Lehman Brothers says forced CDO liquidations have become more likely

Lehman Brothers’ CDO/structured credit monthly report discusses the recent wild swings in mezzanine tranche prices which it says has been driven by fears of forced synthetic CDO unwinds. The bank’s analysts write that they believe the possibility of forced liquidations may have risen but that it is still relatively low.

It says that buy-and-hold investors are typically only forced to sell CDOs if they suffer multiple notch downgrades which would require several defaults and severe credit deterioration in the underlying portfolio. The report adds that some investors, even if they are not required to mark to market for accounting purposes, still worry about marks and could be forced by internal guidelines to sell if the price deteriorates below certain thresholds.

It says that the widening in individual spreads has produced a significant deterioration in price for highly rated CDOs. The report gives a simplified example of a triple A tranche with a delta of five referencing a portfolio that has widened by 80 basis points. Such a tranche could now be marked at 76 cents in the dollar, it concludes.