What to do about synthetic CDOs?

Collateralized debt obligations still plague the financial system. The main concern right now is not the CDOs that invested in subprime-backed securities, though such securities remain a lingering problem. The main concern right now centers on so called synthetic CDOs, which, in many cases, underwrote credit default swaps on corporate bonds and are on the hook if a wave of defaults hits the market. 

Some analysts suggest that the market for synthetic CDOs will inevitably follow the path of the subprime-related CDOs. Which, of course, is terrible news. The last thing we need now is a slew of credit downgrades that pressure owners. But that is a distinct possibility. Bloomberg recently reported that already "investors are taking losses of up to 90 percent in the $1.2 trillion market for collateralized debt obligations tied to corporate credit." As banks, insurers and money managers take losses, it could "spark the next round of writedowns on CDOs after $660 billion in subprime-related losses." 

Obviously, the economy is not helping. There is plenty of reason to fear that we're in for a spate of high-yield blow ups. The Financial Times offers an interesting look at what would happen to credit ratings of synthetic CDOs under various economic slowdown assumptions. It's not pretty.

This is not a bad time to talk about possible courses of action. One consultant has come up with a novel idea: How about a national CDS holiday? Not unlike the depression-era bank holidays. The goal is to basically impose some sort of moratorium on trades, to allow all parties to wind down their trades in an orderly fashion--"without the forced selling and resulting liquidity cataclysm currently caused by desperate CDS traders covering 'naked' bets." 

This will not prevent losses per se, but perhaps it will prevent panic and allow losing parties to seek funds in a less frenzied environment. Of course, all this points to the need for a better settlement system, something we have discussed at FierceFinanceIT. In a way, it's sad that the discussion has moved in this direction, but the market's not looking good and neither is the economy. Hold on. - Jim

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