Equity market turmoil hits Cedo deals

New York-based Moody’s Investors Service downgraded a swath of collateralised equity and debt obligation (Cedo) notes on October 10, as a result of the recent volatility in global stocks.

Originated by Credit Suisse, the Cedo deals constitute equally-weighted long and short portfolios of equity default swaps (EDSs). EDSs are essentially equity barrier options with barriers struck around 30% from the underlying stock’s initial value.

The agency’s rating action affected $1.55 billion of notes. Most of the 42 classes of notes and loan facilities issued by the various Cedo transactions were downgraded by two notches or more. Henry Charpentier, a credit analyst at the agency in Paris, said the action was due to high equity market volatility and the severe fall in some individual stocks, including financials.

“This has led to an increased likelihood of hitting the EDS triggers and a greater likelihood of loss for investors,” he said.

Furthermore, all the affected ratings remain on review for a possible further downgrade by the agency. “The nature of this type of structure is if you’re far away from the trigger you can expect some stability – but as you get closer, the stability of the rating is limited,” added Charpentier.

In a statement, Credit Suisse attributed the fall in ratings to “dislocated equity markets, asymmetric underperformance of the long portfolio versus the short portfolio, as well as a change in [Moody’s] rating methodology”.

Cedo suffered their first downgrades during December 2007, after market ructions caused by the US subprime mortgage market. While Credit Suisse was not the first bank to structure collateralised debt obligations comprising EDSs, its Cedo series is noted for being the first to achieve Aaa ratings from Moody’s.

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