Steve Waldman put a long post up over the weekend on one of the Economonitor's favorite subjects: constant proportion debt obligations, or CPDOs. It would seem that Waldman is rather smarter than anybody at any credit-rating agency:

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...
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...
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... 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...
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.

There's a lot to grapple with here. 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.

More to the point, all credit ratings are based on models: you can either say that "model risk" is endemic to the credit-rating system, or you can say that it is in fact taken into account. But I don't think you can single out CPDOs as being designed to exploit any kind of "loophole". Structured debt has been around for a very long time, and ratings agencies are pretty good, at this point, at evaluating it. In fact, they're probably better at evaluating the risk of financial structures than they are at evaluating the risk of sovereign default in the case of, to use Waldman's example, France.

It's simply wrong to say that model risk is "excluded from ratings", as Waldman does: to the contrary, ratings 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. 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. But if you're still not comfortable with that kind of risk, no one's forcing you to take it.

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.

Waldman's right that CPDOs are attractive investments to banks operating under the Basel II regime. But that doesn't mean the banks are cheating in some way, as Waldman implies:

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... 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.

A large part of Basel II is that it makes that kind of regulatory arbitrage much less easy than it was in the past. Under Basel I, you could just buy Mexican sovereign bonds, say, and have them zero risk-weighted because Mexico is an OECD nation. I don't think anybody thinks that CPDOs are riskier than Mexican bonds. And in any case I don't think that banks are looking to be as risk-full as they can be under Basel. In fact, banks normally have very large capital-adequacy cushions – far larger than Basel requires. Basel II isn't going to change that.