CPDOs: Where the Creators and Ratings Agencies Went Wrong

By Peter Tchir  NOV 12, 2012 1:45 PM

Or, free speech aside, you can't yell, "Fire!" in a crowded movie theater.



Ratings and Rating Agencies

Before going into the details of how a CPDO (Constant Proportion Debt Obligation) works, it is worth talking about what rating agencies are, and what they do. The "big three" are Standard & Poor's, a division of McGraw-Hill (NYSE:MHP)' Moody's Investor Service (NYSE:MCO); and Fitch Ratings, a joint subsidary of FIMALAC (PINK:FMLCF) and privately-owned Hearst Corporation.

I think in most cases rating agencies do a good job, yet I would never rely on them.  I think their “single name” issuer ratings have had a pretty decent history. This is the part of the business where they tend to get access to management and information that isn’t always generally available. They have missed some fraud (but they aren’t alone in that). They have some quirks where they tend to be reluctant (in my opinion) to have companies cross from Investment Grade to High Yield. The fact that being investment grade, or high yield, or even AAA is so important, is something we need to revisit.

Before moving on to the structured side of the business, it is worth spending a couple more minutes on the corporate side. What is the rating of a holding company versus an operating company? What is the difference in rating between senior secured and unsecured debt? Such simple questions have no simple answer. 

All of the rating agencies attempt to rate “probability of default” rather than “probability of loss” for their corporate issues. They can argue that holding companies are more likely to default than operating companies, or that secured debt is less likely to be defaulted on. Many investors like the secured debt of junk bond issuers (leveraged loans) because they feel the rating precludes a lot of other investors from buying, but that the rating overstates the risk if the collateral is good. I’m not sure there is a right answer here, but the distinction of what they are rating becomes apparent as soon as you move into the structured world.

In the structured ratings world, most ratings are tied to probability of loss. Various scenarios are run including expected loss and stress loss, and those calculations are mapped to a rating. It is very methodical, generally conservative, process. However, loss severity plays a key role in the rating of structured debt versus its corporate counterpart.  It's worth noting because it highlights the general differences between structured ratings – mechanical based on no specific additional knowledge, and corporate ratings – personal and subjective with additional company-specific knowledge. The structured side of the business has had far more problems. It is here that CPDOs -- synthetic, collateralized debt instruments backed by a debt security -- were created. Called by different name -- Leveraged Super Senior, Super Senior, Sub-Prime, CDO Squared, ABS of ABS, SIVs, etc. -- CPDOs were unleashed on the world.  Some of the problems inherent with CPDOs are very technical in nature. The following is my opinion of a few of those issues:
Some things that went wrong were hard to see at the time. For all the complaints about sub-prime, it was hard to find many investors who though housing prices could go south so quickly.  

So, in general I’m neither enamored with ratings, nor do I think they are to blame for everything. However, in the case of CPDO, as you will see, I thought, even at the time, that the ratings made no sense and were likely to cause problems.

You Can’t Yell Fire In a Crowded Movie Theater
There are limitations of free speech.  There are certain things that you cannot say.  If you could say whatever you wanted to, there wouldn’t be proceedings related to libel and slander.  So free speech does have its limits.  Before getting into the specifics of why CPDO in particular seemed so bad, there have always been some things that make me question the validity of the free speech argument:
Why CPDO Looked Attractive (The Infomercial)

Before going into the problems of CPDO, it is worth looking at why it looked attractive and why it seemed to work. We will look at a simplified version as it explains most of the concepts without losing too much.

The first thing to remember is investment grade Credit Default Swap ("CDS") spreads were about 40 bps for 5-year CDS at the time.  So you could earn 0.4% per annum for selling investment grade CDS on average.  Bonds traded almost as tightly as the market was doing well.  Sub-prime wasn’t an issue, AIG was alive and well, and you could borrow as much as you wanted in the repo market to fund bonds.  There were banks, and even hedge funds, that ran “basis” books in the billions and even tens of billions of dollars.  Credit was cheap. So let’s create a CDS index, call it CDSI.  It has 10 names (the real ones had 125 names, but this is easier to explain with a smaller index).

You could sell protection on this index and earn 0.4%.  But let’s say you are a “cash” investor, and you need a funded or “structured” note.  You could buy one linked to the CDSI and receive LIBOR + 25 on a BBB rated note.
Now along comes a structured salesperson who tells you they can offer you a structure note that pays LIBOR + 150 and is AAA rated.  Wow!

So in an environment where you can earn L+25 on a BBB structured note linked to the index, here is a product that can pay you L+150 and is AAA rated!.  And wait, not just the coupon, not just the rating, but if the deal performs well, you get a kicker at the end at maturity.  This is all based on the same index that the other unleveraged structured note is base on.  Impossible? No. 

How CPDO Worked (The Alchemy)

So how is this miraculous trade created? How do you transform L+25 BBB notes into L+150 AAA notes with upside? The deal below references the CDSI index (in this case our hypothetical 10 name index). Note, it uses 15 times leverage.  So for every $10 million of exposure taken via the note, the investor takes risk to $150 million of CDSI.

The immediate and obvious question is how do you take something that is BBB and leverage it 15 times and turn it into AAA? This is where it is both clever and complicated, and also where the mistakes come in.

Something So Complex Went Wrong So Simply

After understanding the complexity of the model, and why it worked, you will see how it fell apart so quickly, and frankly simply. Certainly it would have failed in 2001 to 2002, just five years earlier, and could never have withstood backtesting.  That is what is so alarming about the product.

Let’s go back to our 10-name index.  Say each name is trading at 40 bps.  The index trades at 40 bps. Now let’s say one name has a lot of trouble (10% of the portfolio).  Whether the trouble is caused by fraud like WorldCom or Enron, or fear like Dynergy, or overbuilding like Nortel, or writing too much protection like MBIA (NYSE:MBI), to name a few real world examples, it doesn't matter.  Let’s just say two names get into serious trouble during that period.  They don’t default (I will give the model that one).  But let’s say they trade at 40 points up front.  So the CDS goes from nice and tame at 40 bps to 40% up front.  That would imply bonds gapping down to 60%.  The list of names that have seen that is pretty long – I think I forgot to mention Xerox (NYSE:XRX) and Conseco (NYSE:CNO) in the list of earlier examples.

In this environment, let’s say the average name somehow remained unchanged at 40 bps (unlikely but makes it easier).  So nine out of the 10 names remain unchanged, but one name lost 40%.  That is a 4% loss on the index.  That means the index would have a spread of about 135 bps.  Remember, we kept the rating agency's assumption of no default, but what they missed was how much a name can move.  That is the driver, and again, all you have to do is go back to 2001 and 2002 and see how quickly names can default.  It also means this note would have a mark-to-market of about 40% now (a loss of 4% on the index * 15).  If you think 10% of the index universe gapping wider is high, remember it happened in the early 2000’s and then again in 2007 and 2008.

But what about the excess carry, reversion to the mean, and steep curves? If that name was removed because it was no longer investment grade, which is a reasonable assumption, then the new index or CDSI 2 would be at 40 bps.  We made the assumption the names had stayed at 40.  In any case, the key is that if the names that come out see a spike in spread, the CPDO can never earn that back.

Now at a mark to market of 40% of par, and an index at 40 bps, the structure can only sustain a 30% move before triggering.  Now that is only a 50 bp move and wouldn’t even sustain 1 name going to “points up front” in a meaningful way.

The Flaws that were Obvious and Should Have Been Caught

In the end, the rating agencies did a horrible job of assessing the spread gap risk.  They focused too much on default risk and too little on correlation, particularly in bad times when it tends to go to 1. They were complacent about things like steep curves and mean reversion.

At the time, we went back, and tried to use some combination of TRACERS (the first IG CDS index, which was a Morgan Stanley product) and CDX 1 to see what CDX 0 and CDX -1, etc. would have looked like.  What names would have been in and -- based on bond pricing and what historical CDS were  out there -- how it would have performed. It would not have survived 2001-2002.  How can any product be AAA, when less than five years before it would have defaulted?

What Next?

Who knows, but feel free to contact us, as are happy to discuss our views and thoughts and go into more details. 

If you can get your hands on an old Barclay’s report, it is worth reading. They tried to “break” CPDO and couldn’t thus concluding that it was robust.  The problem was they just tweaked the model with different levels of steepness, volatility, mean reversion, etc., but didn’t take the time to go through the common sense approach of asking "would it have survived recent past?" Therefore, they missed analyzing the real risk, which was short term spread movement risk, and names dropping out at the wides.

Editor's Note: For more from Peter Tchir, check out TF Market Advisors.

Twitter: @TFMkts
No positions in stocks mentioned.

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