Alea has found
a tantalizing tidbit from Anthony Morris of UBS, as reported
by Reuters. Apparently CPDOs – structured products which pay high
interest rates on triple-A-rated securities – might have been put together
rather shoddily, at least in the early days:
"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…
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.
Morris’s argument is hard to understand from the Reuters precis – if
someone has more detail on its substance, I’d love to see it. But it certainly
fits in to the narrative we’ve been seeing a lot of, recently – the idea
that if you apply finanial voodoo to low-rated debt and end up with high-rated
debt, then those high ratings are not to be trusted. Indeed, Reuters goes on
to quote Morris as making this astonishing assertion:
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.
Isn’t leveraging A-rated debt by 10 times exactly what the more highly levered
of the two Bear Stearns funds did, to disastrous effect? No one invested in
the stock market has seen their position wiped out. Meanwhile, the ABX-HE-A
07-1 index, which reflects the default risk on A-rated securities, has fallen
from 100 at the beginning of this year to 53.67 now. If you invested in that
at a leverage of 10 times, you would have lost 4.6 times your original investment
by this point.
As for the early CPDO products, I’m not convinced. Morris might be right that
some of the calculations assume that BBB-rated default risk mean-reverts. But
if it doesn’t mean revert, then all that’s going to happen is that spreads remain
tight, and losses in credit markets will be very small indeed. Remember that
in order to break a CPDO, you need the very weird combination of tight spreads
and high default rates. And so far, default rates remain at all-time
lows.