Contents

Succession fears allayed

Potential tax-free spin-offs appear limited

Investor concerns about the possible acceleration of succession events affecting the credit default swaps (CDS) markets were allayed somewhat last week. At the same time, the trading opportunities brought about by the CDS price volatility generated by such events will remain.

Research from Barclays Capital concludes that there may be less to fear from potential succession events than had been thought. "We don't think, at least in the context of a tax-free spin-off, that you are going see several other iterations of Alltel," says Matthew Mish, credit derivatives strategist at Barclays Capital in New York.

While such news is welcome for long-term investors, it could conceivably be less good for trading accounts. Mish suggests that there will still be opportunities, however. "If there is repricing in the market in the same way as we saw to some extent with First Data, for example, I expect there will be opportunities for investors amid uncertainty, that is, perhaps, unfounded," he says.

Tax-free spin-offs involving debt-for-debt exchanges have added a new wrinkle to investor concerns over CDS succession events, highlighting unique risks for sellers of protection. This stands in contrast to the early-2006 market perception of risks related to spin-offs and other capital structure transformations, wherein most risk resided with protection buyers.

In recent instances, however, an exchange of bonds transpired through tax-free spin-offs. Such transactions have resulted in changes to CDS reference entities and pushed 5-year CDS valuations significantly wider.

Barclays Capital's research involved the creation of a framework to evaluate spin-offs that have already been announced and, significantly, screens a range of industry sectors for companies that it believes could, in theory, initiate spin-offs over the longer term.

Mish explains: "We then evaluated the likelihood of a succession event triggered by a debt for-debt exchange using our framework. Our guidelines eliminate most candidates under consideration, suggesting succession events associated with spin-offs are not likely to be widespread."

Investor response to the research has been positive. "In general we have received positive feedback and people have been pretty receptive to the idea of a framework. It helps narrow down the list of candidates which can then be examined in more detail," says Mish.

Indeed, as one fund manager says: "It is always welcome to receive reassurance that these type of issues could not happen to just anyone, but are constrained to fairly controllable or manageable universe."

Tax-free spin-offs are a catalyst for debt-for-debt exchanges because exchanges allow companies to potentially extract value above the tax basis while retaining their tax-free status. Debt-for-debt exchanges involving greater than 25% but less than 75% of a reference entity's bonds or loans will result in a 50/50 split of the CDS contract. This can drastically change CDS valuation if the parent and Spin-off company differ in credit quality, which is often the case when spun-off assets are levered up.

Transatlantic shift

Disparity expected in the target market for US and European LCDS indices

As talks continue among dealers over the make-up of proposed new credit default swap indices referencing their respective leveraged loan markets either side of the Atlantic, it appears the focus of the new products will - initially at least - diverge. LCDX, the new North American Leveraged Loan index - which is scheduled for launch in or after October - is understood to be being designed to facilitate standardised tranches in the same way as the CDX tranche market, thereby broadly targeting structured credit investors.

It is expected that LCDX will reference between 75-100 underlying loans, selected by liquidity in the same manner as the CDX Investment Grade Index, which is enough to provide sufficient diversity for tranching. The index will also be a non-cancellable five year bullet that will trade on price and will almost certainly be cash rather than physically settled. So, LCDX will not exactly reflect the underlying loan market and is therefore likely to be less appealing to the existing single name cash investor base.

"Designing LCDX to appeal to structured credit investors is a bold move and is in contrast to other index markets such as the ABX Home Equity index and the planned European Leveraged Loan index, iTraxx LevX, which are structured in ways that reflect the underlying cash markets, which means that they do not necessarily facilitate structured credit investments," says Michael Hampden-Turner, Structured Credit Strategy at Royal Bank of Scotland.

LevX is scheduled to be launched later this year, but precise details of the index constituents have not yet been confirmed. David Mark, CEO of the International Index Company, nevertheless points out that it will initially be targeted at market participants and will therefore reflect the current make up of the European market. He says: "Obviously, as those participants change the index will evolve alongside the market."

As Pierre Emmanuel Juilliard, head of Structured Finance, AXA IM, explains, there are still challenges in Europe even though the leveraged loan market is now big in volume terms, having grown exponentially in recent years - the number of issuers is still smaller than in the US. Equally, the US has benefited from the earlier introduction of cash indices, making the market more liquid and accessible to a wider range of investors.

Consequently, Juillard adds: "I expect that LevX will be more for interbank loan participants than structured credit investors more broadly, while the reverse is likely to be true with the US index. However, the European index will, sooner rather than later, become the way for a broader range of investors to have access to the asset class, because we are seeing more and more demand from large institutions to have access to leveraged loans."

Building on a strong platform

This week, David Littlewood, director and one of the founding partners of Cairn Capital, responds to SCI's questions

David Littlewood

Q: When, how and why did your firm become involved in the structured credit markets?
A: Cairn Capital was formed in 2004 by a group of market professionals who had many years of experience across the credit markets, with the aim of focussing that experience from an independent platform for the benefit of investors. We all had successful careers but the attraction for us was creating something that we thought the market needed in an area that we found to be stimulating and enjoyable, and where our backgrounds were totally relevant to what we wanted to do. We haven't looked back since!

The idea was that as a result of the incredible velocity at which the credit markets have evolved in the past few years it is very, very difficult for a firm to fully participate in those markets if it is not an investment bank with all the technology, technical skill-set and so on that that entails. If you are a 'normal' investor you are unlikely to be able to invest a huge amount of resource and make credit a core part of your business strategy, so you need to outsource and pay somebody else to do that and manage credit for you.

This is where we come in - we are the participant in the credit market that investors can look at as working for them and having the full skill-set on an independent platform that is on a par with that of an investment bank. We made a fundamental decision from day one that we would operate across the credit markets in their broadest sense.

What investors want is somebody that they can rely on consistently to be a performer right across the board and someone who can offer many different types of product. Conversely, what investment banks want is clients who are active across the credit markets, who buy up and down the capital structure and participate irrespective of what the current credit cycle is doing. Our success and leverage with the investment banks is driven by how attractive we are as a client to them and that translates into a better service for our investors. What that should mean is that we can deliver good products for them, we can get great execution and we can get great allocations.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: For me, first and foremost has been the acceptance of credit as an investment medium across a very, very broad spectrum of investors. The fact that you now have such a wide variety of investors from insurance companies, to hedge funds, to asset managers to family offices involved in this space gives it huge impetus to develop and to continue to do so.

Q: How has this affected your business?
A: It has been the key driver behind our business, because it's the developments in the credit markets that have given us the opportunity to participate in this marketplace in the way that we had originally envisaged. It means that there are many different products that we can offer to investors around many different credit asset classes.

The growth in the use of the indices and index products, for example, means that we are very comfortable with the liquidity in the market place and a very active trader in the market. At the same time, it has meant that we have also had to keep investing in systems and hiring the right sort of personnel to keep pace with the speed of the development of the market, but the transaction opportunities that we have allow us to do that.

Q: What are your key areas of focus today?
A: Our key areas of focus today are corporate credit, asset-backed securities and European leveraged loans. We have been very active in doing CDOs, CPPI products and also fund products in all of these areas.

We like to run funds businesses in a particular asset class alongside CDO and CPPI because we think the synergies between how you manage a fund and the skill-set you need to have to manage a fund is very relevant to how you have to manage some of the CDO and CPPI products in today's marketplace. This combination also means that we are constantly active and therefore always in the market flows and know what's going on.

Q: What is your strategy going forward?
A: Primarily it is to continue to build a credit institution. We have grown slowly and carefully through building the right infrastructure and hiring the right people, because our intention is that we are here for the long term. In future, we want to build on the deals we have done and we want to increase the number of deals we do, and as we see opportunities arise we will add different activities to the platform.

Q: What major developments do you need/expect from the market in the future?
A: In terms of needs, I think we are pretty happy with the way the market is currently, but obviously there are always some 'nice to haves'. We would like to see the market develop more in the leveraged loan space for credit default swaps - I think more work could be done there. Equally the universal acceptance of an established loan index would be very welcome.

As for what to expect, it is probably more a case of continuing to expect the unexpected. We have seen some really quite surprising events over the last couple of years that have turned out to benefit the market. The correlation crisis of last May, for example, was very much a case of taking something that had been theorised about for a long time and then the market actually instilled some discipline into it by showing that it actually doesn't matter what models you come up with because the market is supply and demand driven and that will always rule. So we expect and hope for a continuation of exciting times and the opportunities that they will bring.

About Cairn Capital
Cairn Capital Limited and its subsidiary Cairn Financial Products Limited ("Cairn Capital") form a single platform which can deliver services in either a specific area of the credit market, or across the entire spectrum. Those services can be broken down as follows:
- Asset management: the management of portfolios of asset backed securities, investment grade and crossover corporate credit and leveraged loans in cash and synthetic form, either directly for clients or as collateral pools for public and private transactions.
- Fund products: through a credit opportunities hedge fund.
- Structuring advisory: Cairn will undertake third party advisory mandates where it feels it can benefit clients or investors by bringing its structuring skills to bear. Generally, the completed transactions will continue to be managed by Cairn post execution.
As at 2 August 2006, Cairn Capital manages portfolios totalling in excess of US$16 billion, employing in excess of US$4.5 billion of investor capital.

"The more complex the problem, the more comfortable we are"

Profiling Misys Summit

In this week's Provider Profile we talk to Dan Cohen* and Emmanuel Nusimovici** from Misys Banking Systems.

Misys Summit, part of the Misys technology empire since 1997, attributes its reputation as a star performer in the credit derivatives sector to the fact that its roots are in derivatives software, in contrast to software developers in other markets that have been attracted by the profits being made in derivatives technology and wanted to join the party as a result.

That's not to say it's only a derivatives technology provider: Misys Summit boasts a platform to accommodate all customer profiles, according to Dan Cohen, Product Manager for Misys Summit.

Dan Cohen

Taking advantage of Microsoft architecture, Misys Summit developed a .NET client to enable layers of product to be built up in the back-end, while a smart client sits at the front-end. The result is "a versatile application in which new software can be added for new asset classes without the need for extra programming", says Emmanuel Nusimovici, Product Manager with responsibility for Misys Summit's Credit Derivatives product.

Called Summit MUST (Multiple Underline Structured Trade), the module was developed alongside HSBC. MUST satisfied Misys Summit's objective of providing a single integrated trading and STP environment for the trading of standard instruments and structured products. Cohen sees MUST as affirming the company's "market leadership in complex structured products".

Recognising the need to constantly evolve their market offering, the software has been completely redeveloped since 2001, with a front-end that hosts all applications in real-time – including several graphical components – and added features on the client's screen such as trade blotters. And all this is complemented by a "true STP capability".

Misys Summit has tracked the development of the structured credit sector closely from the early days in the mid- to late-1990s when it supplied solutions for processing trades that by today's standards must seem like very simple structures, such as total return swaps and CDS. The firm was therefore well positioned to be one of the first software houses to recognise the increasing importance of the profitability of the credit derivatives market to structured product desks in London and New York.

Believing that it was now a "pioneer" in credit derivatives technology, the firm saw that more sophisticated technology would be necessary to accommodate the inevitable rise in trade volumes the market would see. "We have always believed that market volumes would increase," comments Nusimovici. "So we sought to develop a best of breed product to cope with increasing trade volumes". MUST, released in 2004, has now been installed in many customer sites globally and has been chosen as the technology on which to base the company's latest credit derivatives module; providing "a highly adaptive platform that can handle a large volume of CDS and the like, and also cope with the more complex structured instruments" claims Cohen.

Misys Summit will release a new version of its credit derivatives module later this summer, specially designed for correlation trades. Correlation is in fact one of the areas that the firm believes will see the most activity in the future.

Additionally, issues such as the rising volume of trade flow and the sheer complexity of trades being seen are, it believes, a pressing concern for banks right now. Such is the pace of development that "eventually we will have CDS on everything", comments Nusimovici.

Complexity issues concern Cohen too: "Cross asset hybrid products such as risky swaps" present the market with a further IT challenge, implying a need for banks to redesign portfolio tools to deal with these complex structured products. Also required is an efficient way to integrate the "large populations of market data in the CDS and CDO market", says Nusimovici.

But which solutions solve these technological headaches? Cohen sees a desire within the trading community to move away from stand-alone solutions: these days banks prefer to deal with the complexity of a multi-asset trading infrastructure comprising of, for example, equities, interest rates, bonds and credit derivatives on a single platform. It is handy therefore that Misys supplies such a solution – and is viewed by customers as a "continuum" to their growth needs, claims Cohen.

And as structured credit trade volumes grow, so too does the need to price these mathematical works of art. However, notes Cohen, "there's a lot of research going on (into pricing models) but no-one is yet saying they're good enough".

Principally when pricing a structure there is the well-known conundrum of precision versus speed to consider before proceeding. It is important to get an accurate price to a client and to do it quickly, but these two needs don't necessarily make easy bed fellows. The solution, according to Misys, is grid computing, the process by which the power of an entire enterprise's available IT infrastructure can be harnessed by an application, such as pricing software, to dramatically speed the process up.

This offers the "brute force" solution to pricing problems, according to Cohen. He continues: "Grid is a good solution when you have, for instance, 135 issues in a bespoke basket. The need to analyse risk and gather data on sensitivity testing can be performed efficiently by grid computing." Accordingly, some of Misys Summit's clients are now using grid computing across the board.

Leadership in market technology is a key factor for Misys Summit's next phase of development, according to Cohen. The firm's objective is to lead the way in providing structuring desks with the technology to develop new products with the speed and flexibility they'll need in the coming years, while also recognising that the buy-side – hedge funds in particular – are often the pioneers in developing new structured credit products.

Providing the buy-side with solutions to move away from a predominance of spreadsheet-based applications is also a goal for Misys Summit, according to Nusimovici. It is here where there are "so many instruments traded and so much innovation seen" that it is "dangerous for risk in (that part of) the hedge fund market not properly invested in technology".

The firm's philosophy – of partnering with customers for the long term – is paying off well. Two major banks are co-developing the next generation of "cutting edge" applications with Misys Summit, according to Cohen, enabling the company to further enhance its reputation – and its excellent customer satisfaction ratings. "Banks are used to buying software now, and very little in-house build is being seen; the markets are evolving so fast that banks have to buy from outside to keep up," notes Nusimovici.

Misys Summit clearly knows its patch well and is determined to keep its position of leadership, so long as clients keep coming up with the complex problems necessary to keep them in their comfort zone.

* Dan Cohen has 20 years experience in building and implementing Capital Markets software. Starting out in developing a Eurobonds trading system he joined Quotient in 1990. This firm subsequently merged with Summit and over the years he has been responsible for Technical services, client developments and some strategic enhancement projects including bonds, FX, back office and accounting. Cohen is now product manager for the Misys Summit product range.

** Prior to joining Misys, Emmanuel Nusimovici ran his own consulting firm for 5 years, servicing banks, asset managers and financial institutions such as Credit Lyonnais or Natexis in the field of capital markets, and also servicing software vendors like Calypso. In particular, Nusimovici was involved in the initial design and presales of Calypso's Credit Derivatives module. From 1994 to 1999, he was the Head of Presales for southern Europe of one of Summit's long time competitors: Infinity. Prior to this, Nusimovici started his career as an FX Option Trader for 3 years at Societe Generale in Paris and New York.

BGI expands credit research

The latest people and company moves

BGI expands credit research
Asset manager Barclays Global Investors (BGI) has announced the appointments of leading academic and industry experts to its extensive global research staff. BGI has built one of the largest scientific research organizations in asset management, with an annual commitment to research of over $120 million. In credit the hires are as follows:

Scott Richardson has joined as head of US Credit Research overseeing fixed income credit research for the firm. Richardson was assistant professor of Accounting, Wharton School, University of Pennsylvania. His research includes firm valuation, corporate governance, earnings management, accounting and contracting. Richardson was on the editorial advisory and review board, Accounting Review, and was formerly in the accounting and advisory practice with KPMG Peat Marwick.

Oren Cheyette has joined as senior research officer where he will focus on mortgage research to support BGI's alpha forecasting models. Cheyette was executive director, New Products Research with MSCI BARRA, where he was responsible for exploration, design and development of new research products. Prior to this, he was executive director, Fixed Income Research for BARRA. He has published numerous papers including a notable paper on empirical credit risk.

Daniel Bergstresser has joined as head of European Credit Research where he will focus on credit research in the UK. Bergstresser was assistant professor in the Finance Unit at Harvard University. His research has covered a variety of areas including impact of taxation, regulation, and market structure on the operation of financial markets, and he has been cited in numerous national news and business publications.

Navneet Arora has joined as research officer where he will focus on Canadian and credit research. Arora was a Director in the research group at Moody's KMV. He has a PhD in finance from the University of North Carolina at Chapel Hill, and has published numerous papers on credit risk and developed KMV's default risk model.

Meanwhile, Brent Canada has joined BGI as a senior collateralised debt obligation structurer from Deutsche Bank and is based in New York.

Mandrekar joins Wachovia
Kiran Mandrekar has moved to Wachovia Securities from RBS Greenwich. He has joined as a vp and synthetic collateralised debt obligation structurer and marketer. Mandrekar is based in New York and reports to Steve Altemeier, head of Correlation Trading. The hire is understood to be part of broader plans to grow Wachovia's structured credit products business.

Calyon hires Plewe
Heidi Plewe, formerly a structured credit marketer at SG Corporate and Investment Banking in London, is now at Calyon focussing on sales to Germany and Austria. Plewe joins as an executive director and reports globally to Paul Byers, head of structured credit sales for Europe and the Middle East, and regionally to Ivonne Arole, local capital markets manager for Germany.

Fitch launches stability scores

A round-up of all the week's structured credit news

Fitch launches stability scores
Fitch Ratings has launched a set of stability scores for synthetic CDOs that are designed to provide a better understanding of the prospective stability of ratings assigned to CDO tranches by indicating the propensity of a tranche to retain its original rating over a period of one year from closing. The move follows a consultation period with market participants.

The key aspects to rating stability include the level of excess credit enhancement, underlying diversity, barbelling of underlying credit, level of overlap in CDO-squareds and term of the deal. The findings were made possible by simulating the possible rating outcomes at a given point in the future after accounting for expected portfolio performance.

"We received overwhelming support from investors to apply this research in a way that provides a greater level of risk transparency to synthetic CDOs being issued," says Richard Gambel, Managing Director, Fitch Ratings. "The product is unique because it is forward looking and it takes into account all transaction and portfolio features, not just the level of excess credit enhancement."

Central to the delivery of the analysis was the concept of a stability score to put the measure of stability into an absolute, as well as relative context. Stability scores range on a scale of ST1 to ST3, with the first indicating a minimum one-year theoretical estimate of stability of 90%, the second between 90% and 80%, and the third less than 80%.

For the moment, stability scores will be generated for AAA tranches of corporate CDOs, but Fitch plans to expand them to lower rated tranches and to CDOs that reference ABS in the future.

Meanwhile, Fitch has released an updated version of its VECTOR default model in Beta format. The changes include an updated user interface, together with other features that focus on ease of use, including an automated data loader for corporate reference entities. The development of the new version includes a review of the entire assumption set, with a focus on both updating assumptions to account for additional data and to improve the integrity of the relationship between these assumption sets.

The new version also includes a revised framework for the analysis of emerging market assets in internationally-rated deals. The proposed approach puts greater weight on regional and country concentrations when determining asset correlation, rather than on industry concentrations.

Fitch's fundamental credit view has not changed, despite the comprehensive updating of assumptions. For the vast majority of Fitch-rated CDOs, the model changes don't indicate any difference in the ratings of the liabilities. But for short-dated transactions, the new model tends to take a harsher view - although this is expected to have a greater impact on the agency's view as transactions season, rather than at inception.

Markit brings standardised ABCDS payment calculations
Markit Group has launched Reference Cashflow Database (RCD) - standardised payment calculations for CDS on ABS in a bid to facilitate settlement in the rapidly growing sector.

While outstanding contracts in the single-name and index markets now total around US$175bn and an estimated US$5bn contracts trade every week, further growth in the single-name sector has been dampened by settlement. ABCDS have a pay-as-you-go structure, in which payment shortfalls are calculated on a monthly basis. But availability of data for the required calculations remains poor and the calculations themselves are complex, with the documentation open to different interpretations.
RCD holds information on almost 15,000 ABS securities.

Legislation broadens ability to market CDOs to pension funds
The US Congress has passed pension reform legislation (the Pension Reform Act) that significantly relaxes the rules governing when ABS - including CDOs and CMBS - may be offered to investors holding certain types of retirement plan assets. Compliance with its stringent fiduciary and prohibited transaction rules has historically made issuance under ERISA impractical for most securitisation issuers.

One regulatory exception (known as the Significant Participation Exception) relied on by issuers of either below-investment grade securitisations or those that are not characterised as debt for tax purposes applies if an issuer does not have 'significant participation' by 'benefit plan investors'. Under current regulations, the definition of 'benefit plan investor' includes foreign plans, government plans and insurance company general accounts, as well as ERISA plans and plans subject to Section 4975 of the Code. The difficulty in tracking holders of securitisations that are held in global form has meant that most issuers relying on the Significant Participation Exception either prohibit ERISA investors or prohibit all benefit plan investors.

In a new definition of 'plan assets', the Pension Reform Act revises the 'significant participation' exception to limit the definition of 'benefit plan investors' to include only those investors subject to ERISA or Section 4975 of the Code. It is also expected that many hedge funds that previously didn't satisfy the Significant Participation Exception will now satisfy the requirements of the exception.

FNX releases Sierra Treasury Select trading platform
FNX Solutions has launched Sierra Treasury Select, a cross-asset trading and processing solutions platform for regional banks and corporate treasuries. The front-to-back solution provides enhanced functionality for multiple asset classes including credit derivatives. It provides additional analytic, risk and position management tools; enhanced workflows and processing capabilities; parallel processing capabilities; and extensive connectivity capabilities, with over 60 plug-in connections to pricing services, prime brokers and accounting solutions.

LatentZero partners with MarketAxess
LatentZero has formed an alliance with MarketAxess to provide improved STP and enhanced electronic trading connectivity for users of its order management and trading solution, Capstone Minerva. The technology offers users cross-asset order management and trading capabilities, the ability to integrate real-time market data from leading providers into its trading blotter, and direct access and algorithmic trading services using the FIX messaging protocol.

Synthetically managing bond portfolios

Replicating bond indices using credit derivatives