There is widespread apprehension about the imminent, and potentially disastrous, impact on the credit risk environment of the forced liquidation of synthetic collateralized debt obligations (CDOs). The 10:1 and 15:1 leverage ratios usually applied to synthetic CDO trades are obvious causes for concern. But beyond the synthetic CDO arena lies the shadowy world of 80:1 (and higher) leverage: speciality funds, called Credit Derivative Product companies (CDPCs), dedicated to shorting default risk on a basket of highly rated debt securities.
Three such funds, Theta Corp., Primus and Athilion, have already been the subject of recent rating downgrades; they will be forced to liquidate their positions if the rating agencies start placing an increasing number of S&P 500 index components on negative watch in forthcoming weeks. In fact, all highly leveraged sellers of CDO default risk must be preparing to face the inevitable: an across-the-board abandoning of commitments in the face of a broad-based recession. Such an event, according to a Citigroup study, could wreck havoc on the marketplace.
Theta Corp., managed by a rather appropriately named UK-based firm Gordian Knot, was last reported to hold $10 billion in client funds. How could that $10 billion be leveraged eighty times, or even higher?
At one end of the leverage spectrum, a leverage-free position would allow a CDPC to sell a maximum of $10 billion notional worth of credit default insurance, akin to a credit default swap, and to receive an income (premium) stream linked to the yields on the components (corporate issuers) of an underlying synthetic CDO. But far from being leverage-free, CDPCs owed their potential to offer exponential rewards to investors by employing the type of leverage which would make the average Wall Street hedge fund manager look like a bit player.
If, to simplify an example, investor money was utilized exclusively to service initial margin deposits and margin calls, the leverage ratio on $10 billion would only be conditioned by the rating matrix of the underlying CDO on one hand and by the related margin requirements on the other. An unchanged rating matrix over a period of time (the third dimension of credit default insurance), would enable the booking of premium inflows as profits and the simultaneous release of margin security; the leverage ratio capability, in that event, could easily breach 100:1.
The problem today is that the rating matrices for the overwhelming majority of the synthetic CDOs are under serious threat. Given their leverage methodologies, CDPCs are subject to cash calls even if a limited number of CDO constituents are downgraded. And as cash calls increase, the CDPC leverage structure begins to contract.
Estimates of the total worth of outstanding synthetic CDO contracts vary, ranging from a low of $1.5 trillion to a high of $6 trillion. These figures do not include the size of the outstanding deals on synthetic CDO option trades and do not capture the real risk inherent in existing CDPC leverage ratios, which are, in most cases, determined by relatively inefficient mark-to-market mechanisms.
Note that CDPCs are not subject to any solvency ratios (AIG) or, for that matter, capital adequacy ratios (LEH, C) when picking the limits of leverage.
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