Another day, another derivative. This month's high-finance innovation is the CPDO, or "Constant Proportion Debt Obligation", and it is truly a wonder. In practical terms, a CPDO is nothing more or less than a synthetic bond. Investors pay money up front, receive coupon payments, and their principal is returned after a set period of time. Investors stand to lose if borrowers default or credit conditions deteriorate. But CPDOs work a secret miracle. These synthetic bonds are designed to score a "triple-A" grade from major bond rating organizations, while paying a spread of up to 2% more than "natural" AAA debt!

CPDOs appear to violate the core constraint of finance, the no arbitrage rule. If the ratings are accurate, selling short a portfolio of ordinary AAA debt and purchasing a portfolio of CPDOs would be a perfect arbitrage, earning risk-free profit for the arbitrageur with no net outlay of capital. Either the CPDO opportunity must be transient (because the number of issues that can be synthesized is limited, or because CPDO and AAA yields will soon converge), or the ratings must be wrong. Or else the wizards at ABN have invented an infinite free-money machine for well-placed arbitrageurs, the financial equivalent of a perpetual motion machine.

So is there a catch? And if so, what is it? Let's first understand how a CPDO works. Despite the complicated acronym, it's not rocket science.

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.

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. And the independent bond rating agencies have double-checked this work. All of the bond industry's prevailing models support the view that a "perfect storm" of deteriorating credit conditions sufficient to tank a CPDO is no more likely than, say, France defaulting on its sovereign debt.

But what are the odds that some structural change in credit markets occurs, such that industry-standard models no longer hold? There is no good way to attach a probability to that event. Structural change in financial markets does happen, usually accompanied by what from the perspective of earlier models look like improbable "long-tail" events. But there is no "meta-model" that we can trust to estimate their likelihood of structural change. We are left with nothing but human judgment to decide whether the model-generated AAA rating of a CPDO issue is in fact as sure as a the same AAA on a traditional "risk-free" bond, given market conditions likely to prevail in the future, rather than conditions of the recent past on which the models were based.

This is good news. There are no perpetual motion machines, no huge gaps in the theory of finance. We can understand where the extra spread in a AAA-rated CPDO comes from: It is a model risk spread. CPDO-buyers will rationally price-in model risk, the risk that despite what Fitch or Moody's says, these complex, "gambler's ruin"-style instruments might not handle a changing credit environment as well as traditional AAA debt. Taking model risk into account, CPDOs ought to have a rating somewhat below ordinary super-high-quality bonds. But when bond-rating agencies generate their ratings from their models, model risk is left out of the equation. And that fact is the loophole these instruments are really designed to exploit.

Who is buying CPDOs? Where is the excitement? If it were true that these instruments were every bit as safe as government debt, but paid a higher yield, nearly every investor would want them in their portfolio. But investors understand model risk. While there is general demand, a specific sort of investor is particularly enthralled by CPDOs. From a Fitch report on these instruments:

[The evolution from earlier principal-insured products ("CPPIs") to CPDOs] 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]

Banks always face a trade-off between safety and profitability — the more risks they take with depositors' money, the more profit they can earn. The Basel II regulatory framework requires banks either to hold less-risky portfolios, or to hold high levels of capital in reserve. Either approach exerts a drag on bank profitability (in the interest of depositor and taxpayer safety). Under Basel II, the safety of bank investment portfolios is judged in part by the ratings on the debt they hold. If a bank finds an instrument that offers an unusually high yield for its rating, that is an opportunity for the bank to increase its profitability without increasing reserves. If the rating of the offering understates its real risk, its availability effectively allows banks to circumvent the spirit of the Basel II reserve requirements.

Bank investors understand as well as non-bank investors that, due to model risk, CPDOs are not as safe as ordinary AAA bonds. But bank investors aren't looking for safety. They are looking for ways to marry the appearance of safety before regulators with opportunities to enhance profits by taking on risk. One risk not included in credit ratings is credit raters' model risk. The investment industry, constantly innovating to serve customers, has invented an instrument that exchanges credit risk (reflected in ratings) for model risk (excluded from ratings), allowing banks to have their risk and hide it too. If all goes well, banks earn more money. If all goes poorly, taxpayers cover depositor losses, while bank managers demur that they complied with regulatory requirements to the letter.

Truly, this is the golden age of finance!

[1] "Rating Credit CPPI and CPDO", by Linden, Lecointe, and Segger, available at, search for CPDO, free registration required.

Update History:
  • 13-Nov-2006, 10:00 a.m. EST: Took superfluous "the" out of title: "CPDOs, the Model Risk Spread, and Banks under Basel II" becomes "CPDOs, Model Risk Spread, and Banks under Basel II"
  • 13-Nov-2006, 10:06 a.m. EST: Made some changes to properly reflect that CPDOs can offer variable (benchmark + spread) coupon payments, rather than fixed as initially implied. Changed "fixed coupon payments" to "coupon payments" in first paragraph. Changed "ordinary AAA bonds" to "ordinary AAA debt" in he second paragraph. Changed "ratings on the bonds they hold" to "ratings on the debt they hold in 3rd-to-last paragraph.
  • 13-Nov-2006, 10:10 a.m. EST: Changed first (nonquoted) use of "Basel II" to "The Basel II regulatory framework" to help less jargon-familiar readers.
  • 13-Nov-2006, 10:12 a.m. EST: Changed "...every bit as safe as government debt, but paid a higher spread..." to "every bit as safe as government debt, but paid a higher yield..."
  • 13-Nov-2006, 11:00 a.m. Tightening up some wording. Removed "else" from "...or else the ratings must be wrong." Removed duplicate use of "event" in a sentence, "...usually accompanied by events that..." to "usually accompanied by what..."
Steve Randy Waldman — Sunday November 12, 2006 at 8:42pm [ 7 comments | 0 Trackbacks ] permalink

Regarding my previous post on CPDOs, the delightfully tart Felix Salmon gets delightfully tart with, er, me. He writes:

It would seem that Waldman is rather smarter than anybody at any credit-rating agency.

Now I'm hardly as bright as your average bread mold, so Salmon is being a bit tough on the credit agencies here. Plus, the last thing I meant to do was accuse the rating agencies of stupidity. On the contrary, rating agencies are being quite as clever as the investment-bank CPDO issuers. They are both, in my opinion, playing the same game, which I'll call "Keynesian sound banking", after the Great Man's famous quote:

"A 'sound' banker, alas, is not one who forsees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him." [1]

Or we might refer to this as "Waldmann's Rule" &mdash not my rule, for heaven sake I don't deserve such a thing — but after Robert Waldmann, for what Brad DeLong learned from him:

What I learned from Robert Waldmann: Almost no professional portfolio manager worries about the lower tail, because if you are in the lower tail the whole world has gone to hell in a handbasket and people have other, more important things to worry about than whether one's portfolio manager had appropriately hedged whatever risk is now roosting on the roof.

My claim is only that the same logic applies to credit-rating agencies and banks. I'm certain the best and brightest at the rating agencies thought of everything I thought of. Rating agencies earn revenue (from the issuing investment banks) when they get to rate a booming new class of credits. Rating agencies get egg on their face if an issue they rate highly defaults. But if that happens in the context of a widespread credit event? Well then it's like Condi Rice and the World Trade Center. Who could possibly have foreseen terrorists flying planes into buildings!

Here's Salmon:

One of the things which makes the CPDO model so robust is that the riskiest risk that it's taking is six-month investment-grade credit risk. Since it's pretty much unheard-of for a company to go from investment-grade to default in less than six months, the rating on the CPDO can be very high. What's more, the CPDO, because it has leverage to spare, can continue to pay out its coupon even if that kind of default does happen.

Model risk is precisely the possibility that "the pretty much unheard-of" occurs. Plus, lightning fast "gap risk" defaults aren't required to break CPDOs. A sequence of general credit-quality deteriorations over several rebalancings of the CPDO portfolio would be sufficient even without default.

During a widespread generalized credit event, or following a sequence of periods during which credit conditions continued to deteriorate rather than reverting to mean, CPDOs would no longer have "leverage to spare". "Leverage to spare" is what Brian Hunter at Amaranth had for the first few meters as the bottom dropped out on the natural gas market, in a pretty much unheard of collapse.[2] Any strategy that involves continually increasing leverage to cover losses is exposed to multiple adverse movements in sequence. That is why the strategy is broadly referred to as "gambler's ruin". Gambler's ruin can be a rational and very profitable strategy, but the whole game turns on the precise likelihood of long series of adverse events. Estimating that likelihood requires a model, and getting the model even a little bit wrong can be the difference between sure profit and sure ruin.

But, Salmon demurs...

[R]atings agencies try very hard to understand every single way in which the model might break, and then stress-test the model under precisely those conditions.

He's simply wrong here. If ratings agency tried to take into account every way their models might break, they would be unable to rate. Ratings agencies are quite aware that there are questionable baseline assumptions they have to make in order to come up with a model at all. They publish their assumptions, and leave it to investors to accept their models or not. Here are some snippets ABN/AMRO's presentation of Surf 100, the first CPDO (now a venerable month or so old):

  • Current modelling assumptions are unlikely to be consistent with actual performance of CPDO
  • Key modelling assumptions are set out in S&P/Moody's base case assumption


S&P base case assumptions
...[10,000] Monte Carlo simulations ...Expected defaults produced by CDO Evaluator 3.0 ...Initial portfolio spread of 32bps with a volatility of 15%, meanreversion (MR) = 40bps at the end of year 1, and MR = 80 at the end of year 10
Moody's base case assumptions
...[10,000] Monte Carlo simulations ...Expected defaults produced by CDOROM

Here's Fitch [3]:

In recognition of the sensitivity of credit CPPI and CPDO to spread widening and volatility, Fitch models spread path as follows:

  • exponential Vasicek model;
  • parameters based on stressful historical periods;
  • back-testing on historical data;
  • spread jumps incorporated if necessary

In all cases, the ratings agencies are being very honest with us. They are pointing out the limitations and assumptions of their models and tests. In no case do these tests qualify as "every single way in which the model might break", and the rating agencies don't pretend that they do. Why does Salmon?

I wrote that...

CPDOs appear to violate the core constraint of finance, the no arbitrage rule. If the ratings are accurate, selling short a portfolio of ordinary AAA debt and purchasing a portfolio of CPDOs would be a perfect arbitrage, earning risk-free profit for the arbitrageur with no net outlay of capital. Either the CPDO opportunity must be transient (because the number of issues that can be synthesized is limited, or because CPDO and AAA yields will soon converge), or the ratings must be wrong. Or else the wizards at ABN have invented an infinite free-money machine for well-placed arbitrageurs, the financial equivalent of a perpetual motion machine...

Salmon responds, and but again mistakenly.

And as for Waldman's ratings arbitrage, where you go short French sovereign debt and go long CPDOs, yes, it does exist – but it's not "the financial equivalent of a perpetual motion machine". Rather, it's just another carry trade. CPDOs are much less liquid than French government bonds, so they should carry a yield premium. Plus, the carry trade can move against you: if the price of CPDOs falls while the price of French government debt rises, you take a mark-to-market loss. And finally, the trade isn't very profitable in any event, since you have to borrow those French bonds somewhere, and the repo rate isn't likely to be much less than the extra spread you're getting on the CPDO.

If indeed a CPDO AAA is statistically indistinguishable from an ordinary AAA, and if indeed a CPDOs consistently earn spread above ordinary AAA debt, then this would not not an ordinary carry trade. Going short a particular issue and long some CPDO would be a carry trade, as there would be price risk related to idiosyncracies of the two securities. But if a diversified portfolio of CPDOs (presuming the asset class takes off) behaves identically to a diversified portfolio of other AAA debt, then highly creditworthy financial institutions (not you, me, or your cousin's small hedge fund) would indeed have a perfect arbitrage, until the spread between CPDO and AAA debt converges. This won't happen, because it is a carry trade, there are different risk profiles to a diversified portfolio of CPDOs and a diversified portfolio of other AAA issues, and that difference is... CPDOs are riskier! And that's exactly my point. CPDOs are risky issues that earn risky spreads, but look for bureaucratic purposes like conventionally "risk-free" debt.

I should comment on my use of the word "risky", both in this and the previous piece. Salmon takes me to task...

First, on a factual level: Waldman says that the proceeds from CPDOs go into "a leveraged portfolio that includes high yield, risky debt" – which isn't true if by "high yield, risky debt" you mean sub-investment-grade debt. The portfolio is all investment-grade; it just isn't AAA.

I don't mean, and didn't previously mean, that current CPDOs are taking on "junk bond" risk. One could be forgiven for thinking my use of "high yield" implied that. I should have said "higher yield". By "risky", I mean non-AAA, since AAA is the category which is generally treated as nearly free of credit risk. The debt behind current CPDO issues is concentrated at the low-end of investment grade.

Finally, back to Salmon:

But if you're still not comfortable with that kind of risk, no one's forcing you to take it.

When banks use novel structured products to take on more risk than bank regulators anticipated, I am being forced to take that risk. We all are. Bank regulation is a complicated subject, and I don't claim that existing bank regulation is anywhere near optimal. I don't disagree with Salmon's contention that while CPDOs might let banks game things a bit, this new gaming is far harder than it was under Basel I. There's a cat and mouse game being played, between regulators getting tighter and banks getting cleverer, and that's perfectly ordinary in its way.

I bother to write about this stuff not because I am interested in the arcane details of a structured credit designed especially for bank investors. I write because I think the game is going awry, the odds of systemic crisis at the collapse of a credit bubble are growing, and CPDO-based regulation skirting is the latest little crack in the dam. Reasonable people can disagree. Salmon clearly does, and he's reasonable even if he is delightfully tart. But you can't pretend that Moody's has worked it all out and we can rest comfortably. There is no adequate model here. There is human judgment. Me, and Paul Volker, and Robert Rubin, a lot of us are worried. And those other guys are much smarter than bread mold.

By the way, if I were Goldman Sachs, I would short dollar-denominated CPDOs and purchase US Treasury debt. CPDOs aren't really financial perpetual motion machines. They just get to look like it, for about two seconds.

Update: Felix responds.

[1] Keynes quote from "Consequences to the Banks of a Collapse in Money Values", 1931. Hat tip to Calculated Risk, writing on Angry Bear.

[2] Thanks to Aaron Krowne in the comments of the previous post for suggesting the Amaranth analogy.

[3] "Rating Credit CPPI and CPDO", by Linden, Lecointe, and Segger, available at, search for CPDO, free registration required.

Update History:
  • 14-Nov-2006, 1:36 p.m. EST: Added link to Felix Salmon's response, and missing links that were missing from footnote 1 of the post.
Steve Randy Waldman — Monday November 13, 2006 at 6:19pm [ 0 comments | 0 Trackbacks ] permalink

I really shouldn't be doing this now.

What with my CPDO arch-nemesis off communing with the penguins, it seems downright ungentlemanly. And I really ought to be working for the man, you know, the one who actually pays me, just now.

But there were some particularly interesting comments to some of the recent posts on CPDOs, and I thought them worth highlighting.

Responding to an earlier post, commenter P. K. Koop notes:

...I would expect the barrier implicit in the 15X leverage limit to act as a target or safety net for those trading against the CPDOs.

This reminded me of an interesting post from Cassandra Does Tokyo, "Amaranth: Was It The Market?":

But there is a... possibility that is understandably NOT discussed in the mainstream media, but surprisingly is not discussed in the trade press either. And this is the possibility that [Amaranth's] clumsy and quasi-public long Natty position was the subject of predatory trading by those with material non-public information about the Fund and it's positions...

Roger Lowenstein's account, When Genius Failed reconstructed the scenario pretty well. Essentially, if you're very leveraged, once someone sees your positions, you're a target. Hillenbrand was seemingly the only one who really understood this risk. He made sure they used multiple Prime Brokers, swapped positions between leverage providers to insure no one saw the full extent of their leverage or their positions. If one cannot be certain as to whether one has an offsetting position at another shop, the risk-reward equation for "gunning" is greatly reduced. After LTCM started to take a hit, and needed either new capital or bigger lines, anyone who might supply the credit that was needed also needed to see "the position". All the Positions. He fought it, but there was recourse, and that was the precise point at which Hillenbrand knew they were dead.

Suppose that ABN's pioneering CPDO issues grow popular and are widely emulated, as investors snap up what seems to be no-risk extra yield. Suppose also that the imitators are not innovators, that they all adopt the same basic strategy in structuring their instruments. Then won't CPDO-owners collectively be something like a large hedge fund whose portfolio, strategy, and response to changing market conditions is fixed and published in advance? If so, what would prevent other funds from taking advantage of the information assymmetry to intentionally break these structures?

It wouldn't be cheap, and it wouldn't be easy. But it might be possible. If so, we'd have an illustration of the signature irony of finance, what Patrick Hynes and David Post have dubbed the "reverse tinkerbell effect". The fact that so many people believe the rating agencies' models will have created the conditions under which those models prove to be unreliable.

The wisest commenter on the internet, the prolific "Anonymous", made an interesting point in response to one of Felix Salmon's posts:

If AAA covers all bonds with a default probability below X, "natural" AAAs will be randomly distributed within the range while synthetics will likely be skewed upwards toward X because the banks have more choice in achieving a rating than governments or corporations. There is some evidence that synthetics have higher default rates than similarly rated naturals. It's a bit like Goodhart's law.

Goodhart's Law could be considered an application of the reverse tinkerbell effect. Anonymous' observation is a financial analog to this recent result regarding political-science academia. [Okay, that's a blogging of the result. The original paper is here.]

Some other CPDO links:

Relevant to nothing: Last week while I was writing about CPDOs, the other project I was working on rhymed. With CPDO. Not so easy.

Steve Randy Waldman — Sunday November 19, 2006 at 4:02am [ 0 comments | 0 Trackbacks ] permalink

Straight outta Antarctica, Felix Salmon calls me forth from a shallow grave, with his rhythmic chanting, "I Heart CPDO / I Heart CPDO". And he mocks, mocks, the Sacred Order of the Credit Cassandra. (Our motto: "We may go bankrupt first, but eventually you will too, and then we'll tell you that we told you so.") [1] All I can say to Felix Salmon is. You bastard. You bloody bastard.

Okay, then. Let us despatch with godspeed Felix's nefarious and very naughty heresies. Felix begins his abominations by conjuring the devil herself, that long-legged vixen of debt-bubble capitalism made flesh, Citibank. (Oh, temptation. Impure thoughts... Curvacious bubbles. Must. Not. Yield. Must. Not. Spread. 1929-1929-1929-1929.) Anyway, Felix trots out somebody from Citibank, with graphs showing many different ways that Bad ThingsTM can happen in credit markets, while CPDOs still do fine.

Just to be mean, I'll note there is nothing much new in these graphs, that they very much resemble the graphs in ABN's early CPDO presentation, and that the re-presentation of this stuff was like a child putting his hands to his ears and shouting "I don't hear you! I don't hear you!" when we, the beneficient, were only trying to show dear Felix the light. (It is a rather dark and depressing light, we'll grant you. It's not quite enough to read by.)

If we must respond to substance, we'll go all jujitso and yield (and spread) where the opposition expects resistance. We concede the truth and wonkiness of the Citibank graphs. We concede that CPDOs are very, very clever synthetics, almost as nice as that synthetic heroin in the Eighties that could give you synthetic Parkinson's disease. If the world behaves even remotely like it has over the last 10 years during the next 10 years, the likelihood of any CPDO going bust is practically nil. Let us understand and extol the cleverness of CPDOs in non-mathematical terms [2]. They are, yay and truly, wonderous inventions:

  1. If nothing bad happens, if credit spreads remain broadly unchanged, CPDO NAV ("net asset value") never falls, but slowly rises. Under this scenario, CPDOs straightforwardly yield full principal and coupon, even shedding (nearly) all credit risk fairly early in their lifespan by "cashing in" when the strategy has earned enough to pay its obligations.

  2. If something bad happens every now and again, a spate of defaults, or some exogenous widening of credit spreads, then CPDO NAV takes a brief hit, and NAV drops. But CPDOs are designed to take on more leverage when this happens (until they hit a floor very far beneath where they start), and the increased spread combined with increased leverage accelerates the post-credit-event earnings of the CPDO! Thus, as the Citibank graphs show, CPDOs undo the damage of a sudden credit widening rather quickly. With CPDOs, yesterday's bad news is tomorrow's very good news. The extra leverage and yield hastens the coming of the glorious "cash-in" event, henceforth to be spake as "the rapture", when the CPDO converts itself from a complex, leveraged play into a bank account with a predetermined withdrawal schedule.

  3. CPDOs are built with a lot of headroom — they earn highly leveraged credit spreads, but promise to yield only 100-200 bps more than LIBOR. They are intended to be conservative instruments, and they can take some hard-knocks: As Felix points out, while they enjoy "roll yield" from selling more protection than they buy every six months, they don't rely on it. They can take severe hits to NAV and bounce back. Under benign circumstances, they "cash-in" very early in their long (10-year-ish) lifespans. If there are less than benign circumstances early on, they can bend a lot but not break, and still have plenty of time to make up all their losses once the market normalizes itself again.

These are clever instruments. If I was the grunt at ABN-AMRO who designed the first one, I'd be damned proud of myself. If it's your job to design structured credits that earn maximum yield for minimum risk under any reasonable model based on recent-past credit-spread history, you Ms-CPDO-Inventor, deserve a big gold star (and a 50 million dollar bonus).

So why am I complaining? (Yes, I am complaining.)

I think that if CPDOs become popular enough, they will break. I really do. But how? First, let's understand some scenarios under which they could break:

Multiple, sequential spread-widenings
Please refer back to the Citibank graph in Felix's post that shows what would happen to a hypothetical CPDO under a credit-spread jump. Look at that worst-case curve, where spreads suddenly jump by 150 bps. It looks bad initially, but recovers quickly, for reasons we've already discussed. Now, imagine that spreads jump not all at once, but in three separate events, one every six months. The fall in NAV under this scenario will be worse than the fall under the single jump scenario. Why? After each individual fall, the CPDO will have levered its credit exposure higher, to make up for the previously lost NAV. Still, the CPDO might well survive and recover. But suppose that there are four, or five, or six such events. Even if nobody defaults, the CPDOs will break.
"Conundrum" defaults
Suppose that there are a substantial number of defaults over the lifetime of the CPDO, but credit spreads don't widen? In this case, the CPDO loses NAV as it has to make good on some of the credit protection it has written, must increase its leverage dramatically to recover (as it earns the same paltry yield on its exposure), and takes deeper losses when yet more defaults occur. A few such episodes would be enough to break the instrument.
Tail-risk Credit Event
Suppose credit spreads jumped not by 150 bps over a single six-month period, but by 300 bps. Goodbye CPDO.

So, how likely are any of these events? That depends on your frame of reference. If you believe that the behavior of credit markets over the past decade is representative of how credit markets will behave in the future, then the odds of any of this happening are practically zero. If you believe that markets may behave in ways not captured by our experience of the recent past, than it's really a judgment call. My judgment is that the likelihood is significant. Why?

  • You don't have to go back very far to find "tail-risk" credit events. Here's a bet: If you run a hypothetical CPDO through the markets of the late 1970s early 1980s, a combination of tail-risk credit events and sequential bad periods would kill a hypothetical CPDO. (I don't have time to do the work right now of testing this conjecture against the data. Doing so would require lots of judgment calls, since no liquid CDS market existed, but it is an exercise reasonable people could attempt, and the conclusions might be clear enough to overwhelm misgivings about the judgments.)

  • The same conditions that created a "conundrum" whereby short rates rose while long rates did not could create a credit spread conundrum. There is preternatural (read "central-bank-and-petrodollar") liquidity in today's debt markets, and I would not be shocked to see a bunch of high profile defaults, followed by remarkably blasé spread widenings, and then all kinds of talk about how "the market" understands that the troubled firms were just "a few bad apples".

  • If CPDOs grow very popular, if a whole lot of much money is invested in basically the same, publicly known, highly leveraged portfolio, then market participants will work to create the conditions that break the portfolio in order to profit from the carnage. Markets adopt new behaviors when too much money starts betting that they'll behave as they recently have. [More here.]

I'd like to have a punchier conclusion than this, but it's late, and I am, after all, a grumpy zombie. So. Yes, CPDOs are very clever. Yes, they're robust to most reasonable scenarios, where reasonable is defined by even the last twenty years of market history. No, I don't care. Yes, I think they might well break. And I'm sure they will be broken if the quantity of CPDO-invested funds grows suffiently large. And I don't like that, as a tax payer, I'm required to insure banks that take out 5-times as much CPDO debt as they are permitted to take on ordinary business debt.

Good night.

P.S. In response to a point of Felix's, I think I should say that yes, corporate-AAA debt is also not default free. But, at least corporate-AAA debt requires a default to break, and a default by a specific entity that one can evaluate independently of some credit agency's AAA seal of approval. If you think Pfizer is goin' down due to some liability issue, eff Fitch's and don't buy their debt. It's hard to evaluate a whole CDS portfolio, other than by stats like what percentage is BBB. CPDOs can be broken by broad market trends and manipulations while a specific, conservative, well-run business cannot be forced to default. If you choose your conservative, well-run business poorly, you might still be toast, but at least you have a choice. And AAA sovereign debt in a currency that the sovereign is allowed to print is an order of magnitude less likely to meaningfully default than any AAA corporates. (The potential for a late-payment due to some momentary budget standoff in the US congress does not count as a meaningful default, so long as the eventual recovery rate is 100%.)

P.P.S. Here are links to Felix's several posts that inspired my bleary rise from a blogospheric grave:

Felix's posts are of course and as always excellent, as are many of the comments. You can be excellent and wrong though. (I usually am. But not here. Not now. I'm right, gosh-darn-double-dang-it!)

[1] With apologies to Brad De Long.

[2] Given a pissing match that evolved in Felix's comment thread about whether a guy who ran a hedge fund with "only" 750M under management had a large enough penis to comment on CPDOs, I feel compelled to mention that I am capable of doing quite a bit of the math, but that it's late, and I'm supposed to be making time to spend with my newly immigrated wife just now, not assigning myself unpaid exercises in quantitative finance. Frankly, I think the nearly complete hegemony of the pseudoquantitive over the qualitative in finance represents a kind of miniature dark age, one that will end soon, darkly.

Update: I should note that this is a "for entertainment purposes only" kind of piece, really, it's after 5 am, and I was supposed to be doing something else. I mean it all — especially the part about Citibank being very sexy — but I've not really responded in a fair, measured, organized, or on-point way to anything anybody actually said. Sorry about that. Rereading the posts that inspired this, I do want to chime in on where Felix responds directly to a previous point of mine directly, regarding an arbitrage strategy of selling ordinary AAA debt and buying CPDO extra yield. If CPDO return-at-maturity is equivalent to a portfolio of other AAA debt held to maturity, an arbitrage strategy would still work. The point about the higher mark-to-market volatility and potential illiquidity of the CPDO is well-taken. But if CPDOs in the end always pull it out, a long-term investor able to bear MTM volatility should indeed sell diverse vanilla AAA and buy CPDO, with the intention of holding both to maturity, until CPDO and vanilla AAA spreads converge. (BTW — do banks have to mark their CPDO positions to market?) I also want to point out that Felix has actually spoken to the CPDO-sort-of-inventor-person, and contrary to the above, Ms-CPDO-Inventor seems to be a boy. I hope he did get the gold star and the 50M bonus. Even though, of course, it will be all his fault when Western Capitalism, nay, Civilzation Itself, crumbles beneath our sweatshop-shod feet.

Steve Randy Waldman — Tuesday December 19, 2006 at 4:56am [ 6 comments | 0 Trackbacks ] permalink