First Generation CPDO: Case Study on Performance and Ratings

by Alexandre Linden of Derivative Fitch (London),
Matthias Neugebauer of Derivative Fitch (London),
Stefan Bund of Derivative Fitch (London),
John Schiavetta of Derivative Fitch (New York),
Jill Zelter of Derivative Fitch (New York), and
Rachel Hardee of Derivative Fitch (Hong Kong)

April 18, 2007

Introduction: Constant proportion debt obligations (CPDOs) are one of the latest product innovations seen in the structured credit markets. Like other more recent structured credit products, the performance of the issued debt obligations is highly dependent on the mark-to-market (MtM) impact of changes in credit spreads. Credit risk as measured by defaults and recovery rates becomes secondary. The market value of the exposure is typically driven by the credit default swap (CDS) premium to be paid for protection on a portfolio of names with credit risk, or a credit index such as iTraxx or CDX.

However, as opposed to traditional structured credit products such as collateralized debt obligations (CDOs), the term "structured" does not refer to the liability side of the issuer, where debt is structured to allocate risk and proceeds in a senior-sub structure, but rather to the asset side where structuring happens by way of increasing or decreasing the exposure dependent on the spread development of the referenced portfolio. Consequently, in most cases there are no "traditional" equity or mezzanine investors to absorb any losses in the transaction arising from spread widening or actual defaults, but it is the sole and hence senior investor in a CPDO who is exposed to the full leverage of the deal.

Fitch has been asked to rate numerous first generation CPDOs, defined as those utilizing 15x initial leverage and referencing "on the run" the investment grade (IG) CDS indices for 10 years. The key performance parameters for these traditional CPDOs are spread volatility, roll-down benefit (RDB), bid/offer levels and, to a lesser degree, default risk. In the context of its rating analysis, Fitch has carried out intensive research into these parameters that can influence the performance and hence the achievable rating of CPDOs. The findings of this research are as follows:

• First generation CPDO transactions' performance and ratings are sensitive to even a minor amendment of the key performance parameters.
• The sensitivity of a CPDO rating towards change in assumptions increases with higher rating levels and easily leads to rating changes of several categories.
• The leverage employed contributes to the sensitivity to key performance parameters and potential ratings instability.
• Comparison to corporate CDOs showed that they are more robustly structured against worst case scenarios than CPDOs at a comparable rating level.
• Changes to the credit markets, new market participants and the rapid growth of the CDS market may lead to greater spread volatility than experienced historically.
• Scenario analysis through historical back testing showed that many of the more common CPDO structures would probably not have been able to withstand high investment grade stresses.
• As opposed to the 10-year tenor of a CPDO, data on the key performance parameters is only available for a little more than four years.
• For these reasons, first generation CPDOs do not achieve high ('AA'/'AAA') investment grade ratings.
• Second generation CPDOs improve on shortcomings of the first.

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