| CDOs react well to Ford and GM downgrades |
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| 22/05/2005 | |
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In the end, the recent downgrades of Ford and GM to junk by S&P have had at least one benefit: it was the first major successful test for collaterised debt obligations (CDOs). But the correlation risk still lurks in the back: if more issuers in the automotive sectors were downgraded, the impact on CDOs could be greater. Following the downgrades, debt issued by fallen angels so far this year skyrocketed to €372.4bn, compared to €7.1bn over the same period in 2004. Investors and analysts expected this massive increase in the stock of junk bonds to have a significant impact on the credit quality of CDOs due to their frequent inclusion of GM and Ford bonds. But in the end, only €62 million worth of CDOs have been downgraded by S&P, while some CDOs were put on negative watch. Given the $80-90bn in CDOs that are issued every year CDOs, the amount is a small one. The strong resilience of CDOs can be explained by their diversified nature, which has worked to dispel investors' short-term fears. CDOs, which are portfolio of diversified bonds nested in a special purpose vehicle (SPV) that is then split into debt tranches with various risk / yield profile, can contain over 100 different names. According to JP Morgan's analysts, GM and Ford each accounts for about 1% of the long exposure of an average CDO. Nevertheless, rating agencies have been quick to warn about the correlation effect as further bad news in the credit market could drag the overall credit ratings of the assets contained in various CDOs to lower levels. This would hit primarily the cash flows emanating from subordinated tranches (also called "equity tranches"), which are directly dependent on the global performance of the assets of the SPV. Senior and mezzanine tranches, the so-called "high grade" tranches, are rated and come with a coupon. Synthetic CDOs Synthetic CDOs, which are not based on real debt, but rather on credit default swap (CDS), are also likely to be affected in the short-term, but have so far reacted well. For a premium, CDS offer protection against the risk of an issuer's default. Prices have logically gone up with the downgrades of GM and Ford. "The downward pressure on credit quality within this sector exposes synthetic CDOs to some level of event risk", stated Fitch Ratings. "Market participants have justifiably questioned the potential knock-on effects in the rated structured credit market, not least because Ford and GM have been very widely referenced in European Synthetic CDOs", said Andrew South, associate director at the S&P's Structured Finance Ratings group, who adds that the market has so far reacted well. "We conclude that the synthetic CDO market has passed its most widespread test to date. Although some tranches have suffered a reduction in their synthetic rated overcollateralization (SROC), the overall impact of the corporate rating actions appears to have been minimal", he said. According to Fitch Ratings, which ran a sensitivity analysis on a cross section of synthetic CDOs, "only when the CDOs were stressed to the point that all autos referenced were downgraded did some CDO ratings come under pressure for downgrade", observing that CDOs are typically structured to provide some resilience to relatively isolated negative ratings migration. Julien Laplante |
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