New Basel rules could hit synthetic CDOs – Goldman Sachs

March 2, 2010

By Jane Baird

LONDON, March 2 (Reuters) – New bank capital rules could deal the final blow to any resurgence of deals in synthetic collateralised debt obligations as well as hurt the value of $330 billion of existing triple-A tranches, Goldman Sachs said.

Proposed changes to Basel II rules, effective end-2010, would increase bank capital requirements by an estimated 11.5 percent overall and 223.7 percent in the trading book, according to a study by the Bank for International Settlements.

At the height of the financial crisis, fears of a market meltdown and defaults of investment-grade credits such as Lehman Brothers drove spreads of synthetic CDOs, also known as collateralised synthetic obligations (CSOs), sharply wider.

Spreads have since largely recovered, and a smattering of new deals have been done, but credit strategists at Goldman Sachs see the potential for new pain.

“For banks, this would mean a much higher cost for running the CSO issuance business,” said strategists Charles Himmelberg, Albert Gallo, Lotfi Karoui and Annie Chu in a note to investors.

A failure of the CSO issuance market to recover, furthermore, will have a long-term impact on the CDS market by comparison with the boom years of 2006 and 2007, when CSO deals boosted demand for CDS and drove spreads to razor-thin levels.

“That means a cap on the size of the CDS market and a higher floor on the level of CDS spreads compared to 2006 and 2007,” Gallo said in a interview.

AAAs HIT BUT NO SUDDEN COLLAPSE

The Goldman strategists said AAA tranches of synthetic CDOs would be hit the hardest, because lower-level tranches are not generally held by the banks.

But they did not predict a sudden market drop.

“Whatever new policies are ultimately introduced would be implemented gradually, limiting the risk of sudden unwinds. Nevertheless, we believe senior tranches would face lower demand going forward and would underperform,” the note said.

They recommended investors buy protection on top AAA tranches of the investment-grade Markit iTraxx Europe index.

Synthetic CDOs are portfolios of mostly investment-grade credit default swaps (CDS) that have been divided into tranches, or slices. The bottom tranche takes the first default losses from any credit in the portfolio, and the senior AAA tranche is hit only after defaults have wiped out all other tranches.

As markets have recovered over the past year, spreads on top tranches of the iTraxx Europe index, have tightened in to 15 to 25 basis points from more than 80 basis points in the crisis.

The strategists now expect the estimated $330 billion of top tranches that remain to underperform the market as demand diminishes.

Spreads on the single-name CDS that were the most popular constituents of CSOs are also likely to underperform, they said.

An analysis of the Standard & Poor’s list of top 100 names in synthetic CDOs shows that they underperformed when the market slumped and outperformed during the subsequent rally, the strategists said.

“We think any further unwind risk would likely result in increased pressure on these single names.”

Reuters published an S&P report at the time on the top 50 CSO names. At the top remain Volkswagen, GE Capital Corp, France Telecom, Deutsche Telekom, Hutchison Whampoa, Telecom Italia, Merrill Lynch & Co., Morgan Stanley, Goldman Sachs and Daimler AG.

(Editing by Jon Loades-Carter) ((jane.baird@thomsonreuters.com, Reuters Messaging: jane.baird.reuters.com@reuters.net, +442075422471))

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