Constant Proportion Debt Obligation - CPDO
If you're reading this, you're probably researching the financial crisis. That's the only plausible explanation to type these four words into a Google Search.
Or...you're trying to predict the source of the next financial crisis, and you're looking at different derivative products that exist in these troubling times. Or maybe society has collapsed, and it wasn't the robots that killed us all, it was the return of mortgage derivatives.
Let's introduce another monster that was unleashed on the markets in 2006 before the mortgage crisis: the Constant Proportion Debt Obligation (CPDO). Federal Reserve Board's Michael Gordy described this as the possible "poster child for the excesses of financial engineering in the credit market" in a post-mortem of the mortgage meltdown.
Explaining a CDPO is like trying to teach a dog Spanish. But we’re going to give it a go.
Similar to CDOs, a CPDO is a structured credit product that is leveraged (as high as 15 times the level of capital) and typically has a ten-year maturity. However, they are highly complex in the ways that they're formed. The process requires the formation of a "special purpose vehicle." Then, after a series of investments in debt notes and swap indices, you end up with a product where investors pay money up front, and then occasionally receive coupons and cash payouts depending on the overall volatility in the market.
We’re just getting started. That’s the easy part. Because from here, it gets weird.
These things are so complicated that the Federal Reserve took more than a year trying to understand the leverage and mechanics of these trading instruments. And even then, they ended up with a paper so mind-bogglingly complex that, if we described how CPDOs actually operated, you would flee from your room in horror.
Launched in 2006, the first CPDO was called ABN Amro’s Surf. The first CPDO default came in November 2007 on a financial product issued by UBS. Widening credit spreads in 2007 and 2008 would lead to significant downturns in the net asset values of these products. By May 2008, a report by the Financial Times noted that Moody's had incorrectly given a lot of these products AAA ratings due to a glitch in their modeling. But many publications and analysts would later accuse the rating agencies of selling AAA ratings to protect their business with the banks.
The CPDO is part of the reason why every American was nearly forced into a Mad Max-style apocalypse in 2008. Feel free to quote us in your research paper. We know how complex these things are. One of our writers did his Master’s thesis on CDOs at Johns Hopkins. He turned ghost-white when we asked him to help draft this page.