Contents

CDR Liquid Index data as at 26 January 2007

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.

Next generation CPDOs on the blocks

Variety of new deals in the pipeline, but ratings issues are causing delays

A plethora of new rated CPDO structures are currently being prepped – ABN AMRO, Barclays Capital, Calyon, Deutsche Bank, Dresdner Kleinwort, JP Morgan, Lehman Brothers and Nomura are all working on CPDO or DPI variants including managed deals and non-index structures. However, many of these deals – which were intended to launch over the past six to eight weeks – have been held up as Moody's reconsiders its rating methodology for CPDOs.

"We are about to see a remarkable evolution in these products," says one banker. "The structure has not yet been truly perfected beyond people coming up with a structure that receives a triple-A and pays a very high coupon. From now on you are not going to see one CPDO equal to the next."

He continues: "New deals will be very flexible. Many will involve high quality managers and the range of underlyings will expand dramatically. At the moment everything is done on the iTraxx and CDX, but from now we'll see deals involving managing short buckets. There will also be long equity/short mezzanine structures, those involving portfolios of asset-backed securities and even CPPIs. And there will be bespoke combinations of all of these."

While variety is potentially beneficial to investors, some observers point out that index-based deals will obviously have greater liquidity. Equally, refined versions could offer higher returns and be potentially less impacted by or on the index roll than CPDOs issued to date.

Whichever forms take precedence going forward, the structures are similar to many other forms of structured credit product in that they are driven by ratings arbitrage. Until recently that arbitrage had an additional kicker, thanks to a differing approach between the rating agencies themselves.

The banker explains: "Everybody has been using short buckets in the structures and Moody's so far has been the only one to give some credit for these buckets. S&P did not want to do the same, so if you compared the two models you get a better credit enhancement with Moody's – so that's why everyone went to Moody's."

In doing so a backlog has built up as the rating agency is now re-thinking its practices. Details or a timeframe are not currently available, but a Moody's spokesperson is able to confirm that a review is underway.

He says: "Moody's has a CPDO methodology that has been applied to several initial CPDO transactions. Some of our assumptions leaned slightly towards the conservative side; however, this is a desirable feature of our model. We have since been shown many more structures, all bearing strong similarities on the surface to the early deals, however, on closer examination are quite different in the details."

The Moody's spokesperson continues: "Some of these structures try to obtain better ratings by benefiting from the conservative bias. As such, we are now in the process of reviewing certain aspects to ensure we are accurate rather than 'conservative', as what is conservative in one deal is generous in another. Once this review process is complete, Moody's will communicate what these assumptions are to the market."

A spokesperson for Standard & Poor's says that it has no plans to change its CPDO methodology at the current time. "If we were to do so it would be communicated to the market from the outset," she adds.

Derivative Fitch has not yet rated any CPDOs. It is, however, believed to be looking at some of the managed deals in the pipeline.

MP

In search of the new

Japanese investors looking at a range of new structured credit products

Market participants in Tokyo report continuing growth in the number and range of new entrants to the structured credit market. At the same time, and noticeably in recent weeks, more experienced Japanese investors are looking at a wider variety of products.

"We have seen consistent demand in Japan for quite conservative structures – notably single tranche synthetic CDOs rated double-A or triple-A – over the past few months," says Vincent Thebault, head of credit markets & CDOs for Japan at Calyon. "More recently there has been more demand for managed versions of these transactions in order to ensure rating stability as a result of the downgrades or ratings migration caused by recent LBO-type events," he adds.

The days of investors focussing on static synthetic CDO deals certainly appear to be slowing down according to Yugo Yamamoto, head of securitised products, Asia Pacific at UBS. "People are not too keen on having a static pool of corporate exposures. Instead they prefer to have a qualified manager manage the pool or even to opt for a self-managed product," he says.

There are signs of growing interest in newer types of products as well, notes Thebault. For example, he says: "We have seen a lot of demand for money market-type products; that is, high quality and highly liquid CDOs."

The bank's R-Evolution DPI (see SCI issue 18) also proved a particular success in Japan, thanks to its triple-A status, the low leverage of the structure and its conservative risk management features. "We expect this trend to continue with demand in Japan for CPPI/CPDO/DPI products concentrated on low leverage structures," comments Thebault.

Takahiro Tazaki, director, head of structured credit research at Barclays Capital in Tokyo, observes: "The leading Japanese index, iTraxx CJ50, spread is around 20bp, which is tighter than both the main US and European indices. In such an environment investors are interested in taking leverage in the global indices and CPDO looks a likely vehicle to do that. The structure is becoming increasingly popular in Japan but there have been no significant transactions yet – the largest was a ¥10bn (US$85m) deal done in December.

However, he adds; "We expect CPDO volumes to grow in 2007. That will happen as investor awareness and understanding of the product increases, but may also require spreads of indices to widen to enable higher end investor targets to be achieved."

Meanwhile, the long-expected increase in Basel II related deals (see SCI issue 4) appears to now be manifesting itself. Thebault says: "This month has seen growing interest in Basel II oriented solutions, with some investors more willing to adopt the look-through type of approach for capital treatment. We are also seeing increasing interest in IG rated products, as long as a minimum subordination amount is provided."

One result of Basel II implementation is increasing interest in structured credit funds. Yamamoto explains: "There are some investors, who are now investing in more fund-like credit structures. Basel II means that for regulatory capital reasons, banks in some circumstances are keener to look at funds rather than CDOs, though they can be any type of credit fund including a fund of CDOs."

Regulations also have meant that cash CDO issuance continues. Yamamoto says: "We also see big balance sheet CDOs from the larger Japanese banks being issued, but these are mainly for regulatory capital purposes and are placed globally rather than being targeted at domestic investors."

Japanese investors continue to be attracted to CLOs, but here too there are signs of a possible change of focus. As Tazaki concludes: "Vanilla US and European managed CLOs remain very popular with a range of investors from banks to insurers and pension funds. These are typically pure cash structures, but we are seeing growing interest in synthetic CLOs thanks to the increasing liquidity and marketability of loan CDS. We believe this could be one of the big areas to watch in Japan in 2007."

MP

Option volatility jumps

Credit option implied volatility is on the increase, spread vol could follow

Short-dated option implied volatility in Europe has risen strongly over the past month. Meanwhile, credit spreads have ground tighter, but their volatility could potentially increase in the longer term.

At Tuesday's close the March 2007 ATM volatility stood at 35%, 40% and 38% for the iTraxx main, HiVol and crossover indices respectively – representing increases of 4%, 2% and 5% on the week, and 5%, 7% and 9% on the month.

The moves have been driven by technical factors, according to Simon Ong, head of European credit product management at JPMorgan. "Many investors, notably hedge funds, have been selling crossover index protection as a way to take long high yield risk exposure in the credit markets; especially given limited high yield bond supply."

As a consequence, he continues: "Some of these hedge funds have also been hedging tail risk by buying short-dated options – typically, greater than 10% out of the money, 225-275 type strikes – which has been driving up implied volatility."

At the same time, such activity has caused implied volatility to move much higher above realised volatility, which in turn provides trading opportunities. As Ong observes: "Some of the larger hedge funds have been selling longer dated options to take advantage of the disparity between implied and realised vol. So, we now have a bit of a bubble where we see low equity volatility with low realised credit spread volatility as spreads have continued to grind tighter, but option implied volatility has gone up."

There are currently no indications that spread volatility will suddenly find its own bubble. However, historic data does give some longer term hope that it could happen.

Recent research from BNP Paribas looks at credit spread volatility patterns. "Current volatility is significantly lower than historic levels and should increase, even if it might be marginal," notes Rajeev Shah, credit strategist at the bank.

The research highlights two examples of when volatility has increased significantly in the past. First, particularly in the years 2000 to 2002, significant corporate bond supply has boosted volatility. This is primarily due to the change in index spread levels when new bonds are added, particularly when they are issued at a premium to secondary market levels.

Second, issuer-specific credit events – especially involving an unexpected downgrade to junk – have a large impact on index volatility. For example, the fall out of Ford and GM from the investment grade indices.

Consequently, Shah concludes: "While we do not expect spread volatility to increase to peak levels seen in previous years, we believe this protracted reduction of credit volatility can only increase from their collapsed extreme lows. We believe that a trigger for this is our expectations of an unwind of the carry trade, coupled with continued credit deterioration and robust supply."

MP

PPA CLOs rocked by insolvencies

Two more deals put on rating watch negative

Tranches from two German profit participation agreement (PPA) SME CLOs – FORCE 2005-1 and StaGe Mezzanine – were put on rating watch negative last week, following the insolvency of underlying portfolio companies. These events are the latest in a series of insolvencies in the sector (see SCI issue 16).

Standard & Poor's placed both the single-A rated Class C and triple-B rated Class D notes of FORCE 2005-1 on rating watch negative due to the bankruptcy filing and likely default of ISE Innomotive Systems Europe. The transaction is backed by PPAs with 57 German SMEs, with the exposure to ISE representing 2.7% of the portfolio.

"We consider that the likelihood of default for ISE is significant, which could have a considerable impact on the level of losses incurred by the issuer under its participation right: losses which will ultimately be passed on to noteholders," says S&P credit analyst Viktor Milev.

ISE issued a €10m equiNotes type A profit participation right to the FORCE transaction. Milev adds: "We will carry out a full analysis of the implications of the bankruptcy filing to assess whether potential losses exceed our initial expectations. This analysis, and our expectation of future losses to be incurred, will govern whether the rating on the notes placed on credit watch will be lowered."

The deal has previously suffered a default on the entity Nici AG and excess spread is already being used to cure that related €10m entry on the principal deficiency ledger (PDL). As of the November 2006 payment date, the Class A notes had amortised to 98.54% of their initial balance and the PDL balance had been reduced to €6.5m.

At the same time, Fitch Ratings simulated a potential PDL event assuming a total loss and found the structural subordination and the excess spread trapping mechanism to be sufficient to affirm the notes at their current ratings.

But the rating agency moved to place the single-A rated Class B notes of StaGe Mezzanine on rating watch negative while affirming the triple-A rated Class As. The action is a result of two separate events: an initiation of insolvency proceedings by one of the portfolio companies (undisclosed) on 22 January 2007, and a payment holiday granted by StaGe Mezzanine to another portfolio entity in September 2006 until July 2008. The exposures are fairly lumpy, with the former company accounting for 5.7% of the portfolio notional balance and the latter 1% (there are 51 PPAs in total).

The rating action will be resolved once a decision is reached by the German courts on the insolvency application. If the German courts accept the application for bankruptcy or the company's failure to pay exceeds 15 days, the PDL in the transaction would be officially triggered. If the other asset does not resume interest payments in 2008 as agreed in the payment holiday, then this will likely lead to a separate principal deficiency event.

The deeply subordinated nature of the assets in both deals means that recoveries are likely to be low.

MP

Tiering takes hold

CLO managers accept pricing differential

Intense competition and an ever-booming market is leading to a hierarchy in the pricing of CLO managers, with the veterans of the industry receiving better terms than their newer or less established counterparts.

Market participants estimate that the top tier of CLO managers can receive between three and four basis points better pricing at the triple-A level – which becomes even more marked further down the capital structure, with as much as a 75bp differential in the triple-B/double-B bracket. Though allocation to the lower-rated strips are much smaller and may not have that big an impact on overall funding costs, adding that up into the average cost of debt could result in some managers receiving better pricing by 5bp.

"There is certainly a tiering of managers in the market with the top tier being better off by up to 15% in spread terms at the double-B level, with pricing ranging from about 340bp to 400bp in late 2006," says Philippe Jodin, partner at Alegra Capital in Zurich.

"It is pretty significant and in a tightening spread market it matters," adds Ian Hazelton, chief executive of Babson Capital Europe in London.

The recognised upper echelons - including the likes of Babson, Harbourmaster Capital and Alcentra, which launched the tightest priced European CLO last year - seem to be profiting from the market's differentiation towards quality proven managers. Babson's Hazelton believes there is a very plausible case for why there should be a large price gulf between an established expert manager and an unproven start-up operation.

"Our business will not evaporate over night and that is an issue if you are a manager that is based on two or three key people. Also, talking to all the arrangers takes manpower and a start-up operation has to work very hard to cover the same ground as a bigger team, like us," he says.

Existing managers and long-term relationships do have an advantage, especially in a crowded market, due to there being less perceived risk compared to newer players. However, one CLO manager that launched its inaugural transaction amid a glut of issuance late last year believes other issues are involved in judging pricing.

"Quality is not the only variable in terms of how the market perceives a manager. There are a lot of new entrants in the CLO space and there will be pricing differentiation. But that could be part of market dislocation because there is so much supply relative to demand; a bank's distribution capabilities; and issuer type," he says.

He adds that neither the firm's lack of track record nor escalating CLO issuance hampered execution of its transaction, which was even upsized due to high demand. "We still had to prove ourselves with our first transaction, and are happy with the pricing and breadth of investors the deal received," he says.

A London-based CLO manager agrees that quality of issuer is a part of pricing, but sees pricing as the least important aspect of a transaction. "I am more worried about the credit quality and the underlying portfolio rather than if I have shaved a basis point off the triple-A this month," he concludes. "I don't think it is fair to compare old with new. Pricing can also shift due to structural differences, time of year and frequency of issuance from a particular manager."

HD

*This issue is also discussed in a new paper from Derivative Fitch – see this week's News Round-up.

Expanding horizons

James Rothman, senior managing director - structured credit at ACA Capital, answers SCI's questions

James Rothman

Q: When, how and why did your firm become involved in the structured credit markets?
A: Our origins are as a financial guaranty insurance company and financial guarantors take financial risks on fixed income and related instruments. As the derivatives market has evolved, the transfer of risk through such instruments has become increasingly common and so we have evolved our business to benefit from derivatives as an alternative way of taking risks that are attractive to us on a risk/return basis. Many of these products fall into the general category of structured credit, such as tranched portfolio credit default swaps.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: We find to be significant the creation of the credit default swap itself and all of the various product extensions now available, both in terms of what kind of risk is transferred through credit derivatives and the permutations available – from a single name CDS transferring risk on a single bond; to index-based products such as tranches and options; to all the various new asset classes such as asset-backed securities, CDOs, leveraged loans and so on.

The other thing that we think is very significant is the development of correlation modelling and its influence on risk pricing. Correlation is an analogue to the use of volatility in the pricing of equity options. Correlation has become a critical concept in understanding the nature of the risk you are taking in structured credit products such as CDOs and whether or not you are being paid properly for that risk.

Ten or twenty years ago correlation wasn't a concept that people in the fixed income world focussed on when thinking about the appropriate approach to pricing structured finance transactions. If you analysed a sub-prime mortgage deal in 1995 correlation didn't enter the equation, but now that those bonds are snapped up by CDO managers and repackaged, correlation has become a critical assumption.

Q: How has this affected your business?
A: The expansion of the credit derivatives market influences both of our businesses – Structured Credit and CDO Asset Management. It influences the way we take risks for our own account and influences the way that we aggregate risk for others in our CDO and fund businesses. We participate in the structured credit markets usually on a tranched basis, while the management of our CDOs is increasingly the management of CDOs that are driven by synthetic executions on underlying cash bonds.

Q: What are your key areas of focus today?
A: On the structured credit side – which is my area of responsibility – our primary focus is broadening the types of risk we can take consistent with our business model. So instead of looking at just the super triple-A tranches of portfolios of corporate risks we also look at underlying ABS risk and underlying CDO risk, and down the road we expect to look at senior secured high yield loan risk.

Again, this is indicative of the way that the credit derivatives market has expanded – in that that the number of products we can tap into has grown and consequently so have our opportunities.

Q: What is your strategy going forward?
A: Essentially it is to continue with our current strategy, which is to build a portfolio of risks that are primarily super senior in nature and thus are very high quality - that is to say well-priced on a risk-adjusted basis and inherently very safe.

Q: What major developments do you need/expect from the market in the future?
A: We expect the market to continue to apply credit derivative technology to new and different underlying risks and that the tranching of those risks will naturally evolve from that. It's the existence of the credit derivative technology that makes this all possible. For our part, we will continue to be involved in that expansion as it occurs, as we have to date, consistent with our mandate to be involved in fixed income credit risk.

It's always helpful when the market agrees on standards – so we are always enthusiastic when ISDA and the dealer community agree on a good document template for a new asset class. For example, the CDS of ABS format seems to work reasonably well, and we look forward to a similar conclusion on loan CDS.

About ACA Capital
ACA Capital is a holding company that provides asset management services and credit protection products to participants in the global credit derivatives markets, structured finance capital markets and municipal finance capital markets. ACA Capital's asset management services are provided through its asset management subsidiary, ACA Management, L.L.C., and its credit protection products are provided through its "A" rated financial guaranty insurance subsidiary, ACA Financial Guaranty Corporation. More information can be found at www.aca.com.

Credit recruitment activity to pick up

The latest company and people moves

Credit recruitment activity to pick up
Most recruitment firms are expecting activity to pick up in the coming weeks after a sluggish start to the year. "We're not hearing of much, it's been slow to take off and as weeks go it's been one of the quietest, certainly at the senior level. You'll see more activity from the middle of February,' says one headhunter.

Activity is currently limited because some banks still have to pay out bonuses, such as BNP Paribas, which will announce packages in the next week. And staff at banks that have paid out seem to be waiting for the cash to clear their accounts before thinking about moving on, say recruiters.

"There will be a certain amount of activity but this will be based on final compensation packages. Those in the senior positions are getting a larger share of the money pot and any movement will be very much up to the individual," adds one recruiter.

One search consultant envisages many banks will be keen to upgrade their structured credit capabilities, particularly in structured sales. "It's a key area for many, that's where the juice is," he says. Another points to activity on trading and structuring desks to intensify with moves occurring across the board from senior to junior positions.

However, one recruiter feels more focus will be in structured finance more broadly. "I think there will be reasonable appetite in credit derivatives, but the year's focus is the ABS/MBS and CDO markets, where banks are trying to upskill on all sides," he says.

The recruiter is not convinced there will be the revolving door of activity as many forecast. "There are some bits and pieces of activity but it will not be a wholesale market, as some banks will handsomely compensate their senior executives," he adds.

Others though are more optimistic. "We are already working on a number of senior mandates for European and US accounts, who are looking to get people in soon after bonuses have been paid. This inevitably will have a knock on effect on people down the food chain," says another headhunter.

Armitage returns to Bear
Tim Armitage has taken over Emmanuel Rousseau's former position as head of European structured credit derivatives trading at Bear Stearns (see SCI issue 22). Armitage was part of the team under Will Collins who left Bear Stearns and went to head up RBC's structured credit trading business in September. Rousseau's plans are not yet known.

ABN adds to principal trading
ABN AMRO has further expanded its principal trading group (see SCI issue 9) with two hires. Ian Samson joins from Standard Chartered Bank, where he was most recently in charge of its on-balance sheet investment portfolio. Sohail Janjuha joins from Winchester Capital, Deutsche Bank's principal finance vehicle, where he was a portfolio manager.

Both appointments are effective immediately and will be based in London, reporting to Scott Eaton, global head of principal trading who joined the bank in September last year. Samson and Janjuha have been brought in by ABN AMRO at director level as portfolio managers focussing specifically on asset-backed securities and CDO issuance.

Cantor sets up in structured credit
Cantor Fitzgerald Debt Capital Markets has established a new structured products group, and announced that Gina Hubbell and Edward LaScala have joined the group.

Hubbell, who will head the structured products group and report to Irvin Goldman, ceo and president of Cantor Fitzgerald, previously ran the UBS credit CDO group. Previously, she was responsible for fixed income product development and structuring at Credit Suisse First Boston. LaScala formerly served as head of debt syndicate at HSBC, and head of syndicate and debt capital markets at Societe Generale and DLJ.

New CDO partner for Mayer, Brown, Rowe & Maw
Edmund Parker, a derivatives and structured securities specialist (in particular in CDOs), is to join law firm Mayer, Brown, Rowe & Maw as a partner in its London Finance Group. He joins the finance team from the London office of Gide Loyrette Nouel (Gide) on 5 February, 2007.

Parker's new practice will have a number of priorities. These fall into three main areas:
• Advising on complex cash and synthetic CDOs, dynamic CPPI and principal protected structures, OTC derivatives and innovative new products; this will be with a view to developing new products for clients of other areas of the firm, including securitisation, insurance derivatives and property derivatives products.
• Advising on issues of asset repackagings and single name, basket and portfolio credit-linked notes as well as broader derivatives work.
• Advising on the listing of structured bonds and advising leading financial institutions on major credit events impacting on their credit derivatives portfolios.

Morrison & Foerster adds two
Morrison & Foerster has elected two new partners who will join its London office, effective March 2007. Peter Green and Jeremy Jennings-Mares, both from Freshfields Bruckhaus Deringer, will join the Capital Markets Group.

Green has considerable experience with complex cross-border structured products and financings and advises on structured derivatives (including credit, equity, commodity and fund-linked securities). Green also acts for CDO lead managers and portfolio managers and advises on CPPI transactions, ABCP programmes and general derivatives matters.

Jennings-Mares has broad experience in derivatives, debt capital markets and structured finance transactions. He advises on structured note issues, derivatives transactions (credit, fund and equity derivatives), fund-linked CPPI note issues, and fund-linked repackagings. Jennings-Mares also advises in connection with tax-based structured products, as well as MTN programmes and other cross-border debt securities offerings.

AXA IM appoints new head of hedge fund activities
AXA Investment Managers (AXA IM) has hired Christoph Manser as head of hedge fund activities. In this role, he will be responsible for managing AXA IM's funds of hedge funds and of its single hedge fund platform, as well supporting the development of hedge fund activities in the other investment franchises of the AXA IM Group.

Manser joins AXA IM from Winterthur Insurance, Switzerland, where he was head of alternative investments, in charge of hedge fund and private equity investments.

SPSE and IVRS join forces
Standard & Poor's Securities Evaluations (SPSE) and Independent Valuation and Risk Services Limited (IVRS) have announced an agreement to offer each firm's valuations to their clients. The agreement initially enables SPSE to provide its full universe of valuations to IVRS and then subsequently IVRS's valuations through SPSE. Each party will be able to offer the other's valuations through their own services in a seamless and automated fashion, broadening the range of securities that both firms can cover.

HD & MP

Fortis' Delacroix CPPI nears launch

A round up of this week's structured credit news

Fortis' Delacroix CPPI nears launch
Fortis Investments will soon close marketing on its Delacroix 2014 principal protected transaction that utilises arranger JP Morgan's Synthetic Portfolio Insurance technology. The Delacroix Managed Credit Fund can take long/short exposure to the credit indices, tranches of the indices and single-name credit default swaps.

Cian O'Carroll, European head of structured finance at Fortis Investments in Paris, says the deal is part of a series of offerings the firm is structuring to benefit from changes in the credit cycle and spread widening. "One theme for the first half of the year is how to benefit from positive credit fundamentals while keeping away from the valuation difficulties of current tight spread levels. There are various different ways to do that, whether convex arguments like a CPPI or out of the money strategies," he says.

Delacroix is one of the newer breed of CPPI transactions that allows the manager to dynamically manage the portfolio by applying different hedges to combat changes in the credit cycle, while still optimising returns.

"We have a lot of flexibility and the trick here is allowing us to turn adequately with the cycle, whilst retaining the basic premise of a positive convex neutrality or near market neutrality at all times. The clever position is to go long fundamentals and short spreads with enough return or carry, so if nothing happens, performance is still good. Those are the sort of strategies we are building," he says.

Fitch releases CLO manager guidance
A report published by Derivative Fitch today highlights the importance of assessing CLO managers in the rapidly growing European leveraged loan market (see also this week's news story on CLO managers). In the report, Fitch gives an overview of the development of the European leveraged loan market and its various constituents. Against this backdrop, the agency provides investors with guidelines on assessing European CLO managers.

Fitch highlights for the benefit of investors the critical areas of focus in its CLO manager evaluation and details industry best practices for those areas, as observed in its various manager reviews. The agency explains how a comprehensive assessment of a CLO manager should focus on its credit analysis skills, deal-sourcing and portfolio selection practices, loan and CLO administration capacity, loan trading and management of distressed situations.

Moody's publishes EMEA CRE CDOs methodology
Moody's Investors Service has published a rating methodology for commercial real estate collateralised debt obligation (CRE CDO) transactions in the Europe, Middle East & Africa region. The agency says that the requirement for a CRE CDO methodology specifically for EMEA has been highlighted by the specificities of EMEA commercial mortgage-backed securities (CMBS) transactions, a dramatic increase in the EMEA B-loans market in recent years and by changing market structures, together with the significant growth of the EMEA CMBS market.

Moody's says: "EMEA CRE CDOs present a number of analytical challenges. For example, given the high concentration of activity in the UK and Germany, we currently observe an extensive overlap in the assets underlying EMEA CRE CDO portfolios. Additionally, in contrast with the early stages of the US CRE CDO market, proposals for EMEA transactions anticipate the emergence of collateral pools that are actively managed, rather than static. Moreover, EMEA transactions are likely to be multi-currency on the asset and, perhaps, on the liability side."

As CRE CDO transactions are likely to be managed, the approach must also ensure that portfolio trades adhere to certain guidelines that assure the integrity of the tranche ratings over time. Moody's methodology: (i) describes the EMEA B-Loan market and the typical collateral composition of an EMEA CRE CDO, (ii) discusses the agency's CRE CDO modelling approach and (iii) notes some of the issues surrounding management and monitoring of the transactions.

Fitch Launches Commodities CDO model
Derivative Fitch has released a beta version of its Vector model for collateralised commodities obligations (CCO). The public Vector CCO Beta model allows market participants to closely replicate Fitch's quantitative analysis for CCO transactions.

"We designed the model to replicate five key risks that we saw in historical data," says Lars Jebjerg, senior director at Derivative Fitch in London. "These are a high frequency of extreme price movements, an occurrence of sudden and large price movements, a tendency for periods of high volatility to follow periods of low volatility, high levels of correlation among similar types of commodities and different levels of volatility across different commodities."

Fitch's quantitative analysis is based on Monte Carlo simulation of the CCO structure. "The model we have developed produces fat tailed commodity return distributions, which replicate the extreme price movements and volatility clustering, which in turn simulates the periods of differing volatility," says Jill Zelter, md at Derivative Fitch in New York. "Adding jumps to the process means the model is able to simulate both sudden dramatic price movements and large gradual price movements. Principal-components analysis is used to model the correlation structure of the reference portfolio."

However, ratings are assigned by ratings committee and the model results are only one input into the rating process. The ratings committee might want to look at scenario testing of such factors as the historical price movements of the commodities in the portfolio, the correlation between these price movements, and structural features of the transaction including the number and level of the commodity price triggers, outside of the model.

CMA adds LCDS
CMA, the credit pricing specialist, has upgraded its CMA QuoteVision price discovery service and can now parse Loan Credit Default Swaps (LCDS) quotes. CMA QuoteVision scans free form messages, extracts pricing information, and stores it in a client side database. It speeds up and simplifies price discovery, improving trading performance and providing valuable information not only for the front-office team, but also risk, finance and research groups.

HD & MP

Trading ideas - flying south

Dave Klein, research analyst at Credit Derivatives Research, looks at a positive-carry short position on Cardinal Health Inc

When we have a fundamental outlook on a credit, we prefer to put on positive-carry, duration-neutral curve trades. In general, this means putting on flatteners when we are bullish and steepeners when we are bearish.

Flatteners can be difficult to put on simply because their roll-down often works against us. With the current steepness of credit curves, positively economic steepeners have been positively difficult to find recently.

Of course, we can always put on an outright trade (long or short a credit) and accept that we are not hedged against parallel curve shifts. Indeed, if our fundamental view is strong enough, an outright trade might be preferable as we expect to capture plenty on the upside.

In today's trade, we express our deteriorating fundamental outlook for Cardinal Health Inc (CAH) in a positive-carry short position. Given CAH's bond levels and curve steepness, this is the best trade available and possesses nice economics.

Go short
Given our deteriorating fundamental outlook for CAH, we want to be short the credit. We can take this position either by shorting bonds or buying CDS protection.

In order to evaluate opportunities across the term structure, we compare CDS levels to bond z-spreads, which we believe is the most straightforward way to compare the two securities. Exhibit 1 compares CAH's bond z-spreads to market CDS levels as well as our fair value CDS levels.

Exhibit 1

CAH's bonds are trading cheap (z-spreads higher) to their equivalent CDS levels. This coupled with our deteriorating fundamental outlook on CAH focuses our search for carry on buying protection and hedging by selling protection in an index.

In order to estimate CDS fair values, we regress each segment (3s-5s, 5s-7s, 7s-10s) across the universe of credits we cover. This results in a set of models with extremely high r-squareds. In our case, we see that CAH's 3's and 5's and 7's are trading below fair value (good for us) and its 7's and 10's are trading above fair value (bad for us).

With the limited liquidity in CAH, we view the 5's as the best potential maturity, and we drill down and look at the trade economics. Specifically, we look at carry, roll-down and the bid-offer spread of each potential trade.

CAH's 5s have a bid offer of 3-4bp and negative roll-down. Given the negative carry and roll-down, we choose to hedge with the DJ CDX NA IG Series 7 index (of which CAH is a member). This pushes us into a positive carry trade with positive roll-down.

Even if CAH and the CDX 7 tighten relative to each other by a little bit, we can still expect to unwind this trade profitably in 6 months time. Exhibit 2 outlines the economics of this trade.

Exhibit 2

Risk analysis
This trade takes a positive-carry short position. It is hedged relative to the CDX 7 but is unhedged against idiosyncratic curve movements. Additionally, we face about 4bp of bid-offer to cross. The trade is modestly positive carry which protects the investor from any short-term mark-to-market losses.

Entering and exiting any trade carries execution risk, but this is not a major risk as CAH has reasonable liquidity in the credit derivatives 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.

CAH has moderate liquidity in the CDS market at the 5Y tenor with a bid-offer of 3-4bp.

Fundamentals
This trade is based on our deteriorating fundamental outlook. Taking a short protection position by its nature means we are placing a lot of faith in our fundamental view of the credit. While we have chosen a security and tenor that we believe offers the best opportunity for profit, our bearish view on the credit is the driver of this trade.

Carol Levenson, Gimme Credit's Health Services Analyst, views the company as having a fundamentally deteriorating outlook. Carol notes that even though Cardinal received a good price for its Pharmaceutical Technologies and Services (PTS) business, this is not a credit-positive event given that CAH plans to use the proceeds for share buybacks.

As free cash flow has diminished and stock buybacks have ballooned, net debt has increased, leading to weaker cash ratios. Additionally, Carol believes the major changes to CAH's business model along with accounting and regulatory overhang are threats to the company's credit.

Summary and trade recommendation
While cardinals are winter birds and tend to stick around during the cold winter months, we believe that CAH is a bird poised to fly south. With diminishing free cash flow and ballooning stock buybacks, net debt has increased, leading to our deteriorating fundamental outlook.

Given the disparity between CAH's CDS and cash spreads and with a lack of positively-economic curve trades available for the credit, we look to take a positive-carry short position. After analysing both the bond and CDS markets for the best opportunity, we have settled on buying 5 year protection on CAH hedged with selling CDX 7 protection.

Reasonable carry and the potential profit of a return to fair value (and beyond) strengthen the economics of the trade. Given our deteriorating fundamental outlook and the current tight levels for the company, we feel this outright position presents the best opportunity for trading this name.

Buy US$10m notional Cardinal Health Inc. 5 Year CDS protection at 22bp and

Sell US$10m notional DJ CDX North America IG Series 7 5Y protection at 31.125bp to gain 9.125 basis points of positive carry.

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

Copyright © 2007 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).

Synthetic ABS Nuances

Mark Adelson and Edward Santevecchi of Nomura Securities International's US structured finance research team discuss some causes of mismatch that can drive pricing disparities between an ABS CDS and its underlying reference security

The term "synthetic ABS" refers to credit default swaps (CDS) on ABS. Users of synthetic ABS – like users of CDS in general – usually intend for the synthetics to closely replicate the risks and benefits of the underlying reference obligations. However, some degree of mismatch is unavoidable. We have previously addressed certain aspects of typical ABS CDS arrangements that can cause such a mismatch (e.g., the treatment of an available funds cap).¹

This paper addresses additional causes of mismatch that can drive pricing disparities between an ABS CDS and its underlying reference security. In particular, this paper addresses access to information, voting rights, disputes, legal uncertainty, counterparty risk, and liquidity in the context of synthetic ABS.

I. Some Essential Background

A. CDS Basics and Vocabulary
A CDS is a contract between two parties in which one buys credit protection from the other. In some respects, a CDS is similar to a guarantee that covers credit risk. For example, in the case of a CDS on a corporate bond, party X might purchase protection from party Y covering the credit risk of Acme Corporation. X is the protection buyer and Y is the protection seller.

Acme is the reference entity under the contract. X agrees to pay Y a periodic fee during the term of the contract unless and until a credit event occurs. A credit event could be Acme's bankruptcy or a default on its financial obligations.

If a credit event occurs, Y has to pay X the amount specified in the contract and the contract terminates. In some contracts, the amount that Y must pay is determined by the decline in the price of Acme's debt securities following the credit event. Such an arrangement is called cash settlement of the contract.

In other cases, X delivers an eligible Acme bond to Y, for which Y must pay par. That kind of settlement arrangement is called physical settlement. Once settlement occurs, the contract is over.

A CDS has a "notional amount", which defines the maximum dollar level of exposure under the contract. A CDS also has a specified term, which defines the time limit of exposure. So, X and Y might enter into a 5-year, US$10m CDS that references Acme.

The notional amount is US$10m and the term is five years. If a credit event occurs during the 5-year term, Y would have to pay X. In a cash settlement scenario, the payment amount would be US$10m times the percentage decline in the price of specified Acme bonds. In a physical settlement scenario, X would purchase Acme bonds in the open market (probably at low prices reflecting the company's distressed condition) and deliver them to Y, who would have to pay US$10m for them.

A typical CDS on an ABS includes an important additional feature. It provides for a potential stream of payments over the life of a security. More specifically, a typical CDS on ABS provides for the protection seller to cover cash flow shortfalls during the entire life of the reference obligation without requiring termination of the contract. This is often called a "pay as you go" or "PAUG" structure. Payments by the protection seller during the life of the contract are called floating payments.

Under some circumstances, the protection buyer has the option to terminate the contract with physical settlement while the security remains outstanding. In addition, a typical ABS CDS follows the amortisation process of its underlying reference obligation. That is, the notional amount of the ABS CDS declines in lockstep with the amortisation of the reference obligation.

B. CDS Documentation
Parties to swap contracts usually establish and document their rights and obligations using the forms promulgated by the International Swaps and Derivatives Association (ISDA). The documentation has five main components.

The first is the ISDA Master Agreement. The ISDA Master Agreement establishes the broad framework for two companies to enter into swap transactions with each other. The ISDA Master Agreement between two parties governs all the swap transactions between them.

There are several versions of the ISDA Master Agreement. The latest one is from 2002 but the 1992 version is more widely used. The ISDA Master Agreement addresses broad issues that pertain to all swap transactions between a pair of companies.

For example, the ISDA Master Agreement addresses netting of payments, the treatment of withholding taxes, representations of the parties, covenants, and events of default. In addition, the agreement covers the parties' rights to terminate some or all of the swaps between them. It also covers the calculation of damages or termination payments when defaults or terminations occur.

The second component of documentation is the Schedule to the Master Agreement. The Schedule contains provisions that are optional or for which the parties must choose among alternatives.
For example, the Schedule is where the two parties to a Master Agreement decide whether cross default provisions or automatic early termination provisions will apply. Part 5 of the Schedule (for both the 1992 and 2002 versions) is where parties add in any kinds of provisions to which they agree.

The third component of documentation for swap transactions between a pair of companies relates to credit support. Credit support provisions are intended to mitigate each party's exposure to the other's credit risk.

The most widely used credit support provisions are in the 1994 Credit Support Annex (the "CSA"), though ISDA more recently released the 2001 ISDA Margin Provisions. Under the CSA, the party with a positive net exposure to the other is supposed to receive collateral from the other party to cover the amount of the exposure. For each ongoing swap, each party's exposure to the other is determined by market quotations for a transaction that would replicate the economics of the swap.

The fourth component of documentation relates to individual swap transactions between the parties. Each swap transaction has a separate Confirmation that documents the terms. A typical confirmation states that:

This Confirmation supplements, forms a part of, and is subject to, the ISDA Master Agreement, dated as of [date], as amended and supplemented from time to time (the "Agreement"), between you and us. All provisions contained in the Agreement govern this Confirmation except as expressly modified below.

A Confirmation specifies the details of a particular swap transaction. ISDA publishes different Confirmations for a wide array of transactions: interest rate swaps, currency swaps, credit default swaps, equity swaps, etc. Confirmations for simple swap transactions, like basic interest rate swaps, can be quite short. Confirmations for complex transactions can be long.

There are several competing forms of Confirmation for ABS CDS. The most widely used form in the U.S. is called the "Dealer Form" or "Form I." ISDA has released several versions of the Dealer Form. The latest version has two parts² and was released on 10 November 2006. That version replaced an earlier one from 11 April 2006.

The April form superseded the previous one, which ISDA had released on 23 January 2006. That version superseded the original form, which ISDA had released on 21 June 2005. We discussed the key provisions of the Dealer Form in our earlier research.³

In addition to the Dealer Form, ISDA publishes various other forms of Confirmations for CDS on ABS. One is called the "End User Form" or "Form II." The monoline bond insurers originally promoted the End User Form because they believed that the Dealer Form was biased in favour of protection buyers. However, as the Dealer Form has evolved, use of the End User Form has diminished.

A third form of Confirmation for CDS on ABS excludes the pay-as-you-go mechanism entirely. It provides for either cash or physical settlement following the occurrence of a credit event (i.e., just like a CDS on a corporate issuer).

The fifth component of documentation for a swap transaction is definitions. ISDA publishes definitions for use in documenting different types of swaps. For ABS CDS, the applicable definitions are the 2003 ISDA Credit Derivative Definitions. The definitions are incorporated into a transaction through the Dealer Form.

Although the total package of documentation for swap transactions between two parties is voluminous, it is necessary. A swap transaction possesses additional dynamics beyond those related to its underlying subject matter. The ongoing obligations of the parties, their ability to transfer or terminate the transaction, and their remedies against each other in case of default are key issues that require documentation.

II. Differences between Cash ABS and Synthetic ABS

A. Access to Information
Unlike the holder of an actual security, a party to an ABS CDS does not have the right to receive information from the issuer. This is because a party to an ABS CDS does not have a direct legal relationship with the issuer of the underlying reference obligation (unless the party also owns the reference obligation or another tranche from the same deal).

Investors in a typical ABS transaction have an absolute legal right to receive monthly reports on the deal. Issuers often make the monthly reports publicly available – through their web sites or through information vendors like ABSNet – but they have no legal obligation to do so. In fact, for most types of ABS deals, even the requirement to file monthly reports with the SEC is only temporary.⁴

When an issuer or its deals get into trouble, the flow of information often slows or stops. Both holders of the affected securities and other market participants are left in the dark. The difference is that the security holders can apply pressure to the issuer to give them the information.⁵

Although a party to an ABS CDS does not have direct access to information about the underlying reference obligation, it can sometimes bargain with its swap counterparty at the inception of the swap to get such access. This presumes that the counterparty owns the reference obligation or otherwise has obtained rights to the information.

This sometimes happens when the holder of an ABS becomes the buyer of protection through a CDS on the security or on another tranche from the same deal. In such a case, the protection buyer has access to information and may agree to share the information with the protection seller.⁶

If the parties to a swap include non-standard provisions that address access to information, those provisions would appear in the Confirmation for the trade. Including such provisions can make the swap more attractive to either side. However, the presence of any non-standard provisions has the potential to make the swap less "liquid" (i.e., harder to transfer).

Not having the legal right to information has potentially different effects on the two sides of a swap. The consequences arguably are not troubling from the perspective of a protection seller. Unless the reference obligation (or its issuer) gets into trouble, information should be available through third-party sources. If and when trouble comes, it likely would be accompanied by payment shortfalls that trigger a floating payment event or a credit event.

The absence of information at that stage does not really make the situation worse for the protection seller. In fact, the absence of information arguably helps the protection seller by possibly delaying the determination of the correct amount of a floating payment for which it is responsible.

Not having the legal right to information can be tougher on a protection buyer. When a protection buyer cannot get information about a troubled deal, it may not be able to demand a floating payment or to declare a credit event when the underlying facts would entitle it to receive payments.

B. Voting Rights
A party to an ABS CDS does not have voting rights to participate in decisions relating to the underlying reference obligation (unless it also owns the reference obligation). This can put a protection seller in a worse position than a holder of the actual security if there is a default or some other situation in which security holders collectively take action in a deal.

As with access to information, the parties to an ABS CDS sometimes address the issue of voting rights in the Confirmation for their swap. For example, this can happen when the protection buyer owns the underlying reference obligation and agrees to let the protection seller exercise its voting rights.

In the context of distressed ABS, voting rights are a component of an investor's total package of rights. By strategically exercising voting rights, investors in distressed ABS attempt to maximise the recovery on the securities. They can do so by pressuring the issuer with the threat to terminate the issuer's servicing rights or to enforce other available remedies.

In addition, voting rights can be important with respect to relations among investors in a deal. For example, if an investor possesses the swing vote on a disputed matter, it may be able to obtain concessions from its fellow investors.

Voting rights give an ABS investor some ability to control his destiny; to have a voice in steering the decisions that will determine (or, at least, affect) his recovery in distressed situations. In contrast, a protection seller in an ABS CDS does not have comparable control. His only alternative to simply riding through the storm is to try to liquidate the position (more on this later).

C. Disputes
Parties to a CDS bear the risk that they may disagree about the details of settlements or floating payments. The ISDA Master Agreement and various forms of Confirmations employ the concept of a "Calculation Agent" to try to minimise the number of disputes that arise.

In a swap transaction, one of the parties usually serves as the Calculation Agent and is responsible for determining payment amounts. Nonetheless, disputes seem to arise with disturbing frequency. According to some estimates, as much as 40% of CDS that have experienced credit events have become the subject of disputes.⁷

ABS CDS are a young derivative product and there have been few occurrences of credit events or floating payment events. At this early stage of the product's lifecycle, it is impossible to tell whether disputes will be more or less frequent for ABS CDS than they have been for other CDS. However, given uncertainty on this point, parties to ABS CDS should be prepared to absorb some measure of additional expense associated with dispute resolution.

Although the 1992 Credit Support Annex specifies a procedure for disputes about the value of collateral, the ISDA Master Agreement does not provide for specific procedures for dispute resolution. Accordingly, unless parties to a swap have specifically agreed to cost-saving measures, such as arbitration, they must be prepared for full scale litigation in New York or English courts when disputes cannot be resolved amicably through negotiation.

D. Legal Uncertainty
Parties to CDS arguably face somewhat greater uncertainty about their legal rights than do holders of actual bonds. Few reported court cases address CDS and some that do appear to express contradictory holdings.

For example, in Deutsche Bank v. Ambac, the District Court for the Southern District of New York ruled that the protection seller under a CDS was excused from its obligation to pay following the bankruptcy of the reference entity because the protection buyer had failed to deliver the reference obligation within the timeframes specified in the contract.⁸ The court applied a principle of strict interpretation of the contract.

Conversely, in Aon Financial Products v. Société Générale, the same District Court seemed to interpret a CDS by looking far beyond the four corners of the documents.⁹ In the Aon case, the court ruled that a protection seller was required to make protection payments even though a credit event (arguably) had not occurred and the conditions to settlement had not been satisfied.

Many market participants feel that the Aon case was wrongly decided. The protection seller in the case is appealing the decision and ISDA has an amicus curiae brief in support of the protection seller's position.¹⁰

E. Counterparty Risk
Each party to a CDS bears the risk that the other party will default on its obligations. This risk is somewhat different from the risk that the parties bear relating to the credit performance of the underlying reference entity or reference obligation.

A protection buyer bears the risk that the protection seller will fail to make settlement payments following a credit event. This can be a significant risk because settlement payments can be large in relation to the notional amount of a swap.

Likewise, a protection buyer on an ABS CDS bears the risk that the protection seller will fail to make required floating payments during the life of the contract. Those payments would be triggered by floating payment events such as shortfalls in interest or principal on principal writedowns on the reference obligation. Conversely, a protection seller bears the risk that the protection buyer fails to make periodic "fixed payments" as specified in the Confirmation for the swap.

Section 5 of the ISDA Master Agreement addresses defaults and remedies. The 1992 version provides several alternative frameworks for determining the amount that an injured party is entitled to recover in cases of default (and in cases of early terminations other than default). The 2002 ISDA Master Agreement is quite different from the 1992 form in its treatment of defaults and remedies.

The changes in the 2002 form were a response to perceived shortcomings of the 1992 form, which became apparent following the Asian and Russian debt crises of the late 1990s.¹¹ Despite the significant changes, most pairs of participants in the swaps arena continue to use the 1992 form.¹²

Credit support provisions, such as those embodied in the 1994 Credit Support Annex, are designed to mitigate counterparty credit risk. As noted above, the 1994 CSA provides that the party with a positive net exposure to the other is supposed to receive eligible collateral to cover the full amount of the exposure.

At first blush, such a system appears as though it should virtually eliminate counterparty risk. However, gaps remain.

First, some pairs of market participants elect to permit a specified level of unsecured net exposure. The documentation implements that approach with the term "threshold." Second, some pairs of parties agree to a "minimum transfer amount," so that small changes in the net exposure do not trigger a requirement for delivery or release of collateral.

Third, the size of exposures can change quickly between "valuation dates," especially if the perceived credit quality of a reference obligation is deteriorating. Fourth, after a valuation date there is a further delay of at least one business day before the delivery of new required collateral. Thus, in unfortunate situations, the party with a positive net exposure may not have sufficient collateral to be fully secured when the other party defaults.

The Bankruptcy Code contains some helpful provisions for parties to swaps. The Bankruptcy Code's automatic stay¹³ does not apply to the liquidation, termination, or acceleration of a swap contract (§ 560) or to master netting agreements (§ 561).¹⁴

F. Liquidity
ABS CDS are less liquid than actual ABS. Even when actual ABS are somewhat illiquid, they generally are more liquid than CDS that use them as reference obligations.

Liquidity is a tricky concept. It can be approached from different angles. From one perspective, liquidity can be measured by the spread between the simultaneous bid and ask prices for an asset. From a second perspective, liquidity is observable in the typical amount of time that it takes to effect secondary trades in the asset.

Although simultaneous bid and ask prices are not continuously available for most ABS, differences in the typical time to execute trades are apparent. Triple A-rated credit card ABS trade in seconds or minutes. Triple B rated home equity ABS trade in hours or days. Distressed ABS and those backed by esoteric assets trade "by appointment only," if at all.

However, all trades in actual ABS are simple from a mechanical perspective. Once traders at two firms agree on a price, they confirm the trade by specifying the subject security (usually by CUSIP), the quantity, and the price. In most cases, the trade settles through the DTC book entry system.

Trading an ABS CDS is another matter entirely. A swap contract is not a freely transferable instrument. It cannot simply be "sold" to another market participant. Once a company becomes a party to an ABS CDS, the simplest way to get out of the position is to negotiate with the counterparty.

However, the counterparty has no obligation to agree to termination of the contract. If the counterparty won't agree to termination, it may agree to accept a transfer of the first party's rights and obligations to another market participant. Such a transaction is called a "novation" and the 2003 ISDA Credit Derivatives Definitions include forms for novations.

When a counterparty refuses to terminate a contract or to accept a novation, the first party may be able to enter into a mirror-image trade. That is, if the first party is the protection seller on the original CDS, it can become the protection buyer on a second CDS that references the same underlying ABS and that has identical terms.

With this approach, the first party hedges away its risk in the reference obligation but not its exposure to the counterparty on the original CDS. In fact the first party takes on new exposure to the counterparty on the second CDS.

So far, the experience of the ABS CDS arena has been that market participants can get into contracts quite readily with dealers as their counterparties. CDOs have been prominent as sellers of protection on CDS that reference residential MBS and home equity ABS.

Conversely, hedge funds have been prominent as buyers of protection on the CDS that reference the same types of securities. Most often, the underlying reference obligations carry ratings in the triple B range and are issued in modest volumes compared to the senior tranches of their related deals. Accordingly, the reference obligations themselves are generally illiquid and only thinly traded in the secondary market.

Participants in the ABS CDS market have less experience, collectively, getting out of trades once they are in them. Anecdotal evidence suggests that getting out is much tougher than getting in, for both sides of the market.

It remains to be seen whether ABS CDS can become as liquid as or more liquid than their underlying reference obligations. If that ever can happen, we would not expect to actually observe it for at least one or two years.

III. More Differences

The preceding section emphasised features of ABS CDS that can make them more complicated or risky than their underlying references obligations. However, the combined effect of those features is often quite modest.

Other differences favour ABS CDS over actual ABS. Two frequently cited advantages of CDS over actual securities are the ability to take "short" positions (i.e., to buy protection) and the ability to take risk without committing significant principal at the inception of a trade (i.e., selling protection).¹⁵ For a company that funds itself at rates materially above LIBOR, the latter feature is extremely attractive.

Likewise, the "fixed cap" feature selected in most ABS CDS slightly favours the protection seller over a holder of the actual reference obligation. The holder of the actual reference obligation would bear the full brunt of interest shortfalls stemming from the "available funds cap" built into the deal's cash flow waterfall. In contrast, under the "fixed cap" election in most ABS CDS, the protection seller's downside is limited to the amount of the premium (fixed payment) that he would have received during the period.

Another difference is the treatment of coupon step ups. Many home equity ABS provide for a coupon step-up if the servicer does not exercise its clean-up call option when the balance of the underlying loan pool declines to 10% of its original amount.

The purpose of the coupon step up provision is to motivate the servicer to exercise the option (in order not to forfeit excess spread cashflows). Section 5 of the Dealer Form addresses the issue of coupon step-ups.

If parties to a CDS elect to use the provisions, a coupon step up in the reference obligation triggers an equal step-up in the protection buyer's fixed payments to the protection seller. However, the step up also gives the protection buyer the option to terminate the swap at no cost, even if the credit quality of the underlying security has improved significantly.

Other mechanical provisions of the Dealer Form tend to favour one side or the other compared to investors in the underlying securities. For example, if parties to an ABS CDS elect to use the "distressed ratings downgrade" credit event, the protection seller on the CDS may be disadvantaged relative to a holder of the reference obligation. The protection seller may be forced to make a settlement payment before the investor incurs any loss.¹⁶

Likewise, the Dealer Form's treatment of "implied writedowns" can require a protection seller to make floating payments (or settlement payments) when there has been no payment shortfall on the reference obligation. This seems to disadvantage the protection seller compared to the holder of the underlying security.

IV. Conclusion

The mismatch between ABS CDS (synthetic ABS) and actual ABS is a fact. Depending on the particular circumstances, the overall effect of the mis match can be slight or material. The key point for investors and other market participants is not to ignore the mis match; not to treat ABS CDS and their underlying reference obligations as perfect substitutes for each other.

In some cases, an ABS CDS offers benefits that can justify a significant pricing premium relative to the underlying security. In other cases, the opposite is true. Much depends on the details of the documentation for a given swap (the Confirmation) and on the optional features selected by the parties. Also, different market participants value liquidity differently.

For now, those who ascribe a high value to liquidity probably will favour actual securities over CDS. In the future though, ABS CDS might become as liquid as their reference obligations, thereby levelling the field by one more increment.

Notes
1. Whetten, M., Synthetic ABS 101: PAUG and ABX.HE, Nomura fixed income research (7 Mar 2006).
2. The two parts are a 33-page "Standard Terms Supplement" and a 5-page "Form of Confirmation."
3. Id. (discussing the January 2006 version of the Dealer Form).
4. For example, Options One's OOMLT 2004 3 deal priced in September 2004. In January 2005, just four months later, the issuer submitted forms to suspend its duty to file the monthly reports. As it turned out, the SEC got only two monthly reports for the deal.
5. The Pooling & Servicing Agreement for a typical home equity ABS deal provides that the master servicer's failure to perform any of its obligations can be cause for its termination.
6. The Dealer Form provides that the "Calculation Agent" for the swap will furnish the parties with the servicing reports for the underlying deal, if they are reasonably available (§ 7(a)). The catch, of course, is reasonable availability.
7. Tavakoli, J., Commentary: Mon Ami ISDA: Crisis in Credit Derivatives, Lipper Hedgeworld (22 May 2006).
8. Deutsche Bank v. Ambac Credit Products, No. 04 Civ. 5594 (DLC) (SDNY 6 Jul 2006).
9. Aon Financial Products v. Société Générale, 2005 WL 427535 (SDNY 22 Feb 2006) (the case is on appeal the U.S. Court of Appeals for the Second Circuit, No. 06 1080 CV).
10. http://www.isda.org/speeches/pdf/ISDA-Amicus-Curiae-Brief05-08-06.pdf
11. For a general discussion of the changes, see International Swaps and Derivatives Association, Users Guide to the ISDA 2002 Master Agreement, at 24 30 (2003 edition).
12. Most users of the 1992 ISDA Master Agreement select the "second method and market quotation" alternative under § 6(e) for determining payments following an event of default.
13. The "automatic stay" feature of the U.S. Bankruptcy Codes temporarily prevents creditors from enforcing their rights against a debtor as soon as the debtor files a petition for bankruptcy protection. The key provision is § 362.
14. See amendments to the Bankruptcy Code in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. L. No. 109 8, 119 Stat. 23 (2005).
15. In the latter case, the amount of collateral that a protection seller must deliver to secure its contingent obligation generally is much less than the notional amount of the contract.
16. However, because the Dealer Form specifies physical rather than cash settlement, the protection seller would step into the shoes of an investor in the actual security and could wait for the eventual payout on the security.

© 2007 Nomura Securities International, Inc. All Rights Reserved. This Research Note was first published by Nomura Securities International on 16 January 2007.