Contents

CDR Liquid Index data as at 30 October 2006

Source: Credit Derivatives Research

CDR Liquid Indices
The CDR Liquid indices represent the CDS levels of the most-liquid names in their respective markets and ratings classes. Liquidity is measured by the number of bid-offers a credit receives. Index values are simple averages of on-the-run five year CDS levels.

CDR Global Market Depth™
The CDR Global Market Depth Index is a daily measure of how many names are actively traded. Liquidity is measured by the number of bid-offers a credit receives. Index values are counts of the number of names that exceed CDR's Liquidity Floor.

CDR Global Market Activity™
The CDR Global Market Activity Index is a daily measure of activity within the global CDS market. Liquidity is measured by the number of bid-offers a credit receives. Index values are simple averages of total bid-offers of all names that exceed CDR's Liquidity Floor multiplied by CDR's Global Base Liquidity Constant.

Blackrock wins CRE CDO race

First European CRE CDO arrives, but market still faces challenges

Morgan Stanley has begun marketing the long-awaited debut European commercial real estate (CRE) CDO: the €342.5m Anthracite European CRE CDO 2006-1. The deal will be managed by Blackrock Financial Management.

Expected to be 90% ramped at close, the transaction is backed by 44 purely European assets from 39 different obligors. Just over a third of the portfolio consists of CMBS tranches, with the remainder being made up of B- and C-notes, as well as mezzanine loans. The deal is expected to price in late November, following a series of investor meetings.

The structure comprises five classes of notes, rated by Moody's and Fitch Ratings. The €142.5m triple-A rated Class A notes have a 6.5-year WAL, the €29m Aa1/AA+ rated Class Bs have a 7.8-year WAL and the Class Cs are rated A1/A+ with an 8.4-year WAL.

The junior notes are split into a €31m Baa2/BBB rated 9-year Class D portion and a €25m Ba2/BB 9.4-year Class E portion. The Class E notes are not being offered publicly, while the residual piece of €66.5m will be retained.

All firms involved in the transaction were prohibited from commenting at press time because of 144a disclosure rules. However, rating agency pre-sale reports are expected to be released within a week.

The absence of a third rating agency on such a landmark deal provoked some comment from rival dealers. "It looks like they've had to drop Standard & Poor's – the rating agency isn't being particularly helpful in terms of CRE CDOs at the moment," observes one.

All of the rating agencies have had to modify their approach to analysing the instruments, thereby creating some issues over which part of the organisation should be rating them – the CDO team or the CMBS team. They have also been criticised for not making their CRE CDO methodologies more transparent to the market.

But perhaps a more significant barrier to the development of the CRE CDO sector in Europe, at least in the short term, is the small volume of subordinated commercial real estate paper coming to the market – despite the significant growth seen in the B-note sector this year. Only around 3% of the market is estimated to be below-investment grade collateral.

Furthermore, as a report released by Fitch in September notes, margins have been tightening on subordinated debt secured by Western European income-producing commercial real estate, especially B-notes and mezzanine loans. If this trend continues, the agency argues, the growth in the market of European RE CDOs investing exclusively in this asset class will be limited.

Consequently, Fitch adds: "An appetite for riskier loans – backed not by investment property but by transitional or speculative assets – may have to emerge among a range of investors (just as it has in the US) in order for a real estate CDO sector to grow into a sizeable asset class in Europe. The fact that a large portion of US RE CDO paper is sold to European accounts suggests that this is not unthinkable."

The forthcoming Investec CRE CDO (which Bear Stearns is thought to be arranging) is widely tipped to be the next such deal to come to the market, one of a handful that are expected to launch over the coming year. The manager is understood to be aiming to mitigate any possible investor concerns over potential future market illiquidity by offering the added attraction of rated underlying collateral.

MP

US secondary market surge

Synthetic CDO volumes rise and cash market term curve emerges

CDO CDS trading has taken off in the US since confirms were standardised in June. It now represents the vast majority of secondary list activity.

That activity is concentrated in structured finance (SF) CDOs, with mezzanine SF CDOs constituting nearly 75% and high-grade SF CDOs another 20%, according to a new report from JP Morgan CDO Research.

To date, single-A has been the most popular portion of the capital structure, followed by triple-B. "There has been some protection buying higher in the capital structure [double-A] but little protection selling, likely reflecting the low proportion of HG SF CDOs which are synthetic," the report says.

"Through mid-October negative sentiment in HEL led to spread widening in both HEL ABCDS and CDO CDS. The increase in protection buyers is somewhat of a positive for market liquidity, in that there is more two-way flow and depth; the increase in OWIC/BWIC ratio has been marked as concerns about collateral risk have increased," adds Christopher Flanagan head of JP Morgan CDO Research in New York.

While increasing CDO CDS trading has focused on SF CDOs, the cash secondary market has remained fairly active with regard to CLOs, high-yield CBOs and trust preferred (TRUPS) CDOs. Indeed, such activity has led to a more apparent term curve emerging in structured credit. The report suggests that a rough benchmark is premium coupon transactions callable in less than two years are trading around ½ to 2/3 of new-issue spreads (run to first call), with significant discount margin (DM) upside upon extension.

For example, two to three year-old triple-A rated CLO paper – in other words, that which is about six months away from the first call date – is trading in the mid-teens versus new-issue (6-8 year) paper at around 24bp; actual coupons are in the 40-45bp range. "Seasoned TRUPS paper also trades at significant discount to new-issue, based on excellent credit performance and likelihood of refinancing. BB CLO tranches that are one to two years older than new-issue paper trade at around 50-75bp discounts," notes Flanagan.

He suggests that such positions are attractive, more so the shorter a trade gets, from the perspective of shorter duration in a call scenario and non-call DM upside. "To put this into perspective, for both senior and sub levels, the CDO term curve is fairly flat – i.e. high spreads on the short end – relative to other sectors," Flanagan says.

Consequently, he argues that given growing liquidity and the positive near-term credit outlook, there is room for tightening – especially at the short end. "We would also look to increase CDO CDS activity for more clarity; such prints would mark a cleaner term curve that reflects current credit spreads, not necessarily any difficulty sourcing cash paper, premium dollar prices, call upside, etc. Lighter activity in CLO CDS to date [accounting for only 5.6% of CDO CDS volume] partly reflects lack of interest from protection buyers and implies further spread tightening pressure," concludes Flanagan.

MP

More credit questions

Cablecom trading raises ire

In the wake of continuing insider trading accusations being levelled at the CDS markets, a dramatic spike in spreads on Cablecom last week caused consternation among some investors. Others were more sanguine, however.

Last Wednesday, details of a new Cablecom €300m 10-year non-call three senior notes were released by leads JPMorgan and Deutsche Bank. The new paper, which effectively refinanced all of Cablecom's existing debt, contains an option for its debt to be folded into UPC - a lower rated Dutch subsidiary.

The sudden appearance of such obvious successor entity issues for CDS, combined with the expectation that such an option would be exercised as soon as next April, saw Cablecom's default swap spread blow out 100% to over 400bp in a matter of minutes after the news was released.

The move brought outcry from a number of investors, including a statement from the principals of hedge fund BlueMountain Capital Management. "BlueMountain Capital Management has proposed to the underwriters of the Cablecom Luxembourg SCA ("Cablecom") bonds described in the draft dated 24 October 2006 of the Preliminary Offering Circular for the bonds (the "Preliminary Offering Circular") that the structure of the transactions described in the Preliminary Offering Circular should be changed," it said.

The statement adds that "the changes proposed would be expected to reverse the unexpected widening in spreads for credit default swaps linked to Cablecom that has occurred recently". The fund's proposals are understood to have involved the remover of successor entity risk on Cablecom's CDS in return for buying some of the new paper at a lower yield.

However, BlueMountain said: "The indications we have received from the underwriters suggest that no such changes are likely to be made. We do note, however, that the Preliminary Offering Circular states that there can be no assurance that the transactions described in that document will occur or that their terms will be identical to those described in it. We reserve the right to make further representations to Cablecom or the underwriters in the future."

While BlueMountain was certainly not alone in its consternation and its calls for an improved management of credit market impacting news, other investors were less concerned. One hedge fund manager observes: "Obviously, any improvements to the way the credit markets operate and increased efficiency and standardisation is to be welcomed, but the major issue in this case is event risk. That is something that we all have to deal with and is, by its very nature, unexpected."

On the other hand, he adds, the attempts to tie in investor reaction with recent concerns over insider trading were all too predictable. "Any such suggestion is ridiculous - the price moves came after the news was announced, not before."

MP

Fundamental value and values

This week, Keith Ashton, head of structured credit at TIAA-CREF, answers SCI's questions

Q: When, how and why did you/your firm become involved in the structured credit markets?
A: TIAA-CREF has been active in structured credit almost from the markets' inception. In 1990, TIAA-CREF formally established a structured securities group with a mandate to develop a structured products platform and invest aggressively in this new and developing asset class.

We approach structured credit from a fundamental credit perspective. We have successfully married that credit discipline with a strong quantitative and analytical process that we believe is necessary to navigate within the structured credit market, especially today.

We found that there was, and continues to be, significant value in structured credit compared to some of the more traditional fixed income markets. A component of that value stems from our ability to express an array of credit views and implement various investment strategies and, when appropriate, become as aggressive as we wish to be where we find compelling opportunities.

Structured credit has also performed relatively well historically, and thus has been an area where TIAA-CREF has successfully delivered value to our participants and investors over a long period of time. That is why we remain very engaged and focused in this market.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: Credit derivatives and CDOs have literally transformed credit markets and redefined how investors take and manage credit risk. It would be hard to overstate the significance of these innovations.

This transformation has created terrific opportunities for investors, like TIAA-CREF, who have long been involved in these markets, and understand them as we do.

Q: How has this affected your business?
A: TIAA-CREF launched its CDO business in 1999 and has since garnered billions of dollars in assets under management through its issuance of CDOs backed by corporate bonds, ABS, RMBS, and CMBS. The CDO business has created opportunities for TIAA-CREF to build closer relationships with institutional investors. And it has opened doors to third-party and institutional accounts who see the value in TIAA-CREF's investment process. All of these benefits provide added value to our participants and investors.

The credit derivatives market, likewise, has been a source of relative value opportunities and a tool for managing credit portfolios. Our portfolio managers regularly use credit derivatives to express their credit views, implement strategies, and find relative value in a way that just wasn't as efficiently accomplished a few years ago.

Q: What are your key areas of focus today?
A: Within structured credit, a key focus continues to be our investment in resources, systems and technology to increase management efficiency and to identify opportunities within the ever-growing breadth and complexity of structured credit products.

We are also keenly focused on innovations within the credit derivatives market, especially those developments involving leveraged loans, RMBS, ABS and CMBS. We feel that such emerging products and technology, once proven and established, will complement our active, credit-focused management style and create an even broader set of investment opportunities and portfolio management tools for structured credit.

Q: What is your strategy going forward?
We see the various signals and trends that suggest that we are nearing, or in some cases past, the 'top' of the market. In either case, we are closer to the next cycle than we were a year ago. Consequently, as we have done in previous cycles, we seek to position our portfolios and adjust our investment strategy for performance. In some cases, that has translated into a more defensive posture; in other cases, we are posturing more aggressively.

Because the scope of our investment activity in structured credit cuts across a great number of sectors and asset classes, we have the luxury of being able to tailor strategies to what is happening on the ground, and leveraging the experience that TIAA-CREF's research staff and portfolio managers bring to the table.

Q: What major developments do you need/expect from the market in the future?
A: When the last cycle hit the ABS and CDO market five years ago, the technology needed to dig deep and analyse these securities was in its early stages; consequently market liquidity suffered and many market participants found that assessing risk and value in such a market to be very challenging. In other words, the product side of the market had gotten ahead of the technology that much of the market needed to efficiently value and analyse those products.

To some extent, in certain products and sectors, we see a similar situation developing. So we see a need for further developments and innovations in technology to support some of the new products and strategies that seem to be getting traction in the structured credit market.

About TIAA-CREF
• TIAA-CREF is one of the world's largest retirement systems, with more than US$380bn in combined assets under management as at 30 June 2006.
• TIAA is one of a handful of life insurance companies to receive the highest-possible ratings from all four major independent rating agencies: Moody's Investors Service, A.M. Best, Standard & Poor's and Fitch.
• The Carnegie Foundation formed TIAA-CREF in New York City in 1918 as the Teachers Insurance and Annuity Association of America, with an endowment of US$1m from the Carnegie Corporation of New York. The company's mission was to provide life insurance and retirement plans to professors and employees of colleges and universities.
• The College Retirement Equities Fund (CREF) launched in 1952. The fund invested in common stocks and offered a variable annuity, a method of managing retirement savings and income that was considered radical at the time, but was later adopted by many other companies and retirement systems.
• Headquartered in New York City, TIAA-CREF has major offices in Charlotte and Denver as well as dozens of smaller offices in communities nationwide.

"A pricing consensus will emerge"

In this week's Provider Profile we talk to software supplier Sophis about pricing challenges in exotic credit structures

Sophis' risk management systems have been at the forefront of the derivatives markets for several years. Initially built as an equity derivatives system, Sophis now offers two full cross-asset derivatives trading and risk management platforms – 'RISQUE', which is used by dealers and 'VALUE' by the buy side.

Jean-Baptise Gaudemet

Sophis' software is based upon an object orientated platform, which aims to allow new products to be added with ease by the client – as you would add "layers to a cake" according to Jean-Baptiste Gaudemet, Sophis' senior consultant, RISQUE. "The newest exotic product is built on top of the next most recent build, and so on," he explains.

Sophis says that its buy-side clients are driving its cross asset approach as much as the sell-side. "They don't want silos for each asset class, they want a global view of P&L, of asset values and risks, and of their VAR, on a single platform," says Gaudemet.

"There is however a big demand right now from both traditional asset managers and hedge funds for a comprehensive structured credit platform," he adds. To this end Sophis supports all single name CDS, CDOs and CDO-squared, and CDS on ABS are now being integrated, mainly with clients trading on the US market. The firm is also preparing to add functionality to manage CDOs on ABS, a process jointly designed via a partnership with a global asset manager.

Looking even further forward Sophis has identified several challenges that the market must meet over the next few years. First is the need to smoothly integrate market practices, for example T+1, on CDS trades. In this respect Sophis works with hedge funds together with their prime brokers, because, Gaudemet says, prime brokers maintain a strong interest in good management of technology and processes for their clients.

The next challenge is accurate pricing. "The complexity of these structures is such that the pressure on financial pricing theory and risk management is huge," says Gaudemet. "This is not new; it was the same with equity derivatives."

To help price exotic structured credit products, Sophis offers client either its fully proprietary 'Calculation Server' package or a 'Calculation Engine' designed to run on DataSynapse, Sophis' grid computing partner. While the off-the-shelf Sophis solution is ideal for those hedge funds that do not have in house, internal, raw processing power, Gaudemet notes that banks now often wish to run a standard grid computing solution they can share between their different applications.

The requirement to add CPU power to price exotics is only going to increase, however. "Scalability will be essential as the market adds complexity, so we will see many hundreds of CPUs added year after year," claims Gaudemet.

At the same time, Gaudemet notes that with complexity comes increased understanding of pricing models. "The two main risks in structured credit today are sensitivity to moving spreads, and to default. Credit risk models cannot yet model both together easily. The market will however evolve to offer stochastic modelling of spreads," he says.

Pricing must improve to help firms to better hedge, and hence to encourage new entrants, says Gaudemet. In the meantime, buy-side firms should be investing with an awareness of the market's imperfect pricing models. "Because today's pricing algorithms are not yet perfect, everyone knows that people will be in trouble if the market turns completely," he warns.

However, an incremental widening of spreads may well be a blessing. "If big volatility hits credit spreads, people may not know how to deal with it. The market might therefore benefit from several small shocks to help us know how to deal with a bigger widening in the future," adds Gaudemet

Even though market participants are working hard on new credit pricing models, no common theory is yet available according to Gaudemet. But he is confident that in time "a pricing consensus will emerge."

Eventually, with greater sophistication in pricing credit derivatives, he believes that liquidity will deepen further still, as opportunities for derivatives on all types of debt are "endless". As access to credit derivatives will then be easier, and hence attract more investors, the end result may mean cheaper debt for cars, housing, and so on.

As Gaudemet concludes: "It is amazing that a retail student loan is now also a credit derivative. In the end there is a social goal for any new financial innovation. In this case it is to make finance easier for people and the market."

JW

Chapdelaine to be bought by CST

The latest company and people moves

Chapdelaine to be bought by CST
Collins Stewart Tullet (CST) is set to buy New York-based brokerage Chapdelaine Corporate Securities (CCS) for US$95m. CCS provides brokerage services in corporate bonds, credit derivatives, mortgage-backed securities and equities.

CST says the acquisition will "deepen and strengthen" its capabilities in North America, particularly in credit products. It is expected that the acquisition will be completed by the end of the year, with a further announcement being made in due course.

Fusion for Aladdin
Aladdin Capital Management is understood to have hired John Brewer and Tim Goodale, principals of Fusion Asset Management in London. Brewer will be head of European credit trading and Goodale head of European sales at Aladdin's European fund division.

Dow Jones steps away from CDX
Dow Jones Indexes and CDS IndexCo have announced a mutual decision to formally end the collaboration to jointly publish the Dow Jones CDX family of North American and Emerging Market credit derivative indexes by December 31, 2006.

Bradford Levy, managing director, firmwide eBusiness group at Goldman Sachs and acting chairman of CDS IndexCo, says: "CDS IndexCo has worked closely with Dow Jones Indexes from the outset, at a time when CDX was a new product in the marketplace, and Dow Jones Indexes has been invaluable in helping build a strong brand around the index family. Now that CDX has become a heavily traded flow product, embraced by an ever-increasing number of institutional investors, we feel able to assume responsibilities for the branding and marketing from Dow Jones Indexes, and further develop the product."

The CDX Indexes were formed from the merger of the North American TRAC-X and iBoxx credit derivative indexes in April 2004. In March 2005, Dow Jones Indexes was appointed branding and licensing agent, in addition to joint marketing agent alongside CDS IndexCo – a consortium of 16 investment banks.

Calypso and Markit team up
Calypso is to integrate Markit Trade Processing into its software platform. The companies say that the alliance will dramatically improve the processing of OTC derivative transactions for mutual clients, whatever the asset class or complexity of the instrument.

The partnership will enable users to pass data seamlessly from Calypso's trade capture system to Markit's trade processing platform, thus automating a variety of post-trade services – including trade day affirmation, DTCC trade confirmation, non-STP confirmation workflow and portfolio reconciliation.

Leo Schlinkert, evp and head of trade processing and distribution at Markit, explains: "Markit is very much focused on helping the industry achieve greater operational efficiency at a time of dramatic market growth in the OTC derivative markets and increased regulatory concern over the infrastructure supporting these markets. By linking our platform to industry utilities and leading vendors such as Calypso, we are able to pave the way for a more efficient marketplace."

O'Toole joins Deutsche
Conor O'Toole has joined Deutsche Bank's European securitisation research team. He was previously on the buy-side at Sumitomo in London, and prior to that a structured credit analyst with AIB in Dublin. In his new role, O'Toole will report to Ganesh Rajendra, the bank's head of securitisation research, Europe & Asia.

MP

New protocol readied

A round up of this week's structured credit news

New protocol readied
ISDA convened a customer-dealer call on Monday, 30 October, to discuss the proposed timeline for settlement of the bankruptcy filing of Dura Operating Corp. A protocol to facilitate settlement will open for adherence in early November, the trade association says.

The move follows long-standing credit market speculation over the future of Dura (see SCI issue 5). The US automotive systems manufacturer has now put a bankruptcy filing package in place, which is expected to lead to a formal filing for bankruptcy.

This action, in turn, will activate ISDA's new protocol for the settlement of credit derivatives referencing Dura. The new protocol is expected to not only incorporate index trades, as previous protocols have, but also other major types of credit derivatives, such as single name CDS and bespoke tranches.

CME files CDS futures application
The Chicago Mercantile Exchange has filed an application with the Commodity Futures Trading Commission to list "Credit Event Futures". It is expected to launch these single-name CDS-type contracts as early as Q1 2007.

In its CFTC filing, CME says that it initially intends to list contracts on Centex Corp.; Jones Apparel Group and Tribune Corporation. Additional reference entities may be listed at the discretion of the exchange, it adds.

CME explains: "[Credit Event Futures] are designed to dovetail with current futures accounting practices, i.e., they require an initial performance bond deposit and are subsequently marked-to-market (MTM) on a daily basis. As the expiration date of a CME Credit Event Futures contract draws near, the entire value of the protection will have been paid from long to short through the MTM process. If a credit event occurs prior to the expiration date, the Credit Event Futures contract will terminate and the short position is marked-to-market at a fixed amount as defined by the exchange."

First Spanish subordinated CDO launched
Confederación Española de Cajas de Ahorro (CECA) is in the market with the first-ever Spanish CDO to be backed by subordinated debt. The €298m floating-rate deal will be issued by AyT Deuda Subordinada I Fondo de Titulización de Activos.

The portfolio comprises a static pool of nine subordinated bonds issued by nine Spanish saving banks. CECA will purchase the bonds and then sell them on to the SPV on the closing date. The SPV will use the proceeds of the notes for this purchase.

Similar to other Spanish pooled transactions, the bonds will be tailor-made and issued specifically for this transaction. They will have a 10-year maturity, with terms and conditions matching those of the issued notes.

Rated by Standard & Poor's, the deal comprises €214.5m triple-A rated Class A notes, €60.7m single-A rated Class Bs and €22.8m triple-B minus Class Cs.

Lloyds TSB joins jumbo CLO party
Lloyds TSB has closed its inaugural balance sheet CLO, adding to the growing number of banks seeking to transfer risk on their corporate loan exposure ahead of the implementation of Basel II. The £1bn unfunded synthetic transaction is called Ascot Black CLO.

As Mark Grant, managing director and head of debt capital markets at Lloyds TSB Corporate Markets, explains: "This transaction, combined with the securitisation of [our] residential mortgage book, clearly demonstrates the Group's objective of improving the way in which its balance sheet is managed – moving from a 'buy and hold' approach towards an 'origination and distribution' framework."

The deal consists of six tranched CDS, with each CDS benefiting from the subordination of the respective lower tranches and a synthetic excess spread feature. "A synthetic construction allows the bank to better manage risk adjusted returns without losing valuable client relationships," says Reinald de Monchy, director of CDO origination and structuring at Lloyds TSB Corporate Markets. "And now in conjunction with our portfolio management team we can start to look at other assets for similar value."

Rated by Moody's and privately placed with institutional investors, the senior CDS is triple-A rated and accounts for 87% of the capital structure. Lloyds has retained a small first-loss position, which features a synthetic spread construction.

The portfolio comprises approximately 1,600 reference obligations of over 1,300 entities – with an average current outstanding loan value of just over £600,000 and an average credit quality of Ba1/Ba2. The largest regional exposure is London and the South East (36%), but the portfolio is distributed across 33 separate industry categories.

Moody's highlights whole loan CRE CDOs and large loan CMBS differences
Growing interest in whole loan commercial real estate (CRE) CDOs and the small number of such deals rated to date are driving some market participants to use large loan CMBS as benchmarks for comparison. But Moody's warns in a new report that such a practice presents an analytical challenge, as the flexible deal structures of whole loan CDOs introduce many structural factors that affect their credit subordination levels and thus are not a good choice for comparison.

"Whole loan CRE CDOs have a number of features that makes their credit and structural profiles very different from those of large loan CMBS deals, even though their credit enhancement levels may seem similar," explains Moody's senior analyst Mark Hsu.

One major difference between large loan CMBS and whole loan CRE CDOs is that the CDO is able to reinvest its principal proceeds after its initial closing. Furthermore, CRE CDOs have collateral quality tests that mandate the type of assets reinvested into, meaning that there can be some drift in credit quality. Moody's rating process accounts for changing credit quality by running the worst-case scenario in its models.

The risk of credit drift has also prompted the rating agency to carefully examine the experience of CRE CDO collateral manager.

LMA publishes new provisions
The Loan Market Association has published a series of financial covenant provisions for use with the LMA leveraged primary document, first launched in January 2004. The provisions relate to leverage, interest cover, cashflow cover, capital expenditure and excess cashflow, and are the result of work undertaken by a specific working party comprising leading lending institutions and law firms.

The provisions are intended to be a starting point for negotiations between borrowers and lenders, and include a number of options. A Users' Guide has also been published to accompany the provisions.

FAAB meeting concludes
The Fitch Academic Advisory Board (FAAB) has concluded its inaugural meeting. It involved senior executives and analysts from Fitch Group meeting with leading academics to bridge relevant academic research with case studies in evaluating risk in the financial markets. One of the primary topics discussed at the meeting was efficacy of portfolio risk models in the presence of a potential liquidity shock in the economy.

A related theme was the role of expected loss mapping for CDO pricing: the board members discussed the benefits and shortcomings of this methodology, and proposed some enhancements. A third strand was how Basel II guidelines have affected (and will continue to affect) investment flows, as well as the creation of new and innovative financial engineering techniques and instruments.

Strong start for TradeWeb
Thomson TradeWeb announced last week that it has seen a strong start for its new European credit derivatives marketplace, with trading volumes rising fast. September trading volume increased by 33% compared to the previous month, with more than 50 clients executing trades. There are now nine dealers providing liquidity to over 150 users in Europe, with more joining every month, the company says.

Bloomberg adds CMA and Reuters offers Bear
Bloomberg has added CMA's same day closing CDS prices, CMA DataVision, to its Professional service. CMA DataVision provides data for more than 2,000 single name CDS, indices and tranches delivered by 5pm London and 5pm New York time.

Meanwhile, Reuters announced that its clients will now be able to receive credit default swaps and interest rate swaps pricing evaluations from Bear Stearns Pricing Direct. The firm says that this is the first step in a broader credit derivatives strategy for Reuters Pricing and Reference Data to provide customers with independent class-leading credit derivative pricing based on a Reuters' composite, alongside pricing from premier partners.

MP

Trading ideas - rush hour

Dave Klein, research analyst at Credit Derivatives Research, suggests a capital structure arbitrage trade involving General Motors Corp

GM is one of the most liquid North American CDS reference entities and was trading 'up- front' less than five months ago. Over the course of the year, the company has rallied significantly both in the equity and credit markets.

With a GM bankruptcy seeming remote and our stable fundamental outlook, we feel comfortable looking across the company's capital structure for trading opportunities. This survey has yielded a mismatch in the equity options and credit derivatives markets' valuation of GM's short term default risk and results in this trade.

Capital structure opportunities
Credit and equity risk are unambiguously linked as the risk of debt holders not receiving their claims is akin to the risk of equity prices falling to zero. Both credit and equity risk are directly tradable with liquid instruments such as credit default swaps (CDS) and equity puts. We continue to analyse hedging CDS with specific (deep out-of-the-money) equity put options.

The overall logic is that owning a corporate bond is equivalent to owning a Treasury bill and writing a put option to the issuer. This put option gives the firm's equity holders the right to default on or before maturity of the debt, in exchange for transferring ownership of the firm's residual assets to debt holders. CDR's Trading Technique article – Credit Risk Models – provides significantly more detail on this relationship.

As perceived credit risk rises, we would expect firm volatility to rise (this would increase the value of the put option) thus increasing the likelihood that equity holders would default on the company's debt. The payoff profiles of an out-of-the-money equity put and a CDS are very similar and thus misalignments in that relationship are potentially profitable.

Delving into the data
When considering market pricing across the capital structure, we compare equity prices and equity-implied volatilities to credit market spreads. There are a number of ways of accomplishing this, including the use of structural models that imply credit spreads (through an option-theoretic relationship) from equity prices and the analysis of empirical (historical) relationships between the two markets. Again, we refer to a CDR Trading Technique article – Capital Structure Arbitrage – for more detail.

The first step when screening names for potential trades is to look at where equity, equity options (implied volatility) and credit spreads stand in comparison to their historic levels. Exhibit 1 shows the year-to-date percentiles for GM's stock, put implied-volatility and CDS spreads. Notice that the stock is at or near its year-to-date highs while CDS spreads and implied volatilities are at or near their lows. In a best-case scenario, we'd like to see equity prices high, implied volatility (and therefore put prices) low and CDS spreads high. For our trade, outlined below, that would mean we'd be buying equity options cheaply and selling protection richly. GM provides two out of the three conditions.

Exhibit 1

Clearly, current market percentile levels only give an idea of how rich or cheap each leg of the trade is compared with recent history. In order to judge actual richness or cheapness, we rely on a fair value model. Given that our trade is a combination of CDS and equity puts, we consider the empirical relationship between CDS and equity-implied volatility. Exhibit 2 plots equity-implied volatility (y-axis) vs. CDS premia (x-axis). If the current levels fall below the trend line, then we view CDS as too rich and/or equity puts as too cheap. Above the trend line, the opposite relationship holds.

Exhibit 2

We next consider this relationship over time, finding a "fair value" for implied volatility based on the CDS level. We do this for two reasons. First, we want to assure ourselves that the implied volatility is low to fair value. Second, we want to see how often implied volatility and CDS converge to fair value. Exhibit 3 shows the trend for GM over time. We note that GM implied vol has dropped significantly this year and that implied vol has consistently moved above and below fair value. For our trade, this is good news and reinforces our confidence that the options and credit markets eventually converge to fair value.

Exhibit 3

Hedging default risk with equity puts
Our analysis so far has pointed to a misalignment between the equity-implied-volatility markets and credit spreads of GM. It would appear that we should sell spreads (buy credit) against a long position in equity volatility. The most suitable way to take this position, especially given the greater volatility misalignment, is to trade CDS against Equity Puts.

As default approaches, we see CDS rates increase (to points upfront) and equity prices fall close to zero. In this situation, an equity put will increase in value as CDS rates increase (and equity prices fall). If we expect equity volatility to rise also, then this will be a double-whammy for the put option value. This relationship, therefore, means that we can hedge default risk (and CDS changes) through the use of equity puts.

If we can buy equity put options (as a credit hedge) cheaper than the relative costs of selling CDS protection (buying credit), then we can position ourselves correctly for the trade and benefit from positive carry for the life of the option. This is what makes capital structure arbitrage opportunities hard to place - finding the right relationship misalignment with the right economics.

GM's current price levels across the capital structure, as seen in Exhibit 4, offer us exactly the right combination of positive carry (in the longer-dated options), hedged default risk, and long equity option, short CDS. Translating the cost of our puts into basis points, we find that the trade has an overall carry of 202bps for the first two years. We have omitted the details of our calculations in this report but will happily share them with interested clients.

Exhibit 4

The main trade opportunity here is that the stock price could fall below the put strike without the occurrence of a credit event that triggers a CDS liability. Thus the holder of the short CDS / long put position could potentially obtain a put pay-off without being liable on the CDS. We also note that the break-even recovery rate on this trade is -8%, well below what analysts expect for short-term GM bonds (and below zero to boot).

In our case we like the positive carry of the hedged position of around 202 basis points until the option expiry. The mismatch in maturities (five-year CDS versus two-year hedge) also provides us with a natural short forward credit position. This position implies a two-year forward three year position of 670 basis points compared to current three-year rates of only 365 basis points and current two-year forward three-year CDS-implied rates of 637 basis points.

We therefore recommend selling protection in five-year CDS against buying longer-dated LEAPs (put options) on GM for a 202 basis points pick up in carry, hedged default risk, and short forward position.

Risk analysis
This position does carry a number of very specific risks:

• Recovery and 'Default' Stock Price Assumption: In the default scenario the cheapest-to-deliver CDS obligation may have a lower than expected market value and the stock price might not fall to $0.75 as assumed.
• CDS and Equity Put Timing Mismatch: When the CDS durations exceed that of the put, investors could be exposed to an un-hedged CDS liability. However, shorter dated CDS may be available that can be tailored to the equity put expiration and/or longer dated puts may be offered in the over-the counter equity options market. Alternatively, at expiry or over the duration of the put contract, the short CDS position may be re-hedged with puts of later expiration. Moreover, the trade may possibly be unwound profitably before the put expiry. In our position this un-hedged position is actually a positive given the relative pricing of the current forward curve. However, it does represent the greatest risk to trade profitability.
• CDS Present Value (PV): The CDS PV is an expected value, but not necessarily a realised outcome. In practice, the CDS may trade on an up-front and/or running basis. GM was trading upfront as recently as June of this year.
• Corporate Actions: Spin-offs and Private Equity Buyouts, for instance, could force an early settlement of the equity puts, leaving investors with un-hedged short CDS positions. Our fundamental outlook warrants some concerns, but recent results may avert any major risks.
• Mark-to-Market: In our view, credit and equity derivatives markets operate largely independently and this can lead to trade opportunities. At the same time, however, any relative mis-pricing may persist and even further increase, which could lead to substantial return fluctuations.

Overall, frequent re-hedging of this position is not critical but the investor must be aware of the risks above and balance that with the strong positive carry with minimal default risk over the options' life.

Liquidity
Liquidity is a major driver of any longer-dated trade - i.e. the ability to transact effectively across the bid-offer spread in the bond and CDS markets. Our data on liquidity, created from the volume of bids, offers, and trades we see each day, provides us with significant comfort in both the ability to enter a trade in GM and the bid-offer spread costs.

GM, a member of the Dow Jones CDX HY index, is regularly among the top 10 quoted credit trades by dealers on a daily basis. Bid-offer spreads are narrowing to around five basis points in the five-year maturity.

Equity puts are available through LEAPs and from analysing historical volumes it seems trades can be done in reasonable size. A potential alternative is to transact in an OTC trade rather than through the exchange to better tailor positions.

Fundamentals
This trade is somewhat impacted by the fundamentals. Until recently, business headlines were filled with speculation about the timing of a possible GM bankruptcy. While the news has been better recently, GM is still at the beginning of its turnaround effort.

While the chances of a GM default currently seem remote, analysts believe that short-term bonds will recover at or near par, given GM's cash position. This is excellent news for our trade. Coupled with our stable fundamental outlook and higher than market forward CDS levels, we feel comfortable putting on this trade.

Summary and trade recommendation
GM's uncertainty and volatility has, over the past couple of years, left us generally unenthusiastic about potential trade opportunities. As investors in the credit and equity markets decided whether yesterday's results were good, bad, or ugly, we noticed some potential misalignments.

Our fundamental outlook on GM recently moved up to stable allowing us to consider selling (rich) forward protection on GM by way of a capital structure trade. While the company faces incredible challenges and we face un-hedged exposure to default after two years, we are bullish on this trade given that its implied forward premium exceeds the market-implied forward premium. Given our fundamental outlook, we view the likelihood of a GM default as remote, recovery-rate risk minimal, and are happy to earn the well-hedged carry this trade generates.

Sell $1mm notional General Motors Corp. 5-Year CDS at 465bps
Buy 64,900 General Motors Corp. Jan-09 10 Strike Equity Puts (649 lots) at a cost of $51,920 (519bps of notional or 263 bps of CDS DV01 equivalent) to capture 202bps of positive carry to option maturity.

For more information and regular updates on this trade idea go to: www.creditresearch.com

Copyright © 2006 Credit Derivatives Research LLC. All Rights Reserved.

Note: This article is intended for general information and use and does not constitute trading advice from Structured Credit Investor (see also terms and conditions, below, section 12).

FTD baskets and correlation - part 2

In this second in a series of three articles, Shreepal Alex Gosrani, Priya Shah and Domenico Picone of the structured credit research team at Dresdner Kleinwort look at the motivations for FTD trading and the correlation aspects and calculations involved

Motivation for FTD basket trades

Yield enhancement and leverage
The advantage of the FTD is that it pays the protection seller a yield which is higher than any of the individual credit spreads in the basket due to the increased risk of a potential default¹. The protection seller also benefits from the leverage offered by the FTD structure as, although he is exposed to the credit risk of the entire portfolio of entities (each of a certain notional amount), his potential loss is limited to that (after recovery – LGD) of only the first defaulting entity.

The spread, however, on the basket will generally be a multiple of the largest spread in the basket, depending on homogeneity of spreads. Therein lies the leverage; on the same notional, as a single-name CDS, the protection selling FTD investor receives more spread than he would on any of the individual CDSs, without taking on the risk of all names defaulting. The leverage can be further increased by selecting a portfolio with a low correlation and by selecting a more homogeneous basket in order to limit tail risk (i.e. reducing the effect of the distressed credit).

A low cost method of hedging
From a protection buyer's perspective, the FTD basket provides a low cost method of hedging their portfolio of credits from the unexpected deterioration in quality of a single name. This is particularly beneficial for investors who are exposed to significant concentration risk in their credit portfolios. The protection buyer, although protected from losses resulting from the first default, is still, however, exposed to the risk of multiple defaults. The protection buyer would select names from his portfolio to put into a FTD basket saving himself premium as the basket premium is only a proportion of the sum of the spreads on the basket entities.

Creation of a senior exposure
An investor with an existing long credit exposure to several securities (either directly or synthetically) can effectively create a long senior tranche position by buying FTD protection on a portfolio. Similar to a vanilla CDO, the first loss will then be covered by the FTD leaving the investor exposed to only the risk of multiple defaults that affects the senior region of his existing portfolio.

Correlation trading
FTD baskets can be used highly effectively to trade correlation in credit portfolios. An investor that has a view on a particular basket's correlation, which differs from the market, can use such strategies dynamically to monetise from his view. For a pure correlation strategy a suitable trading position using a delta-hedged FTD basket can be undertaken, thereby immunising the portfolio value from small changes in underlying spreads.

For example, an investor with a lower than market view on correlation can buy protection on the FTD basket. As correlation decreases, the investor has a MTM gain, ceteris paribus. As underlying spreads change and as the contract approaches maturity the individual credit deltas also change and therefore, the position, although delta-hedged at the outset, would have to be re-balanced. So to trade correlation effectively delta hedging plays an important role and which we explain below.

The investor can reduce the impact of any negative carry in a delta-hedged context by taking advantage of his lower correlation view by using a higher delta to sell more protection. Thus the negative carry would be more limited than that implied using the market correlation level to calculate the hedges. The carry, in addition to being impacted by correlation, is also a function of the homogeneity and credit rating of the underlying basket.

Each of these trading strategies is discussed in more detail in part 3 of this Research Note using an emerging markets basket example that we propose.

Delta-hedging

As discussed the pricing of the FTD is driven by underlying spreads and the correlation among the credits. Before proceeding to looking at the various types of trading strategies in greater detail, we discuss here the spread risk in terms of the hedged portfolio.

Spread risk
The spread risk of a FTD basket can be hedged dynamically by entering in an offsetting CDS position on each of the individual underlying credits. The quantity of CDS protection to buy/sell is determined by the FTD basket's delta, or first-order spread sensitivity, with respect to each credit, and this is calculated using a pricing model calibrated on market observable parameters and the investor's view on correlation. For more details on the mechanics of delta hedging we refer the reader to Delta-hedging: a primer, 12 April 2006. The behaviour of the FTD basket is analogous to the equity tranche as both are bearers of first losses; however, the key difference is that the FTD default basket unwinds on the first default. As with the equity tranche, the sensitivity of the FTD basket spread to changes in each underlying credit spread decreases as correlation, and hence the probability of no loss, increases.

This delta-hedging immunises the protection buyer from small changes in the underlying credit spreads, however, spread convexity risk (second-order risk) arises because of the non-linearity of the MTM function and the FTD basket spread. Convexity has a different impact depending on whether it is a result of systematic or idiosyncratic volatility.

iGamma – single-name convexity
Idiosyncratic volatility – iGamma risk – arises when a single underlying credit spread widens or tightens by a large amount. When the credit spread widens the protection buying FTD position benefits whilst the long CDS hedge positions lose value. For small changes in spread the portfolio is immunized and therefore the gains and losses offset each other, leaving the investor's MTM unchanged. However, for large increases in a single credit, the FTD basket's delta with respect to that name increases and, as a result, the position is now under-hedged, resulting in a net convexity gain since more is gained on the short FTD than is lost on the long CDS hedge. Similarly, when the single credit tightens significantly the loss on the FTD position is less then the gain arising from the CDS hedges positions as a result of the now over-hedged exposure to the single name, following a decrease in its delta. As an example the following chart shows iGamma benefit achieved on a homogenous portfolio of 4 entities, with a notional of $10m each, a recovery of 40% and priced assuming correlation of 60% and all entities initially priced at 100bp.

Gamma – market convexity
Systematic volatility – Gamma risk – arises when the entire basket of credits widens or tightens together. If spreads widen significantly it results in an overall gain on the protection buyer's FTD position, due to the increased risk. Overall, the sensitivity of the FTD basket to the underlying credits decreases resulting in an over-hedged position in the long CDS position which loses value. Gains on the FTD position are now not sufficient to offset the losses on the CDS hedges, resulting in an overall convexity loss. Similarly a substantial collective decrease in spreads in the basket leads to an increase in basket sensitivity and the position becomes under-hedged meaning that more is lost on the short FTD position than is made on the CDS hedges, resulting in a net loss. This effect can be seen in the chart below.

For a more detailed discussion on spread convexity please refer to Gamma, The story of convexity, published by Dresdner Kleinwort 23 May 2006. Risk due to spread convexity can be mitigated by regularly re-balancing the delta-hedged portfolio; however transactions costs and liquidity constraints need to be considered. Alternative hedging techniques, such as using credit indices or 2nd, 3rd to nth to default baskets may be used in place of the single name CDS contracts but liquidity constraints may make such hedging strategies unfeasible.

In sum, a delta-hedged FTD protection buyer is long iGamma and short Gamma. When trading correlation, investors generally strip out spread risk by delta hedging using single name CDS leaving themselves with a correlation exposure.

Delta and carry
Generally, the delta of a credit with respect to an FTD basket will be far from 100% and the total carry on the hedging portfolio of CDS will therefore be lower than the carry on the FTD basket. For a protection buyer, this negative carry is the cost for earning a net expected upside upon a default event. Since the delta of a given name in the portfolio is substantially lower than one in general, the loss on the CDS leg from a default is lower than the gain on the short FTD protection leg.

This explains why a delta-hedged FTD protection buyer trader has a net negative carry. This can be mitigated somewhat when calculating hedge ratios as we explore in the section on FTD trading strategies, which will appear in part 3 of this Research Note.

The Gaussian one-factor model

A common approach for pricing correlation products, such as first-to-default baskets and synthetic CDO tranches, is the use of the one-factor Gaussian model. This technique simplifies the computation of the expected losses for the underlying portfolio and reduces the dimensionality of the problem thereby significantly reducing the computation time, compared to numerical simulation techniques (i.e. Monte Carlo simulation).

Step 1: Modelling the firm value
The first step in the process is the modelling of the firm value evolution for each of the underlying credits. In the one-factor approach it is assumed that the risk inherent in a firm's asset value is driven by two main components: a systematic risk factor, which is influenced by the general market conditions, and a firm specific risk factor. Through their nature these two factors are independent and in the Gaussian one-factor model case are modelled using a normal distribution with zero mean and unit variance. Conditional on the value of the common market factor the default probability of each entity is therefore also assumed to be independent (conditional independence).

Suppose there are n securities in the underlying multi-asset portfolio.
For i = 1...n the individual process of the ith firm's asset value, Xi, is then defined as: 

Where:
M = common market factor
Zi = idiosyncratic risk for the ith firm
Xi, M and Zi are independent random variables, normally distributed with zero mean and unit variance.
?i represents the sensitivities of Xi to the common market factor M

Using this setup we can make the following inferences:
• Firm Xi's risk breakdown into systematic and idiosyncratic risk is driven by the value of ?i. If ?i is equal to 0 the full risk of the firm is due to firm specific factors, whilst a value of 1 specifies that the firm value is driven purely by prevailing market conditions.
• For two different firm i and j their pair-wise correlation is defined as ?i?j

Step 2: Modelling the conditional default probability
Using a similar approach as Merton's structural model, the one-factor model assumes that a firm i will default if its asset value, Xi, falls below a threshold default barrier, defined as Di.

Suppose the marginal default probability for firm i by time t is defined by Pi(t), which can be calibrated using market observed CDS spreads. Then the default barrier Di is defined as

Where ?-1 is the inverse of a standard normal distribution.

Once this default barrier has been calculated the conditional default probability of firm i, by time t, is then defined as:

Where m is a realised of the common market factor M and ? is the standard normal distribution.

This set-up requires the calibration of n market correlations ?i , one for each firm, which is not always feasible for a large portfolio and therefore to ease computation it is sometimes assumed that all correlations ?i are equal and constant across all entities i.e. ?i = ?. The choice of this correlation is crucial as it affects the shape of the loss distribution, and hence the risk of the FTD baskets and other correlation products.

Step 3: Probability that there will be d defaults in the n entity portfolio
The next step is the calculation of the conditional probability of d defaults from the basket. This is calculated recursively starting initially with a basket with just one entity and gradually adding all the n entities, one entity at a time.

Let
QK(d,t|m) = probability of d defaults by time t, conditional on market factor m, based on a reference portfolio of K credits. Therefore d takes integer values between 0 and K.
PK+1(t|m) = conditional default probability of adding an extra credit (indexed as K+1) to a portfolio of K credits. K = 0 to n-1
Starting with the degenerate distribution for K=0, Q0(0,t|M)=1 we can then calculate recursively the distribution of number of defaults using the following equation, upto K=n:

Step 4: From conditional to unconditional probability
The above steps 2 and 3 are repeated for a number of realisations of the market factor m. The larger the number of simulations undertaken the greater the precision of the calculation.

The conditional default distribution can then be used to calculate the unconditional probability of d defaults in the n entity basket, by integrating out the common factor M:

Where ? is the standard normal distribution

Step 5: Calculating the value of a FTD basket
The value of a FTD basket is driven by whether or not there will be at least one default in the basket of n entities.

Let p(t) = the probability that at least one entity having defaulted by time t. This can be calculated using the unconditional probabilities as:

These probabilities can then be used to calculate the default and premium legs of the FTD using the standard CDS default and premium leg calculations, as can be found in Meneguzzo and Vecchiato (2002). The spread that equates the two legs is then the FTD default spread for a particular correlation assumption.

Notes
1. Apart from the extreme case of unity correlation in the basket, in which case the fair FTD premium is the spread of the widest name.

© 2006 Dresdner Kleinwort. This Research Note was first published by Dresdner Kleinwort on 3 October 2006.