Posted on the Financial Times Alphaville blog:
News that CIT’s potential bankruptcy could impact a number of synthetic CDOs — in Europe in particular — hit the wires earlier this week:
NEW YORK, July 14 (Reuters) - Standard & Poor’s said on Tuesday that 1,881 synthetic collateralized debt obligations are exposed to CIT Group (CIT.N: Quote, Profile, Research), the troubled small business lender struggling with a liquidity crisis.
Synthetic CDOs are structured products backed by a portfolio of credit default swaps.
Europe has the largest exposure to CIT, with 977 synthetic CDO transactions, followed by the United States, with 701, Japan with 104, and the Asia-Pacific region excluding Japan with 99. S&P on Monday downgraded its counterparty rating on CIT to CCC-plus, one of the lowest rating categories above default, saying near-term liquidity concerns have mounted because of CIT’s failure to secure government-guaranteed funding.
S&P accordingly put 136 tranches of synthetic CDOs on review for a downgrade. It’s important to note here that since these are synthetic CDOs they aren’t actually backed by any tangible collateral (like RMBS or ABS) but instead are backed by CDS contracts which reference some sort of collateral — in this case CIT CDS.
A wave of CIT-related CDO downgrades would likely result in mark-to-market losses for the institutions which hold them — banks, hedge funds, etc. It would also probably force banks to ratchet up their capital, since riskier assets require higher capital cushions under regulatory rules. Margin calls and collateral postings may also need to be made — further tightening liquidity in the financial system.
In short, bad things would happen for institutions with CIT CDO exposure.
There is a sliver of hope, however.
While S&P seems to be inching towards CDO downgrades, ratings agency Fitch has taken a rather different stance:
NEW YORK (AP) — Fitch Ratings said Thursday that a failure of commercial lender CIT Group Inc. would have minimal impact on the ratings of collateralized debt obligations.
After downgrading CIT debt earlier in the day, Fitch said the ratings on synthetic CDOs already reflect any potential loss tied to CIT.
“Recently completed sensitivity analysis showed many tranches rated ‘CCC’ and below are likely to default and suffer losses while investment-grade tranches can absorb a potential loss and maintain their current ratings,” Fitch said in a statement.