‘More bad news’ on bank CDO exposures to come, BofAML says

Posted by Tracy Alloway on Dec 22 09:15.

FT Alphaville wrote in October 2008 that, by and large, banks’ holdings of synthetic corporate CDOs had yet to be written down. Fast forward to December 2009, and it looks like the same might still be true for the majority of those holdings.
Recall that synthetic CDOs are not backed by tangible collateral (RMBS, CMBS and the like) but by CDS contracts which reference such collateral. In this case, CDS on corporations.
According to Bank of America Merrill Lynch European banking analysts Stuart Graham and Alexander Tsirigotis, the issue is that lots of those corporations were rather lacklustre financial companies.
Here’s what they say:
We have been talking in our research about the risks for banks as holders of synthetic corporate CDOs since early September. This is a $1.6 trillion market, with very little clarity on which banks hold such instruments. Until recently, it has been a “dog which hasn’t barked”. However, the credit events at several US financials are now filtering through into rating agency downgrades of CDO tranches. The credit events at the Icelandic banks will also provide further downgrades. We think we will be hearing more bad news on exposures to synthetic corporate CDOs in the coming weeks.
We have long argued that a major risk for corporate synthetics was the over-exposure to the financials sector and certain names within that sector. In late September S&P downgraded 168 tranches of RM European Banks 20 October 2008 19 synthetic corporate CDOs and placed a further 600+ on rating watch negative. Chart 18 shows that these downgrades are very severe – nearly ¾ of all US tranches were downgraded by a full letter or more, while European tranches saw 60% of all affected tranches downgraded by a full letter or more. Moreover, the migration from investment grade to high yield was also significant with 30 US tranches (and 19 European) moving from investment grade ratings to speculative grade ones – or c. 30% of all downgraded tranches, in Europe and US. Recent events at KBC show how such downgrades can translate into large impairments.
And if you’re curious as to just what kind of financials those could be, the analysts have provided the below, rather interesting, table. Lehman Brothers and AIG, among others, make an appearance:

Related links:CDOs, a tendency to liquidate – FT Alphaville
S&P’s CDO rating methodology is unpatriotic – FT Alphaville
The CDO unwind waiting to happen – FT Alphaville