Imagine you are a structured credit investor standing on a cliff by the ocean. From your senior perch you observe more junior investors sunning themselves and reclining with e-readers on the beach below.
They’re doing pretty well down there. Being on the beach is a bit risky, you see. This particular spot is known for rogue waves. It’s okay, though, the investors down there are being paid a lot to be on the beach — certainly more than you’re being paid to stand up on the cliff. And those guys read all the warning signs about the rogue waves and are aware of the risk they are taking.
As you are standing there, you see one of those freak waves sneak up and wash away some poor chap’s iPad. That’s a bit unlucky. He’ll have to buy a new one using the returns he was earning. He kinda expected that though. All the guys on the beach expect at least some of their belongings to get taken by the waves on a fairly regular basis. It’s the risk they accept for the pleasure of sitting on the beach and earning high returns. It isn’t nearly as much fun, or as rewarding, to be up on the cliff.
Suddenly the tide recedes a lot faster than normal and sirens go off in the distance. There’s going to be a tsunami. You have no idea how big it will be.
Those poor guys on the beach!!
In a way, that’s okay too. They knew this could happen. As you look down at them you notice that they look positively calm about it. It’s just inevitable. They’d be taking little hits from the waves over time, but now the one big wave will come and that’s it for them. They’ll be completely wiped out.
But now you’re worried… is the cliff high enough or will the water reach you? And if it does, is it just going to take away your iPad or is it going to take everything?
The guys positioned on the equity beach know their time is up (red line decreasing). At the same time, the senior investors standing on the cliff are wondering if they are going to get wiped out (blue line up).
From the credit team at Citi, minus the beach:
Tranche markets are a barometer of tail risk and are increasingly indicating systemic risk fears. If we consider the distribution of expected loss in the capital structure we can see that a considerable proportion of the risk has shifted to the senior portions relative to equity (Figure 1). We are now at levels not seen since 2008 as markets weigh the chance of European sovereign defaults. The graph illustrates the percentage of expected loss in equity versus senior tranches illustrating periods of systemic risk fears.
Related link:
Tranches show rising fears of a systemic event, says Citi – CreditFlux