Hawk, I have to disagree with Georges Assi of Lehman. It's interesting that the CPDO's are structured so that if they have a loss in value due to spreads increasing they then increase the leverage and put on additional spread positions.
I believe a variation of that is what happened to Long Term Capital Management. LTCM was running quite a few active investment strategies but one of the larger positions was short emerging market debt and long US Treasuries. They felt that the spreads were too large by historical standards. But as the spreads expanded the strategy was structured so they increased their leverage and sold more emerging market debt while going long more US debt thus driving the spread relationship more strongly in the direction it was heading.
I'll have to take a look and see if those were the specifics of LTCM in 1998, but the strategy that CPDO's use to obtain the "AAA" rating works because the statistical chance that the CPDO "Blows up and losses all of it's value is low in individual Monte Carlo simulations. The Cummulative risk of several of these blowing up and going through all of their underlying assets may be greater given the way the CPDO's are structured to handle initial losses.
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a couple of comments I have seen on the CPDO's .....
I asked some folk about this basically, in addition to Chengs comments I got that:
For this correlation desks leverage up when the market widens,(sell protection) but they should deleverage when it tightens (buy protection). Whether this increases/reduces volatility is a different story if you ask me.
Some hedge funbds are buying these things as collateral (hmmmmmm). But it seems its mostly retail cleints that are having a look.
As for the rating...nothing too clear.. it maybes boils down to 'Once the CPDO has achieved sufficient returns to match the present value of its coupon and principal payments, the deal is unwound.'
At which point I had to go and get lunch and the guys telling me this had to go and make more spreadsheets.
My instinct is that if more of these print, as the article suggests, the market will be crushed. Its bad enough without x10 leverage.
But if there is some sort of trigger (of which I have no idea what that could be) there could be a lot of volatility...
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this is from the nuclear phynance site.....
The products are (currently) rated AAA. Im not at all positioned to really know about this so this might be bull, but I heard the product exploits S&P's ratings methodologies (like all structured credit products) which basically runs a monte carlo simulation and if the path of the simulation leads it to a place where there would be any loss whatsoever this counts as a "failed run". S&P then compare the number of failed runs to good runs to determine rating. IE, they do not distinguish between a 1 cents loss at maturity and total wipeout. This product stays alive because if the current coupon return is insufficient to ensure a 200bp coupon then leverage is increased up to a max leverage amount, so there are very few failed runs, but failure means total loss. (The max leverage is fixed in the 7-15x zone, and typically product starts max levered and delevers if it achieves sufficient returns so that current coupon more than covers L+200 by 1.x times, or whatever). If product hits like 10 points of NPV it liquidates, and I think the remaining GAP risk sticks with the issuer....Really pushed the index market tighter, and made the index trade rich... Things will get nasty one day, in x years, with all of this kind of crap out there
nuclearphynance.com |
