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Thursday, March 12, 2009

Some CDO Equity for You, Sir?

Much in line with the instruments Frank Partnoy described in his 1997 Wall Street thriller F.I.A.S.C.O, principal protected notes (PPNs) provided the structuring banks with an additional outlet for selling CDO equity.

Among others, pension funds and private clients -- often unknowingly -- became the eventual holders of CDO equity, blessed with an investment grade rating, usually AAA.

What is a Principal Protected Note (PPN)?

PPNs typically comprise of two components: a principal component (not CDO equity) and an interest component (often CDO equity).

Principal Component:
  • typically AAA-rated, zero-coupon US Treasury strip (non-cashflowing)
  • accretes to a specified principal amount at maturity
Interest Component:
  • typically lowly rated or unrated "first loss" piece of a CDO (CDO Equity)
  • earns residual (excess) interest to CDO
How Does This Work?

The AAA rating awarded by the rating agencies to the PPN is what we call a "pass through" rating. It is based solely upon the rating of the abovementioned principal component.

Thus, because the AAA-rated Treasury strip accretes over time (since it pays no interest coupon), on maturity it will have achieved the promise on the PPN, by design. In other words, the rating of the PPN addresses the return of ultimate principal by maturity (not principal plus interest).

How may this instrument be sold (to you, by your financial advisor)?: Well, you have upside if the CDO equity performs well, while losing nothing in the alternative scenario (assuming the US government does not default on its debt). And thus a PPN makes sense.

Or does it?

Time will tell how well those investments will turn out. Right now, they're not looking too good. In other words, we hope you don't own any.

To end off with a quote:
"I have trouble understanding public pension funds' delving into [CDO] equity tranches, unless they know something the market doesn't know.'' - Edward Altman, director of the Fixed Income and Credit Markets program at New York University's Salomon Center for the Study of Financial Institutions.

5 comments:

JV said...

Gene:

Thanks for pointing thsi out. I might be one of those who unwittingly walked into this "trap". I will know soon. I wish I had known this earlier. I might

Jay

Avant_Garde said...

@JV that makes 2 of us. peeved but it's prob still better than my pension fund!

VadisCFO said...

JV are you forced to hold this until maturity or can you sell out sooner?

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