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Opinion

CPDOs: When will the tail wag the dog?

How much CPDO volume can be produced before it starts to affect the market of which it is a derivative?

Hats off to ABN Amro, whose structurers came up with the idea of constant proportion dynamic obligations. Managing to get a triple-A 10-year security to offer Libor plus 200 basis points, with the extra bonus of having no direct correlation risk, is impressive. Investors will bite the hand off anyone offering a product like this. And given that CPDOs are remarkably straightforward it is no surprise that various market participants have rushed to follow up (see structured finance news).

Apparently having approved the structure, the rating agencies took another look following the sharp rally in the main investment-grade credit tranches as dealers pre-hedged a significant pipeline of replica deals. It seems that they continue to endorse CPDOs, but they surely should be worried about the possible systemic issues arising from the effect of this structure on the underlying indices. Unless spreads contract dramatically, CPDO production will continue apace. So at some point the rating agencies will have a judgement call to make: how much CPDO volume can be produced before it starts to affect the market of which it is a derivative?

It will be interesting to see whether at some point the new index continues to price wider than the old index because of its six-month longer maturity. The rating of the notes does rely on that fact that the credit curve tends to be upward sloping. It is probably still a long time off but at some point it is feasible that the sheer weight of demand for rolling into the new index will flatten or invert the credit curve between 4.75 and 5.25 years. If such an event occurred that would be negative for the product.

If spreads widen, losses are incurred and CPDOs rules require the buying of credit protection. This could encourage the market to go wider still. However, this might be mitigated by the possibility that wider spreads will trigger more CPDO production and therefore the selling of protection. The problem, again, is that it comes down to whether there are so many CPDOs that structurers buy protection on aggregate.

When does the tail start wagging the dog? Many questions will be answered in March when the first roll happens but until then it is definitely a big judgement call from the agencies.

CPDOs are not the first market value product that the rating agencies have approved.

Take, for example, leveraged super senior transactions. But CPDOs highlight the changing nature of rating securities. It is no longer about pure default risk but also about market liquidity.

Is it possible to rate liquidity? That is the question that the rating agencies should be asking themselves following their backing of the latest structured credit whiz. In normal circumstances the answer is yes. But anyone with a memory that goes back 10 years knows that liquidity is rarely there when you need it most.

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