium is equivalent to about 18.5% (50 points x 3.7

DV01 + 5% running coupon). The index hedge reduces carry by 9.4% (63 bps five-year CDX IG x 14.9 leverage). The investor
is left with about 9% annual carry, or $900,000 per $10 million equity tranche notional.
Michael Cloherty 212 933 2039 David Goldman 212 933 2926
9
Banc of America Securities
Situation Room, May 9, 2005

Why Investors Are Faced with Big Losses

Lately, the mezzanine In fact, correlation has changed, and tranche levels are moving differently than expectations. From
tranche has been Friday, May 6, to Monday, May 9, the index widened 3 bps, from 60 bps to 63 bps. Based on
negatively leveraged... leverage, the mezzanine tranche should have widened 21 bps (3 bps index widening x 7 leverage).
Instead, the mezzanine tranche tightened 16 bps (228 bps to 212 bps). That is, effectively the
mezzanine tranche was negatively leveraged.
Figure 9 shows actual versus expected tranche premiums for the equity tranche. The thick blue
difference line (right-hand scale) shows performance of a delta hedge with the index. Since April
…causing equity tranche 1, 2005, the delta-hedged equity strategy has lost about 6 points. Figure 10 repeats the analysis for
investors to lose money a delta hedge with the mezzanine tranche. Since April 1, this hedge strategy has lost 15 points, a
on both sides of the trade full 9 points more than the index hedge. That is, the investor has lost money on both sides of the
trade: first from being long risk on the equity tranche (which widened) and second from being
short risk on the mezzanine tranche (which tightened).

Figure 9. Hedged with Index, Equity Lost 6 Points… Figure 10. ...but Hedged with Mezz, Equity Lost 15 Points
Actual vs. Expected 0% - 3% Premium, Based on Leverage Actual vs. Expected 0% - 3% Premium, Based on Leverage
Thick blue line shows performance of delta hedge with index Thick blue line shows performance of delta hedge with mezzanine
50 7 50 15

48 48 13

Expected or Actual Premium (pts)

6
Expected or Actual Premium (pts)

46 46
5 11
44
44 9

Difference
4
Difference

42
42 7
3 40
40
5
2 38
38
3
36
1
36
34 1
34 0
32 -1
32 -1 1-Apr-05 12-Apr-05 23-Apr-05 4-May-05
1-Apr-05 12-Apr-05 23-Apr-05 4-May-05 Expected (with Rehedging): IG 0-3 (Points Upfront) Hedged with IG 3-7
Expected (with Rehedging): IG 0-3 (Points Upfront) Hedged with Index Actual Premium: IG 0-3
Actual Premium: IG 0-3 Diff (right)
Diff (right)

Note: Five-year sector. Note: Five-year sector.

Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates.

Losses More than Offset Extra Carry

Figure 11 shows that losses from the mis-hedge with the mezzanine tranche more than offset extra
carry. Since April 1, 2005, the gray line shows that an investor who sold equity tranche protection
and delta-hedged with the index would have lost about $500,000 per $10 million tranche notional.
Assuming a 10% initial margin requirement, this gives a return on equity (ROE) of about –50%.
These very significant losses were magnified for investors who hedged with the mezzanine:
despite higher carry, these investors lost about $1.4 million per $10 million tranche notional, for
an ROE of about –90%.3

3We assume a 15% initial margin requirement for an investor who sells equity tranche protection and hedges with the
mezzanine. Initial margin requirements are higher than for the index hedge because of the risk that the mezzanine tranche may
move differently from correlation model expectations. Initial margin requirements vary significantly among investors due to
differences in counterparty risk.
Michael Cloherty 212 933 2039 David Goldman 212 933 2926
10
Banc of America Securities
Situation Room, May 9, 2005

Figure 11. P&L from a Delta-Hedged Equity (0%–3%) Tranche Strategy

Delta-Hedged with the Index (Gray Line) or Mezzanine (3%–7%) Tranche (Black Line)
Despite higher carry, a hedge with the mezzanine tranche underperformed by $900,000

900
0
800

-200 700

600
-400
P&L ($000)
500

Difference
-600
400

-800 300

200
-1000
100
-1200
0

-1400 -100
1-Apr-05 12-Apr-05 23-Apr-05 4-May-05
P&L: IG 0-3 (Points Upfront) Hedged w ith IG 3-7 P&L: IG 0-3 (Points Upfront) Hedged w ith Index
Diff (right)

Note: Based on $10 million equity tranche notional. Five-year sector.

Source: Banc of America Securities LLC estimates.

We see a similar pattern in Europe, where this strategy may have been more prominent. Since
April 1, 2005, investors who sold equity tranche protection hedged with the (iTraxx) index lost
about EUR 270,000 per EUR 10 million tranche notional—no small loss. But despite higher carry,
investors who hedged with the mezzanine tranche lost about EUR 675,000.

Michael Cloherty 212 933 2039 David Goldman 212 933 2926
11
 Banc of America Securities
Situation Room, May 9, 2005

Why This Is Happening

Broadly speaking, structured credit products have two main risks: market spread movements and
single-name (often called “jump-to-default” or “idiosyncratic”) movements. Delta-hedged equity
tranche investors are long market spread movements, that is, they expect to make money for
small, proportionate changes in overall spreads. By contrast, equity tranche investors are short
jump-to-default risk; in other words, they expect to lose money for large spikes (or jumps) in
single-credit spreads.
In the broader credit market, we have generally seen three trends:
We are now essentially
seeing a stop-loss on 1. Auto spreads spiked in March: This caused the equity tranche to reprice wider, but for
equity tranche trades investors who sold delta-hedged equity protection in early 2005, high carry earned in
January and February kept overall P&L positive.
2. LBO risk in April: Credits that have been the main focus of LBO concerns (such as
grocers and retailers) were not generally seen as high-risk credits. For example, grocers
that were trading in the 50-bps range spiked to about 100 bps. In turn, the risk of
exhausting equity tranche (first loss) notional increased, sending equity tranche
premiums wider.4
Moreover, correlations were low between credits that were the main focus of LBO
concerns (such as grocers and retailers) and other high-risk credits. For example, a
potential default in the auto sector should have little impact on a potential default in
grocers. This caused equity tranche correlations to drop, causing marked
underperformance. P&L turned negative for investors who had not already unwound the
trade.
3. Autos downgrade in May: As auto spreads have spiked even wider, those investors who
are still in the equity tranche have essentially executed a stop-loss. That is, demand to
buy back equity tranche protection has risen significantly, causing the equity tranche to
dramatically underperform. At the same time, demand to sell mezzanine tranche
protection has also risen, helping the mezzanine to outperform.
Part of this may also be due to fear of potential forced selling. We estimate that credit hedge funds
as a whole were down 1% to 2% in April 2005, raising the risk that investors who remain in the
equity tranche may receive significant margin calls. To avoid having to post additional capital on
an unprofitable trade, investors are getting out now. Partially mitigating this is the large
participation in equity tranche trades of broker-dealers, who generally are not subject to margin
requirements.

Economic Research
German industrial
production declined 0.8%
mom in March, but was
still up 1.0% qoq
Lorenzo Codogno
+44 20 7174 4101
German Industrial Output: A Slippery Slope
It is hard to find reassuring German figures these days. Today’s data were no exception, but we
think the headline figures overstate the underlying situation.
German seasonally adjusted industrial output declined a larger-than-expected 0.8% mom in March
following an unrevised 2.1% drop in February. Courtesy of a 2.8% surge in January, the quarter is
still up a healthy 1.0% following a 0.1% monthly drop in the previous quarter. This will likely
allow a nice contribution to GDP growth in 1Q 2005, which—according to our estimates—is
likely to end up rising at least 0.6% qoq (the first estimate is out on Thursday). Due to the
declining monthly profile, however, 2Q 2005 will start on a very weak basis. According to our

4For more details, please see “The Impact of LBOs on Structured Credit: Balancing Wider Spreads With Demand for Yield,”
April 1, 2005.
Michael Cloherty 212 933 2039 David Goldman 212 933 2926
12
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Credit Strategy Research
Jeffrey A. Rosenberg
Head of Credit Strategy Research
Investment Grade
Jerry S. Bennikutty
Neal Jordan
High Yield
Olivera Radakovic
Susan Wu, CFA
Portfolio Strategy
Elizabeth A. Bram
Michael Contopoulos
Mingsung Tang
Yulia Yudelevich
Xiaodong Zhu
Derivatives Strategy
Glen Taksler
International Research
Raja Visweswaran, CFA
Head, International Research
James Carey
European Credit Strategy
Ivy Li
Asian Credit Strategy
Inge-Lise Peetz
European Financial Institutions
John Schofield
European Credit Strategy
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Banc of America Securities — Research Directory
David Goldman, Head of Debt Research (212) 933 2926
High Yield Research High Grade Research
(212) 933 2927 Larry Bland (212) 847 6502 Timothy K. Patrick (704) 386 2363
Head of High Yield Research; Global Head of High Grade Research;
Healthcare, Deathcare Automotive
(704) 388 5213 Ryan B. Bailes, CFA (212) 847 6781 Stan August (704) 388 5373
Metals & Mining, Building Products, Homebuilding Domestic Banks, Insurance, Brokers
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Ana Goshko (212) 847 5936 Matthew J. Bartlett (704) 388 1897
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Technology, Industrials Global Financial Institutions
Michael S. Weiner (212) 583 8478
+44 (20) 7174 5459 Interest Rates Research
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Stephen Weiss (646) 313 8820 Gerald Lucas (212) 933 2846
+44 (20) 7174 5314
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Food & Beverage, Restaurants Head of European Interest Rate Strategy
George D. Goncalves (212) 933 2593
+44 207 174 4583 Cross-Product Research US Treasury/Agency Strategy
Michael Cloherty (212) 933-2039
+44 207 174 1518
Senior Strategist
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