Contents

Risk lags spreads

Below the surface of the past week's action

The past week has seen significant narrowing of spreads in all iTraxx credit derivatives, providing plenty of action for those active traders still at their desks. However, for longer term investors there are also deeper issues to consider.

The 5y iTraxx IG index dipped below the 30bp barrier for the first time in three months on Monday and was still there at Tuesday's close on 28.13bp. Similarly, the index's equity (0-3%) tranche is close to historic tights as well - closing Tuesday at 17.1% up-front plus 500bp running, which is again close to the lows set in early May when the 0-3% tranche was trading at 16.7%.

Dealers reported a thin market, thanks to many taking a summer break, had exacerbated moves. However, a number of relative value players were seen taking advantage of the opportunities the market lows presented.

A more quantitative way of looking at the capital structure than pure tranche spread movements is necessary for structured credit investors according to Raja Visweswaran, head of international credit strategy research at Bank of America. "It is important to not just look at spreads, but those spreads relative to risk as there is often a disconnect there - at present in Europe, for example, spreads have narrowed faster than risk," he says.

"Consequently," Visweswaran continues, "it is necessary to adopt an approach that is neutral to markets to decide whether something that might look good on paper will do so really. To make that judgment, the risk as well as the return on each tranche has to be quantified. Our proprietary credit risk modelling tool, Lighthouse, is able to quantify potential losses on portfolios of credit via an application of the Merton corporate capital structure model."

Bank of America's model currently shows that the senior tranche offers more efficiency, which it defines as the compensation for bearing risk, i.e., the spread of a tranche divided by its risk. However, Visweswaran is keen to stress that the model is for long term rather than short-term assessment.

He explains: "We hope that it will be part of a move towards more widespread use of combined portfolio analysis, which in turn will help investors more successfully avoid concentration risk. Ultimately, that leads to the better construction of bespoke portfolios."

Single-name LCDS still in the air

To cancel or not to cancel

The disparity between European and US single name loan-specific CDS (LCDS) remains a concern for many investors. Meanwhile, some further progress appears to be being made on the LCDS index front.

"All we want is a universal tool enabling us to access the loan markets as effectively as CDS allow us to with corporate bonds. If standardisation can be established, the sector's potential is huge," says one structured credit investor.

Dealers and buy-side representatives have continued to meet informally to discuss the standard format for documentation for LCDS contracts in Europe. No decisions have yet been made but focus is increasing on the development of a non-cancellable CDS contract in Europe, to match that traded in the US.

Kai Seeger, head of European corporate integrated credit trading at Barclays Capital says: "There is always extensive discussion when there are differences between European and US credit derivatives practice. However, the most important thing for the market is finding a meeting place for protection buyers and sellers."

Nevertheless, whichever compromise is reached there will potentially be some that will not be satisfied. Global trading accounts would prefer non-cancellable contracts as they would tie in more closely with US ones, while local protection buyers are more likely to prefer cancellable as they would more accurately reflects their underlying loan investments.

In any event, LCDS contracts traded either side of the Atlantic are unlikely to be identical, as US ones incorporate a substitution clause. "As a consequence of the European market being more private than the US, substitution will be more difficult to achieve here," says Seeger.

At present, European LCDS contracts trade at a premium of at least 10% to US swaps due primarily to the value of the call option. To date, this differential, combined with the uncertainty over which way the European market will go on the contract front, has discouraged some investors from entering the market.

It is hoped that the introduction of LCDS indices will provide greater encouragement for the buy-side community, but US and European discrepancies exist in this context as well (see SCI Issue 1 - August 9th). No firm date has yet been set for launch of the indices but it is understood that September 20th is being targeted for a first-lien European LCDS index with 35 constituents and a subordinated LCDS index, also with 35 reference entities, while the much broader CDX version is expected in October.

From the very beginning

This week, Matthew Natcharian, md and head of Babson Capital Management's Structured Credit Team, answers SCI's questions

Matthew Natcharian

Q: When, how and why did your firm become involved in the structured credit markets?
A: We have been involved in credit since the 1950s, when as part of a US insurance company we primarily invested in mortgages, real estate and corporate credit. The latter started out mainly focussed on private placement loans and grew through the ensuing decades to become a group of very experienced fundamental, bottom up credit analysts that worked on corporate credit generally.

In the 1980s and 1990s we started to branch out from that group to build more specialised departments. Our division, corporate securities, is now made up of several departments along with the structured credit team (SCT): one is still the private placement business; then there is mezzanine debt, which makes subordinated mezzanine loans to companies primarily on a private basis; there are also public high yield and public investment grade corporate bond departments. The firm also has large US and European bank loan teams.

Babson Capital's very first structured credit trade was a CBO in 1991, which was a high yield bond deal; we were involved right from the beginning of the CDO market because we saw that it was a natural extension of our credit capabilities. Now, structured credit is an important vehicle for our portfolio management capabilities across each of our different teams. For example, Babson Capital Europe has issued 7 CLOs, our US bank loan team has issued a long series of US CLOs and our public investment grade corporate bond team manages cash CDOs based on public bonds as well as synthetic CDOs. Then there is the SCT itself that that buys CDO tranches primarily managed by other managers and manages four CDOs of CDOs

The SCT started in 1999 and we did our first CDO of CDOs in 2001. By 1999, Babson Capital had already invested in a large number of CDO deals and had become comfortable with the range of deal structures available; at the same time Babson Capital was also a CDO manager so we knew a lot about CDO collateral. As a consequence, we felt that if there were other managers out there of whom we thought highly and who had CDOs that were attractive to us in terms of both the structure and underlying portfolio, we would invest in them for several of our accounts as appropriate. SCT has now grown into a team that manages about US$5bn in CDOs across our four CDOs of CDOs, as well as a variety of separate accounts for outside institutions and the internal accounts we manage.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: Undoubtedly the explosion in trading of credit default swaps and the growth in that market compared to the corporate bond cash market. But in addition the growth in structured credit more broadly in terms of both its liquidity and variety has been very significant for us – we have been right at the forefront of that and have been able to expand as the market has grown.

Q: How has this affected your business?
A: We have had to integrate our monitoring of the structured credit markets, the public corporate bond markets and the CDS markets; and bring that all together to develop products that are interesting for institutional investors and to design attractive investments for our own portfolios.

Q: What are your key areas of focus today?
A: We have recently been in the market with synthetic CDOs that are the creation of a joint venture between SCT and our public corporate credit team, whereby they select the credits and we provide all of the modelling capabilities required for synthetic CDOs. Furthermore, each of the other teams within Babson Capital manages some assets within CDOs, so CDOs as a total platform represent the second largest client for Babson Capital after our parent company MassMutual.

Q: What is your strategy going forward?
A: We aim to continue in the same vein – making good investments based on our outlook for credit. The great thing about structured credit is that within it you can easily customise your risk profile to be either more or less conservative or aggressive. So we will utilise that to continue to create products that precisely reflect our risk profile based on our fundamental bottom up credit views.

Q: What major developments do you need/expect from the market in the future?
A: Nothing specific. Right now we are working on synthetic versions of cash CDO tranches; that could not be termed a major development, but it is a new focus for us.

About Babson Capital Management LLC
Babson Capital and its subsidiaries manage over $87.5 billion as of June 30, 2006 for sophisticated investors in the U.S. and abroad. The firm offers a wide range of absolute return, co-investing, financing and customized mandates utilizing equity, fixed-income and derivative instruments. Based in Boston and Springfield, Massachusetts, the firm has six additional offices in the US and an indirect subsidiary, Babson Capital Europe Limited, in London. Babson Capital is a member of the MassMutual Financial Group.

"One size doesn't fit all."

Profiling Calypso

In this week's provider profile we talk to Umang Vithlani, sales executive responsible for credit derivatives, and Mas Nakachi, director of corporate development, at software house Calypso.

Founded just nine years ago, Calypso is the brainchild of former Infinity software engineers who saw the need for a system that was designed to be cross-asset and function from front to back and could also deal with the increasing complexity of markets such as structured credit. Calypso was built starting with the back office through to the front, and as such it could be described as a company that has been built from the bottom up, dealing with the part of the post-trade that some software companies often prefer to leave to others.

The company claims that their solution provides a full STP capability and ensures that the back-office is fully integrated from the very start, offering an end-to-end solution to its clients. By adopting this approach Calypso appears to have impressed the market, by building a system that now services around fifty clients across a variety of asset classes.

Umang Vithlani

Calypso then expanded to provide other sectors of the market with a solution, as Vithlani explains. "It would have been a mistake to remain on the investment bank trading floor. We realised early on that the market was merging; new players were being attracted from outside and they needed a system. For example, in the pre-deal stress test analysis of a new CDO, the pricing requirement is on both sides of the deal - buy and sell side - so a system has to cope with both users' requirements."

Constant growth and innovation in the market have, as has been well documented, put pressure on the back office and demanded much more efficient post-trade STP capabilities. Calypso claims that its advanced processing technology put its clients ahead of the game when having to deal with the backlog of credit derivatives trades that regulators came down heavily upon in the autumn of 2005.

"Traditional post-trade systems have become quickly antiquated in the dynamic credit markets. As flow CDS trading has become more standardised, we have concentrated on innovating the back-office functionality as demanded by the market. Our workflow engine means that the system can be expanded along with the trading activity and it has the flexibility to add new products. We also adopt new market processes, as flow products, be they CDS or Indices, are fundamentally about process innovation, so we interface to T-Zero and to the DTCC for matching," says Mas Nakachi, director of corporate development at Calypso.

With the market still adding new products at a constantly high rate, there are of course still many challenges to meet – particularly in credit event management. "These days you can have many complex credit trades with many single entities embedded within them. Crucially, you need to be able to isolate those names and calculate your exposure quickly and accurately, in case of default. For example, when Parmalat defaulted many dealers had a hard time unpicking trades and accurately defining their exposure as well as managing each stage of the credit event," notes Vithlani.

Mas Nakachi

The markets generally have attracted new players in search of yield, and in recent years real money accounts have been seen entering the market, adopting what traditionally for institutional investors are exotic strategies, such as short selling. Vithlani explains further: "The participants involved in the market have seemingly expanded. We now see real money trading new asset classes, such as credit and inflation derivatives, as the returns from the cash markets - for example, long dated bonds - have diminished with tighter spreads. We expect more real money flows into these markets."

Nakachi continues: "There's a new gene pool in the market. There are, for example, crossover players emerging: macro hedge funds traditionally have not been able to take a short position in the US real estate market but are now coming in to trade the ABX index - that's a fairly new trend. Similarly, the big participants in the single-asset ABCDS market are the cash MBS/ABS players and not the traditional corporate credit derivatives guys. The use of credit derivatives technology by these new players is an exciting development in the overall market."

All these new entrants require a system to cope, says Nakachi. To emphasise the need to satisfy the demands of clients from all corners of the financial markets, he adds: "We now have a dedicated asset management group at Calypso, as there are so many requirements out there on the buy-side. Similar to the way sell-side desks reorganize to better serve the needs of their clients, for example when they merged cash and CDS credit, we occasionally reorganize as well to better serve the evolving needs of our clients. One size doesn't fit all."

Unsurprisingly, Calypso has a definite view on how the structured credit markets are likely to develop from here: they will develop more complexity, for example there will be greater convergence between cash and synthetic products which will increasingly result in deals having both components, volumes across the board will continue to increase, and ever more new players will be attracted by the promise of extra yield delivered through the application of continuously innovative financial technology.

Babson Capital hires structured credit official

The latest people and company moves

Babson Capital hires structured credit official
Jeffrey Prince has joined Babson Capital Management from Citigroup, where he served as a CDO strategist. In his new role, Prince will be responsible for CDO security analysis and selection, as well as CDO portfolio strategy/management. He will report to Matthew Natcharian, managing director and head of the firm's structured credit team.

Prior to Citigroup, Prince worked for four years at Wachovia Securities, first as an associate in CDO banking and structuring, and then as vice president, CDO research analyst. He holds a number of degrees from the University of Michigan, including a master of science in financial engineering, a master of science in computer engineering, a master of science in mechanical engineering, and a bachelor of science in mechanical engineering.

Relocation for Merrill Lynch's Lattanzio
Merrill Lynch's Dale Lattanzio, head of EMEA credit, real estate and structured products, is relocating from London to New York to co-head fixed income, currencies and commodities (FICC) in the Americas with Doug Mallach, previously head of Americas fixed-income sales. Their new brief excludes structured finance, commodities and commercial real estate, which will be run separately as global products.

Lattanzio has also been appointed global head of structured credit product sales and trading, including cash and synthetic CDOs. In this role, he will focus on improving the firm's derivatives platforms within structured credit products and help monitor the firm's risk in credit products globally.

Calyon recruits three CDO bankers
Calyon's aggressive expansion in the cash CDO sector continues, with the recent appointment of three bankers to its business. Yuri Umak has joined from Wachovia Securities and Raymond Li from Trepp, both based in the US.

Additionally, Fred Simkin has been named executive director in product management and syndicate. He is based in London and will focus on building global sales of cash, hybrid and synthetic ABS CDOs.

Umak and Li report to Alex Rekada, head of US cash CDOs, while Simkin will report to Ally Chow, head of product management and syndicate in London.

Stocklin joins BNP Paribas
Kevin Stocklin has joined BNP Paribas to head up its US CDO origination and structuring efforts, with responsibility for cash transactions. He will be based in New York and reports to Sean Reddington, head of US securitisation. Stocklin was previously a director of CDO origination at Dresdner Kleinwort and has held various structured product positions at Gen Re Securities and Salomon Smith Barney.

In addition, the firm has taken on Sinal Khot and Inho Choi who have joined as directors in the structured credit group from JP Morgan. They report to Patrick McKee, head of US structured credit sales.

CDS trader switches to RBS
The Royal Bank of Scotland has hired CDS trader Peter Furlong from Morgan Stanley. He joins the firm in a new flow trading role, reporting in to Ben Gulliver. Furlong will link up with a host of former Morgan Stanley traders at RBS, including Robert Boeheim and Taro Goto, who joined RBS in April this year.

Morgan Stanley recruits CDS flow trader
Morgan Stanley has poached Alex Kirgiannakis, a flow CDS trader from Deutsche Bank. He begins his new role this week and reports to Patrick Lynch, executive director and head trader of the corporate credit group in London.

Derivatives veteran joins RBC
RBC Capital Markets has hired HSBC's high-profile head of investor sales for Asia, Ferdy Khouw. He will take up a senior regional sales role and is expected to start work in the coming weeks.

Clutch of CDO rarities hit the market

A round up of this week's structured credit news

Clutch of CDO rarities hit the market
The extent of the flexibility of CDO technology was on full display last week, with a variety of unusual underlyings being offered to investors, including hedge fund collateral, equity default swaps (EDS) and subordinated insurance debt.

First off the blocks, was the EUR116.5m RMF Four Seasons CFO - only the second CDO in Europe to reference hedge fund collateral - through IXIS CIB. The portfolio is invested in units issued by RMF Fund, which comprises 182 hedge funds with a NAV of EUR12bn and is managed by its RMF Investment Nassau branch. The capital structure includes four classes of rated notes and unrated zero coupon notes: all but the triple-A tranches are rated to ultimate interest and principal, with the triple-As rated to timely interest and ultimate principal. A number of structural features of the transaction address the issues associated with hedge fund investments that have historically made the asset class difficult to securitise, such as the risk associated with uncertain performance, liquidity and redemption rights of investors.

Morgan Stanley has become the latest dealer to bring an EDS transaction to market, with the launch of its so-called Corporate Portfolio Trigger Securities. JPMorgan tapped the sector first with a private transaction in 2004, while Credit Suisse was soon to follow with its CEDO programme.

At US$2m, the size of the new deal - as registered with the US Securities and Exchange Commission - has led some market participants to speculate that a larger portion of issuance may have been sold privately. The seven-year notes reference 100 North American stocks, with payment at maturity linked to the number of entities that experience a trigger event over the life of the transaction.

A trigger event will occur if the closing price of a stock falls below 85% of its initial value or if the referenced entity goes bankrupt. The final payment amount reduces in equal portions for every trigger event until portfolio has experienced five events, at which point investors receive nothing.

Meanwhile, spread guidance was offered on the EUR300m Dekania Europe CDO II, only the second transaction to be backed by subordinated hybrid instruments issued by European insurers (which otherwise would have difficulty accessing the capital markets). Merrill Lynch arranged the deal, which will be managed by Cohen Brothers' affiliate Dekania Capital Management.

The EUR165m and EUR30m triple-A rated Class A1 and A2 notes were talked at 40bp area and 55bp area over Euribor respectively. Ratings on these notes address timely interest and ultimate principal, while those of the deal's other tranches - ranging from double-A to double-B - address the ultimate payment of cumulative interest and principal. Up to 25% of the pool may comprise perpetual instruments.

Surf's up
ABN Amro has launched Surf, the constant proportion debt obligation (CPDO) structure mentioned in last week's edition of SCI. Surf aims to give fixed-income investors fully rated and leveraged exposure to the main credit derivatives indices.

ABN says the product is designed to appeal to investors who want exposure in a form that is not directly affected by correlation volatility, who may require high certainty of principal and coupon payments, or those who wish to diversify their structured credit portfolio and look for alternative sources of liquidity.

Indeed, Steve Lobb, global head of credit and alternative derivative marketing at ABN, expects the new structure to have a similar impact on the market as the introduction of synthetic CDOs did. "The absence of a full rating has made it difficult for investors to assess the risks and appropriately place dynamically leveraged credit products into a portfolio. By creating the CPDO with a full rating for the timely payment of both principal and interest, we have solved this issue for our institutional investors and broadened the asset choice available to managers of credit portfolios."

Although Surf has a combination of synthetic CDO and credit CPPI features, it won't take exposure to the correlation risk associated with CDS. It is rated triple-A by Standard and Poor's and pays a coupon of 200bp over Libor.

The size of the portfolio is adjusted dynamically, so that the CPDO only uses the leverage it needs in order to make scheduled principal and interest payments. The structure of the product is designed to carry a stable rating with a high likelihood of "cashing-in" to a risk-free investment.

Malaysian SME CLOs on the horizon
News that Malaysia's central bank is preparing for the securitisation of SME loans made by local financial institutions has sparked speculation about the development of a CLO sector in the country. Plans are also being implemented to relax the environment for foreign institutions focusing on the SME segment.

The central bank has greatly improved the viability of small and medium enterprises - which account for around 99% of businesses in the manufacturing, service and agricultural sectors - in recent years, including the introduction of an interest subsidy for institutions that lend in the segment. Opening the market to the securitisation of SME loans will provide local institutions with the opportunity to transfer lending risk off-balance sheet.

Preferred CDS index to launch
An index of CDS on preferred securities is set to start trading next month. The new index, dubbed PCDX, will be managed by the CDX credit derivatives index consortium, which currently includes indices of CDS on high-yield, investment-grade, cross-over and emerging market credits. It is being modeled on the CDX.IG.HVOL index and will replace the Lehman Brothers PDX index, which began trading last September.

The composition of the PCDX index is not expected to be decided until about a week before its launch. But it is likely to include between 40 and 60 names.