As if the credit markets did not have enough problems with actual credit default swaps (CDS) and collateralized debt obligations (CDO), now it has to worry about their synthetic relatives (see WSJ article). While synthetic CDOs have been talked about for a while, additional pain from synthetic CDO losses may be on its way, possibly setting back any recovery in the credit markets.

Synthetic CDOs essentially allow banks, hedge funds, and insurance firms to invest in a diversified portfolio of companies without directly purchasing the bonds of the companies. Unlike normal CDOs, synthetic CDOs do not contain actual bonds or debt. In order to provide the normal income stream generated by CDOs, synthetic CDOs provide income by selling insurance against debt default. Each synthetic CDO typically has numerous companies with good to high investment-grade credit ratings (often AAA or AA). Like a normal CDO, different tranches, or levels of risk and return are sold. Insurance companies typically purchase the higher rated senior and mezzanine tranches, while hedge funds, looking for higher return, yet willing to bear or hedge the additional risk, might invest in the lower-rated or unrated equity tranches. As the credit crunch progressed, many CDOs had exposure to financial companies, such as Lehman Brothers. Such exposure has caused previous AAA-rated products to now trade for 50 cents on the dollar, falling from 60 cents just a few weeks ago. The resulting hedge fund liquidation is pushing up the cost of default insurance, which in turn is raising the cost of borrowing, and putting more pressure on the credit markets.

Specialized funds, such as Constant Proportion Debt Obligations (CPDO) are also causing problems. If you felt that CDOs were not complex or risky enough, no problem. CPDOs juice returns by adding leverage, as much as 15 to 1. Of course, such leverage is risky, so many CPDOs have safety triggers that force them to exit their investment if their losses reach a certain level. Unfortunately, many are starting to reach their trigger levels. Some companies that sell protection on credit derivatives, called Credit Derivative Product Companies (CDPC) or Derivative Product Companies (DPC), have made matters worse by leveraging as high as 80 to 1. The CDPCs are similar to the monoline financial guarantee companies (remember Ambac, MBIA, etc.), except they do not have the burden of regulation (ah, remember the days). In order to stabilize company returns and ironically help secure a AAA rating, such companies would not post collateral, since posting collateral on trades could force collateral calls on losing trades and force portfolio selling. Of course, now, many firms are learning what forced selling is all about, or even worse, insolvency.

Hindsight is usually 20-20 (except when you still don't understand the product or exposure), but you still have to wonder how things were allowed to get so out of control. As an analogy, does it really make sense for me to be able to take out insurance on my neighbor's house, as well as mine? Should every neighbor on my street be allowed to insure against my house burning down? Or even better, on a house that does not even exist? Apparently so. Greed and common sense are not always close friends.

Unfortunately, it will not be enough to suffer losses from just regular credit default swaps (CDS) and collateralized debt obligations (CDO). As reported in the WSJ, additional pain from synthetic CDO losses may be just around the corner. Synthetic CDOs have been around for a while, but have become popular in the last few years as a way for insurance companies, banks, and funds to invest in a diversified portfolio of companies without directly purchasing the bonds of the companies. While many of the problems with CDOs linked to mortgage debt have been uncovered and are currently being felt, problems with CDOs linked to regular corporate debt are now raising the interest of rating agencies.

Unlike normal CDOs, synthetic CDOs do not contain actual bonds or debt. In order to provide the normal income stream generated by CDOs, synthetic CDOs provide income by selling insurance against debt default. Each synthetic CDO typically has numerous companies with good to high "investment-grade" credit ratings. Like a normal CDO, different tranches, or levels of risk and return are sold. The tranche structure allows some investors to receive higher returns (while taking higher risk), while making it possible for others to take much less risk, but also receive lower returns. Again, much like a normal CDO, it is possible to create a higher investment grade asset (tranche) out of lower quality securities. Additional details regarding collateralized debt obligations can be found here.

Insurance companies typically purchase the higher rated senior and mezzanine tranches, while hedge funds, looking for higher return, yet willing to bear or hedge the additional risk, typically invest in the lower-rated or unrated equity tranches. As with any CDO, in order to increase the returns of the equity tranche, the banks that created the CDOs can simply include lower-grade (higher return) debt. As the credit crunch progressed, more of these lower-grade companies have defaulted on their debt, causing the CDO losses to move up to the higher tranches. Given the synthetic nature of the CDO, rating companies are now being forced to develop new methodologies that will allow them to examine synthetic CDOs.

New downgrades will surely result from this closer examination, forcing additional selling of already distressed securities, putting further pressure on the markets. Combined with higher energy costs, this should prove to be a challenging time for some companies and investors, as well as the market in general. The old saying, "may you live in interesting times," will certainly get tested as we move into the dog days of summer.