***CPDO UPDATE** we always knew these were crap!!!!!!
Moody's May Downgrade CPDOs After Error in New Model (Update2)
By Neil Unmack and John Glover
Sept. 4 (Bloomberg) -- Moody's Investors Service said it may cut the ratings of 854 million euros ($1.2 billion) of constant proportion debt obligations after disclosing a second error in the way it assesses the securities.
Moody's review was ``prompted by the identification of a coding error in a model used for monitoring CPDOs,'' the New York-based firm said in a statement today. Moody's will probably downgrade the affected CPDOs by one or two levels, it said. The securities were sold by banks including ABN Amro Holding NV, JPMorgan Chase & Co. and Lehman Brothers Holdings Inc.
Moody's ousted the head of its structured finance unit two months ago, saying employees broke rules by failing to change the way CPDOs were assessed after discovering a fault in its rating model. Moody's awarded the top Aaa ratings to at least $4 billion of the securities, funds backed by credit-default swaps, before they lost as much as 90 percent of their value.
``This highlights the problems that Moody's and the other ratings firms had in modeling structured credit,'' said Jeroen van den Broek, head of investment-grade credit strategy at ING Bank NV in Amsterdam. ``That's why they wound up giving Aaa ratings to deals that should never, ever have received them.''
U.S. and European regulators are tightening rules for Moody's, Standard & Poor's and Fitch Ratings after the companies provided top grades to securities backed by U.S. subprime mortgages that triggered more than $500 billion of writedowns and credit losses at Wall Street institutions.
Ratings Review
The latest error ``was modest but material, so that's why we're reviewing the ratings,'' Richard Cantor, chief credit officer at Moody's, said in a telephone interview from New York. A major fault would have led to mistakes in the grades that an analyst would spot immediately, he said.
Moody's is carrying out a review of all its major ratings models and has set up a group of experts to supervise their creation, testing and monitoring, Cantor said. Even so, ``no vetting process will ever eliminate every error,'' he said.
Moody's Corp., the parent of the ratings company, fell as much as 71 cents, or 1.7 percent, to $40.54 and was at $40.57 at 11:50 a.m. in New York Stock Exchange Composite trading. The stock has risen 14 percent this year.
ABN Amro created the first CPDO in 2006, promising investors top-ranked bonds with returns of as much as 2 percentage points above money-market rates.
Moody's is reviewing CPDOs rated between A3, its seventh- highest credit ranking, down to B1, four levels below investment- grade status.
CPDOs sell contracts based on indexes of credit-default swaps, contracts conceived to protect bondholders against default. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.
To contact the reporters on this story: Neil Unmack in London nunmack@bloomberg.net; John Glover in London at johnglover@bloomberg.net
Last Updated: September 4, 2008 12:21 EDT
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Message 22986612
To: John Pitera who wrote (7437) 11/7/2006 6:14:28 PM
From: John Pitera Read Replies (1) of 9897
Squeezing Into the Latest Derivative Fashions (credit default swaps)
Tuesday, November 7, 2006
A CLASSIC SHORT SQUEEZE is helping to send the cost of corporate credit tumbling.
The squeeze is taking place in the huge but opaque and arcane market for credit derivatives. One genus of the species, credit default swaps, is basically an insurance policy on whether a company won't make good on its debt.
With a credit default swap, an investor can buy protection against the default on a credit, just as a homeowner takes out a flood insurance policy. Or an investor can sell an insurance policy that the credit won't go bust, just as Allstate does on a home, to make a profit.
Investors who buy a CDS are buying the functional equivalent of a put option -- a negative bet -- on the company's credit. As the corporate bond market keeps strengthening, these put options are losing value. And so these investors -- or more accurately, traders -- are scrambling to cover by selling these instruments, just as a short seller who bets on a stock's decline is forced to buy back that stock if it rises, which push the price even higher.
Investors looking to take on credit risk can sell credit protection in the CDS market. Just as put sellers profit in a bull market, sellers of credit protection have made out well.
If all that sounds a bit complicated and convoluted, as they say on late-night infomercials -- Wait, there's more.
CDOs, for their part, also are eminently tradable; far more so, in fact, than corporate bonds, which require a company to be of the mind to issue a bond to the public. A CDO can be created by a derivative dealer to meet the desires of its customer, who can than take a position in that credit in the absence of a bond and without worrying about such nonsense as where interest rates are headed.
CDOs also can be assembled into indexes. The CDX is like the Dow of the credit derivative world, tracking major investment-grade issuers, while the iTraxx is the European equivalent. And, of course, those indices are dandy trading vehicles for anybody (hedge funds, especially) who has an opinion about corporate credit.
And those index products can be reassembled into new structures. The latest and greatest is the Constant Proportion Debt Obligation, or CPDO. Leaving out the details, which are comprehensible only to derivatives professionals, suffice it to say that, with the magic of 15-to-1 leverage, CPDOs provide the marvelous combination of upwards of 200 basis points (two percentage points) over Libor (the London interbank offered rate, the money-market benchmark) for a something deemed a triple-A credit. Real high-grade bonds, when you can find them, trade at only a handful of basis points over governments.
Not surprisingly, CPDOs have caught fire. And that's rippled through the credit derivatives market.
"When CPDOs are priced, index trades are executed," explains Lisa Watkinson, head of Global Structured Credit Business Development at Lehman Brothers. "The leverage in the trades could mean billions need to trade in the CDX and iTraxx indices. The daily volumes in the indices are anywhere from $30-50 billion per day."
"Billions would have to print in the CPDO market to be the sole catalyst behind significant spread tightening," she adds. But Jeffrey A. Rosenberg, credit market strategist at Bank of America, avers that CDS spreads (their margin over risk-free government debt yields) have been driven to record lows by heavy supplies of "synthetic" instruments, including the introduction of CDPOs.
In the process, those who bought credit protection in the CDS market are on the losing side of that game. So, now they're furiously trying to sell protection, like any squeezed short.
Of course, these new-fangled products aren't the sole reason for tight corporate spreads. The economy is growing amid "The Great Moderation," as Fed chairman Ben Bernanke has dubbed it, which implies no precipitous downturns. And so risk premiums have been squeezed down, from corporate credit to the stock market, as encapsulated by everybody's favorite fear gauge, the VIX.
One would have to be churlish indeed to wonder about what could go awry in this best of all possible worlds for credit derivatives. Just because mind-numbingly complex structures are traded by the billions in an unregulated market by hedge funds? It's not as if they're natural-gas futures, for goodness sake.
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Message 22989190
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Message 22989215
To: John Pitera who wrote (7448) 11/8/2006 11:34:33 AM
From: John Pitera Read Replies (3) of 9897
Ratings Alchemy: Turning "BBB" into "AAA" (the new CPDO Structure)
riskchat.com
From: Lara
Affiliation: Consulting
Address: www_lara@yahoo.co.uk
Date: 29 Sep 2006
Time: 16:33:19
Comments
Has any one looked at the ABN's new "AAA" rated Structured Credit product, the CPDO 10-year note? It basically takes the DJ CDX index and iTRAXX index (made up of average A-BBB rated obligations), leverages it up by about 15 times, and issues it as "AAA" rated FRN (ratings issued by S&P and Moody's). Here are the details: from FinanceAsia.com "ABN AMRO continues to lead credit derivative innovation with its first-ever Constant Proportion Debt Obligation ABN AMRO this week launched its first public constant proportion debt obligation (CPDO). This new form of synthetic credit investment carries a full AAA rating from Standard & Poors on both principal and coupon. It uses elements from both CDO and CPPI technology to produce a new non-principal-protected, fixed-income, credit-investment tool. The CPDO generates returns through exposure to a portfolio of credit default swaps (CDS) which is linked to highly liquid CDS indices. The size of the portfolio is adjusted dynamically so that the CPDO only uses the leverage it needs in order to make the scheduled principal and interest payments. The structure of the CPDO is designed to have a stable rating with a high likelihood of “cashing-in” to a risk-free investment that pays the stated coupon and principal at maturity. "This is the most exciting development in the credit market for several years. The absence of a full rating has made it historically difficult for investors to assess the risks and appropriately place dynamically leveraged credit products into a portfolio. By creating the CPDO with a full rating for the timely payment of both principal and interest we have solved this issue for our institutional investors and broadened the asset choice available to managers of credit portfolios," says Steve Lobb, global head of credit and alternative derivative marketing at ABN AMRO. He adds that the new product allows a wide range of investors who are restricted from investing in unrated securities to access credit instruments that use dynamic leverage for the first time. "
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Message 23074122
To: Hawkmoon who wrote (7465) 12/5/2006 6:26:47 PM
From: John Pitera Read Replies (2) of 9897
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
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fantastic missive that Bill Gross wrote Nov 30th of 2006 on the insane risk appetite and the financial alchemy that had produced CPDO's his note is highly worth reading.
Message 23058323 |
