That CPDO thingie again

A couple of years ago, Guambat began to take note of some of the credit instruments that were being concocted by financial wizards, named like alphabet soup. CDOs, CDSs, CPDOs and the like were all the rage.

Creating these things had a circus air about it as the market's marketeers drove these things higher and higher, into the stratosphere and, yes, walked blind folded, carrying frightened kittens, over the chasms between the buildings on Wall Street and Fleet Street. Why, you could hear the band play, the men hoot in admiration, see the children hide their eyes and the clowns, always the clowns, whipping up the enthusiasm.

Guambat doesn't and didn't know a toot about how these things were assembled or meant to work, but the hoopla over them seemed mighty darn peculiar. Like the smaller crowds around the snake oil salesmen in the side carnivals following the circus.

Of the CPDO, for instance, he said, incredulously, "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".

Trying to understand those things, he turned to Felix Salmon, who, safe to say wishes he hadn't, said, "The whole point of AAA debt is that it doesn't default, even "in the context of a widespread credit event"."

Of course, Felix began backing off that high wire act almost immediately, saying, "John Dizard at the FT helps to clarify further just how these newfangled CPDO thingies work.... In other words, I was wrong."

Which is not to punch up Felix, but merely to illustrate that even a critical thinker as he could get caught up in the financial glamouratory of the moment. It's like an engineer creating something that shouldn't exist and won't work, but is enchanted by how his elegant contraption looks simply because, in the first case, he could piece it together, and, more importantly, some other fool would buy it. Like the US automobile industry since the 1960's.

In the event, Guambat was persuaded by Steve Waldman and not Felix Salmon, who also came to accept his arguments, which makes this blogging stuff just that more interesting. Steve said,

When banks use novel structured products to take on more risk than bank regulators anticipated [and declined to regulate, Guambat might add, when finally forced to anticpate], I am being forced to take that risk.... I bother to write about this stuff not because I am interested in the arcane details of a structured credit designed especially for bank investors. I write because I think the game is going awry, the odds of systemic crisis at the collapse of a credit bubble are growing, and CPDO-based regulation skirting is the latest little crack in the dam.

And like a mad-engineer's faulty bridge, the "structured credits" that the financial houses built and sold and packed our retirement funds with were riddled with fault: design fault, construction fault, and put to faulty uses under faulty representations.

Which brings us to this story of the latest collapsing bridge.

Trouble for Banks, Insurers May Lurk in Synthetic CDOs

Even as some lending markets begin to recover from last month's demise of Lehman Brothers Holdings Inc., the securities firm's default -- together with those of other U.S. and European banks -- is causing new dislocations in the multitrillion-dollar market for complex investments known as synthetic collateralized debt obligations.

As opposed to regular CDOs, which contain actual bonds, synthetic CDOs provide income to investors by selling insurance against debt defaults, typically on a pool of a hundred or so companies or individual bonds. Given the size of the market, synthetic CDOs can have a large impact: By various estimates, they have sold insurance on the equivalent of between $1.25 trillion and $6 trillion in bonds.

The problems with synthetic CDOs stem in part from the way they were made. In many cases, the banks that created the CDOs stuffed them with companies, such as Lehman and Iceland's Glitnir, that paid the highest possible return for their top-notch credit ratings. That made the CDOs more attractive, but also riskier, because they contained companies that the market perceived as more likely to get into trouble.

When investors attempt to get out of synthetic CDOs, they push up the cost of default insurance. That, in turn, raises the cost of borrowing for companies, which use the cost of default insurance as a guide when deciding what interest rate they must pay on new bonds.

That could mean trouble for banks, hedge funds and insurance firms around the world, which used synthetic CDOs as a way to invest in diversified portfolios of companies without actually buying those companies' bonds. Many synthetic CDOs contain a heavy dose of exposure to financial companies, including Lehman, U.S. thrift Washington Mutual Inc. and recently nationalized Icelandic banks Glitnir Bank hf, Kaupthing Bank hf and Landsbanki Islands hf.

As a result, the users of synthetic CDOs are facing a wave of credit-rating downgrades and outright losses, which are coming to light gradually as ratings firms pore over hundreds of individual synthetic-CDO deals.

Dealers are offering about 50 cents on the dollar or less for some pieces of synthetic CDOs that used to be rated triple-A, according to one trader. That is down from about 60 cents on the dollar only three weeks ago.

Perhaps the weakest link in the market are specialized funds, known as "constant-proportion debt obligations," that work much like synthetic CDOs but with one important difference: They use borrowed money, or leverage, to boost the returns they can provide for investors, a strategy that also magnifies losses.

CPDOs, for example, typically borrowed about $15 for every dollar their investors put in. They also contain safety triggers that force them to get out of their investments if their losses reach a certain level. Analysts estimate that most CPDOs reach those triggers when the cost of default insurance hits about the level where it is now.

Other specialized funds, known as "credit derivative product companies," borrow as much as $80 for every dollar invested, according to a recent report from Citigroup Inc.

If those funds are forced to exit from their investments, it "could wreak havoc on the marketplace," Citigroup analysts wrote in the report.

Note that the market already wreaks of havoc.

And would sir care for more havoc with your havoc?

And for a final word on this faulty engineering of structured debt and other financial wizardry, Guambat notes that one of the most Merlynesque of the wizards, KKR's Henry Kraviz, recently said "Financial engineering is no longer viable".

Mind you, he didn't say it is or ever was faulty. He is just saying it is harder to make money now that people are paying more attention and debt is paying such higher rates of interest that such shenanigans are not "viable". That is, he just can't make as much easy money off the chumps as what he is used to doing.

Nevertheless, the WSJ was impressed at what passes in that world for "frankness", even if of the disingenuous sort:

It was a startling admission for a buyout king. Private-equity dealmakers normally wince when accused of making billions through mere financial sleight-of-hand. They create value, they say, by identifying companies with untapped potential, taking them private and revamping their operations.

But Mr. Kravis acknowledged an open secret of the buyout business: In the go-go years these firms made a chunk of their profits through quick flips and maneuvers such as "dividend recapitalizations" -- taking big cash payments out of the companies they owned by paying themselves a fat dividend. These payments totaled $51 billion in 2006 and 2007 combined, according to Standard & Poor's. They have now disappeared, with only $1.2 billion in dividend recaps year to date.

Staring in the face of a deepening recession, private-equity firms are now engaging in financial machinations of a different sort. Where once the game was about stripping cash out, now it is all about hoarding cash in portfolio businesses to keep them alive.

But their engineering tools have not been laid down:

Some companies are buying back their own debt at a discount to cut their interest bills. In other cases, companies are conserving cash by exercising options on so-called "payment-in-kind toggle" bonds that allow firms to pay interest in the form of new debt rather than cash.