Thursday, May 1, 2008

Synthetic CDO issuance versus CDS spreads

(FT) Is something wrong in credit markets? A simple look at the risk premiums, or spreads, on cash bonds and those on credit derivatives shows a heightened dislocation has developed since last summer, says Geraud Charpin at UBS.

The market, he says, has become polarised between buyers of risk that focus on new corporate issues (cash bonds) and sellers of risk that focus on credit default swaps (CDS), the derivatives that provide a kind of insurance against non-payment of corporate debt.

“In cash bonds, companies [that wish to borrow money] provide an offset to investors [who wish to lend]. This allows an equilibrium between supply and demand to form. In CDS, the lack of supply side creates a major imbalance, which increases volatility.”

The problem is that complex investments known as synthetic collateralised debt obligations previously acted as big buyers of credit risk. But these products have withered and left the CDS market dominated by people who want to sell credit risk (go short, or buy protection) when things look bad, or switch to buying back credit risk to cover their shorts when the outlook improves.

“Until the synthetic CDO market re-emerges, the CDS market might be doomed to heightened volatility, moving above cash levels in bear runs (everyone buying protection) and below in bull runs (everyone covering shorts), while volatility of cash spreads will be tamed by supply/demand forces.”

2 comments:

David said...

Recently, there has been a blip of issuance on in the Synthetic CDO space, referencing CDS and TRS - issuance source http://www.sifma.org/uploadedFiles/Research/Statistics/
SIFMA_GlobalCDOData.pdf
I am trying to determine what are the driving factors for this pick up in issuance. Could it be related to the movement of spreads in the CDS market ? What are the economic fundamentals necessary to make this type of transaction work ? I would love to know your input as I am interested in what will arise from the ashes of the CDO market in general. Best wishes, David.

Cormick Grimshaw said...

David, I'm not seeing any Q3 blip in synthetic CDO issuance in that SIFMA report. The only blip I know of in the securitization space is for Re-Remics. Can you point me to the right cell in the SIFMA tables? CG