Structurers of true sale collateralized debt obligations in the U.S. are attempting to stem losses from interest rate hedges, which have moved out of the money since the deals' inception. The fixed-to-floating interest rate hedges were executed between 1997-2000 and are siphoning premium from senior note holders toward swap counterparties, said CDO pros. Swap losses have also contributed to many structures being downgraded, they added.
The problem has become acute because, since the CDOs were issued, the U.S. economy has witnessed some of the highest default rates and lowest interest rates in recent history. If the CDO structurers and managers had opted for a balance guaranteed swap, instead of a plain-vanilla swap, this would not have occurred, because the notional size of the swap would have decreased as the portfolio amortized, explained one credit derivatives professional.
In a perfectly hedged transaction, any extra costs due to a drop in interest rates would be matched by a saving in interest payments. For distressed early vintage CDOs, however, an increased number of bond defaults have tripped overcollateralization triggers, which has required senior notes to be paid down, explained Stephen Anderberg, head of the cash flow surveillance group at Standard & Poor's in New York. For example, a deal that was structured with USD200 million in senior assets may have been paid down to USD150 million. Meanwhile, the notional size of the swap liability remains USD200 million.
Anderberg said structurers have been asking S&P, which has to approve changes in deals it has rated, if they can enter offsetting swaps to stem losses. The ratings agency recently approved this strategy for the first time in which a CDO, which Anderberg declined to name, pays a floating rate and receives a fixed coupon. This strategy, however, leaves senior note holders unhedged against any spike in rates.
