Derivative Fitch last week said the string of so-called "first generation" CPDOs that have come to the market over the last nine months would not warrant a triple-A or even double-A rating using its own methodology.

Both Fitch and its rival, Dominion Bond Rating Service, last week spoke out about the risk related to CPDOs. The rating agencies primarily cited structural concerns and challenges related to modeling future performance of the early structures, although both Fitch and DBRS projected a relatively optimistic tone regarding future CPDO deals - proposals of which both agencies are currently reviewing.

"We wanted to get our views known to the marketplace and out to investors," said John Schiavetta, a group managing director at Fitch. Schiavetta said CPDO arrangers have approached the agency for ratings since the first deals began hitting the market.

ABN AMRO issued the first CPDO in August 2006. The bank's SURF CPDO deal received much acclaim when it hit the market - primarily because noteholders were promised unheard-of yields for triple-A rated notes. A flood of copycat deals followed, along with criticism from industry participants who worried not only about the validity of ratings tied to the highly levered, heavily market-sensitive structures, but also their effect on volatility within the investment-grade corporate indices they referenced.

Standard & Poor's and Moody's Investors Service have been criticized for assigning triple-A ratings to the early structures, which some say exploited rating agency methodology. Although S&P and Moody's have reviewed their CPDO methodology, neither rating agency has issued downgrades to the structures. "Our methodology is rigorous and appropriate for existing CPDO structures," said S&P spokesman Adam Tempkin. S&P in late March announced "CPDO Evaluator," a new tool for modeling CPDO risk.

Credit derivatives expert Janet Tavakoli, president of consultancy Tavakoli Structured Finance, specifically cited the triple-A CPDO ratings in a public comment to the Securities and Exchange Commission regarding the proposed Credit Rating Agency Reform Act of 2006. "It is nice that they finally jumped on the bandwagon," Tavakoli said of Fitch and DBRS. "It is better late than never."

The initial CPDOs to hit the market made levered bets - as much as 15 times - on U.S. and European investment-grade corporate indices, and in some cases yielded roughly 200 basis points over Libor. The structures obtained a triple-A rating in part by providing a fixed coupon to noteholders - but their strategy and mark-to-market sensitivity have raised a number of eyebrows.

For example, if spreads widen on underlying reference obligations, CPDOs actually increase leverage, a nuance that some described as "chasing losses." The structure was even the subject of a cartoon circulated among industry insiders, who scoffed at the triple-A rating assigned to such a highly levered vehicle.

The deals essentially achieved a triple-A rating on both principal and coupon by providing a fixed coupon that increased in leverage as the underlying reference obligation's spread widened. When enough leverage is achieved to pay off the coupons and principal payments, the deal unwinds into a low-risk bond. Adding to early rating agency comfort, the reference portfolio is rebalanced every six months when the referenced credit indices roll into a new series - helping to defray the risk of default or downgrade on names in the series.

But the contractual obligation for the structures to roll every six months into a new on-the-run index led many to criticize its vulnerability to market manipulation - along with its effect on volatility.

The "second generation" of CPDOs, as the rating agencies call them, move away from some of the perceived flaws of earlier structures. Current proposals that build upon earlier CPDO structures include fully managed deals, short buckets, bespoke portfolios and reference obligations other than corporate indices.

(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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