Will Synthetic Credit Derivatives Slow The Credit Freeze Thaw?

As if the credit markets did not have enough problems with actual credit default swaps (CDS) and collateralized debt obligations (CDO), now it has to worry about their synthetic relatives (see WSJ article). While synthetic CDOs have been talked about for a while, additional pain from synthetic CDO losses may be on its way, possibly setting back any recovery in the credit markets.

Synthetic CDOs essentially allow banks, hedge funds, and insurance firms to invest in a diversified portfolio of companies without directly purchasing the bonds of the companies. Unlike normal CDOs, synthetic CDOs do not contain actual bonds or debt. In order to provide the normal income stream generated by CDOs, synthetic CDOs provide income by selling insurance against debt default. Each synthetic CDO typically has numerous companies with good to high investment-grade credit ratings (often AAA or AA). Like a normal CDO, different tranches, or levels of risk and return are sold. Insurance companies typically purchase the higher rated senior and mezzanine tranches, while hedge funds, looking for higher return, yet willing to bear or hedge the additional risk, might invest in the lower-rated or unrated equity tranches. As the credit crunch progressed, many CDOs had exposure to financial companies, such as Lehman Brothers. Such exposure has caused previous AAA-rated products to now trade for 50 cents on the dollar, falling from 60 cents just a few weeks ago. The resulting hedge fund liquidation is pushing up the cost of default insurance, which in turn is raising the cost of borrowing, and putting more pressure on the credit markets.

Specialized funds, such as Constant Proportion Debt Obligations (CPDO) are also causing problems. If you felt that CDOs were not complex or risky enough, no problem. CPDOs juice returns by adding leverage, as much as 15 to 1. Of course, such leverage is risky, so many CPDOs have safety triggers that force them to exit their investment if their losses reach a certain level. Unfortunately, many are starting to reach their trigger levels. Some companies that sell protection on credit derivatives, called Credit Derivative Product Companies (CDPC) or Derivative Product Companies (DPC), have made matters worse by leveraging as high as 80 to 1. The CDPCs are similar to the monoline financial guarantee companies (remember Ambac, MBIA, etc.), except they do not have the burden of regulation (ah, remember the days). In order to stabilize company returns and ironically help secure a AAA rating, such companies would not post collateral, since posting collateral on trades could force collateral calls on losing trades and force portfolio selling. Of course, now, many firms are learning what forced selling is all about, or even worse, insolvency.

Hindsight is usually 20-20 (except when you still don't understand the product or exposure), but you still have to wonder how things were allowed to get so out of control. As an analogy, does it really make sense for me to be able to take out insurance on my neighbor's house, as well as mine? Should every neighbor on my street be allowed to insure against my house burning down? Or even better, on a house that does not even exist? Apparently so. Greed and common sense are not always close friends.