A CDO backlash?

Following all the turbulence in May, the structured credit market has – on the face of it at least – simmered down. After blowing out to 60 basis points, the iTraxx credit derivatives index has ground back in to the levels seen before the downgrades of General Motors (GM) and Ford on May 5. Correlation has picked up, equity tranches have outperformed and some modicum of liquidity has returned to the market, enabling dealers and hedge funds to close out loss-making positions.

The dislocation has meant some hedge funds and dealers have had to face nasty mark-to-market losses on their structured credit investments. London-based hedge fund GLG Partners, for instance, wrote to its investors last month to inform them of a 14.5% loss on its Credit Fund in May (see page 13).

These losses could spark a rise in redemptions come June 30, with some investors deciding that enough's enough after several months of disappointing hedge fund returns. However, this is unlikely to be large enough to seriously affect the vast majority of funds – it's certainly not serious enough to cause any major market dislocation, in which hedge funds desperately liquidate assets to meet soaring redemptions.

But one potential problem for the credit market lies in the seemingly unquenchable thirst for mezzanine risk from real money investors. Mezzanine tranches have performed strongly, despite the spike in overall market spreads in May. This is a result of predominantly buy-and-hold real money accounts, which, not subject to mark-to-market accounting, have continued to invest in and hold these tranches as a means of generating yield. Many investors have gone a step further by snapping up CDO-squared transactions over the past few years, willing to take the additional leverage in exchange for enhanced returns.

The question is: what if there is further turbulence in the credit market, more downgrades and more defaults? Standard & Poor's reported that only 10 of the 745 rated collateralised debt obligation tranches that contained GM or Ford were downgraded. However, CDO-squared transactions showed greater erosion in the level of subordination needed to maintain their ratings than traditional CDOs (see pages 32–33). How will investors react if there are further defaults, subordination levels are eaten away and investors are facing losses?

Last month, Bank of America and Italian bank Banca Popolare di Intra (BPI) settled their €40 million lawsuit, in which BPI claims it was mis-sold several CDO investments by Bank of America. In this month's cover story, Nicholas Dunbar looks at the deals at the centre of the dispute, analysing term sheets and trade tickets from two of the seven transactions (see pages 22–24).

It would be naive to think that this is the last court case that will emerge. A number of investors and regulators have already voiced concern about the level of complexity in some investment products. With something as complicated as CDO-squared, it's not hard to imagine more investors claiming they were mis-sold investments if the credit cycle takes a turn for the worse.

Nick Sawyer, Editor