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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.


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
  • Low six month jump to default risk, doesn't mean 5-year CDS can't jump by significant amounts. Time and again, companies, particularly highly leveraged ones, or frauds, have seen gaps in CDS that preceded actual default (or in some cases, recovery).
  • When names gap wider on being downgraded, and you are forced out of those names via the roll, you accentuate the problem, ensuring that you are exiting at worst possible levels and receiving new names that cannot compensate for those losses
  • Curves are steep in good times, but inverted in stress, so even if a name stays in, you may sell protection in the new index at tighter levels than where you are buying it back in the old index
  • The trade itself caused CDS to go to abnormally tight levels, so any mean reversion should have accounted for that (i.e., would revert wider because CPDO itself was causing the tightening), and it should have accounted for the spread widening that would be attributed to any potential unwind or even fear of CPDO unwinding which was real (and worked in conjunction with the aforementioned leveraged super senior).

No positions in stocks mentioned.

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