Tuesday, February 19, 2008

Default protection puts CPDOs at risk

The class of complex credit investments invented by ABN Amro less than two years ago is being pushed closer to widespread collapse by the dramatic increases in the cost of protecting corporate debt against default in derivatives markets.

Constant proportion debt obligations (CPDOs) take highly leveraged bets on the main investment-grade US and European credit derivatives indices, the CDX IG and iTraxx Europe, both of which have seen spreads hit record levels recently.

The rise in spreads - or the cost of protection - leads to mark-to-market losses on the net asset value of the CPDOs' exposures to the indices, which can eventually lead them to hit stop-loss triggers and force them to unwind their bets, with investors losing 90 per cent of their money.

The number of CPDOs in issuance is limited but their leverage levels of up to 15 times investors' principal heightens their impact on the markets. Fears of CPDO unwinds and other, more popular structured investments known as synthetic collateralised debt obligations are a strong factor in the rising cost of protection in the credit derivatives markets.

"If these [structured products] do get unwound en masse, the effect on the market will be horrible," said credit strategist Barnaby Martin at Merrill Lynch. "Between $1,000bn and $2,000bn of synthetic CDOs have been issued over the last four years. Any unwinding will likely be crammed into a much shorter time period."

Moody's, the ratings agency, downgraded 16 CPDOs from a series of issuing banks on Friday, many of which had already been dowgraded once in January.

Moody's cut the ratings on eight CPDOs issued by ABN, seven of which were downgraded in January and are now rated A2 by the agency, five notches below their original Aaa ratings. They remain on watch for further downgrades.

Deals issued by Lehman Brothers, Dresdner Kleinwort, BNP Paribas and Merrill Lynch were also hit with either initial or repeat downgrades. A number of deals from UBS that focused their exposure on financial companies have already either been unwound, with investors losing most of their money, or have had their ratings withdrawn while they are restructured.

Moody's said the net asset value of the CPDOs downgraded had fallen to between 40 per cent and 75 per cent of face value as the average spread on the underlying credit derivative indices had jumped from 35 basis points to 120bp.

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