The strange and the completely predictable

Two facts. It is with no shock whatsoever that I report that Moody's has made yet another stuff up in CPDO modelling.

What is bizarre, though, is that someone at the FT seems to know what a copula is. See here for both.

Keys not judgements

What were the ratings agencies doing really? Frank Portnoy writing in the FT, tells it like it is:

the rating business has shifted from providing information to selling “regulatory licences”, keys that unlock financial markets. Consider Constant Proportion Debt Obligations, the financial Frankensteins that the agencies’ flawed mathematical models said were low-risk. Does anyone believe parties paid for triple A ratings of such instruments because those ratings gave them valuable information? More likely, ratings were valuable because they permitted investors to buy something triple A-rated that paid 20 times the spread of other triple A-rated instruments.

In other words ratings can only really be objective when they are not used for anything. The SEC has already removed reliance on ratings from many of its rules, but I am not holding my breath waiting for Basel to do the same. However sensible an idea it might be, I doubt regulators are willing to admit how ill-conceived the Basel credit risk rules really are.

About that model risk

On Monday I said:

The combination of leverage and complexity is a massive concentrator of model risk

By Wednesday we find in the FT:

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...after a computer coding error was corrected, their ratings should have been up to four notches lower.

The product was CPDOs. But that doesn't matter. This kind of thing will happen with leverage and complexity. A bug in the ratings model for French yoghurt companies might change the rating of Danone by one notch. But for structured stuff, it's likely to be a much bigger error.

Never mind the quality, feel the fees

Oh to be a litigator today. There are so many delicious cases to sate yourself on. Should you take on one of the 'significant legal challenges which will hold up the resolution of the monoline issues for years'? Sue the State of New York perhaps, or something in Wisconsin? Or maybe you want to represent CPDO investors in a suit against the banks who ran them, the ratings agencies who rated them, or both? With the current deleveraging, these cases may well be filed soon. Or perhaps you fancy having a go at Citigroup over their suspension of hedge fund redemptions? Then of course there are the hedge funds who own significant positions in Northern Rock. And that's just one day's news.

Update. A nice take on subprime-related litigation is here.

CPDO: Endgame

The end of some of the CPDOs nears. I did hint earlier that a yield of Libor + 200 implied that they were not AAA securities, and indeed it turns out that, once again, straightforward beta rather than alpha was the cause of the return. Anyway, Bloomberg reports:

ABN Amro Holding NV clients face 90 percent losses on two credit derivative products totaling 120 million euros ($176 million), according to Moody's Investors Service.

The so-called constant proportion debt obligations have seen their net asset value fall to 10 percent, meaning they will have to unwind, or ``cash-out,'' Moody's said in an e-mailed statement today.

Leveraging up as spreads widened didn't turn out to be such a good idea after all then. Of course, investors in the ABN product were unlucky with the size of the moves experienced:

Credit-default swaps on the Markit iTraxx Financial index of 25 European banks and insurers soared to a high of 84 basis points this week on concern credit rating downgrades at bond insurers including Ambac Financial Group Inc. and MBIA Inc. will cause bank losses to surge. The index traded as low as 20 basis points in November.

Still, given that a number of commentators thought the CPDO was a really bad idea when it launched (see for instance here or here), you can't say no one said I told you so.

Finally, perhaps in the bolting the door after the horse has run away category, I leave you with a link to a paper on Rating Criteria for CPDO Structures. It may be that this is of purely historical interest.

Yes my CPDO is burnt

Completely predictable news of the week from the FT:

Moody’s [...] said on Monday that eight financial-company focused constant proportion debt obligations (CPDOs), most of which are currently rated AAA, had been put on review after their net asset values had been hurt by credit-market volatility.

[...]

Two of the deals facing downgrades are from ABN, the other six are from UBS.

Obviously ABN (the inventor of the CPDO) has had a certain amount of stick about this: see for instance Mark Gilbert who points out

One of the ABN CPDOs, called Chess III, went on sale in July priced at 100 percent of face value with that golden Aaa rating. This week, it was worth about 41.5 percent of face value, according to ABN prices.

So why hasn't it been downgraded already?

Anyway, apparently

The UBS deals were the first to face downgrades in the late summer and had all been either downgraded or restructured in September.

So some of these deals have been restructured once already and they are on review for the second time in four or five months. Impressive, huh?

Update. Moody's did the decent thing on the UBS deal according to Alea and downgraded it from AAA to C. In one go. Because, you see, investors have taken a 90% loss. That's the kind of risk you get in AAA investments. Oh yes.

It's all about funding baby

From the FT:

Standard & Poor’s issued a string of downgrades and negative watch notices on a number of SIV-lite programmes late on Tuesday night.

SIV-lites, a type of collateralised debt obligation that rely on short-term commercial paper to fund senior debt, have come under intense pressure due to falling values in their investments combined with a liquidity crunch in commercial paper markets.

“A vast majority of the portfolio of each of these market-value structures is invested in US mortgage securities,” S&P said.

A few things are becoming clearer. Firstly isn't it amazing the number of structures that have MBS in them? I guess you can think of CDO of CLO paper as a Libor floater, but putting in a money market fund is just bizarre. Putting some in a SIV makes more sense, but weren't SIVs meant to be diversified? Having a vast majority of your funds in anything is not diversification.

Secondly it's fascinating that the price of liquidity is such a dominant factor at the moment. No one much cares if these structures are ultimately money good. What is hurting is how much it is costing to keep them afloat in the current liquidity market. This makes ABCP look like a much worse idea now that it did a couple of months ago.

Finally this is so predictable it is deeply amusing:

Meanwhile, Moody’s said a constant proportion debt obligation run by UBS had been hurt by falls in net asset values and put it on review for possible downgrade.

I'd be interested to know how ABN's CPDO structures are doing...

Update. According to Bloomberg, CPDOs Rated AAA May Risk Default, CreditSights Says. In the immortal words of my friend Sue, no shit Sherlock.