Contents

CDR Liquid Index data as at 12 February 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.

CDO reporting lags wider ABS market

Investor attempts to improve transparency met with mixed results

The recent effort by structured credit investors to work with dealers on ways to improve transparency in the market has met with some success. However, CDO issuers and managers are still far behind their peers in other securitisation sectors in terms of investor reporting.

Representatives of the investor community have held a series of meetings with major CDO and CMBS issuers in Europe over the past few months in order to solicit their feedback, following a discussion seminar on investor reporting last November. "Investors have now met all the main issuers in Europe on a one-to-one basis and are in the process of getting follow-up responses from them," confirms one trader at a London-based investment house.

He continues: "The feedback has been quite positive from all the main players. Virtually all the major CMBS issuers are now on board and are willing to drop passwords from their reporting sites (the passwords had prevented certain investors from accessing transaction information). However, CDOs still lag behind wider ABS reporting standards - it is proving to be a heck of a lot trickier to persuade CDO issuers to drop passwords."

Reluctance to provide greater transparency on CDO deals appears to be linked to concerns over revealing extensive portfolio details. Many CDO structurers are understood to be willing to fall in line with their CMBS colleagues over investor reporting, but CDO managers have expressed doubts about the move.

In particular, there is thought to be some concern from managers over disclosure on more widely accessible sites such as Bloomberg. Equally, doubts have been expressed on the disclosure of specific asset-level items such as shadow ratings.

Nevertheless, it is widely agreed that improved reporting is vital for the further development of the CDO market. "The whole project underlines the importance of disclosure rules. Not releasing this information pertains potentially to insider trading, which is the key to this effort - to ensure that no investor can ever be caught out as having greater access to information than any other investor," confirms one buy-side account.

Investor representatives are expected to continue to work with dealers and managers to find a way to move forward with the project. In the meantime, the next official step in the process is - once the passwords have been dropped from any outstanding issuers' websites - for investors to review the quality of reporting and the different types of information that is contained on these sites.

The investor suggests that in reality the next step is a more fundamental one. "We need to watch what actually happens - all that has happened so far is promises. We now have to see whether it can be actually done," he concludes.

MP

ABX spreads balloon

Market driven by fundamental fears and technical reality

The past week has seen a continued dramatic spread widening in the lower-rated ABX indices. Notwithstanding a short-term rally during Tuesday's trading, the technical factors driving the market mean indications are not good for the launch of ABX tranches at New York's open today.

The dramatic widening in spreads over the past week is a result of weak performance of the US sub-prime mortgage market. This was highlighted by announcements from New Century Financial, the second largest sub-prime mortgage originator in the US, that it was restating earnings and from HSBC which intends to increase its allowance for its sub-prime mortgage loan losses.

The former is obviously of legitimate concern, given New Century's extensive reach in the market. However, reaction to HSBC's announcement could be overstated.

A report published by Nomura Research in New York on Monday notes: "HSBC appears to be taking a reasonable and measured response to conditions in the sub-prime mortgage sector. Therefore, the sudden ABX spread widening late last week seems somewhat an over-reaction. At this point, we think that the word 'uncertain' is the best way to describe the outlook for sub-prime mortgage ABS at the triple-B rating level."

The report continues: "Signals are decidedly mixed. On the negative side, delinquencies and early payment defaults are up, home price appreciation is weak, many loans face reset risk, and recent vintages have high proportions of piggyback seconds, first-time homebuyers and stated-income loans. On the positive side, the job market is solid, interest rates are moderate, and the US economy is growing. Whichever way the story ends in a year or two, it likely will be a surprise to a large portion of the market."

One portion of the market that seems certain about its future path are the US hedge funds that have been consistently shorting the lower rated ABX indices during the past few months. In doing so, they have created the technical environment that has exacerbated the effects of the recent spate of negative news in sub-prime.

There is no natural long holder of the ABX indices because of their limited size, so in the face of the hedge fund flows dealers have ended up significantly long. Then, as spreads on the indices have continued to widen at a far more significant rate than the ABS they are holding as a hedge, the dealers have been forced out of positions at a loss.

"The hedge funds are still shorting and that caused the recent big price falls. It's a classic case of a couple of people trading large size in thin liquidity. The slight rally on Tuesday was just a result of people covering shorts," explains one ABS trader.

The impact of this activity has now spread, according to the trader. "It has moved up the curve, so we're now in the ridiculous position of single-As trading at 175bp when a new issue launches at 40-50bp," he says.

The lack of ABX liquidity is evidenced by the fact that bid-offer spreads have blown out to around 1.5 points and that not all of the 16 market makers on the products are offering prices. This environment does not augur well for the launch of ABX tranches today, 14 February.

The trader says: "We'll just have to see if tranches get shorted too, but they may generate some natural longs, which could provide some relief. However, they'll be hampered by the lack of two-way prices – I guess only a handful of firms will offer them to begin with. In any event, like all other index product launches, we expect immediate trading away from par as the fix rates are not sustainable."

MP

Listed funds announce dividends

Structured credit funds release results and highlight diversification positives

Two listed structured credit funds announced their latest results last week. Both are bullish about future returns, and expectations are that more such products will follow.

Carador, which is managed by Washington Square Investment Management (WSQIM), announced its first-ever dividend. The company expects to pay a dividend of not less than 2.00 cents per share for the period to 31 March 2007. At the time of launch, the company announced a target total return in the range of 12% to 14% per annum once fully invested, which it achieved in November 2006.

"We are pleased with the quality of the portfolio, which was fully invested ahead of schedule following launch. The lower initial dividend reflects both the ramp up period of the Carador portfolio, as well as the ramp up period of the underlying investments," says Miguel Ramos Fuentenebro, managing partner at WSQIM.

"The price has been very stable, which I think is a function of an extremely diversified portfolio - at present we are close to 2,200 underlying credits. That, combined with the fact that we have overweighted classes such as secured loans, means that we are not affected by the current real estate downturn," he adds.

Real estate is a strong focus for the majority of listed structured credit funds, not least Caliber Global Investment, which is managed by Cambridge Place Investment Management. However, in November last year, Caliber began looking at taking steps to actively manage its portfolio and in particular to shift the investment focus away from US RMBS into "areas of more attractive investment opportunity such as European public asset-backed securities".

In its latest quarterly results announced on Monday, Caliber conceded that its performance was negatively impacted by losses incurred in US RMBS as it continues to reduce exposure to the sector. Nevertheless, the company was able to report net profit for the first quarter to December 31 2006 of US$6.3m and an interim dividend of US$0.25 per share, payable on March 23 2007.

Looking ahead, increasing diversification in these instruments is likely to be a strong theme, according to Ramos Fuentenebro. "There are more and more structured products being talked about as potential listed candidates and I think that it is good in the sense that there will be a very wide range of options for investors," he says.

Equally, Ramos Fuentenebro sees independence as a strong attraction for listed products. He explains: "An important aspect of Carador is that it cannot invest in WSQIM-managed deals. Investors wanted the fund to avoid completely any potential conflict of interest."

MP

Merrill withdraws CPDO

Market or lack of investor demand causes re-think

Merrill Lynch is understood to have withdrawn the CPDO it has been marketing since October (see SCI issue 9). The move comes amid tightening spreads and increased investor wariness of CPDO structures.

Merrill's rated enhanced dynamic index (REDI) floating-rate notes, which were to have been issued through its C.L.E.A.R. SPV, had their provisional ratings withdrawn by Moody's last Friday. The rating agency confirmed the move and explained "this transaction is currently not going ahead", but declined to comment further. Officials from Merrill Lynch failed to return calls by press time.

Given the high-profile nature of the deal - it was expected at one point to be the market's second CPDO issuance - speculation is rife among rival dealers as to what was behind the deal being dropped. Consensus appears to be that the market has moved against the proposed transaction.

"My best guess is that the index market grinding tighter eventually scuppered the structure. It's very difficult to get triple-A with current spreads," says one dealer.

However, the possibility that Merrill simply couldn't find any buyers for the deal was floated by another. "The mark-to-market volatility that these kinds of products have has put off some clients. Many seem to be swaying towards DPI structures instead because of the way the leverage works. On a CPDO the leverage rises when the structure is in trouble, but with DPI it rises when it is making money - which is a very compelling arrangement for investors."

It is not clear whether the REDI structure will be resurrected at some point in the future. The planned notes were scheduled to be offered in amounts of €250m, US$250m, £50m, ¥10bn and A$100m. They were to have a leveraged non-tranched exposure to the investment grade on-the-run Dow Jones CDX and iTraxx Europe indices.

The deal featured dynamic leverage, which increases as the NAV decreases and vice versa. The leverage was capped at 15x and the cash ledger was to be used to capture the excess spread above the promised coupon, which would then be used against rebalancing, roll and default costs.

A cash-in event was to occur when the NAV exceeded the NPV of liabilities. The index portfolio would then be unwound, and all promised payments made. A trigger event would occur if the NAV fell below 10% of par: the index portfolio is then unwound, coupon payments ceased and investors should receive the proceeds from the unwinding.

MP

Bright futures?

Buy-side firms upbeat about new European contracts

Derivatives exchange Eurex's plans for trading futures on the iTraxx Europe five-year index from 27 March are garnering strong European support, at least from the buy-side. However, there is less momentum in the US, where the Chicago Mercantile Exchange (CME) and the Chicago Board Options Exchange (CBOE) are jostling for first-mover advantage in the sector.

Buy-side response to the initial contract – which could be complemented by HiVol and Crossover contracts, depending on market demand (see SCI issue 20) – is upbeat, with many stating their desire to make the product to work. "We are positive about the launch and will look to support this new initiative," says Jamie Grant, investment manager at AXA Investment Managers in London.

"The fact that launch is going ahead is a significant factor on its own," adds Graham Neilson, portfolio manager at Credaris in London. "It may not herald a huge new wave in traded credit, but it is a part of a natural progression that opens up credit that bit further. It takes away a barrier to entry for some and allows more players to take macro views either outright or against existing risk."

Though many funds are unable to use credit derivatives due to mandate restrictions imposed by clients, they are allowed to use futures. "A credit futures market is an inevitability. Having an exchange-traded product will make it easier for managers to talk to clients on the advantages of using credit derivatives," says Nigel Sillis, head of credit research at Baring Asset Management in London. "You get more efficient markets, better transparency of pricing, standardised documentation and less counterparty risk with anything that is exchange traded and a future."

AXA IM's Grant believes traction of the product and potential volumes will be contingent on the number, but also the willingness of market participants – particularly the sell-side – to become involved. "We think it is important that the market markers realise how beneficial this is to the buy side and then act accordingly. If they want to provide real client service, then they have to step up their efforts in providing liquidity in this product," he says.

Some view credit futures as appealing to credit funds in the market, which will benefit from a further increase to the range of instruments and arbitrage opportunities. But Credaris' Neilson adds this could also open up the market more directly to retail investors. "It is possible we may see dislocations between the CDS contract prices and the future, which could be capitalised on," he says.

Ideally, Grant would prefer longer contracts to the current five-year maturity that is proposed, particularly due to the sterling market operating with longer benchmarks than the euro one. "That is an issue, but we are pragmatic and stated to Eurex that, if this product is successful, in time we will work with them to launch a ten-year contract," he says.

In contrast, launch of such a product in the US is quickly becoming a battle over terminology, with the CBOE claiming that the CME's proposed contracts do not fall within the Commodity Futures Trading Commission's jurisdiction and can be traded only on a securities exchange.

"They are arguing with one another over basically nothing and this appears just to be posturing, gamesmanship and semantics," says Janet Tavakoli, president, Tavakoli Structured Finance in Chicago.

The CBOE is offering contracts on five to 10 companies, while the CME will provide quotes based on three companies during the first quarter of the year. However, a number of observers view their plans with some reservation, stating that the two exchanges are joining late in the game and with the wrong tactics.

"They are way behind the eight ball in getting into the market and doing this on a handful of names is not going to be successful. I don't think they have done their homework and they are not going in big enough or smart enough," concludes Tavakoli.

HD

Successfully diversifying mortgage risk

Grant Harris, a fund manager in the Funds Management division of MFS Investment Management, answers SCI's questions

Grant Harris

This Fund, which has been in existence now for nearly seven years, is a retail unit trust that offers investors target rates of return for investments of 6, 12 or 24 months' duration. The Fund's genesis provided the wider MFS Group access to investor capital which was used to fund construction and development loans on the eastern seaboard of Australia.

With this structure and single-sector asset allocation (residential property-backed mortgages), the Fund was able to offer to its investors target rates of return that represented a significant margin above prevailing domestic cash interest rates for the best part of seven years, and funds under management grew to around A$500m.

However, towards the end of 2006 the Australian residential property market was experiencing a rather sharp cyclical downturn which subsequently began to limit opportunities to lend funds to property developers. Coincidentally, as a result of the Fund's continued success, growth in funds under management accelerated to a point where inflow significantly outstripped the supply of new construction and development loans that MFS could secure.

Indeed, this was a challenge that many mortgage-backed investment funds in Australia found themselves faced with around that same time. For many, where mandates required them to remain fully invested, they were forced to approve loans of lesser credit quality – thereby increasing the underlying risk of the fund without being able to compensate investors with a correspondingly higher rate of return. For some, who were not prepared to increase the underlying risk of the investment portfolio, it meant building large cash holdings within the fund and subsequently reducing the returns that they could distribute to investors.

By contrast, MFS' Premium Income Fund – thanks to its broadly-based investment mandate – was able to implement a portfolio diversification strategy that allowed the Fund to seek investments in asset classes other than residential property-backed mortgages but with similar (in terms of orders of magnitude) individual risk and return characteristics. The key to the success of the diversification strategy is in identifying asset classes that are less than perfectly correlated with residential mortgages. Structured credit in the form of CDOs was an asset class that provided a very obvious opportunity for portfolio diversification: floating rate versus fixed interest rates charged to property developers; corporate and commercial asset-backed investments versus residential property-backed investments.

In summary, the Premium Income Fund has been able to maintain the competitive target rates of return that it offers to investors by using structured credit investments as a separate asset class to successfully diversify the risk associated with domestic property-backed mortgages.

Q: In your view, what has been the most significant development in the credit markets in recent years and how has this affected your business?
A: MFSIM is a relatively unsophisticated user of structured credit investments and, consequently, I would like to pre-empt my response here with the caveat that it may appear a little blunt and bereft of any great insight – for which I apologise to those of your far more sophisticated readers.

That having been said, for MFSIM the most significant development has been the use of financial engineering to create bespoke synthetic products that can be tailored to the risk preferences of different investor groups. This engineering has allowed MFSIM to choose the return levels and risk exposures it thinks are suitably matched to the objectives of the diversification strategy outlined above.

Q: What are your key areas of focus today?
A: At the portfolio level, MFSIM's key focus remains one of successful asset class diversification and the maintenance of competitive target rates of return for investors. At the asset class level, its focus continues to be that of managing the challenges of successfully implementing that diversification strategy.

This is partially relevant at the moment to MFSIM's structured credit investments: upon review by the new cio of MFSIM and Fund Manager of the Premium Income Fund, a decision was made to outsource the management of these investments to external fund managers.

Q: What is your strategy going forward?
A: MFSIM's current strategy involves invoking exit strategies from those structured credit investments held directly within the fund and then appointing a number of recommended external fund managers that specialise in this asset class. This will allow MFSIM to make a greater allocation to this asset class in both absolute (dollar) and relative (percentage of total funds under management) terms in the future.

Q: What major developments do you need/expect from the market in the future?
A: MFSIM is very much a "market-taker" in that it will asses new offers and opportunities as they come to market, but it does not actively participate in what form these offers and opportunities might take. However, one aspect of the current market in which MFSIM would welcome some development is that of greater competition among fund managers offering investment expertise in managing structured credit investments.

While MFSIM is not suggesting fees are too high (they are as high as the market will bear), it is natural that competition will lead to a differentiation of product at many levels – one of which most obvious is price – and that as an investor ourselves MFSIM welcomes any development that reduces transaction costs.

About MFS
MFS Limited is an investment and funds management company with a diverse range of investments throughout Australia, New Zealand and Asia.
Listed on the Australian Stock Exchange, MFS Limited currently has a market capitalisation of around A$2bn and manages over A$3bn of assets on behalf of its shareholders and 40,000-plus investors.

MFS Limited's core business is the creation, development and on-going management of a wide range of innovative investment solutions. By adopting a rigorous approach to compliance and corporate governance, MFS has built an industry reputation of integrity and spectacular growth culminating in attractive returns for its shareholders and investors and the receipt of a number of financial services industry awards.

Hanna exits Cheyne

The latest company and people moves

Hanna exits Cheyne
Syd Hanna recently left Cheyne Capital after four years there. He was the co-founder of structured finance business and was responsible for setting up several innovative platforms including Queen's Walk, a publicly listed €406m investment company, and the firm's US$20bn ABS SIV. His plans are currently unknown but are rumoured to include establishing a number of new investment platforms spanning the structured credit, infrastructure and energy sectors.

ABN adds more to principal trading...
Jeremy Vice has joined ABN AMRO's growing principal trading group headed by Scott Eaton (see SCI issues 9 & 24). Aideen Macdonald has also transferred into principal trading from ABN AMRO's conduit franchise to act as a portfolio manager.

Vice will be responsible for illiquid assets, repackagings and building out a CDO manager franchise for the group. He was most recently md and head of credit derivative structuring and new product development at Dresdner Kleinwort.

... And subtracts elsewhere
Costas Katsileros, credit options trader at ABN AMRO in London, has been made redundant and is understood to have returned to Greece. It is unclear if he has left the industry.

Max Graziosi, who headed up Italian fixed income sales and had a focus on structured credit at the Dutch bank, has also left after just six months. He joined from CIBC, where he was head of Southern European sales, to replace Alberto Matta, who left for Barclays Capital to run Southern European structured credit marketing.

Niall Cameron's post as global head of traded markets at ABN AMRO has been abolished as part of a reshuffle by Gary Page, the bank's head of global markets. Cameron's position at the bank is still undetermined, as he is understood to be in consultation about his future.

Davies heads to SAC
Mark Davies, global head of credit trading at Bear Stearns in New York, resigned last week and is understood to have moved to SAC Capital to head the hedge fund group's fixed income business.

Those at Bear who had reported to Davies – David Carlson, global head of structuring and marketing; James Kenny, global head of flow credit trading; and Martin St. Pierre, global head of structured credit trading – now all report to Jeff Mayer and Craig Overlander, global co-heads of fixed income.

RBS adds CDO marketer
Royal Bank of Scotland has hired Darron Weinstein from Dresdner Kleinwort, where he worked in the CDO product marketing team. He joins RBS in a similar role.

WestLB boosts trading
WestLB has boosted its credit trading team with two hires. John Allum joins from Barclays Capital and will be responsible for financial cash and credit default swap trading. Cristina Cabeza will focus on selling credit and structured credit products to Iberian accounts and moves from a similar position at Dresdner Kleinwort. Both recruits report to Andrew Sheppard, head of credit trading.

Lorenzen joins Citi
Hans Peter Lorenzen has left BNP Paribas, where he was credit strategist, to join Citigroup in a similar role. He reports to Matt King, head of quantitative credit strategy.

In addition, Priya Nair, global head of credit structuring at Citigroup in London, has added global syndicate responsibilities to her role.

Internal moves at Bank of America
Marc Geffroy last week moved internally at Bank of America from his position as senior credit default swap trader to principal in CDS sales. He now reports to Alex Smith, head of credit sales.

Charlie Cho, head of European credit spread sales and trading at BoA, has also added to his team. Nick Dhanani has moved from capital markets – where he traded hybrids – to trade bank and finance CDS, while Mayur Jethwa, head of bank and finance and investment-grade trading, has taken over trading of investment grade industrials.

German switch for Fletcher
Jonathan Fletcher has moved from Dresdner Kleinwort where he was a credit default swap telco trader. He will join Deutsche Bank's CDS trading team in the near future.

AXA REIM opens in Stockholm
AXA Real Estate Investment Managers (AXA REIM) has opened an office in Stockholm to support its expansion into Scandinavia. Jérôme Arnaud will lead the operational presence in Stockholm as head of asset management for Sweden, Norway, Finland and Denmark. He was previously senior asset manager for AXA REIM France, in charge of shopping centre portfolios and major office assets.

DTCC's new London office
DTCC has opened a new London office to "support a growing range of global offerings and a customer base that increasingly operates around the world". The DTCC London office serves as the regional customer centre for its global services, including DTCC Deriv/SERV and the Trade Information Warehouse for OTC derivatives, the Global Corporate Action Validation Service (GCA VS), and a new service being developed for the alternative investment product (AIP) market.

HD/MP/JW

Babson closes hybrid TRS CDO

A round up of this week's structured credit news

Babson closes hybrid TRS CDO
Babson Capital Management has closed an innovative US$600m hybrid CDO via Banc of America Securities. Dubbed Sapphire Valley CDO, the transaction consists of leveraged loan and CLO securities.

Sapphire Valley's portfolio consists of approximately 80% leveraged loans and 20% securities. Of the securities, 40% are expected to be sourced synthetically via total return swaps (TRS), providing investors with assets that are difficult to source in the cash market.

"We are very pleased with investors' interest in Sapphire Valley," comments Thomas Finke, md and head of Babson's US bank loan team. "Its hybrid structure allows us to leverage the capabilities of both our leveraged loan and structured credit teams."

The weighted average cost of the debt for the transaction was 46bp over Libor. A wide range of US and non-US institutional investors participated in the deal.

"The addition of TRS adds an additional dimension to the CDO," says Matthew Natcharian, md and head of Babson's structured credit team. "TRS allowed us to increase our exposure to top tier managers from strong CLO vintages while reducing the time required to ramp-up. "

Meanwhile, a report released last week by Derivative Fitch notes that US CLOs that are leveraged via TRS have shown comparable rating performance to similarly rated tranches from traditional cash CLOs. The agency has rated 100 public and private total rate of return (TRR) CLO mezzanine tranches originally rated triple-B plus, triple-B or triple-B minus since 1996.

Issuance of TRR CLOs grew rapidly between 1996 and 1999 before dropping significantly in 2002, following the higher default rates and general credit crunch in the non-investment grade corporate debt markets. However, Fitch md Kevin Kendra says that the agency has seen renewed interest in the instrument as the credit environment has improved, with Fitch rating 12 new TRR CLOs since 2004.

Fitch has downgraded 13 tranches and upgraded three among the TRR CLOs it has rated in the last ten years. Overall, approximately 13% of mezzanine TRR CLO tranches have been downgraded by an average of 4.31 notches versus approximately 14% downgraded by an average of 4.33 notches for the mezzanine tranches from Fitch-rated cash CLOs. While the downgrade rating performance is comparable, the longer reinvestment periods and other structural differences between cash and TRR CLOs explain the difference in upgrade rating histories, notes Kendra.

"Additionally, mezzanine TRR CLO notes combine the traditional debt instrument return profile with an equity-like return through an unrated additional coupon and/or residual payment at termination," he adds.

Moody's set to rate several CDPCs by mid-year
Moody's has announced that it has proposals for 24 credit derivative product companies (CDPCs) in its pipeline. The agency expects such vehicles to play a significant role in the burgeoning market for credit derivatives.

Most of the new proposals involve US entities, but around a quarter would be established in Europe. About half the would-be sponsors of the new vehicles are asset management firms, with the rest drawn from the ranks of banks and insurance firms.

That CDPCs are highly flexible partly accounts for the fact that only a few of them have been rated. "Because there is no template for CDPCs, sponsors are free to explore a large number of possible paths for future business," notes Moody's analyst Algis Remeza.

But while there is a cost to complexity and flexibility, there is also a benefit: CDPCs should be able to adapt to changing market conditions in the credit derivatives market. By altering their business mix, they can gear their efforts towards the most profitable sub-sectors.

To date, Moody's has issued ratings to Primus Financial Products, Athilon Acceptance Corporation and Theta Corporation. It has also issued provisional ratings to Deerfield Financial Products and Aladdin Financial Products.

"The surge of CDPC pipeline activities in the last six to twelve month period has been unprecedented. We have been beefing up our analytical staff and streamlining the rating process to evaluate the CDPC proposals", says Yvonne Fu, a team md with the agency's derivatives group. She adds that Moody's is fully committed to the CDPC asset class and will continue to provide market participants with updates of any new development and refinement of rating approach in this sector.

Downgrade decline for European CDOs in 2006
Moody's annual study of European structured finance rating transitions has concluded that the downgrade rate of CDOs has declined.

Overall, the average credit quality of structured finance securities in Europe continued to improve in 2006 relative to 2005 as the total number of rating changes fell and the number of upgrades exceeded the number of downgrades. There were roughly 2.4 upgrades per downgrade in 2006, versus an upgrade-to-downgrade ratio of about 4 to 1 in 2005 and a historical average of 1 to 1.

"CDOs were again the most active in terms of rating changes across the major sectors of the European structured finance market. 60 ratings involving 52 transactions were downgraded and 71 ratings involving 42 transactions were upgraded, resulting in an upgrade-to-downgrade ratio of 1.2. While this ratio represents a decline from 2.2 in 2005, it is the second consecutive year that upgrades outnumbered downgrades for CDOs in Europe," according to Hadas Alexander, co-author of the study.

She adds: "Static (not actively managed) synthetic arbitrage transactions accounted for 82% of all CDO downgrades and 72% of all structured finance downgrades in Europe in 2006. The heightened downgrade activity of synthetic arbitrage CDOs was mainly the result of the increases in the corporate downgrade rate, which rose to 8.9% on a global basis in 2006, from 8.3% in 2005 and 8.1% in 2004. As a result, the one-year downgrade rate of synthetic arbitrage CDOs rose to 6.8% from 4.6% in the prior year."

Meanwhile, upgrade activity was also significant for CDOs, making up 43% of all upgrades for European structured finance. Most of the upgrades affected the securities issued in 2002 as a result of deal seasoning and strong collateral performance, according to the report.

Citigroup closes second generation credit fund for AXA IM
Citigroup has closed the US$475m-equivalent Riveria, a second generation principal-protected long/short credit fund actively managed by AXA Investment Managers. The 7- and 10-year fund-linked transaction is structured in either funded or unfunded format, and is denominated in euros, US dollars and various Eastern European currencies.

Drawing on dynamic portfolio insurance (DPI) technology, the manager has the flexibility to vary leverage within limits. The transaction is linked to a leveraged credit fund exposed to a portfolio of global CDS, indexes and bonds.

AXA IM will actively manage this portfolio using a full spectrum of long/short and relative-value strategies, with the aim of achieving stable returns over various credit cycles. Citigroup marketed the transaction globally, including in Europe, Asia and the Middle East. Erste Bank assisted with the syndication in Central and Eastern Europe.

The first closing delivered more than 40 institutional investors with exposure to the credit fund through 19 individual structures, accommodating investors' choices of issuer, tenor, currency and coupon. The global investor base spans from India and Qatar/Abu Dhabi to Austria, Germany, Italy and Iberia, as well as Hungary, Bulgaria, Croatia and Latvia in Eastern Europe.

Due to the strong interest in Riveria, a second tap of a further US$50m to US$100m is expected in March.

SG launches Albatros CPPI
IXIS Asset Management is in the market with Albatros, a long/short constant proportion portfolio insurance (CPPI) structure on asset-backed securities and corporate CDS. Société Générale arranged the transaction.

Albatros offers an ABS and pure credit leveraged exposure without any correlation risk. The managed portfolio will be composed of three different buckets: ABS will bring stability to the structure; the long corporate exposure will create value through its positive carry; and the added-value bucket will enable the manager to generate return without market directionality.

Notes will be offered across a range of currencies, maturities (7-years and 10-years) and formats (zero-coupon, contingent coupons and high return notes). The aim is to provide diversification to institutional investors while offering an attractive risk/return profile.

Albatros will benefit from the leverage mechanism driven by the Gap Value at Risk (GVaR) approach developed by SG. This unique approach fully takes into account the diversification and the stability brought by the ABS bucket and the short exposure, which characterise the transaction.

Béatrice Benhamou, responsible for credit structuring for France, Belgium and Luxembourg at SG, comments: "Capitalising on Ixis Asset Management's strong expertise in structured credit, Albatros gives investors the opportunity to access the rewarding corporate credit market while benefiting from the stability of the ABS asset class."

Ibrahima Kobar, head of the insurance and CDO department at Ixis AM, adds: "Albatros provides a lot of flexibility and, thanks to the CPPI structure and GVaR model, is particularly adapted in case of adverse market scenarios. Effectively, the portfolio managers can adjust their global leverage and, at the same time, take views on the market and generate performance by exploiting relative value strategies."

Advanced training sees significant take up
Structured Credit Investor announces that places are now strictly limited on its 'Credit Derivatives – Advanced Products and Applications' two-day interactive open training course led by Robert Reoch. Attendees will learn about the latest market developments including CPDO and bespoke tranche strategies; innovative CDO structures and applications; and dealing with defaults and cash settlements. Click here for more details.

MP

Trading ideas - load balance off?

Dave Klein, research analyst at Credit Derivatives Research, looks at a positive-carry short position on Whirlpool Corp

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.

This trade is a little different than our normal improving/deteriorating outlook long/short position. Although we have an improving fundamental outlook on Whirlpool Corp. (WHR), the company ranks fairly high on our LBO likelihood models.

Combined with recent analysis by Gimme Credit, we are recommending a positive-carry short position. Given WHR's bond levels and curve steepness, this is the best trade available and possesses nice economics.

Go short
Given our LBO view for WHR, 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 WHR's bond adjusted z-spreads to market CDS levels as well as our fair value CDS levels.

Exhibit 1

WHR's bonds are trading both rich (z-spreads lower) and cheap (z-spreads higher) to their equivalent CDS levels. Since it can be difficult to short a bond, we choose to express our view on WHR by buying protection.

In order to offset the protection premium and to hedge against overall market movements, we will sell protection on 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 WHR's 3's, 5's and 7's are trading below fair value (good for us) and its 10's are trading above fair value (bad for us).

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.

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

As long as WHR and the CDX HVOL 7 do not widen relative to each other by more than 5bp, we 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 HVOL 7 but is unhedged against idiosyncratic curve movements. Additionally, we face about 4bp of bid-offer to cross.

The trade has 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 WHR has good 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. WHR has good liquidity in the CDS market at the 5Y tenor with a bid-offer of 4bp.

Fundamentals
This trade is based on our view of the LBO risk surrounding WHR and is contrary to our improving fundamental outlook for WHR.

Craig Hutson, Gimme Credit's Household and Personal Products expert, maintains an improving fundamental outlook on WHR. Craig notes that although WHR lowered its EPS guidance last week, the company has done a good job of executing on its Maytag integration.

Craig also notes that fourth quarter numbers were the first indication that the housing slump is impacting Whirlpool. The company has a strong balance sheet and good credit ratios, but Craig believes WHR must improve earnings given the current operating environment it finds itself in.

Craig notes that, although there have been no specific LBO rumours on WHR, spreads have widened due to general LBO concerns. From a fundamentals perspective, the company does look like a compelling LBO candidate. Although Craig is hesitant to change his fundamental outlook on WHR based on rumours (or rumours of rumours) alone, he does note that WHR bondholders have limited protection.

At CDR, our LBO models also rate WHR fairly high on the LBO viability. With LBO-viability, rumours and current WHR CDS levels in mind, we would rather be short this credit than long and are therefore proposing this positive-carry short position.

Summary and trade recommendation
We find ourselves in a slightly contrary mood with this one, recommending a short on a fundamentally improving name. Given the LBO concerns surrounding WHR (although lacking specific rumors) and the results of our fundamentals- and options-based LBO viability screens, we would rather be short WHR credit than long.

Given WHR's tight CDS spreads and a lack of positively-economic curve trades available, 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 WHR hedged with selling CDX HVOL 7 protection.

Excellent carry and the potential profit of a return to fair value (and beyond) strengthen the economics of the trade. Given our view on a potential WHR LBO 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 Whirlpool Corp. 5 Year CDS protection at 51bp and

Sell US$10m notional DJ CDX North America IG HVOL Series 7 5Y protection at 75bp to gain 24 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).

Renaissance with a twist?

Hybrid CDOs are discussed by Panayiotis Teklos, Michael Sandigursky, Michael Hampden-Turner and Matt King of the European quantitative credit strategy and analysis group at Citigroup

Cash and synthetic CDOs have co-existed for some time but have been separated by the practical differences of combining synthetic and cash collateral. Hybrid CDOs bridge this gap by bringing some of the advantages of synthetic structures to Cash CDO investors. Although some of the mechanics designed to overcome the practical difficulties of including CDS in a cash structure are cumbersome, the stability of the waterfall structure is unaffected and there are substantial advantages for investors.

Cash CDOs are structured on a pool of physical assets that have to be sourced, purchased and funded; these assets are typically subject to prepayment. A combination of tranching and waterfalls are used to provide structural credit enhancement to the notes issued from the collateral pool.

Tranching provides classic subordination protection for the issued notes. The waterfall structure enhances this by providing a set of rules that determines how surplus cash should be distributed. In a classic structure surplus cash is reinvested so that the collateral pool becomes larger than the total sum of the liabilities (i.e. the issued notes).

The ratio of collateral to liabilities is called the Over Collateralisation Ratio (OC Ratio). Interest Coverage (IC Ratio) tests require the structure to maintain a minimum interest coverage test for each rated note class. This surplus of collateral and interest acts like an equity tranche providing additional protection for investors.

If losses occur to the collateral pool this excess can absorb them. If losses to the structure mean that the OC/IC Ratio cannot be maintained at a target level then cash is diverted to pay the liabilities down, typically the super senior first then the next most senior etc until the target ratios for each tranche is met again. Waterfall payments/diversions are governed by rules and ratios that are established up front; there are many variations in their structure.

Synthetic CDOs follow a different building and payment process. Firstly, the ramp up process is almost immediate as the assets are sourced synthetically in the form of selling protection in the CDS market. The synthetic nature of the pool means that there are fewer constraints on portfolio notional size.

Secondly, CDS are typically bullet and of fixed maturity with the result that there is much more certainty in the maturity of the notes. Therefore there is often no need for a collateral manager.

Thirdly, there is no payment waterfall structure. Any losses result in erosion of subordination and reduction in notional of the equity tranche. Once the first-loss tranche is fully depleted, the next tranche will start bearing the losses.

Both CDO worlds have co-existed happily for a number of years. Cash and synthetic CDOs were arranged by different bank groups, managed by different asset managers and furthermore, developed their own distinct investor clientele.

While synthetic structures went down the road of faster ramp-up to almost "on-demand" deals, cash CDOs remained focused on a greater structural protection provided by the cash flow waterfall. Hybrid CDOs emerged as the union of the two. Combining the two types of underlying reference assets allows the product to benefit from advantages of both structures: shorter ramp-up period, lower funding costs, as well as maximum structural protection.

Hybrid renaissance

The recent renaissance of the product came about as a result of investors wanting to diversify their portfolios while searching for yield but being constrained by the supply of cash collateral. The advent of synthetic issuance has revolutionised the credit markets across the entire board of asset classes.

In 2006, hybrid CDOs have seen a dramatic growth. Figure 1 below shows the quarterly growth in cash, hybrid, and synthetic resecuritisation CDOs within the last two years. Out of US$45bn of new issue resecuritisation CDO volume in the third quarter of 2006, nearly 40% was due to hybrid structures.

This is almost twice the volume seen in the second quarter of the same year. As a result there has been a reduction in the overall funding cost for mezz deals, allowing the market to function amidst a backdrop of tightening asset spreads for much of the year.

Combining the ABS class with other asset classes such as leveraged loans and HY bonds enhances diversification considerably due to the negative asset correlations between ABS and most of the other asset classes. Figures 2 and 3 below show pairwise asset correlations between six asset classes that are popular candidates for the collateral portfolio of hybrid CDOs.

Asset correlations appear to be low to moderately positive between most of the asset classes with the exception of ABS, which is negatively correlated with all but the Emerging Market Index. In fact, default correlations inferred from the asset correlations using the standard Gaussian copula framework will be even smaller and hence will make the loss distribution of the CDO less dispersed; i.e., the expected loss of junior and mezzanine classes will be reduced.

Mixing different classes of assets at a time where credit and asset swap spreads are quite tight creates more opportunities for yield pick up. Attractive spreads across ratings for ABS assets such as CMBS and sub-prime RMBS as well as for leveraged loans have lured cash CDO investors of all sorts. In the investment grade space, European CLOs tend to have the highest spreads across ratings, followed closely by ABS assets such as CMBS and sub-prime RMBS (Figure 4).

The ISDA standardisation of Pay-As-You-Go (PAUG) documentation enables the creation of CDS referencing ABS as well as loans (LCDS), which has opened up an otherwise constrained cash market. Both loan and ABS CDS were launched in 2006 and the universe of reference assets has expanded significantly since then.

Market-specific reasons for each of these classes have also helped to boost their performance. The continued speculation on the housing market – especially in the US – has turned the attention of many investors in search of yield to look for relative value opportunities in the Commercial Real Estate (CRE) and residential property markets.

Additionally, the creation of traded indexes for both ABS and LCDS contracts allowed investors to obtain broad and diversified exposure without the need to physically own the assets. The supply of CDS is theoretically limitless compared to actual assets; therefore CDO managers have an opportunity to reference the lucrative "hard to find" assets synthetically.

Although complex, cash deals have an array of attractive features that appeal to investors. Waterfalls, although cumbersome, are the one aspect of cash CDOs that investors would like to see preserved when "going synthetic".

The main strength of cash flow waterfalls is their flexibility to build internal checks and balances (i.e., OC/IC tests) that provide additional stability for senior investors. Although identically rated, tranches structured without waterfall will have a significantly higher loss exposure as compared to the tranches with the structural protection of the waterfall.

In fact, it is not only the senior tranches in the structure that benefit from this set up. Equity investors benefit as well. In structures with no waterfall, the losses eat up into the notional of the equity tranches and eventually the tranche becomes depleted. This is less than desirable in a volatile situation with sharp front-loaded losses.

This is in contrast with the waterfall type structures where the equity has over-collateralisation protection and may receive no cash flows, but still remains in the game. Should circumstances improve, there is a possibility for the tranche to recover and for IRRs to improve.

Traditional cash CDO investors will find hybrids quite appealing, as the scale of demand for loans and ABS – in many cases augmented by hedge funds moving into traditional CLO space – is creating a shortage of assets for single-class structures, despite record issuance. In addition, hybrids allow them to remain in their comfort zone with respect to the investment and payment process. The creation of a reserve account or a liquidity facility serves the same purpose of trapping cash as in cash CDO structures.

Structure mechanics

Structurally, hybrid CDOs closely resemble typical cash CDOs. The arranger engages an SPV to issue the rated notes and equity to investors. The proceeds are used to purchase the assets in order to ramp-up the reference portfolio.

Cash flows generated by the portfolio assets (interest, premium and principal repayments) are channelled through the SPV to pay the investors. A complex system of priorities (the waterfall) regulates the order in which proceeds are distributed to pay arranger and manager fees, expenses and finally, interest on the notes.

On the asset side the main twist with hybrid CDOs is that they can take credit risk exposure in both cash and synthetic form. Most of the existing structures we have seen use CDS and TRS (total return swaps) to reference ABS and leveraged loans synthetically. Although most of the existing structures concentrate on corporate and ABS credits, some of them provide a bucket for other more complex strategies (i.e., cash–CDS basis, index skew, synthetic equity, etc.)

On the liability side, the hybrid nature of the collateral portfolio enables the structure to be partially funded. The lower part of the capital structure is typically funded and represents the traditional rated notes (Class B, C, D) and the equity. The large senior part of the capital structure (the super senior) remains unfunded and is usually taken up by the arranging bank. This mechanism allows the structure to lever up beyond the initial investment size.

The major complication with hybrid CDOs is how to deal with the losses that occur in the synthetic part of the portfolio. Since the capital structure is only partially funded, there is no collateral readily available to pay out to CDS counterparties.

Unlike in synthetic CDOs, default losses do not eat into the notional of the most junior note holders of the hybrid CDOs – the equity notional remains unchanged. Instead, the structure relies on a bridge loan provided by the liquidity facility to fund the shortfall.

The arranger or another well-rated bank typically provides the liquidity facility. Once drawn, the cash proceeds from the reference portfolio are diverted to pay down the bridge loan and interest. This provision makes the liquidity facility the most senior note in the waterfall.

Some structures use super-senior revolvers, where the liquidity facility is combined with the super senior (SS) tranche. Under this arrangement, super senior investors (typically the arranging bank) are required to make a payment to cover the loss of the synthetic part of the portfolio.

Any such payments form the drawn part of the super-senior revolver, which is funded at Libor plus spread until repaid. Similar to the case of the liquidity facility, cash amortisations and/or prepayments of assets are diverted to first pay the drawn portion of the SS revolver.

The key issue from a ratings perspective is to ensure that future cash amortisations are sufficient to cover draws on the liquidity facility or super senior revolver. This is addressed by creating a reserve account. It can be either pre-funded from the rated notes proceeds or funded from the portfolio proceeds in the waterfall.

To produce the required ratings, the liquidity facility should have enough depth to cover the remote eventuality of correlated default. Typically, rating agencies require that the liquidity facility covers the amount of the synthetic exposure on the asset side. This comes at a price, increasing the funding cost of the structure. Further, the additional draws on the facility leak the excess spread otherwise available to the equity investors, making the investment less attractive.

Another key invention of the synthetic CDO world is the super senior tranche. Use of the synthetic assets in hybrid CDOs have made it possible to structure liability in a similar way. It is generally easier to place the large senior tranche in an unfunded form, thus providing a CDO equity holder with the crucial cheaper source of funding.

Product advantages and risks

The following table summarises the main points and rationale for both investors and managers of the hybrid structure:

What next?

More of the same.... As we look forward to 2007, we expect further growth of the hybrid and synthetic waterfall structures.

On the asset side, it looks like a one-way street. As markets embrace more and more synthetic technology liquidity improves cutting transaction costs. As the cash assets get harder and harder to find CDO managers will be tempted to use increasingly larger synthetic buckets. Thus, classic cash structures become increasingly threatened with extinction.

On the liability side, there is little contention as well. Use of synthetic assets allows for a large super senior tranche that keeps funding costs down while making distribution more efficient.

Finally, the key advantage of a cash structure is in its waterfall. For historic reasons waterfalls are strongly associated with the cash structures.

We believe that this is about to change as synthetic waterfalls enter the mainstream of CDO issuance. These structures can "have their cake and eat it too" – they maintain the broad investor appeal of the traditional cash CDO while still benefiting from the advantages of synthetic structures.

© 2007 Citigroup Global markets. All rights reserved. This Research Note was first published by Citigroup Global markets on 22 January 2007.