cpdos a primer

8 November 2006

Table of Contents − Overview

− Definition

− The Key Risks

− The Outlook for CPDOs

OVERVIEW

The past few months have witnessed the emergence of a new product in the synthetic collateralised debt obligation (CDO) market that has generated considerable interest.These Constant Proportion Debt Obligations2 (CPDOs) have developed as an offshoot of the credit index tranche market and represent an attempt by banks to repackage the equity tranches of synthetic CDOs in a rated form.

Synthetic CDOs typically offer to counterparties super-senior, mezzanine and equity tranches. In the past, the sole rated tranche has usually been the mezzaninetranche, with ratings in a Baa to Aaa range, while the super-senior and equity tranches were generally unplaced and unrated.3 As demand for the mezzanine tranche increased, mezzanine spreads contracted and attention has shifted to other parts ofthe capital structure. For example, super-senior tranches have been repackaged in the form of Leveraged Super-Senior transactions. More recently, attention has turned to the equity tranche. A CPDO is an example of such an investment in the equitytranche of a synthetic credit portfolio

This Special Report aims to describe the mechanism behind CPDOs and the key risksinvolved in such transactions.4 A future Moody’s publication will describe in detail the quantitative analysis of this product, as well as the documentation issues that may arise.

1 Jeremy Gluck contributed to this report as a research consultant. 2 “Constant” refers to the proportion of notional exposure associated with each name in the reference portfolio. 3 Only a handful of protection sellers, such as monoline insurers, have been interested in super-senior tranches. 4 We assume that the reader has some familiarity with credit derivatives and, more specifically, synthetic credit indices.

International Structured Finance Europe, Middle East, Africa

Special Report

CPDOs: A Primer Synthetic Arbitrage CDO

Authors1 Olivier Toutain Vice President – Senior Credit Officer +33 1 5330-1042 [email protected]

Mehdi Kheloufi-Trabaud Associate Analyst +33 1 5330-5979 [email protected]

Beryl Marjolin Analyst +33 1 5330-1065 [email protected]

Additional Contacts Anne Le Henaff Team Managing Director +33 1 5330-1067 [email protected]

Gareth Levington Team Managing Director +44 20 7772-5506 [email protected]

Yuri Yoshizawa Team Managing Director +212 553-1939 [email protected]

Investor Liaison New York

Brett Hemmerling Investor Liaison Specialist +1 212 553-4796 [email protected]

Client Service Desk London: +44 20 7772-5454 [email protected]

Paris: +33 1 5330-1047

Monitoring [email protected]

Website www.moodys.com

mailto:[email protected]



2 • Moody’s Investors Service CPDOs: A Primer

DEFINITION

The Structure in Essence The typical synthetic CPDO structure4 that Moody’s has seen so far is depicted in

Chart 1.

Chart 1: CPDO structure at closing date

Reference portfolio of one or several major indices

(like Itraxx or CDX)

The reference portfolio amount is initially set at EUR 1,500

EUR 100 risk free liquid investment SPV EUR 100 NotesIssuanceDeposit

Total return swap with SPV as protectionseller and a bank as a protection buyer

As suggested in the above chart, a special purpose vehicle (SPV) issues notes, theproceeds of which are used to invest in non-risky, liquid assets (typically a cash deposit).In parallel, the SPV enters with the arranging bank into a total return swap (TRS) with theSPV as protection seller. The portfolio referenced by this TRS is that of a widely tradedinvestment-grade index like Itraxx or CDX, and amounts at closing to a notionalsignificantly larger than the outstanding amount of the notes: in our example, the ratioof the TRS notional to the investment is 15:1. This ratio represents the degree ofleverage in the transaction. The senior risk is typically retained by the arranging bank. Atypical maturity for a CPDO would be 10 years.5

There are two key differences between the TRS and a traditional CDS:

1) The notional amount of the TRS is not held constant; rather, it is automaticallyadjusted according to a formula described below.

2) The underlying reference portfolio is not fixed: instead, the portfolio changes witheach semi-annual rollover of the referenced index. The reference portfolio of the newseries of the index automatically replaces the reference portfolio of the old series ofthe same index.

Each change of the notional amount (point 1) may require a payment to or from the SPV.For example, if the leverage formula (see below) leads to an increase in the notionalamount of the swap, the bank must compensate the SPV for taking on the incrementalswap notional. Therefore, as part of its commitment under the TRS, the bank would payto the SPV an amount that augments the cash deposit account.

More generally, under the TRS, the bank pays to the SPV any index premium and anygains following a partial or total unwinding of the series, and the SPV pays to the bankany default loss due to a credit event, or a loss following a partial or total unwinding ofthe series. Each semi-annual rollover (point 2) of the index normally entails such apayment.

5 We focus here on single credit-default-swap (CDS) structures, but multiple CDS could be involved.

CPDOs: A Primer Moody’s Investors Service • 3

Rebalancing the Portfolio: the Leverage Formula As described above, the flows associated with the TRS depend partly on the leverage

formula that determines the size of the TRS notional amount. The leverage formula isfixed in the transaction documentation and is applied automatically over the life of thetransaction. While the specific leverage formulas may differ from deal to deal, theyalways follow the same general principles:

− The leverage is a multiple of the difference (the “Shortfall”) between:

• The present value6 (as defined in the legal documentation of the transaction) ofall the payments owed by the SPV, including principal and interest payments onthe notes and certain fees. In addition, there may be some cushion in order toincrease the protection for investors; and

• The net asset value (NAV) of all the assets held by the SPV including thedeposit account plus the mark-to-market (MtM) value of the referencedportfolio.

• Such multiple will be determined as a function of the premium income to beearned by the SPV

At the start of the transaction, the Shortfall is positive (mainly because the discount rateused to calculate the present value of the payments due by the SPV is usually lower thanthe coupon on the notes). The SPV relies on its future income, or more accurately itsfuture excess spread7, to compensate for this difference.

On each day, the target leverage is determined using market data and the appropriateformula. To limit transaction costs that may arise from daily rebalancing, the TRSnotional is adjusted only if the calculated leverage moves beyond a preset range.

Note that a rebalancing of the portfolio and the change of index series have noinstantaneous impact on the Shortfall as the change of the mark-to-market of the TRS iscompensated by a change in the amount of the risk-free collateral held by the SPV.However, over time, these changes will likely have an impact on the Shortfall.

Cash-In and Unwind Events We have described above the normal evolution of the CPDO. However, there are two

conditions under which the investment strategy would be fully unwound:

− A Cash-In Event: when the Shortfall is reduced to zero, the swap is unwound and theSPV’s assets are given to the bank in exchange for the latter’s promise to pay allfuture coupons and principal to noteholders. This event is defined to prevent theSPV from taking on any more risk after it has generated sufficient value to pay offthe remaining coupons and principal on the Notes.8

− An Unwind Event (or Cash-Out Event): when the NAV of the SPV (the deposit + theMtM of the referenced portfolio) falls below a certain level in relation to the notionalof the credit portfolio (typically less than 10%), the swap is unwound and theremaining proceeds are distributed to noteholders. This corresponds to a casewhere the Shortfall has become too large.

An Analogy To understand how the CPDO works, we can draw a parallel with a simple coin-toss

game. The outcome of the toss is either “heads” or “tails”. Heads results in a 100%return and tails a 100% loss.

The player has an initial stake of 1000, comprised of 100 from his own pocket and 900borrowed from a friend. At the outset his strategy is as follows: if he succeeds inconverting his stake into 2000 of winnings, he will stop and reimburse his friend, havingthus multiplied his initial investment by 11. This corresponds to the Cash-In Event.

6 The discount rate used to calculate present value is generally close to a risk-free rate. 7 In this report, we will use the words “excess spread” as this is a well known term in structured finance transactions. Note that the words

“leverage spread” could be more relevant as it would indicate that the excess cash is generated by the leveraged nature of this structure. 8 Rating triggers normally apply to ensure that the bank will meet its obligations with an extremely high likelihood.


At the same time, his friend is concerned about his stake and thus if the player losesmore than 100, he will stop playing. This corresponds to the Cash-Out Event. (For eachtoss, the player bets 1% of the difference between his current stake and 2000--thesimple rebalancing rule in our example.)

If he bets 10 from the initial stake on “heads”, there are two possible outcomes:

− “Heads”: the player’s stake rises to 1010, so at the next round he will bet only9.90.

− “Tails”: he now has only 990, so at the next round he will bet 10.10.

Such a strategy is based on the notion that if “heads” has appeared more frequentlythan expected, it is less likely to continue appearing, and similarly for “tails.” In otherwords, the strategy is based on the concept of “mean reversion.”

THE KEY RISKS

Investors in CPDOs are exposed to several different types of risk:

− Spread risk, as any increase in the spread of the indices will erode the value ofoutstanding TRS;

− Default risk, which will require loss payments out of the deposit;

− Interest rate risk, through the computation of present value;

− Liquidity Risk

− Market risk upon voluntary early termination (for the non-buy-and-hold investor).

Spread Risk Since the CPDO investor takes on a leveraged exposure to synthetic credit indices, the

evolution of credit spreads can significantly affect the transaction. The rebalancingmechanism may aid the investor in coping with spread changes, particularly if spreadstend to move in unison.9 On the other hand, the value of the swap may be adverselyaffected by idiosyncratic downgrade risk, i.e. when the spread of the indices increases asa result of a few downgrades rather than a general increase in spread. In this case, onewould not necessarily expect mean reversion to aid the investor.

Default Risk As protection sellers, investors are exposed to default risk. However, two elements

within CPDO structures help to mitigate default risk. First, the roll of the indices ensureson a semi-annual basis that the reference portfolio will be comprised of investment-grade-rated entities, thus diminishing the likelihood of defaults. In addition, the excessspread (i.e., expected income in excess of coupons and fees) offers enhancement thatcan absorb the first losses in the reference portfolios.

Interest Rate Risk Although a CPDO transaction will be exposed to changes in interest rates, the impact on

performance is muted. The present-value calculation that affects leverage is sensitive tointerest-rate levels, but the discounts applied to both assets and liabilities will partiallyoffset each other. The floating coupon will also be more difficult to pay as interest ratesincrease; however, this sensitivity is naturally hedged by the cash deposit that accrues atLibor.10

Liquidity Risk Another key issue is the liquidity of the underlying indices. Although at present the credit

index markets are sufficiently liquid, Moody’s will monitor the relationship between theindex market and CPDOs going forward.

9 This will tend to be the case if spreads truly follow a mean-reverting process. While market-wide spreads have indeed tended to be mean

reverting, the same cannot be expected of individual credit spreads. 10 In addition, in some of the transactions that we have seen, the notional invested in each index is in its natural currency, thus introducing a

foreign exchange risk in the transaction. Any change in the FX rate may impair the diversification inherent in the reference portfolio and magnify the losses measured in the transaction’s accounting currency. For the CDX, the base currency is the US dollar. For the Itraxx, it is the euro.

CPDOs: A Primer Moody’s Investors Service • 5

Market Risk Upon Voluntary Early Termination Moody’s ratings do not address the risk that an investor will suffer a loss through the

voluntary liquidation of an investment prior to the termination of the rated transaction. Itis nonetheless worth noting that the leveraged nature of CPDOs implies a high degree ofpotential market risk. A change of just a few basis points in the indices can result in adramatic change in the value of the notes through large changes in the NAV.

Alternative Market Scenarios and their Associated Risks The table below describes a number of different scenarios and, in each case, the

resulting impact on a typical CPDO. Note that the possible scenario impacts will varyaccording to the leverage formula and the specific characteristics of any giventransaction. This table is thus merely illustrative.

Table 1: Some Scenarios for a CPDO

Default Spread Evolution Risk? Comment

No Default Smooth and continuous increase in the

spread over the life of the transaction.

Low level The structure will benefit from an increase in

spread and is likely to trigger the Cash-In

Event before the losses to the notes can

occur. The positive effect on income is likely

to more than offset the losses associated

with each rollover.

No Default Smooth and continuous increase in the

spread of each series that may result

from a smooth pattern of downgrades

for each series.

Medium level The roll cost will hit the structure and may be

compensated by the excess spread generated

by a possible increase in leverage.

No Default Smooth and continuous decrease

in the spread

Low level The investment strategy has a positive MtM

that is likely to trigger the Cash-In Event.

No Default Sudden large increase in the spread. High level The structure cannot adapt to the new

conditions quickly enough.

Expected Incidence of Default Smooth decrease in the spread. Low level The default is likely to be hedged with the

increase in the MtM of the index.

Expected Incidence of Default Smooth increase in the spread. Low level The default is likely to be hedged with the

increased spread received by the SPV.

Wave of Defaults within

a short period

Decrease in the spread. High level The gain in the MtM of the index will not

compensate for the large number of defaults

and the decreased income.

Wave of Defaults within

a short period

Continuous increase in the spread

over the life of the transaction.

Medium level The excess spread generated by the leverage

is likely to cover a reasonable number of

defaults.

SF85982isf

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THE OUTLOOK FOR CPDOS

The CPDO is one of the newest structures to emerge within the highly innovative marketfor synthetic CDOs. In general, our view is that noteholders in these transactions aremainly exposed to spread risk and less to default risk.

The transactions that we have rated to date have been based on the European and theUS synthetic credit indices for investment grade corporates. Nonetheless, the conceptcould equally be applied to subsets of these corporate indices, to ABS indices or even toa bespoke portfolio under certain conditions.

Moody’s analysis of CPDOs is based on a two-stage simulation of credit spreads: (i) asimulation of the rating migrations of the underlying entities/obligations and (ii) asimulation of the evolution of the credit spread of a given rating category over time. Weplan to publish a Rating Methodology report in the near future that will explain in detailour quantitative approach to the rating of CPDOs, as well as our treatment of CPDOdocumentation.

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