Contents

CDR Liquid Index data as at 5 March 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.

Japanese government mulls CLO issuance

Long-term fiscal plan could involve intensive structured credit issuance

Japan's government has begun exploring the possibilities for securitising part of its extensive loan portfolio. It has announced as part of its fiscal restructuring plan that it aims to remove ¥130tr of loans from government books over the next ten years, utilising a variety of methods including securitisation. The first step in the latter effort is likely to be a ¥100bn deal executed in this fiscal year (ending March 2008).

"Obviously ¥100bn is a very small amount compared with the ¥130tr total, but it is a start of what could be an extensive programme. The first deal should be a test to ensure that the securitisation is a cost-effective solution," says Chinatsu Hani, senior director at Merrill Lynch.

At this point in time, it is unknown exactly what kind of securitisation the government is planning. As Hani explains: "We don't know the scheme the government is considering because discussions haven't begun yet, but we do know that it will involve loans to government financial institutions. The loans are basically government institution credits and therefore will be fairly highly rated and much like an agency bond, except the deal will be collateralised so it is likely be closest to what we know as a CLO."

The government making its intentions public at such an early stage is a welcome move toward transparency, according to local market participants. "The government has announced the plan now because it is trying to pre-warn the market so investors are prepared – and it has also begun speaking with arrangers at this early stage so that they have a clear idea of exactly what's involved," says one.

Hani concurs: "The government is trying to get structured credit professionals involved early in what could end up being a ¥100tr programme over the next ten years – again, provided that it turns out to be cost-effective. Discussion in the market is that the first transaction is likely to be priced close to an agency bond, but obviously the pricing should reflect the difference in cash flow structure as compared to a straight bond."

She continues: "There is also a question of whether investors will look at it as a securitised product or as a quasi-government bond. The same discussion came about initially with the Government Housing Loan Corporation RMBS programme. Some people considered it to be a government agency bond and some people considered it as a securitisation product – which caused a pricing differential. Securitisation investors required higher spread."

Investor perception will consequently depend a great deal on how the transaction is marketed. But Hani believes – again, subject to clarification on the structure – that there should be ample demand for it. "Local investors are getting used to government-related structured issuance – Aside from GHLC MBS, we also have an SME CLO market sponsored by the government, for example," she concludes.

MP

Index markets settle

Calmer conditions allow some respite, albeit perhaps temporarily

By this morning, Wednesday 7 March, the explosive activity in the credit markets seen over the past week appeared to have calmed somewhat. Dealers and investors alike are at last able to consider the wider picture and market expectations going forward.

"The whole episode has been driven by a multitude of factors - from equity markets to the ABX market - and it's been difficult for most people to assess the wider picture," confirms one dealer. "It almost doesn't matter what the drivers were because the net effect was the same: the market had been long on risk and quickly became risk averse, and we have seen massive volumes on the back of that - three times normal levels at least."

"CDS indices traded in huge volumes Monday, with fast money accounts focusing on 'index vs names' arbitrage, to take advantage of intra-day swings in the skew. Notably, index option players have also awakened from hibernation and become very active," says Gregory Venizelos, structured credit strategy at Royal Bank of Scotland.

The latter point is unsurprising, given the spike in implied volatility seen in the market. Tuesday's close in the iTraxx Crossover index - regarded as the best barometer of market sentiment over the past week - saw Mar 07 ATM implied vol at 80%, up 16% on the week and 44% on the month.

However, volumes on Tuesday and this morning were significantly down from Monday. "On Tuesday we saw some opportunistic portfolio hedging from accounts offset by momentum players setting up longs. Despite a wide headline range, 229-242bp, iTraxx Crossover spent most of the day in the 232-236bp range. Crossover has traded between 4bp and 7bp tighter this morning [Wednesday], with a lot of activity at the 225bp level - possibly due to swaption related activity at the 225bp strike level," continues Venizelos.

"We're getting the sense that it's simmering down a little," adds the dealer. "Most people now seem to be treating the experience as a road bump and a necessary correction across all asset classes. No-one appears to be thinking that this is the turn in the credit cycle, but many are now waiting to see whether the market will stabilise or if there is more volatility to come."

Staying out of the market seems to be the advice consistently being offered to ABX investors, one of the prime drivers of the recent volatility. Going into Tuesday's close the market remained on a knife-edge - despite a few days of strong rallying activity - with all involved aware that it would not take much to trigger a reversal.

MP

JDA receives mixed response

New bank ratings policy to have a range of effects on structured credit

Moody's implementation of its joint-default analysis (JDA) methodology has caused some consternation in the cash markets over the past week or so. But the agency's incorporation of its view on the likelihood of external support into its bank ratings has been met with more of a mixed response from those involved in structured credit.

Moody's move makes fundamental sense, according to a report from RBC Capital Markets' Credit Research. "Generally speaking we agree that banks have been underrated in recent years, given their excellent default record and the steady improvement in their risk monitoring and management capacity, as well as the significant strengthening of regulatory controls over the past two decades. Also, there is plenty of empirical evidence supporting the assertion that supervisory authorities are prepared to step in on a timely basis to prevent a distressed bank from suffering any liquidity and debt service problems," it says.

The JDA, which is being rolled out globally in phases, has already had an impact on the market – notably in Iceland, where Kaupthing, Glitnir and Landsbanki all received upgrades to triple-A which caused their 5-year CDS to tighten significantly. The new methodology has also affected the CDS indices, although it is difficult to ascertain to what extent given the broader extensive market volatility. Equally, more structured transactions are also likely to be impacted.

"Although many issuers' CDS spreads tightened significantly on this, we believe that the market has not fully incorporated the likely increase in volatility elsewhere in the capital structure. While governments may well repay deposits and senior debt, they aren't strictly obligated to do the same for subordinated debt including tier 1s. Therefore tightening the differential to senior debt may prove misplaced in the long run," says Raja Visweswaran, head of international credit strategy research at Bank of America.

He continues: "For banks benefiting from the ratings upgrade, the primary implication is a decline in costs of issuing debt, as well as increased flexibility in issuing instruments lower down in the capital structure. The downside though is the more direct linkage with sovereign ratings. While that is usually a good thing, a number of European sovereigns face potential ratings downgrades in coming years, due to demographic factors. This would argue for increased volatility, and lower access to financial markets for such banks, when sovereign ratings are threatened."

Additionally, a new set of structured products benefiting from wraps of triple-A rated banks may become feasible in many countries. This will help banks in some higher-rated countries like Iceland to securitise their books.

The RBC report concurs: "Moody's move accentuates the polarisation of borrowers across the rating scale, as Moody's admits itself. The polarisation of corporate bond markets in credit rating terms combined with the structural rise in demand for 'yieldy' – albeit still investment grade rated bonds – may further heighten the shortage of single-A and triple-B rated assets, further encouraging the creation of synthetic credit investments (CDOs etc), hybrid securities etc in the mid-range of the rating scale."

Other rating agencies are set to tackle the issue of external support for banks, but are not expected to produce JDA-like proposals. For example, Fitch Ratings has announced that it will shortly publish bank-specific Support Rating Floors for all of the banks to which the agency currently assigns an Issuer Default Rating (IDR). The support floors complement the agency's Support Ratings, which on a scale of one to five provide an opinion on the likelihood and source of external support, should a bank experience financial difficulties, Fitch says.

MP

TABX convergence possible

New report identifies potential future path for ABX.HE tranches versus mezz SF CDOs

Since the launch of tranches on the ABX.HE index (TABX) on 14 February (see SCI passim), ABX prices have plummeted and wide TABX prints have put pressure on mezzanine structured finance (mezz SF) CDOs. However, a new report from JP Morgan CDO Research suggests the two products will begin to converge.

The report attempts to determine how much of the current TABX/mezz SF spread differential is reasonably based on differences in HEL credit quality. "Significantly worse collateral composition justifies a large portion of the current basis. However, the gap appears too wide and we expect convergence," it says.

The report explains that both TABX and mezz SF CDOs leverage exposure to subordinated HEL risk. Significant differences between the two products include worse collateral quality in the TABX (as implied by spreads and fundamental analysis) and higher concentration risk (in the form of 100% HEL exposure and increased single-name concentrations).

The TABX is also static, so that while an SF CDO manager could periodically remove bonds for small losses, TABX investors are exposed to potentially large and unavoidable losses (similar to the situation that static IG CSO investors faced during the 2001 to 2003 period). ABX tranches don't offer debt investors the benefit of over-collateralisation (OC) tests or excess spread diversion – although this may be less relevant, given the trend towards OC-less transactions in the fully distributed, managed SF CDO space, the report argues.

The report adds that since launch, TABX spreads have moved in directions generally consistent with JP Morgan's model projections. Spreads have increased relatively more at the top of the capital structure (where implied levels were overshooting observed levels). And mezz SF single-A and triple-Bs have sold off (single-As near 500bp in secondary, with some 2006 vintage triple-Bs reaching 1000bp), driving convergence from the CDO end.

Such trading has involved a variety of market participants. "Early TABX trading focused on price discovery and accounts crossing dealers; in latter days correlation traders and hedge funds taking pure long or short positions were active – particularly in the 25-40% and 40-100% TABX triple-B minus tranches. There has also been two-sided interest in the 0-5% tranche. Typical size is US$10m (US$25m for 40-100%), with some US$5m trades," says the report.

Notwithstanding these early moves, JP Morgan expects further widening to occur. "Our conclusion of convergence does not mean ABX/TABX is oversold – just that single-name HEL ABCDS and SF CDOs are undersold relative to ABX/TABX.

The report concludes with some suggestions as to potential trading ideas. "To implement a convergence trade, we recommend one go long TABX from 10-40% and short double-A to triple-B single-name CDO CDS. For an ABX-widening trade, we would short the 40-100% TABX triple-B minus (especially given the short-covering rally late last week). For an ABX-tightening trade, we would go long the 15-25%; the 10-25% range is the TABX 'sweet spot'. We remain underweight SF CDOs, given that risks remain skewed to the downside: the real estate adjustment is in its early stages," it says.

MP

Real estate reporting issues

The CRE CDO market currently lacks transparency, but participants are upbeat about potential improvements

The variety and complexity of commercial real estate (CRE) CDO structures is making deal comparison difficult for investors. Though there is a lack of standardisation of information, reporting standards are improving.

"There are some efforts under way to provide some sort of industry standard, which I expect will come to light in the medium term and will provide more consistency in reporting of the various transactions," adds Gene Kilgore, evp, structured securitisation, Arbor Realty Trust in Uniondale, New York.

The Commercial Mortgage Securities Association is developing an investor reporting package to advance the availability and transparency of information in the CRE CDO market. One advocate feels it is imperative to receive information immediately after a deal launches and on the performance of the underlying assets. "We need regular information and not a closed-shop system," declares a portfolio manager.

However, Kilgore suggests a standard for the market is hard to adopt due to the transitional nature of CRE CDO assets, not to mention the diversity of possible assets underlying the transactions. "There is a fair amount of variability among the transactions that are in the market and the information provided," he says.

"CRE CDOs capture everything from repackaged CMBS securities to loans and everything in between. Adopting a single standard for all CRE CDOs is difficult and unachievable," Kilgore adds, noting that Arbor Realty Trust's own deals can comprise whole loan, preferred equity, B notes or mezzanine.

Private equity firms have fast become a predominant source of lending and origination in the CRE CDO market, resulting in a situation of less transparent information and trickier transaction analysis. Raw information about loan contracts is difficult to get, notes Peter Vinella, president and ceo of Wilmington Trust Conduit Services in New York.

Terms and conditions and covenants can differ significantly from loan to loan and conversion features in the loans mean that one property or borrower can be swapped for another. "So, trying to reverse engineer these deals is almost impossible without the raw data," Vinella says. "There is just no standardisation around the loans themselves or the reporting and there are just not a lot of data sources. It is still an inefficient market in terms of information and a very difficult market to trade in."

A lack of historical data has also made it difficult to gauge probability of default, loss given default, and exposure at default on the type of credit exposures investors are analysing. "You do not have enough of a history of statistical or loan-specific information under varying economic conditions to say, if rates back off 200bp to 300bp, default rates will be here. You really do not know what you are buying on a risk-adjusted basis," says Vinella.

For its part, Wilmington Trust is promoting greater transparency, via its role as collateral administrator and the information it holds on underlying loans and CMBS securities. "We can model waterfalls of CRE CDOs and the underlying loans in a much more granular fashion, so you can start applying more credit risk analytics against the structures," he says.

Arbor Realty Trust supplements trustee reports with more detailed information on its transactions. "A manager provides the colour as to what is happening on the ground with the asset, particularly if it is transitional in nature. We provide qualitative as well as quantitative data in investor reports, which delve much deeper into the underlying assets," says Kilgore.

He notes that the market has made significant strides in its improvement of reporting and envisages greater standardisation and more reporting over the next 6-12 months.

"The key for the investment community is to speak up and tell bankers and issuers what information they have to provide. If a manager wants to be a repeat manger, he has to provide it or be punished in the market. The bottom line is that the market will ultimately dictate what has to be reported," concludes Kilgore.

HD

"Tracking the underlying credits requires a more sophisticated approach"

In this week's Provider Profile we talk to CMBS analytics and commercial real estate data provider Trepp

Trepp has been supplying the US domestic CMBS market with analytics, trading tools and data management and modelling software for 25 years. TreppDerivative is the firm's newest toolkit that supplies the markets with both data for the CMBX index and analytics and surveillance on over 100 US-based CRE CDOs. Now, with the first European CRE CDO issued and more in the pipeline, Trepp believes it is well placed to help investors further understand the challenges presented by both the US and European markets.

Trepp's system is aimed at all players in the CMBS market: hedge funds, real money investors, managers and dealers. Given its pure focus on CMBS, Trepp is confident that it maintains unique tools and data that support the vast majority of CRE CDO deals. "Trepp has modelled over 130 US-based CRE CDO transactions. This represents close to one hundred percent of the outstanding issuance," says Dan Gottlieb, the firm's coo.

TreppDerivative allows a user to create and track bespoke baskets of CDS based upon underlying CMBS credits and tranches. Investors can examine underlying credits by sector and asset type and perform sensitivity analyses based upon defaults, delinquencies and prepayments as well as monitor their CDS positions for floating rate events. TreppDerivative also provides support for the CMBX indices.

The CRE CDO sector has grown highly sophisticated over the recent past, according to Trepp. It has seen the market develop from a passive CMBS-only play, to deals that might include a pool of assets which change quite dramatically during the ramp-up period.

Gottlieb explains further: "A CRE CDO is backed by a diverse asset pool, and so investors will need to see how underlying assets correlate and how hidden exposures overlap. If an investor is bearish on hotels, then they generally need to be able to simulate a default on the hotel sector and calculate the resulting triggers, bond cash flows and yields."

He continues: "We also see mezz, 'B' notes and corporate debt mixed into deals, and of course there is correlation to related fixed income sectors; we believe the recent fall-out in the US sub prime mortgage sector may have had a temporary effect on the CMBS markets."

As the sector grows increasingly complex, so the mix of investors evolves too. Trepp claims that about 50% of US CRE CDO deals have European investors, seeking yield and diversification from the fast maturing US market. The European market is therefore already educated and aware of the opportunities in the sector, and so Gottlieb expects that more deals will appear in Europe in 2007.

"At present in Europe we have Anthracite as the first CDO deal, but I expect that in the second and third quarters more deals will come to market. There is also a healthy interest from US investors," Gottlieb suggests.

The European CMBS and CRE CDO market does however exhibit a number of structural differences from the US that may slow the growth of the market, according to Trepp. "In Europe, disclosure and reporting of changes in the financials of the underlying properties comes less frequently than in the US," observes Allison LaFleur, Trepp's European Account Manager based in London.

"We are also are faced with a data issue as both borrowers and deal arrangers are more reluctant to disclose certain information they deem more proprietary. However, the market is seeing that when a greater quality and depth of data is made publicly available, then investors will have more confidence to commit to a deal and better execution and liquidity will follow," she adds.

"In the US, standard data reporting formats have been in place for quite a while. In Europe, we are involved in several committees to make that happen here and have several advocates on the dealer and investor side to help achieve this," LaFleur continues.

Another challenge lies in the differences in pre-payment terms. There is a penalty on pre-payments in the US to compensate investors for their early return of principal or otherwise a lockout period to prevent the early payoffs. The structures of these penalties are less uniform in European commercial mortgages. "Investors find the lack of consistency in prepayment restrictions in European transactions a source of added uncertainty and this sometimes means extra analysis is needed by US investors when they invest in European CMBS," adds LaFleur.

Interest in securitised property debt in Europe is also not at the levels seen in the US, another factor holding back growth in both levels of investment and technology. "We see property making up about 10% of a portfolio, so the need for a dedicated system tracking a complex portfolio of deals is not quite there. However as the CDO market develops investors will understand that the difficulty in tracking the underlying credits requires a more sophisticated approach," says Lafleur.

"To date, the market is also highly localised in Europe; for example Germany has a huge investor base, London is always important, and we see more and more interest in Eastern Europe. As the market moves though from single country transactions to more of a pan-European collateral mix, we expect Trepp's tools to be an excellent resource for investors to take specific views on each of the individual property markets," she concludes.

JW

Moffat to join Harbourmaster

The latest company and people moves

Moffat to join Harbourmaster
Mark Moffat is leaving Bear Stearns, where he successfully led the build-up of the bank's European CDO origination business. He is to become co-head of Harbourmaster Capital Management with existing head Alan Kerr. He will start towards the end of April and be based in Dublin.

Moffat's departure appears to be an amicable one, with Bear hopeful of continuing its relationship with Harbourmaster. "Mark did an excellent job building the London CDO business. He leaves Bear Stearns with strong capabilities in CDO origination, trading and distribution, and a robust pipeline of future mandates. We look forward to continuing to work with him in his new capacity and wish him success in his new endeavors," says a spokesperson from the bank.

Bear Stearns has appointed Kassem Shafi as head of its European CDO group and head of product marketing in its strategic finance group. The bank says that Shafi will work in partnership with Doug Lucas, head of CDO trading and syndicate, to grow its business.

Previously, Shafi had been a senior member of Bear's product management team for US and European CDO transactions, with a focus on distribution into Europe and Asia, which is a mandate he maintains in his new capacity. He continues to report globally to Lesley Goldwasser, head of strategic finance in New York, to Yves Leysen and John Moore, co-heads of fixed income in Europe and to Ira Wagner, head of the CDO group in New York.

WestLB relocates flow trading
WestLB has decided to centralise its flow credit trading business out of Düsseldorf with London continuing to act as the key focus for its structured credit business. "We are not closing our credit business, we are centralising it. We already have a successful blueprint from concentrating our global FX activities in one location last year," said Friedhelm Breuers, head of global markets. "It makes competitive sense to leverage our FX experience into flow credit at this time."

Although WestLB would not confirm departures, it is understood that among those leaving are Andrew Sheppard, head of credit trading, Ian McCann and John Allum, who only joined the bank last month. In addition, five members of the emerging markets trading are thought to have left.

RBS hires Golledge
Brett Golledge has left his trading role at Deutsche Bank and will be joining RBS as head of high-grade CDS trading. He will report to Stewart Booth, head of credit trading.

Papadopoulos joins BNP Paribas
Dimitris Papadopoulos is joining BNP Paribas on 13 March from CIBC as senior structurer on the European CDO desk within securitisation. He will report to Christos Danias, head of European CDOs.

Canabarro back at MS
Eduardo Canabarro returned to Morgan Stanley on Monday as a New York-based managing director in quantitative risk management after a three-year stint at Lehman Brothers, where he was global head of quantitative risk management. He reports to Thomas Daula, the firm's chief risk officer.

High yield musical chairs
Mike Srba has joined Lehman Brothers in high-yield trading after leaving a similar position at Citigroup, which has moved quickly by adding Conor Davis as head of high-yield and distressed debt trading from Deutsche Bank. He reports to Mickey Brennan, head of Citi's European high-yield trading, sales and research.

SunTrust fills gap
SunTrust Robinson Humphrey had shifted several people from within its structured product group to help fill the gap left by the departure of 13 members of its CDO team, including its head James Bennison. "SunTrust remains committed to the CDO business, our strategy remains the same and we expect to fill any vacant positions. We are re-establishing a team to accumulate collateral, structure, and distribute CDOs and will continue to augment the existing CDO team - and overall structured product group - with high-performing talent," says Michael McCoy, spokesperson for SunTrust in Atlanta.

BMO replacements
BMO Capital Markets has begun replacing the six members of its securitisation group that departed last month. Stephen Hutchinson, director, and Francis Kestler, vp, have joined the sales and trading team and there has been an internal hire to the analytics team within the group. The group is in the process of hiring four more people for its origination and structuring team.

"We have reassigned some relationship and market sector coverage responsibilities to address the recent departures. The securitisation division continues to operate at full speed and continues to provide exceptional customer service to the highly structured end of the securitisation market," says Patrick O'Herlihy, spokesperson for BMO Capital Markets in Chicago.

Freydefont moves on
Marc Freydefont, director in structured credit trading at Credit Suisse in London, has left the firm. His destination is not yet known.

Jenkins departs DB
Gary Jenkins, European head of credit research and fundamental strategy at Deutsche Bank in London, has left the bank and is pursuing opportunities on the investment management side of the business.

ICG adds in mezz
Aleksander Ferenc has joined Intermediate Capital Group as assistant director, responsible for new mezzanine investments in the Central and Eastern European market. Ferenc was previously an investment director at Baring Private Equity Partners, managing the Baring Central European fund.

Citi primes up
Citigroup has opened a prime brokerage office in Singapore and hired Alexis Fosler to run prime brokerage sales in Asean countries and India. Paul Weir joins as client services manager from Bear Stearns where he was in charge of the bank's European fixed-income prime brokerage operations. Further additions are expected this year.

...As does Deutsche
Jeff Dorman becomes head of global prime finance for Deutsche Bank in North America, replacing Mark Haas who has been promoted to the new position of head of business development for global prime finance. Dorman joins from Bear Stearns, where he was global co-head of prime brokerage. He and Haas will report to Jonathan Hitchon and Barry Bausano, co-heads of global prime finance, and to Robert Karofsky, head of global markets, equity in North America.

CDO² partners with University of Surrey
Financial analysis company CDO² has partnered with the University of Surrey to work on a three-year research project aimed at improving CDO²'s service offering.

The project provides access to both expertise and resources at the University of Surrey in Financial Grid computing, allowing CDO² to innovate in the analysis it undertakes for its customers.

London-based CDO² develops pricing and risk technology for banks, hedge funds and investment firms involved in trading structured credit products, specifically CDOs. The collaborative project, worth £160,000, will seek to strengthen CDO²'s pricing and risk analysis technology by using university expertise in Grid computing.

Dr Lee Gillam of the Department of Computing, leading the University's input, has designed systems for analysis of financial data in previous UK and EU funded research projects. He has also specified, designed and built Grid computing systems.

NumeriX and ClusterSeven team up
Derivatives pricing software provider NumeriX has announced a strategic partnership with ClusterSeven, the developer of enterprise spreadsheet management and control software. The combined technologies give customers the capability to quickly and accurately price and execute financial products without leaving Excel, the companies say.

As a result of this partnership, ClusterSeven customers will gain access to NumeriX analytics through NumeriX for Excel, a series of flexible add-in templates. Currently, structurers model financial products through software developed in-house; the models are then exported to Excel for pricing and execution, which creates the risk of lost data and latency in trade execution. The combined ClusterSeven/NumeriX technology aims to help eliminate this risk while accelerating the time-to-market by building underlying analytics right into the Excel interface.

HD & MP

LCDS indices delayed

A round up of this week's structured credit news

LCDS indices delayed
International Index Company has announced that iTraxx LevX Index roll market participants have agreed to postpone the next planned roll of the LevX indices, which was to have been 20 March. The postponement is to facilitate the continuing discussions on European index and single name LCDS documentation (see SCI issue 27).

Meanwhile, the launch of the US loan CDS index LCDX – which had been scheduled for Q1 07 – looks likely to slip slightly. Dealers say that the launch date is now being tabled for 3 April.

Smart PFI 2007 launches
Sumitomo Mitsui Banking Corporation Europe (SMBCE) has become the first of around half a dozen banks expected to tap the PFI CDO market in 2007 to gain regulatory capital relief. The deal, Smart PFI 2007, is co-arranged with Deutsche Bank who also acted as lead manager. SMBCE previously partnered up with NIB Capital in November 2005 on the Stichting PROFILE transaction.

Smart PFI is a synthetic securitisation of exposures to project loans under the private finance initiative (PFI) and public/private partnership (PPP) projects in the UK originated by SMBCE. Like Stichting PROFILE, Smart's structure is based on KfW's securitisation platform.

Below a senior CDS, the transaction comprises £100,000 triple-A rated Class A+ notes, £5m triple-A rated Class As, £3.25m double-A rated Class Bs, £2.55m single-A rated Class Cs, £4.75m triple-B rated Class Ds, £5.7m double-B rated Class Es and £4.3m single-B rated Class Fs. The deal features a four-year reinvestment period, during which maturing and amortising exposures may be replenished with other exposures, subject to satisfying certain eligibility criteria.

The ratings of the notes are linked to the credit quality of the certificates of indebtedness (schuldscheine) issued by KfW. If KfW were to be downgraded below triple-A, any note rated higher than the then-outstanding rating of KfW would be downgraded accordingly.

LMA launches Islamic Finance Users Guide
The Loan Market Association has launched a Users Guide to Islamic Finance. The purpose of the Guide is to serve as an introduction for new investors in Islamic facilities or investors who are not yet fully familiar with structures in the Islamic finance market.

By increasing market participants' familiarity with how Islamic finance documents address allocation of risks and rewards, it is hoped that the Guide will help to promote liquidity for Islamic products among LMA members and the banking market generally. The principal form of Islamic facility described in the Users Guide is a murabaha facility.

ISDA responds to UK FSA
ISDA has written a comment letter on FSA Discussion Paper 06/6: Private equity: a discussion of risk and regulatory engagement. The trade association raises concerns over the regulator's suggestion that CDS may somehow contribute to uncertainty and/or instability in the markets.

One of the areas ISDA highlights is that the DP refers in broad terms to the risk of "unclear ownership of economic risk". The letter says that it is apparent that this is intended to cover three separate points, namely:

(i) operational issues such as confirmations backlogs;
(ii) the possibility that the notional amount traded in CDS markets may in some cases exceed the amount of underlying assets available for settlement; and
(iii) the possibility that new types of loan market participant (and implicitly those more traditional loan market participants who have hedged all or part of their credit risk by means of credit derivatives and other risk transfer practices) may not have the same approach to the survival of distressed companies as more traditional loan market participants (that is, that the "London approach" may be dead).

ISDA argues: "These three points, although related in a broader sense, are very different in nature and carry different degrees of risk, and so for purposes of our response we would like to address them separately. Our view is that the first and second of these points could have a potential for market impact if they were not properly addressed by the industry (which, as noted below, we believe they have been) but that the third is more an issue for the companies concerned and their stakeholders."

Pan-European SME CDOs remain stable
Fitch Ratings says European SME CLO performance remained stable in Q306, with a reduction in the amount of outstanding defaults across most jurisdictions while maintaining low loss levels.

In its latest Pan-European SME CDO Performance Tracker, Fitch highlights the downgrade of the Autonomous Community of Catalonia to A+/F1 from AA-/F1+ at end-2006 in Spain. Catalonia is a guarantor of ultimate payment of interest and principal for nine tranches of seven Spanish SME CLO deals. The agency deems the current rating of Catalonia to be sufficient to support the deals' ratings based on internal credit enhancement and the benefit of the guarantee.

In Germany the bankruptcy filing of a German auto supplier has raised concerns for the performance of two German mezzanine debt SME CLO transactions, Force 2005-1 Limited Partnership and Stage Mezzanine Societe en Commandite Simple. Force 2005-1 has been affirmed as of 29 January 2007, while for the latter transaction, the event has resulted in the assignment of negative rating watch.

The European SME CLO market continues to grow, with the main drivers being Germany and Spain, says Fitch. Eleven new issuances were seen in the German market over the course of 2006, while Fitch has rated 12 new transactions in Spain. Additionally, it is worth noting that in 2006 the first Fitch-rated SME CLO debuted in both Bulgaria and Finland.

Fitch has been involved in rating SME CLOs in Europe since 1999 and has rated more than 95 transactions to date. Launched in 2004, The SME Tracker provides objective and standardised performance analysis on all Fitch-rated European SME CLOs. The agency will continue to publish the SME Tracker on a quarterly basis, providing updates on the performance of existing transactions and covering newly rated transactions.

Moody's KMV launches new credit risk tool
Moody's KMV, the credit risk measurement and management product provider, has launched its RiskFrontier solution. The product aims to provide financial institutions of all sizes an accessible, enterprise-wide tool for measuring and understanding credit portfolio risk.

Moody's KMV says: "RiskFrontier offers unparalleled modelling capability, enabling users to measure credit risk across multiple asset classes, from loans and bonds with options to CDS and CDO tranches. Specifically, RiskFrontier will allow users to assess capital adequacy and concentration risks more precisely than any other commercially available software and analytics solution."

This clarity is critical to strategic decision making as financial institutions allocate economic capital to customers and business units against a backdrop of increased competition and regulatory imperatives, such as the Pillar 2 requirements of the Basel 2 Accord.

"Moody's KMV has always led the way with state-of-the-art data and analytics, and now we've remade our portfolio solution to be much more accessible with an intuitive user interface and more users will be able to take advantage of our credit insight. This new solution provides financial institutions with a way to measure portfolio-level credit risk using advanced analytics (with several major enhancements of previous methodologies), compare that risk to the economic returns of other portfolios and, most importantly, identify specific actions designed to improve portfolio performance," says Andrew Huddart, president of Moody's KMV.

Thomas Villadsen of Jyske Bank, one of RiskFrontier's beta testers, adds: "This new solution is a great leap forward in almost all dimensions."

MP

Trading ideas - sub-prime performance

Dave Klein, research analyst at Credit Derivatives Research, looks at a long butterfly trade on Countrywide Home Loans Inc

We most often trade a single-name credit curve with a view towards an improving or deteriorating outlook. This view translates into an expected flattening or steepening of part of the curve.

Sometimes, however, we find positive carry trades on names for which our fundamental outlook is stable. In this case, we look for dislocations from fair value of parts of the curve and construct trades to take advantage. Butterfly trades are good candidates because they are hedged against both parallel shifts and twists of the credit curve.

Countrywide Home Loans, Inc. (CFC) has excellent CDS liquidity and its recent sell-off has triggered a number of our fair-value models. CFC's 5 year levels have doubled in the last week and almost quadrupled over their year-to-date lows.

We find that both the 3s-5s flattener and 5s-10s steepener have positive carry and positive roll-down. The 5s-10s steepener is significantly wide to fair value. Furthermore, when employing our butterfly fair value model (which judges fair pricing for five-year risk given threes and tens), we find that CFC's five-year sits wide of fair value compared to its wings.

Given the liquidity across the term structure of CFC and the positive economics of the package, we feel a duration-hedged 3s-5s-10s butterfly offers good relative value while being generally hedged against parallel or twist moves in the curve.

Hot wings
To estimate the fair value of the 3-5-10 butterfly, we model the 5 year bid level as a linear combination of the 3 and 10 year offer levels. This is undertaken across the universe of credits whose 3's and 10's are close in value to CFC, and the output of the regression is shown in Exhibit 1.

Exhibit 1

For each issuer, we produce an expectation of the five-year CDS bid level. This is compared to the current market five-year CDS bid level in Exhibit 1. The regression has an R-squared of over 99% and so we can be quite confident of its findings.

The Exhibit clearly shows that CFC is trading (y-axis) wider than our fair value model would imply. If the modelled bid level is below the 5 year market level, we expect the 3-5 leg to flatten or the 5-10 leg to steepen.

This is an indication that the five-year body is trading cheap to the three-ten wings and a butterfly is potentially applicable. In order to consider the potential driver of any relative-value pick-up we next look at the individual legs of the trade – a 5s-10s steepener and 3s-5s flattener.

Nice legs
The fives-ten curve is about 14bp flat to fair value, as seen in Exhibit 2. Our fair value curve model for US credit shows that the current level for a steepener (which is the equivalent leg) is above the solid black line (as seen by the green square). This leg has both positive carry and positive roll-down, strengthening our confidence in the trade. 

Exhibit 2

The threes-fives curve, on the other hand, is at about fair value as shown in Exhibit 3. Although currently just below fair value, our flattener leg offers positive carry and positive roll-down as well as hedges the 5-10 leg. 

Exhibit 3

Clearly, the flatness of the 5-10's leg is driving this trade. Given the dramatic market moves of the past week, we choose the butterfly as a way to pick up carry and roll-down and avoid taking a directional bet on the curve.

Trade economics
Three of our models indicate that the trade is warranted, but we must consider the actual economics of the trade. The carry of the DV01-neutral butterfly is often more important than the expected behaviour of individual legs of the trade. In the case of our DV01-hedged butterfly, we find around 17 basis points of positive carry, which along with over 50 basis points of MTM relative value we would expect provides some significant upside, given the nature of the butterfly trade.

Additionally, over the next year we would expect to gain about 10 basis points of MTM roll-down, due to the both steepness of the 3-5's leg as well as the flatness of the 5-10's leg, even if the CFC curve did not move. Taken together, these gains more than offset the 13-15 basis points of bid-offer spread we must cross on our trade.

The butterfly trade is hedged (for small moves) against both parallel shifts as well as twists to the credit curve. Given our stable fundamental view on the credit, we are exploiting the relative 3-5-10 levels to pick up carry, roll-down and relative-value.

Risk analysis
The butterfly is constructed to be duration- (and slope-) neutral with 3-5-10 weights of 2.0-2.6-0.75 based on the respective DV01s. Given our stable fundamental outlook as well as the dramatic sell-off of the past few days, we prefer to be hedged against both shifts and pivots. The position has a minimally short default risk position (we are long protection in US$27.5m and short protection in only US$26m).

As is clear, the parallel shifts and curve twists do generate some P&L (due to convexity differences) but these are minimal for moderate movements and the carry earned (and MTM relative-value realisation and roll-down) outweighs this.

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

In general, the biggest challenge to a butterfly is the ability to unwind the trade profitably. With three legs, we must cross three bid-offer spreads. As stated earlier, we face about 13-15 basis points of bid-offer spread that is offset by healthy carry, MTM roll-down and MTM relative value gain. This is the most significant challenge to the trade.

Entering and exiting any trade in these maturities carries execution risk, but this is not a major risk as CFC has excellent liquidity in the credit derivatives markets. We see quite a bit of volatility in indicative levels for CFC. We only recommend the trade if the 3s-5s-10s levels are close to those stated here. If the 3s-5s flattens or 5s-10s steepen, the trade will lose much of its profit potential.

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. CFC has good liquidity in the CDS market. Bid-offer spreads are low and we are well-compensated with the healthy carry the trade earns.

Fundamentals
This trade is technical in nature and is not based on any fundamental outlook. Even without a fundamental view on the credit, we would be comfortable putting on the trade. That said, it is always good to keep an eye on the fundamentals of the underlying credit of even the most technical trade.

CFC's 5 year CDS levels currently sit almost 4 times wider than at the end of January when rumours of a Bank of America takeover surfaced and those levels have doubled in the past week. While the company claims that it does not currently hold sub-prime loans at its bank, the credit market has punished CFC over the past few weeks. As everyone waits for the next shoe to drop (one wonders how many shoes can drop?), we prefer to be hedged against both flattening and steepening.

Summary and trade recommendation
CFC reported today that 20% of all sub-prime mortgage borrowers were late on their payments at the end of last year. Although CFC claims it only holds prime loans at its bank, the credit market has been a brutal place recently for the company.

Five year spreads have doubled in the last week and almost quadrupled since rumours of a Bank of America acquisition sparked a rally at the end of January. While we are hesitant to take a directional view on CFC, especially given the volatility seen in the market, the flatness of CFC's 5s-10s CDS curves suggest an interesting relative-value play.

Using our 3s-5s-10s fair value model, we find the 5 year CDS to be wide of fair value given its 3 and 10 year levels. Given the positive carry of the 3s-5s leg and good carry and roll-down of the 5s-10s leg, we view the butterfly as a strong trade candidate. Excellent carry, roll-down and the potential profit of a return to fair value strengthen the economics of the trade.

Buy US$20m notional Countrywide Home Loans, Inc. 3 Year CDS protection at 38bp and

Sell US$26m notional Countrywide Home Loans, Inc. 5 Year CDS protection at 61bp

Buy US$7.5m notional Countrywide Home Loans, Inc. 10 Year CDS protection at 87bp to gain 17.35 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).

Credit default swaps - part 2

This, the second of a two part primer by Michael Hampden-Turner, Panayiotis Teklos, Michael Sandigursky, Hans Lorenzen, Matt King and Peter Goves of the European quantitative credit strategy and analysis group at Citigroup, looks at utilising CDS contracts

We will now look at what types of investors are buying and selling credit default swaps and how the market is enticing them in growing numbers.

CDSs have revolutionised credit markets by enabling investors to go short credit easily. Previously, this had to be done through repo markets, a more complex and less liquid route. A CDS enables investors to express pure credit views without interest rate exposure. The following are examples of motivations to buy or sell protection.

Bonds versus CDS
An understanding of the relationship between bonds and CDSs is essential to understanding a number of common trade strategies. Some of these trade strategies can be complex, but the underlying relationship is simple. This is best illustrated by demonstrating how a CDS can be used to create a bond synthetically. Consider two portfolios:

The two transactions are identical if the bond and CDS contract reference the same legal entity. In the case of default, the investor will be left holding the defaulted asset in both cases (although, some small risk remains in funding the CDS unwind).

CDS spread versus asset swap spread
The relationship outlined above also highlights that there is a close relationship between the spread on CDSs and asset swap spreads.

This example in Figure 4 illustrates how an investor who has entered into an asset swap is in almost an identical position to one who has sold CDS protection on the same entity. In both cases the investor receives the same premium streams, and in the case of default, the investor is left with a defaulted asset. A few marginal risks remain, as we shall see shortly, but the fact that this relationship can be monetised means that the asset swap spread and CDS spread should remain linked.

Bloomberg analytics
Bloomberg provides many different spreads on bonds to aid in analysis. The majority of the functions can be found by typing YAS [GO] when a bond is loaded on the screen.

To further explain this Bloomberg example:

Simple yield spread: This is the spread to the nearest benchmark Treasury. For example, this is the T 4 5/8% 11/15/16, which yields 4.682, compared with the Ford bond, which yields 9.928. The difference is 524.6bp.

Option adjusted spread: This takes into account the whole shape of the curve and flows when calculating spread. OAS to Treasuries (constant maturity Treasury curve, or CMT) and the US dollar swap curve (I52) have been calculated. If a bond has an option embedded in it, the value of this is deducted. A full description of the method can be found by typing OAS1 [go] when in the YAS screen.

Z-spread: The basis point value that must be added to the zero coupon curve, such that the security's discounted cash flow equals the market price. The Z-spread is similar to the OAS, except that it is the spread to the zero coupon curve rather than Libor or Treasuries, and it makes no adjustment for embedded options. The Z-spread of a bond is often compared with the C-spread of a CDS. The C-spread adjusts the CDS spread to account for the fact that a CDS has a term structure, while a Z-spread is a simple parallel shift. It makes a better comparison when analysing the basis.

TED spread: This is the simple yield spread between the bond and the euro-futures strip. (This is only calculated for bonds of less than ten years).

Asset swap spread: This calculates the spread that could be achieved by entering into an asset swap at current rates. It takes into account all flows and is considerably tighter in this example than the other spreads because the bond is trading at 77 cents while a swap is at par (see ASW [Go] for details).

ISPRD: The I-spread is the simple yield spread to the interpolated reference curve (US dollar swaps in this example).

DSPRD: The D-spread is the duration matched yield spread between the bond's modified duration and the modified duration of the reference curve (US dollar swaps in this example).

Benchmark Treasury spreads: Simple yield spreads are given to a basket of benchmark Treasuries.

Basis trades
Basis trades are designed to be a broadly credit-risk-neutral method to monetise differences between asset swap spreads and CDS spreads. By convention, investors refer to the basis as being:

CDS spread – asset swap spread

Therefore, a negative basis is when the asset swap spread (ASW) is wider than the CDS, whereas a positive basis is where the CDS is trading wider than the ASW.

Buying the basis or going long basis is a trade that seeks to profit from a widening of the basis (that is, taking the view that the basis will become more positive). To put this trade on, an investor must buy the bond, execute a swap and buy protection on the CDS.

Selling the basis or going short basis is, conversely, a trade that seeks to profit from a tightening of the basis (that is, taking the view that the basis will become more negative). To put this trade on an investor must sell the bond, execute an interest rate swap and sell protection on the CDS.

Basis trades are designed to be broadly credit-risk neutral. However, small risks remain, such as the possibility of the credit and CDS counterparty defaulting at the same time.

Many of these strategies can be more extensively explored in Citigroup's publication The Added Dimensions of Credit: a Guide to Relative Value Trading, Rohan Doctor, 3 May 2005.

Basis trade example
Consider the following example, which assumes a trade date of 20 January 2004. An investor feels the current spread (82bp) on the BATSLN 4.875% 2009 bond is too high relative to the BAT 5yr CDS that is trading at 62bp. To take advantage of this, the investor decides to "buy the basis".

An investor looking to hold the trade to maturity might opt for a series of bespoke trades where coupons and dates are perfectly aligned. However, for a quicker turnaround, many investors would be more likely to trade on-the-run CDSs and interest rate swaps to reduce friction/transaction costs of a trade only designed to last a few months.

This would involve:
• Buying €10m BATSLN 4.875% 25/2/2009
• Paying 5yr fixed IRS at current market rates, maturing 20 January 2009
• Buying 5yr on-the-run BATS CDS protection, maturing 20 March 2009

An investor pursuing such a strategy would have to duration hedge. This involves matching the sensitivities of the various components to ensure that the sensitivity of the components is hedged. Because the bond is shorter dated, this requires buying slightly less CDS and IRS to hedge the bond to make sure the DV01 and interest rate sensitivities are matched.

This strategy would not be suitable for buy-and-hold investors, as they would be left with a mismatch of exposures at maturity.

For example, if the CR01 sensitivity of the €10m BATSLN 4.875% 25/2/2009 is €4,400, and the CR01 sensitivity of the 7yr on-the-run BATS CDS is €6,000, then the hedge amount would be:

4,400 / 6,000 * €10m = €7.4m BATS 7yr CDS

An alternative might be to deliberately mismatch components to trade more than one view at a time. For example hedging a 5yr bond with a 7yr CDS might combine a curve-shape view with a basis view.

Drivers of basis
Given the arbitrage potential, it seems strange that the basis should exist at all for any length of time. There are a number of factors that drive the basis, many of which are market or asset idiosyncrasies. The following are only a selection:

Supply and demand: Not every bond is available at all times, bond issues are finite and certain bonds (special) can be difficult or impossible to short. Therefore, although selling the basis looks attractive, it is often not practical.

Structured bid: When CDOs are issued, traders hedge their structured exposure by selling protection into the single-name market, often in large quantities. This excess supply can temporarily squeeze the spread of single names and indices. This has probably driven the average basis on large numbers of bonds negative in recent months.

Bonds trading above/below par: Bonds with particularly high coupons may trade substantially above par. In these cases, basis trades become more complex. A bond worth 110% will be incorrectly hedged by an equal notional amount of CDS, as the CDS contract returns par on default while the loss on the bond will be larger. We typically adjust for this in all our basis calculations (by comparing Z-spread with an adjusted CDS spread (C-spread), but there is no strict market convention on the topic.

Cheapest to deliver: CDS contracts allow one of a range of reference assets to be delivered at the choice of the protection buyer. A basis trade runs the risk that a mismatch occurs between the bond in the asset swap and the cheapest to deliver (CTD) in the CDS contract.

Unwinding an asset swap is not risk free: In the event of default, there may be a MTM cost involved in unwinding an asset swap (or funding). As a result, basis trades carry some additional risks.

Many investors cannot or are unwilling to fund long-term positions at Libor: Since the basis itself is quite small, basis trades require considerable leverage to generate substantial return on positions, which may need to be held for some time. Many are unwilling to put on long-term basis trades for small returns — and the risk of mark-to-market volatility in the meantime.

Regulatory and accounting rules: Assets and derivatives are on and off balance sheet, respectively. Therefore, regulatory and economic capital calculations as well as accounting treatment (such as IAS 39, fair value versus accrual) can motivate investors' preferences, resulting in a corresponding skew to the basis.

Idiosyncratic asset features: Some assets contain structural features that might make them poor candidates for basis trades. Calls are one example; coupon steps and covenants are another. These may sometimes make the basis more attractive, but they almost always make it harder to analyse.

The CDS and bond markets typically attract different types of investors. A trader hedging a CDO might need to hedge large amounts of CDS without necessarily keeping an eye on their value relative to bonds. A real money investor might want to take exposure to a name but be unable to add CDS to his/her portfolio. The result is that a temporary basis can develop as markets move to accommodate different types of investors.

CDS index products

CDS indices grew out of the corporate benchmark bond indices of the last decade. Each bank had rival indices such as JECI (European Credit Index) and HYDI (High Yield Credit Index).

Once CDSs enabled investors to take unfunded exposures to these indices, it was realised that there was value in having independent indices that all market participants used collectively. Banks folded their own indices into DowJones Trac-X and later CDX (administered by DowJones) and iTraxx (administered by the International Index Company).

As trades in index CDS are private over-the-counter transactions, there are no absolute statistics on volumes. However, among others, the British Bankers Association conducts annual surveys on credit derivatives.

The BBA's statistics demonstrate that index CDSs now occupy 30% of the market relative to single-name CDS (33%) — up dramatically from 9% in 2004. More anecdotally, early indices such as Trac-X typically could offer liquidity of US$10m on a 5bp bid/offer spread, while investment-grade CDX indices today can offer 0.25bp bid/offer spread on US$200m notional.

It is this depth of liquidity that enables investors to take exposure or hedge exposure to broad areas of the credit market quickly and efficiently. It also enables banks to structure complex products such as CDOs and dynamically hedge their exposure.

Index mechanics
CDS indices enable investors to take synthetic exposure on a large diversified basket of names quickly and easily. A series of standardised traded indices exist with rule-based mechanics and composition.

For example, the CDX Investment-Grade Index consists of 125 North American investment-grade names selected on a combination of criteria that include diversification, liquidity and underlying asset availability. Therefore, an investor interested in taking a broad exposure can execute a single CDS trade on an index rather than incurring the cost and trouble of simultaneously purchasing 125 contracts to make up a diverse portfolio.

Indices have a similar roll methodology to single-name CDS. They are rolled every six months, at which time the current constituents of the CDS index are reconsidered and a new index is issued with a revised list.

The old contract continues to trade, although its liquidity is reduced. The rules governing these indices have come from market consensus, but independent companies administer the indices themselves.

Further explanation can be found in the Citigroup publication Credit Derivatives Indexes, by Jure Skarabot and Gaurav Bansal, 19 January 2006.

Trading conventions
Although index CDSs are designed to be identical to holding a basket of constituent single-name CDSs, there are some important conventions designed to facilitate liquidity. The number of liquid contracts and roll dates are reduced. Some index contracts will only have a single maturity, and while single-name CDSs roll every three months, CDS indices roll every six months.

The most practical difference is the way in which the spread premium is paid. When two single-name CDS counterparties trade at market they enter into a CDS at prevailing market spreads.
However, in the case of index CDS, the two counterparties enter into a CDS at a standardised contract spread. Therefore, an investor who trades into and out of the same series index CDS will do so at the same contractual spread, even though the "quoted spread" might have moved in the meantime.

This is achieved by an upfront MTM exchange. The PV of the difference between the contractual spread and the spread that the deal was traded at is exchanged at inception.

To illustrate this, consider the CDSW [Go] screen for the 5yr iTraxx IG S6 contract. This trade matures on the 20 December 2011, has a contractual spread of 30bp and as of the 28 December 2006 was trading at 23bp.

The market value of a CDS is the difference between the PV of the protection leg at the contractual spread and the spread at which the CDS has been dealt (a difference of 7bp in our example). In this case, €31,588.91. Note that the value is slightly different to seven times the DV01 as a result of convexity. The CDSW screen is considered to be the market standard method for calculating index CDS payments.

The accrued interest is an ACT/360 interest calculation on the contractual CDS of the coupon. As the last quarterly coupon fell eight days prior, on 20 December 2006 in this example, the accrued interest is: €10m * 30bp * 8/360 = €666.67.

A protection buyer would, therefore, receive €31,588.91 up front from the protection seller for agreeing to pay 30bp of premia for five years (when the going rate is actually 7bp less at 23bp). However, having bought protection in the middle of a period and being obliged to pay the full premium at the next coupon date (premiums are paid in arrears), an accrued interest payment is also received up front as calculated in the previous paragraph.

Therefore, in our example, the protection buyer receives an additional €666.67 for a total of €32,255.57.

Payments at default
The index CDS contract is designed to be equivalent to holding a portfolio of CDS contracts, so the procedures at default of one of the entities are equivalent to the single-name CDS, except that the index CDS is assumed to be cash settled. (See the description of cash settlement in the "CDS default events" section for details of this process.)

Therefore, if a member of the index defaults, a single payment is made to the index CDS protection buyer. This is in line with the equivalent single-name CDS payment and is equal to:

1/125 * notional * (1-R)
(where R is the Recovery Rate of the defaulted asset)

In addition to this, the notional on future premia is reduced by 1/125 * original notional. This is because the defaulted name is removed from the portfolio and the index protects fewer names than before.

Index fair value and skew
We have discussed the way in which an index CDS is designed to be equivalent to a portfolio of single-name CDS. Therefore, it follows that it must be possible to calculate a theoretical or "fair value" of the index. Market participants refer, by convention, to the index skew as the difference between the price of the index CDS traded in the market and the fair value. (Sometimes this is also referred to as the index "basis"; we prefer not to use this term for fear of confusion with the cash-CDS basis.)

To illustrate the fair value calculation process we will use the CDX Crossover Series 7 (XO 7) Index as an example. If we consult the Bloomberg CDSW screen (see Figure 9) we discover that the contractual spread for the CDX XO7 is 165bp. To calculate the fair value of the basket we need to calculate the PV of a theoretical portfolio of the CDS underlying the index contract.

It is worth noting in Figure 9 that the maturity date of the index CDS is different from the single-name CDS that will make up our theoretical basket. The maturity of the CDS index is 20 December 2011 (it rolls semi-annually), while the on-the-run CDSs mature on 30 March 2012 (they roll quarterly). This maturity mismatch needs to be reflected in the calculations.

The table in Figure 10 assumes that a portfolio of all 35 names underlying the index has been purchased at the contractual spread. In our example, we assume US$10m per name and calculate the PV of each off-market CDS as follows:

We will take the first credit in the basket as an example: 5yr American Axle is trading wide at 341bp. If we had bought American Axle at the contractual spread (165bp) of the crossover index our CDS would be deeply in-the-money, that is, it would have a large positive NPV. In this particular example we are paying 165bp for protection worth 341bp, so the PV of this theoretical CDS is US$739,200.

From this table we can see that the average PV in our theoretical basket is US$-88,682. The next step is to iteratively find how many basis points in our index CDS priced at its contractual spread would need to be shifted to reflect a PV of US$-88,682. This should be done using a full pricing model but can be estimated using the CDSW. In Figure 9 we can see the DV01 is US$4,205 per US$10m nominal.

Therefore, the fair value of the index is US$-84,482/US$4,205 = -20bp less than the contractual spread of the index. The contractual spread is 165bp. Therefore, the fair value is 145bp. The current market spread of the index (taken from the right side of the CDSW screen in Figure 9) is 141bp. Thus, the index skew is 141bp - 145bp = -4bp.

Why is there a skew at all?
Although an index CDS should be very close to the average of its constituents, there are a number of factors that create an index skew. The following factors make index arbitrage more difficult and, as a result, a skew can exist:

• Single-name CDSs are traded at market prices, while index CDSs are traded at contractual spreads.
• Index CDSs are rolled every six months, while single-name CDSs are rolled quarterly, resulting in reliance on interpolation.
• Arbitraging an IG index with 125 names requires executing 125 single-name CDS trades simultaneously.
• Single-name CDS investors and index CDS investors often have different investment objectives.
• There are some contractual differences that affect CDX indices. For example, the differences between the Mod-R and No-R restructuring clauses between the index and single-name CDS markets results in a difference in spreads of up to 4%.
• Extreme market moves/fast markets can result in a temporary dislocation.
• The dispersion of single-name CDS in an index is a driver of skew. By construction, indices tend to have reduced dispersion among constituent CDS at inception, which changes as names rally or widen as a result of idiosyncratic credit events. For more detail see The iTraxx Roll – All Skewed Up, Michael Sandigurksy and Matt King, Citigroup, 18 September 2006.

Investment strategies
The liquidity and depth of the CDS index market means that these indices have become a very popular tool in credit markets, enabling investors to gain exposure/hedge in particular markets and sectors. They are an important addition to the single-name CDS market and in 2006 broke even in terms of share market volumes.

A summary of particular applications:

• A quick way to take long or short market positions: The macro view can be efficiently monetised. Citigroup has traded more than €10bn notional of investment-grade indices in times of market stress. Executing this kind of volume in single names (or worse, bonds) would be extremely difficult.
• Portfolio diversification and rebalancing: Investors can quickly and easily rebalance a portfolio of credit to express a view or hedge an exposure.
• Structured credit: This would not be possible without a liquid market in which to hedge risk arising from structured credit notes. Indices enable considerable leverage to be applied quickly and efficiently, enabling products such as CDOs, CLOs, CPDOs and CPPI to be created.
• Hedging: Index CDSs enable investors to short credit markets and therefore hedge their investment portfolios on a macro level (rather than just name by name with single-name CDS).
• Relative value trading: Index CDSs enable investors to take credit views between different sectors, parts of the curves and on technicals.

The transformation of the credit landscape has been dramatic and the pace of innovation is likely to continue. From its birth not much beyond three years ago, the CDS business has metamorphosed from a credit-specific, exotic OTC-type of derivative into something approaching an exchange-traded commodity.

In March 2007, Eurex plans to take that final step and offer iTraxx index CDS and a number of European single-name CDS as exchange-traded futures; the CME is set to follow with a similar product for CDX. We look forward to keeping a close eye on these developments for you.

© 2007 Citigroup Global markets. All rights reserved. This Research Note was first published by Citigroup Global markets on 8 February 2007.