Investors are taking losses of up to 90 per cent in the $1.2 trillion market for collateralised 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 losses among banks, insurers and money managers may spark the next round of writedowns on CDOs after $660 billion in subprime-related losses. They may force lenders to post more reserves against losses after governments worldwide announced $3 trillion in financial-industry rescue packages since last month, according to Barclays Capital.
“We'll see the same problems we've seen in sub-prime,” said Alistair Milne, a professor in banking and finance at Cass Business School in London and a former UK Treasury economist. “Banks will take substantial markdowns.”
The collapse of Lehman Brothers, Washington Mutual Inc and the three banks in Iceland prompted Susquehanna Bancshares Inc, a Lititz, Pennsylvania-based lender, to lower the value of $20 million in so-called synthetic CDOs by almost 88 per cent last week.
KBC Groep NV, Belgium's biggest financial-services firm, which had 377.4 billion in assets as of June 30, wrote down ¤1.6 billion ($2.1 billion) after downgrades on company- and asset-backed debt. Brussels-based KBC had ¤9 billion in CDOs as of October 15, primarily linked to corporate debt, according to an investor presentation.
10 Cents: Some synthetic CDOs, tied to credit-default swaps on corporate bonds, are trading at less than 10 cents on the dollar, according to Sivan Mahadevan, a derivatives strategist at Morgan Stanley in New York.
CDOs parcel fixed-income assets such as bonds or loans and slice them into new securities of varying risk, providing higher returns than other investments of the same rating.
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The synthetic variety pools credit-default swaps, which are derivatives based on bonds and loans and used to protect against or speculate on defaults. Should a borrower fail to meet debt agreements, the contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent. An increase in the agreement's cost indicates a deteriorating perception of credit quality.
About $254 billion of CDOs tied to mortgages for borrowers with poor credit histories have defaulted, according to Wachovia Corp. Tracking defaults on those linked to corporate bonds will be difficult because the market is largely private, said Mahadevan.
Derivatives are contracts whose value is derived from assets including stocks, bonds, currencies and commodities, or from events such as the weather or changes in interest rates.
‘Severe’ Recession: Downgrades of corporate CDOs will force investors to boost capital, according to an October 17 report from Barclays Capital analysts led by Puneet Sharma in London.
Buyers of deals graded AA by Standard & Poor's and Aa2 by Moody's Investors Service, the third-highest rankings, may have to increase cushions against losses to cover the full amount of the investment, up from 1.2 per cent now, Sharma said. His estimate is based on the world economy entering a “severe” recession.
Demand for synthetic CDOs pushed the cost of default protection to record lows in 2007, driving down company borrowing expenses. Sales surged to $503 billion in 2006, from $84 billion five years earlier, according to Morgan Stanley.
High Return: Bankers loaded the securities with bonds and swaps offering the highest return for a given credit ranking, indicating additional risk. An AA rated European issue offered an average yield of 50 basis points over money-market rates when sold in 2006, according to UniCredit SpA analysts in Munich. Similarly rated corporate bonds paid 9 basis points. A basis point is 0.01 of a percentage point.
“The maths ended up driving the way CDO portfolios were put together,” said Nigel Sillis, a fixed-income and currency analyst at Baring Asset Management Ltd in London.
The banks that structured the securities and investors both failed to do “fundamental credit analysis,” said Janet Tavakoli, president of Tavakoli Structured Finance in Chicago. “They were using correlation models, they were using spread models, but they weren't doing analysis on the underlying corporations.”
Fitch downgraded 422 classes of CDOs on October 13 after seven financial companies defaulted or were bailed out since September. The company didn't disclose the total number of classes it rated.
The downgrades force payment of the credit-default swaps packaged in the debt, causing losses for investors or eroding capital.
“The same kind of shudders that went through the asset- backed CDO market will probably go through the corporate CDO market,” said Sillis. “We'll see a pickup in default rates.”
Lehman, WaMu
Barclays Capital estimates that 70 per cent of synthetic CDOs sold swaps on Lehman. Swaps on Kaupthing Bank hf, Landsbanki Islands hf and Glitnir Banki hf were included in 376 CDOs rated by S&P. The company ranks almost 3,000.
About 1,500 also sold protection on Washington Mutual, the bankrupt holding company of the biggest US bank to fail, according to S&P. More than 1,200 made bets on both Fannie Mae and Freddie Mac, the New York-based rating company said.
The collapse of Lehman, WaMu and the Icelandic banks, as well as the US government's seizure of the mortgage agencies, will have a “substantial” impact on corporate CDO ratings, S&P said in a report October 16.
The government in Reykjavik seized Kaupthing Bank, the country's largest lender, earlier this month. Assets and liabilities from Landsbanki Islands and Glitnir Banki were transferred to state-owned entities, triggering default swaps.
‘Marking Down’: Nonpayment on speculative-grade corporate bonds may rise to 7.9 per cent worldwide in a year, from 2.8 per cent at the end of the third quarter, as the credit crisis deepens, Moody's said October 8. Those in the US may rise to 7.6 per cent, said S&P.
“As there are credit events, you'll have losses in portfolios and marking down of other assets,” said Claude Brown, a partner at law firm Clifford Chance LLP in London.
Investors may sell the CDOs back to banks, which will unwind protection they wrote to hedge swap transactions, Barclays said. The chain of events will push up the price of default protection and company borrowing, according to Barclays.
Doubling Cost: Banks unwinding hedges helped double the cost since April of default insurance on the lowest-ranking equity portion of the benchmark Markit CDX North America Investment Grade Index, to 75 per cent upfront and 5 per cent a year. That equates to $7.5 million in advance plus $500,000 annually on $10 million of debt for five years.
For European investment-grade company debt, as shown by the Markit iTraxx Europe index of credit-default swaps, the price for protecting against nonpayment may climb 55 basis points to a record 200 next year, Barclays forecasts.
Some investors are choosing to buy protection and determine their losses now, according to Edmund Parker, head of derivatives at law firm Mayer Brown LLP in London.
National Australia Bank, the country's biggest lender by assets, paid A$100 million ($67 million) this year to hedge the risk of loss on six company-linked CDOs totaling A$1.6 billion. It will pay a further A$60 million annually for the next five years, according to company filings.
‘Drawn a Line’
“The upside is that you've now drawn a line on those assets and you know you're not going to lose more than your hedging costs,” Parker said. “Unless, of course, your counterparty goes under.”
Companies most frequently referenced in synthetic CDOs include Philadelphia-based Radian Group Inc., the third-largest U.S. mortgage insurer, whose stock fell 68 percent in New York trading this year. Another is CIT Group Inc., an unprofitable commercial lender in New York that dropped 83 percent. The company faces about $2.4 billion in debt repayments by the end of 2008, according to data compiled by Bloomberg.
''We feel very strongly that we have adequate claims-paying capabilities for both our financial-guarantee business and our mortgage-insurer business,'' said Radian spokesman Richard Gillespie.
CIT spokesman Curtis Ritter declined to comment, pointing to the company's statement last week that it will meet funding needs for the next 12 months.
Forecasts for ratings downgrades are ''going to force a lot of activity'' in unwinding CDOs, said Rohan Douglas, former director of global credit derivatives research at Citigroup Inc. He now heads Quantifi Inc., a provider of valuation models for the debt. ''Buy-and-hold investors suddenly find themselves in a situation where they will have to sell these assets.''