Nov 14, 2008

New wave of CDOs at risk of default [Financial Times]

New wave of CDOs at risk of default 
By Paul J Davies 
Published: November 13 2008 23:55 | Last updated: November 13 2008 23:55
Synthetic CDOs, the risky and complex debt products that are based on pools of corporate credit derivatives, are under increasing pressure after suffering a wave of default-related losses on top of general credit market deterioration.
Synthetic collateralised debt obligations based on exposure to corporate bonds through the derivatives market have already seen $24bn of losses from the recent defaults of Lehman Brothers and other financial institutions, according to analysts at JPMorgan.
Deals worth $103bn have been left in what the analysts call a “binary” position and could see a quick descent into losses if more defaults materialise, the analysts said. Between $32bn and $56bn of these mezzanine, or middle ranking, tranche deals are at risk of high capital losses with the next default.
JPMorgan estimates there are about $757bn outstanding of synthetic CDO tranches based solely on corporate debt derivatives, many of which were created and sold during a boom in issuance through 2006-07. 
Synthetic corporate CDOs were instrumental in driving down spreads, or risk premiums, on credit default swaps during the height of the credit bubble, because the banks that created these products hedged them by selling contracts for protection against default on hundreds of individual companies referenced in the CDOs.
The main concern for credit markets is that a flight by investors away from CDOs would lead to a reversal of this process, whereby banks would be forced to buy back huge volumes of protection and so push spreads dramatically wider from their already elevated levels.
The JPMorgan analysts expect the rate at which investors look to unwind their trades will remain slow and gradual for now, in part because there are no market value triggers to cause a run for the door.
“Having said that, the size of this market remains significant and investors experience of the first capital losses could be a turning point in their decisions around holding these trades,” said Yasmine Saltuk of JPMorgan. 
At the moment, market value losses exceed credit losses by most estimates. Analysts at Citigroup put market value losses on an estimated $584bn of outstanding synthetic CDOs at $67bn by November 10. This is a recovery from the $81bn loss position on October 24 when CDS spreads were around their widest.
The private nature of the CDO industry makes estimating even just the size of the market difficult, hence the difference between the Citi and JPMorgan estimates. 
Ms Saltuk and her team estimate market value losses on about $436bn of remaining mezzanine tranches to be in the region of 30-40 per cent, or up to $174.4bn.
Michael Hampden-Turner of Citi is more sanguine about the pace of unwinds, saying that investment grade defaults in the near future are not likely to be as numerous as during the recent weeks of extreme financial crisis. “The pace of [CDO] unwinds and restructuring has increased, but it still remains low and orderly given the overall size of the market,” he said.

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