A group of hedge funds, convinced they have found the next Big Short, are looking to bet against bonds backed by subprime auto loans. Good luck finding a bank willing to do the trade.
Money managers have looked at betting that subprime auto securities will tank for many of the same reasons that investors wagered against risky mortgage bonds in the run-up to the financial crisis: Loan volume has mushroomed in the last few years, lending terms have become looser and delinquencies are ticking higher. Mary Kane, an asset-backed securities analyst at Citigroup Inc., wrote in a note late last month that the bank has received "an explosion of calls" in recent weeks, after the movie "The Big Short" portrayed a group of traders that wagered against subprime bonds.
The demand now is coming from hedge funds that trade everything from stocks to bonds, analysts said. But many banks, including Bank of America Corp. and Morgan Stanley, are not interested in making the bet happen for clients, according to representatives of the firms. Some said they fear that helping clients wager against car loans would be bad for their reputation, and that new capital rules and other post-crisis regulations would make the transactions difficult or even impossible to put together.
"Most trading desks just don’t take that kind of risk now," said Mike Edman, a former Morgan Stanley executive who helped invent credit derivatives that helped Wall Street banks bet against subprime mortgage bonds.
At least one trading desk has done this sort of trade. Etai Friedman, who runs hedge fund Crestwood Advisors LLC and manages $250 million, said he was able to work with a salesman he had known for years to buy an option that performed well if a custom-made index of subprime auto bonds fell. Friedman declined to identify the bank that did the trade, on which he earned a 36 percent return, but said finding a dealer was hard.
"A trade like this is just taboo now," Friedman said.
Banks’ reluctance to help investors bet against subprime auto loans signals that may be paying more attention to how their trades will play with regulators and in the media, after having been criticized for crisis-era transactions. Goldman Sachs Group Inc. paid $550 million in fines and restitution to settle SEC charges that it misled investors when it helped hedge fund Paulson & Co. bet against mortgage bonds, and also faced a Senate subcommittee hearing and report about its role in the deals.
Regulators have also been pressing banks to think hard about the ethics of the trades they do for customers after a series of market manipulation scandals in markets ranging from benchmark interest rate Libor to foreign exchange. William Dudley, president of the Federal Reserve Bank of New York, has warned banks that if they do not do more to stop wrongdoing, regulators will consider breaking them up. The U.S. Financial Regulatory Authority, an industry regulator, identified fixing banks’ culture as a top priority this year.
Tempting Proposition
In addition to Bank of America and Morgan Stanley, Deutsche Bank AG and Barclays Plc, will not do these trades, said people with knowledge of their policies, asking not to be named because they were not authorized to speak publicly on the matter.