Questions lie behind CPDO hype
Questions lie behind CPDO hype
Published: November 13 2006 22:27 | Last updated: November 13 2006 22:27
When ABN Amro went public with the first of a new type of structured derivatives deal in late August, Steve Lobb, global head of structured credit marketing, was pretty excited about its prospects.
He confidently told the Financial Times then that it could be “the most exciting development in credit investing since the single-tranche [collateralised debt obligation]”, the instrument that revolutionised the market.
But even he could not have expected the massive impact this new kid on the block would be having two months later, when only a couple of deals have actually seen the light of day.
The credit derivatives market has been abuzz in recent weeks with fevered talk about constant proportion debt obligations, or CPDOs.
It says they have been a significant factor in driving credit derivative indices to record low levels; they have rejigged the pricing of other structured products; investment banks have all been working frantically to mimic and improve on the first deals done; and every investor in the field has been seeking a piece of the action.
But behind the hype, there are still more questions than answers about these products and it is far from clear what risks are involved or how stable they will be.
In simple terms, the first CPDOs are leveraged bets on the credit quality of a number of investment-grade companies. They generate income by selling protection on the main US and European indices of credit default swaps, which provide a kind of insurance against non-payment of corporate debt.
Only about €1.5bn ($1.9bn) of these deals have so far been sold, but up to €5bn of deals are rumoured to be close to hitting the markets as other banks catch up with the early movers ABN and Lehman Brothers.
With maximum leverage levels of 15 times, €5bn of new deals implies a near-term demand for selling protection on the main US and European credit derivative indices of about €75bn - $30bn-$50bn of contracts are traded on the indices daily, traders say.
This begs the question of whether it was the products themselves, or traders front-running them that helped the indices rally so strongly - pushing down the cost of protection - up to the early part of last week.
The indices’ record lows also raise the question of whether many of the rumoured deals will actually make it to market at all. As spreads on the indices fall, the ability of CPDOs to generate large enough returns to pay the high yields of libor plus 200 basis points promised by the early movers while maintaining a triple-A rating becomes less certain.
Standard & Poor’s, the rating agency, sent out generic guidelines to banks late last week. These suggested that at the recent lows, a new CPDO deal might only be able to pay Libor-plus-100bp at a AAA rating.
However, S&P says that the coupon potential of different deals can vary significantly depending on the levels of fees and the way in which leverage is applied.
It is the ratings of CPDOs that hold the key both to their attractiveness to investors and to their complexity.
The AAA ratings are supported by the significant amount of excess spread, or yield, the structure is expected to generate over and above what is needed to pay the initial coupons.
This provides a cushion to help absorb any defaults, or more likely any mark-to-market losses in the value of the index trades when they are rolled over into the new series every six months.
This also says something about the evolution of what a rating agency does in modern capital markets. As Paul Czekalowski, global co-head of credit structuring at UBS, put it: “The agencies have definitively jumped out of rating default risk into rating market value risk.”
However, the high coupons promised illustrate the true nature of these products. As Moody’s points out in a recent note, the investor’s stake is actually an equity, or first loss piece, of a much larger structure.
If there are big market value- or default-related losses, the investor’s position will be wiped out before those losses can eat into the leverage that the sponsoring bank provides.
Such losses could be caused by sudden spread widening across the board, or by large individual defaults - the impacts of which on the investor are increased by the leverage involved in the structure.
What is worrying is that many investors may simply be looking at the rating and coupon and buying into these deals without any great understanding of what they really are or how they could behave.
“Once again, the rating agencies have proved that when it comes to some structured credit products, a rating is meaningless,” says Janet Tavakoli, an independent consultant.
“CPDOs have an extreme amount of mark-to-market and liquidity risk. The ratings volatility is likely to be very high . . . All AAA’s are not created equal, and this is a prime example.”
The original CPDOs are likely to be just the starting point for a much more complex series of products. One way to try to defend a deal against market value losses for instance could be to have an active manager in place to avoid bad credits.
They could also begin to use different underlying assets, for example the derivatives of loans or asset-backed securities.
Mr Czekalowski thinks that the bigger picture behind the development of CPDOs is that they provide a cheap and simple way for a bank to create a derivative product company on its balance sheet.
Many banks and other specialists have tried for some time to set up credit DPCs, which make a business out of the long-term selling of protection on a leveraged basis - something like an insurance company built entirely on derivatives.
But it is a long and costly process and many such plans have been scrapped.
“Derivative product companies cost millions of dollars to set up, can take up to 12-18 months and demand a lot of people and operational infrastructure,” Mr Czekalowski says.
“The CPDO rating structure creates a kind of simple DPC-lite, you might call it.”
For now it is to be hoped that in the ongoing hunt for yield, investors take a good long look before they leap.
A constant proportion debt obligation explained
Constant proportion debt obligation is the name dreamt up by ABN Amro for the first of a new kind of structured product that is essentially a leveraged bet on the credit quality of a bunch of US and European investment-grade companies.
It aims to generate income by selling protection on the two main indices of credit default swaps - which offer a kind of insurance against non-payment of corporate debt - the iTraxx Europe and the Dow Jones CDX.
The high ratings of these deals - they have been AAA-rated investments so far - is based on two main defence mechanisms. First, they expect to generate more income and market value gains than is needed to pay the initial coupons, providing a cushion against losses.
Second, the exposure is rolled over with each six-monthly change in the index series, so that deteriorating credits are expunged on a regular basis.
The high leverage involved means that the investor’s principal acts as a first-loss piece on a much bigger - up to 15 times bigger - exposure to the indices.
The idea is that the structure will earn enough to cover all future coupon payments before the deal hits maturity, and it can then be “cashed out” into a low-risk bond.
However, if there are losses and the CPDO’s net asset value begins to fall from its target, the leverage is increased to try to earn more at a faster rate. This has been compared with a gambler chasing losses.
Copyright The Financial Times Limited 2007