Investors say that Cairn – an asset manager set up by former JPMorgan banker Tim Frost – believes that it can add value by managing the roll, and by not being fully levered at launch. The early versions of CPDOs start with 15 times leverage. The concern of some is that when the credit market deteriorates there could be substantial mark-to-market downside. These deals should perform fine in a mean-reverting scenario but might not otherwise.
Also there has been concern that static CPDOs could be subject to a lot of volatility going through the index roll. JPMorgan has altered leverage ratios – the structure’s leverage is capped at 12 – and the speed at which it levers up and levers down.
Accrete notes
Investors also say that Lehman Brothers has a structure called Accrete Notes in development. Based on the ABX index, it has much lower leverage than a credit CPDO, is structured to early redemption and has roll periods extended by up to two months to avoid possible poor liquidity.
"The equivalent of CPDOs for the credit indices is being worked on the ABS side. As always, part of the bottleneck is the rating agencies getting comfortable with the methodology and also, in parallel, getting clients comfortable with the product, especially given the weakness that is going on in sub-prime in the US right now," says Georges Assi, co-head of CDOs and structured credit.
Giancarlo Saronne, European head of structured credit origination, says CPDOs offer fascinating opportunities for the market.
Gap risk
"Rating agencies are now rating something different, which is the diffusion rather than default probabilities," says Saronne. "That is going to be extremely interesting especially when you think about developments in the volatility market.
"Right now it’s a purely rating driven product, but in the future you have the potential of recreating the paradigm that was so successful for synthetic CDOs, which was a rating approach compared to a risk management approach. The tools are still far from perfect because volatility curves are too short but nonetheless there is that potential."
Assi says: "A lot of investors are looking at long-short strategies – they are not that worried about idiosyncratic risk. They are more worried about mark-to-market consequences if spreads were to widen. Many of the structurers in the CPPI and CPDO space are working on long/short strategies with some dynamic control of leverage."
Evolution
This is exactly the thinking behind DPI (dynamic protection insurance), which sponsor DrKW describes as an "evolutionary" CPDO as it combines the benefits of that structure with those of a CPPI. The key selling point of the DPI is its dynamic leverage cap. Thus, as the index spread widens the dynamic leverage cap on the reserve increases, and if there have been losses the dynamic cap will kick in and reduce leverage.
DrKW claims that this will generate roughly 30bp to 50bp higher returns at triple-A than a CPDO but still with rated coupon and principal. There is no principal protection with a DPI and there is consequently the potential for 100% of the notional to be lost. But the cap should act as a safety net and there is a cash-out set at 5%.
Testing of the structure has shown that the lock-in point (the point at which the rated cashflows are fully collateralized and the structure is unwound) can be triggered much sooner with a DPI (in three to five years) than with a CPDO (around seven years).