John Dizard of the Financial Times has learned that Goldman is trying to find a counterparty for a bearish position on banking industry risk. Is this a house bet, a hedge, an attractive product, or is the firm merely trying to find a taker for a punt a client wants to make?
Regardless, the actions of savvy players say more than their public pronouncements….
From the Financial Times:
So, through the magic of globalisation, we have dollar paper moving off the books of the world’s banks and dealers, onto the books of the central banks.
This won’t be enough. In the end, I believe, the Fed will have to take a more direct role in taking risk on to its own book. There will need to be more, large, sales of equity in banks and dealers, most readily to the sovereign wealth funds.
We are getting there, though. Just in case we don’t and there is a meltdown, Wall Street firms are buying parachutes. A Powerpoint presentation for one such crossed my e-mail last week, with a note from a buy-side person saying “Fell off a Truck”.It was from Goldman Sachs for what were termed “Large Bank Basket-Stability Notes”. This is definitely not a retail product. To summarise, the “Notes”, which have a three year term, pay 10 per cent a year to the holder to take the other side of a Goldman bearish position.
The Notes are a basket of 50 international bank stocks. “In this structure,” the Powerpoint document says, “investors earn 10 per cent for each reference stock, as long as that stock does not decline by more than 50 per cent during the next three years.”
I’m assuming the firm retained the bearish position as part of a global hedge against “gap risk”, or disaster. Given how unsatisfactory alternative approaches have been this year, such as dynamic hedging of mortgage risk through rapid-fire sale of the ABX, it is not surprising that the smarter people are buying their insurance in advance.
The earlier part of Dizard’s article is worth reading. It discusses why central bank operations to increase liquidity haven’t been successful so far and suggests a remedy.
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A too-big-to-fall bank failure is a very real possibility.
Thank you for pointing this out.
as per any structured note, it won’t be goldman directly taking the opposite bet, they will be hedging it out in the market. while i’m no expert on equity structuring, my bet is that since they have high dividend yields, AND because there are probably a lot of shorts in this sector, goldman can buy the individual stocks, clip the relatively large dividend yield that most of these stocks will offer, and repo them out at good rates, since a large short base will create demand to borrow the shares. and they can also sell 3y 50% OTM puts to bring in extra premium.
I bet if you actually run the numbers for what the package is worth, goldman are simply arbitraging to generate up-front profit.
move on, nothing to see here!
“As per any structured note, it won’t be goldman directly taking the opposite bet, they will be hedging it out in the market.”
A few things here. “Will be” may not be the right tense. This basket could be offered because it hedges a position that Goldman already has on its books. Or, as you say, maybe it will just be hedged out, and the timing of the product is based on the fact that the vols and the correls are high at this time, and Goldman can make a particularly attractive price (i.e. offer a particularly attractive rate of interest). Or, maybe Goldman will keep a part of it on its book, because it likes the odds. Only Goldman knows why…
In response, Deutsche Bank, SG and UBS have devised new methods of stress-test hedging their capital-protected structured hedge funds business. “We have issued a large number of bonds that will redeem early if specific funds of funds drop by more than 20%,” says Carson. These two-year bonds resemble reverse convertibles – which are similar to convertibles, but rather than buying a call option on a stock, the investor sells a put on the stock or index – and are effectively a 20% out-of-the-money put on a fund of hedge funds, except the strike rebalances every month. Investors receive around 50 basis points against the possible risk that they lose a proportion of their principal should the value of the underlying fund of hedge funds fall by more than 20%. This hedges Deutsche Bank against an adverse downward move. “There is a huge demand for these bonds, which we push through distributors,” Carson adds.
SG and UBS have also sold ‘stability notes’ to hedge themselves against a drastic drop in the market. “These are products that are going around at the moment where banks basically buy back some of the gap risk protection,” says the head of equity derivatives trading.
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