More CDO Defaults in the Offing

What is intriguing about this article describing the likelihood of more synthetic CDO woes is that no one has a grip on how big a problem this might be and who might be exposed. From the Financial Times:

Synthetic CDOs, the risky and complex debt products that are based on pools of corporate credit derivatives, are under increasing pressure after suffering a wave of default-related losses on top of general credit market deterioration.

Synthetic collateralised debt obligations based on exposure to corporate bonds through the derivatives market have already seen $24bn of losses from the recent defaults of Lehman Brothers and other financial institutions, according to analysts at JPMorgan.

Deals worth $103bn have been left in what the analysts call a “binary” position and could see a quick descent into losses if more defaults materialise….Between $32bn and $56bn of these mezzanine, or middle ranking, tranche deals are at risk of high capital losses with the next default.

JPMorgan estimates there are about $757bn outstanding of synthetic CDO tranches based solely on corporate debt derivatives…

Synthetic corporate CDOs were instrumental in driving down spreads, or risk premiums, on credit default swaps during the height of the credit bubble, because the banks that created these products hedged them by selling contracts for protection against default on hundreds of individual companies referenced in the CDOs.

The main concern for credit markets is that a flight by investors away from CDOs would lead to a reversal of this process, whereby banks would be forced to buy back huge volumes of protection and so push spreads dramatically wider from their already elevated levels.

The JPMorgan analysts expect the rate at which investors look to unwind their trades will remain slow and gradual for now…

“Having said that, the size of this market remains significant and investors experience of the first capital losses could be a turning point in their decisions around holding these trades,” said Yasmine Saltuk of JPMorgan.

At the moment, market value losses exceed credit losses by most estimates. Analysts at Citigroup put market value losses on an estimated $584bn of outstanding synthetic CDOs at $67bn by November 10. This is a recovery from the $81bn loss position on October 24 when CDS spreads were around their widest.

The private nature of the CDO industry makes estimating even just the size of the market difficult, hence the difference between the Citi and JPMorgan estimates.

Ms Saltuk and her team estimate market value losses on about $436bn of remaining mezzanine tranches to be in the region of 30-40 per cent, or up to $174.4bn.

Michael Hampden-Turner of Citi is more sanguine about the pace of unwinds, saying that investment grade defaults in the near future are not likely to be as numerous as during the recent weeks of extreme financial crisis. “The pace of [CDO] unwinds and restructuring has increased, but it still remains low and orderly given the overall size of the market,” he said.

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  1. Doug

    Could Paulson step in and nullify the contracts? I think that’s the lesson learned from sticking his hand into the AIG snakepit.

    Besides, these CDOs are “synthetic”, which implies that they might be “imaginary” as well.

    I do recall that “Whatever I do is above the law and not reviewable by any court” line in the initial Tarp plan. I think it is time for that clause to be wheeled out from the tool shed.


  2. fresno dan

    “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.” Financial Armageddon article.
    From what I have read about Lehma and Iceland, how is it that that stuff is worth even 10 cents?

    Now probably I am too dumb to really understand this, but it seems that since so many of these CDO’s are contingent upon so many “outside events” (default of Iceland) that firms may be obligated far beyond the apparent terms of the CDO. Yes, a house of cards.

  3. TallIndian

    Synthetic CDOs are credit default swaps that have been ‘sliced/diced’ into tranches.

    The underlying can be be single names, indexes, or most often, some kind of ‘asset’ (and I use the term loosely) such as mortgages, consumer loans, commercial loans.

    Vanilla CDS are impossible to hedge (other than buying back the position!). Tranched CDS are, if there such a term, even more impossible to hedge.

    Declaring these contracts ‘null and void’ would destory the people who paid good money to buy this protection. Surely, we have not yet descended to that level of a banana republic.

  4. Anonymous

    tallindian – I believe Vanilla CDS’s were hedged using synthetic bonds. Pretty much anything can be hedged synthetically.

  5. Chris

    Does anyone have any idea whether these apparently separate categories of derivative products actually are what they appear to be?

    Is it meaningful, from a policy point of view, to take CDO’s as something self-evident, without asking how they relate to, for example interest rate and forex swaps and other over the counter products?

    On page 56 of the September 2008 BIS report a discussion of forex settlement risk begins

    This discussion indicates, given the CLS Bank settlement method (payment against payment, not sequential) what the effect of hedging forex risk incurred in CDO transactions might be as a multiplier in particular transactions. Interest rate hedges might then be thought of as inverse currency hedges and the multiplier treated accordingly.

    This section of the report also raises questions about the relationship between CLS Bank with its forex settlement activities (15 currencies trillions of dollars of volume), DTCC with its custodial services and non-forex settlements (stocks, bonds, derivatives etc) and the New York Fed. EAch of these companies have web-sites which describe what they do. CLS Bank and DTCC seem to be joint products and ventures of the New York Fed and some of the TBTF crowd, acting with the central banks which are part of the BIS.

    I’m wondering what people think about this because it looks like a sorcerers’ apprentice type issue, as one product is brought under control, or viewed as a problem, a myriad more are created. Why continue to treat them separately?

    But if CLS Bank’s Forex, and DTCC’s efforts are really related or integrated as they appear to be from their own descriptions, through the NY Fed and the TBTF ‘quondam banks’, then dealing with the whole mess would surely be a lot easier and more economical than attempting to deal with each apparent part.

  6. TallIndian

    Anon 7:08

    Only way to create a synthetic bond is to use a CDS.


    You bring up an important point. Sellers of CDOs now have large contingent payments that must be made in USD, EUR, JPY, etc. They suddenly need to hedge both the FX and interest rate risk.

  7. doc holiday

    Re: “is that like putting melamine in the milk”

    Anon, that was a great metaphor, because the whole idea of substituting or exchanging something of value for something that is worthless is the very backbone and foundation of this synthetic pyramid scam! I think Wall Street learned this from cocaine dealers that added baby powder as a cutting agent, i.e, a substitute filler that increases profit margin. Also, like cocaine dealers, the guys with the bags of blow are the guys snorting the most product and making bigger and bigger deals. Their CEO drug addled brains are addicted to the stimulation and as they get more and more, they can’t help but add more and more substitution, as they try to steal everything in site — the greedy f’ing bastard pirates! They all should spend some time at the electric chair IMHO!

    One last thing, in your example of using melamine, these f’ers don’t care if they kill people or animals, and of course we have examples of tainted pet food and human foods — so these are the business people of the world who have been given a green light to literally kill for profit or to use slave labor to make clothing or toys and then ship this shit form China to places like wal-mart …


  8. tugtrash

    It would seem that Wedemeyer’s Law of Complexity is applicable here. “The more complex a thing becomes, the more vulnerable to a catastrophic breakdown it is.” We shall see.

  9. ccm

    Can anyone help me here? (Tallindian, maybe)

    JPM estimates $757 B outstanding synthetic corp debt CDOs mostly issued in 2006-7 (see original article)

    JPM estimate $436 B outstanding mezzanine tranches.

    This implies about $320 in AAA tranches.

    First question: Do these figures include the super senior (unfunded) tranche?

    Preliminary guess/answer: No, because $320 on $756 is too small to include the super senior (roughly speaking usually at least 75% of the deal).

    However, compare with SIFMA data: Funded tranches (i.e. excluding super senior) of all synthetic CDOs issued from 2004 through 2007 total $237 B. This should include corporate and ABS synthetic CDOs.

    How is it possible that SIFMA reports $237 B in equity, mezzanine and senior tranches, while JPM estimate $436 B of mezzanine outstanding.

    What gives?

  10. russell1200

    If all of these are in off balance sheet SIVs, I don’t understand why the issuing bank is forced to buy them back. It’s the SIV that is going to collapse. Correct?

  11. Jim T

    What a laugh! Why would anyone listen to what JPM says about Derivatives, CDOs, CDSs or SIVs?

    When it comes to culprits in these markets JPM is public enemy #1 and by a long shot! This ENTIRE CRISIS is about Derivatives and CDS contracts. If they did not exist we have a speed bump of a Recession, not the Fricken Depression we are about to endure!

    When this thing finally blows up and it will soon, DON’T FORGET WHO IS TO BLAME!

    It’s not Joe The Plumber!

    Jamie Diamond and crew at JPM should be put on trial first in the State of Texas where Capital Punishment means something.

  12. Mencius Moldbug

    I can’t say how pleased I am to see people actually thinking a little bit, even very tentatively as above, about regulating duration mismatches, ie, maturity transformation.

    Granted, the issue is just too complicated to demagogue. But it can’t be too complicated to regulate…

  13. Frank

    There is not enough money in the treasuries of governments around the world to fix this problem. The total value of derivative contracts is many times the GDP of the world. The entire mess is now starting to devolve entropically. The TARP money is going into a black hole. Every thing put in will disappear without effect. This is a black hole that can swallow the entire world economy. A redesign is required for the entire system, worldwide. The capitalism experiment is over. This is the end of a 500 year era of growth economics based upon exploitation: first of the “New World” and slavery, later of fossil fuels and exploitation of the natural world. There are no longer increasing supplies of cheap fossil fuels available, and the natural world is now about to exploit humans constructs through climate change and other unpleasant effects of ecological overshoot in a kind of karmic reply. After awhile, trying to sort out the financial crisis becomes an exercise in mental masturbation. Truly yours Frank from EntropyPawsed where we attempt to design for the new era.

  14. tom a taxpayer

    Terra Incognito. The problem is we are in uncharted territory, and it is getting more uncharted every day.
    Governments are taking extreme and unprecedented measures are an increasing pace.
    It is virtually impossible to figure out what will happen because there are too many balls in the air, too many cooks in the kitchen, and too many unintended consequences.

    This Yeats poem may seem over-dramatic, but who knows…:
    Turning and turning in the widening gyre
    The falcon cannot hear the falconer;
    Things fall apart; the centre cannot hold;
    Mere anarchy is loosed upon the world,
    The blood-dimmed tide is loosed, and everywhere
    The ceremony of innocence is drowned;
    The best lack all conviction, while the worst
    Are full of passionate intensity.

  15. Steve Diamond

    I blogged on synthetics recently at Global Labor. I think the trouble in this market may have scared Paulson away from the original purpose of the TARP. He realized he would be pushing on a string to buy up troubled assets like CDOs – he might as well buy yesterday’s lottery tickets.

  16. Anonymous

    Ok – We know CDOs are toxic and bad.

    But we do not know how big the CDO market is – Only a guess.

    When will the problem be realized?

    Answer those questions – And you will know when life gets back to normal.

  17. Anonymous

    The perfect storm hits the “unsinkable” Titanic.
    All hands to deck,man the life boats, bankers and hedge funds first.
    She’s going down boys.

  18. Anonymous


    yeah, i feel like the little boy calling out the “king is naked”. I don’t have an advanced degree and have never worked for a wall-street firm but when I’m wading in bull-sh*t up to my arm pits I can figure out where the stench is coming from.

    I see 15,000 expert economists using the all latest computer-based sophisticated statistical analytic programs and modeling techniques, all couched in insider jargon and technical blather, that we dumb general public yokels just couldn’t possibly understand. And how many of these gurus saw this crisis coming? Having no shame, many of these so called experts have the audacity to share their deep understanding of these matters in the comment section of blogs such as this.

    Hundreds of thousands of accountants purporting to provide services by way of financial statements that arms investors with useful information on predicting a company’s future cash flows. Knowing full well, the general investing public wouldn’t know what an accumulated adjustment account is for, haven’t the faintest idea about the assumptions that are made in calculating deferred tax assets\liabilities, nor the journal entries required booking transactions surrounding hedges, Or intelligently weighing the merits of so called fair-value accounting, as if there is a single objective value that can be assigned to an asset on the balance sheet date, that has any real meaning for an investor. SEC, Sarbanes-Oxley, GAAP, IAS, transparency. yeah I smell bull-sh*t here, how about you?

    I see wall street financial analysts, apparently setting on their thumbs, while disasters such as the internet bubble, enron and worldcom type scandals, as well as the mortgage-backed security mess and looming credit default swaps crisis have literally popped up all around us, destoying our children’s future. Lacking in any shame, they still make their regular appearances on CNBC Squak Box, sharing their expert opinions without even blushing. Risk management with Synthetic CDOs implemeted with credit default swaps, special purpose entities, and leveraged super tranches, indeed! I smell bull-sh*t, how about you?

    And then there are your global software companies that keep busy cornering the technology market. Threatened by open standards that just might unleash a torrent of technological innovation, with the promise of creating “real” wealth and improving quality of life around the globe, these technology behemoths have been busy hijacking the standards setting bodies and spuing out tons of marketing hyberbole, convincing the general programming community that without their proprietary software frameworks and solutions, information solutions are just not possible. And I’ll be darned if all the IT customer base isn’t buying into it. Just, what in the hay has the anti-trust division of the Justice departments been doing with themselves over the last 30 years?

    I keep reading the comments on this blog, searching for someone who is proposing concrete solutions. You got any? Comments that demonstate ones deep knowledge of the credit default swap market after it tanks are about as useful as nipples on a male pig. Risk management, hah! Let’s see we’ve got liquidity risk, business risk, credit risk, systematic risk. How about stupidity risk?

    I’m not very smart skippy, but given the conditions on wall street, it looks like I’ve got plenty of company.

    Avg John

  19. Anonymous

    Frank is completely correct when he says this problem is larger than all the money/GDP in the world. James Bruges says the same thing in The Little Earth Book.

  20. Anonymous

    @Avg John,
    How smart is it to create a system of artificial wealth, who’s value is determined by the people in control, on a minute by minute basis?

    These people are cleaver, not smart as they will burn down everyone house to save their own.

    I started my business career back in the early 70s/7th grade, doing totals in my mothers book keeping/accounting/printing business. To see a red, green or black bound ledger still reminds me of youth lost. Since that I have worked in OEM, Supply and Sales, to the executive level. In all that time the most prevalent observation I made was the moral loss one needed to rise to the top.

    We are experiencing a economic meltdown but, feel it all started with the moral one.


  21. Anonymous

    Avg John-
    Most of them (including Greenspan) were blinded by the money and the sheer size of the thing. Having known physicists and quants, it’s easy for the model to become more important than reality especially when that’s where your next meal comes from. It’s no different than the fishermen who can’t figure out where all the fish have gone. This comes back to simple human frailties: managers desire for a free lunch, workers hoping simple models are realistic, greed and now fear.

    As to solutions? Well there don’t really seem to be any. The money is gone (credit was created on the back of unworthy assets and insolvent debtors), it’s just a question of who get’s bailed out first and whether we revert to an agrarian society at this point.

    The paths are uncharted. I hope they figure out a way to keep the Ponzi scheme going long enough for me to die of old age… but I don’t expect it.


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