July 23, 2007 / 5:01 PM / 12 years ago

Early CPDOs far riskier than ratings imply-UBS

NEW YORK, July 23 (Reuters) - Some Constant Proportion Debt Obligations, one of the most talked about credit derivative products in the past year, may be far more risky than their “AAA”-ratings imply because the methods used to rate the early deals were inadequate, UBS Securities said on Monday.

CPDOs have generated a lot of buzz and controversy since they were introduced last year, as the first deals generated coupons as high as 200 basis points over the London Interbank Offered Rate (LIBOR) while also holding ratings of “AAA” or “AA.”

Last week Fitch Ratings and Dominion Bond Rating Service, neither of which have rated CPDOs, said that the early deals may be highly sensitive to small changes in the assumptions underlying them. For details, see [ID:nL18292745]

“We think that early CPDOs, the ones that were introduced last summer and fall, have a very fundamental problem with them,” said Anthony Morris, executive director in structured products research at UBS on a conference call on Monday.

“Get out of early CPDO products, I wouldn’t touch them with a 10-foot pole,” Morris said. However, deals backed by higher rated credits have a lot of value, he said.

CPDOs are designed to generate higher coupons by taking leveraged exposure to investment grade credit derivative indexes, and the leverage can be raised or lowered according to market moves to protect against losses.

A key assumption in achieving high ratings is that the index spreads will “mean revert,” meaning that they eventually gravitate back towards some long-term average.

And this is where the ratings fall down, according to UBS’ Morris. The risk and returns of CPDOs is not based on spreads but instead is based on returns, and the returns of “BBB”-rated credits, which make up around half those in the investment grade index, do not mean revert, he said.

If the assumption that “BBB”-rated credits mean revert were taken out of the ratings models, the deals would be rated 10 notches lower, or an “AA”-rated deal should be rated “B-plus,” four levels below investment grade, he said.

Rather than arguing that CPDOs are inherently bad, however, Morris argues that the structures can be good investments if they are based on higher rated indexes, which have strong reversion to the mean.

“Leverage is not necessarily evil,” he said. “Structured products are only as good as what goes into them, you can’t squeeze blood out of a turnip and you can’t put garbage in and expect to get quality out.”

Leveraging an “A”-rated index by 10 times would still be less volatile than taking an unleveraged position to high yield credits, or to stocks, he said.

“One of the really cool things about this product format is that it allows ordinary investors to benefit from leveraging something that deserves to be leveraged and that something is higher quality credit exposure,” Morris said.

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