Wednesday, December 31, 2008

Constant-Proportion Debt Obligations

Noah Millman, a blogger and Wall Street banker working in structured finance, has posted his eye-of-the-storm view of how banks and ratings agencies worked together to create products that self-evidently never merited their AAA ratings. He provides as an example the constant-proportion debt obligation, or CPDO, which Millman describes as "an ingenious little fraud of a product."

Here’s how it worked.

Some clever structurer noticed that, historically, investment-grade companies don’t default very often. Rather, they deteriorate for a while first, get downgraded to junk status, and eventually they default. That’s why the short-term ratings for relatively low-rated investment-grade companies may be reasonably high: even BBB companies are generally good for the next 90 days; if they weren’t, they wouldn’t be rated BBB. And this suggested the possibility of a trading strategy.

What if you bought a portfolio of investment-grade corporate debt and, every six months, purged it of the bonds that were downgraded to junk, replacing these with new investment-grade bonds. Obviously, you’d expect the downgraded bonds to underperform the remainder of the pool, so you’d have losses you need to make up, so assume you also sell out of a handful of bonds that have done well, and replace these with higher-yielding bonds that are still investment-grade, thus keeping your yield relatively constant. You’d still expect some losses if you wanted to keep your average rating relatively constant, though. So you need some excess yield to make up for these losses.

You find that yield by leveraging the portfolio. After all, it’s an investment-grade portfolio, very unlikely to default in the short term. You can borrow very cheaply short-term, invest in longer-term bonds, and earn the spread differential. If the bonds go against you, that’s OK, because you’re going to hold them to maturity and you’ll always be able to roll your short-term borrowing. And, if you can get a high enough degree of leverage, the excess in current yield from the differential between where you borrow and the yield on your portfolio should more than pay for the cost of rolling out of your losers every six months. And if you do that successfully, you’ve got a trading strategy that never loses principal, but has a surprisingly high expected yield. Sound good?

Well, it sounded great to the ratings agencies, who blessed this strategy by giving it a AAA rating.

How did they justify that AAA rating? By looking at the historic cost of rolling credit derivatives on indices of investment-grade corporate issuers, which generally have a high-BBB rating. These had been around for about three years when the first CPDOs were rated, and the roll had never cost more than 3 basis points. Factoring in that cost, at a leverage of 15-to-1, and using historic 6-month default rates for the portfolio (since the index would be rolled every six months), the proposed trading strategy would never lose money. Hence a AAA rating.

Let me reiterate that, just to drive the point home. The ratings agencies said: you can take a BBB-rated index, leverage it 15-to-1, and follow an entirely automatic trading strategy (no trader discretion, no forecasting of defaults or anything, just a formula-driven adjustment to the leverage ratio and an automatic roll of the index), and the result is rated AAA.

Needless to say, this worked out really well for all concerned. But that’s not really the point. The point is: the notion that you could grant a AAA based on a trading strategy for which there was at best three-years of data (three years that encompassed not a single recession, I’ll note) is mind-boggling. And, worse than that, nobody at the agencies apparently stood up and said, “wait a second: how can you turn a BBB into a AAA by leveraging it 15-to-1? That’s impossible!” Which, of course, it is.

I want to be very clear about something: we’re not talking about a CDO where the AAA investor is providing leverage, and there are subordinate investors below who bear the first risks of loss. This was a trading strategy; the investor in the AAA CPDO had first-loss risk with respect to a BBB portfolio. The trading strategy was just supposed to generate enough returns to create “virtual” subordination to justify the AAA.

When I first heard about this product, I thought: whichever agencies rated this thing have lost their minds. When people asked me whether it made sense as an investment, I said: it’s an outright fraud. You’re practically guaranteed to lose money. I never bought or sold one of these things myself, and neither did anyone else in our group. But the existence of such a ridiculous product should have been a wake-up call about just how divorced from reality the agencies were. And if they were out to lunch on something as straightforwardly absurd as the CPDO, how out to lunch were they on other products, ones that were far more significant to the markets and the economy, where the absurdity of their assumptions was less-obvious? (emphasis added).

These products were offered by, among others, ABN-AMRO. If you invested money in a CPDO, you may want to consider whether the true risks of this product was disclosed to you.


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