Toxic corporate CDOs may touch $1 trillion

LONDON: Investors are taking losses of up to 90% in the $1.2 trillion market for collateralised debt obligations tied to corporate credit as the failures of Lehman Brothers and Icelandic banks send shockwaves through the global financial system.

The losses among banks, insurers and money managers may spark the next round of writedowns on CDOs after $660 billion in subprime-related losses. They may force lenders to post more reserves after governments world-wide announced $3 trillion in financial-industry rescue packages since last month, according to Barclays Capital.

���We���ll see the same problems we���ve seen in subprime,��� said Alistair Milne, a professor in banking and finance at Cass Business School in London and a former UK Treasury economist. ���Banks will take substantial markdowns.���

The collapse of Lehman Brothers, Washington Mutual and the three banks in Iceland prompted Susquehanna Bancshares, a Pennsylvania-based lender, to lower the value of $20 million in so-called synthetic CDOs by almost 88% last week.

KBC Groep, Belgium���s biggest financial-services firm, which had 377.4 billion in assets as of June 30, wrote down e1.6 billion ($2.1 billion) after downgrades on company and asset-backed debt. Brussels-based KBC had e9 billion in CDOs as of October 15, primarily linked to corporate debt, according to an investor presentation.

CDOs pooling asset-backed securities have been blamed for losses at the world���s biggest banks, from UBS to Citigroup. Now, corporate CDOs are starting to be affected as defaults rise and speculation mounts that the world economy is headed for a recession.

Some synthetic CDOs, tied to credit-default swaps on corporate bonds, are trading at less than 10 cents on the dollar, according to Sivan Mahadevan, a derivatives strategist at Morgan Stanley in New York. CDOs parcel fixed-income assets such as bonds or loans and slice them into new securities of varying risk, providing higher returns than other investments of the same rating.

Credit-default swaps are derivatives based on bonds and loans and used to protect against or speculate on defaults. Should a borrower fail to meet debt agreements, the contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent. An increase in the agreement���s cost indicates a deteriorating perception of credit quality.