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Lehman, AIG troubles weigh down on synthetic CDOS

18 Sep 2008

Lehman’s bankruptcy and AIG’s downgrade spell bad news for the synthetic CDO market. CDO tranches referencing Lehman might face a one to two notch downgrade and about a 10% mark to market loss, predicted research analysts.

Standard & Poor’s said that Lehman is a reference entity in 1,364 tranches of 999 deals in Europe and AIG in 1,153 tranches of 819 deals.

It has taken ratings actions on 65 CDOs in Europe.

A credit research analyst and a CDO banker said that Lehman was a reference entity in just about every synthetic CDO of investment grade credits they had seen.

Fitch found that Lehman acted as swap counterparty to 27 CDOs publicly rated by Fitch in Europe, and 35 private.

The default will cause equity tranches to tighten and mezzanine tranches to widen on the iTraxx and CDX index tranches, said structured credit strategists at Barclays Capital in a report published on Wednesday called Correlation Market Reactions. This will be because of correlation desks’ needs to rebalance their correlation hedges for bespoke portfolios.

The spectre of AIG’s hedges unwinding caused panic in the market earlier in the week.

"The cost of replacing AIG is much, much bigger," said a credit research strategist at a bank in London on Monday. "There’s much more potential for a knock on, domino effect. Of course, now Lehman has been allowed to fail it has made people much more worried about AIG."

Even now that the Fed has bailed out AIG, there is still the possibility that it will unwind its credit default swap positions as it seeks to delever the balance sheet.

The notional amount of AIG’s super senior CDS is $441bn — $173bn in hedges sold in corporate loans, $133bn on prime residential mortgages, $80bn of negative basis trades on multi sector CDOs (about $58bn of which has subprime exposure) and $54bn in arbitrage trades on CLOs and corporate debt.

"An AIG default may cause investors across the board to re-hedge their long super-senior positions that AIG had wrapped," said BarCap strategists on Wednesday. "This will likely lead to wider super senior spreads across the board."

While many banks collateralised their bank exposure (such as Lehman) after the Bear Stearns episode, people tended to think AIG too big to collateralise, said one loans trader earlier in the week.

AIG is not just a provider of hedges on loan and ABS assets, it also bought cash bonds.

AIG holds $99bn of RMBS, CMBS and CDO of ABS assets at fair value. A liquidation could have an even greater depressive impact on the structured finance market than the liquidation of SIVs has done in the past 12 months.

18 Sep 2008