The Economonitor, it seems, has found his first blog obsession – one of those themes which all good bloggers come back to over and over again. And in my case it's CDSs (credit default swaps) in general, and CPDOs (constant proportion debt obligations) in particular.

Now, I have to say that I'm far from being an expert on CPDOs – but I have a plan here. When I get back from holiday (I'm leaving on Thursday, back December 6), I'm going to start talking to the people who really are experts on CPDOs. And as I do, I'll let you, my gentle readers, know what I've learned. I believe it's called "journalism", I'm not sure.

In the meantime, I'm stuck in pundit mode, and feel compelled to respond to Steve Waldman's response to my response to him. Says Steve:

Rating agencies get egg on their face if an issue they rate highly defaults. But if that happens in the context of a widespread credit event? Well then it's like Condi Rice and the World Trade Center. Who could possibly have foreseen terrorists flying planes into buildings!

Well, we won't get into foreseeing terrorists flying into buildings. But we will get into the subject of triple-A debt defaulting. The whole point of AAA debt is that it doesn't default, even "in the context of a widespread credit event". If a bunch of AAA-rated issues (and there are going to be quite a lot of CPDOs pretty soon) all start defaulting, then the ratings agencies will have a lot of egg on their face. After all, it's their job to stress-test these things, in precisely the kind of situations that would lead to default.

On the other hand, I recall quite vividly during the Gingrich-led government shutdown about 10 years ago, there was a very real chance that the US Treasury might actually be forced to miss some coupon payments or otherwise default on its debt. It didn't happen, but it was a close-run thing. But no one seemed to mind the fact that Treasury bonds retained their AAA rating. Steve seems to think that CPDOs are much riskier than traditional AAA securities, but that's only because he's thought more about the kind of things that might lead to a CPDO default than he has about the kind of things that might lead to a sovereign default. (Unsecured corporate triple-As are pretty much unheard-of these days.)

Steve continues:

Lightning fast "gap risk" defaults aren't required to break CPDOs. A sequence of general credit-quality deteriorations over several rebalancings of the CPDO portfolio would be sufficient even without default.

Now, as I say, I'm not expert on CPDOs, but from what I understand, I'm not at all sure that this is true. If I sell six-month credit protection on a portfolio of European corporate bonds, and none of them defaults, then after six months I have my money and I've taken no losses, even if the credit quality of the index deteriorated sharply over that time. During the six months, I might have mark-to-market losses, but by the time I need to make my coupon payment, that's all history. For the next six months, the spread I get from writing credit protection on the index is much higher, so I need to write less of it to get the desired return. But in any case, I can't see how CPDOs break without actual defaults: simple credit deterioration or spread widening won't do it. (Now, that doesn't mean that the secondary-market price of CPDOs wouldn't fall in such a situation. It just means that they wouldn't default.)

(UPDATE: I now think I'm wrong about this.) 

Finally, Steve tries to explain again how the purported "financial perpetual-motion machine" works:

If a diversified portfolio of CPDOs (presuming the asset class takes off) behaves identically to a diversified portfolio of other AAA debt, then highly creditworthy financial institutions (not you, me, or your cousin's small hedge fund) would indeed have a perfect arbitrage.

But I still don't get it, sorry. If there's a perfect arbitrage, isn't it available to everyone? And what is this perfect arbitrage? If it involves going short other AAA debt, doesn't that debt need to be borrowed? Or when Steve says "behaves identically" does he mean not only in terms of long-term default probabilities but also in terms of short-term price action? Never mind CPDOs, no two AAA bonds behave identically, even if they're both plain-vanilla (World Bank vs US Treasury, say).

Steve concludes:

If I were Goldman Sachs, I would short dollar-denominated CPDOs and purchase US Treasury debt.

Now that's a risky trade, because it has a negative carry. The only way it's profitable is if the price of CPDOs falls significantly. And even if Steve's right that such an event is possible, I fail to see how he can be so sure that such an event is probable.