Constant proportion debt obligation
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A Constant proportion debt obligation (CPDO) is a type of
credit derivative In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the '' credit risk''"The Economist ''Passing on the risks'' 2 November 1996 or the risk of an event of default of a co ...
sold to investors looking for exposure to
credit risk A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
. A CPDO is normally embedded in a note rated by a
credit rating agency A credit rating agency (CRA, also called a ratings service) is a company that assigns credit ratings, which rate a debtor's ability to pay back debt by making timely principal and interest payments and the likelihood of Default (finance), default ...
. CPDOs employ dynamic leveraging in a similar (but opposite) way to Credit CPPI trades. CPDOs are formed first by creating a SPV that issues a debt note. The SPV invests in an index of debt securities, commonly credit default swap indices such as CDX and
iTraxx iTraxx (Thomson Reuters Eikon code 'ITRAXX'; Bloomberg code 'ITRX') is the brand name for the family of credit default swap index products covering regions of Europe, Australia, Japan and non-Japan Asia. Credit derivative indexes form a large se ...
(in theory, this could be deal-specific, such as a bespoke portfolio of
sovereign debt A country's gross government debt (also called public debt, or sovereign debt) is the financial liabilities of the government sector. Changes in government debt over time reflect primarily borrowing due to past government deficits. A deficit o ...
), similar to a CDO. The structure allows for continual adjustment of leverage such that the asset and liability spreads stay matched. In general this involves increasing leverage as when losses are taken, similar to a doubling strategy, in which one doubles one's bet at each coin toss until a win occurs. The investment index is periodically rolled, whereby the SPV must sell protection on the new index and buy back protection on the old index. In doing so, it incurs rollover risk, in that the leaving index may by than the new index.


Initial reaction

The first CPDO deal was issued in 2006 by ABN-AMRO and was rated AAA/Aaa. Many analysts were initially skeptical of the rating assigned, partly because the CPDO note paid interest of
Libor The London Inter-Bank Offered Rate is an interest-rate average calculated from estimates submitted by the leading banks in London. Each bank estimates what it would be charged were it to borrow from other banks. The resulting average rate is u ...
plus 200 bp but also since the deal contained a majority of market risk (spread risk) rather than credit risk - an exposure not normally rated by rating agencies. A few months later,
Moody's Moody's Investors Service, often referred to as Moody's, is the bond credit rating business of Moody's Corporation, representing the company's traditional line of business and its historical name. Moody's Investors Service provides internationa ...
released a comment to the effect that, while they still stood by their original rating, they acknowledge that the rating is highly volatile compared to other triple-A rated instruments. They also indicated that future deals would be highly unlikely to achieve the same rating with the same spread. Fitch Ratings in April 2007 released a report warning the market on the constant proportion debt obligations (CPDO) dangers. Later CPDOs had more conservative structures and were offered at AAA/Aaa with a much lower spread. Financial Times reported on May 21, 2008 that an investigation by FT has discovered that Moody's awarded incorrect triple-A ratings to billions of dollars' worth of a type of complex debt product due to a bug in its computer models. Internal Moody's documents seen by the FT show that some senior staff within the credit agency knew early in 2007 that products rated the previous year had received top-notch triple A ratings and that, after a computer coding error was corrected, their ratings should have been up to four notches lower.


Credit crunch

The sudden widening of credit spreads that occurred in 2007 and 2008 as a result of the credit crunch caused considerable losses to the ''
net asset value Net asset value (NAV) is the value of an entity's assets minus the value of its liabilities, often in relation to open-end, mutual funds, hedge funds, and venture capital funds. Shares of such funds registered with the U.S. Securities and Exc ...
'' of many CPDOs. The rating agencies that had entered the CPDO rating business have downgraded many of them and some have already defaulted. The failures of these highly rated notes has been used by critics in criticisms of the rating agencies, although not all agencies have rated them and some agencies had provided the market with early pre-crisis warnings.


References

{{Reflist * Dorn, J.: Modeling of CPDOs – Identifying optimal and implied leverage, Journal of Banking & Finance 34, no 6, 2010. * Rama Cont & Cathrine Jessen (2009
Constant Proportion Debt Obligations (CPDO): Modeling and Risk Analysis

Modeling of CPDOs-Identifying Implied and Optimal Leverage
Derivatives (finance)