A prime example of this predicament is the Alliance Boots deal. The underwriting banks are stuck with £9 billion ($18 billion) of debt issued to finance the retailer’s takeover by Kohlberg Kravis Roberts. It’s even worse in the TXU case, where Citi and JPMorgan and four other banks have been saddled with $26.1 billion of debt.
Hedging this risk effectively has become a real challenge. Using single-name credit default swaps to hedge is almost impossible because spreads are wide and liquidity has dried up. The obvious answer was to buy protection on indices such as the LCDX, CDX or iTraxx. Unfortunately, that strategy backfired spectacularly. With everyone piling into the indices, in August spreads tightened in even as they widened on single names. That meant banks were left with losses as their short hedging positions went out of the money.
"The hedging of the new-issue pipeline is much harder because the sizes are particularly large," says Matt King, global head of credit products strategy at Citi in London. "In terms of the ability to hedge that, in the short term it’s going to remain difficult.