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CPDOs: Where the Creators and Ratings Agencies Went Wrong


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

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.
  • It is only LIBOR + 25 because the entity selling the note charges LIBOR – 5 bps on the funding -- and the dealer is trying to make 10 bps on the index. Not exact but some variation of that is at work.
  • It is rated BBB or maybe BBB+ because the WARF (weighted average ratings factor) of the 10 names gives that rating.
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.
  • Excess Carry. The first thing to note is that the index earns 40 bps (or did at the time). When you multiply that by 15, you get 600 bps of income to play with. If the dealer takes 100 bps as fee, and another 100 bps comes out as various deal fees, you are still left with 400 bps. But the coupon on the note is only 150 bps. So there is 2.5% per annum of excess carry. This money is meant to accumulate and protect against future losses. This part makes some sense. It basically relies on the fact that few investment grade companies default, so saving up some income and using that as a form of "portfolio" insurance makes sense on the surface. There are lots of reasons that it doesn't stand up to scrutiny but that is for later.
  • Spread Not Default Risk. The other innovation was that the deal didn't just sell protection on the "on the run" index. It wasn't a strategy of selling CDSI and sitting on the trade for five years. The trade was to "roll" the protection into the new "on the run" index. Since the index, when it is created, has to be investment grade, it meant, that you only had "six months of jump to default risk." The indices rolled every six months. So you would sell protection today on CDSI 1 and in six months buy that back and sell protection on CDSI 2. Since CDSI 2 had to be only investment grade names, you could argue, that you were only taking 6 months of "default risk" -- the risk that an investment grade company would default within 6 months of having that rating, which was obviously small. Technically the assumption correct. This let the rating agencies rely on credit spreads, rather default risk, and is where it all went wrong.
  • Steep Curves. Another erroneous assumption with model was that the CDSI indices appeared reasonably "steep". The models assumed that if you sold one Index at 60 bps, the new one would be at a similar or even wider level. This is an important but horribly wrong assumption for two reasons we will go into later. In the theoretical model world, this was a huge assumption that benefitted CPDO. Say you wrote $150 million of protection at 40 bps and six months later sold it at 50 bps. You lost 10 bps. The duration of the index was about 4.25. So that 10 bp loss turns into 0.425% loss. With 15 times leverage, the note would have lost 6.375% (0.1% * 4.25 * 15). At the same time, the note was accruing "Excess Carry" and in 6 months would have made 1.25% of carry. So the mark-to-market on the note would be 94.875% (100% - 6.375% + 1.25%). It is important to note how critical the assumption of steep curves is. Now the model would assume the new index is also at 50 bps. So it earns 10 bps more than before. That means the excess spread goes from being 2.5% per annum to 4% per annum (2.5% + 0.1% * 15). So Steep Curves and Excess Carry work hand in hand to absorb losses in a spread widening world according to the model.
  • Mean Reversion. The next element was a "mean reversion". Those selling these instruments argued, reasonably well, that spreads had a tendency to mean revert. I will give that to them. I think many things tend to mean revert. The big question is what do they revert to? A near term mean? A longer term mean? That distinction can make a difference. It plays a role here too, particularly in the model. I cannot remember the exact mean reversion, but I think they assumed spreads were already tight, so the reversion would be to something higher, let's say 60 bps. On the surface that seems bad, but it isn't according the model. If you did a trade at 40 bps and it went to 60 bps you would have a mark-to-market loss bigger than the one in the example above. But your Excess Carry would be even bigger and you would make more. It got really bizarre once you start going wider than the mean reversion level in scenarios. The trades would do great, because they would get even more excess carry for a period of time, and then make big gains as the CDSI levels reverted and went back from say 80 to 70 to 60.
  • 90% Loss Trigger. Here is the final piece, the piece that no one thought could happen, but did. The structured note can only lose $10 million but, with 15-times leverage, you actually had $150 million of exposure so the loss could in theory be $150 million. So the note "triggers" if the note is ever only worth 10% of notional. In theory you would need the CDS spreads to go out to about 180 bps (or 140 wider for this to occur), a 1.4% spread move * 4.25 duration * 15 leverage = 90%. That is a big spread move. Many saw it as near impossible. In fact with Excess Carry and the way duration works for CDS, it would have had to be an even bigger spread move as a one-time gap to knock you out of your trade. At the time 10-year CPDO's were even riskier because they could withstand even less spread widening.

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