CPDOs: Can Profit-lust Destroy Obligations (to Honesty?)
Take some low single-A or high-BBB rated debt, lever it up 15 times. If spreads back up, lever up more, and buy more at the higher spreads, and hope spreads don’t continue to rapidly widen, such that you have to break the deal and realize the losses. If spreads tighten enough, de-lever, and declare victory. That is a great bull market strategy to make money in investment grade credit, but it is not a high quality strategy.
If I created a Collateralized Debt Obligation [CDO] out of similar instruments, with what would be light leverage of 15 times, and it had just two tranches — 94% senior, 6% junior, the senior obligations would get a AAA (probably), but the junior obligations would be rated BB or so — just my back-of-the-envelope guess, but consistent with my experience.
But for Constant proportion debt obligations [CPDOs], they were not rated BB but AAA, because the dynamic portfolio management would allow the structure to survive modest bear markets in credit. Unfortunately, when a lot of parties lever up credit, the historical statistics on how the credit markets behave at lower leverage levels don’t apply. The odds of a sharp self-reinforcing bear market in credit rise.
So, it is not a surprise that I was an early bear on CPDO structures. Here’s a summary piece on what I wrote, and when I wrote it.
Now today it gets revealed in the Financial Times that Moody’s had a mistake in their ratings model for CPDOs that allowed them to offer ratings equivalent to those of S&P. Needless to say, this is getting a lot of coverage today, from:
- Reuters — nice fact summary
- Felix Salmon at Market Movers
- FT Alphaville
- Creditflux (another early skeptic)
- Naked Capitalism
- Calculated Risk
There are conflicts of interest in the way that ratings agencies get paid by the issuers, and the CPDO debacle highlights them. I don’t think you can create a system where the users of ratings carry the full weight of the ratings process. The issuers have the concentrated interest in a way buyers do not.
But maybe there is a way to re-align matters. What if the ratings agencies received half of their fee by receiving interests in the juniormost class? (For non-structured deals, make that a subordinated interest strip.) My, but I think that subordination levels would rise. Also, I think the ratings agencies would become more generally cautious.
From my angle, though, the CPDO debacle is more egregious than other rating failures, because the agencies deviated from their normal way of rating debt, seemingly just to make more money. Well, they made the money, but how much is a reputation for quality ratings worth? In the long run, the CPDO deals will be net losers for Moody’s and S&P, and a net win for skeptics like Fitch and Dominion.
May 21st, 200812:51 pm at
You should mention Dominion in the same breadth as the other rating agencies. What they did in Canada was the most ignorant and inept ratings process ever. No other agency permitted Candadian style liquidity recognizing it as a worthless liquidit arrangement. They were the only ones to permit it and it was their core business. That ineptitude cost Canadian pension holders about $6billion out of a $32billion business. Relative to the scale of Canada its on par with the subprime crisis. Worse since everyone else outside Canada told them it was idiotic and the subprime crisis it can’t all be chalked up to ratings. Here is an article by Pimco on DBRS’s stupidity.
http://www.pimco.com/LeftNav/Global+Markets/Canadian+Perspectives/2007/Canadian+Perspectives-+05-2007.htm
May 21st, 20082:14 pm at
I share your concerns about CPDOs and especially what happened at Moody’s.
However, I would be wary of criticizing them “because the agencies deviated from their normal way of rating debt.” Whether or not they were motivated by profit remains to be seen and is a premature judgment at this time. More importantly, Moody’s and their ratings lot were criticized madly for NOT adjusting their models to account for the differences in handling the mortgage risks of RMBSs and their CDOs.
You can’t have it both ways.
May 21st, 20087:11 pm at
Lilguy — If we can criticize them for using their CDO models, then a criticism on CPDOs was fair, because the model was worse than their CDO model from a theoretical point of view.
PK — Every rating agency has weak spots. Sophisticated investors use ratings as a jumping off point for real analysis. Anyone who has traded corporate bonds knows that ratings reflect spreads on average, but individual credits are often mis-rated. Dominion got CPDOs right; they got Canadian style liquidity wrong. Rating agencies make mistakes — they always will, so investors have to do their own due diligence.