End of the line for CPDOs

Analysts say the demise of Constant Proportion Debt Obligations (CPDOs) now seems certain.

On Monday, Paris-based ratings agency Moody’s Investors Service downgraded 13 CPDOs, affecting approximately €714 million of debt securities.

The affected obligations, which were rated between Ba3 and Caa1, have now been reclassified to between B1 and Caa3 and are under review for further downgrades. Moody’s said the changes were prompted by worsening market conditions: “Over the last year or so the market has experienced unprecedented spread movements (especially in terms of volatility) that led these transactions to crystallize substantial losses.”

David Watts, a London-based strategist at research firm CreditSights, described the outlook for CPDOs as being “dark”, commenting: “I do not think they have a future… I just cannot imagine any bank wanting to structure these things”.

Watts identified the problems as lying with the uncertainties inherent to the structures and argued they were not deserving of their original high ratings.

“While CPDOs are an interesting and innovative trading strategy, they are not a AAA rated instrument because to get that AAA you make far too many assumptions, and the assumptions you have to make are too sensitive. These things are all subject to change, none of them are certain, and yet they were rated on the basis that those variables can be accurately predicted into the future.”

“The ratings agencies have demonstrated that they do not have an astonishing crystal ball, which gives them the ability to predict macroeconomic or credit spreads ten years into the future any better than anybody else in the market. Without that, there’s no way you can call this thing a AAA. In reality it just boils down to a trading strategy.”

According to Moody’s, only three CPDOs avoided downgrades this week - but those had already been downgraded to Caa1 in previous reviews.

The downgrades are the latest to affect a number of CPDOs which had originally been assigned the highest possible ratings. Upon the product's inception in 2006, notes paying a coupon as high as 200 basis points were created, carrying AAA ratings from Standard & Poor's and Moody's - many of the products downgraded this week were rated Aaa as recently as December 2007. Both firms subsequently lowered their evaluations significantly.

Ratings agency Fitch, which refuses to rate CPDOs, said it stood by a report issued in April last year that said first-generation CPDOs did not deserve AA or AAA ratings. The decision was based on the structure's sensitivity to very minor movements in its key risk parameters, namely spread volatility, roll-down benefit and bid-offer levels. It also warned that the products depend on historical performance data going back only four years in benign conditions, for structures with maturities of 10 years.

A mis-ratings scandal engulfed Moody’s in July, when it was revealed it had acted to avoid making CPDO downgrades suggested by a change in its analysis model in early 2007. On September 4, the agency admitted it had discovering another coding error in the model used to monitor the securities and placed €854 million worth of European CPDOs under review. Moody’s denied that the error stemmed from a fault in rating rationale or methodology.

ABN Amro is credited with the invention of the CPDO in July 2006. They typically involve taking a leveraged position selling protection on the Markit CDX or iTraxx credit derivatives indexes. At the roll of the indexes, the CPDO closes out its old positions and sells protection on the new series - thereby making a small gain due to the fact the new series tends to have slightly wider spreads, reflecting its longer maturity.

See also: CPDOs under review as Moody’s announces further error
Senior Moody's exec to leave after CPDO ratings cover-up revealed