What are Constant Proportion Debt Obligations?
Constant Proportion Debt Obligations, or CPDOs for short, are a type of investment that some companies set up to make money. The way it works is pretty tricky.
Creating a CPDO
To start a CPDO, a company will create what’s called a “special purpose entity”. This is basically a separate mini-company that exists just for the CPDO.
The unique purpose entity will issue things called “notes”. Notes are really just a way for people to lend money to the entity. In other words, people pay money to buy the notes, giving the entity the cash it needs to get started.
So now the unique purpose entity has money from selling notes. It takes this money and buys investments that are considered very safe. These safe investments make up what’s called the “collateral”.
Selling insurance on risky debts
But buying safe investments isn’t how a CPDO makes money. To try to make more money, the unique purpose entity does something else at the same time.
It sells a type of insurance called “credit default swaps.” These swaps are a way for the entity to bet against a bunch of companies or governments that have borrowed money.
The basic idea is that the entity gets paid fees for promising to spend money if certain risky debts aren’t paid back. It’s like the entity says, “I bet these debts will be paid – if they aren’t, I promise to cover the losses.”
Using leverage to make bigger bets
Here’s the key part: the special purpose entity sells way more of these credit default swaps than the money it has from selling notes. In other words, it’s making huge bets compared to how much money it actually has.
This is called using leverage. If the bets go well, the entity can make a lot of money. But if the bets go wrong, the entity can lose a lot of money too.
How CPDOs can go wrong
There are a couple main ways that CPDOs can get into trouble:
Problem 1: Risky debts start defaulting
Remember, the special purpose entity sold insurance promising to pay if certain debts went bad. If a bunch of these debts actually do go bad, the entity will owe a lot of money on the credit default swaps it sold.
Problem 2: Worries about defaults drive up costs
Even if debts haven’t defaulted yet, people might start getting worried that they will. As people get more worried, the cost of the insurance that the entity sold goes up.
When this happens, the rules of the CPDO say that the special purpose entity has to buy even more insurance. It has to double down on its bets.
This creates a cycle that can spiral out of control. Worries drive up costs, which forces the entity to take on even bigger risks, which makes people even more worried.
The 2008 financial crisis
CPDOs became popular in the mid-2000s. Banks and insurance companies liked them because they seemed to offer high returns with low risks.
However, the risks turned out to be a lot bigger than many people realized. During the 2008 global financial crisis, a bunch of CPDOs failed when the mortgage market collapsed.
Many of the debts that CPDOs had bet against ended up defaulting. The CPDOs didn’t have enough money to pay what they owed on all the credit default swaps they had sold.
In the end, CPDOs played a role in making the 2008 financial crisis worse. They allowed a lot of risky bets to be made with money borrowed from investors.
New rules and regulations
After the financial crisis, governments around the world put new rules in place to try to prevent these kinds of problems from happening again.
These rules aim to make it harder for companies to use too much leverage or make bets that are too big compared to the amount of money they actually have.
The rules also require companies to be more upfront about the risks of complex investments like CPDOs. They have to clearly explain how the investments work and what could potentially go wrong.
