When the CPDO structure was first introduced, with the launch of ABN Amro's SURF deal in August 2006, there was concern that the structures might not hold up in a volatile market, given that they are highly levered and market sensitive.
With recent spread widening already causing some mark-to-market losses, it seems this fear is beginning to be justified.
For example, the first generation CPDO transaction SURF, which references Globox, a combination of iTraxx and CDX investment-grade indices, was trading around 35 basis points when it launched, said Alexandre Linden, senior director at Derivative Fitch.
Now it is trading at around 57 basis points, he said, a widening of 22 or 23 basis points.
"If you factor in leverage of 15 times and a duration longer than five years, that results in a mark-to-market loss of a bit more than 15%, which would mean these notes would have a value today of 80% or 85% of par," Linden said.
Investors were also not keen on the structural risks.
"There is a lot of market risk here. If the whole vehicle goes down in price and you try to readjust it, in a very fast market, you are screwed," a CDO market participant said. "I am sure some are going to be downgraded."
Indeed, late last month, Moody's Investors Service put on review for a potential downgrade a 30 million financial CPDO swap rated Aa2' and arranged by UBS. The rating action was a result of the recent spread widening on financial names underlying the swap that negatively impacted the net asset value of the deal, Moody's said.
"The widening on financials over the past month has been more than what we expected in our average scenario," said Moody's senior associate Mehdi Kheloufi-Trabaud. The UBS transaction is a buy-and-hold financial portfolio. These trades were a bit more sensitive to widening because they are exposed on a 10-year contract, Kheloufi-Trabaud said, noting that at the beginning of the trade, it is more sensitive to spread variations resulting from the duration effect of the contracts. At the same time, the financial sector has been strongly affected by the liquidity crisis, which has caused net asset value (NAV) to fall below 50%. The original NAV for the deal was 60% to 70%. However, UBS has restructured part of the trade, which should improve NAV, Kheloufi-Trabaud said. Moody's is currently reviewing the changes.
Another risk for these transactions is that spread widening might indicate further potential default, Linden said. "If we were starting to see a surge in defaults in the U.S., especially in the financial sector, obviously the value of these structures would decline even more because each default would result in a further reduction in the value of the note." he said.
A New Series
However, the CPDO structure that references the iTraxx and CDX indices is a revolving mechanism, which should lock in a higher spread when the indices reroll into a new series on Sept. 20. "The carry they would get from the leverage of 15 times, which at the moment is around 5% per annum, would go to something like 9% if we assume spreads remain where they are," Linden said. "So this 9% per annum may, over time, repay."
Moody's was optimistic about CPDO deals that follow this structure, specifically the standout SURF strategy, as they refer to it.
"We are not really worried because of the possibility to lock in higher premiums," Kheloufi-Trabaud said, adding that the recent widening of spreads on those indices corresponds to the average path simulated by the rating agency as their mean reverting levels are around 80 basis points for those kinds of portfolios. "In most of our scenarios, when the spreads rise to 70 or 80 basis points in the portfolio, they crystallize a loss but then recover."
Whether or not these Aaa' deals face the potential of a downgrade depends on how much the market becomes volatile, Kheloufi-Trabaud said.
"As long as it stays between the level before the crisis and 100 to 120 basis points, the market does not deviate from our average path. If the market rises to 200 basis points, like it did in the 2002 credit crisis, we may have to take future rating actions. But the future will tell."
However, investors who are not prepared to endure such mark-to-market volatility in the short term may want to exit now - at a loss - because of concern that spreads will widen further. And though CPDO models suggest that an early-cycle spread widening is beneficial, early-cycle defaults and downgrades can be disastrous, said David Watts, analyst at CreditSights in a research note, since CPDOs tend to run at or near maximum leverage.
CPDOs are structured to sell more protection if the index widens sufficiently and should subsequently benefit from a new, wider spread level, Watts said. However, realizing mark-to-market losses and buying back protection would have the opposite affect, and the CPDO would experience "an interperiod of capital outlay, which it can little afford," he said.
Further, hitting the trigger of a CPDO would result in the forced buying back of protection on probably $21 billion worth of CDX and iTraxx, according to a recent JPMorgan Securities report. However, the bank was not worried about these products unwinding as a result of recent volatility.
"The products were structured with triggers set to unwind the products when the net asset value reached only 10% of the initial NAV. Though there are different products in the market, we estimate current valuations to be hovering around 80%, very far from the 10% trigger level," JPMorgan said.
But given the risk-averse conditions of the market and subsequent lack of liquidity, especially for highly complex and relatively new transactions, these structures may not stick around for much longer, according to one source.
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