The way it worked was very basic. Lets assume a 5 year transaction with European investment grade credit exposure, the so called Itraxx (125 names in the index that resembles Eurostoxx in the credit world) on a EUR 10m. notional.

Investor was long credit exposure leveraged 10 times (for example). If credit gets cheaper (credit spreads widen) then leverage increases to 11, 12, ... up to 15 times. Basically when credit is cheap you buy it and the other way around when credit becomes expensive (therefore credit spreads tightens).

This means that on day one you are long 10 times the notional at risk, in this case EUR 100m (10x10m).

The beauty of CPDOs was that Moody´s decided to award them (I have intentionally used the word "award") with a AAA rating, the highest possible rating. At the time the level of credit spreads used as a reference was trading at 0.20% (20 basis points) over libor. Moody´s used mean reversion assumptions to model credit spreads... Not very elegant taking into consideration that spreads were stuck at their lowest level ever.

You do not need to be a rocket scientist to know what happened next... In 2008, spreads widened up to 150 basis points and CPDOs lost almost all the value...

Moody´s has just reckoned that they had a bug in their CPDO mathematical model and changed ratings to a more reasonable BBB. (I buy in this new rating by the way). Click here for Bloomberg article on the matter.

Problem is that the street is questioning whether Moodys and the other rating agencies will review their structured credit methodologies biassing to the low end of the rating spectrum...

What have we learnt in this exercise?

1. Rating agencies should be paid by investors not by banks!
2. Rating agencies should be much more regulated/challenged/punished.
3. Investors should take investment decisions based by their own judgement. Not by a simplified "letter" approach.

My forecast...

I would not be surprised if one of the top 3 rating agencies goes into bankruptcy (Arthur Andersen style) right after investors get fed up with the low quality of their assessments pretty much biassed towards Investment Banks (their clients).

...Finally if you want to learn more about structured credit products look at this amazing article.