Synthetic CDO 'Slow-motion' Meltdown

By Jane Baird
LONDON, Nov 28 (Reuters) - Around half of the 3,648 synthetic CDO tranches rated by Standard & Poor's worldwide are at risk of ratings downgrades in the near future that could push investors to dump many of them on the market.
What's more, nearly a quarter of the synthetic collateralised debt obligation (CDO) tranches that started with investment-grade credit ratings from S&P have already been cut to "junk", according to data from S&P, which rates around three-quarters of the $600 billion market.
Synthetic CDOs are bundles of between 100 and 150 credit default swaps (CDS) on investment-grade companies -- bets that these companies will honour their debts -- that have been sliced into tranches based on degree of exposure to defaults.
S&P's monthly SROC (Synthetic Rated Overcollateralisation) figures are the key measure the agency uses to determine potential ratings changes.
An SROC of 100 means that a tranche has just enough cushion to absorb the expected defaults and downgrades of companies in the CDO portfolio to justify its current rating.
When the SROC goes below 100, S&P typically puts the tranche on review for a potential downgrade and then makes a decision on whether or not to change the rating within three months.
S&P released its monthly global SROC report for October late last week, showing that 1,951 tranches have SROC numbers below 100. The total includes around 300 tranches already rated at the bottom end at CCC- and D, at which point ratings downgrades are unimportant. "It's the SROC report that is the basis for the downgrades that follow," said Jamie Stuttard, head of pan-European fixed income for Schroders, which had about 18.2 billion pounds ($28.1 billion) of fixed income assets under management at end-September.
"The SROC numbers are critical, and the market is not as clearly focussed on these numbers as it should be, because SROCs are rather arcane," he added.
EFFECT ON CDS MARKET
Schroders does not invest in synthetic CDO tranches, but Stuttard pays attention to the monthly SROC reports as leading indicators of the impact on the credit default swaps (CDS) market of potential CDO downgrades and fears of unwinds.
"The synthetic CDO market has got real problems," he said. "When people put these deals together, they didn't believe that names they viewed as money-good like Lehman and the Icelandic banks would jump straight from investment-grade to default."
Two waves of panic about synthetic CDO unwinds have hit the CDS market so far, helping widen spreads to record levels in February and again in October. More could occur.
As opposed to the effect of market fear, actual unwinds are occurring gradually, dispersed by the wide variety of deals and investors, and are unlikely to take place all at once in a rapid meltdown, analysts and investors say.
In addition, S&P has made a series of adjustments to assumptions on correlations, probabilities of default and industry classifications for sectors such as broker/dealers, insurance companies, real estate companies.
S&P's "approach has been to publish pieces of their new methodology one at a time, and the implementation of the changes is still unclear", JPMorgan credit strategists said in a recent note, adding that S&P rates about $450 billion worth of CDOs in the market.
The SROC report for October consists of more than 100 pages of ratings, with ratings and figures for each of 3,648 tranches. The report did not provide aggregated figures.
Out of all tranches that started off with AAA ratings, around 63 percent are still rated AAA, 22 percent have been downgraded but still hold other investment-grade ratings and 15 percent have fallen to "junk" ratings, an S&P analyst said.
The lower the initial rating, the larger the percentage of tranches that have dropped to "junk". (Click on for a table.)
S&P has already taken some actions following the SROC results for October.
On Nov. 17, the ratings agency placed 260 European synthetic CDO tranches on review for possible downgrades, adding to roughly 500 that were already on CreditWatch negative.
"It is clear that downgrades are occurring, and the sub-par SROCs indicate many more are to come," said Matt Leeming, a credit strategist at Barclays Capital.
"This may increase pressure on ratings-sensitive investors to restructure or unwind transactions," he added.
On Friday, S&P downgraded 61 Japanese synthetic CDO tranches. A further round of downgrades on European synthetic CDOs is likely any day.
Some investors have mandates that may not allow them to hold investments with ratings below AAA or below investment-grade.
Ratings are also important for banks because of ratings-based capital requirements. A downgrade from AAA to junk can force a bank to increase its capital reserves for that investment from less than 1 percent of notional value to as much as 100 percent.