International Structured Finance

Special Report

Europe, Middle East, Africa

CPDOs: A Primer
Synthetic Arbitrage CDO

Authors1

Table of Contents

Olivier Toutain
Vice President Senior Credit Officer
+33 1 5330-1042
Olivier.Toutain@moodys.com

Overview

Definition

The Key Risks

Mehdi Kheloufi-Trabaud
Associate Analyst
+33 1 5330-5979
Mehdi.Kheloufi-Trabaud@moodys.com

The Outlook for CPDOs

Beryl Marjolin
Analyst
+33 1 5330-1065
Beryl.Marjolin@moodys.com

Additional Contacts
Anne Le Henaff
Team Managing Director
+33 1 5330-1067
Anne.LeHenaff@moodys.com
Gareth Levington
Team Managing Director
+44 20 7772-5506
Gareth.Levington@moodys.com
Yuri Yoshizawa
Team Managing Director
+212 553-1939
Yuri.Yoshizawa@moodys.com

Investor Liaison
New York
Brett Hemmerling
Investor Liaison Specialist
+1 212 553-4796
Brett.Hemmerling@moodys.com

OVERVIEW
The past few months have witnessed the emergence of a new product in the synthetic
collateralised debt obligation (CDO) market that has generated considerable interest.
These Constant Proportion Debt Obligations2 (CPDOs) have developed as an offshoot
of the credit index tranche market and represent an attempt by banks to repackage
the equity tranches of synthetic CDOs in a rated form.
Synthetic CDOs typically offer to counterparties super-senior, mezzanine and equity
tranches. In the past, the sole rated tranche has usually been the mezzanine
tranche, with ratings in a Baa to Aaa range, while the super-senior and equity tranches
were generally unplaced and unrated.3 As demand for the mezzanine tranche
increased, mezzanine spreads contracted and attention has shifted to other parts of
the capital structure. For example, super-senior tranches have been repackaged in the
form of Leveraged Super-Senior transactions. More recently, attention has turned to
the equity tranche. A CPDO is an example of such an investment in the equity
tranche of a synthetic credit portfolio
This Special Report aims to describe the mechanism behind CPDOs and the key risks
involved in such transactions.4 A future Moodys publication will describe in detail the
quantitative analysis of this product, as well as the documentation issues that may
arise.

Client Service Desk

London: +44 20 7772-5454
csdlondon@moodys.com
Paris: +33 1 5330-1047

Monitoring
monitor.cdo@moodys.com

Website
www.moodys.com

1
2
3
4

Jeremy Gluck contributed to this report as a research consultant.

Constant refers to the proportion of notional exposure associated with each name in the reference portfolio.
Only a handful of protection sellers, such as monoline insurers, have been interested in super-senior tranches.
We assume that the reader has some familiarity with credit derivatives and, more specifically, synthetic credit indices.

8 November 2006

DEFINITION
The Structure in Essence
The typical synthetic CPDO structure4 that Moodys has seen so far is depicted in
Chart 1.

Chart 1:
CPDO structure at closing date
Reference portfolio of one
or several major indices
(like Itraxx or CDX)

Total return swap with SPV as protection

seller and a bank as a protection buyer

The reference portfolio

amount is initially
set at EUR 1,500
Issuance

Deposit

EUR 100 risk free liquid investment

SPV

EUR 100 Notes

As suggested in the above chart, a special purpose vehicle (SPV) issues notes, the
proceeds of which are used to invest in non-risky, liquid assets (typically a cash deposit).
In parallel, the SPV enters with the arranging bank into a total return swap (TRS) with the
SPV as protection seller. The portfolio referenced by this TRS is that of a widely traded
investment-grade index like Itraxx or CDX, and amounts at closing to a notional
significantly larger than the outstanding amount of the notes: in our example, the ratio
of the TRS notional to the investment is 15:1. This ratio represents the degree of
leverage in the transaction. The senior risk is typically retained by the arranging bank. A
typical maturity for a CPDO would be 10 years.5
There are two key differences between the TRS and a traditional CDS:

1) The notional amount of the TRS is not held constant; rather, it is automatically
adjusted according to a formula described below.

2) The underlying reference portfolio is not fixed: instead, the portfolio changes with
each semi-annual rollover of the referenced index. The reference portfolio of the new
series of the index automatically replaces the reference portfolio of the old series of
the same index.
Each change of the notional amount (point 1) may require a payment to or from the SPV.
For example, if the leverage formula (see below) leads to an increase in the notional
amount of the swap, the bank must compensate the SPV for taking on the incremental
swap notional. Therefore, as part of its commitment under the TRS, the bank would pay
to the SPV an amount that augments the cash deposit account.
More generally, under the TRS, the bank pays to the SPV any index premium and any
gains following a partial or total unwinding of the series, and the SPV pays to the bank
any default loss due to a credit event, or a loss following a partial or total unwinding of
the series. Each semi-annual rollover (point 2) of the index normally entails such a
payment.

We focus here on single credit-default-swap (CDS) structures, but multiple CDS could be involved.

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CPDOs: A Primer

Rebalancing the Portfolio: the Leverage Formula

As described above, the flows associated with the TRS depend partly on the leverage
formula that determines the size of the TRS notional amount. The leverage formula is
fixed in the transaction documentation and is applied automatically over the life of the
transaction. While the specific leverage formulas may differ from deal to deal, they
always follow the same general principles:

The leverage is a multiple of the difference (the Shortfall) between:

The present value6 (as defined in the legal documentation of the transaction) of
all the payments owed by the SPV, including principal and interest payments on
the notes and certain fees. In addition, there may be some cushion in order to
increase the protection for investors; and

The net asset value (NAV) of all the assets held by the SPV including the
deposit account plus the mark-to-market (MtM) value of the referenced
portfolio.

Such multiple will be determined as a function of the premium income to be

earned by the SPV

At the start of the transaction, the Shortfall is positive (mainly because the discount rate
used to calculate the present value of the payments due by the SPV is usually lower than
the coupon on the notes). The SPV relies on its future income, or more accurately its
future excess spread7, to compensate for this difference.
On each day, the target leverage is determined using market data and the appropriate
formula. To limit transaction costs that may arise from daily rebalancing, the TRS
notional is adjusted only if the calculated leverage moves beyond a preset range.
Note that a rebalancing of the portfolio and the change of index series have no
instantaneous impact on the Shortfall as the change of the mark-to-market of the TRS is
compensated by a change in the amount of the risk-free collateral held by the SPV.
However, over time, these changes will likely have an impact on the Shortfall.

Cash-In and Unwind Events

We have described above the normal evolution of the CPDO. However, there are two
conditions under which the investment strategy would be fully unwound:

A Cash-In Event: when the Shortfall is reduced to zero, the swap is unwound and the
SPVs assets are given to the bank in exchange for the latters promise to pay all
future coupons and principal to noteholders. This event is defined to prevent the
SPV from taking on any more risk after it has generated sufficient value to pay off
the remaining coupons and principal on the Notes.8

An Unwind Event (or Cash-Out Event): when the NAV of the SPV (the deposit + the
MtM of the referenced portfolio) falls below a certain level in relation to the notional
of the credit portfolio (typically less than 10%), the swap is unwound and the
remaining proceeds are distributed to noteholders. This corresponds to a case
where the Shortfall has become too large.

An Analogy
To understand how the CPDO works, we can draw a parallel with a simple coin-toss
game. The outcome of the toss is either heads or tails. Heads results in a 100%
return and tails a 100% loss.
The player has an initial stake of 1000, comprised of 100 from his own pocket and 900
borrowed from a friend. At the outset his strategy is as follows: if he succeeds in
converting his stake into 2000 of winnings, he will stop and reimburse his friend, having
thus multiplied his initial investment by 11. This corresponds to the Cash-In Event.

6
7

The discount rate used to calculate present value is generally close to a risk-free rate.
In this report, we will use the words excess spread as this is a well known term in structured finance transactions. Note that the words
leverage spread could be more relevant as it would indicate that the excess cash is generated by the leveraged nature of this structure.
Rating triggers normally apply to ensure that the bank will meet its obligations with an extremely high likelihood.

CPDOs: A Primer

Moodys Investors Service 3

At the same time, his friend is concerned about his stake and thus if the player loses
more than 100, he will stop playing. This corresponds to the Cash-Out Event. (For each
toss, the player bets 1% of the difference between his current stake and 2000--the
simple rebalancing rule in our example.)
If he bets 10 from the initial stake on heads, there are two possible outcomes:

Heads: the players stake rises to 1010, so at the next round he will bet only
9.90.

Tails: he now has only 990, so at the next round he will bet 10.10.

Such a strategy is based on the notion that if heads has appeared more frequently
than expected, it is less likely to continue appearing, and similarly for tails. In other
words, the strategy is based on the concept of mean reversion.

THE KEY RISKS

Investors in CPDOs are exposed to several different types of risk:

Spread risk, as any increase in the spread of the indices will erode the value of
outstanding TRS;

Default risk, which will require loss payments out of the deposit;

Interest rate risk, through the computation of present value;

Liquidity Risk

Market risk upon voluntary early termination (for the non-buy-and-hold investor).

Spread Risk
Since the CPDO investor takes on a leveraged exposure to synthetic credit indices, the
evolution of credit spreads can significantly affect the transaction. The rebalancing
mechanism may aid the investor in coping with spread changes, particularly if spreads
tend to move in unison.9 On the other hand, the value of the swap may be adversely
affected by idiosyncratic downgrade risk, i.e. when the spread of the indices increases as
a result of a few downgrades rather than a general increase in spread. In this case, one
would not necessarily expect mean reversion to aid the investor.

Default Risk
As protection sellers, investors are exposed to default risk. However, two elements
within CPDO structures help to mitigate default risk. First, the roll of the indices ensures
on a semi-annual basis that the reference portfolio will be comprised of investmentgrade-rated entities, thus diminishing the likelihood of defaults. In addition, the excess
spread (i.e., expected income in excess of coupons and fees) offers enhancement that
can absorb the first losses in the reference portfolios.

Interest Rate Risk

Although a CPDO transaction will be exposed to changes in interest rates, the impact on
performance is muted. The present-value calculation that affects leverage is sensitive to
interest-rate levels, but the discounts applied to both assets and liabilities will partially
offset each other. The floating coupon will also be more difficult to pay as interest rates
increase; however, this sensitivity is naturally hedged by the cash deposit that accrues at
Libor.10

Liquidity Risk
Another key issue is the liquidity of the underlying indices. Although at present the credit
index markets are sufficiently liquid, Moodys will monitor the relationship between the
index market and CPDOs going forward.

10

This will tend to be the case if spreads truly follow a mean-reverting process. While market-wide spreads have indeed tended to be mean
reverting, the same cannot be expected of individual credit spreads.
In addition, in some of the transactions that we have seen, the notional invested in each index is in its natural currency, thus introducing a
foreign exchange risk in the transaction. Any change in the FX rate may impair the diversification inherent in the reference portfolio and magnify
the losses measured in the transactions accounting currency. For the CDX, the base currency is the US dollar. For the Itraxx, it is the euro.

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Market Risk Upon Voluntary Early Termination

Moodys ratings do not address the risk that an investor will suffer a loss through the
voluntary liquidation of an investment prior to the termination of the rated transaction. It
is nonetheless worth noting that the leveraged nature of CPDOs implies a high degree of
potential market risk. A change of just a few basis points in the indices can result in a
dramatic change in the value of the notes through large changes in the NAV.

Alternative Market Scenarios and their Associated Risks

The table below describes a number of different scenarios and, in each case, the
resulting impact on a typical CPDO. Note that the possible scenario impacts will vary
according to the leverage formula and the specific characteristics of any given
transaction. This table is thus merely illustrative.

Table 1:
Some Scenarios for a CPDO
Default

Spread Evolution

Risk?

No Default

Smooth and continuous increase in the

Low level

spread over the life of the transaction.

Comment
The structure will benefit from an increase in
spread and is likely to trigger the Cash-In
Event before the losses to the notes can
occur. The positive effect on income is likely
to more than offset the losses associated
with each rollover.

No Default

Smooth and continuous increase in the

Medium level

The roll cost will hit the structure and may be

spread of each series that may result

compensated by the excess spread generated

from a smooth pattern of downgrades

by a possible increase in leverage.

for each series.

No Default

Smooth and continuous decrease

Low level

in the spread
No Default

Sudden large increase in the spread.

The investment strategy has a positive MtM

that is likely to trigger the Cash-In Event.

High level

The structure cannot adapt to the new

conditions quickly enough.

Expected Incidence of Default

Smooth decrease in the spread.

Low level

Expected Incidence of Default

Smooth increase in the spread.

Low level

The default is likely to be hedged with the

increase in the MtM of the index.
The default is likely to be hedged with the
increased spread received by the SPV.

Wave of Defaults within

Decrease in the spread.

High level

a short period

The gain in the MtM of the index will not

compensate for the large number of defaults
and the decreased income.

Wave of Defaults within

Continuous increase in the spread

a short period

over the life of the transaction.

Medium level

The excess spread generated by the leverage

is likely to cover a reasonable number of
defaults.

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Moodys Investors Service 5

THE OUTLOOK FOR CPDOS

The CPDO is one of the newest structures to emerge within the highly innovative market
for synthetic CDOs. In general, our view is that noteholders in these transactions are
mainly exposed to spread risk and less to default risk.
The transactions that we have rated to date have been based on the European and the
US synthetic credit indices for investment grade corporates. Nonetheless, the concept
could equally be applied to subsets of these corporate indices, to ABS indices or even to
a bespoke portfolio under certain conditions.
Moodys analysis of CPDOs is based on a two-stage simulation of credit spreads: (i) a
simulation of the rating migrations of the underlying entities/obligations and (ii) a
simulation of the evolution of the credit spread of a given rating category over time. We
plan to publish a Rating Methodology report in the near future that will explain in detail
our quantitative approach to the rating of CPDOs, as well as our treatment of CPDO
documentation.

SF85982isf
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