16 October 2008

Dirty Ice hits the CDO fan

CDOs Imperiled by Collapse of Iceland Banks, S&P Says (Update1)
By Shannon D. Harrington

Oct. 16 (Bloomberg) -- Iceland's collapsed banks pose a ''substantial'' risk to collateralized debt obligations that made bets on corporate debt, according to Standard & Poor's.

Kaupthing Bank hf, Landsbanki Islands hf and Glitnir Bank hf were included in 376 CDOs worldwide, S&P said. Another 297 made bets on two of the three banks. The CDOs packaged credit-default swaps that pay investors if there is a default, and the government's placement of the banks into receivership triggered a settlement of the contracts.

Because the so-called synthetic CDOs also bet on Lehman Brothers Holdings Inc., which filed for bankruptcy on Sept. 15, and Washington Mutual Inc., the bankrupt holding company of the largest U.S. lender to fail, the ''impact of these exposures is likely to be significant,'' S&P said in the statement yesterday.

KBC Group NV, Belgium's biggest financial-services company by market value, yesterday wrote down 1.6 billion euros ($2.15 billion) on its CDOs. Moody's Investors Service said Oct. 14 that it's reviewing 2.88 billion euros of the Brussels-based lenders' five CDOs linked to Icelandic banks.

Iceland's bank regulator took control of the country's three biggest lenders last week when they couldn't secure short-term funding on their about $61 billion of debt. The nation's benchmark stock index plunged 77 percent on Oct. 14, the biggest decline on record, after trading resumed following a three-day suspension.

Iceland Default Swaps

The cost of hedging against default by the Icelandic government has soared to 948 basis points, according to CMA Datavision prices for credit-default swaps. That means it costs 948,000 euros a year to insure 10 million euros of debt for five years. It compares with 118 basis points for the Czech Republic and 238 basis points for Morocco.

Sellers of credit-default swap protection must pay the buyer face value in exchange for the underlying securities or the cash equivalent after a bankruptcy filing.

Many of the deals also will lose payments and loss cushions from contracts linked to Fannie Mae and Freddie Mac, the mortgage-finance companies seized by the U.S. government last month. The takeovers caused a technical default on the credit swaps.

The CDOs sell notes to investors that are repaid using the proceeds of credit-default swap premiums. Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt.

The cost of protecting corporate bonds from default rose today on investor concern a global recession will sap earnings and companies' ability to repay their debt.

The benchmark Markit iTraxx Crossover Index of 50 European companies with mostly high-risk, high-yield credit ratings jumped 23 basis points to 737, according to JPMorgan Chase & Co. prices at 9:32 a.m. in London. In Tokyo, the iTraxx Japan climbed 23 basis points to 208, Morgan Stanley prices show.

To contact the reporter for this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net

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