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Thursday, October 23, 2008


synthetic CDOs to unwind

from the financial times, following on a bloomberg piece:

The article is referring to synthetic CDOs: that is, CDOs which are not backed by tangible collateral (RMBS, CMBS, for example) but CDS contracts which reference some form of collateral. In this case, CDS on corporations

[W]hat can be expected to happen to the market as we move through a recession in the coming months[?] ... Huge, disastrous downgrades: exactly mirroring the structured finance downgrades from ABS CDOs which have brought the financial system to its knees already. Don’t forget, moreover, that these CDOs aren’t backed by dodgy subprime collateral, but are supposed to reference the investment grade corporate world. More proof that it’s not the collateral which is to blame, but the structuring. The medium is the message, and all that.

We guess the impact of this might make itself felt in three ways:

Firstly, there will likely be the mark-to-market losses on the CDO notes themselves. As the Bloomberg article noted, in some cases this is equivalent to a 90 per cent loss on capital. The question here then, is who is holding these notes? Hedge funds were certainly big buyers of synthetic CDOs. But guess what - banks are also holders too. And by and large, banks synthetic corporate CDO holdings haven’t been written down.

Secondly, trouble in the synthetic CDO market will - just as with ABS CDOs - have huge regulatory capital impacts for banks. ... Downgrades of synthetic CDOs, in other words, will have a devastating caustic effect on banks’ capital ratios - with the potential to completely offset government recapitalisation actions.

Thirdly - crisis for synthetic CDOs will suck money out of the banking system in other ways. Synthetics are “unfunded”. In a normal asset-backed CDO, the cash raised from selling bonds is used to buy assets, but in a synthetic CDO, the cash raised from selling bonds is not used up front: as a protection seller, the CDO collects premiums on CDS contracts which only cost it money in the event of a default (when the CDO must make good on its protection). Of course, depending on what is happening to the spread on the various CDS contracts a synthetic CDO might hold, the CDO might also need to make margin calls. ...

The point here is that the “collateral” account of synthetic CDOs usually takes one of two forms: a bank deposit, or a similar cash-equivalent holding: a money market deposit, for example. As spreads widen, and collateral posting (the red line in this diagram) comes into force, synthetic CDO SPVs will be drawing money out of banks and money market funds to meet their obligations. Given that there are quite a few synthetic CDOs out there, the effect shouldn’t be too insignificant.

Complicated all the above might be. The long and the short of it is that the synthetic CDO market has used derivative technology to build a huge amount of leverage. With recession now biting, the whole house of cards is dangerously close to collapse.

then please consider -- via paul kedrosky -- that the banks have already eaten through what the government is gifting them by the TARP.

The gist: Government recapitalization and other fund-raising has largely been in service of banks' prior subprime losses, while corporate and consumer loans are just starting to hit bank balance sheets. It won't take much to tip banks over into insolvency again.

is there any avenue which the banks did not exploit in an attempt to destroy themselves? this seals it -- there is utterly no way for any of the major money center banks to avoid wholesale nationalization, and the sooner we get about it the better.

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well, gm. opening bell and we're off. good luck, pal.

see you on the other side, so to speak.

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is a rally too predictable or impossible, dc? i can't tell anymore. a 6% gap down isn't going to go unfilled, though, i suspect.

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i don't think anyone can tell anything anymore. more and more, things are making less and less sense.

there are too many forces at work -the worst being the fed and treasury - to undercut every play and every strategy being attempted.

safes and cash in mattresses are starting to look very comforting.

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