Constant Proportion Debt Obligation

A Constant Proportion Debt Obligation (or CPDO) is a type of credit derivative sold to investors looking for long term exposure to credit risk on a highly rated note. They employ dynamic leveraging in a similar (but opposite) way to Credit CPPI trades.

CPDOs formed with a debt issuing SPV backed by an investment in an index of debt securities (commonly credit default swap indices such as CDX and iTraxx. In theory this could be deal specific, such as a bespoke index of sovereign debt) similar to a CDO. The investment index is periodically rolled, whereby the SPV must buy protection on the old index, and sell protection on the new index. In doing so it incurs rollover risk, in that the leaving index may by priced much wider than the new index. The structure then allows for continual adjustment of leverage such that the asset and liability spreads stay matched. In general this involves increasing leverage as when losses are taken, similar to a martingale strategy.

Initial Reaction

The first CPDO deal was issued in 2006 by ABN-AMRO and was rated AAA/Aaa despite paying Libor plus 100bp. Many analysts were initially sceptical of the rating assigned, particularly since the deal contained a majority of market risk (spread risk) rather than credit risk - an area not normally covered by rating agencies. A few months later, Moody's release a comment to the effect that, while they still stand by their original rating, they acknowledge that the rating is highly volatile compared to other triple-A rated instruments.^{[citation needed]} They also indicated that future deals would be highly unlikely to achieve the same rating with the same spread. Fitch Ratings in April 2007 released a report warning the market on the constant proportion debt obligations (CPDO) dangers.

Later CPDOs had more conservative structure and were offered at AAA/Aaa with a much lower spread.

Financial Times reported on May 21, 2008 that an investigation by FT has discovered that Moody’s awarded incorrect triple-A ratings to billions of dollars worth of a type of complex debt product due to a bug in its computer models. Internal Moody’s documents seen by the FT show that some senior staff within the credit agency knew early in 2007 that products rated the previous year had received top-notch triple A ratings and that, after a computer coding error was corrected, their ratings should have been up to four notches lower.

Credit Crunch

The sudden widening of credit spreads that occurred in 2007 and 2008 as a result of the credit crunch caused considerable losses to the Net Asset Value of many CPDOs. The rating agencies that had entered the CPDO rating business have downgrades many of them and some have already defaulted.

The failures of these highly rated notes has been used by critics in criticisms of the rating agencies, although not all agencies have rated them and some agencies had provided the market with early pre-crisis warnings.

References

• Dorn, J.: Modeling of CPDOs – Identifying optimal and implied leverage , Journal of Banking & Finance 34, no 6, 2010

External links

• Constant Proportion Debt Obligations (CPDO): Modeling and Risk Analysis
• First Generation CPDO: Case Study on Performance and Ratings
• Modeling of CPDOs-Identifying Implied and Optimal Leverage