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!''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:
``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.
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?