The growth of structured credit markets in Europe and across the world seems pretty much unstoppable. According to the British Banking Association, at the end of 2003 the global market for credit derivatives (excluding asset swaps) accounted for $3.5 trn (e2.9trn) and could reach $8.2 trn by 2006.
Collateralised debt obligations (CDOs) have become very significant and hugely diversified. Having originated from the banks in the form of synthetic CDOs, they are now more likely to be leverage-driven and/or managed synthetic CDOs. As the innovation and complexity grow, investors need to keep a close analytical eye on these products and have a clear understanding of the types of risks involved.
A recent paper* from Standard & Poor’s analyst Andrew South, discusses synthetic CDO transactions and suggests that the high degree of portfolio overlap between the transactions is a significant risk factor that ought to be factored into investor decisions. A rating action on a single corporate name can have a widespread effect on many CDOs. “For most CDOs the obligors referenced in one transaction may also be referenced in others. Indeed, such portfolio overlap is sizeable. This effect has occurred in parallel with the increasing importance and widespread application of standard credit default swap (CDS) indices,” writes South.
He describes how the limited number of corporate names in the indices leads to portfolio overlap between CDO transactions and relatively high obligor concentrations across the asset class. He notes that the top three corporate names are each referenced in more than 80% of transactions and each of the top 40 appear in more than half of transactions. He suggests that one important effect of this portfolio overlap is that rating actions on CDO transactions can be highly correlated.
While portfolio overlap is a real concern for investors, South suggests that shrewd investors should be able to keep a clear knowledge of the underlying portfolio and be aware of the overlaps. He also argues that the straightforward overlap/correlation effect can be greatly mitigated by credit enhancement, and that the increasing prevalence of portfolio/pool management in the synthetic CDOs protects both the CDO ratings and their investors.
The message is clear: caveat emptor.
* ‘CDO Spotlight: Overlap Between Reference Portfolios Sets Synthetic CDOs Apart’, Structured Finance Commentary, Sept 26, 2005. Standard and Poor’s (S & P)