Ratings firms Standard & Poor's and Moody's have already downgraded several synthetic-CDO deals containing or related to Lehman, Washington Mutual and U.S. mortgage companies Fannie Mae and Freddie Mac.
The problems with synthetic CDOs stem in part from the way they were made. In many cases, the banks that created the CDOs stuffed them with companies, such as Lehman and Iceland's Glitnir, that paid the highest possible return for their top-notch credit ratings. That made the CDOs more attractive, but also riskier, because they contained companies that the market perceived as more likely to get into trouble.
Perhaps the weakest link in the market are specialized funds, known as "constant-proportion debt obligations," that work much like synthetic CDOs but with one important difference: They use borrowed money, or leverage, to boost the returns they can provide for investors, a strategy that also magnifies losses.
CPDOs, for example, typically borrowed about $15 for every dollar their investors put in. They also contain safety triggers that force them to get out of their investments if their losses reach a certain level. Analysts estimate that most CPDOs reach those triggers when the cost of default insurance hits about the level where it is now.
Three CPDO funds launched in 2006 by Dutch bank ABN Amro Holding NV have already been forced to liquidate after credit insurance costs spiked and they were downgraded by S&P.
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