More on CLOs and CDSs

Today’s NY Times column by Floyd Norris reflects concerns regarding collateralized loan obligations (CLOs) and credit default swaps (CDSs) similar to those in last week’s postings here (below).

The evaporation of the CLO market has substantially reduced the demand for high yield corporate debt. Borrowing costs are certain to rise, which is one of the reasons why Moody’s has predicted a quadrupling of the default rate on non-investment grade credits in 2008, from 1% to over 4% (which, incredibly, would still be below the historical average of nearly 5%). Defaults will trigger payment obligations under CDSs, as buyers of default protection look to sellers. At that point we will discover how many of the default protection sellers, especially smaller hedge funds and other alternative investment vehicles who saw opportunities for high profits in a low default rate environment, properly assessed and priced their risks and adequately reserved against losses. Of particular worry is this observation by Norris:

Many of [the $45 trillion in CDSs] cancel each other out — or will if everyone meets their obligations. The big banks say they run balanced books, in which they sell insurance to one customer and buy insurance on the same borrower from another customer. But if some customers cannot pay what they owe, this could be another shock for bank investors.

In other words, the banks and other larger players, while having to meet their obligations as CDS sellers, may, as CDS buyers following a default by the same borrower, find themselves unable to collect from sellers that overextended themselves.

Expect the credit market turbulence to continue unabated in 2008.


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