AAA rated Credit Deriv. have same default risk as junk

[luso]

CPDOs Rated AAA May Risk Default, CreditSights Says (Update1)

By John Glover
Sept. 6 (Bloomberg)
-- Credit derivatives awarded the top ratings by Moody's Investors Service and Standard & Poor's may be as vulnerable to default as high-risk, high-yield bonds, according to independent research firm CreditSights Inc.
Constant proportion debt obligations use credit-default swaps to speculate that a group of companies with investment- grade ratings will be able to repay their debt. An increase in credit rating downgrades for investment-grade companies may cause losses that CPDOs would struggle to recoup, CreditSights said in a report entitled ``Distressed CPDOs: We're Doomed!''
``If you assume defaults and downgrades come in bunches rather than being evenly spaced out, CPDOs' default rates are more what you would expect for low junk ratings than for AAA,'' David Watts, a CreditSights analyst in London, said in a telephone interview yesterday.
Investors and lawmakers have criticized Moody's and S&P, the two biggest ratings firms, for assigning their top Aaa or AAA grades to securities including those backed by U.S. mortgages, and failing to issue downgrades before prices plunged. U.S. Senate Banking Committee Chairman Christopher Dodd last month said credit rating companies must explain why they assigned ``AAA ratings to securities that never deserved them.''
Felicity Albert, a spokeswoman at S&P, and Moody's spokesman James Overstall, both in London, declined to comment on the CreditSights report.
Declining Value
CPDOs were first created last year by banks ranging from Amsterdam-based ABN Amro Holding NV, the largest Dutch lender, to New York-based Lehman Brothers Holdings Inc.
Banks set up at least $4 billion of CPDOs, promising annual interest as high as 2 percentage points above money-market rates.
The securities earn an income by selling credit-default swaps, a type of insurance contract that pays a buyer face value if the borrower can't meet payments on its debt. CPDOs typically provide debt insurance on a basket of 250 investment-grade companies by using the benchmark CDX North America Investment- Grade Index and the iTraxx index in Europe. The indexes rise when credit quality deteriorates.
Moody's and S&P assign their top credit ratings to CPDOs because of rules designed to ensure they never have to pay a debt insurance claim. The securities only reference investment- grade companies, ranked Baa3 or higher by Moody's and BBB- by S&P, and replace the contracts every six months when the indexes ``roll'' to weed out any companies cut to junk.
Dropping Out
The CPDO model is being challenged as worsening perceptions of credit quality reduce the value of the credit-default swap contracts included in the securities. Those CPDOs that provided insurance on the 125 companies in the CDX index in March for a premium of 36.75 basis points, or $36,750 for every $10 million of debt, will have to pay nearer 70 basis points to end the contract when the index rolls on Sept. 20, based on current prices.
To make matters worse, the CPDOs are likely to earn a lower premium on the new CDX Series 9 index because the credit risk will be lower as the downgraded companies drop out. At least five companies in the CDX and iTraxx indexes have lost investment grade ratings and will have to be replaced, according to Watts.
Without the downgraded companies, the new CDX index may be priced 11 basis points tighter than the current benchmark, JPMorgan Chase & Co. analysts led by Eric Beinstein in New York said in a report published this week.
Prices of CPDOs dropped to as little as 70 percent of face value last month.
``The removal of those five to eight names could cause spreads to tighten by more than CPDO models anticipated,'' said Watts. ``Even a relatively small number of downgrades in each index series means CPDOs will suffer and their ability to repay par at maturity will be far from certain.''
-- With reporting by Shannon D. Harrington in New York. Editor: Serkin (ajr)
To contact the reporter on this story: John Glover in London at johnglover@bloomberg.net
Last Updated: September 6, 2007 07:45 EDT

 

[bob]

I find this hilarious. A beautiful example of a feature sold as decreasing the risk of a product actually increasing it.

 

[DominiConnor]

Indeed.
I think the point is that a rating of "AAA" or any other grade is basically a snapshot, not a long term commitment. As a headhunter I will have to tell you that that the pay for people working at a ratings agency is massively lower than the quants at a big bank or hedge fund.
It is not that unusual for the people creating the Credit instrument to be earning 10 times that of the people whose job is to vet their work.
I'm not saying that ratings agency people are dumb, but this is not a fair fight.
Working for a ratings agency can be a good career move to learn stuffl, but with a view to move to the other side of the fence.

 

[naeron]

The compensation comparision mentioned above DOES NOT REFLECT ANY POINT for the current status of the rating agencies. No matter how much you are paid , I DONT BELIEVE that it has anything to do with "how one will rate the bonds" at employee level. I think that discussion in the last reply is not relevent to the topic.

 

[SteveTownsend]

The compensation comparision mentioned above DOES NOT REFLECT ANY POINT for the current status of the rating agencies. No matter how much you are paid , I DONT BELIEVE that it has anything to do with "how one will rate the bonds" at employee level. I think that discussion in the last reply is not relevent to the topic.

I disagree w the statement that this is not relevant. It's also relevant in my view that rating structured products is hugely more profitable for the agencies than handling vanilla bond ratings.

The agencies are de facto regulators who are paid for their work by the regulated bodies, viz. the banks that create these products. And now here we are.

 

[naeron]

Yes its not relevent at the employee level. and this is even more malicious if they are not paying employees much from the revenues generated from rating structured finance securities...