Thursday, September 18, 2008

CPDOs Approach Cash-Out Events

(FT Alphaville) From Moody’s:

Paris, September 17, 2008 — Moody’s Investors Service today downgraded and left under review for possible downgrade 20 series of CPDO notes, static and managed.

These actions are based on significant spread widening, which increases the probability of a cash out event. The spread movements are attributable to widespread concerns about the performance of financial institutions, including market reaction to the placement of Fannie Mae and Freddie Mac in conservatorship on 8 September 2008, the bankruptcy filing by Lehman Brothers’ Holding Inc. on 15 September, and the announcement of rescue assistance for AIG by the US Federal Reserve.

All 20 CPDOs are now junk - most hovering barely above default at Caa/Ca. In total, they’re worth about $1.35bn, though the notional size of their CDS portfolios will be considerably more.

Spread widening on the CDS indices the CPDOs reference impacts directly a CPDOs net asset value. CPDOs must continually mark their portfolios to market - the wider spreads move, the lower the net asset value of the CPDO falls as it is forced to post more collateral with its sponsor bank (via a total return swap - the sponsor bank is the one which writes the CDS protection on the CPDO’s behalf).

Anyway - the point being that NAVs are now hovering just above 10 per cent, meaning spreads have widened sufficiently for the CPDOs to lose nearly 90 per cent of their value. If they move lower than 10 per cent it’s game over. The CPDO is forced into mandatory unwind and investors - who bought those originally AAA rated CPDO notes - get nothing. Not even 10 cents on their dollar, in fact, since there are various charges and unwind costs to see to.


On a relatively minor scale, the CPDO bondholders themselves will of course lose all their money. There aren’t too many of them.

In market terms though, the arranging bank will have to buy protection from the market in order to sterilise the extant trades. That could be tricky. How do you buy protection with a notional value of several billion dollars on the market right now? The credit indices are very volatile right now:

The extent of the volatility and and trading chaos in the markets was illustrated late Monday evening when Markit Group, which runs the indices, announced that dealers had voted to delay the upcoming 6-monthly index changes by one week.

The index “rolls”, which refresh the lists of companies to be included via a dealer poll of the most liquid qualifying names, are traditionally among the busiest periods for trading in credit default swaps, which provide a kind of insurance against non-payment of corporate debt.

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