Surging Windstream Spreads Remind Wall Street Why Synthetic CDO's Are A Bad Idea

Just a couple of weeks ago, we wrote a post about Citibank and the 35 year old they recently put in charge of once again making the bank into a powerhouse in the Synthetic CDO market.  Less than a decade after being forced to take a taxpayer funded bailout to avoid an embarrassing bankruptcy filing, it seemed as though Citi had learned precisely the wrong lesson from the 2009 financial collapse, namely that their bad behavior would forever be backstopped by the American taxpayerBut please don't lose too much sleep over the risk to your tax bills because this time Citi says they're positive they're building the business in a "way that insulates them from any losses."

Now, fast forward just a couple of weeks and it seems that the serial high-yield issuer, Windstream Communications, is suddenly reminding wall street why it's a bad idea to package up a bunch of synthetic securities referencing risky credits, lever it 10x and then tranche it up and pretend there is no risk.

As Bloomberg points out today, in the beginning of August, Windstream's 2-year credit spreads were historically tight to 5-year risk, a phenomenon partially attributable to a surge in Synthetic CDO demand for short-dated contracts.  But that all changed in a matter of weeks after Windstream missed earnings, cut its dividend and got slapped with lawsuit from a hedge fund alleging that one of the company's spinoffs amounted to a default.

The telecommunications company features in an estimated $3.5 billion of complex wagers -- known as synthetic CDOs -- that the global credit boom will keep America’s heavily indebted companies out of trouble for a while longer. Junk-rated Windstream, along with the magic of financial engineering, helped Wall Street turbocharge yields and breathe new life into an exotic investment that had been left for dead in the wreckage of the 2008 financial crisis.


Now, the company has emerged as a troubling omen as it tussles with a hedge fund that Windstream says is trying to push it into bankruptcy. After synthetic CDO bets sent the cost of insuring the company’s debt in the short-term toward historic low levels, Windstream’s sudden troubles are giving investors a flavor of how quickly their fortunes can turn.


“We have seen this movie before,” said Peter Tchir, a strategist at Academy Securities Inc. in New York, who has traded and advised on credit derivatives for over two decades. “Investors become convinced that while there might be risk, it is further in the future. It leaves the market susceptible to surprises.”


“Just like in early 2007, when curves were very steep and it seemed as though everyone was a seller of credit protection, especially short dated protection - we saw how quickly that could reverse,” Tchir said.

Mass confusion, eerily reminiscent of 2008, quickly ensued as holders of Synthetic CDOs on the hook for $350 million worth of short-term Windstream credit risk attempted to hedge their positions resulting in an inversion of the company's curve.

As Bloomberg notes, the process all started when demand from Synthetic CDOs forced the spread between 5 and 2-year credit risk to all-time wides...

Because the latest synthetic CDO trades have largely been limited to three years or less, the contracts are suppressing yields on shorter-term credit swaps, leaving CDO investors vulnerable to a sharp correction were sentiment to sour in the next few years.


That’s what happened with Windstream. During the first half of 2017, the resurgent CDO market pushed down the amount investors are paid for two-year Windstream credit swaps to about four percentage points less than what investors in a five-year swap would have been paid. During the previous decade, the gap was about two percentage points, meaning that two-year swaps investors earlier this year were getting paid about half the amount they would have received in previous years relative to the longer-term contracts.

...which rapidly changed in mid-August resulting in substantial losses that could threaten to wipe out the riskiest slugs of CDOs depending on their level of exposure to the credit.

By August everything had changed for Windstream. The cost of two-year swaps soared as the company missed analysts’ sales forecasts and halted its dividend amid customer losses and a declining landline business. S&P downgraded the company in September.


Also last month, Windstream said it received a letter from a bondholder, later identified by Bloomberg News as Aurelius Capital Management, who claimed the company’s spinoff of a unit amounted to a default on its debt.


Two-year swaps surged so much that the annual premium surpassed what investors buying five years of protection were paying -- an anomaly in the market known as an inverted curve. By the end of September, credit-swaps traders were demanding an annualized 25 percentage points to insure against a Windstream default for two years, a level that implied a 60 percent probability of default.


The stakes are high for CDO investors because an estimated $350 million of Windstream credit swaps insuring its debt have been included in CDOs since 2015, according to the market participant familiar with the transactions. That’s almost two thirds of the net $550 million of outstanding credit swaps covering the firm’s debt as of Sept. 1, according to the latest data from ISDA.

For those who have forgotten how Synthetic CDOs work, below is a quick reminder.  To summarize, you go out and find a bunch of suckers willing to backstop trillions of dollars worth of credit risk in return for a few bps in annual premium payments.  You then tranche out the risk being taken by the CDO investors so that those at the top can get a AAA-rating and, in return, tell their investors that they're taking no risk at all.  Those investors then lever up their capital another 10x so they can make 8% returns on a 'risk-free''s basically as safe as having you're own printing press from the U.S. Treasury.

Typically, these CDOs pool together about 100 different credit-default swaps tied to various companies, which are then sliced into varying levels of risk called tranches -- senior, mezzanine and equity. Over the life of a deal, which generally lasts two to three years, the swaps generate a steady stream of income for “long” investors (and are paid by “short” investors on the other side of the trade who want insurance against a potential default).


The equity tranche has the biggest risk of getting wiped out if losses from defaults exceed roughly 5 to 7 percent, and nets the highest returns.

Synthetic CDO

And guess who's buying all this garbage?  If you guessed 20-something year old pension and insurance fund investors who were in middle school during the last financial crisis then you're absolutely right...congratulations.

Yet after years of rising markets, declining corporate defaults and tighter credit spreads, the trade is finally attracting greater interest. Increasingly, pension funds and endowments have become senior tranche investors in many of Citigroup’s synthetic CDOs. And because the CDOs are derivatives, they have small upfront costs and amplify returns.


“There is a whole generation of people in finance who never knew or forgot what the problems were with synthetic CDOs,” said Janet Tavakoli, a 30-year veteran of the financial markets who runs a consulting firm and has written books on structured credit and CDOs. “Just as derivatives can lever up the upside, they can lever up the downside.”

Then again...maybe this is just a great opportunity for more Synthetic CDOs to come along and Buy The Fucking Windstream 2-Year CDS Dip.