Has the turn come to the CPDOs – Part V?

Just realized that an old quote could be recycled in the context of CPDOs, and ratings in general!!!

“The point is, ladies and gentlemen, that: ratings, for lack of a better word, are good. Ratings are right; ratings work. Ratings clarify, cut through, and capture the essence of the evolutionary spirit. Ratings, in all of its forms, ratings of life, of money, of love, knowledge — has marked the upward surge of risk tolerance and ratings, you mark my words — could had saved not only the CPDO but that other malfunctioning institution called the credit market.”- Hans Byström

The original quote was as follows:
"The point is, ladies and gentlemen, that: greed, for lack of a better word, is good. Greed is right; greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all of its forms, greed for life, for money, for love, knowledge — has marked the upward surge of mankind and greed, you mark my words — will save not only Teldar Paper but that other malfunctioning corporation called the USA."
- Gordon Gekko

Has the turn come to the CPDOs – Part IV?

Has the turn come to the CPDOs – Part IV?

Who could have guessed? The fantasy AAA-ratings of the CPDOs issued by Moody’s seem to have been based on a typo in the computer code used to compute the ratings!! According to FT (today), the ratings should instead have been four notches lower!
Again, common sense together with a basic knowledge of risks and returns in financial markets seems to have won over greed, overstretched models and naïve quants with their mechanical use of historical data.

And most importantly, I was right all along! :)

Weak covenants as a cause of lower recovery rates in the near future! – Part II

In a piece in this blog on January 8, I asked for more discussion on the issue of weak covenants in loan agreements. I am sure these things have been discussed extensively elsewhere since then but I cannot resist referring to Wilbur Ross in FT (May 2). He does not seem to think that widespread covenant-lite financing will help the typical struggling company get through the crisis alive. I agree with him fully on that! He further argues that the only new thing is who will pull the (default-) trigger. Its used to be banks (who wanted their money back), now it is instead the trade creditor. And this is done much more sudden! Sounds logical to me! As a result [my interpretation] we might see a whole lot of sudden defaults, smaller as well as larger, in 2008 and 2009. And as a consequence of the cov-lites the recovery rate might be lower than the historical average.

After the Age of Innocence comes the Age of Turbulence

Back in 2005 and 2006 the market for credit derivatives was best characterized as going through an age of innocence. Spreads were steadily declining and the volatility, albeit fairly high, was remarkably stable. There was only one smaller shock to the system and that was the crisis in the US automobile sector in spring 2005. At that time, I thought that should had been a lesson to learn from but few seemed to agree. In an article written back in 2006 “Back to the Future: Futures Margins in a Future Credit Default Swap Index Futures Market” (The Journal of Futures Markets 27 (1), 2007) I wrote

”Although the General Motors episode [of 2005] might not repeat itself, it should nonetheless be a lesson for the future; whether or not the credit environment becomes riskier over the next couple of years, similar sudden changes in CDS spreads most likely will strike the CDS index market from time to time.”

Today few would argue against the importance of an explicit focus on low-probability tail events in the credit market! Still however, I think few understand the degree of stress the credit derivatives market is under. Therefore, in my new paper The Age of Turbulence - Credit Derivatives Style [available upon request] I try to stress how extreme the movements in the credit derivatives market have become and how multi-sigma credit spread changes have become the name of the day. As an example, in July 2007, every second day saw a 5-sigma iTraxx CDS index spread change. A corresponding return history in the US stock market (S&P500) would be a sequence of 11 extreme July-returns in S&P500 of -9.1%, -6.5%, -4.1%, -3.9%, -3.4%, 3.4%, 3.6%, 4.3%, 5.5%, 7.4% and 8.6%. In July only!
Basically, I think July 2007 will be to the credit market what October 1987 has become to the equity market!