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Synthetic CDOs: Production slows down

But credit tranche activity has held up despite the GMAC fallout

It is two months since massive volatility in credit tranches hit hedge funds and dealers, causing significant and unexpected losses. These investors' view on the credit markets had encouraged them to create long correlation trades. This involved taking a long position in equity tranches of the CDX and iTraxx indices while hedging delta with the index or the mezzanine tranches of the same indices.

The rise in idiosyncratic risk and resultant fall in correlation caused by GMAC's downgrade resulted in well-publicized losses for the funds and dealers, which largely copied the trade. Although many of the leveraged hedge funds were forced to unwind the trade because of mark-to-market losses, it appears that arrangers/dealers were not undermined in quite the same way and have worked their way out of their positions since May as credit spreads tightened.

"I had expected the credit tranche business to freeze up but that has not happened," says Michael Fuhrman, head of e-trading at inter-dealer broker GFI. Volumes have not quite returned to previous levels and liquidity always suffers in July and August but dealers, who at first suffered from diminished appetite after suffering substantial losses, are identifying opportunistic trades.

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