CPDO's Newest In Alphabet Soup Derivatives Mess
MBS, CDO, ABS of CDO & MBS, add another to the widening alphabet soup of derivatives that is going to blow up.
Once again, the banks who are already carrying the asset backed paper no one wants, will have to pay the difference on CPDO's which have gone from AAA to junk.
Constant proportion debt obligations, known as CPDOs, use credit-default swaps to speculate that a group of companies with investment-grade ratings will repay their debt.
The securities earn an income by selling credit-default swaps, a type of insurance contract that pays a buyer face value if the borrower can't meet payments on its debt.
Last year, banks set up about $4 billion of CPDOs, promising annual interest as high as 2 percentage points above money-market rates.
The banks used leveraged borrowing to increase assets to as much as 15 times the initial capital, or up to $60 billion.
The CPDO model is being challenged as worsening perceptions of credit quality reduce the value of the credit-default swap contracts included in the securities.
An increase in credit rating cuts for investment-grade companies may cause losses that CPDOs would struggle to recoup.
Prices of CPDOs dropped to as little as 70% of face value last month. Those CPDOs that provided insurance on the 125 companies in the CDX index in March for a premium of 36.75 basis points...
or $36,750 for every $10 million of debt, will have to pay nearer 70 basis points to end the contract when the index rolls on Sept. 20, based on current prices.
David Watts, a CreditSights analyst: "If you assume defaults and downgrades come in bunches rather than being evenly spaced out, CPDOs' default rates are more what you would expect for low junk ratings than for AAA.''
Hat tip to John Glover at Bloomberg.
Once again, the banks who are already carrying the asset backed paper no one wants, will have to pay the difference on CPDO's which have gone from AAA to junk.
Constant proportion debt obligations, known as CPDOs, use credit-default swaps to speculate that a group of companies with investment-grade ratings will repay their debt.
The securities earn an income by selling credit-default swaps, a type of insurance contract that pays a buyer face value if the borrower can't meet payments on its debt.
Last year, banks set up about $4 billion of CPDOs, promising annual interest as high as 2 percentage points above money-market rates.
The banks used leveraged borrowing to increase assets to as much as 15 times the initial capital, or up to $60 billion.
The CPDO model is being challenged as worsening perceptions of credit quality reduce the value of the credit-default swap contracts included in the securities.
An increase in credit rating cuts for investment-grade companies may cause losses that CPDOs would struggle to recoup.
Prices of CPDOs dropped to as little as 70% of face value last month. Those CPDOs that provided insurance on the 125 companies in the CDX index in March for a premium of 36.75 basis points...
or $36,750 for every $10 million of debt, will have to pay nearer 70 basis points to end the contract when the index rolls on Sept. 20, based on current prices.
David Watts, a CreditSights analyst: "If you assume defaults and downgrades come in bunches rather than being evenly spaced out, CPDOs' default rates are more what you would expect for low junk ratings than for AAA.''
Hat tip to John Glover at Bloomberg.
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