Watchdog frets over 'toxic' threat

EVER since Chancellor Gordon Brown was lampooned for lecturing the electorate about 'neo-classical endogenous growth theory', public figures have been wary of using polysyllabic financial argot.

Until Tuesday night, that is, when Sir Howard Davies, the City's chief regulator, warned of an exotic new beast that threatened the stability of financial markets - synthetic collateralised debt obligations.

'One investment banker recently described these instruments to me as the most toxic element in financial markets today,' Davies said. 'It's not surprising, then, that we are taking a heightened interest in this area.'

Synthetic CDOs are a sub-species of ordinary CDOs, sometimes also called collateralised loan obligations.

With ordinary CDOs, banks package up parcels of loans they no longer want on their balance sheets and place them in a special purpose vehicle. This SPV then issues securities and sells them to investors like insurance companies which want a reliable stream of income.

With synthetic CDOs, the bank does not transfer the loans off its books, but merely the credit risk. Again an SPV is created, which issues credit-linked notes to investors. In the event of defaults by borrowers of the original loans, it is investors in the SPV which in theory suffer the losses, not the bank.

The danger is two-fold, the FSA believes: first that insurers do not fully appreciate the risks they were taking on with these complex instruments. Secondly, that they were untested legally. Banks which think they are offloading risk may not in fact be doing so.