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CPDOs: Where the Creators and Ratings Agencies Went Wrong

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

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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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