In many realms of knowledge, the rare and arcane have little bearing on society at large. What wins on “Jeopardy!” doesn’t often move markets.
But in finance, obscurities that are hidden to most can be calamitous. And one such instrument, known as a bespoke tranche opportunity, or BTO, is on the rise again as big investors hunt for yield in a low-interest-rate market.
So it’s important for investors to have at least a rudimentary grip on BTOs, which resemble some of the financial instruments that played an outsize role in the 2008 financial crisis. That downturn destroyed $9.8 trillion of wealth in the U.S. as housing prices and investment accounts took a beating, and millions lost their homes and jobs.
In fact, the closing seconds of the 2015 Oscar-winning film “The Big Short” are dedicated to bespoke tranche opportunities, which are ominously described as being just another name for collateralized debt obligations, or CDOs. Those instruments are closely tied to the U.S. housing market that helped plunge the U.S. into the Great Recession.
Here’s a brief look at this remote corner of Wall Street with a history of outsize economic influence:
— What is a bespoke tranche opportunity?
— Pros of bespoke tranche opportunities
— Cons of bespoke tranche opportunities
— Bottom line: Re-embracing risk
What Is a Bespoke Tranche Opportunity?
Bespoke tranche opportunities are a niche structured financial product that allows investors to buy a specific grouping of cash-producing assets in a CDO. For example, if a sophisticated investor wanted to gain exposure to a pool of BBB-rated mortgages in the Southwest or a grouping of AAA-rated U.S. auto loans, they could use a bespoke tranche opportunity to make that happen.
It makes sense when you break down the term: the “bespoke” part refers to it being custom-tailored to an investor’s fancy.
“A tranche is, if you will, a slice of the risk,” says Janet Tavakoli, president of Tavakoli Structured Finance LLC, a Chicago-based risk consultancy firm for derivatives and structured finance. While CDOs will bundle all loans of a certain type together, with a BTO, “you’re going to pick one specific tranche.”
As for the “opportunity” part of a BTO? Perhaps that’s merely a touch of poetic license.
In any case, BTOs aren’t readily available to retail traders. They’re created on an ad hoc basis for institutional investors.
“If you want to have AAA- and AA-rated assets, you’d expect those to go to money market funds, some bank portfolios or people using them as collateral for another deal,” Tavakoli says. BBB-rated loans might end up in fixed-income portfolios, while for the “highly risky stuff,” you might expect hedge funds to drive demand, Tavakoli says.
Although the market is opaque, demand in recent years has been robust. In 2018, trading volume in synthetic CDOs clocked in at more than $200 billion, according to a Reuters report. To some, this may echo loudly of the financial crisis, when banks faced cascading liabilities from leveraged bets on pools of loans that went sour, in some cases despite sterling credit ratings.
The flip side of the bailouts that helped resuscitate the American economy in 2008 and 2009 is the problem of moral hazard — the phenomenon where parties that are bailed out or insured consciously take on more risk. Today, many large banks are involved in the trade of bespoke tranche opportunities, including Citigroup Inc. (ticker: C), Deutsche Bank AG ( DB), Goldman Sachs Group Inc. ( GS) and JPMorgan Chase & Co. ( JPM).
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Pros of Bespoke Tranche Opportunities
One notable benefit to institutional investors pursuing bespoke tranche opportunities is the ability to reap higher yields, something not readily available for fixed-income investors in today’s low-interest-rate environment. U.S. Treasurys simply don’t cut it for most yield-seeking investors in an era when the 10-year Treasury yield sits near 1.3%.
Tavakoli points out another advantage to BTOs: “There’s still a market for them because people want to tailor their risk, and there’s nothing wrong with that,” she says.
Another “pro” to these relatively unknown structured products — and this one cuts both ways — is the ability to use leverage.
“If you want a bespoke tranche made just for you, what helped facilitate that was derivatives,” Tavakoli says. “Derivatives are similar to the same idea but can provide more leverage. Instead of having a real portfolio of assets, you can just reference an imaginary portfolio of assets.”
She adds, “Instead of actually buying a certain asset, you can merely use those assets as a reference.” What derivatives allow you to do is have a notional idea of an asset in order to transfer risk, Tavakoli says.
Cons of Bespoke Tranche Opportunities
Unlike stocks or exchange-traded funds that trade publicly in high volumes every day, BTOs, as specially tailored investments among institutions, aren’t very liquid and can be difficult to establish a value for on a day-to-day basis. That illiquidity also makes them tough to offload when you want to exit the trade.
“CDOs are extremely similar to bespoke tranches in that they are relatively illiquid, and it is difficult to model how they will act in times of market stress,” says Lisa Fall, CEO of the Boston Security Token Exchange.
On top of that, BTOs are unregulated, which compounds the risk involved due to the lack of oversight. How do you prevent blatant fraud or erroneous risk ratings? This remains an open issue.
“That’s what happened in the financial crisis: Unfortunately, some bespoke tranches that were sold as AAA were really junk from the outset. They didn’t deserve a AAA rating; they didn’t even deserve an investment-grade rating,” Tavakoli says.
There’s also the systemic downside of these instruments: “The main challenge of bespoke tranche opportunities is that the potential risks they pose for the financial system are not well understood by the majority of market participants,” Fall says.
Bottom Line: Re-embracing Risk
Although bespoke tranche opportunities and collateralized debt obligations have their place — there’s a place for instruments that sophisticated investors can use to tailor risk, returns and yields to their liking — the leverage, unregulated nature of these investments and catastrophic potential for them to implode make them highly risky “opportunities.”
More than a dozen years after the greatest financial crisis the globe had seen in decades, some lessons remain thoroughly unexamined.
“If you look at the financial crisis, instead of looking at the underlying portfolio, people just looked at ratings,” Tavakoli says. “And instead of doing due diligence and drilling down, they said, ‘Well, it’s diversified.’ But diversification didn’t help you. It was just a buzzword.”
“We never fixed a lot of our problems,” Tavakoli says.
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