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CPDOs: Where the Creators and Ratings Agencies Went Wrong


Or, free speech aside, you can't yell, "Fire!" in a crowded movie theater.


Ratings and Rating Agencies

Before going into the details of how a CPDO (Constant Proportion Debt Obligation) works, it is worth talking about what rating agencies are, and what they do. The "big three" are Standard & Poor's, a division of McGraw-Hill (NYSE:MHP)' Moody's Investor Service (NYSE:MCO); and Fitch Ratings, a joint subsidary of FIMALAC (PINK:FMLCF) and privately-owned Hearst Corporation.

I think in most cases rating agencies do a good job, yet I would never rely on them. I think their "single name" issuer ratings have had a pretty decent history. This is the part of the business where they tend to get access to management and information that isn't always generally available. They have missed some fraud (but they aren't alone in that). They have some quirks where they tend to be reluctant (in my opinion) to have companies cross from Investment Grade to High Yield. The fact that being investment grade, or high yield, or even AAA is so important, is something we need to revisit.

Before moving on to the structured side of the business, it is worth spending a couple more minutes on the corporate side. What is the rating of a holding company versus an operating company? What is the difference in rating between senior secured and unsecured debt? Such simple questions have no simple answer.

All of the rating agencies attempt to rate "probability of default" rather than "probability of loss" for their corporate issues. They can argue that holding companies are more likely to default than operating companies, or that secured debt is less likely to be defaulted on. Many investors like the secured debt of junk bond issuers (leveraged loans) because they feel the rating precludes a lot of other investors from buying, but that the rating overstates the risk if the collateral is good. I'm not sure there is a right answer here, but the distinction of what they are rating becomes apparent as soon as you move into the structured world.

In the structured ratings world, most ratings are tied to probability of loss. Various scenarios are run including expected loss and stress loss, and those calculations are mapped to a rating. It is very methodical, generally conservative, process. However, loss severity plays a key role in the rating of structured debt versus its corporate counterpart. It's worth noting because it highlights the general differences between structured ratings – mechanical based on no specific additional knowledge, and corporate ratings – personal and subjective with additional company-specific knowledge.
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