Monday, February 18, 2008

CPDOs on the cusp of delevering

(FT Alphaville) On Friday afternoon, Moody’s downgraded 16 constant proportion debt obligations (CPDOs) - all linked to corporate names.

In fact, all of those downgraded reference a GLOBOXX portfolio - that is iTraxx EUR IG and CDX NA IG in equal measure. Weeks of widening spreads have naturally taken their toll, with net asset values for the CPDOs now hovering around 60 per cent, according to Moody’s (the range quoted being 45 - 75). The NAV is simply a measure of portfolio asset worth to noteholder par.

Now CPDOs don’t “cash out” - liquidate - typically until that NAV drops to around 10 per cent. For now, that is a little way off (not so of course, for all those bespoke second generation CPDOs referencing purely financial names). So at first glance it might seem like there are still grounds to be sanguine.

But the 60 per cent mark is nonetheless a dangerous tipping point: beyond it, CPDO’s go into forced deleveraging.
At its birth a CPDO usually has about 15 times leverage. (Among other things, it’s the leverage and the huge notional CDS portfolio sizes that have credit traders worried)

Leverage in a CPDO is capped by two rules: 15 x the note notional and 25x NAV. Whichever of these has the lesser value is applied.

min(15 x note notional, 25 x NAV)

At inception then, imagine a CPDO which issues £100 of notes. NAV is, accordingly, 100. Leverage is thus determined as 15 x 100 = 1500. (the higher of the two cap tests, in this case 25xNAV - 2500, is discounted). Let’s say the market moves against this CPDO and the NAV drops to 90 (reflecting, perhaps, a MtM portfolio loss). Leverage remains at 15x (because 25xNAV = 2250 and 15x 100 = 1500)

But now let’s say - as is the current real world case - NAV drops to 60. What happens to leverage? Well, 15 x note notional is still 1500. But 25xNAV is now also 1500. In other words, if the NAV drops any further, then the second leverage cap suddenly becomes applicable.Let’s say NAV drops another 10 per cent, to 50. Now, 25 x 50 = 1250. Accordingly, the CPDO delevers from 15x to 12.5x.

In market terms, that deleveraging translates into the CPDO’s arranging bank having to close out earlier CDS positions and buy an equivalent amount of protection back, which in turn, will likely push spreads wider still in the markets. Another factor to look out for on the credit indices in the next couple of weeks.

For the CPDOs in question, a bad situation might well become worse, since higher spreads, of course, will have a further MtM impact on CPDO NAVs. Add in too the “scare factor” of banks buying big protection positions, and the markets could well move disproportionately.

For what it’s worth, the swap counterparty for half of those CPDOs downgraded (The SURF series) is ABN Amro.

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