CPDOs – according to a report from independent rating agency CreditSights, released Thursday – may be the next structured finance disaster. They’re rated AAA – and as they go wrong, the big rater’s current models won’t notice a thing.
While CPDOs aren’t going to bring any market down (not big enough) they’re possibly the best example yet of an ultra-complicated and ultimately risky financial product designed specifically with the ratings in mind (and the inventors’ in pocket).
A CPDO – Constant Proportional Debt Obligation – is basically a souped-up, glitzier CDO. Like a CDO, a CPDO is essentially a large basket, providing investors with exposure to a range of asset-backed bonds. But unlike a CDO, a CPDO’s basket does not contain the bonds themselves. Instead, similarly to what is known as a synthetic CDO, CPDOs use credit default swaps against the bonds to synthetically transfer the risk and the yield from those bonds into their pot.
Still with us? Good. There’s more. Because on top of the above, CPDOs continually roll their exposure to the CDS indices which they contain. By keeping everything in “constant proportion”, CPDOs are thus purportedly able to eliminate the kind of mark-to-market losses that plague other structured products. But this is where the worry should start to creep in, because to “keep everything in constant proportion” as they so easily make it sound, requires CPDOs to use a Martingale strategy.
For example: If a couple of underlyings on the CDS index start to have widening spreads, that will cause a mark-to-market hit on the portfolio’s net asset value as the old index rolls over. But the CPDO can recoup that loss because those widening spreads on the outgoing index will allow it to charge more for protection on the new index. It’s then simply a matter of increasing the leverage to bolster the gain on the new index.
With all that in mind then, sponsors were claiming way back in May that CPDOs were the next big thing – capable of delivering yields comparable to those on junk bonds, but with AAA ratings. That alchemy, of course, was achieved after intensive “negotiations” with the rating agencies.
Easy. Only not so.
Because CPDOs are not a license to print money. The use of the martingale strategy – doubling up your bets when you lose – was built only really to account for run-of-the-mill for fluctuations in swap spreads. CPDO engineers did not take into account what might happen if one of the underlying assets of those swaps actually defaulted or was significantly downgraded.
Moreover, that martingale strategy gets ever riskier as spreads widen. And the Itraxx and CDX indices of credit spreads have been going crazy.
CreditSights note that there are five firms within both Itraxx and CDX – Alliance Boots, Alltel, Boston Scientific, Expedia and ResCap – who have suffered big rating downgrades from at least two agencies. Those names will have to be removed from the indices at the next rollover under operational rules. There are a further three possible removals on the cards, says the independent agency, and together it could all add up to reduce the average spread on the Itraxx and CDX indices to 10bp.
Sounds puny? Well according to CreditSights, that shift could have “serious ramifications for CPDO ratings”:
CPDOs rely heavily on the CDS indices rolling into subsequent series with more generous spreads than their predecessors finished because of the maturity extension.
What’s worse:
We suspect that CPDO ratings should be largely unaffected by the spread volatility because the agencies appear to have no intention of employing more realistic assumptions regarding downgrades and defaults within the indices.
…CPDO ratings, very much like LTCM’s investment strategy, depend on using historical asset price movements to predict with a reasonably high degree of accuracy how those asset prices will behave in future. And like LTCM, CPDOs then use these predictions to make heavily leveraged investments. It is worth noting that while historical credit spreads are by definition mean reverting there is no law that dictates that the future’s mean spread will be the same as the past.
Using rating agency models, a CPDO will fail to pay par at maturity 0.09 per cent of the time – nine out of every 10,000 runs. But according to CreditSights, if you use current data, those AAA CPDOs will fail to pay in 2,000 of 10,000 runs: 20 per cent of the time.
Scary, eh?