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Regulatory Arbitrage

Arbitrage within the capital markets used to be a simple term that described a mostly risk-free profit in the mispricing of an asset in different markets.  For example, if wheat futures were trading on two different exchanges at two different prices you would simply buy the lower priced wheat contract and short the higher priced contract thereby locking in the pricing differential as an arbitrage profit.  True arbitrage trades have gotten more complex over time and happen in fractions of a second, so for all but the fastest market making computers in the world true arbitrage is dead.

The term arbitrage has morphed to cover many more realms of trading such as:

  • Merger (risk) arbitrage: buy a takeover target’s stock and short the acquirer company’s stock
  • Convertible arbitrage: buy a convertible bond, short interest rate futures to hedge interest rate exposure, short company stock to hedge embedded equity option exposure, short company CDS to hedge credit exposure all to lock in a slight premium
  • Statistical arbitrage: a term that can encompass many things but usually implies trading the spread between two like securities on a short time scale as discussed before
  • Municipal Arbitrage: trading the spread between LIBOR (London interbank offering rate-liquid AA rated yield curve) and the tax adjusted SIFMA (Security Industry and Financial Markets Association-Municipal Yield Curve)

I could go on and on about different strategies that have indoctrinated the word “arbitrage”, but needless to say the term covers a much broader spectrum of trading.  It has become as meaningless as the term “hedge fund” in describing hedge funds as hardly any of them are truly hedged.  The one area that I would like to discuss in detail is “Regulatory Arbitrage”.  I heard on NPR the term Regulatory Arbitrage being used to describe institutions playing the SEC (Securities Exchange Commission) versus the CFTC (Commodities Futures Trading Commission), but I would say that is not the standard definition of Regulatory Arbitrage.

In general, regulatory arbitrage is used to describe the play between regulatory capital requirements and security ratings.  Insurance companies and banks are required to hold different amounts of capital depending upon the ratings of the securities that they hold.  For example, if an insurance company holds AAA rated bonds from Johnson and Johnson, they hold significantly less capital than holding CCC bonds from CIT.  Since the insurance company only has so much capital at hand, this effectively limits how much low-quality debt they can hold on their balance sheet.  This problem is the same for banks and creates massive imbalances in the market when there are large amounts of downgrades in ratings.  When S&P and Moody’s cut the ratings of many securities, banks and insurance companies are forced to sell which quickly forces prices down (just look at bond prices at the end of 2008).

Regulatory arbitrage is effectively trying to “game” this system.  Before the credit crisis the trade du jour was the CDO.  By packaging a bunch of crappy loans together and slicing the structure into different tranches with subordination levels, the investment banks were able to create AAA rated structures that paid  BB yields.  With a AAA rating the insurance companies and banks held very little capital and with the BB level yield they made tremendous profits.  The problems arose when the AAA ratings were downgraded to CCC levels in one swing of the axe by Moody’s and S&P, the same two who gave the structure a AAA rating in the first place.  You can read more about that problem here.

The second aspect of regulatory arbitrage happens in reverse.  If an insurance company has a boatload of crappy commercial mortgage loans on its books, it can get capital relief by creating its own structured product with the help of an investment bank (and by paying hefty fees).  Basically you take all of the crappy loans on your balance sheet, give them to the investment bank, have the investment bank create a fancy complicated structure with different tiers of risk levels, have the investment bank get a blessing from S&P or Moody’s to rate the highest tranche a AAA and voilà!  We have capital relief for the insurance company even though it holds the same crappy loans as it did before.

You tell me if any of this makes sense.

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