Buy senior protection ahead of Basel II changes, says Goldman

In latest “Credit line” research, published on Friday, Goldman Sachs strategists look at the implications of Basel II proposals on the credit default swaps market.

These changes to the Basel II regulation would be effective from 31 December this year. They introduce higher capital requirements for banks to trade and hold CDS products in their books. Goldman thinks this would cap future growth in synthetic securitisations and increase bank regulatory capital.

The new capital charges would probably weigh heaviest on super-senior (triple-A) CDS tranches. Goldman calculates that around $330 billion of risk-adjusted notional could be affected. Although gradual implementation would limit the risk of sudden unwinds, senior tranches would face lower demand going forward and would underperform their delta to the index. Goldman recommends expressing this view by buying iTraxx Europe S9 22-100% protection, delta hedged.

The most popular credits in synthetic CDO portfolios underperformed the market during the crisis, but have since recovered. Protection buying caused by the unwind of senior tranches puts these names at risk of renewed underperformance.

The impact of the new charges would vary strongly bank by bank. Overall, Goldman thinks capital regulations would benefit large bank credits with strong franchises and solid earnings power across a diversified set of businesses.