The linked post perfect describes how **cked up things were

Interfluidity :: CPDOs, Model Risk Spread, and Banks under Basel II

The post was written in 2006.

Banks were buying AAA rated synthetic bonds that had 2% higher yields than regular AAA bonds. You cannot buy such securities and expect not to have big risk; it fails the basic smell test.

Here is how the security is supposed to work

A CPDO issuer accepts principal from investors, and commits up front to a coupon and principal repayment schedule. The issuer puts the money in a leveraged portfolio that includes high yield, risky debt (or credit derivatives), earning a yield higher than would be required to cover coupon payments to investors. In the most benign scenario, after a while, the CPDO portfolio earns enough extra money to trade in the risky debt for a risk-free portfolio of government bonds sufficient to cover the coupon and principal repayments promised to investors. Thus, the CPDO issuer has temporarily taken on credit risk to earn the promised excess spread, and then quickly locks in gains by putting investor assets into ordinary AAA bonds.

But what happens if something goes wrong? Suppose that while the CPDO holds its leveraged, risky portfolio, credit conditions deteriorate. Then the portfolio loses value, and the issuer’s ability to meet the agreed-upon payment schedule becomes uncertain! Wouldn’t this possibility translate into lower-than-perfect ratings by rating agencies? You might think so. But the CPDO-issuer makes a promise that offsets this risk. The CPDO-issuer promises that if the risky portfolio loses money, the CPDO will double-down, increasing the degree of leverage as required to make up for the loss and meet the structure’s promised payment schedule to investors.

But that is impossible. Anyone who has any finance common sense knows that this is (much) risker than a regular bond. It is simply a fancy way of betting that the credit spread will not shrink too much.

Well, that makes me feel better. You? Let’s give the devil her due: This is a very model-tested approach. CPDO-issuers have carefully reviewed credit-spread history, and have come up with rebalancing-and-releveraging schemes that should nearly always manage to recoup losses. If there is no structural change in the bond markets, if the markets behave as models say they behave, then the likelihood that a CPDO will experience a sufficiently long sequence of adverse events to prevent the doubling-down strategy from recouping losses is very, very small, comparable to the probability of a default on an ordinary AAA-rated bond….

… From a Fitch report on these instruments:

[The evolution from earlier principal-insured products (“CPPIs”) to CPDOs] …is mainly driven by Basel II: under the revised international capital framework, bank investors are likely to need a rating on both principal and coupon for their credit investments. [1]

The security may have been profitable for a while, but the 2% spread indicates that it must be risky. The rating is high, because the underlying names are high credit quality, and because the credit spread had never widened that much.

Today, the security is defaulted, and is pays 0.10 on the dollar. No-one should be bailed out by the government on that security. They took their 2% spread already, and now they should take their lumps.

More and more, I am feeling like the regulation was screwed up–there is no way to get around this though. It is an arms race-the faster you impose rules, the faster smart people can figure out ways around them, and make a lot of money doing so.

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2 Comments on “The linked post perfect describes how **cked up things were”

  1. Lucky Says:

    nice info tq……

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