Mixed News on Credit Crunch Front: Libor Continues to Improve, but CDO Worries Worsen

Overnight Libor showed marked improvement, but with the big worry has not been availability of funding overnight, but the willingness of banks to lend to each other at longer tenors, particularly thirty to ninety days, and the ability of corporations to sell commercial paper at those maturities.

Libor continues to improve, but the gains overnight were dramatic, while the ninety-day tenor showed continued progress, but rates and stress indicators are still high. From Bloomberg:

The London interbank offered rate, or Libor, that banks charge each other for overnight loans in dollars fell 16 basis points to 1.12 percent, the lowest level since June 2004, the British Bankers’ Association said.

The rate for three-month loans dropped 29 basis points, or 0.29 percentage point, to 3.54 percent.

The Libor-OIS spread, a gauge of cash availability that measures the difference between the three-month rate and the overnight indexed swap rate, narrowed to 250 basis points for the first time since Sept. 30.

Don’t kid yourself, a Libor-OIS spread of 250 is high by any measure except the last month.

Bloomberg, in a separate story, points out that a lingering worry, collateralized debt obligation exposures, is moving to the fore. Ed Harrison of Credit Writedowns yesterday sent a link to a specific example of new CDO-related pain, that National Australia Bank had experienced seven defaults in its portfolio of synthetic CDOs and may face additional capital charges.

The Bloomberg story gives a broad overview. The markdowns are mind-numbing. It turns out Merrill Lynch’s so-called fire sale of CDOs (nominally 22 cents on the dollar, although 25% was in cash, the rest contingent on performance) now looks fair to favorable to the brokerage firm:

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 against losses 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 in assets as of June 30, wrote down 1.6 billion euros ($2.1 billion) 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.

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….

About $254 billion of CDOs tied to mortgages for borrowers with poor credit histories have defaulted, according to Wachovia Corp. Tracking defaults on those linked to corporate bonds will be difficult because the market is largely private, said Mahadevan…

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…

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…

“The same kind of shudders that went through the asset- backed CDO market will probably go through the corporate CDO market,” said Sillis. “We’ll see a pickup in default rates.”

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.

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.

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 banks, 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…

“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.”’

Print Friendly, PDF & Email


  1. Art

    Its getting worse, when everyone expected to at least take a brake from bad credit news. We are not even talking about main street here, it still financial firms in the midst of it. Whats next? because at the rate its going right now, something major will happen again and soon. We going from worse to much worse.

    What shocking to me, is that most people (in my MBA graduate school) think this will change soon, well most of them don’t realize what is happening to begin with. They just think its “not good”.

  2. foesskewered

    Talking about Taleb, was wondering if he read this (no insensitivity intended) book; The Pig that Wants to be Eaten – the chapter on the Indian and Ice seems to describe perfectly the situation that people in the finance industry face; not just black swans but thinking that something far off might just be that eye-opening event/object that one has not seen.

    Wonder what models/simulation these synthetic instrument authors used to test their products?

    does anyone consider that mutli-variate (modified) might make a good first level litmus test?

  3. RBG

    Why is it that the Lehman auction was on Oct 10 and we are hearing about the impact to CDO market only now?

    It seems that your comments were relatively benign for the Lehman CDS auction’s impact on the $400B+ Lehman CDS market, but you sound quite worries about its impact on the $1.1T* Synthetic CDO market which only “includes” Lehman CDS?
    Would you mind helping me understand this?

    I thought October is the month to watch $55T CDS market as series of CDS auctions starts. How come we haven’t heard much about CDS market melting?? And why is it that we are not as worried about $55T CDS market as we are about $2.6T CDO market?

    Yes, so far Lehman was the only serious one that went on auction, but isn’t it enough to read across the likely result of WaMu, AIG, MBIA, Merrill, and Ambac?

    I would very much appreciate your thoughts.

    *I calculated as $1.6T Synthetic CDO market size * 70% of it has Lehman comment from Bloomberg in the post.

  4. Yves Smith

    I have never said that CDS market will not have a later blow-up. However, it appears that some of the claims made by defenders of CDS were true, at least as far as Lehman-related trades were concerned. Many CDS were hedged by offsetting CDS (as in gross positions greatly overstated the net). And even though I was not certain these measures were adhered to, apparently a significant portion of CDS did require them to be marked daily and collateral posted if the protection seller’s exposure increased.

    The net exposures on Lehman were indeed surprisingly small. Gross exposures were over $400 billion, net somewhere between $4 and $8 billion.

  5. RBG

    Thanks, Yves.

    But still trying to understand how worried should I be on this synthetic CDO front. The market itself is only $1.6T and Lehman, Wamu, Islandic banks, etc’s portion of underlying shouldn’t be dominant.

    Just curious.

  6. Chegland

    you’re right, Lehman et al don’t dominate the 1.6 trillion market, but dominance isn’t the problem–higher than expected losses are.

    I think (and I would welcome a correction from wiser heads) that the basic structural problem that hit the residential mortgage securities also affects the synthetic CDOs–it doesn’t take many individual defaults before the top tranches tumble. So if 70 percent of the synthetic CDOs took a hit from Lehman, per the Barclays research, and smaller numbers took hits from the other defaults, then the affected synthetic CDOs have lost some of their ability to absorb future defaults. The individual CDSs may not be a problem (at least not yet), but the structured nature of the CDOs comprised of those CDSs are.

  7. RBG


    Would it be fair if I say CDO is still a bigger threat to CDS?

    It seems that CDS’s net exposure is relatively small (judging from Yves’ comment on Lehman CDS), probably bearable to the underwriters.

    Whereas CDO’s structure and the ratings make it the holders quite vulnerable to margin calls as they are not quite hedged??


Comments are closed.