Synthetic Bets Threaten Rally for GE, Glencore Debt

Structured credit investments with about $800 billion in bets on companies including General Electric Co. and Glencore International AG may prevent the cost of protecting those corporations’ bonds from dropping further, according to Goldman Sachs Group Inc. strategists.

Tighter capital requirements expected to be put in place by yearend may prompt banks holding pieces of the so-called synthetic collateralized debt obligations to unwind the positions, strategist Alberto Gallo said in an interview yesterday. As trades used to hedge the deals are reversed, related credit-default swaps are likely to rise relative to the rest of the market.

“If there is a slowdown in the economy, as we expect, and if regulation becomes tougher, then the names most included in synthetic CDOs may underperform the rest of the market,” he said.

Goldman recommends that investors buy credit swaps on 13 of the companies most frequently included in corporate synthetic CDOs, which pay investors yields backed by cash flows from credit-default swap premiums on a group of companies. Those include Glencore, General Electric’s finance unit, Warren Buffett’s Berkshire Hathaway Inc. and European automakers BMW AG and Daimler AG.

At the same time, investors should sell protection on the Markit CDX North America Investment Grade Index, a bet that swaps on the individual companies will increase more or decline less than the broader market, Goldman strategists wrote in an April 9 note.

‘Bullish’ on Spreads

“We remain bullish on credit spreads and on the market, but let’s say regulation comes into play in an environment where economic growth is slowing down,” Gallo said. “Then we would probably see those names underperforming compared to the rest of the market.”

Synthetic CDOs sell credit-default swaps that receive annual premiums in return for taking on the risk of losses from corporate bond defaults. That risk is sliced into so-called tranches. Investors may, for example, take losses only after the first 5 percent of companies in the portfolio default, minus the recovery value. If the losses reach 6 percent, that tranche is wiped out.

Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Unwinding Trades

Proposed changes to bank capital requirements by the Basel Committee on Banking Supervision may in some cases double the amount banks must hold against credit derivatives, Gallo said. That “could make it uneconomical for dealers to hold certain positions on their books and push dealers to unwind the trades,” he said.

It also may hinder the creation of new synthetic CDOs, a process that practically shut down during the financial crisis, Gallo said.

Investors in 2008 took losses of up to 90 percent on the investments after the bankruptcies of Lehman Brothers Holdings Inc., the collapse of Iceland’s three biggest banks and the government seizure of mortgage-finance companies Fannie Mae and Freddie Mac. The failures eroded the built-in cushions that protected investors from losses and, in many cases, prompted rankings firms to give certain portions of the synthetic CDOs their top AAA ratings.

Fitch Ratings last month said that about 10 percent of the synthetic CDO tranches it rates are likely to lose principal after a Wisconsin regulator’s seizure of some subprime mortgage assets at Ambac’s bond insurance unit triggered payouts on credit swaps protecting against the unit’s failure.

Ambac Assurance Corp. was ranked seventh on a Standard & Poor’s list of companies that synthetic CDOs most frequently bet on.

Fitch Ratings said today that it downgraded 99 slices of synthetic CDOs because of defaults and the “continued deterioration in portfolio credit quality.”

To contact the reporter on this story: Shannon D. Harrington at sharrington6@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net

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