Contents

First public cat CDO launched

Groundbreaking insurance deal could set a trend

ABN AMRO has put together the first publicly rated CDO of natural catastrophe risk on behalf of insurer Catlin Group. The deal, via Catlin's SPV Bay Haven, is expected to close at the end of this month and pave the way for a number of such deals to come to the market.

The decision to structure Bay Haven as a CDO means that it is likely to appeal to a broader range of investors than traditional catastrophe (cat) bonds have attracted in the past. As Erik Manning, in the insurance & weather derivatives group at ABN AMRO, explains: "For the first time, pension funds and other institutional investors will have the ability to invest in these near zero-beta investments, providing genuine investment portfolio diversity with the benefit of high investment grade ratings. Bay Haven has opened up the world of insurance-linked securities to a whole new breed of investors."

The deal involves Catlin Insurance Company of Bermuda entering into a catastrophe swap agreement with Bay Haven that would provide the firm with coverage of up to US$200.25m in the event of a series of severe natural catastrophes. Bay Haven will in turn issue US$200.25m in three-year floating rate notes, split into US$133.5m of Class A and US$66.75m of Class B notes. The proceeds of the notes will comprise the collateral for Bay Haven's obligations to Catlin Bermuda under the catastrophe swap.

Catlin expects Standard & Poor's to assign a double-A rating to the Class A notes and a triple-B minus rating to the Class B notes. Thus, also making Bay Haven the first transaction linked to natural peril risk to be rated double-A by S&P.

The catastrophe swap corresponds to covered risk events occurring during a three-year period. No payment will be made for the first three such risk events.

However, Bay Haven will pay Catlin Bermuda US$33.375m per covered risk event thereafter, up to a maximum of six events. The aggregate limit payable to the firm is US$200.25m.

The categories of risk events to be covered by the transaction are: US hurricanes (Florida, Gulf States and East Coast), Californian earthquakes, New Madrid (US Midwestern) earthquakes, UK windstorms, European (excluding UK) windstorms, Japanese typhoons and Japanese earthquakes. Only one payment will be made for each covered risk event, but the catastrophe swap will respond to multiple occurrences of a given category of risk event, such as if more than one qualifying US hurricane occurs during the period.

The first two events paid under the catastrophe swap will impact the Class B notes. Subsequent events, up to the limit of six events over the three-year period, will impact the Class A notes.

The catastrophe swap will be triggered for US risk events if aggregate insurance industry losses, as estimated by Property Claims Services, meet or exceed defined threshold amounts. Coverage for non-US risk events will be triggered if specific parametric criteria, such as wind speeds or ground motions, are met or exceeded. The stochastic risk analyses, definitions of covered events and parametric trigger solutions have been developed by Risk Management Solutions, a provider of catastrophe modelling solutions.

It is advances in both catastrophe risk modelling and CDO technology, combined with the increasing needs of re-insurers to transfer risk due to capacity constraints in their traditional markets that is leading many players to believe that cat CDOs could take off as an asset class. "Bringing such deals into the public domain and tapping the broader investor base – which gains instant diversification – has got plenty of potential," notes one insurance product structurer.

In the meantime, private deals in the asset class continue to emerge. Last week Calyon closed Pinnacle, a transaction covering US wind and earthquake risk. The structure was unusual in that it was tranched – offering the senior and mezzanine portions of a US$128m reference portfolio.

MP

ABX tranches have mixed appeal

Banks in a hurry, but investors not so sure

Dealers are planning to roll out tranches on the ABX index in an effort to capture structured credit investor interest. However, although there is interest in standardised tranches, such an effort could be a question of too much too soon.

Leading banks in the synthetic ABS space have been offering bespoke tranches on ABX ever since the index was launched, but to date agreement on standardised instruments has eluded them. Consequently, buy-side interest in such products is yet to translate into substantial volumes.

However, agreement between dealers over what product to roll out as an underlying benchmark is believed to be close. Expectations are that tranches will be offered on a new index, which could be launched before year-end. But many doubts still remain over issues of pricing and the construction of the index.

"The market has been talking about trying to trade ABX tranches like CDX tranches for a long time, but progress has been somewhat challenged by a number of issues, notably including pricing. ABS do not really have the concept of event risk like corporates, where default timing in year one makes more sense," says Poh Heng Tan, senior portfolio manager at Washington Square Investment Management.

While the planned index is expected to offer 40 reference names, thereby making it approximate to a typical CDO in terms of underlying entities, it is still not yet certain how many tranches will be offered. In any event, Tan says: "It may be tough to launch tranches on a 40 name index - that's still way too few. I guess it will take some time before it's possible to have a bigger portfolio - of, say, at least 100 issues - and consequently before we see any active tranche trading."

Nevertheless, once the product is up and running, it is expected to garner substantial liquidity. "If ABX goes anything like the way standardised tranches on the other indices are, it has the potential to be a success. Ultimately, we expect that ABX tranches will gather a lot of liquidity," confirms Ned Bowers, md and ceo of Structured Credit Holdings.

Markit Group has been slated to oversee the marketing, administration and calculation of the index, and is believed to be currently involved in discussions with dealers regarding the number of tranches that will be offered. In the meantime, no decision has yet been made over which law firm will draft the documents for the products and talks are ongoing.

JD

Four sector fund management

This week, Zoë Shaw, managing partner and ceo of New Bond Street Asset Management, answers SCI's questions

Zoë Shaw

Our activities today are similar to what we were doing at BGB since I joined it in 1995 – focussing on four core credit asset classes. Today, we invest in both cash and synthetic securities referencing corporates, financial institutions, sovereigns and ABS.

My experience is with credit start-ups and NBSAM is the third time I've done this. I first did it for WestLB, broadening its involvement in the credit universe by establishing securitisation and syndicated lending in London. Then I went to BGB and started a credit capital markets operation there on an even broader basis, including credit derivatives – and so what we have done now is focus on credit in the fund management arena.

That's the when and how, but not the why. Fundamentally, we think that credit is a fantastically interesting market, which has had a marvellous product evolution, particularly in the synthetic space. Synthetics give you such an edge because they are flexible and easy to execute. There's no ramp up period, so you have faster earnings when you are putting portfolios together; you can create bullet notionals; you can customise maturities; choose the level of attachment point you want for risk; and, very importantly, you have visible mark to market on the underlying.

Furthermore, you can trade in a lot of these instruments to produce additional profit. For instance, once mezzanine tranches of corporate CSOs are significantly in the money, you can cash them in anywhere during the 1-3 year period and make a significant cash gain and redeploy the equity in a new deal. Now that's an amazingly flexible opportunity, probably enabling you to double the ROE of the original transaction.

Of course, being successful is not just about sourcing assets, it's also about the ability to risk-monitor them and whether there are the IT systems to help you manage them. We found that we were able to have customised screen-based tickets with Allied Irish Bank, which does our managed account outsourcing, and a suite of risk management reports that have live feeds from Markit Data Partners so that we can mark our portfolio to market on a daily basis. We use QuoteVision for intraday pricing.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: The development of the, above-mentioned, technology in the synthetic space and credit derivatives indices have created tremendous opportunities to both make additional money and manage/hedge your exposures. In addition, this has led to some other exciting product developments coming along.

CPPI is currently the most visible development, but I think CPDOs are possibly even more interesting. CPDOs were created from investor feedback about the bank guarantee-type concept that you see with CPPI: a lot of money is paid to the banks for the guarantee and, consequently, you lose quite a lot of value out of the transaction.

If anything, investors wanted to take more leverage while still having a rated product – which, of course, is part of the appeal of CPDOs. Not many have been done so far, but an awful lot of people are working on them and we expect them to be very successful.

But investors should be aware that the risk with CPDOs is that they have potentially quite significant mark-to-market volatility. We actually gauge on, say, a ten-year transaction paying Libor plus 200bp the mark-to-market volatility might be as much as 20%. However, the great thing is that the structure can be customised to pay less: say, Libor plus 100bp with less leverage – perhaps 7 times rather than 15 times – and you'd get maybe only 10% volatility.

Q: How has this affected your business?
A: We were very fortunate with our timing in that we launched in May 2004 when some of this market development had taken place, so there was enough depth in the market to help us build a quickly successful business. And, in fact, our business has grown faster than we would have expected and we are able to look at a broader range of products than we could have hoped two years ago.

Q: What are your key areas of focus today?
A: We have three business platforms. First, we provide bespoke managed accounts, which can involve one or all of the asset classes we pursue – corporates, financial institutions, sovereigns and ABS.

Second, we put together CDOs. We offer both CDOs of ABS – where, for instance we launched a US$1bn deal in July – and corporate CSOs (we have done six and are currently roadshowing the seventh). Part of our success with these products is that we always invest in the CDOs that we manage (and not just at the triple-A level – anyone can do that), so we are always closely aligned with the interests of the investors.

Our third area of focus is a new one: the development of credit funds. While CPPI and CPDOs are like a form of CDO and, although CPPI is an open ended fund, what we are now looking to launch is a traditional Dublin-based Open Ended Investment Company (OEIC).

The difference is that the fund will be a cash and synthetic credit fund – with a target yield of Euribor plus 4% net of costs – investing in our four core credit asset classes. This will be a very interesting development because it enables pension funds and insurance companies to access the credit markets who haven't done so before and from our perspective makes it easier to diversify our investor base.

Q: What is your strategy going forward?
A: What we want to do is to attract funds from institutions that have previously found the barriers to entry too high to access the credit markets, particularly to CDOs. The idea being that if they partner with us, we can offer access in all the many different forms, explained above.

Q: What major developments do you need/expect from the market in the future?
A: We expect that CDS on CDO tranches is an area that is going to show significant growth once standard documentation is in place. What we would like to see from the market is improved liquidity. To enable this to happen, the ABS sector has introduced standardised ISDA confirmations, together with the development of indexes and pay-as-you-go language. In that way, the ABS market will come up the curve in the same way as the corporate CDO market already has.

About New Bond Street Asset Management
Based in the West End of London, NBSAM is a manager of investment grade credit for institutional investors. NBSAM has assets under management in excess of €5.5bn – of which €1.5bn is on a delta-weighted basis – as at 30 June 2006.

NBSAM says its success is based on:
• expertise in evaluating credits
• knowledge of securitisation/CDO technology
• experience in sourcing efficient funding and
• big-league investor status

The firm has a long-term corporate partner in Kaupthing Bank, the largest Icelandic financial institution, and has a total staff of 22.

NBSAM is authorised and regulated by the UK Financial Services Authority.

MP

"The possibilities are endless"

This week's Provider Profile looks at software firm Principia Partners

Principia Partners provides the new generation of buy-side firms specialising in structured finance with a technology solution that enables them to manage their entire operational infrastructure. Principia SFP is a solution that allows firms to concentrate on their core competence – investing in structured finance securities and credits, while managing a dynamic funding pool of short- and medium-term liabilities.

Douglas Long

Having a relatively small staff, coupled with the need to maintain high credit ratings, inevitably requires an intensive use of technology. For example, Long says: "A SIV needs to manage its accounting, cash flows, operations and risks. The vehicle is buying structured credit assets, and issuing commercial paper and MTNs to fund this activity. But it must also remain market neutral through the use of hedging derivatives."

SIVs also have many compliance tests to satisfy, such as capital adequacy, liquidity, portfolio composition and cash outflow tests. And the limits within which they must stay are extremely narrow. "The ability to demonstrate compliance across these myriad tests on an ongoing basis, through cashflow and exposure analysis as well as dynamic portfolio management techniques, is absolutely key to maintaining their triple-A rating," notes Long.

"This is an incredibly complex set of operations to run," he adds. "And they need consistency in their operations to maintain market neutrality; any unnecessary risks need to be taken away. Principia enables them freedom to do all this by consolidating all these administrative tasks into a single package. So far we help around 60% of the SIV market to manage their operations in this way."

Tracking a dynamic, ever-changing portfolio – due to the prepayment risk of underlying investments, for example – means that the management of technology is a core competence. "Technology gives the transparency and consistency in accounting. You can drill down on risks, and expose and pre-empt potential problems. Will I break any of my compliance limits? SIVs need this re-assurance to be able to prove what's going on and report back to investors," Long explains.

He says that a SIV is unlikely to grow or evolve without a backbone of technology in place. "It's fine to get a snapshot and say you're OK now, but it's managing the ongoing process that makes it so complicated. You need to be able to make a change in the portfolio and see the impact on compliance and mark to market. It's an operationally complex process."

CDPCs must also have a strong infrastructure in place, as ratings agencies look set to rate the managers themselves to provide an independent verification. According to Long, key factors in achieving a good rating are robust operations, technology and back-up support, as well as the contingencies that are in place for when a key person leaves.

The funding of the operation is increasingly important too. "The mezzanine capital notes issued will in time also need to be rated, especially when Basle II fully comes into effect; people will not want unrated debt on their books. However, right now it's still up to an individual SIV to publish the rating," adds Long.

The operational support requirements of these firms are tending to merge in today's market, which is characterised by deepening liquidity and reduced spreads. "You cannot talk about SIVs, CDPCs and the like in their own right anymore. There is a convergence of product investment, as firms leverage techniques from other areas because of reduced arbitrage opportunities caused by increased liquidity. Therefore technology is needed to help innovate in a market with tight spreads: it enables you stay one step ahead," says Long.

Increased transparency in market data has cemented the comfort level for managers, as new products emerge to create such liquidity. Long sees a rapidly evolving market with an emerging product set as offering a platform for diversity. "CDPCs will create more liquidity in structured products. Look at how the market has evolved in recent times: CDPCs don't just write protection on single names now, they have evolved considerably. The single name market has moved on, to mature and deepen. You can now invest in CDS on ABS and tranched products; the possibilities are endless."

Long therefore recognises that CDPCs are an "ideal growth vehicle for diversity" in structured credit, with new activity observed on both sides of the Atlantic. He says: "There are possibly twelve new firms coming to the market in the next eighteen months, out of both the US and Europe. We can only see this increasing given the opportunities and growth appetite within the structured credit market.

The advent of CDPCs will undoubtedly be a strong evolutionary influence on other structured finance vehicles and the structured credit market. It will further contribute to the convergence of dynamic portfolio management and funding techniques as witnessed in the cross-breeding of managed operations such as CDPCs and SIVs with traditionally more-static businesses such as CDOs.

However, there are still several structural challenges to overcome if the full evolution of structured credit is to occur. As Long concludes: "The old problems are still there in the structuring of CDOs: full transparency and independent pricing of the payment waterfall is not yet there. That said, the structured finance operating companies are rapidly resolving such age-old issues by borrowing best-of-breed portfolio management and administration practices. Moreover, evaluated pricing for structured finance securities and credit derivatives have become more widely available, providing more reliable and consistent market data. Look at how the market has changed in the last two years. It is has come on miles from where it was, and it will be miles further on in another two years."

JW

ABN ramps up principal trading

The latest company and people moves

ABN ramps up principal trading
ABN AMRO has made two key hires as part of its long-term strategy to expand its principal trading group. Scott Eaton is the new global head of the group and joins from Royal Bank of Scotland, where he was head of risk financing and repackaging in the bank's principal investments group. Prior to RBS, he was co-head of Winchester Capital, Deutsche Bank's principal finance operation.

At the same time, Ken Reich joins as senior trader for ABN's principal trading group. He was previously at hedge fund Archeus Capital. It is understood that ABN is targeting further hires for the unit in the weeks ahead.

The principal trading group will integrate the functions of four different trading areas: asset swaps, risk repackaging, portfolio trading and illiquid credits. The portfolio function is expected to revolve around building large portfolios of high grade assets, in which the group will keep a portion of the risk and either hedge the balance or sell off mezzanine and senior risk through CDOs.

Deutsche hires in Scandinavian sales
Deutsche Bank has taken on Zuzanna Slaninkova from Merrill Lynch to work in its Scandinavian structured credit sales team. In her new role, Slaninkova will be based in London and report to Mads Steenberg, md and head of Scandinavian sales.

Goldman nabs Lehman md
Gail Krietman, formerly at Lehman Brothers in New York, has been hired by Goldman Sachs as an md in structured products and mortgage sales. Krietman will report to Stacy Bash-Polley, md and head of rates and mortgage sales.

Structured credit salesman leaves Bear
Peter Gray has joined Wachovia Securities from Bear Stearns as a structured credit sales director. He will focus on credit and rate sales to Switzerland, reporting to Dalit Nuttall, head of European fixed income sales.

Goldman trader rejoins the fold
Ritesh Shah has rejoined Goldman Sachs only two months after he left to head up the correlation desk at CDPC Primus. Based in Goldman's New York office, Shah trades synthetic CDOs and will report to Bryan Mix, md.

UBS takes on Nordic salesman
UBS has hired Stefan Vakker as a structured credit salesman for the Nordic region. He will be based in London and report to Hendrik Sandefeldt, head of Nordic sales. Vakker was previously at Goldman Sachs, where he operated in a similar position.

JP Morgan hires structured credit vp
Jessica Eistrand has joined JP Morgan as vp in structured credit for the Nordic region. Eistrand reports to Lode Keijser, head of European (except UK) credit rate sales. Eistrand was formally at UBS, where she was head of Scandinavian sales.

Lefferts joins Markit
Markit Group has appointed David Lefferts as a New York-based director. Intially, he will focus on developing tools to determine 'fair value' and to measure best execution.

Lefferts joins Markit from NASD, where he was vp and head of fixed income strategy, and was responsible for TRACE (Trade Reporting and Compliance Engine), NASD's corporate bond reporting facility. Before joining NASD in 2003, he worked at Instinet Group, where he spent 10 years in the equity and debt capital markets divisions.

Send all your people moves to John Donnelly

Merrill 'REDI' with new CPDO

A round up of this week's structured credit news

Merrill 'REDI' with new CPDO
Merrill Lynch is currently marketing its first and the market's second constant proportion debt obligation (CPDO) structure (see SCI issues 2 & 3) – rated enhanced dynamic index (REDI) floating-rate notes, to be issued through its C.L.E.A.R. SPV.

REDI notes have a leveraged non-tranched exposure to the investment grade on-the-run Dow Jones CDX and iTraxx Europe indices. The deal features dynamic leverage, which increases as the NAV decreases and vice versa. The leverage is capped at 15x to avoid over-leverage. The cash ledger is used to capture the excess spread above the promised coupon, which will then be used against rebalancing, roll and default costs.

A cash-in event occurs when the NAV exceeds the NPV of liabilities. The index portfolio is then unwound, and all promised payments will be made. A trigger event occurs if the NAV falls below 10% of par: the index portfolio is then unwound, coupon payments cease and investors receive the proceeds from the unwinding.

The triple-A rated REDI notes will be offered in amounts of €250m, US$250m, £50m, ¥10bn and A$100m.

CDOs drive US securitisation
A new report from Deutsche Bank finds that, this year to the end of September, the US ABS market including CDOs has grown 11.8%; however, the ABS market excluding CDOs contracted 4.9%. The contribution to growth from the rapidly expanding CDO sector is becoming more pronounced with each passing month as other traditional sectors such as sub-prime RMBS slow.

"The unbridled pace of issuance activity in the CDO market appears to be yet another case of technicals that are not yet in line with fundamentals. We continue to maintain that this cannot last indefinitely," Deutsche adds.

"Much of the euphoric bid by CDOs for sub-prime RMBS has been driven by the exceptionally strong collateral performance. With recent vintages showing signs of underperforming their earlier peers, it is unlikely that CDO buying will continue unabated," it concludes.

Fed welcomes progress
Last week's meeting between the Federal Reserve Bank of New York and major derivatives market participants to discuss credit derivatives processing generated a positive statement from the regulator. "The New York Fed welcomes the progress achieved over the past twelve months," it said.

In addition, the Fed stated that since September 2005, the major firms have:

• ended the market practice of assigning trades without obtaining prior consent of the counterparties,
• reduced the number of all confirmations outstanding by 70% and confirmations outstanding for more than 30 days by 85%,
• doubled the share of trades that are confirmed on an electronic platform to 80% of total trade volume, and
• agreed upon a protocol for the settlement of a credit event.

Looking ahead, the Fed said that it is important that market participants sustain their progress toward a more automated post-trade processing environment where the vast majority of trades now are processed electronically and where there are strong risk mitigants for more complex trades. "We also believe it is important to see the participants' robust adoption of the newly created trade information warehouse," it added.

ISDA publishes cash protocol
ISDA has published a new protocol to enable the cash settlement of credit derivatives. As expected (see SCI issue 5), the new protocol goes beyond its predecessors in permitting cash settlement of a wider range of instruments: single-name, index, tranche and certain other plain vanilla credit derivative transactions.

The new cash settlement mechanism will be utilised for settlement of the earliest credit event under the 2003 ISDA Credit Derivatives Definitions and corresponding index documentation. ISDA says that the protocol's effectiveness will be assessed on completion of the settlement process for affected trades. The cash settlement mechanism will ultimately be incorporated into a new set of Credit Derivative Definitions, which will also address dispute resolution for credit derivative transactions and are expected to be published in 2007.

OCC to focus on credit derivatives
The latest quarterly bank derivatives report from Office of the Comptroller of the Currency (OCC) reports that US commercial banks' holdings in credit derivatives increased 20% in the second quarter to US$6.6tr. "Credit derivatives have grown 60% since the second quarter of 2005 and the continued strong growth in credit derivatives is an area receiving close attention from the OCC," says deputy comptroller for credit and market risk Kathryn Dick.

"While credit derivatives can be a very effective credit risk hedging tool, most of the activity in this business is creating structured products that can meet the increasingly aggressive yield requirements of investors," Dick adds.

US notching to stop?
A new US law could potentially end the practice of notching that some rating agencies employ as part of the CDO rating process with the aim of basing their ratings on those of other agencies and reduce costs for issuers. Legal experts say that, while the law has the potential to restrict the practice, it is too early to be certain that it will be eradicated completely.

The Credit Rating Agency Reform Act of 2006 was signed into US law last Friday. The new law establishes a standardised procedure for a credit rating agency to apply to the SEC for designation as a "nationally recognised statistical rating organisation", or NRSRO. The benefit of such a designation is that credit ratings from a NRSRO confer benefits under certain regulations while ratings from a non-NRSRO rating agency do not.

Study favours internal models
ISDA and the International Association of Credit Portfolio Managers (IACPM) have published a credit capital model study that suggests regulators should consider an internal models-based approach for the calculation of regulatory capital, similar to the use of VAR models for market risk.

The study – which compares the results of economic capital models (both off-the-shelf vendor models and in-house methodologies) applied to simple hypothetical credit portfolios – demonstrates that advances in the modelling of credit risk and credit portfolios have not only created more sophisticated models, but have also increased understanding of how these models behave and how they compare. Model results are shown to converge when parameters and calculation choices are controlled, and allow firms to consistently capture critical effects of portfolio composition. In addition, the findings illustrate that when resulats do not converge, it is possible to account for the divergence.

The study, which involved 28 financial institutions, spanned almost two years. Model outputs were collected by Rutter Associates.

The hypothetical portfolio is available as a database from ISDA and IACPM upon request.

Intex's European database expands
Intex Solutions, the provider of analytical tools for the structured finance market, has announced the expansion of its European securitisation library to over 1,000 transactions – representing roughly 7,000 individual securities.

Over the past 20 years, Intex has modelled and maintained more than 20,000 global transactions across the RMBS, CMBS, ABS and CDO asset sectors. The Intex deal library enables users to monitor the performance of deals and to conduct complex scenario analysis, such as cashflow projections and related price/yield analytics under different prepayment, default and interest rate forecasts.

Fitch sees continuing Taiwan boom
Speaking at Fitch Ratings' Taiwan Structured Finance and CDO Conference last week, Jackie Lee, associate director structured credit at Fitch, attributed Taiwan's booming structured credit market to banks using such products as a way of regaining lending flexibility.

"Many banks are keen to use CDO technology to rebalance their lending capacity and capital usage. Otherwise, local banks may not be able to lend further to specific high-growth industries, such as TFT and DRAM," he said.

Fitch sees around NT$100bn (US$3bn) of structured credit products in the pipeline for the jurisdiction. "The expected deals are mainly on-balance sheet CLOs and structured bond-driven transactions. Currently, the market seems to have a preference for asset-backed commercial paper to a term note structure, given the popularity of the recent issues of Ta Chong Bank 2006-1 and 2006-2 ABCP SPTs," Lee elaborated.

MP

Back in business

The return to favour of market value CLOs is examined by Domenico Picone, Richard Huddart and Shreepal R. Alex Gosrani of the structured credit research team at Dresdner Kleinwort

Recently, we have witnessed a resurgence of market value (MV) CLOs, which are also known as credit opportunity funds. Their share of the primary issuance of CLOs collapsed in 2000-2002 following the high market volatility of those days. However, in a low volatility market, they have a reason to exist.

The charts below show the market value returns of the European (S&P/ELLI) and the US (S&P/LSTA) leveraged loan indices. The US market value returns are monthly returns whereas the European returns are weekly returns. Moreover, the US returns are based on a much longer data set, from January 1997, whereas the European data set was available to us from January 2004. Both charts are evidence of the current low volatility of the leveraged loan market.

The primary difference with cash flow Leverage Loan CLOs is the market value risk which is embedded in MV CLOs. In cash flow Leverage Loan CLOs the risk is default and recovery risk. High defaults together with low recovery rates may cause a principal loss, even for the senior note investors. Alternatively, when investing in MV vehicles, the price volatility of the assets and their liquidity risk (the risk that assets cannot be liquidated when required) are the crucial aspects to consider.

Structure
The rating of the MV CLO notes, and hence the overcollateralisation in these deals, is based on the concept of the 'Advance Rate', which is calculated to offset the potential price decline of the collateral over a given time. The advance rate is based on the type of collateral, so that more volatile assets are given a lower advance rate, thus signalling that they have more potential to 'lose value' in MTM terms.

The asset advance rate also depends on the rating of the liability. So, for example, when rating the senior notes, the asset advanced rate is lower than the advanced rate used when rating more junior notes. This way, the advance rate resembles the concept of value at risk, and summarises the maximum asset value that can be lost, over a certain period of time, with a given probability level.

MV OC Tests
As in cash flow CLOs – where OC tests are regularly performed by comparing the asset par-value with the liabilities – in MV CLOs we find MV OC tests, which are calculated on a weekly basis, and use the market value and the advance rate of the assets. If the OC tests are breached, the manager is required to cure them within a very short period (usually a week) otherwise the structure will be liquidated. This way, the advance rate is linked to a time exposure, which is an integral part of the rating process of MV CLOs.

Thickness and credit enhancements
Tranche thickness and credit enhancement are very important factors to consider in comparing the CDO notes of different deals. Together they tell us, once the credit enhancement of a note is exhausted, how fast or slow the principal of a note is eroded for a given amount of collateral loss.

In the table below, we compare the European and US cash flow CLOs issued in June 2006 with a list of selected MV CLOs. Note: for the European and US cash flow CLOs, we only show their averages.

Firstly, we can see that MV CLOs issued debt down to BBB level whereas most cash CLOs also issue BB notes.

Secondly, MV CLOs are not as leveraged as cash flow CLOs (see column Leverage (x)). This is because in MV CLOs collateral losses are caused by negative price changes, which are more likely than asset defaults to occur, as the asset valuation is performed at least every week. As a consequence, BBB MV CLO notes benefit from larger credit enhancement levels than cash flow CLOs.

However, MV CLO notes are, on average, thinner than cash flow CLO notes with the same rating. As a consequence, once the credit support of the equity (and of more subordinated notes) is exhausted, their principal may be eroded faster than the principal of cash flow CLOs with the same rating. To offset this risk, MV tests are performed at shorter intervals than OC tests of cash flow CLOs. This is designed to avoid rapid market value deterioration of the collateral.

Looking at the capital structures, there is more variation amongst MV deals. This is an indication that MV managers have launched deals with different collaterals and trading restrictions, which inevitably bring different capital structures.

The same variation seen in the capital structures cannot be seen in the primary spreads of MV mezzanine and senior paper, which priced in a similar way to each other. Standard AAA priced in the range of 29-31bp, and VFN and Jr. AAA wider between 32-35bp. At mezzanine levels, AA priced in the range of 47-48bp and A in the range of 73-76bp, with the only exception being Oak Hill.

Why investors should look at these deals – spreads, responsive MV tests and short volatility trades
When comparing MV CLOs with cash flow CLOs we find that the former pays a spread pick-up over cash flow deals as the table above indicates.

As we saw earlier, MV OC tests are performed on the collateral market prices, and so are more responsive to a quality deterioration of the collateral portfolio. In addition, as tests are also done more often (on a weekly basis), any rise in the volatility would be picked up and would eventually lead to MV OC tests being breached and the deal being unwound. Hence, the note investors benefit from these extra structural features.

MV CLOs are in essence short volatility trades. They can be compared with corridor credit options (such as credit range accruals), i.e. options which pay a coupon as long as the reference index spread remains within an upper and a lower barrier. The MV OC tests can be seen as the equivalent of the barriers of credit options. As long as the MV OC test is not breached, the note pays a coupon. When the test is breached it must be cured, otherwise the deal is unwound. This is to protect the note investor against a further deterioration of the collateral quality.

Manager experience and dependence
In MV CLOs there is greater dependence on the manager's skills, as market price movements, rather than collateral defaults, provide the main risk. Managers have the ability to dynamically manage their collateral; hence it is important that the investor is comfortable with the ability of the manager to trade loans and high yield bonds.

MV CLO manager track-record is important, but nevertheless difficult to assess given the young nature of the MV sector. So, it is important to also highlight the different backgrounds of key personnel MV CLOs, where a loan trading/syndication rather than a pure credit background can be valuable.
In addition, short buckets should be present, as they offer the manager a tool to short the market.

© 2006 Dresdner Kleinwort. This Research Note was first published on 18 September 2006, as part of a 'Structured Credit Products Monthly' report of the same date.