14% of CSOs hit by all three Icelandic credit events, says Barclays Capital

In a report entitled CDO unwind headwinds, Barclays Capital calculates that at least 70% of deals will have been hit by at least one of the seven recent investment grade events: Lehman Brothers, Washington Mutual, Fannie Mae, Freddie Mac and the Icelandic banks.

The researchers estimate that 70% of Standard & Poor’s-rated CSOs contain Lehman Brothers, 57% include WaMu and 32% contain at least one Icelandic bank. The report notes that 14% of deals are in the unfortunate position of having exposure to Landsbanki, Glitnir and Kaupthing.

The report says that recession-related corporate downgrades and defaults pose a significant risk to the ratings of synthetic CDOs, and could force investors to unwind. The report notes that the risk of unwinds is one of the most powerful technical forces in investment grade credit at the moment. With approximately $1.2 trillion of delta-adjusted protection written on the iTraxx and CDX indices, even moderate unwinds could put substantial pressure on spreads, write the authors.

Barclays Capital recently carried out scenario analysis on different CSO tranches using iTraxx Main as a hypothetical portfolio. The report concludes that a mild recession with one default in the portfolio, would lead to a two notch (Moody’s) downgrade on a seven-year Aaa tranche and would prompt a seven-year Aa3 tranche to fall four notches to Baa1. A mild recession with three defaults would cause the same tranches to fall five and seven notches respectively.

A severe recession would cause bigger downgrades. The researchers calculate that even in the absence of a credit event, a severe recession would cause the Aaa tranche to fall six notches to A3 as a result of corporate ratings migration alone. That scenario would lead to an eight notch downgrade of the Aa3 tranche to Ba2.