Call them super-sophisticated or call them super-reckless, buyers of structured credit equity tranches are a relatively rare breed. This is not, however, the only problem: they are also all alike. This riskiest part of the capital structure still lies largely in the hands of fast-money hedge funds and it isn’t hard to figure out what that means: any market shock is likely to turn them all into sellers overnight. These aren’t the kind of buyers that will ride out sustained mark-to-market volatility since they cannot take a lot of pain before getting hit with margin calls.
This became all too evident in May 2005 during the correlation crisis precipitated by the downgrade of Ford and GM. Mezzanine tranches of structured credit should have widened out the most but they didn’t – the equity did. This was because the hedge funds were all long equity and short the tranche above it: there was only one type of investor in this part of the capital structure and they were all trying to do the same thing.
In order to avoid a repeat of this situation on a larger scale, the market needs to find more buyers for equity.