Another chapter for credit

The credit markets are certainly keeping dealers on their toes. Just as things were getting back to normal after the dislocation in the correlation markets in May, the Chapter 11 filings by Northwest Airlines and Delta Air Lines in September, followed hot on the heels by US auto-parts maker Delphi last month, has reignited fears of a downturn in the credit cycle, sparking a few days' frenzied trading in the credit default swaps market.

Spreads popped out, particularly after Delphi – a component in the credit default swap indexes and a frequent inclusion in CDO portfolios – filed for bankruptcy protection. Unlike the downgrades of Ford and General Motors to junk status in May, however, dealers saw the bankruptcy of Delphi coming a mile off. All in all, there hasn't been anywhere near the problems experienced in May – the market has continued to trade in an orderly fashion, there's been no squeeze in the tranche market, and no reports of sizeable hedge fund losses.

But that's not to say the Delphi bankruptcy has passed by without incident. For a start, the Chapter 11 filing has prompted dealers to look closely at the settlement processes in place for tranche and index trades. The International Swaps and Derivatives Association published a draft protocol to allow cash settlement of those credit derivatives tranche and index trades incorporating Delphi, and an auction is planned in early November. It will be the third time the industry has come together to facilitate the cash settlement of index trades, and dealers reckon this will eventually become a standard feature of credit derivatives contracts (see page 16).

Delphi's going under has also hit the collateralised debt obligation (CDO) market. All three of the major rating agencies have been quick to publish reports detailing the impact of Delphi on rated CDO tranches. And while the CDO market performed relatively robustly after the downgrades of GM and Ford in May – just 10 of the 745 CDO tranches rated by Standard & Poor's that contained GM or Ford were downgraded – the impact of Delphi looks to be a lot more serious. S&P said it had lowered the ratings on 127 of the CDOs with exposure to the US firm – that's 5.6% of its total universe of publicly rated CDOs in Europe and North America (see page 16).

After the downgrade of GM and Ford, S&P pointed to CDO-squared transactions as showing the greatest erosion of subordination levels. CDO-squared deals typically have significant overlap between the names in the various inner tranche portfolios. As such, the default of a popular name such as Delphi is likely to drastically erode subordination levels further. Too much more, and investors in CDO-squared transactions will start to see significant losses on their investments, say dealers. n

Nick Sawyer, Editor