I wish I'd never followed this thread

Having started down this CPDO path, Guambat doggedly - no guambatedly - tracks along behind, no thanks but full credit to Felix Salman, who has carried the story all the way.

His latest explanation of it is that, near as Guambat can understand, which is like Saskatchewan being near to Tierra del Fuego, the CPDO is a ten year triple-A bond paying LIBOR plus 200 bps which bowls strikes every time yet goes down the lane sort of like those wonky pet toys which roll haphazardly around the floor to amuse bored pussies.

Says the Economonitor:

A CPDO is rated AAA, and all that means is that there's an extremely high (greater than 99.2%, or thereabouts) chance that all the coupons and the principal of that particular issue will be paid in full and on time. The amount of money in the structure can decline precipitously, to well below the amount of money that needs to be repaid at final maturity. But so long as the interest and principal payments are made, there's no default. [Well at least Guambat understands that last sentence.]

The CPDO has promised to pay out a certain coupon, and then par at maturity. The combination of spread widening and coupon payments is damaging to the value in the CPDO, which can drop significantly. But even if spreads gap out from 40bp to 190bp, the instrument still makes its money back by maturity. There's volatility along the way – and the CPDO certainly couldn't issue new triple-A debt at say year two, as a plain-vanilla triple-A issuer like France can. So a CPDO is not, and does not pretend to be, a proxy for other triple-A debt. But if you buy your CPDO, go to sleep, and then wake up in 10 years' time, you can be very confident that all your coupon and principal payments will have arrived in full and as scheduled.

All of the criticism of CPDOs misses the really clever thing about them: the fact that, contrary to what many commentators are saying, they're largely immune to corporate defaults. If a lot of investment-grade companies suddenly were to start defaulting, that would be very bad for the markets, and spreads would widen. But as spreads widen, so does the income on CPDO structures. So one of the only ways to break a CPDO is for there to be a lot of defaults along with spread tightening. Which is something I'm happy to bet will never happen. (Remember we're talking about investment-grade defaults here: think Enron. They happen, but they're not very common. And there would need to be a lot of them in a very short time, since CPDOs incorporate 250 different credits.)

A CPDO which starts out with 15x leverage is not intended to stay at 15x leverage for long. If things stay relatively normal, the CPDO will end up in risk-free securities with no leverage relatively quickly. On the other hand, if things go to pot, then the CPDO will have to keep that leverage for longer in order to make all of its scheduled payments. That's why it has a ten-year maturity: to be very safe on that front. The large leverage doesn't only increase the coupon rate; it also increases the amount of losses that the structure can recoup.

It's true that a triple-A security paying 200bp over Libor seems a bit unnatural; it's also true that with leverage often comes increased risk. But those are just lessons learned from experience. Maybe the experience of CPDOs will help to change those lessons.

Are we clear on that?