In a recent research report, Dissecting the losses in synthetic CDO investments and their implications for the credit markets, Lehman Brothers researchers point out that marks on corporate synthetic CDOs continue to deteriorate. They say a valuation below 50% of par is quite possible even if the reference credit portfolio is relatively high in quality.

They take the hypothetical example of an August 2006 10-year double A rated CSO issued at par paying 100bp over Libor at issuance and with collateral invested in a monoline GIC. The deal is linked to a 4-5% tranche of a 100-name portfolio with an average rating of strong triple B and an average spread of 42bp.

They estimate the current value of that deal as 42 cents in the dollar. Most of that fall in value comes from the general widening in credit spreads, which are on average 2.5 times wider than they were when the transaction was issued. The researchers calculate that this has contributed a 34% decrease in the value of the deal after taking account of the gain from convexity and moves in correlation. The decline in the value of the cash collateral has added a 20% loss in value with the balance from transaction costs.

The paper concludes that unwinds or restructurings of CSOs have the potential to send spreads wider and curves steeper and to cause credits which are popular in synthetic CDOs to underperform. But Lehman says that significant unwinds are unlikely in the near term unless there are unforeseen accounting or regulatory changes or large-scale changes of rating methodology.