Contents

CDR Liquid Index data as at 18 December 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.

More LCDS talk

European contract negotiations continue

The expected meeting and vote over the contract specifications for European LCDS (see SCI issue 19) failed to materialise on Monday. It has been postponed as further efforts are made to resolve what is believed to be the outstanding issue of the scope of deliverable obligations.

The area of dispute revolves around whether European contracts will reference an obligor or specific loans. In the past week a small group of dealers, representing both sides of the debate, have been exploring the areas of consensus among them and working towards a possible compromise solution to the issue. The aim of those meetings is to develop a proposal that can be put to the wider group of firms involved in LCDS discussion to date.

A meeting of that wider group is expected to be scheduled as soon as the smaller group's proposal is finalised. It is understood that attempts are being made to do so before the end of this week, but participant availability could preclude this before the New Year.

Overall, indications are that there is optimism over other European LCDS issues - including whether the contracts should be cancellable or not and the potential for convergence with the US LCDS market. For example, Markit Group published a report on its LCDS-related activities last week indicating that the standard European loan CDS contract is expected to evolve to a point where it can survive a refinancing.

"Europe currently uses a 'cancellable' contract due to the interests of some commercial banks. These banks are the natural buyers of loan CDS protection. In North America, development of the product has been driven more by hedge funds and other institutional investors. Europe and North America will almost assuredly continue to have different definitions of a credit event, as well as other significant differences reflecting the differences between the two cash markets," the report explains.

Markit went on to say: "As discussions have been progressing rapidly on altering the standard contract in Europe to survive a refinancing, it is expected that the LevX will be modified to use 'non-cancellable' loan CDS in the future. With further growth in volumes over time, the index is likely to gain broader dealer support."

Furthermore, it adds: "The LCDX (North American loan CDS Index) is expected to launch in the first quarter of 2007. Current discussions relate to issues for determining a cash settlement procedure for the index as well as single name loan CDS. The LCDX has complete backing of nearly all the major dealers that contributed to the North American LCDS product."

MP

ABX tranches advance

New documentation and new trades

The sell-side advanced talks on standardised tranche documentation on the US ABX index this week. Meanwhile, some increased buy-side interest in the products has also been in evidence.

Bankers discussed the first draft of the documentation this week under the auspices of ISDA and are due to review a revised draft in the first week of January. Comments so far are understood to be positive and non-conflicting, giving hope that standardised docs could be published as early as the end of January.

Full details such as attachment and exhaustion points have not been finalised, but some dealers are already quoting two-way prices - albeit on a non-standardised and low volume basis. It is expected that once standardisation is achieved volumes will increase dramatically, not least from the buy-side.

Investors have so far not been overly enthusiastic about the product (see SCI issue 9), partly because of the lack of standardisation, but also because of the small number of names in the ABX indices. However, there has been increasing interest of late in the lower rated indices from hedge funds. Those with a negative view on the prospects of the US housing market have been putting on long protection positions in the ABX BBB and BBB- series.

A report published by Nomura Research in New York on Monday notes: "The change in sentiment towards home equity loan asset quality is reflected in the recent volatile performance of the lower-rated tranches of the ABX index. BBB- spreads reached 405bp on December 8, an increase of 92bp from the close on December 1."

"Over the past week, the spread on the BBB- index tightened to 379bp, offsetting some of its recent widening. The BBB rated index performed similarly. On December 8, BBB spreads reached 243bp, a 48bp increase from the prior week's close. Over the past week, BBB spreads compressed about 10bp to 233bp. Over the same two week period, AAA and AA spreads traded relatively flat. The A rated tranche at 58.6bp tightened 7bp from its wide of 65.6bp last week, but remains 3bp wider than its spread at the start of the month," Nomura adds.

Volumes have not been spectacular however, which has been exacerbating the price moves. A key catalyst for the recent volatility has been the closure of the subprime lender Ownit Mortgage Solutions on 6 December and the subsequent negative headlines about rising mortgage delinquencies.

"The weakness in the lower quality tranches of ABX is bound to persist into the New Year, at least till solid signs of a bottoming out in the US housing market appear. And even then, concerns about the quality of the 2006 home equity loans' vintage are likely to limit any performance reversal in these tranches," says Gregory Venizelos, structured credit strategy at Royal Bank of Scotland.

MP

First Russian local CDO arrives

Innovative emerging market deal could lead to more such trades

OJSC Bank Zenit has launched the first CDO backed by a portfolio of Russian local corporate debt exposures. The transaction was structured by JP Morgan and is managed by Bank Zenit.

The two-year synthetic transaction, called Red Square, is denominated in Russian roubles and references a portfolio of 40 Russian local corporate names. The deal transfers the risk on a RUB6.7bn (US$255m) portfolio comprising second- and third-tier corporate exposures equally weighted at 2.5%.

The primary difficulty in creating a synthetic Russian local corporate deal is the absence of an onshore CDS market, which is principally due to a continued lack of legal certainty for OTC derivatives for all asset classes in the country since the 1997 financial crisis. However, for the purpose of the CDO JP Morgan and Bank Zenit were able to put together a reference portfolio of CDS replicated by physical assets.

Within Red Square, second-tier corporates are defined as middle-sized private and government-owned industrial, telecommunication and retail enterprises with a turnover of US$0.5bn to US$3bn. Third-tier corporates are defined as rapidly growing privately-owned companies mainly operating in the consumer goods or construction sectors with a turnover of US$150m to US$1bn.

The portfolio is split between 5% first-tier, 65% second-tier and 30% third-tier corporates. The largest industry concentrations are 22% in retail and 14% in the telecommunication sector.

The risk has been tranched into 10% equity, 10% mezzanine notes and 80% senior notes. The notes are unrated, reflecting the fact that the underlying names are unrated. Bank Zenit has, however, provided investors with its own credit ratings on each name.

The yield on the underlying portfolio is 8.9% and the notes pay an average spread of 300bp over Russian government bonds (65bp over for the senior paper, while the mezz and equity have coupons of 8.75% and 13.25% respectively) and will settle in US dollars, meaning that investors bear the currency risk. Accounts across Europe and Asia participated in the deal, attracted by the generous yields and diversification opportunities on offer.

Given that local currency debt is a largely unexploited market for structured credit, Red Square is expected to open up a range of opportunities for CDO issuers and investors. The Russian local corporate debt market is growing rapidly, with a market capitalisation of RUB785bn and 311 issuers active in the sector.

MP

Citi sets SAILS

New product aims to help investors protect against LBO risk

Citigroup is believed to be the first bank to offer its customers leverage-triggered credit default swaptions. The instruments are primarily targeted at fund managers looking to hedge their bond holdings in the face of the continuing flood of leveraged buy-outs, but have a variety of uses for a range of investors, the bank says.

"Significant Acquisition and Increased Leverage Swaptions (SAILS) ... should protect bondholders from spread widening caused by companies that leverage their balance sheets. SAILS are structured as CDS options (swaptions), which can be exercised by a buyer upon the occurrence of leverage events that satisfy predetermined conditions," explains a report from Citigroup's fixed income quantitative strategy team in New York.

SAILS are structured in a similar manner to vanilla single name payer CDS swaptions. For example, both instruments are knocked out in the event of default.

SAILS optionality is European (exercised only at maturity) and the contract is settled physically. The strike of the underlying swaption is defined as an at-the-money forward implied by the CDS curve at inception. The instrument's succession rules are also similar to a vanilla CDS contract.

However, while any spread widening affects the vanilla CDS swaption, only spread widening that follows a 'leverage event' directly affects SAILS payouts. The contract is only triggered in the event of a company going private or 'aggressively' increasing its leverage.

The latter is defined as the company's debt/EBITDA ratio as of the exercise date increasing more than a pre-agreed percentage from the trade date and the company's total debt as at the exercise date exceeding a pre-agreed percentage of its total debt as at the trade date. Consequently, the price of SAILS should always be lower or equal to CDS payer swaptions.

In certain circumstances, leverage and total debt of a credit can go up as a result of a merger or another change in the company's capital structure while the spreads actually tighten. In this case, SAILS will expire out of the money even if the leveraging event occurs.

In addition to protecting bondholders from leverage events, there are other possible trading strategies investors should consider, according to Citi. "SAILS can also be used for expressing one's views on the likelihood of a leverage event. Furthermore, investors can utilise SAILS for executing directional and relative value trades," it says.

Nevertheless, Citi adds that investors should keep in mind several risks when considering the product:

• The liquidity of SAILS can be spotty and bid-offers can be wide. Therefore, it could be somewhat costly for investors to get out of their positions before expiration (similar to the situation with CDS swaptions).
• Delta hedging SAILS might be complicated because the contract's payout is conditional on a leverage event that cannot be easily hedged by any tradable instrument.
• SAILS are triggered only upon the closing of the announced transaction, which takes time. The underlying credit spreads immediately react to the announcement. If the announcement was made when SAILS are near their expiration, the SAILS would not necessarily offset the losses on the long credit position.
• As the SAILS contracts are not standardised, there is a potential legal risk with the mechanics of the product.

MP

"We're fanatic about automation of data"

Structured fixed income deal modelling data firm Intex is the subject of this week's Provider Profile

Boston and London based Intex Solutions has been providing structured finance models and analytics since 1985. Today, it maintains a database of over 16,000 deals covering RMBS, CMBS, ABS and CDOs.

The firm's deal coverage originally encompassed those of US origination, but it now also increasingly includes European issues. Intex has incorporated well over 1,000 European deals across different asset classes into its database, despite only gaining improved access to data from European issuers in recent years.

Chris Kilborn

As Chris Kilborn, who runs Intex's London office, explains: "We first looked at expanding our cash-flow database into Europe roughly five years ago, though it is only within the last three years that it has been viable for us to fully commit to Europe. This is because of an improvement in the availability of the necessary data we need to model the deals."

This improvement comes from the market evolving, according to Kilborn. "There has also been a growing trust in Intex as a deal modeller in Europe, as evidenced by the growing use of Intex's services among leading European arrangers and investors. Intex does not charge arrangers to model their deals, and models deals from all European arrangers, whether or not the arranger is also an Intex client," he says.

Intex says that it now uses its capacity to model most new European RMBS, ABS, CMBS and CDO deals as they are issued, as well as to backfill older deals in its clients' portfolios. However, the firm still sees the European market as having a way to go to catch up with the level of data transparency enjoyed in the US.

"In the US, it's typical for loan level collateral to be provided by trustees and servicers for most deals every month; Europe is usually more of a quarterly paying market, and the level of information and relative lack of loan level data characterises the European market," observes Jim Wilner, the firm's US based vp.

"We therefore often rely upon original data presented in the prospectus and updates from trustees' reports and the like. Clients understand the issues we face, and come to appreciate us for the hallmarks of our success: breadth of coverage, accuracy of our deal waterfall, and timeliness of new deals and updates to seasoned deals in the system. When issuers in Europe are ready to provide loan level data, Intex already has the infrastructure to incorporate this information into our deal update files," Wilner adds.

The firm claims that key to its market appeal is maintaining a full cash flow analysis for each deal in its library. "Our analytical products are much more than a simple warehouse of data. Intex models the waterfall of the cash-flow of a deal and allows the user to stress this model for different prepayment and loss scenarios," says Kilborn.

Intex says its dedication to customer service sets it apart still further. A core competence is having the necessary skill-set to take complex data from a prospectus and accurately translate the rules in a deal into its deal library, while also keeping up with new issuance. "We're fanatic about automation of data within the system so that clients get the best possible quality of data as well as timely access to deal updates" adds Kilborn.

This approach means, the firm says, that it already has a significant core of investors and arrangers in Europe using Intex systems. Wilner also expects demand for the product to keep growing, especially if economic conditions were to change.

"The relatively low default level in Europe, coupled with the age of the market, means that there hasn't been quite the urgency to have good analytics as we see in the US, but the trend is up. The possibility of rising default levels means people see that having good analytics is crucial to stress testing the tranches they own. A surveillance database on its own is not enough," he says.

At the same time, the secondary market is of growing importance to the firm, and Intex claims that the very existence of their software in the market to price and stress test deals helps foster more growth. In addition to keeping pace with new deal issuance, it is also concentrating on backfilling any missing deals in the supported asset sectors.

"Client demand, along with access to necessary deal documents, dictates which deals get backfilled first. Our goal is to increase our already significant coverage to as close to 100% as possible in the asset classes we cover," adds Kilborn.

Equally, the number of markets Intex covers is also growing. Deals from Australia, Japan and Russia are all recent additions to the firm's database.

A complete data set is a key part of the decision to buy off the shelf, Intex argues, as is encouraging clients to concentrate on their core business competency as the market develops. Wilner explains: "As investors ramp up they need to focus their energies on the business of analysing deals, rather than collecting data, interpreting deal documents and building deal models. People shouldn't need to model deals themselves anymore; they can use software to do so. Our system allows them to cease building by spreadsheet, and so in effect lets them get out of the software business to manage their portfolios more effectively."

He continues: "Another typical set of users are those that value the ability to stress a deal for pre-payment and default. In the past they might have relied upon a bank or a ratings agency and simply have been a viewer of data. Now as they increase their coverage they also see the need to bring the capability to analyse the model in-house."

JW

Wachovia continues to build European CDOs

The latest company and people moves

Wachovia continues to build European CDOs
Wachovia has added more key staff to its London office as part of its long-term expansion plans in Europe (see SCI issue 7). Neil Basu joined this week from Nomura International, where he was director and head of CDOs.

Basu has been named md and head of European CDOs and structured credit products at Wachovia. Along with former colleague, Chandrajit Chakraborty – who joins as a director – his primary role is to build CDO origination. Basu reports to Yu-ming Wang, head of structured credit products in New York.

Moody's buys Wall Street Analytics
Moody's has acquired Wall Street Analytics, the structured finance analysis and monitoring software developer. The firm will now be known as Moody's Wall Street Analytics.

Moody's says the acquisition will broaden its capabilities in the analysis and monitoring of complex structured debt securities, while increasing the firm's analytical and product development staff dedicated to creating new software and analytic tools for the structured finance market. In particular, the addition of Wall Street Analytics enhances Moody's current CDO product suite and immediately adds MBS and ABS analytic software capabilities.

Terms of the transaction will not be disclosed and the financial impact to Moody's is not expected to be material.

Lehman re-draws Europe
Lehman Brothers has announced the appointment of Riccardo Banchetti in a newly created role as ceo for Italy. Banchetti will assume full responsibility for the firm's activities in Italy and will report to Roger Nagioff, coo for Europe. For the past four years, Banchetti has been head of European fixed income sales and, for the last year, coo for Italy.

Following Banchetti's appointment, David Bizer will be returning to Europe from the US to assume the position as head of European fixed income sales. In his new role, he will be responsible for managing all aspects of fixed income sales in Europe, including liquid market credit, mortgage and structured finance. Bizer will report to both Andy Morton, head of European fixed income, and Tom Humphrey, global head of fixed income sales.

Additionally, Philippe Dufournier will take on a newly created role running all of the fixed income solutions businesses across global finance and fixed income. His mandate will include the risk solutions, pension solutions, intellectual capital and structured solutions groups. Dufournier will also report to Morton and Humphrey, as well as continuing to report to Philip Lynch, head of global finance, Europe.

Deutsche appoints Nicholls as European head
Deutsche Bank has appointed David Nicholls as head of global finance Europe, within its global markets division. In his new role Nicholls will be responsible for developing performance improvements across Deutsche Bank's pan-European global finance platform and innovating new methods of multi-asset class financing, structuring and interest rate trading.

Nicholls, who was previously head of global finance in London, will continue to be based there and will report to Alan Cloete, head of global finance and foreign exchange.

Calyon team arrives at Mizuho
Alexander Rekeda has joined Mizuho Securities as head of structured credit, Americas. His mandate is to build a US structured credit operation to originate, warehouse, structure, trade, underwrite and globally distribute cashflow and synthetic CDO products including CLOs, ABS CDOs and CRE CDOs.

Rekeda joins Mizuho Securities from Calyon, where he had been employed since July 2004 running the firm's cash CDO business. Paolo Torti has also arrived from Calyon as head of structured credit trading, reporting to Rekeda. They are joined by several key members of Calyon's structured credit team – Benjamin Lee, Yuri Chumak, Xavier Capdepon, Gwen Snorteland and Rachel Yang – who have all previously worked with Rekeda.

Doug Munson and Jim Shepard have also been appointed co-heads of Mizuho's US debt capital markets department. Joining them are Bill Budd, Dan Will and Clifford Condon, who previously worked together at Calyon. The team will be responsible for distributing new product lines including project finance, corporate bonds, 144A and private placements, and developing new client relationships to take advantage of these expanded product offerings.

As a part of the department, Bill Budd will head structured credit sales. His team will be dedicated to distributing the debt and subordinate tranches of the transactions originated by the structured credit department. Dan Will joins the firm to focus on project finance and special projects.

MP

Eurex releases iTraxx futures details

A round up of this week's structured credit news

Eurex releases iTraxx futures details
Eurex has confirmed that it will launch its exchange-traded credit derivatives contract on 27 March 2007; a future based on the iTraxx Europe 5-year index series. In addition, dependent on market demand and sufficient market-maker support, Eurex will list futures contracts on the iTraxx HiVol and iTraxx Crossover indices, either simultaneously with the main index product launch date or soon after.

The exchange says that Eurex iTraxx credit futures will have a fixed coupon and semi-annual maturity dates in March and September. The contract size is €100,000; the tick size is set at €5 per tick.

The product will be cash settled, with reference to the iTraxx index values of IIC. In the case of a credit event, cash settlement of the single name entity will be made with reference to the ISDA CDS protocol. The Eurex iTraxx Europe futures contract will be supported by designated market makers.

Chicago Mercantile Exchange is also scheduled to launch its 'credit event futures' (see SCI issue 13) in Q1 2007.

Cedulas CDOs show collateralisation ratio anomaly
A new report released by Fitch Ratings says that collateralisation ratios (CRs) for CDOs of cedulas hipotecarias (CH) have reversed their declining trend in Q306 for most Spanish financial institutions due to a lack of CH issuance. Fitch adds that as more CHs are anticipated shortly, a return to the decreasing trend seems highly likely.

In Q306, 51 out of a total of 57 CH issuers showed an increase in their mortgage books. In the same period, a low level of CH issuance was seen.

The eligible mortgage portfolio ratios of some institutions, however, remain close to the limit established by Spanish law. Nevertheless, Fitch has verified that these CRs remain in line with a triple-A stress scenario and are still above those legally required.

OCC sees strong credit derivatives growth
Insured US commercial bank holdings of credit derivatives grew 20% to US$7.9tr in Q306, according to the latest Quarterly Report on Bank Derivatives Activities from the Office of the Comptroller of the Currency. "We continue to see very strong growth in credit derivatives, as well as progress in reducing outstanding confirmations and improvement in overall infrastructure," comments Kathryn Dick, deputy comptroller for credit and market risk.

DTCC warehouse enhancements
DTCC has struck a deal with FX risk reduction network CLS Bank International (CLS) to provide central settlement of payments for contracts housed in DTCC Deriv/Serv's Trade Information Warehouse. Meanwhile, technology providers are upgrading their products to enable access to the Warehouse.

The DTCC-CLS partnership will aim to provide an integrated global payment processing infrastructure for the OTC derivatives market, linking the Trade Information Warehouse with a central settlement facility. The new service will come on-stream sometime in 2007, the two firms say.

Thunderhead has launched a new version of its XML Adapter for Deriv/SERV which includes support for the Trade Information Warehouse. This new version is being made available to Thunderhead customers through a new service offering designed to ensure continuing compliance with all current and future DTCC Deriv/SERV messaging standards. The product is the first off-the-shelf solution in the industry to announce full support for DTCC's current messaging standard for the Deriv/SERV Trade Information Warehouse.

And Interwoven has upgraded its Scrittura Messaging module to allow its buy- and sell-side clients access to the full functionality of the Trade Information Warehouse. Scrittura Messaging is embedded into Interwoven's Scrittura Dealer and Scrittura BuySide solutions, and generates and validates trade confirmation messages for all OTC derivatives products, including DTCC messages for all product types such as credit, equity and interest rate derivatives.

Q-WIXX launches automated execution services
Q-WIXX, an electronic platform for trading large credit derivative portfolios, has announced its inaugural beta trade – a portfolio of US$1bn and €500m consisting of 131 North American and European credit derivatives names.

The transaction took ten minutes to execute on the Q-WIXX platform; in the past such a transaction would have required significantly more time, the firm says. Q-WIXX is expected to be in beta mode until January 2007, at which time a formal global launch is planned.

Quantifi offers base correlation term structure model
Analytics provider Quantifi has launched Quantifi Version 8.5, which includes Quantifi's base correlation term structure model that aims to provide more accurate pricing of CDO structures. The tool is specifically aimed at CDOs which are sensitive to the term structure of correlation, such as interest-only tranches, off-the-run index tranches and bespoke CDOs.

Other enhancements in Quantifi's new release include:

- Expanded support for base correlation surface mapping, which now includes mapping based on moneyness, moneyness PV, probability, senior spread, equity spread, expected loss ratio and expected loss ratio PV.
- Added improved support for interest-only, principal-only, funded and floating CDO structures.
- Expanded credit derivative index option calculations.

MP

Trading ideas - viva Las basis

Dave Klein, research analyst at Credit Derivatives Research, looks at a negative basis trade involving MGM Mirage

Based on our survival-based valuation approach – which implicitly judges how rich or cheap bonds are to the CDS curve (see SCI passim) – MGM Mirage Inc's bonds are trading both rich and cheap to the CDS market. Specifically, the 8.375's of 2011 bond is about US$1.75 cheap to fair value.

Exhibit 1 indicates the 'price-based' term structure of MGM and indicates that both of MGM's bonds are trading cheap. Please note that not all bonds have traded recently and so some of the levels will not be executable. Also note that this is a senior subordinated bond so that much of the "cheapness" comes from its subordination. We discuss this further below.

Exhibit 1

Importantly the bonds that we pick out are reasonably liquid and currently active – as evidenced by our data from Bloomberg's CBBT and Market Axess's Bond Ticker. MGM is reasonably active in the credit derivative markets and has liquid cash bonds. Based on our analysis of bond cheapness and market activity, the 8.375's of February 2011 is viable for the long bond leg of our negative basis trade.

We must now look at the actual spreads to judge whether we are trading at a negative basis, and, maybe more importantly, can position ourselves with positive carry.

Comparing the bond z-spreads (for the active bonds) with the CDS term structure, Exhibit 2 shows that the shorter-dated bonds are indeed trading wide of CDS. Importantly, we must note that the bond is trading wide of its interpolated maturity-equivalent CDS (five year) which reflects our second basis adjustment discussed above. We also note that MGM's z-spread curve is steeper than its CDS curve in shorter maturities. This helps motivate our trade.

Exhibit 2

The MGM CDS curve is 'well-behaved' and has no serious inflexion points. There is also reasonable liquidity in the seven-year on-the-run maturity. We have seen solid two-way pricing on Bloomberg's ALLQ screens for the 8.375's of 2011.

Given that we have identified the MGM 8.375's of February 2011 bond as trading cheap to the CDS market (from our survival-based framework) and its z-spread as being wide of on- and off-the-run CDS levels, we must ensure that we account correctly for any premium or discount at which the bond is trading.

As we discussed previously, we must adjust for the impact of loss given default differences between the bond and CDS market. This maximum 'gearing' effect is translated into our adjusted basis and carry calculations. At current levels, the package has a raw basis of -29 basis points, and a positive carry of 14 basis points. This shows the impact of correctly adjusting our bond-CDS comparison for bond price and curve steepness.

Over the hedge
There are two significant risks that need to be hedged in a bond-CDS negative basis trade. The first is default, which can be accounted for primitively in the adjustments we suggested previously to the CDS leg notional amount. In a perfect world, we would suggest frequent re-hedging of the CDS leg to account for changes in the bond price, but this is impractical in reality.

A practical approach is to hedge the bond's default risk with the most liquid (and closest in maturity) CDS according to the average of current and final bond price adjustments. Our initial hedge amount should be based on a minimisation of expected loss in default– we calculate the initial hedge as (Bond Price – Recovery)/(Par – Recovery).

For a bond trading at US$110 and assuming a 40% recovery, the initial hedge amount should (110-40)/(100-40)=117%. We should buy US$11.7mm protection for each US$10mm of face value bond we buy.

This hedge will, obviously, be over-hedged as the bond pulls to par at maturity. We would want to hold a 100% weighting in the CDS as we get close to maturity. So we simply average our initial and final hedge amounts – (117-100)/2= 108.5% - to arrive at our 'simple' initial hedge. We therefore buy US$10.85mm protection for each US$10mm of bond face value we buy. This hedge is, on 'average' our most optimal hedge.

We have a slightly more directional perspective on this hedge. Given that we are basically hedging the impact of default on our position, if we felt strongly that the credit was unlikely to default, then we would prefer to receive more carry for more default risk. Vice versa, if we felt that fundamentals were weakening and the credit was more likely to default, then we might prefer to be slightly over-hedged.

Utilising Gimme Credit's Credit Scores – which reflect the fundamental outlook for the issuer, we adjust our single CDS hedge. If the outlook is improving then we will prefer to hedge only 100% of face value to maturity. If the outlook is deteriorating then we would hedge at our maximum current hedge amount (117% in our example). If the outlook is stable then we will choose our mid-point optimal hedge (108.5% in our example).

Once this hedge is put on, we will monitor bond price levels and default risks to ensure that our hedge is still 'close' to default neutral. This is more reasonable than adjusting frequently and paying the bid-offers, and even more importantly can often provide more carry in the short-term on a credit that is a low default risk.

In our specific trade today, the bond is trading at US$105.25 (best ask) and so our maximum hedge would be (105.25 – 40)/(100-40) = 108.75%. However, today's trade is not a "pure" negative basis trade in the sense that the bond we have chosen is not deliverable as a reference obligation on the CDS (see below). Given our stable fundamental outlook for MGM and the fact that it is often difficult to transact in odd lot size, we feel it is more realistic to assume a 100% hedge.

Adding in mid-dated CDS to balance the hedge is possible and we are happy to discuss the use of a second CDS position with any investors who prefer to be more 'perfectly' hedged. Given the relatively light liquidity of MGM, we strongly suggest the single CDS to bond 100% hedge and a less frequent but vigilant re-hedging program. We can generate a forward-based price projection for the bond based on the CDS curve – to show how we expect the bond price to drop (premium) or rise (discount) until maturity – which may help some investors with their hedging strategies.

The second (and often overlooked) hedge is the simple interest rate hedge on the bond. Our basis trade is positioned to benefit from any convergence of the credit risk perspectives of the cash and CDS markets and further, the bond is cheap on the basis of its CDS curve (only credit-risk based). We therefore must ensure that our bond is hedged against interest rate movements and the impact these will have on the price of the cash instrument. Note that the CDS is exposed to interest rate movements but only in the discounting of cashflows and this interest rate sensitivity is minimal (and we ignore it in this case).

Investors could choose to asset swap the bond to minimise the interest rate sensitivity but we suggest otherwise. The asset swap has a number of shortcomings (not the least of which are lack of liquidity, premium/discount bond price errors, and default cash flow timing mismatches). We suggest buying the bond outright – benefiting from the most positive carry – and hedging interest rate risk on a portfolio basis.

We assume that many investors will not be carrying a single bond exposure and therefore it is more efficient to manage overall interest rate risks in a portfolio context. Also, assuming that investors will be over-, or under-weight issuers against their bogeys (in the traditional fixed income shops), this portfolio-based interest rate risk management allows for a more direct allocation of funds that reflects the interest rate 'view' of the manager.

Given the cheapness of MGM's bonds, negative basis and positive carry of our overall position, we suggest this negative basis trade (long bond and long protection) as a default-neutral way to pick up 29 basis points and more importantly potentially realise the bond's relative value differential.

Risk analysis
This position is close to spread duration-neutral. There is a slight maturity mismatch which is driven by the need for liquidity in CDS but does not concern us as we expect convergence long before our CDS position matures and the curve steepness between maturities is not a major factor.

This bond ranks as Senior Subordinated and therefore is not deliverable if MGM goes into default. Given our stable fundamental outlook, we do not believe that MGM is a good candidate for default over the expected medium-term life of our trade. We do expect the bond z-spread to be highly correlated to the Senior CDS curve however and this motivates our seniority mismatch.

Additionally, the bond has a poison put at US$101. If MGM goes LBO, we'd expect 5Y CDS to widen to the 300bps range whereas the poison put provides a floor for the bond price and hence a ceiling for the z-spread. In the case of an LBO, we'd expect a tidy profit from the credit sell-off.

We do, notably, understand that many investors would still prefer to understand the interest rate risks associated with this position. Exhibit 3 shows the overall and key-rate sensitivities for the bond that can be used to specifically hedge any residual interest rate risk and offers the investor some more insights into the price sensitivities of the position.

Exhibit 3

The trade is positive carry – given the current levels. This carry cushion protects the investor from any short-term mark-to-market losses.

Entering and exiting any trade in these maturities carries execution risk, but this is not a major risk with MGM in this maturity as it is increasingly liquid. Our largest concern is execution in size in the bond markets.

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, provide us with significant comfort in both the ability to enter a trade in MGM and the bid-offer spread costs.

MGM is a member of the CDX XO Series 7 and shows reasonable liquidity in the five-year maturity with bid-offer spreads narrowing to around 5-10 basis points. Recent bids and offers (seen on Bloomberg's ALLQ) for the 2011 MGM bonds have been reasonable and there is liquidity in both directions.

This trade possesses a fair amount of liquidity risk. We recommend the bond leg of the basis be worked first, looking for a price below US$107.07 (our model fair-value).

Fundamentals
While this trade is technical in nature and not necessarily impacted by fundamentals, we must confirm there are no surprises in the short-term that could cause divergence between cash and CDS markets such as LBOs or major M&A activity. The trade is based on the bond market being mispriced relative to the CDS curve, rather than an expectation of general curve movements.

There are no major concerns with this credit's stable fundamental outlook, especially given the technical nature of the trade and the expectation of CDS and bond markets reacting similarly to 'good' or 'bad' news. We are comfortable that the trade makes sense and that there is little potential for major differentials between cash and synthetic credit.

We also note that our internal LBO screens are mixed on MGM with our fundamental screen indicating the company to be a poor candidate whereas the options market gives a higher likelihood. As noted above, we believe the bond's poison put provides a hedge against an LBO blowout. Tracinda Corp. has made a tender offer which could potentially boost its stake of common stock to 61%.

Summary and Trade Recommendation
As Kirk Kerkorian boosts his stake in MGM yet again and with credit spreads near their recent tights, we find relative value when comparing MGM's bonds to CDS. MGM's shorter-dated bonds are trading cheap to its CDS curve, based on our CDS-implied Bond Valuation model.

The traditional z-spread-to-CDS raw basis is negative and our 'curve and bond price'-adjusted basis remains negative and shows positive carry. Given a stable fundamental outlook, we feel a negative basis trade is an excellent opportunity to earn carry while waiting for the bonds to converge to fair value.

While this bond-CDS pair does not provide a complete hedge against default (a possibility we view as remote), the protective covenant in the bonds will reward us in the case of an LBO (as CDS underperform). If, instead, events continue to improve at MGM then we would also expect to profit as the senior-sub divide is likely to narrow as spreads tighten.

Given these two scenarios outperformance expectations, we recommend this positive convexity trade which provides 29 basis points of carry.

Buy US$1mm notional MGM Mirage Inc. 5 Year CDS protection at 167bps

Buy US$1mm notional (US$1.05 mm cost) MGM Mirage Inc. 8.375% of February 2011 bonds at a price of US$105.34 (z-spread of 196bps) to gain 29 basis points of positive carry.

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).

Constant proportion debt obligations

Satyajit Das looks at the structure, economics and market for CPDOs

The structured credit markets have emerged as a significant source of yield and return enhancement for investors. A primary feature of structured credit is the use of leverage to enhance returns. Constant proportion debt obligations (CPDOs) are the market's latest effort at using leverage to increase returns for credit investors¹.

CPDOs emerged in 2006. The originator of the idea is believed to be ABN AMRO. The product was driven by a combination of factors including:

• A benign credit environment characterised by low levels of default and strong corporate profitability, cash flows and balance sheets.
• Decreasing corporate credit spreads driven in turn by the credit market conditions and a marked imbalance between credit investment capital and available credit assets.

The product was also driven by some more idiosyncratic factors. In 2005, temporary dislocation in traded credit markets allowed investors to create triple-A high yielding credit assets – Leveraged Super Senior Notes². The downgrade of General Motors and Ford to non-investment grade and the resulting change in traded credit correlation enabled investors to generate returns of LIBOR plus 50bp and above on triple-A assets.

The correction in that market limited the opportunity to continue to use that structure to generate high returns. The CPDO is targeted at these investors seeking triple-A rated assets at higher returns than available in the market.

Structure
The basic idea underlying the CPDO structure is a highly leveraged trade on selected credit indices.

The basic elements of the structure are as follows:

• The structure is fully funded. The investor purchases a note (say US$100m) with a final legal maturity of 10 years. The note is rated triple-A by the rating agency. However, the principal and interest of the note is not specifically guaranteed.
• The Note pays a coupon of around LIBOR plus 200bp pa. The economics of the spread rely on leverage (as detailed below). The leverage typically deployed is around 15 times.
• The dealer structuring the CPDO hedges as follows:
1. Dealer invests the US$100m in high quality collateral.
2. Dealer sells protection on US$1,500m notional on credit indices – typically, the DJ CDX IG-7 and the iTraxx.
3. Dealer must re-balance the hedge every 6 months by rolling the credit index position to the new series of the index.
• If there are no losses, then the investor receives full return of principal invested. However, if there are credit events on the names in the index, then normal settlement is effected, lowering the principal returns to the investor.
• The structures have a natural "defeasance" or "cash-in" effect that may reduce the "economic" life of the transaction.

Economics
The primary driver of the economics of the CPDO structure is the significant leverage utilised. The economics can be illustrated with a hypothetical example:

• Assume the example above - US$100m 10-year note. The note principal is placed in high quality collateral. Let us assume it earns money market returns at LIBOR flat.
• The investor is selling protection on US$1,500m on the 10 year selected credit indices. Assuming the spread on the index is 35bp pa. The investors earns 525bp (35bp x 15).
• Investor receives LIBOR plus 200bp pa on the CPDO.
• Assume the arranger receives 60bp pa.
• The net position is 265bp (525 - (200 + 60)).
• The excess spread is set aside to cover certain costs:
1. Roll costs (as index is reset)
2. Mark-to-market costs.

The defeasance/cash-in effect inherent in the CPDO structures is predicated on the net spread. The excess net spread (after adjustment for the costs that must be covered) builds up over time if there are no defaults.

This creates a buffer that prior to scheduled maturity covers the remaining coupons and fees. It effectively defeases the outstanding interest owed, allowing the transaction to be cashed in before the final legal maturity.

In a typical structure, the model indicates:

• 50% probability of being cashed in after 5 years.
• 75% probability of being cashed in by 7/8 years.

The economics of the cash-in can be illustrated (using the previous example):

• If we assume the 10-year swap rate is 4.85% pa, then the present value of the spread (200bp pa) is US$15.56m.
• The net spread (assuming no defaults) is 265bp pa (US$2.65m). This equates to a cash in target of around 5.9 years ((US$15.56/US$2.65).

Analysis
The value in the CPDO relies on using a highly leveraged structure to monetise an expectation of no defaults (specifically early defaults) in the underlying credit risk assumed.

The primary credit risk mitigation is based on:

• Diversification - credit is diversified through selling on 250 names (equally weighted between CDX IG-7 and i-Traxx).

• Rolling the index – the requirement of semi-annual rolls to a new series of the underlying credit indices is designed to reduce credit risk. In effect, the rolls should lead to the less liquid and deteriorating names dropping out every time the index rolls. This should reduce the risk. In effect, the investor's risk is always to the default of any one name in the portfolio within the relevant six month period.

A major attraction of the CPDO is its triple-A rating. The rationale for the triple-A rating is clearly the perceived low risk. This low risk is as a result of the investment grade underlying credit risk of the portfolio.

This risk is mitigated via the rolls, which, as noted above, limits the risk horizon to 6 months. Rating agency stress tests obviously support triple-A probability of repayment of coupons and principal.

The leveraged structure means that the investor is effectively providing the highly levered equity on a large portfolio of credit risk. The structure carries significant credit risk: (1) event risk (an investment grade credit defaulting unexpectedly); and (2) credit cycle risk (rising default rates as a result of an overall weakening in the economic and credit conditions).

It is not clear how the structure will perform where defaults occur and the credit environment weakens significantly. It is likely that in those conditions, the CPDO itself will have significant rating downgrade risk.

The level of credit risk in the structure is easily discernible. Assume 1-3 defaults per year over 5 years with 40% recoveries. The economics of the CPDO (using the previous example) is apparent.

Each default equates to 0.40% of portfolio (1/250) before recoveries. The loss after recovery is 0.24%. This is equal to US$3.6m (calculated as US$1,500 m x 0.24%). This means that 3 losses equal US$10.8 m to be covered from the net spread (US$2.65m pa).

The CPDO structure also carries maturity and liquidity risk. Investors also find the "projected" term (shorter than the final 10 year maturity) of the CPDO attractive. This assumes early defeasance. However, early defaults will means that leverage will not come down and the term will lengthen.

The investor in the CPDO also has significant liquidity and related spread risk. This is related to the required semi-annual rolls. The investor is fully exposed to the impact of liquidity and roll costs every 6 months when credits drop out and are replaced. The high leverage of the structure means that US$5bn of the CPDO issues creates US$75bn of index selling and rolls.

The CPDO structure assumes modest roll costs (around 2bp). The assumed roll cost may be low. In addition, under stress conditions in the credit markets, it is not clear whether the rolls are feasible. In this context, it is useful to remember that the market credit indices and trading in instruments based on the indices is a relatively recent and untested.

The investor is also exposed to the impact of spread changes on each roll date. This may increase the credit spread accruing to the investor (if market spreads widen) or decrease the return (market spreads decrease).

However, the bigger effect of credit spreads changes will be on the mark-to-market of the CPDO notes themselves. Small changes will effectively be magnified by the high leverage employed. Rising defaults and the simultaneous increase in credit spreads may trigger large losses (both realised and mark-to-market) in the CPDO.

Market
The CPDO market has attracted significant interest. It is assumed to be a factor in falling credit spreads in the market. As at November 2006, volume of CPDOs issued were estimated at around US$1.5bn to US$2.0bn. There are already signals from the rating agencies that the levels of fees and leverage used may need to be lower to achieve triple-A ratings.

The CPDO is an interesting innovation that uses the precedent of the Leveraged Super Senior Note to increase leverage to enhance yield at the highest end of the credit spectrum. Such trades are attractive in the benign credit conditions that have prevailed in recent years, but may well prove significantly less attractive in more hostile credit market environments.

Notes
1. See Consoli, Victor (31 October 2006) "Views Across The Grade: Levered CDX Index Notes Have Been Compressing CDS Spread"; Credit Strategy and Economics, Bear Stearns, New York; Davies, Paul J. "Questions Lie Beyond CPDO Hype" (14 November 2006) Financial Times.
2. See Das, Satyajit "CDO Structures – New Investment Products" (December/ January 2006) FOW 45-48.

© 2006 Satyajit Das All right reserved.

About Satyajit Das
Satyajit Das works in the area of financial derivatives and risk management. He is the author of a number of key reference works on derivatives and risk management. His works include Swaps/Financial Derivatives Library – Third Edition (2005, John Wiley & Sons) (a 4 volume 4,200 page reference work for practitioners on derivatives) and Credit Derivatives, CDOs and Structured Credit Products –Third Edition (2005, John Wiley & Sons).

He is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall), an insider's account of derivatives trading and the financial products business filled with black humour and satire. The book has been described by the Financial Times, London as " fascinating reading ... explaining not only the high-minded theory behind the business and its various products but the sometimes sordid reality of the industry".

He is also the author (with Jade Novakovic) of In Search of the Pangolin: The Accidental Eco-Tourist (2006, New Holland), an unique travel narrative offering passionate and often poignant insights into the natural world and the culture of eco-travel.