CDO values in free-fall

The gloomier outlook for corporate debt in the US and Europe is turning a spotlight on another banking business that exploded during the credit boom, growing from next to nothing into a trillion-dollar industry in little more than four years.

Repackaging credit derivatives to create leveraged investments was a tiny business in the early years of this decade, but between late 2003 and the middle of last year analysts estimate that between $1,000bn and $1,500bn worth of these deals were sold.

The products in question are synthetic collateralised debt obligations. Now, after a year of highly volatile credit markets and with rating agencies under pressure to tighten up their standards across complex structured products, there is growing talk about how to deal with a problem that has the potential to be very expensive.

The systemic increase in risk premiums or spreads in credit derivatives markets means that the values of synthetic CDOs could be less than 50 cents in the dollar, even if the underlying portfolio is relatively high quality, according to analysts at Lehman Brothers.

The bespoke and private nature of the synthetic CDO business makes it near impossible to dig up solid figures for the asset class as a whole, but taking Lehman’s view, investors are easily sitting on unrecognised market value losses of several hundred billion dollars.

This is leading to increasing questions about whether investors – who are mostly banks, insurers and some traditional money managers – should cut their losses and sell, or unwind, such deals or whether they should try to restructure them.

However, specialist bankers in the field say there is relatively little activity tackling this problem asset for two main reasons. First, there is great uncertainty about whether rating agencies will make changes to the way they rate such deals.

Secondly, most of the banks and insurers who bought these CDOs accounted for them as hold-to-maturity assets and so will not have to take any pain until they have to judge such losses as permanent impairments.

Cutting a path through the mezzanine maze
Mezzanine tranches of synthetic CDOs

Synthetic collateralised debt obligations are used to create individually tailored slices of credit risk for investors. They are based on a pool of corporate credit derivatives of individual companies.The investor buys a single slice, or tranche, of exposure to losses from the pool.

For a long time, the most popular were mezzanine tranches, named after their place in the order in which the various tranches of a CDO are exposed to losses.

The equity takes the first 3 per cent of credit losses from a portfolio then comes the mezzanine tranches, the first of which commonly covers the next 3 per cent of losses up to the 6 per cent mark. Others can also be created to cover losses up to the 12 per cent mark, beyond which come the senior, triple A rated tranches.

Restructuring options

If investors do not want to sell out either back to the bank that first sold them the deal, or to a specialist investor looking to create value through their own unwind strategies, they have two main strategies.

First, they can make substitutions in their portfolios to swap riskier credits for safer ones. This costs money, but can be paid for in a number of ways, such as reducing the overall coupon of the deal, or extending its maturity and giving up the extra yield this would have granted.

Second, they can make structural changes, such as adding subordination, or moving their tranches higher up the capital structure so that they only take losses after say 4 per cent of the portfolio has already gone.

The less investors do, the less likely their deal would have to be rerated, but the more likely it is to be almost as risky as before.
“Investors are in a quandary,” say Gaurav Tejwani and Fabien Azoulay, analysts at Lehman. “Even those who expect to hold these instruments to maturity and are less sensitive to mark-to-market movements have been struck by the poor valuations and the sense that the dislocation in marks no longer appears temporary.”

The main reason why valuations have been so hard hit is that a large proportion of the outstanding deals were structured and sold when credit conditions were at their most benign and so spreads were at historic lows.

Analysts at Dresdner Kleinwort estimate the majority of deals were done in 2006 and the first half of 2007. “Issuance in 2006 and 2007 accounted for 70 per cent of total volumes to date and was one of the factors that led to the historical credit spread tightening seen prior to the credit crunch,” says Domenico Picone, analyst at Dresdner.

In the intense hunt for higher yields during that period, deals were structured with increasing levels of leverage, longer maturities, less diversification and lower rated credit, Mr Picone adds, with financial credits being particularly favoured.

However, financial debt has been the hardest hit in the past year’s turmoil due to the exposure of banks’ and insurance companies’ to mortgage related bonds and other structured credit.

Analysts at Morgan Stanley say this is one reason why such deals have performed worse than credit broadly. “Levered exposure to certain financials and housing related credits is partly why many such mezzanine tranches [synthetic CDOs] have today underperformed the corporate credit markets broadly,” they say. Mezzanine tranches were long the most popular form of synthetic CDOs because they offered very high returns for a BBB or sometimes A rating. They are called mezzanine because of their place in the order in which the various tranches of a CDO are exposed to losses (see box).

“For banks, insurers and long-only money managers, mezzanine CDO tranches were used as a proxy to get diversified credit exposure,” says one experienced structured credit banker. “All these deals are most likely held at cost and if investors don’t want to take the hit, then they should restructure.”

The banker adds, however, that most of the restructuring strategies being touted are defensive moves that allow investors to buy themselves some protection, though not much if defaults tick up to anywhere near what credit spreads are predicting.

One problem for investors who do want to restructure is the uncertainty surrounding how deals will be rated in the future. Fitch has already reworked its system for synthetic CDOs and now has much more conservative models, which have led to a wave of downgrades.

Moody’s and Standard & Poor’s are much more important to the market and rate a far higher proportion of deals, according to bankers and analysts.

While they have not yet made any changes, bankers insist it remains impossible to restructure a deal to the extent it would need re-rating while all three agencies are either simply not taking on the work, or where their future ratings practices are still uncertain.

Other bankers are more sanguine about the synthetic CDO problems, however. Vaibhav Piplapure, global head of CDOs at Credit Suisse in London, says that of all structured credit assets, investment grade single tranche synthetics are among the least affected from the view of long-term credit losses and are often the smallest part of structured credit portfolios by notional value.

”The fact that most holdings are not mark-to-market means investors are much more able to put the problems in perspective because credit spreads are implying losses far greater than most expect to see in their investment grade credit portfolios,” he says.

"Most investment grade CDOs are managed and most allow various forms of portfolio rebalancing to substitute riskier credits.”

Mr Piplapure says that for banks especially the bigger picture is more important,

“Banks have finally come to the realisation that they need a system-wide solution for their structured credit portfolios, which are made up mainly of dollar-based ABS [asset backed bonds], CLO and CDO assets.”

Another London-based structured credit banker says the reason there is not much restructuring yet is partly because there have been few CDO downgrades and partly because there have been almost no bond defaults. “ But we do expect a very busy fourth quarter,” he says. “As credit continues to deteriorate, people will come back from holiday with year-end concerns and that will provide a big new impetus.”

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