I really shouldn't be doing this now.

What with my CPDO arch-nemesis off communing with the penguins, it seems downright ungentlemanly. And I really ought to be working for the man, you know, the one who actually pays me, just now.

But there were some particularly interesting comments to some of the recent posts on CPDOs, and I thought them worth highlighting.

Responding to an earlier post, commenter P. K. Koop notes:

...I would expect the barrier implicit in the 15X leverage limit to act as a target or safety net for those trading against the CPDOs.

This reminded me of an interesting post from Cassandra Does Tokyo, "Amaranth: Was It The Market?":

But there is a... possibility that is understandably NOT discussed in the mainstream media, but surprisingly is not discussed in the trade press either. And this is the possibility that [Amaranth's] clumsy and quasi-public long Natty position was the subject of predatory trading by those with material non-public information about the Fund and it's positions...

Roger Lowenstein's account, When Genius Failed reconstructed the scenario pretty well. Essentially, if you're very leveraged, once someone sees your positions, you're a target. Hillenbrand was seemingly the only one who really understood this risk. He made sure they used multiple Prime Brokers, swapped positions between leverage providers to insure no one saw the full extent of their leverage or their positions. If one cannot be certain as to whether one has an offsetting position at another shop, the risk-reward equation for "gunning" is greatly reduced. After LTCM started to take a hit, and needed either new capital or bigger lines, anyone who might supply the credit that was needed also needed to see "the position". All the Positions. He fought it, but there was recourse, and that was the precise point at which Hillenbrand knew they were dead.

Suppose that ABN's pioneering CPDO issues grow popular and are widely emulated, as investors snap up what seems to be no-risk extra yield. Suppose also that the imitators are not innovators, that they all adopt the same basic strategy in structuring their instruments. Then won't CPDO-owners collectively be something like a large hedge fund whose portfolio, strategy, and response to changing market conditions is fixed and published in advance? If so, what would prevent other funds from taking advantage of the information assymmetry to intentionally break these structures?

It wouldn't be cheap, and it wouldn't be easy. But it might be possible. If so, we'd have an illustration of the signature irony of finance, what Patrick Hynes and David Post have dubbed the "reverse tinkerbell effect". The fact that so many people believe the rating agencies' models will have created the conditions under which those models prove to be unreliable.

The wisest commenter on the internet, the prolific "Anonymous", made an interesting point in response to one of Felix Salmon's posts:

If AAA covers all bonds with a default probability below X, "natural" AAAs will be randomly distributed within the range while synthetics will likely be skewed upwards toward X because the banks have more choice in achieving a rating than governments or corporations. There is some evidence that synthetics have higher default rates than similarly rated naturals. It's a bit like Goodhart's law.

Goodhart's Law could be considered an application of the reverse tinkerbell effect. Anonymous' observation is a financial analog to this recent result regarding political-science academia. [Okay, that's a blogging of the result. The original paper is here.]

Some other CPDO links:

• CPDO For Dummies on the excellent Alea.
• Mark Gilbert at Bloomberg is much harsher than I was: CPDOs Are Derivatives Market's New Alchemy Trick
• A nice Financial Times article: Questions lie behind CPDO hype
• More from the FT, fairly harsh: John Dizard: Challenging nature's forces [Hat tip: Felix Salmon]
• A very insightful thread on Wilmott [Hat tip: P. K. Koop]
• A very insightful thread on NuclearPhynance
• An ABN-AMRO presentation of a CPDO product. [Hat tip to commenter Holmes on the NuclearPhynance thread above]

Relevant to nothing: Last week while I was writing about CPDOs, the other project I was working on rhymed. With CPDO. Not so easy.

Chris Dillow asks, "Why is protectionism popular? The answer is the title, and perhaps I should leave it at that.

But no. I have a reputation for verbosity to protect.

First, the current incarnation of free trade is coming under pressure not because people are stupid, but because people are smart. The publics in countries like the United States and Britain have been remarkably tolerant of free trade over the last two decades, because the policy-relevant public "gets it", has been persuaded by economists from Ricardo on down that free trade is a positive-sum good thing. The arguments for protectionism that Chris catalogs are old tropes that we had almost managed to put behind us.

I've done no study, but here's a conjecture: The countries where protectionism is becoming popular are those with both growing current account deficits and shrinking tradables sectors. A shrinking tradables sector is not the same as a declining industry. Declining industries are normal and good. Even the near extinction of manufactures as a whole is okay. But a shrinking tradables sector is not. A shrinking tradables sector means a decline in nation's capacity to produce goods or services of any sort that citizens of other countries want to buy, at competitive prices.

Free trade is positive sum because of specialization. The idea is that if someone else makes cars better or more cheaply than the UK can, Brits will do some other thing in which they have a comparative advantage, maximizing both overall productivity and the wealth of both nations. But there's a catch to this ancient Ricardian reasoning, a hidden assumption: The other thing that Brits do has to be tradable. If the UK stops building cars, and instead concentrates on home-building and retail sales, then there are no certain gains to trade.

Ricardo probably failed to agonize over this point, because if a country ceases to produce tradables, it stands to reason that it ceases to have the capacity to trade, and the question of whether trade is beneficial or harmful is rendered moot.

But Ricardo is dead, and we live in a brave new world where, at least for a while, some countries are willing to trade persistently for debt not backed expanding (if adjusting) tradables capacity on the part of the debtor. This is not a Ricardian paradise. This is economic terra incognito, and citizens are right to be spooked.

Chris writes:

People lose their minds when they think about national economies. It's obvious that, as individuals, we get rich by specializing in the trade we are least bad at, and buying stuff from others. When I go to work, I'm exporting. When I go to Tescos, I'm importing. No-one thinks of it this way, though.

I think he's wrong. I think that nearly everyone thinks of it this way, both on a personal level and at a national level, and that's precisely why "free trade" is under pressure. At a personal level, when we import by buying stuff at Tescos, but fail to export enough at work to fund our imports, we consider that a problem. When our credit card balances grow large relative to our expected capacity to pay-off or even service our debt, we get very nervous.

So it is, and ought to be, on a national level.

A consumer "importing" more than she is "exporting" has a bunch of alternatives: She can force herself to "import less", by cutting consumption or by turning to imperfect home-made substitites (fire the maid). Or she can increase her capacity to export, by, for example, upgrading her skills and getting a better job. The latter choice is best, both for the consumer herself and for the world as a whole. But if she can't succeed at increasing exports, cutting back on imports is much better than simply letting unfundable liabilities mount.

On a national scale, increasing exports is also better than forcibly cutting imports. But so far, some "rich countries" seem unable to expand exports relative to imports. When the first-best solution to a serious problem proves inaccessible, reasonable people eventually turn to less optimal strategies.

And that's why protectionism is becoming popular again.

Regarding my previous post on CPDOs, the delightfully tart Felix Salmon gets delightfully tart with, er, me. He writes:

It would seem that Waldman is rather smarter than anybody at any credit-rating agency.

Now I'm hardly as bright as your average bread mold, so Salmon is being a bit tough on the credit agencies here. Plus, the last thing I meant to do was accuse the rating agencies of stupidity. On the contrary, rating agencies are being quite as clever as the investment-bank CPDO issuers. They are both, in my opinion, playing the same game, which I'll call "Keynesian sound banking", after the Great Man's famous quote:

"A 'sound' banker, alas, is not one who forsees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him." [1]

Or we might refer to this as "Waldmann's Rule" &mdash not my rule, for heaven sake I don't deserve such a thing — but after Robert Waldmann, for what Brad DeLong learned from him:

What I learned from Robert Waldmann: Almost no professional portfolio manager worries about the lower tail, because if you are in the lower tail the whole world has gone to hell in a handbasket and people have other, more important things to worry about than whether one's portfolio manager had appropriately hedged whatever risk is now roosting on the roof.

My claim is only that the same logic applies to credit-rating agencies and banks. I'm certain the best and brightest at the rating agencies thought of everything I thought of. Rating agencies earn revenue (from the issuing investment banks) when they get to rate a booming new class of credits. Rating agencies get egg on their face if an issue they rate highly defaults. But if that happens in the context of a widespread credit event? Well then it's like Condi Rice and the World Trade Center. Who could possibly have foreseen terrorists flying planes into buildings!

Here's Salmon:

One of the things which makes the CPDO model so robust is that the riskiest risk that it's taking is six-month investment-grade credit risk. Since it's pretty much unheard-of for a company to go from investment-grade to default in less than six months, the rating on the CPDO can be very high. What's more, the CPDO, because it has leverage to spare, can continue to pay out its coupon even if that kind of default does happen.

Model risk is precisely the possibility that "the pretty much unheard-of" occurs. Plus, lightning fast "gap risk" defaults aren't required to break CPDOs. A sequence of general credit-quality deteriorations over several rebalancings of the CPDO portfolio would be sufficient even without default.

During a widespread generalized credit event, or following a sequence of periods during which credit conditions continued to deteriorate rather than reverting to mean, CPDOs would no longer have "leverage to spare". "Leverage to spare" is what Brian Hunter at Amaranth had for the first few meters as the bottom dropped out on the natural gas market, in a pretty much unheard of collapse.[2] Any strategy that involves continually increasing leverage to cover losses is exposed to multiple adverse movements in sequence. That is why the strategy is broadly referred to as "gambler's ruin". Gambler's ruin can be a rational and very profitable strategy, but the whole game turns on the precise likelihood of long series of adverse events. Estimating that likelihood requires a model, and getting the model even a little bit wrong can be the difference between sure profit and sure ruin.

But, Salmon demurs...

[R]atings agencies try very hard to understand every single way in which the model might break, and then stress-test the model under precisely those conditions.

He's simply wrong here. If ratings agency tried to take into account every way their models might break, they would be unable to rate. Ratings agencies are quite aware that there are questionable baseline assumptions they have to make in order to come up with a model at all. They publish their assumptions, and leave it to investors to accept their models or not. Here are some snippets ABN/AMRO's presentation of Surf 100, the first CPDO (now a venerable month or so old):

• Current modelling assumptions are unlikely to be consistent with actual performance of CPDO
• Key modelling assumptions are set out in S&P/Moody’s base case assumption

[...]

S&P base case assumptions

...[10,000] Monte Carlo simulations ...Expected defaults produced by CDO Evaluator 3.0 ...Initial portfolio spread of 32bps with a volatility of 15%, meanreversion (MR) = 40bps at the end of year 1, and MR = 80 at the end of year 10

Moody’s base case assumptions

...[10,000] Monte Carlo simulations ...Expected defaults produced by CDOROM

Here's Fitch [3]:

In recognition of the sensitivity of credit CPPI and CPDO to spread widening and volatility, Fitch models spread path as follows:

• exponential Vasicek model;
• parameters based on stressful historical periods;
• back-testing on historical data;
• spread jumps incorporated if necessary

In all cases, the ratings agencies are being very honest with us. They are pointing out the limitations and assumptions of their models and tests. In no case do these tests qualify as "every single way in which the model might break", and the rating agencies don't pretend that they do. Why does Salmon?

I wrote that...

CPDOs appear to violate the core constraint of finance, the no arbitrage rule. If the ratings are accurate, selling short a portfolio of ordinary AAA debt and purchasing a portfolio of CPDOs would be a perfect arbitrage, earning risk-free profit for the arbitrageur with no net outlay of capital. Either the CPDO opportunity must be transient (because the number of issues that can be synthesized is limited, or because CPDO and AAA yields will soon converge), or the ratings must be wrong. Or else the wizards at ABN have invented an infinite free-money machine for well-placed arbitrageurs, the financial equivalent of a perpetual motion machine...

Salmon responds, and but again mistakenly.

And as for Waldman's ratings arbitrage, where you go short French sovereign debt and go long CPDOs, yes, it does exist – but it's not "the financial equivalent of a perpetual motion machine". Rather, it's just another carry trade. CPDOs are much less liquid than French government bonds, so they should carry a yield premium. Plus, the carry trade can move against you: if the price of CPDOs falls while the price of French government debt rises, you take a mark-to-market loss. And finally, the trade isn't very profitable in any event, since you have to borrow those French bonds somewhere, and the repo rate isn't likely to be much less than the extra spread you're getting on the CPDO.

If indeed a CPDO AAA is statistically indistinguishable from an ordinary AAA, and if indeed a CPDOs consistently earn spread above ordinary AAA debt, then this would not not an ordinary carry trade. Going short a particular issue and long some CPDO would be a carry trade, as there would be price risk related to idiosyncracies of the two securities. But if a diversified portfolio of CPDOs (presuming the asset class takes off) behaves identically to a diversified portfolio of other AAA debt, then highly creditworthy financial institutions (not you, me, or your cousin's small hedge fund) would indeed have a perfect arbitrage, until the spread between CPDO and AAA debt converges. This won't happen, because it is a carry trade, there are different risk profiles to a diversified portfolio of CPDOs and a diversified portfolio of other AAA issues, and that difference is... CPDOs are riskier! And that's exactly my point. CPDOs are risky issues that earn risky spreads, but look for bureaucratic purposes like conventionally "risk-free" debt.

I should comment on my use of the word "risky", both in this and the previous piece. Salmon takes me to task...

First, on a factual level: Waldman says that the proceeds from CPDOs go into "a leveraged portfolio that includes high yield, risky debt" – which isn't true if by "high yield, risky debt" you mean sub-investment-grade debt. The portfolio is all investment-grade; it just isn't AAA.

I don't mean, and didn't previously mean, that current CPDOs are taking on "junk bond" risk. One could be forgiven for thinking my use of "high yield" implied that. I should have said "higher yield". By "risky", I mean non-AAA, since AAA is the category which is generally treated as nearly free of credit risk. The debt behind current CPDO issues is concentrated at the low-end of investment grade.

Finally, back to Salmon:

But if you're still not comfortable with that kind of risk, no one's forcing you to take it.

When banks use novel structured products to take on more risk than bank regulators anticipated, I am being forced to take that risk. We all are. Bank regulation is a complicated subject, and I don't claim that existing bank regulation is anywhere near optimal. I don't disagree with Salmon's contention that while CPDOs might let banks game things a bit, this new gaming is far harder than it was under Basel I. There's a cat and mouse game being played, between regulators getting tighter and banks getting cleverer, and that's perfectly ordinary in its way.

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. Reasonable people can disagree. Salmon clearly does, and he's reasonable even if he is delightfully tart. But you can't pretend that Moody's has worked it all out and we can rest comfortably. There is no adequate model here. There is human judgment. Me, and Paul Volker, and Robert Rubin, a lot of us are worried. And those other guys are much smarter than bread mold.

By the way, if I were Goldman Sachs, I would short dollar-denominated CPDOs and purchase US Treasury debt. CPDOs aren't really financial perpetual motion machines. They just get to look like it, for about two seconds.

Update: Felix responds.

Another day, another derivative. This month's high-finance innovation is the CPDO, or "Constant Proportion Debt Obligation", and it is truly a wonder. In practical terms, a CPDO is nothing more or less than a synthetic bond. Investors pay money up front, receive coupon payments, and their principal is returned after a set period of time. Investors stand to lose if borrowers default or credit conditions deteriorate. But CPDOs work a secret miracle. These synthetic bonds are designed to score a "triple-A" grade from major bond rating organizations, while paying a spread of up to 2% more than "natural" AAA debt!

CPDOs appear to violate the core constraint of finance, the no arbitrage rule. If the ratings are accurate, selling short a portfolio of ordinary AAA debt and purchasing a portfolio of CPDOs would be a perfect arbitrage, earning risk-free profit for the arbitrageur with no net outlay of capital. Either the CPDO opportunity must be transient (because the number of issues that can be synthesized is limited, or because CPDO and AAA yields will soon converge), or the ratings must be wrong. Or else the wizards at ABN have invented an infinite free-money machine for well-placed arbitrageurs, the financial equivalent of a perpetual motion machine.

So is there a catch? And if so, what is it? Let's first understand how a CPDO works. Despite the complicated acronym, it's not rocket science.

A CPDO issuer accepts principal from investors, and commits up front to a coupon and principal repayment schedule. The issuer puts the money in a leveraged portfolio that includes high yield, risky debt (or credit derivatives), earning a yield higher than would be required to cover coupon payments to investors. In the most benign scenario, after a while, the CPDO portfolio earns enough extra money to trade in the risky debt for a risk-free portfolio of government bonds sufficient to cover the coupon and principal repayments promised to investors. Thus, the CPDO issuer has temporarily taken on credit risk to earn the promised excess spread, and then quickly locks in gains by putting investor assets into ordinary AAA bonds.

But what happens if something goes wrong? Suppose that while the CPDO holds its leveraged, risky portfolio, credit conditions deteriorate. Then the portfolio loses value, and the issuer's ability to meet the agreed-upon payment schedule becomes uncertain! Wouldn't this possibility translate into lower-than-perfect ratings by rating agencies? You might think so. But the CPDO-issuer makes a promise that offsets this risk. The CPDO-issuer promises that if the risky portfolio loses money, the CPDO will double-down, increasing the degree of leverage as required to make up for the loss and meet the structure's promised payment schedule to investors.

Well, that makes me feel better. You? Let's give the devil her due: This is a very model-tested approach. CPDO-issuers have carefully reviewed credit-spread history, and have come up with rebalancing-and-releveraging schemes that should nearly always manage to recoup losses. If there is no structural change in the bond markets, if the markets behave as models say they behave, then the likelihood that a CPDO will experience a sufficiently long sequence of adverse events to prevent the doubling-down strategy from recouping losses is very, very small, comparable to the probability of a default on an ordinary AAA-rated bond. And the independent bond rating agencies have double-checked this work. All of the bond industry's prevailing models support the view that a "perfect storm" of deteriorating credit conditions sufficient to tank a CPDO is no more likely than, say, France defaulting on its sovereign debt.

But what are the odds that some structural change in credit markets occurs, such that industry-standard models no longer hold? There is no good way to attach a probability to that event. Structural change in financial markets does happen, usually accompanied by what from the perspective of earlier models look like improbable "long-tail" events. But there is no "meta-model" that we can trust to estimate their likelihood of structural change. We are left with nothing but human judgment to decide whether the model-generated AAA rating of a CPDO issue is in fact as sure as a the same AAA on a traditional "risk-free" bond, given market conditions likely to prevail in the future, rather than conditions of the recent past on which the models were based.

This is good news. There are no perpetual motion machines, no huge gaps in the theory of finance. We can understand where the extra spread in a AAA-rated CPDO comes from: It is a model risk spread. CPDO-buyers will rationally price-in model risk, the risk that despite what Fitch or Moody's says, these complex, "gambler's ruin"-style instruments might not handle a changing credit environment as well as traditional AAA debt. Taking model risk into account, CPDOs ought to have a rating somewhat below ordinary super-high-quality bonds. But when bond-rating agencies generate their ratings from their models, model risk is left out of the equation. And that fact is the loophole these instruments are really designed to exploit.

Who is buying CPDOs? Where is the excitement? If it were true that these instruments were every bit as safe as government debt, but paid a higher yield, nearly every investor would want them in their portfolio. But investors understand model risk. While there is general demand, a specific sort of investor is particularly enthralled by CPDOs. From a Fitch report on these instruments:

[The evolution from earlier principal-insured products ("CPPIs") to CPDOs] ...is mainly driven by Basel II: under the revised international capital framework, bank investors are likely to need a rating on both principal and coupon for their credit investments. [1]

Banks always face a trade-off between safety and profitability — the more risks they take with depositors' money, the more profit they can earn. The Basel II regulatory framework requires banks either to hold less-risky portfolios, or to hold high levels of capital in reserve. Either approach exerts a drag on bank profitability (in the interest of depositor and taxpayer safety). Under Basel II, the safety of bank investment portfolios is judged in part by the ratings on the debt they hold. If a bank finds an instrument that offers an unusually high yield for its rating, that is an opportunity for the bank to increase its profitability without increasing reserves. If the rating of the offering understates its real risk, its availability effectively allows banks to circumvent the spirit of the Basel II reserve requirements.

Bank investors understand as well as non-bank investors that, due to model risk, CPDOs are not as safe as ordinary AAA bonds. But bank investors aren't looking for safety. They are looking for ways to marry the appearance of safety before regulators with opportunities to enhance profits by taking on risk. One risk not included in credit ratings is credit raters' model risk. The investment industry, constantly innovating to serve customers, has invented an instrument that exchanges credit risk (reflected in ratings) for model risk (excluded from ratings), allowing banks to have their risk and hide it too. If all goes well, banks earn more money. If all goes poorly, taxpayers cover depositor losses, while bank managers demur that they complied with regulatory requirements to the letter.

Truly, this is the golden age of finance!