CPDOs (constant proportion debt obligations) are in the news currently. In spite of a judge describing a CPDO issued by ABN Amro as ‘grotesquely complicated’ the basic concept behind the instrument is pretty straightforward. This article describes the strategy behind a CPDO at a high level.
Overview of a CPDO
A CPDO is a financial instrument issued by a bank that a sophisticated investor can invest in. To the investor CPDOs behave like bonds that pay a higher rate of interest than similar instruments issued by the bank. So the investor gives the bank some money for a certain period, usually several years. The bank pays a high rate of interest throughout the period and, in theory, gives the money back at the end.
To achieve this higher rate of interest the bank effectively speculates with the money they are given. They speculate in quite a distinctive way, however.
The Basic Strategy – Sell CDS Protection to Generate Income
The first thing the bank does is to invest the money the investor has given them in something that will pay them the normal rate of interest. If that was all they did obviously they would not be able to pay the high rate of interest to the investor.
So the bank needs a way of generating extra money. To do this they use CDS. I have written an earlier article on the exact mechanics of CDS, but you don’t need to know the details to understand CPDO. What you do need to know is that CDS are like insurance contracts: if you sell protection on a CDS you receive periodic payments in return for a small chance that you will have to pay back a much larger sum. You pay back the larger sum if the a specific company gets into financial difficulty: this is known as a ‘credit event’ or ‘default’.
Note that the banks actually use CDS indexes in CPDOs, which are CDS on a basket of companies rather than one company. However the idea is the same.
The basic strategy is that at the start of the period the bank sells enough CDS protection to easily generate enough money to pay the high rate of interest to the investor for the period of the investment, assuming there is no need to pay anything back because of defaults. The bank works out how much protection to sell using a set of rules that are defined in the CPDO documentation.
Once they have done that they leave everything alone for a while. After a set period of time they look at how the CPDO is doing. At this point they may change the amount of CDS protection they are selling. This is known as ‘rebalancing’.
The CPDO may be doing well: none of the CDS may have had credit events, for example. In this case the bank might reduce the amount of CDS protection they are selling.
Conversely some of the CDS in the CPDO have suffered defaults. It may be that the amount of CDS that have been sold will no longer be enough to generate the money needed to repay the investor. In this case the bank might increase the amount of CDS protection they are selling.
The bank will do this rebalancing periodically throughout the life of the CPDO. It is usually done every six months to coincide with the dates that the CDS indexes are updated.
Note that all of this is done according to the set of rules that are defined in advance: it’s not a judgment call. The rules can look fairly complex. However all they really do is describe a way of calculating ‘leverage’, which is the value of the money to be received from the risky CDS contracts outstanding versus the amount of cash they need to generate, maybe multiplied by a fixed factor. The bank will try to keep the leverage constant at every rebalancing: if the amount of cash to be generated has increased (because there have been defaults) then the value of the money from the CDS contracts needs to be increased, so we enter into more contracts.
Possible Results of the Strategy
The aim, of course, is to generate plenty of money through this speculation in CDS. The ideal is to generate so much money that it can all be invested in relatively riskless instruments and still pay for the cashflows on the CPDO. At that point you don’t need to speculate any more: you can ‘cash in’ the CPDO.
An alternative is that you lose so much money from paying out on the CDS that you get to the point where it’s clear you won’t be able to pay the interest rate and principal on the CPDO. The rules governing the CPDO usually define this ‘cash out’ point: when it is reached the structure will be unwound and the bank will pay what money is left back to the investor.
A final alternative is that the ‘cash in’ or ‘cash out’ points are never reached, but and the CPDO just expires but without sufficient cash to repay the investor in full.
Those of you who are familiar with gambling will recognize this as a simple martingale strategy. If you lose you increase the amount you are betting. This is in the hope that you will win next time and get all your money back. Of course if you lose again you can increase the amount you are betting again, but you run the risk of losing substantial amounts of money.
Effects of Market Moves
There are a few other points to notice about this product:
- The best case for the investor is to get the high rate of interest on their investment and all of their money back. The CPDO is not speculative in the sense that the investor can make better returns if the market moves favourably.
- The investor is selling protection in the credit markets. The CPDO will lose money when companies get into financial difficulty. If many get into financial difficulty simultaneously the CPDO may well suffer large losses. This means the investor will not get much of their money back. Of course, that’s exactly what happened with many of these instruments.
- It’s possible to structure a CPDO such that in normal market conditions there is a good chance that the CPDO will cash in. If the bank is simply trying to get a little bit of extra interest by speculating in CDS over a long period of time then they might usually win their bet.
- I’ll leave it to the reader to decide whether this is really a product that anyone should have been ‘investing’ in, AAA-rated or not.
This article has given a very high-level overview of CPDOs. It has inevitably glossed over some details, but hopefully it explains the basic idea.
CPDOs were invented in the credit boom, and when the crash came they lost many people a lot of money. I doubt we shall see them again any time soon except in lawsuits.