Shrinking CDO market hits Citi, Deutsche, TCW

NEW YORK (Reuters) -The incredible shrinking market for restructured debt will be in retreat until 2008, withering profits for banks ranging from Citigroup (C.N) to Deutsche Bank (DBKGn.DE) and reducing returns at hedge funds that had gained on their high yields.

While parts of the market for collateralized debt obligations are showing signs of life, CDOs backed by asset-backed securities, known as ABS CDOs, contributed to an evaporation of global sales starting in June, followed by a massive revaluation of portfolios.

Top CDO manager TCW, based in Los Angeles, and smaller hedge funds such as Greenwich, Connecticut-based Airlie Group, all took hits due to their investments in subprime mortgages. The obscure world of structured credit now could lower banks' income by $8.5 billion, according to UBS AG.

"The ABS CDO new issue market is essentially dead," said Vishwanath Tirupattur, an executive director and CDO analyst at Morgan Stanley in New York. "You need to see a recovery in the underlying subprime ABS, and we think the worst is yet to come."

Banks make a 1 percent margin on creating a CDO and a 50 basis point margin for managing so-called asset-backed commercial paper conduits, debt structures for shorter-term loans, and some analysts expect a loss of about half of the business.

"A halving of these revenues is a $8.5 billion revenue hit" in 2008, UBS analysts Alastair Ryan and Gert Van Rooyen co-wrote in a recent report.

"Structured credit must now be a revenue pool impaired for several years," UBS said. "Those investors who are keen to buy these must shrink."

Swiss Bank UBS on Monday announced its first quarterly loss in nine years due to the credit crisis and said it would cut 1,500 jobs at its investment bank.

Citigroup, the largest U.S. bank by market value, said on Monday that its third-quarter net income will drop by 60 percent. Among reasons for the bank's warning were $1.4 billion in pretax write-downs on leveraged loan commitments and $1.3 billion in pretax losses on loans and bonds it had planned to repackage into CDOs.

The $500 billion market of cash CDOs in 2006 were heavily bought by market participants in the $1 trillion ABCP market, which UBS estimates will shrink by 50 percent or more.

Global sales of CDOS already plunged more than 50 percent in the third quarter, to $61.6 billion from $120.1 billion for the same period in 2006, as deteriorating subprime loans sapped demand for structured debt, according to Thomson Financial.

A CDO is a debt instrument backed by a portfolio of bonds or bank loans. Rating a CDO depends on evaluating the underlying portfolio of debt, and how likely the credits are to default at the same time.

"Credit woes and contagion resulted in an evaporation of CDO sales," said Richard Peterson, director of capital markets at Thomson. "There's a been a push back on anything that's structured and that's the overarching issue."

Last year there were $477 billion in global CDO sales, a record, according to Thomson.

FUNDS HIT

Among portfolios impacted recently, TCW Asset Management began selling $3.2 billion of mortgage securities backed by CDOs after the market value of the collateral pool began to deteriorate.

The CDO, known as the Westways Funding X CDO, did not experience any delinquencies, but a decline in price forced the manager to begin selling securities, TCW said.

"The resulting pricing declines, while modest by most financial market standards, have been sufficient to cause the structure's 'net asset value' to fall below a critical threshold," TCW said in an e-mail. As a result, TCW "began the orderly sale of the collateral securities of the fund."

Moody's Investors Service last month cut six classes of the Westways CDO, including some debt that was misjudged by 11 notches, resulting in a cut to "Ca," among the worst of junk-rated debt, from "Baa2," the second-lowest high-grade.

INVESTMENT BANKS

Issuance and trading of CDOs will decline in the fourth quarter and beyond, according to David Viniar, Goldman Sachs Group's (GS.N) chief financial officer.

Deutsche Bank Chief Executive Josef Ackermann also said recently the bank was heading for a rocky third quarter due to some exposure to U.S. subprime loans. The bank, which is due to report third-quarter results on October 31, may see profits take a hit of up to $2.4 billion (1.7 billion euros), sources familiar with the issue told Reuters last month.

Anthony Thompson, a managing director at Deutsche Bank, acknowledged the growing risk to investment banks, during a recent speech at the American Securitization Forum conference in New York.

"Lots of these risks are now everywhere, and we all, everyone in this room, probably have some indirect exposure to what's going on," Thompson said. "We probably couldn't have said that a decade ago."

In recent months, many investment banks have stepped up efforts to auction off debt after non-traditional buyers, such as hedge funds, stopped buying them.

"We're really just starting to see this python start to swallow the rat and the CDO is really at the very end of this snake," Thompson said.

(Additional reporting by Jane Baird in London and Al Yoon)