by Calculated Risk on 11/23/2007 01:53:00 PM

From Alea (via Reuters): World’s First : UBS Triple A CPDO Blows Up

Moody’s cut its rating on one tranche of a deal issued via UBS nine notches to “C,” one step above default, from “Ba2,” after unprecedented spread widening in credit default swaps on financial companies included in the deal hit triggers that required it to be unwound.

The unwind of the deal known as a Constant Proportion Debt Obligation (CPDO) caused an approximate 90 percent loss for investors, Moody’s said in a statement.

This was a small deal, but there is probably more coming:

The downgrade impacts 11.5 million euros (US$17.04 million) of debt that was due in 2017. ... Moody’s has also placed under review for downgrade 340 million euros worth of debt from five CPDOs that are also exposed to financial companies.

What is a CPDO? Just another complicated way to make lose money. From the Financial Times last November: Credit derivative spreads

“Constant proportion debt obligations” are the latest must-have for those dissatisfied with the paltry returns from traditional investments.

CPDOs take credit exposure in the derivatives market of up to 15 times the amount invested. The complex structures involve selling credit default swap protection on corporate credits using, for example, European iTraxx index contracts. Piling on leverage amplifies a meagre return of roughly 0.25 per cent a year to nearer 4 per cent. That covers the cost of the transaction, a healthy return to investors and a cushion. Meanwhile, investors’ money is in the bank earning interest. Early deals promised buyers a whopping 2 percentage point premium over Libor on structures that, partly thanks to the return cushion, were rated triple-A.

If everything goes smoothly, leverage falls as the instrument accumulates excess returns. Once it is sufficiently well funded to pay everyone over the instrument’s life of, say, 10 years, it holds just cash. But the reverse is also true. If a CPDO makes losses because of unexpected defaults or a worsening credit outlook, leverage can rise, up to a cap, in an effort to “win back” any shortfall.

Update: In the comments, the Rub suggests this PIMCO article from May 2007: Demystifying the Structured Credit Jargon and Identifying the Opportunities.