Learning about CPDO’s
The WSJ introduces us to a new, seemingly perilous world, that of constant-proportion debt obligations, on which insurance costs have skyrocketed in recent weeks, with potentially further sour consequences for the economy:
Credit-default swap contracts have been written on the equivalent of some $43 trillion in all types of bonds, according to the Bank for International Settlements. Analysts estimate that about $6 trillion of those contracts tied to corporate bonds have been pooled into investments called synthetic collateralized-debt obligations, or CDOs, and constant-proportion debt obligations, or CPDOs, which channel the insurance payments on multiple contracts to investors.
The trouble is brewing in the market for these esoteric investments. Markit iTraxx Europe tracks the cost of insuring a basket of 125 investment-grade debt issues by European companies, including banks such as Barclays PLC, beverage company Diageo PLC, and retailer Tesco PLC. The Markit CDX North America Investment-Grade Index references the cost of insuring against default by 125 U.S. and Canadian investment-grade companies, including telecommunications company AT&T Inc., retailer Wal-Mart Stores Inc. and fast-food operator McDonald’s Corp.
As of yesterday, the annual cost of five years of insurance against default on $10 million in bonds on the CDX index had risen to $152,000 from $80,970 at the start of the year. The cost of €10 million ($14.7 million) of insurance on the iTraxx had rose to €123,750 from €51,320 at the beginning of the year.
A rise in the cost of insurance means a loss for investors who sold insurance, because the only way to get out of these investments is to buy another insurance policy to replace the policy they sold in the first place. For example, if the cost of five-year insurance on the CDX rose to $100,000 a year, an investor who had sold the insurance for $50,000 a year would have to pay an added $50,000 for five years to get out of the contract — a loss with a present value of about $200,000…
Even in the absence of greater defaults, the moves in the indexes can cause a great deal of havoc, triggering a downward spiral in which the forced unraveling of complex investment products drives ever-larger losses for investors and rises in the cost of insurance, which in turn could ultimately drive up borrowing costs for companies all over the world…
Among the most vulnerable are the CPDOs, which have only been on the market two years. They offered a supposedly safe stream of income to investors by selling default protection on all of the companies in either the iTraxx or the CDX, or in some cases on a basket of financial firms that included bond insurance companies. But they had a flaw: They used borrowed money, or leverage, to increase the returns they could provide to investors — a strategy that also magnifies losses. They also contain triggers that force them to call off their bets if losses reach a certain level, a feature that can force them to rush into the market to buy insurance just when the market is falling.
“Whether you bought without leverage or with leverage, you’ve been hurt,” said Steve Lobb, head of credit and alternatives marketing at ABN Amro Holding NV, which sold CPDOs. “If you bought…with leverage, you’ve been hurt more.” Still, he said, CPDOs “are not the problem in the market. They are a tiny piece of what exists out there.”
We have been feeling for some time, given that the audit season for financial institutions is upon us, that the worst of the disclosures have been made about credit problems. Perhaps we were wrong. The CPDO’s are a “tiny piece” of the $45 trillion outstanding in credit default swaps and similar instruments, and these CPDO’s appear to be performing very badly. We would appear to be in Phase II of the Credit Crunch. Just how far it has to run is beyond our ken to predict.