Market Inefficiencies, CDO Edition

Some of us sip cappuccinos on Sundays, and if we do any weekend blogging it's as likely as not to be something silly like constructing an entire blog entry which lacks the letter e. Alea, however, seemingly spends his time reading press releases from second-tier investment banks – something for which the rest of us can be very grateful.

You know all those stories about how the abundance of hedge funds out there means that simple arbitrages and profit opportunities have become as rare as hen's teeth? Well, it turns out that's not exactly true. Consider the case of a special-purpose entity known as Balthazar CSO I BV – or Balthazar, to its friends. Balthazar issued three tranches of debt, and one tranche of equity, in 2003. All those tranches then traded in the secondary market.

Now here's the weird thing: the debt markets soared after Balthazar came into existence, so one would expect the value of the equity tranche to go up as well. But in the secondary market, it was trading at only 60% of par. (Or, rather, it wasn't trading at 60% of par, but if you wanted to sell your holding, that's all that the investment banks would offer you.)

Enter NewSmith Capital, who bought up enough debt to be able to vote to unwind Balthazar. When that happened, the equity was released, and turned out to be worth not 60% of par, but 145% of par. In other words, its value, to its owners, more than doubled, essentially overnight.

What does this mean? Well, the obvious conclusion is that investment banks are making a fortune when they trade exotic instruments such as CDO equity tranches. And that the buy-side can and should be a lot more aggressive and a lot less trusting when it gets bids which seem far too low.