Wall Street and sub-prime

http://www.nytimes.com/2007/12/06/business/06hedge.html?ex=1354597200&en
=ee60a35aacff1a9c&ei=5089&partner=rssyahoo&emc=rss
As the subprime loan crisis deepens, Wall Street firms are increasingly
coming under scrutiny for their role in selling risky mortgage-related
securities to investors.

Many of the home loans tied to these investments quickly defaulted,
resulting in billions of dollars of losses for investors. At the same
time, many of the companies that sold these securities, concerned about
a looming meltdown in the housing market, protected themselves from
losses.


The Wall Street banks that foresaw problems say they hedged their
mortgage positions as part of their fiduciary duty to shareholders.
Indeed, some other companies, particularly Citigroup, Merrill Lynch and
UBS, apparently did not foresee the housing market collapse and lost
billions of dollars, leading to forced resignations of their chief
executives.

In any case, the bankers argue, buyers of such securities -
institutional investors like pension funds, banks and hedge funds - are
sophisticated and understand the risks.

Wall Street officials maintain that the system worked as it was
supposed
to. Underwriters, they say, did not pressure colleagues on trading
desks
or in research departments to promote securities blindly.

Commercial Paper

A company or group of companies looking to enhance liquidity may sell receivables to a bank or other conduit, which, in turn, will issue them to its investors as commercial paper. The commercial paper is backed by the expected cash inflows from the receivables. As the receivables are collected, the originators are expected to pass the funds to the bank or conduit, which then passes these funds on to the note holders.

In practice, most commercial paper has a maturity of between 5 and 45 days, with 30-35 days being the average maturity. Many issuers continuously roll over their commercial paper, financing a more-or-less constant amount of their assets using commercial paper.
Commercial paper is issued by a wide variety of domestic and foreign firms, including financial companies, banks, and industrial firms.

Money market mutual funds (MMFs) and commercial bank trust departments are the major investors in commercial paper. MMFs hold about one-third of the outstanding commercial paper, while bank trust departments hold between 15 and 25 percent.7 Other important investors, holding between 5 and 15 percent, are nonfinancial corporations, life insurance companies, and private and government pension funds.

Commercial paper entails credit risk, and programs are rated by the major rating agencies. Because commercial paper is a rolling form of debt, with new issues generally funding the retirement of old issues, the main risk is that the issuer will not be able to issue new commercial paper. This is called rollover risk.

Asset Backed Commercial paper (ABCP) programs provide cost-effective funding to a sponsoring bank’s customers. They allow
receivable sellers that otherwise cannot directly access the commercial paper market to finance
their receivables at favorable rates. Even sellers that are able to access the commercial paper
markets participate in ABCP programs because they provide alternative sources of funding and
the seller generally remains anonymous in a multi-seller conduit; investors are protected through
various program enhancements built into the structure of ABCP programs.
A bank also benefits from ABCP programs. Instead of lending to its customers through its own
balance sheet, the bank is able to refer its customer to the ABCP conduit, avoiding higher
regulatory capital charges. A bank earns fees for the services it provides to its customers and the
ABCP conduit.
An ABCP program functions similar to a term securitization. Each seller transfers receivables to
the conduit, which is typically a variable interest entity (VIE), usually in a two-step transfer.
(The accounting for the transfer is outside the scope of this paper.) The seller receives cash at a
discount to the receivables’ face values in order to provide credit support to the conduit and to
cover payment of the conduit’s funding costs. Each seller is provided a facility limit and term.
Many ABCP programs are revolving in nature. For example, interests in new receivables or
other financial assets meeting pre-determined eligibility criteria can be sold to the conduit when
previously transferred interests are repaid by their related obligors. Other ABCP programs
involve static amortizing pools of assets.

When new paper is not sold to roll over the matured paper, the bank must pay the investors of the maturing paper and hold the unsold paper in its own account until sold. This requires the bank to record the outstanding paper it holds on its balance sheet, increasing its liability, which raises reserve and capital requirements, and lowering its profit margin.

mark-to-market explained

When one buys a cash instrument, for example 100 shares of ABC Inc., the payoff is linear (disregarding the impact of dividends). If we buy the shares at $50 and the price appreciates to $75, we have made $2500 on a mark-to-market basis. If we buy the shares at $50 and the price depreciates to $25, we have lost $2500 on a mark-to-market basis.

Instead of buying the shares in the cash market, we could have bought a 1 month call option on ABC stock with a strike price of $50, giving us the right but not the obligation to purchase ABC stock at $50 in 1 month's time. Instead of immediately paying $5000 and receiving the stock, we might pay $700 today for this right. If ABC goes to $75 in 1 month's time, we can exercise the option, buy the stock at the strike price and sell the stock in the open market, locking in a net profit of $1800.

If the ABC stock price goes to $25, we have only lost the premium of $700. If ABC trades as high as $100 after we have bought the option but before it expires, we can sell the option in the market for a price of $5300. The option in this case gives us a great deal of positional flexibility with a different risk/reward profile.

Mark-to-market is a way of accounting for financial products in which an inventory of financial products is revalued a pre-set interval (usually at the end-of-business on a daily basis) at current market rates. The combination of realized and unrealized profit and loss is booked to the profit-and-loss account. Mark-to-market accounting is a good practice for the management of any financial portfolio.

It is mandatory for financial institutions to report their financial accounts in this fashion. In the near future, initiatives like the Financial Accounting Standards Board Statement No. 133 will require mark-to-market accounting from non-institutional end-users, as well.

Credit Derivative Products

The most common credit derivative products include credit default swaps, credit-linked notes ("CLNs"), OTC
deposits, and synthetic collateralized debt obligations ("synthetic CDOs"). Credit default swaps
are the most basic EMCD product and involve payment of a premium by one counterparty
(protection buyer) in exchange for a contingent payment by another (protection seller) in the
event of a specified credit event vis-à-vis a reference obligation or entity (typically, but not
exclusively, sovereign bonds or bonds of blue-chip corporates). Credit default swaps are based on standard ISDA contract documentation, frequently involve standardized contract sizes, and,
in the case of the most liquid underlying sovereign credits and a limited number of blue-chip
corporate credits, enjoy an active broker market with dealers quoting two-way pricing for
standard contract sizes
Credit-linked notes and OTC deposits are moderately more complex products that eliminate the
exposure of protection buyers to the counterparty risk of protection sellers and, as on-balancesheet
instruments, allow those investors restricted from engaging in OTC derivative transactions
to obtain similar economic benefits as offered by credit default swaps. CLNs involve upfront
payment by the protection seller of par value for a note, in exchange for a spread paid by the
note issuer reflecting both the default probability of the reference entity and issuer
creditworthiness. If a credit event occurs, the note redeems early and the investor takes
delivery of a defaulted asset of the reference entity from the CLN issuer, with the investor
sustaining a loss based on the reference asset’s loss.
OTC deposits are similar to CLNs, but involve the placement by the protection seller of a
deposit with the protection buyer - rather than upfront payment of note principal - in exchange
for a coupon incorporating the premium for default protection on a reference asset together with
a spread reflecting issuer credit risk. In a credit event, the depositor typically forfeits the deposit
and takes physical delivery of the defaulted underlying reference asset. OTC deposits are not
Euroclearable and are not listed and are thus generally cheaper and easier to effect.
Synthetic CDO's are among the most complex EMCD products. Synthetic CDOs are typically
"structured" transactions in which a special purpose entity ("SPE") is established to sell credit
protection on a range of underlying assets via individual credit default swaps. The SPE in turn
issues several prioritized tranches of notes to investors, with note proceeds typically invested in
collateral consisting of high-quality government paper to meet contingent credit default swap
payments, while noteholders (in order of seniority) receive both cash flows on the underlying
collateral and premiums on the SPV default swaps. Synthetic CDO's provide an attractive way
for banks and other financial institutions to transfer credit risk on pools of loans or other assets
without selling the assets.
Credit derivatives may involve single name reference assets or a basket of names and can be
customized to meet investor needs. Of the major products, sovereign single- name credit
default swaps appear to be the most liquid. Transactions on corporate credits tend to be more
customized and structured, with CLNs, OTC deposits, and structured default swaps most
prominent.

Structured products

Structured products are synthetic investment instruments specially created to meet specific needs that cannot be met from the standardized financial instruments available in the markets. These products are created through the process of financial engineering, i.e. by combining underlyings like shares, bonds, indices or commodities with derivatives. Examples of Structured products are :


IRD:
Interest Swaps, Swaptions, FRA’s, Caps and Floors, Inflation Swaps, and Bullet Payments.


FX:
Foreign Exchange Swaps, Spots, Forwards, and FX Options.


Credit:
Single-name Credit Default Swaps, Credit Default Swap Indices and Baskets.


Equity:
Equity Swaps, Equity Options, Variance Swaps, and Total Return Swaps.

The 'Structured Products Group' inside an Investment Bank develops new products and tailors customized solutions to satisfy specific and sophisticated client requirements. Example deals: Oil monetization for a Petrochemical company, Securitizing ticketing receivables for an Airline.

Yield Curve explained

from: http://www.traderdaily.com/magazine/article/16853.html

Be it steep or inverted, traders enjoy a good yield-curve bet. But with the long bond taking on a life of its own and credit markets gone haywire, playing rate spreads can be one dangerous game.

Anyone who has ever attempted pairs trading can attest to the degree of difficulty involved in trying to call two simultaneous directional moves. Two securities, two chan­ces to be wrong.

Some might argue that a spread trade should, theoretically, be somewhat less risky than taking an outright position. Extracting tasty spread profit from two ends of the U.S. interest-rate yield curve is an old standby, and it can be done — if you know what you’re doing. But it’s hazardous prospecting. Nego­tiating the curve gets particularly difficult in turbulent trading environments — such as those seen in these credit crisis–plagued months, in which wrenches in the works (whether flung by the Fed or some rogue tra­der) are constantly undermining even the most reliable givens.

Granted, “buy the two, sell the 10” doesn’t sound especially intimidating, but let’s back up for a moment. As we all well know, a yield curve is nothing more than a plotted pattern playing out on an L-shaped graph: maturities along the horizontal, yields along the vertical. That spectrum of yields versus maturities, from 30-day bills to 30-year bonds, typically charts as a curve, with traditionally smaller yields corresponding to shorter durations and yields inching upward as the durations get longer. If I lend a friend 20 bucks for a half-hour, I don’t expect much in return except my 20 bucks; if he requires a month to pay it back, well, he had better be prepared at least to buy me a beer.

A yield curve exists for all interest-rate markets, including corporate and municipal bonds, inflation-linked bonds and interest-rate swaps. However, when someone speaks of the yield curve, he’s referring to the U.S. Treasury market.

Market strategists have used the yield curve as an economic barometer for decades. An inverted yield curve, in which short-term yields grow larger than long-term, often serves as a harbinger of recession. Then again, nothing about the yield curve is ever set in stone; it has, over time, bewildered the best of them. Still, “the yield curve is far and away the best indicator of trends in the economy,” says Peter Borish, a director at Pali Capital, a Manhattan-based financial-services firm.

The curve is an indicator of inflation, of stock prices and of the economy in general. As interest rates move, so do yield curves, which generally exhibit three common shapes: normal, flat or inverted. “The shape of the curve is more important than the absolute level of rates,” Borish points out.

Things can (and do) get kinky. It’s not unusual for the rates for three- and six-month Treasury bills to be higher than those for, say, two-year Treasury notes. Those two-year note yields can, at times, be higher than 10-year-note yields.

The Chicago Board of Trade’s two-, five- and 10-year Treasury futures are among the principal instruments for trading this serpentine phenomenon, with the “two-10” spread considered the most common play. The CBOT actually had a number of yield-curve spread futures approved by the CFTC in the mid-’90s, though they never garnered much attention and were soon delisted.

Six or so years ago, when the 30-year bond was still the long end, the note-over-bond, or “NOB,” spread was the happening trade. That has since drifted into obscurity given the 10-year note’s new prominence as the long-end benchmark and the sporadic issuance of 30-year bonds. The current flavor of the month is the “tens-under-twos,” or “TUT,” spread.

Yield-curve spread trades come in two main varieties: flattening and steepening. Banks have traditionally been the biggest ­players. “Big-money center banks have money coming in every day,” explains Gregory Cotter, president of Roslyn Heights, New York–based Tri Global FX and former chief FX dealer at Société Générale. “They’re always long in cash and always looking to lend, which makes them trade the curve to manage their risk.”

The spread trade is a hedge of sorts: buying one security while selling another, hoping to profit on a convergence or divergence. For many traders accustomed to outright directional bets, this is a foreign concept. “I’m not a good spread trader,” admits Borish, who prior to Pali Capital ran OneChicago. ­Going back further, he was director of ­research at Tudor Investment Corp. Tantal­izing as is it may be to take a tea-leaf reading and dive in, Borish knows that correctly calling the curve is easier said than done. “If I’m trading twos against tens, I want to win on both sides of the trade,” he says, “even though I know I can’t.”

One’s comfort level with the curve is often a byproduct of one’s trading background. “If you came in on the commodities side, like beans or cotton, you were probably trained as a spread trader,” Borish says. “The energy guys, the agriculture guys, were spread traders, along with the bond guys.”

The off-the-floor traders, especially those who were brought up in the heyday of the 1990s equities bull market, were more used to simple directional trading. Cotter, who trades currencies, keeps a close tab on the overall shape of the curve at all times. “I watch the steepness,” he explains. “If banks get a steep curve, they can make money all day long. If the curve is steep, eventually the economy will be all right.”

In reality, some argue, these relationships were never as strong as alleged. They began to collapse in the mid-’90s, when the Japanese experiment in near-zero interest rates led to the creation of an international yield curve anchored at the short end by Japanese short-term rates. Such a situation made everyone else’s effective yield curve positively sloped as part of the yen carry trade. This global trend contributed to the late-’90s and mid-2000s asset bubbles in stocks and real estate, respectively.

Most traders understand just how difficult it is to curve-trade. “More than a few well-known traders got hammered trading the curve last year,” Cotter points out. “I’m talking about some of the smartest guys out there. That they couldn’t get it right shows it’s just not easy to do.”

Delta, Gamma & Delta Hedging

http://www.riskglossary.com/link/delta_and_gamma.htm

Delta hedging

'Commercial Paper' links

From Wikipedia:

Commercial paper is a money-market security issued by large banks and corporations. It is generally not used to finance long-term investments but rather to purchase inventory or to manage working capital. It is commonly bought by money funds.



There are two methods of issuing paper. The issuer can market the securities directly to a buy and hold investor such as most money funds. Alternatively, it can sell the paper to a dealer, who then sells the paper in the market. The dealer market for commercial paper involves large securities firms and subsidiaries of bank holding companies. Direct issuers of commercial paper usually are financial companies that have frequent and sizable borrowing needs and find it more economical to sell paper without the use of an intermediary. Direct issuers save a dealer fee of approximately 5 basis points, or 0.05% annualized, which translates to $50,000 on every $100 million outstanding. This saving compensates for the cost of maintaining a permanent sales staff to market the paper.

from Fed reserve of Richmond:

Most commercial paper has a maturity of between 5 and 45 days, with 30-35 days being the average maturity. Many issuers continuously roll over their commercial paper, financing a more-or-less constant amount of their assets using commercial paper....Backup lines of credit are intended to provide funds to retire maturing commercial paper when an event prevents an issuer from rolling over the paper. Such an event may be specific to an issuer: an industrial accident, sudden liability exposure, or other adverse business conditions that investors perceive as significantly weakening the credit strength of the issuer.

Here is the Chevron Website page that explains their 'Commercial Paper' offering....and this is the pdf-link to the 'Offering Memo'.

This is the 'Commercial Paper Rates and Outstanding Data' published daily by the Federal Reserve.

Lately, Commercial Paper has run into bad press, here is an explanation from Money Week:

The main problems are in a sub-sector of the commercial paper market known as asset-backed commercial paper (ABCP), loans backed by assets such as mortgages or credit-card debt. ABCP is mainly held in special investment vehicles (SIVs) or conduits, which are set up by banks, but crucially, are kept off the bank’s balance sheet. These SIVs issue short-term commercial paper and use the funds raised to buy assets such as mortgage-backed securities and other debt that matures over a longer period of time. The profits come from the fact that the long-term debt it buys pays a higher yield than it pays out on its commercial paper.

As these vehicles are off balance sheet, they can borrow and invest as much as they want without affecting the sponsoring bank’s ability to lend money for other reasons. This area of the market has been booming, now accounting for around $2trn of all the commercial paper outstanding, according to The Economist.

So what’s gone wrong?

Subprime mortgages. As markets belatedly realised that giving home loans to people with no incomes, job or assets was a terrible idea for anyone who cares about getting their money back, so investors in ABCP began to panic. The idea that some of the assets backing commercial paper were unsound meant that investors began to demand their money back and refused to keep rolling over the loans. This left SIVs scrabbling to find the money to repay investors.

Equity Swap is a special type of Total Return Swap

The five generic types of swaps, in order of their quantitative importance, are: interest rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps.
An equity swap is a special type of total return swap, where the underlying asset is a stock, a basket of stocks, or a stock index.
Most swaps are traded Over The Counter (OTC), "tailor-made" for the counterparties. Some types of swaps are also exchanged on futures markets, for instance Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board Options Exchange and Frankfurt-based Eurex AG.
The cash flows are calculated over a notional principal amount, which is usually not exchanged between counterparties.

Syndicated Loan

http://www.wcsr.com/downloads/pdfs/cm120205.pdf

A syndicated loan is a loan with more than one lender, and the primary market for a syndicated loan is the group or syndicate of other lenders that the lead bank or “agent” bank (which in some cases may be a task shared by more than one bank as co-agents) recruits to join the lead bank in making a credit facility available to a borrower.
Often, a syndicated loan begins with a borrower approaching one or more banks with a proposal for financing. In other cases, a bank may approach a potential borrower with a proposal. The potential lead banks, which may or may not include a bank with which the borrower has a long-term banking relationship, negotiate with the borrower and compete with each other to win the “mandate” from the borrower to lead the syndication.

Repo

http://www.derivativesstrategy.com/magazine/archive/1997/0297fea1.asp

Repo, officially the sale of securities with a simultaneous commitment to repurchase them in the future, was traditionally a financing vehicle used by banks to raise money off their bond portfolios.
In a standard repo, the cash borrower puts up a portion of the bond portfolio as collateral and the lender advances cash. For bond-rich investors, repo meets their top-three money market requirements: it's flexible (with time frames from intra-day to three months); it's safe (because it is a collateralized loan); and it often offers the best yields when compared to other alternatives.
Now, among other things, it greases the wheels of even the most mundane derivatives trades. Say a trader buys an option and hedges it with the purchase of the underlying bond. A repo would be used to fund the purchase of the bond.
Hedge funds typically use REPOs in exotic OTC transactions, they can't do one of these trades without repo. Conceptually, the repo is used to finance the hedge portion of a complex OTC transaction. And hedges come in all shapes and sizes. That means that in some cases the repo may be done in the currency of the original swap or option. In other cases, in order to pick up more yield or put on a different risk spin, a cross-currency repo could be used.
Repo is thought of as a short-term vehicle-overnight repo is the most popular form-but it is possible to extend the repo term to a year and beyond.