Ed Harrison of Credit Writedowns alerted us to the impact on collateralized debt obligations, which have been crowded out of the headlines as a source of worry by other credit market train wrecks, like the failure of Libor to show much movement despite heroic central bank interventions.
Note that the Iceland-related damage applies to a subset of CDOs, the the so-called synthetic CDOs. Synthetic CDOs bundled cashflows from premium payments on credit default swaps and then tranched them, like CDOs that (more conventionally) held tranches from other securitizations, such as pieces of subprime securitizations (they also could hold whole loans, but they tended to be a small part of the mix) Even in this sector, there was a great deal of heterogeniety in the structures and underlying assets. Many were called “trades” and never intended to be resold.
Many had also had tremendous embedded leverage, This hit mainly the lower tranches, but even with the top tranche, if you crossed a magic threshold in loss expectations, you often see very sudden, dramatic decay in value.
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…
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.