CDO Cuts Show $1 Trillion Corporate-Debt Bets Toxic(Update3)

By Neil Unmack, Abigail Moses & Shannon D. Harrington

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.

AUnt Fannie & Uncle 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.


For more info on this Credit Derivative follow the link below this article

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
Last Updated: October 22, 2008 12:33 EDT

What is CDO?
Cash Collateralized debt obligation (CDO)
by David Harper, CFA, FRM, CIPM

* Explain the structure of a typical cash collateralized debt obligation (CDO), including the use of a special purpose vehicle.

A CDO is an asset sale and a risk transfer into securities

A cash CDO is an asset sale. The originator (e.g., a bank) sells credit-sensitive assets to the special purpose vehicle (SPV). There are several motives for the bank to sell its assets. These motives include, but are not limited to: to remove the assets from the bank's balance sheet, to receive cash ("to monetize" the assets), and to transfer risk. The risk transfer is an essential feature. Consider the following CDO:



In this case, we illustrate mortgages as the underlying collateral. But the collateral (the credit assets) can be commercial mortgages, corporate bonds, preferred stock, among several other securities types including notes issued by other CDOs! Note the fundamental mechanics above:

* The bank (not shown) sells a portfolio of credit-sensitive assets to the special purpose vehicle (SPV) in a so-called true sale.
* How does the SPV pay for the assets? The SPV issues securities to investors (facilitated by underwriters, who broker the securities)
* The blue line above illustrates the risk transfer. Consider the investors: they purchase securities and, in exchange, they receive the principal and interest (P&I) on the underlying credit-sensitive assets. In general, they now collectively bear the credit risk.
* The green line above illustrates the asset monetization. The bank has sold the assets for cash. So, the bank achieves three things: removes assets from the balance sheet, receives funds, and transfers credit risk to the investors.
* The holder of the junior tranche has a risky and residual claim: this investor is selling default insurance (as the originator is essentially re-insuring the assets) but gets paid the excess spread

Risk transfer

As the sub-prime debacle proves, the risk transfer is not simple. Investors purchase securities that represent different tranches (French for 'slices,' says John Maudlin). The credit assets have been repackaged into tranches, essentially. The tranches are arranged in a sort of totem pole hierarchy. Defaults "flood the bottom," so to speak, at first and then rise up the totem pole. At the bottom is the tranche variously called the junior tranche, the equity tranche, the first loss piece and famously the toxic waste tranche. This junior tranche absorbs the first defaults and therefore enjoys a higher yield.

The senior tranche is often rated AA or AAA. This is partly a function of the underlying basket of assets, but it is more a function of correlation (read: diversification). The less correlated the assets, the less likely defaults will reach the senior tranche. Of course, a student of risk will recognize at least two challenges right-away (get more detail in this excellent primer from the knowledgeable Accrued Interest):

* Correlations are dynamically time-varying. The spike at the worst times, when it really matters, and render the diversification plank irrelevant
* To the extent the assets are illiquid, there is already significant model risk. The parsing (into tranches) of illiquid assets creates model risk on an epic scale.

Special purpose vehicle

The learning outcome asks about the "special purpose of the SPV." The purpose of the SPV is to enable a true sale of the assets away from the originator (bank) to a third-party. In principle, the idea is very simple: if the bank still controls or owns the assets, it should consolidate them on its balance sheet. As assets on the balance sheet, they decrease return on assets (ROA) (all other things being equal) and the bank must hold capital against them under the Basel Accord. But the details are not so simple.

FASB Statement No. 140 (FAS 140) lists four criteria for a true sale:

1. The SPV is bankruptcy remote and the assets in the SPV are sufficiently isolated from the originator to survive Chapter 7 or Chapter 11 bankruptcy.
2. Permissible activities of the SPV must be significantly limited, must be specified at deal inception/incorporation of the vehicle, and can be changed only with approval of a majority of interest holders other than the originator or its affiliates or agents.
3. The originator must surrender “effective control” over the assets
4. The SPV must have the right to pledge/resell/exchange the assets acquired from the originator. The buyer must have a “perfected interest” in the acquired assets.

So FAS 140 was violated by Enron, for example, because they did not consolidate securitized assets that were effectively controlled by Enron. This famous violation, in turn, gave rise to FIN 46R (the "anti-Enron" rule) which tried to close the loophole.
In summary

One of customers recently asked, "Isn't the purpose of securitizing to get assets off balance sheet?" To which, the answer is yes. But it is not the only motive. We have mentioned three motives here, in the context of a CDO:

* Transfer risk: the bank wants to transfer credit risk (default risk) to the investors
* Monetize: the banks wants to receive cash
* Shrink the balance sheet: the bank wants to shrink its balance sheet which has several benefits. Some of those benefits may be real and economic, but some are "merely" motivated by accounting (how can we avoid consolidation?) rules and regulations (how can we minimize capital required by Basel I/II?)

The investors have motives, too, of course. They are earning higher yields. The junior tranche holders take high yield, high risk positions. In the case of sub-prime mortgages (i.e., CDOs collateralized with subprime mortgages), we might say junior holders are selling a sort of catastrophe insurance. The problem in the case of subprime, is that the defaults are progressing up the totem pole into higher-quality tranches that are supposed to be buffered by diversification of the basket.

Source: http://bionic.pmhclients.com

Under MPE condition where the economy does not starve for cash &/or credit - such an 'animal' as this above example of Cash CDO flowchart is not needed. Life is so much more joyful & simpler, don't you know? mms


Global CDO issuance Chart as of Friday, May 23, 2008



Source:http://www.highyieldblog.com/2008/05/cdo-issuance.html
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