16 June 2013

FT: Bid to relaunch synthetic CDO unravels

JPMorgan Chase and Morgan Stanley have scrapped a plan to sell "synthetic collateralised debt obligations" – pools of credit derivatives – after failing to find investors willing to take on all of the deal's different pieces.

An attempt by two big Wall Street banks to revive notorious credit boom-era securities blamed for exacerbating the global financial crisis has failed after investors balked at buying some of the derivatives on offer. Bankers at the two Wall Street firms were looking at reviving synthetic CDOs, which were criticised for adding to losses during the financial crisis, after receiving inquiries from some investors hungry for higher yielding investments.

Synthetic CDOs pool derivatives known as credit default swaps and then divide them into different pieces, or “tranches”, with varying levels of risk. The deals allow investors to make amplified, or leveraged, bets on the underlying loans or bonds.

Investors balked at buying the top slice of the floated deal, according to people familiar with the talks. Finding the appropriate prices for these senior tranches has proved difficult since CDOs were created.

While synthetic CDOs with a range of tranches have yet to stage a comeback, some banks have been striking customised “single tranche” deals with investors. In such a transaction, banks typically sell the equity or middle slice of a derivatives portfolio to a hedge fund. The fund agrees to guarantee a certain amount of losses, allowing the bank to save some regulatory capital against the portfolio.

Such bespoke deals are different from the syndicated full capital structure synthetic CDOs which proliferated before the crisis. In addition to selling just one slice of a portfolio to investors, the transactions typically include derivatives tied to corporate loans or commercial credit instead of securities backed by home mortgages.

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