The CDO unwind waiting to happen

Posted by Sam Jones on Oct 23 14:46.
http://ftalphaville.ft.com/blog/2008/10/23/17365/the-cdo-unwind-waiting-to-happen/

Are the days of CDO carnage behind us?
Apparently not. Bloomberg reported on Wednesday:
Oct. 22 (Bloomberg) — Investors are taking losses of up to 90 percent in the $1.2 trillion market for collateralized debt obligations tied to corporate credit as the failures of Lehman Brothers Holdings Inc. and Icelandic banks send shockwaves through the global financial system.
The article is referring to synthetic CDOs: that is, CDOs which are not backed by tangible collateral (RMBS, CMBS, for example) but CDS contracts which reference some form of collateral.
In this case, CDS on corporations.
All of which may sound dreadfully esoteric. Until you ratchet up the numbers. On Friday last week, Barclays analyst Puneet Sharma put out a report on a possible synthetic CDO unwind, and what can be expected to happen to the market as we move through a recession in the coming months.
In graph form, here’s what would happen to the ratings on prime and high-grade tranches of the trillion dollar synthetic CDO market:
Huge, disastrous downgrades: exactly mirroring the structured finance downgrades from ABS CDOs which have brought the financial system to its knees already. Don’t forget, moreover, that these CDOs aren’t backed by dodgy subprime collateral, but are supposed to reference the investment grade corporate world. More proof that it’s not the collateral which is to blame, but the structuring. The medium is the message, and all that.
We guess the impact of this might make itself felt in three ways:
Firstly, there will likely be the mark-to-market losses on the CDO notes themselves. As the Bloomberg article noted, in some cases this is equivalent to a 90 per cent loss on capital. The question here then, is who is holding these notes? Hedge funds were certainly big buyers of synthetic CDOs. But guess what – banks are also holders too. And by and large, banks synthetic corporate CDO holdings haven’t been written down.
Secondly, trouble in the synthetic CDO market will – just as with ABS CDOs – have huge regulatory capital impacts for banks. Shama at Barclays produces another set of graphs to demonstrate:
Downgrades of synthetic CDOs, in other words, will have a devastating caustic effect on banks’ capital ratios – with the potential to completely offset government recapitalisation actions.
Thirdly – crisis for synthetic CDOs will suck money out of the banking system in other ways. Synthetics are “unfunded”. In a normal asset-backed CDO, the cash raised from selling bonds is used to buy assets, but in a synthetic CDO, the cash raised from selling bonds is not used up front: as a protection seller, the CDO collects premiums on CDS contracts which only cost it money in the event of a default (when the CDO must make good on its protection). Of course, depending on what is happening to the spread on the various CDS contracts a synthetic CDO might hold, the CDO might also need to make margin calls. Here is a quick diagram of the generic structure:
The point here is that the “collateral” account of synthetic CDOs usually takes one of two forms: a bank deposit, or a similar cash-equivalent holding: a money market deposit, for example. As spreads widen, and collateral posting (the red line in this diagram) comes into force, synthetic CDO SPVs will be drawing money out of banks and money market funds to meet their obligations. Given that there are quite a few synthetic CDOs out there, the effect shouldn’t be too insignificant.______
There’s one other point too: synthetic CDOs almost always have a super senior swap written on them. You can see it in the above diagram, technically sitting “outside” – above – the structure. The swap effectively offers the arranging bank protection against its position. The question is, who writes these swaps? LSS conduits, for one (another layer of SPV fun – backed by CP), insurers do (monolines and AIG, for example) and other banks do.
Complicated all the above might be. The long and the short of it is that the synthetic CDO market has used derivative technology to build a huge amount of leverage. With recession now biting, the whole house of cards is dangerously close to collapse.
The CDS markets should feel the impact when it does. One way synthetic CDO managers can offset losses- or rather, crystalise them at acceptable levels – would be to buy protection in the market to sterilise their portfolios.