With the extraordinary growth of the rated credit derivatives market, credit derivative product companies have stepped in to fill a need for highly rated counterparties that sell credit protection. CDPCs offer financial institutions and other market participants credit protection on a variety of entities, including single names or pools of corporations, sovereigns, asset-backed securities, collateralized debt obligations and other new asset classes in the form of credit-default swaps.
Much of the current interest in CDPCs was driven by Primus Financial Products' successful public stock offering in 2004. Primus is one of two CDPCs rated by Moody's Investors Service, the other being Athilon Capital Corp.
CDPCs rely on their ratings to gain entry into the competitive CDS markets. Another important aspect of CDPCs is they often fund themselves through the issuance of debt. So a CDPC may very well have two types of ratings; a counterparty rating, which is given to the company and enables the CDPC to transact with other rated entities, and a debt rating.
How Do CDPCs Operate?
Moody's Investors Service classifies CDPCs in the broader category of structured financial operating companies: highly-rated, stand-alone companies with tightly defined risk parameters and risk objectives that offer credit protection from a highly-rated counterparty. The credit quality of the reference pools or entities can range from mezzanine-type portfolios to highly-rated entities and/or tranches.
There are currently only a few CDPC sponsors in the market, though this number may grow dramatically. Interest in the vehicles stems from their capital efficiency, ability to adapt to changing market conditions, and long-term cost efficiency. Despite these advantages, there are some obstacles: Setting up a CDPC requires a significant commitment of time, effort, and money. The start-up cost for a CDPC can reach millions of dollars and take years to bring to market, especially for the most ambitious and complex endeavors.
Counterparty Rating
Moody's counterparty rating expresses its opinion of the risk faced by a counterparty transacting with the CDPC.
To the protection buyer, Moody's counterparty rating represents the expected loss to the CDPC's counterparties. Since the CDPC's obligation as a protection seller arises only upon the occurrence of a credit event, the counterparty rating must therefore capture the variable aspect of the CDPC's promise. Hence, loss is calculated with respect to claims, not the notional size of a contract.
To the protection seller, the counterparty rating represents an assessment of the CDPC's ability to pay the CDS premium. For other counterparties, such as those associated with interest-rate and foreign-exchange swaps and options, the rating represents the ability to pay on payments arising in connection with those derivatives.
CDPCs commonly utilize triggers that relate to the counterparty rating. These suspension or termination triggers are structural features that either freeze the company's activities--or, more precisely, limit trade activities to those that result in improvement--or force a sell-off of the company's assets if its counterparty rating becomes impaired.
The capital adequacy test that underlies the triggers is based on a comparison of expected-loss hurdles to the estimates of expected loss calculated by a CDPC's own capital model. A CDPC is ultimately a portfolio of CDS, so the expected-loss analysis is similar to that of CDOs, especially synthetic CDOs with cash-flow features.
Debt Rating
Debt ratings are based on the agency's structured finance and corporate approach to expected loss. This approach calculates the difference between the expected and present value of the payments.
A CDPC can choose to have its notes rated "with model" or "to covenanted worst." If a CDPC has its notes rated with model, it adopts a suspension or termination trigger approach analogous to that used for the counterparty rating, but with lower threshold hurdles corresponding to the desired rating of the notes. For example, if the expected loss for an A2-rated note exceeds expected loss levels consistent with an A2 rating, then a suspension event occurs. In contrast, if a CDPC has its notes rated to covenanted worst, then there is no direct consequence to deterioration in the rating of the notes, but any rating on the notes would reflect the lack of such safeguards.
A CDPC's long-term debt can take the form of term notes, auction notes, or preferred stock. A CDPC can issue debt at different seniority levels with different ratings. Such debt typically matures after the CDS in the CDPC's portfolio; otherwise, expected-loss estimates must reflect stressed conditions where notes mature ahead of other obligations, leaving less capital to cover all losses.
CDPCs usually issue unrated equity. Equity is typically paid dividends so long as there are no suspensions and debt holders continue to be paid. It is also the first-loss piece: any losses in the CDPC's reference and investment portfolio are first drawn from equity capital.
Analyzing Operating Guidelines And Capital Model
The operating guidelines are the authoritative source on what actions a CDPC may take. They encompass the CDPC's capital structure, the types of permitted business activities, the forms of permitted CDS, eligible counterparties and its ability to issue additional debt or equity, among other aspects. It also specifies circumstances in which the CDPC must enter into suspension or termination, which most commonly will occur when there is a capital adequacy failure according to the capital model.
The capital model assesses the CDPC's key risks by evaluating the CDPC's full exposure and also estimates expected loss. The capital model is typically based on Monte Carlo simulations that drill down through pooled exposures--for example tranches--to the individual reference entities that underlie the CDPC's full set of exposures. The model then computes the losses for each of these counterparties separately and outputs a number of projections: expected loss per counterparty, the expected loss given claims, and a loss tolerance ratio for the full CDPC's exposure--this is relevant for CDPCs that specialize in highly-rated entities. The model also projects expected loss for any debt issued.
Moody's approach to issuing both a counterparty and debt rating also considers secondary risks that are common to most securitizations, but contain some subtleties specific to CDPCs:
* eligible investment risk;
* liquidity risk;
* interest-rate risk; and
* foreign-exchange risk.
Investment Risk
The CDPC faces market-value risk when investing the proceeds of its debt and equity. To assess investment risk, Moody's either expects CDPCs to model these risks directly within the capital model or adjust the market value of such investments by amounts consistent with market exposure and a limited holding period in the event of suspension or termination.
Liquidity Risk
Liquidity risk is the risk that cash outflow may fall short of its cash on hand. The agency uses a dynamic test to measure the projected daily difference between the net cash outflow and the net cash inflow for a period of time, depending on the type of the eligible investments. Extreme events and unexpected losses are also tested.
Interest-Rate Risk
Interest-rate risk could arise if the CDPC's floating-rate liabilities are backed by fixed-rate collateral or vice versa. Generally, CDPCs mitigate or measure interest-rate risk by matching interest-rate bases, hedging the risk, and modeling interest-rate exposures.
Foreign Exchange Risk
Foreign-exchange risk encompasses any number of risks. These include issuing liabilities in a currency other than the CDPC's base currency, if the swap counterparties make payments in a different currency, or if the International Swaps and Derivatives Association Master Agreement's definition of post-credit event standard currencies could include a non-base-currency settlement. The CDPC's capital model is expected to measure such risks or take measures to eliminate them.
This week's Learning Curve was written by Al Remeza, v.p. and senior analyst at Moody's Investors Service in New York, and Rodanthy Tzani.
