27 October 2008

CDO Cuts Show $1 Trillion Corporate-Debt Bets Toxic

I think its all going pear shaped here, sub-prime, alt-a, corporate CDO's and the financial implications of a sudden demand shock. The whole thing is spinning out of control because it ran on trust alone.

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 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 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 subprime,'' said Alistair Milne, a professor in banking and finance at Cass Business School in London and a former U.K. 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 percent last week.

KBC Groep NV, Belgium's biggest financial-services firm, which had 377.4 billion euros ($485 billion) in assets as of June 30, wrote down 1.6 billion euros after downgrades on company- and asset-backed debt. Brussels-based KBC had 9 billion euros in CDOs as of Oct. 15, primarily linked to corporate debt, according to an investor presentation.

10 Cents

CDOs pooling asset-backed securities have been blamed for losses at the world's biggest banks, from UBS AG to Citigroup Inc. Now, corporate CDOs are starting to be affected as defaults rise and speculation mounts that the world economy is headed for a recession.

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.

Credit-default swaps 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.

Private Market

About $254 billion of CDOs tied to mortgages for borrowers with poor credit histories have defaulted, according to Wachovia Corp. Estimating losses on those linked to corporate bonds is difficult because the underlying debt and the structure of the transaction can vary in this private market, 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.

Downgrades of corporate CDOs will force investors to boost capital, according to an Oct. 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 percent now, Sharma said. His estimate is based on the world economy entering a ``severe'' recession.

Record Lows

Demand for synthetic CDOs helped fuel growth in the credit- default swap market and pushed the cost of default protection to record lows in 2007. That in turn drove down company borrowing expenses. Sales of such CDOs surged to $503 billion in 2006, from $84 billion five years earlier, according to Morgan Stanley.

Bankers loaded the securities with bonds and swaps offering the highest return for a given credit ranking, indicating higher 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.

Credit Analysis

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 Oct. 13 after seven financial companies defaulted or were bailed out since September. The company didn't disclose the total number of classes it rated.

Defaults and so-called ``credit events,'' which can include government takeovers, force payment of the credit-default swaps packaged in the debt. This causes losses for investors or erodes capital.

The U.S. Treasury has broad powers under a $700 billion rescue plan enacted on Oct. 3 to purchase an array of distressed assets. While Treasury Secretary Henry Paulson has said that home loans and related securities are the main focus of the plan, CDOs or other non-mortgage-related derivatives could qualify under the law. Congress would have to be notified of their inclusion.

Treasury spokeswoman Michele Davis didn't immediately respond to a request for comment.

Barclays Capital estimates that 70 percent 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.

Fannie, Freddie

About 1,500 also sold protection on Washington Mutual, the bankrupt holding company of the biggest U.S. 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 U.S. government's seizure of the mortgage agencies, will have a ``substantial'' impact on corporate CDO ratings, S&P said in a report Oct. 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.

Default Forecasts

Nonpayment on speculative-grade corporate bonds may rise to 7.9 percent worldwide in a year, from 2.8 percent at the end of the third quarter, as the credit crisis deepens, Moody's said Oct. 8. Those in the U.S. may rise to 7.6 percent, 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 the banks that structured them, 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.

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 percent upfront and 5 percent 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 50 basis points to a record 200 next year, Barclays forecasts.

Buy Now

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.

``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.''

Still, investors don't have to unwind CDOs. They could hold on until the debt instrument matures if they judge defaults won't be bad enough to prevent them getting their money back, according to Barclays Capital analysts.

Radian, CIT

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. 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.''

To contact the reporters on this story: Abigail Moses in London Amoses5@bloomberg.net; Neil Unmack in London nunmack@bloomberg.net; Shannon D. Harrington in New York at sharrington6@bloomberg.net

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