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Thursday, September 06, 2007

MMI: From the Department of You Call This Insurance?

by Tanta on 9/06/2007 07:43:00 AM

This CPDO thing is a great test of whether media reports make any sense, because they have nothing to do with mortgages or any other form of consumer debt or any gems of Western Literature or seventies rock classics. Therefore I know nothing about them except what I read in the papers.

According to Bloomberg,

Constant proportion debt obligations use credit-default swaps to speculate that a group of companies with investment- grade ratings will be able to repay their debt. A wave of credit rating downgrades for investment-grade companies may cause losses that CPDOs would struggle to recoup, CreditSights said in a report entitled ``Distressed CPDOs: We're Doomed!''

``If you assume defaults and downgrades come in bunches rather than being evenly spaced out, CPDOs' default rates are more what you would expect for low junk ratings than for triple- A,'' David Watts, a CreditSights analyst in London, said in a telephone interview yesterday. . . .

CPDOs were first created last year by banks ranging from Amsterdam-based ABN Amro Holding NV, the largest Dutch lender, to New York-based Lehman Brothers Holdings Inc. . . .

The securities earn an income by selling credit-default swaps, a type of insurance contract that pays a buyer face value if the borrower can't meet payments on its debt. CPDOs typically provide debt insurance on a basket of 250 investment-grade companies by using the benchmark CDX North America Investment- Grade Index and the iTraxx index in Europe. The indexes rise when credit quality deteriorates.
OK, that all more or less makes sense, I guess. It's a big world, so there would have to be some people who would take the other side of a bet on whether investment-grade companies will pay their debts. But then:
Moody's and S&P assign their top credit ratings to CPDOs because of rules designed to ensure they never have to pay a debt insurance claim.
Ooooh Kaaaay. Can someone help me with the economic purpose of a form of insurance that involves rules that insure that claims never have to be paid? Of course we all love a good risk-free investment, but, um, who buys this "insurance"? Why? Have we just stumbled onto a major problem with our finance-based economy, or should I just go back to bed?