Unlevered High-Risk Debt vs Levered Low-Risk Debt

Alea has found

a tantalizing tidbit from Anthony Morris of UBS, as reported

by Reuters. Apparently CPDOs – structured products which pay high

interest rates on triple-A-rated securities – might have been put together

rather shoddily, at least in the early days:

"We think that early CPDOs, the ones that were introduced last summer

and fall, have a very fundamental problem with them," said Anthony Morris,

executive director in structured products research at UBS on a conference

call on Monday.

"Get out of early CPDO products, I wouldn’t touch them with a 10-foot

pole," Morris said. However, deals backed by higher rated credits have

a lot of value, he said…

If the assumption that "BBB"-rated credits mean revert were taken

out of the ratings models, the deals would be rated 10 notches lower, or an

"AA"-rated deal should be rated "B-plus," four levels

below investment grade, he said.

Morris’s argument is hard to understand from the Reuters precis – if

someone has more detail on its substance, I’d love to see it. But it certainly

fits in to the narrative we’ve been seeing a lot of, recently – the idea

that if you apply finanial voodoo to low-rated debt and end up with high-rated

debt, then those high ratings are not to be trusted. Indeed, Reuters goes on

to quote Morris as making this astonishing assertion:

Leveraging an "A"-rated index by 10 times would still be less volatile

than taking an unleveraged position to high yield credits, or to stocks, he


Isn’t leveraging A-rated debt by 10 times exactly what the more highly levered

of the two Bear Stearns funds did, to disastrous effect? No one invested in

the stock market has seen their position wiped out. Meanwhile, the ABX-HE-A

07-1 index, which reflects the default risk on A-rated securities, has fallen

from 100 at the beginning of this year to 53.67 now. If you invested in that

at a leverage of 10 times, you would have lost 4.6 times your original investment

by this point.

As for the early CPDO products, I’m not convinced. Morris might be right that

some of the calculations assume that BBB-rated default risk mean-reverts. But

if it doesn’t mean revert, then all that’s going to happen is that spreads remain

tight, and losses in credit markets will be very small indeed. Remember that

in order to break a CPDO, you need the very weird combination of tight spreads

and high default rates. And so far, default rates remain at all-time


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