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Wednesday, December 03, 2008


more on the synthetic CDO unwind

the ft has a lengthy bit posted on alphaville -- examining the role of "super-senior" traunching and the CDS written on super-seniors, sometimes through conduits -- and then more importantly the role which is just now about to be played out of synthetic CDOs.

Alas, the leveraged super senior catastrophe is not over. Most of the severe unwinds have been taken against the value destruction in ABS CDOs. The synthetic CDO market - particularly the corporate synthetic CDO market - ironically the place where super-senior technology originated, has not yet collapsed.

One article which has been doing the rounds is a piece in Australia’s Business Spectator by Alan Kohler. He writes:

As the world slips into recession, it is also on the brink of a synthetic CDO cataclysm that could actually save the global banking system.

It is a truly great irony that the world’s banks could end up being saved not by governments, but by the synthetic CDO time bomb that they set ticking with their own questionable practices during the credit boom.

Kohler’s assumption is that most synthetic CDOs were written as naked positions: banks simply bought CDS protection from the vehicles they created in a one-sided bet. The banks, in other words, would only win in the event of a default, when the vehicles they created would pay them out.

Unfortunately that’s not the case. The very invention of the synthetic CDO was born out of the desire for banks to hedge existing loan positions on their books. JPM started it all with a deal called BISTRO. In fact, there are already examples of synthetic deals coming a cropper and forcing banks to unload corporate loan exposures in order to try and avert onerous capital charges. Barclays and the unwind of the appropriately named Black Diamond being a case in point.

And where banks didn’t own the underlying assets the portfolio CDS referenced, they would almost always write protection and sell it into the market to offset their “naked” position with the synthetic CDO they sponsored.

The actual CDS underlying synthetic CDOs are probably then best thought of as being part of a zero-sum game played by the financial sector.

The risk is with the noteholders of the synthetic CDOs. And just as with ABS CDOs, those noteholders are likely to see some very severe losses. Synthetic CDOs are only now about to experience the same kind of dramatic collapse that plagued ABS CDOs way back in late 2007 and early 2008.

The trigger will be the growing number of corporate defaults, which just like assumptions on subprime mortgage defaults, was, in many synthetic structures, underestimated. Barclays analysts see a “rising tide” of synthetic CDO downgrades on the horizon. Downgrades which could well have huge regulatory capital requirements on the super-senior positions banks have on their books.

chris whalen thinks this is the death-blow that forces wholesale nationalization of the banking system in 2009. it reminds me again of michael lewis' excellent piece. i just cannot find a way to want to be long this mess.

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