Contents

CDR Liquid Index data as at 12 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.

R-Evolution returns

Structure re-launches following rating agency CPDO hiatus

Calyon is marketing a revised version of its R-Evolution product, a dynamic portfolio insurance (DPI) trade, which was first seen at the end of last year (see SCI issue 18) prior to the rating agency CPDO rethink (SCI passim). R-Evolution is believed to be the first transaction rated by Moody's since its revisions began causing such structures to be put on hold.

Rated triple-A by Moody's, the product offers leveraged exposure to the CDX and iTraxx investment grade indices, with investors receiving a coupon during its ten-year term as well as a return of principal at maturity. However, Ally Chow, global head of credit markets product management at Calyon, explains that R-Evolution is not a CPDO – its leverage mechanism is the inverse of a CPDO's, where leverage increases when spreads widen.

"It is inspired by DPI technology involving a dynamic mechanism with a daily stress scenario computation on parameters including spreads and defaults to decide how large the size of the portfolio (and effectively the leverage) should be. The leverage of R-Evolution is much lower than that of a typical CPDO – initial leverage is seven times and a maximum of 11 – and therefore the mark-to-market volatility of the transaction should be much lower than on a CPDO," she says.

Overall, Chow says that little has changed in the structure since the first version of R-Evolution was marketed. "The way the portfolio size has been determined is more or less the same, but – as expected with the rating agency methodology rethink – Moody's has increased the number of stresses it uses to test the structure," she explains.

Nevertheless, Chow adds: "The spread payable is relatively attractive compared with the other available CPDO transactions – 160bp assuming a weighted average spread of the indices of 30bp. We are expecting to issue around €500m in aggregate, incorporating the first couple of taps. The amount we estimated from day one was similar, so – despite the month or two we have been waiting for the rating agency – investor appetite is still there for the product, which is a clear sign that customers agree the structure is more stable than a CPDO product."

R-Evolution is expected to close by the end of March, by which time it is likely that many of the CPDO or CPDO-like deals being planned will also be beginning to emerge.

Cairn Capital is already out with JP Morgan marketing what is expected be the first managed CPDO and Société Générale Corporate and Investment Banking is close to launching its first CPDO, which is likely to feature a short bucket. At the same time, Dresdner Kleinwort is thought to be prepping its own DPI product and Citigroup is believed to be working on a number of constant proportion-based structures, but is not actively marketing anything yet.

Overall, fifteen banks are known to have applied for ratings on CPDO-like structures. Not all of these transactions will see the light of day, but other front-runners in the sector are understood to include ABN AMRO, Deutsche Bank, Lehman Brothers, Merrill Lynch and Nomura.

MP

Vol opportunities

Mixed value for structured credit issuers during heightened volatility

Increased volatility and consequent wider spreads in recent weeks has theoretically brought with it structured credit opportunities – not least in the CDO of ABS space, given the events in the ABX index and its underlying markets.

However, the impact of such volatility can be approached in two ways, according to Richard Huddart, structured credit analyst at Dresdner Kleinwort. "You could argue that spreads have gone out, so the arbitrage potential in CDO of ABS has increased. But if you look at the liabilities of CDOs of ABS, their notes have started to price considerably wider as a result of what has happened – especially if you go down to the double-B area."

He continues: "Another problem is that if managers begin trying to ramp up deals with so much vol around, then arranging banks may not be too keen to take on this shorter-term warehousing risk. Rising CDO spreads will only stress this issue further. To a certain extent the ABX indices could be used to hedge this short-term mark-to-market risk, however it seems that deals in the warehousing stage are coming under pressure to launch as soon as possible."

Recent market events have had a similarly mixed impact elsewhere in the structured credit sector. As Domenico Picone, head of structured credit research at Dresdner Kleinwort, observes: "Market value CLOs may not be such an interesting opportunity now that volatility has risen – and maybe that particular asset class has reached its peak for the time being."

Nevertheless, he adds: "We still think CLOs are very interesting for investors for the simple reason that they are hit when actual defaults materialise and recovery is low, whereas market price volatility alone does not have an effect per se on the asset class."

While volatility may still be above previous lows, spreads have quickly narrowed again from their widest point – meaning that many opportunities for issuers have already disappeared. Not least, there was brief talk of a resumption in rated equity issuance.

Such talk made sense when spreads were at their highest, according to Olivier Renault, credit structurer at Citigroup in London. "As with many structured credit products, if spreads are wider you can reach return targets much more easily and you can print more of anything. But this is even more important for rated equity because the rating depends on how much cash you can divert from the equity into the reserve account in order to secure the rating," he says.

"That's why we have seen little rated equity issuance in the first few months of this year. If spreads aren't wide enough, you have to issue alternatives, such as combo notes," Renault adds.

Furthermore, he says: "Issuers only have a very small window of opportunity in temporary spread widening such as we have just seen – by the time you re-optimise a trade, call up the investors and start marketing it, a week could have passed. Equally, increased volatility tends to push bid-offers wider, which makes hedging more expensive and consequently reduces the return for investors."

MP

Japanese CDS boost

New index and potential curve plays bolster market

A new iTraxx Japan 80 index is set to be introduced, with effect from Series 7 on March 20 2007, following requests made by iTraxx Japan market-makers. The index comprises 80 investment grade Japanese entities and will trade with a 5-year maturity.

The new index will be tradable alongside the existing iTraxx Japan index that comprises 50 investment grade Japanese entities. Its constituents were decided by market-maker vote at the beginning of this week.

Some market participants had called for a new 100-name index, but others had suggested it was too soon to introduce such a broad index. Industry discussions brought a compromise at 80 names and a consensus that such an index will attract strong liquidity, which it is hoped will feed into single name trading as well.

"There was a need to create an 80-name index to enable a move toward the larger index markets in Europe and the US, and to make it easier for correlation traders to hedge. The new index constituents will not be selected by simply referencing the existing index – dealers selected them from scratch, but it was inevitable considering the current situation that there would be significant overlap," explains Takahiro Tazaki, director, head of structured credit research at Barclays Capital in Tokyo.

Vincent Thebault, head of credit markets & CDOs for Japan at Calyon, observes: "That's good news for the market. The result of this vote shows the positive evolution of the Japanese market and the efforts to attract new market participants. A wider index is a positive move for correlation desks and for structurers. We expect more new products to be derived from the iTraxx Japan Series 7."

The focus on the benefits for the correlation market is unsurprising, given that tranche trading is yet to really take off in Japan. Although some dealers are understood to be bulking up their desks, the expectation is that it will be a while before volumes really begin to rise.

Tazaki says: "Index correlation trades are happening here, but they tend to be small in size. One of the major issues is that there are no hedge funds in Japan who are natural users of such products and so the market will take time to grow."

There are, however, increasing signs of overseas hedge funds being attracted to the Japanese CDS market, according to Tazaki. "Dealers have been putting relative value trading ideas to hedge funds outside of Japan in connection with the Japanese CDS curve being flatter than that in the US and European markets," he adds.

It seems that such advice is being acted upon. Notably, Softbank's 5-10y curve flattened over the last year, but since January it has steepened dramatically despite the lack of news or announcements that would normally drive such a move.

As Tazaki concludes: "The expectation is that there will be increasing focus on the relative value of CDS curves globally. Consequently, there will be growing numbers of these kinds of transactions using something similar to a momentum model."

MP

Eurohypo brings second European CRE CDO

Asset manager pips rivals with pure CMBS deal

Eurohypo Asset Management is in the market with Europe's second commercial real estate (CRE) CDO, ahead of names such as Investec and Prudential M&G, which had been expected to take that place. The transaction, dubbed Glastonbury Finance 2007-1, will also be the first sterling-denominated CRE CDO – reflecting the dominance of sterling assets in the portfolio.

Dresdner Kleinwort is sole bookrunner on the £353m deal, alongside joint-lead Commerzbank and joint-arranger Eurohypo. The banks have been roadshowing the subordinated tranches – rated double-B and double-B minus – over the last two weeks and report a strong response from investors.

The portfolio is entirely composed of European CMBS rated triple-B or higher (S&P/Fitch), split between two-thirds UK and one-third European collateral (from across five countries) in order to reflect the make-up of the underlying market. In terms of property type, the pool comprises retail, office, mixed-use, pub and multi-family assets (in that order by volume).

The combination of Eurohypo's experience in the European real estate market and the deal's conservative portfolio is expected to unlock the European investor base for this asset class. "It is a straightforward structure, with no B-notes or mezzanine assets, to enable investors to get comfortable with the CRE CDO concept – most of them have never looked at B-notes or mezz loans, but do understand CMBS very well," explains Neil Lawson-May, md at Eurohypo Asset Management (manager on the deal).

Europe's debut CRE CDO – BlackRock Financial Management's €342.5m Anthracite Europe transaction from December through Morgan Stanley – was backed by European collateral, but domestic investor take-up is understood to have been limited due to the novelty of the asset class and the inclusion of B-note/mezzanine assets in the portfolio.

Lawson-May notes that Eurohypo has worked hard to create a structure that offers investors a high level of certainty, and that the bank's unique position in both European commercial real estate finance and capital markets enables it to go far beyond the usual investment banking analysis of the portfolio. In addition, Eurohypo will align itself with the transaction by retaining the equity piece.

Below a £5.65m triple-A rated Class X tranche, the capital structure comprises £205m triple-A rated Class A-1 notes, £33m triple-A Class A-2s, £32m double-A Class Bs £31m single-A Class Cs, £16m triple-B Class Ds, £10m double-B Class Es and £4m double-B minus Class Fs. The Class A-1 tranche is a variable funding note which may be drawn in either pound sterling or euro; the remaining notes are solely denominated in British pound sterling. Certain upfront expenses will be amortised over the first eight years of the transaction through the mechanism of the class X notes.

The expected ratings of the Class B, C, D, E and F notes address the ultimate payment of interest and principal at maturity. For the class X, A-1 and A-2 notes – for which a deferral of interest constitutes an event of default – the ratings address the timely payment of interest and ultimate payment of principal.

The deal is expected to be 100% ramped at close, with a reinvestment period of three years – mainly to manage prepayments in the underlying collateral.

Prior to the launch of Anthracite Europe, some industry professionals were predicting that as many as 20 CRE CDOs would be launched in 2007. This prediction has subsequently been revised to a more conservative figure of around seven deals, with Wharton Asset Management, LNR, Wachovia and Fortress Investment Group – as well as Investec and Pru M&G – all thought to be prepping such transactions.

The debate surrounding the long-awaited European CRE CDO market has been focused on the ability to source suitable collateral.

MP

Diversifying CDPCs

Credit derivative product companies are looking to widen their product offering

The nascent credit derivative product company industry is gravitating towards other asset classes. Adding diversity is welcomed though venturing into the ABS and loan markets needs to be closely evaluated.

Loic Fery, global head of credit markets and CDO at Calyon in London, believes that credit derivative product companies are a welcome addition to the market. "The emergence of CDPCs is a good thing as the companies are helping to increase liquidity in the credit market. They will also contribute to a further re-pricing of the capital structure and the emergence of new players will also contribute to bring spreads tighter on the senior level of the capital structure," he says.

The biggest issue to overcome is getting the capital model right and attaining rating agency approval and though CDPCs have different business models, Fery believes the more the competition, the better the transparency. "There are different segments being touched by the CDPC world, primarily the corporate segment where most start off, with a few companies involved in structured finance. Nonetheless, this is adding to greater supply and more diversification in the market," he says.

Tom Jasper, ceo of Primus Guaranty in New York, states that various factors need to be taken into account when establishing a CDPC: which products to offer – and which firms feel comfortable managing – and appeasing the requirements of the rating agencies.

"You need products that are a natural fit for a CDPC, which is a creature of the rating agencies. The business is all about positioning yourself to take advantage of a market opportunity," he says.

Jasper cites the example of Primus moving into the ABS arena in the fourth quarter of 2006 as case in point. "We view ABS as an important additional component to our operating flexibility and it is a great market for us as it is one that has turned. That allows us to pick our spots and sell protection in a market in turmoil, like the sub-prime sector, where all the CDS activity is," he adds.

Ian Hawkins, president of Invicta in New York, says the firm aims to build as diverse a portfolio as possible and operate only in sectors where it has the in-house credit expertise to analyse transactions. Invicta is in the process of acquiring rating agency approval to transact in RMBS and CMBS and expects to write protection on single-name RMBS in the short term. He also highlights the potential for companies to offer product in the auto and credit card markets over time.

"New asset classes will always add diversity and we have to take a view as to whether they are good value at any particular time and whether we have the expertise," he says.

The firm is also expecting to participate in the loan market this year, while Primus is keeping a watchful eye on developments. "It is a very natural extension of the business we are doing between our asset management franchise and our CDPC activities," says Jasper.

Walter Gontarek, ceo, Channel Capital Advisors in London, notes the addition of other asset classes has its advantages, such as portfolio diversification and greater relevancy to the Street. Nonetheless, challenges with adding new asset classes to a CDPC's business line must be taken into account. For instance, vehicle complexity grows, plus structural and documentation issues need to be taken into account.

"We are being pragmatic and aim to launch initially on corporate tranche and CDO products. Once well bedded down, we will evaluate other asset classes for the CDPC," Gontarek says.

The amount of capital that the CDPCs will have to commit to credit derivatives is tiny compared to the market's overall size, so newer entrants are being welcomed. "The long and short of it is that there will be enough business for us and the new CDPCs to do, as we recognise that their strategies are different to ours," concludes Primus' Jasper.

HD

Managing collateral and more

Peter Vinella, president and ceo of Wilmington Trust Conduit Services, answers SCI's questions

Peter Vinella

Q: When, how and why did you and your firm become involved in the structured credit markets?
A: Prior to joining Wilmington Trust I ran my own risk management consultancy and between 2000 and 2004, about 90% of our business was Basel-related credit risk management implementations. We got heavily involved in structured products because they tended to be the more complex instruments for these implementations.

In 2005 it was becoming apparent that opportunities were evolving for specialised fund administration, primarily because many banks that had captured facilities for structuring their own balance sheet didn't have operational support internally.

Wilmington Trust, which already had a presence in the structured products sector and wanted to expand its offerings to include CDO collateral administration, saw the same opportunities. In 2006 Wilmington Trust formally decided to establish a subsidiary – Wilmington Trust Conduit Services LLC – to serve the CDO market.

I was named president and ceo of this entity, and nine people from my consulting firm came with me to perform operational and technology work. We specialise in providing trust and collateral administration, entity management, risk management, operational support, and advanced reporting for issuers and managers of structured products, including CDOs.

As structured credit products have become more complicated, the back office/accounting/risk management requirements have also become more complicated. It's difficult and expensive for many fund managers to put the necessary infrastructure in place and still grow their business. We supply managers with quality data, operational integrity, and leading analytics, all delivered using the best technology available. Our goal is to provide our clients with compliance reporting that far exceeds industry standards.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: There are several important ones. One is the ability of credit derivatives to isolate credit as a pure investment vehicle, as opposed to having to invest in instruments that come with a host of other risks such as interest rate, FX, and liquidity. With a credit derivative you can strip all that out and focus on the idiosyncratic credit risk of a specific obligation. This has made the whole structured product market fundamentally different. Until the advent of credit derivatives, earlier structured products such as ABS, RMBS, and TRS were still a market risk play with diversified credit exposure. There were many obligors to reduce exposure to a single name. Now, it is all about pure credit plays on a specific obligation. That has been the biggest driver of the market, as both a hedge instrument as well as a pure investment play.

Two, some banks have realised that they can use their capital more effectively by acting as a conduit to supply money from private equity and hedge funds into loans, rather than by using their capital for lending. Instead of using their balance sheet, these banks are primarily arranging the lending facilities and helping with the securitisation. They can make investments in the equity or higher tranches as they see fit and lay the rest off on investors who need yield, such as insurance companies and pension plans which are not subject to the bank's regulator "tax". This has created a lot more liquidity in the market and allowed the banks to use their balance sheet in a much more effective way.

Three, regulators seem to be comfortable with this market, whereas with interest rate swaps in the late 1980's, derivatives were perceived as market-threatening instruments shrouded in a veil of complex mathematics. As such, regulators and politicians seemed to want to regulate everything about swaps. With credit derivatives they seem to have realised that the markets are efficient and well controlled, and that because market participants are professional investors who appreciate and instil a rigorous risk management discipline on their own, they only need to use a light touch.

Q: How has this affected your business?
A: The amount of structuring has accelerated, and that has really helped our business. In fact, it's now clear that we underestimated the market potential by about half three years ago when we looked to the future.

Today, many firms are eager to outsource their operational and technology functions because they don't have the capacity in house or the time or institutional energy to ramp it up. As a result, we're finding very strong interest in our services. This is especially true for US managers launching UK-based operations. They like the fact that we can support them where they do business, and we're excited that they understand and appreciate our value proposition.

Q: What are your key areas of focus today?
A: Our key areas of focus are supporting CDOs – CLOs in particular. However, we believe there will be other opportunities in the near future to extend our services to other types of structured products. Right now, though, there is such demand from the CDO business that we're concentrating on that.

At the same time, we probably have a more sophisticated technology environment than any of our competitors – both in the number and quality of our systems. That said, advanced technology also represents some real challenges, so we're trying to ensure that our technology is rolled out in a logical and controlled way. Our technology provides significant value to our clients because it's scalable. However, that's not at the expense of providing the human expertise necessary to administer the deals.

Q: What is your strategy going forward?
A: Our strategy is to provide specialised and customised services to the structured finance markets and to continue to invest in the necessary technology enhancements that will improve our capabilities.

Specific to our CDO services, getting involved in the earlier stages of the deals will allow us to use our experience to identify potential operational or risk management nuances and add real value to the success of the transaction.

Q: What major developments do you need/expect from the market in the future?
A: Innovation never stops. So our focus is on flexibility – flexibility in our business plan, operations, and technology. That's what clients need today. They need to have confidence that our systems are designed to support any conceivable structure with any conceivable underlying asset.

We also expect that the structured credit market will continue to offer a premium since market risk is ubiquitous and can be effectively hedged, whereas idiosyncratic credit risk is not. The biggest issue for the market is where to get the underlying assets to securitise – but we don't see supply drying up in the near-term, or long-term for that matter, because people will still need to borrow money. In fact, the length of this favourable lending market may be due in no small part to the fact that with a greater pool of liquidity, especially for investors with an appetite for leveraged and distressed debt, the markets aren't subject to the typical credit crunch caused by the banks' limited balance sheets.

About Wilmington Trust
Wilmington Trust Corporation is a financial services holding company that provides regional banking services throughout the Delaware Valley region, wealth advisory services for high-net-worth clients in 36 countries, and corporate client services for institutional clients in 86 countries. Its wholly owned bank subsidiary, Wilmington Trust Company, which was founded in 1903, is one of the largest personal trust providers in the US and the leading retail and commercial bank in Delaware.

Wilmington Trust formed a subsidiary in October 2006, Wilmington Trust Conduit Services LLC, through which it conducts most of its CDO services business. Wilmington Trust's full suite of collateral administration, trustee, custodial, and bookkeeping services for CDOs includes compliance monitoring and testing, payment calculations and disbursements, record maintenance, trade settlement, and the safekeeping of assets, among other services.

JP Morgan gets Sheen

The latest company and people moves

JP Morgan gets Sheen
Colin Sheen is joining JP Morgan in New York to trade synthetic ABS after leaving a similar position at Merrill Lynch. He will report to Matthew Cherwin, head of ABS trading in the US for JP Morgan.

Mendes/Derrer head to Merrill
Merrill Lynch is understood to be hiring Rui Mendes and Adam Derrer. Mendes was formerly a CDS and index trader at ABN Amro, while Derrer was a CDS trader at Credit Suisse.

Khan leaves ABN
Adeel Khan, correlation trader, is understood to have resigned from ABN Amro and to be joining a hedge fund.

Two depart BofA
Tim van den Brande is understood to have left Bank of America last Friday, while Marshall Insley, ABS trader in New York left the bank on 6 March. Both destinations are not yet known.

Deutsche hires for CRE CDOs
Deutsche Bank has hired Charles Lee to its global banking division as a director in the global commercial real estate (CRE) group, specialising in CMBS and CDO execution. Lee joins Deutsche Bank after 10 years with JPMorgan, where he was most recently a vp on the commercial real estate securitisation team.

Lee will be based in New York and report to Lainie Kaye, md and head of CMBS securitisation. He will also have reporting responsibilities to Emile Van-Den-Bol, md and global head of CRE CDOs.

ClusterSeven partners with DoubleHelix
ClusterSeven has announced a strategic alliance with DoubleHelix to offer spreadsheet management solutions for mission critical spreadsheets in major investment banks, asset management firms and private banks. DoubleHelix is a management consulting firm that specialises in derivatives, credit derivatives and treasury departments. ClusterSeven is the provider of enterprise spreadsheet management software.

According to a recent survey conducted by ClusterSeven, 89% of banks believe spreadsheets are now a compliance issue for the FSA, Basel II, SOX and MiFID. The highest concern was the area of new products where spreadsheets contain banks' intellectual property and the profit margins are made. 91% of banks heavily depend on spreadsheets for new business analysis and support while 82% frequently use spreadsheets for new product/instrument creation.

HD & MP

German SME CLOs face another bankruptcy

A round up of this week's structured credit news

German SME CLOs face another bankruptcy
S&P has placed the Class C, D and E notes of the CB MezzCAP transaction on creditwatch negative following the bankruptcy filing on March 12 of Erich Rohde, one of the SMEs in the underlying portfolio to which the issuer made cash advances. The company is a German shoe manufacturer based in Schwalmstadt-Ziegenhain and is the latest in a string of companies to face difficulties after entering into such profit participation agreements (see SCI issue 24).

"We consider that the likelihood of default for Erich Rohde is significant, which could have a considerable impact on the level of losses incurred by the issuer under its participation right," says S&P credit analyst Viktor Milev. "Erich Rohde had issued a €15m profit participation right to CB MezzCAP and is the largest asset in the transaction. The current portfolio share is 7.92%."

He adds: "We will carry out a full analysis of the implications of the bankruptcy filing to assess whether potential losses exceed our initial expectations. We will keep in close contact with the financial adviser and transaction monitor to fully assess potential recoveries. This analysis and our expectation of future losses to be incurred will govern whether the ratings on the notes placed on creditwatch will be lowered."

CB MezzCAP has previously suffered a default on the Nici entity. The loss was cured through excess spread and the recovery benefit gained from the sale of the Nici asset.

Meanwhile, Moody's has published a report on EMEA SME securitisations that presents its views on such transactions and sets out the information it finds helpful to analyse them thoroughly.

The report finds that SME transactions have consistently represented a significant and increasing share of the overall volume securitised – accounting for 32.9% of the overall EMEA ABS volume rated in 2006. "The securitisation market for SME receivables has increased significantly in the last several years and is expected to continue to grow quickly, partly because it provides investors with the opportunity to diversify their portfolios away from the consumer finance sector whilst avoiding event risk," explains Silvia Baumann, Moody's associate analyst and author of the report. "Furthermore, this type of securitisation supports the banks' lending business to the SME sector."

SME CLOs have a slightly different profile from standard consumer receivable transactions, in that they have a lower level of granularity, less homogenous assets and a performance which may be even more dependent on the general economic condition of the country of origination, the agency observes.

Hair today...
Kevin Gould, founding member of Markit Group, and Grant Lovett, head of credit default swap trading at UBS in New York, are having their heads shaved to raise funds for St. Baldricks, a children's cancer charity on 16 March.

At the time of writing, the pair were a significant way towards their goal of raising US$100,000, but still need more support. Click here to add yours.

Moody's rethinks JDA methodology
Moody's has postponed the release of the JDA-prompted rating changes due for Iberian, French and Italian banks until 16 March. The move comes amid an industry outcry over the rating agency's joint-default analysis proposals and is motivated by its wish to review the methodology (see SCI issue 29).

The review – likely to consider proposals for qualitative analysis to be included in the methodology – is expected to affect both forthcoming and previous rating changes. It could mean, for example, that the long-term deposit ratings of banks which benefited most from the first batch of JDA-related upgrades two weeks ago will be downgraded.

A precise schedule of the adjustments/new ratings will be issued this week. But Moody's has definitively stated that there will be no changes to the local currency deposit ceilings and neither will its methodology on bank financial strength ratings change.

LCDX further delayed
It now looks likely that the US loan CDS index – LCDX – will not meet its targeted launch date of 3 April. "Everyone involved wants to make sure everything is nailed down before the product is launched," says one source close to the dealer discussions.

He adds: "There are still some settlement issues that need to be normalised with the single name contract, together with some other minor details to be finalised. It is just a question of a bit more time being needed."

How much time is not yet known, but a revised firm launch date is hoped for by the end of the month.

CME plans HiVol-like index
The Chicago Mercantile Exchange (CME) has opted to begin trading credit futures whose value fluctuates with the likelihood of bankruptcy associated with a group of companies, rather than with individual companies as previously planned. Designated 'CME North American Investment Grade High Volatility 1', the cash-settled credit index is slated to launch on April 23.

CME filed an application for approval of the contracts last week with the Commodity Futures Trading Commission. The index will comprise 32 North American investment grade corporate reference entities selected by the exchange for their broad representation of industrial sectors, the liquidity of their CDS and whether they conform to OTC index derivative practices with respect to the constitution of indexes.

The indexes will be reconstituted on a semi-annual basis in March and September.

BNP Paribas brings multi-maturity CDO
BNP Paribas' SPV Omega Capital Investment will issue on 15 March in excess of €255m equivalent of Waypoint CDO Credit linked notes. The initial portfolio of Waypoint includes 4-year, 6-year and 8-year assets.

The deal has been dubbed a 'multi-maturity CDO' to differentiate it from a traditional synthetic CDO with a bullet maturity portfolio. The portfolio is managed by Solent Capital, which will have the flexibility to select assets with a shorter maturity than the tranche maturity dates and during the life of the transaction adjust the maturity for each asset and therefore the average life of the portfolio, based on both its fundamental credit views and curve relative value opportunities.

The notes are expected to be rated from triple-A to triple-B by S&P and Fitch and will be issued in €, US$ and Yen. The overall maturity of the transaction is June 2015 and may be tapped in May according to BNP Paribas.

Sydbank returns with local currency EM CDO
Sydbank and Citigroup have teamed up once more to launch a synthetic emerging market CDO, following their ground-breaking Evolution EM deal (see SCI issue 11). The US$450m Emerald Capital Series 2007-01 transaction references notes linked to local currency sovereign debt and transfers the credit risk of these entities (all of which are emerging market sovereigns) and associated FX losses and gains to investors.

Below a US$180m triple-A rated super senior piece, the deal comprises six tranches of floating-rate notes rated between Aaa and B2 by Moody's. All notes are due in 2010.

Provisional ratings are primarily based upon: an assessment of the eligibility criteria applicable to the synthetic exposures to control the credit and the FX risk; the credit quality of the total return swap counterparty, Citigroup Global Markets Ltd; protection against losses through the sequential nature of principal payments; additional protection provided through the diversion of the interest due on the subordinated notes; the quality of the portfolio management by Sydbank; and the legal and structural integrity of the issuance.

Moody's quantitative analysis of the deal is derived from two elements: the use of CDOROM to determine the loss distribution due to credit losses, assuming a flat US dollar-adjusted recovery-in-default rate of 5% across all 65 entities included in the selection universe; and a bootstrapping of the historical FX rates for similarly diversified portfolios, using the full universe of potential investments.

Quantifi launches CPDO-compatible pricing model
Analytics and risk management solutions provider Quantifi has launched Version 8.6 of its pricing and risk assessment model for credit derivatives, with functionality designed for some of the market's latest innovations – CPDOs, options on CDO tranches and forward-starting CDO tranches.

Other key enhancements in Quantifi's new release include: extended functionality for synthetic CDO substitution tools useful for managed CDO analysis or structuring CDOs, as well as beta support for CDS of ABS and CDOs of ABS.

Strong SIV pipeline expected
Participants at Fitch Ratings' annual ABCP/SIV conference last week were told that between eight to 12 new SIVs are expected to be established by the end of 2007.

The SIV panel discussed the healthy pipeline of potential new vehicles and new managers. While new entrants have helped to reduce contagion risk and create a more heterogeneous market, it was observed that the challenge for investors is to differentiate among potential investment opportunities. Indeed, the single most important consideration for investors is the capability of the manager.

Meanwhile, in its evaluation of evolution in the market, the opening panel expressed surprise over the lack of substantial development in the establishment of synthetic conduits in the ECP market, despite their success in the US and the flexibility that synthetic platforms offer. In contrast, the panel expects to see acceleration in the acquisition of synthetic assets by conduits.

The conference heard that an increase in emerging markets activity is likely to be a key theme this year, with a number of conduit sponsors investigating opportunities in emerging markets.

CDO upgrades outpaced downgrades in 2006
Moody's upgrades of US and European CDOs outpaced downgrades at a rate of 1.35 to one in 2006, says the rating agency in a new report. Continued strong performance of the corporate credit markets and better performance by ABS underlying resecuritisation CDOs contributed to the improved ratio.

CDO upgrades and downgrades respectively increased by 39% and 27% in 2006. "The performance of certain ABS sectors has been volatile in the recent past, which affected the performance of earlier vintage resecuritisation CDOs," comments Moody's svp Danielle Nazarian, author of the report.

"However, those ABS sectors have since stabilised, and their performance – paired with strong corporate credit performance – buoyed overall performance of the CDO market," she adds.

Strong performance of corporate credit was reflected in the performance of arbitrage cashflow CBOs, arbitrage cashflow CLOs and synthetic arbitrage CDOs. Arbitrage cashflow CBOs, arbitrage cashflow CLOs and US$-denominated synthetic arbitrage CDOs showed 2006 downgrade rates of 7%, 0.6% and 5% respectively.

Arbitrage cashflow CLOs, in particular, remained highly stable. Moody's downgraded only eight tranches from seven such transactions in 2006. Six of the eight tranches were from the 1997 and 1998 vintages, and had undergone at least one downgrade in previous years. The remaining two were initially rated below investment grade.

Resecuritisation CDOs also showed improvement as their downgrade rate declined to 2.8% in 2006 from 6.9% in 2005 and 11.7% in 2004. The severity of downgrades also declined: the majority of downgraded tranches saw rating movements of three or fewer sub-categories.

Overall CDO credit performance in 2007 will largely depend upon the strength of the corporate credit and real estate markets that underlie CDO assets over the near to medium-term, the rating agency concludes.

Rating changes of maturing CDOs examined
As US CDOs enter their amortisation period, the transactions' shrinking WALs, declining portfolio diversification and changes in subordination levels could significantly impact ratings on the CDO notes, says Moody's in a new report.

"In terms of overcollateralisation and Moody's credit ratings, there is a definite tendency for the strong tranches to improve and weaker tranches to deteriorate further as CDOs go through their amortisation period," observes Moody's senior associate Gary Lo, author of the report.

The rating agency observed this phenomenon in certain CDOs rated in the late 1990s to early 2000s, as these deals have begun to amortise over the past few years. Given the growth of the CDO market, Moody's expects to continue to see these trends in the future as more deals enter their amortisation period.

Over time, there is a non-linear relationship between the change in the portfolio's expected default probability versus the change in each tranche's expected loss thresholds, especially as the tranches approach their final payment dates. "Even if the portfolio assets do not experience any rating migration, the credit profile of the rated liabilities is still dynamic over time," explains Moody's vp - senior credit officer John Park.

Moody's modelled a CLO structure as it progresses through the amortisation period and found that the CLO waterfall payment feature tends to strengthen the credit quality of tranches with strong overcollateralisation (greater than 100% of the outstanding debt) and weaken tranches with less overcollateralisation (less than 100% of the outstanding debt).

CDX adds Fitch to eligibility criteria
CDS IndexCo, the consortium of sixteen investment banks licensed as market-makers in the ABX, CDX and CMBX indices, has added Fitch Ratings as a determinant for an entity's inclusion in the indices, in addition to Moody's and S&P. This change to the inclusion rules governing CDX will take effect on the next index roll on March 19 2007.

Brad Levy, md, firmwide ebusiness Group at Goldman Sachs and acting chairman of CDS IndexCo, says: "CDS IndexCo has added Fitch Ratings to the CDX index composition methodology in order to make name selection more robust by including ratings from all three major rating agencies. The CDX indices are the most widely traded synthetic indices in North America and the universe of traded names in the credit derivatives market has grown dramatically since the launch of CDX. We will continue to refine the selection methodology to promote the liquidity and transparency of the index."

Canadian earthquakes and UK floods covered
S&P has assigned preliminary credit ratings to the US$150m principal-at-risk, variable-rate notes Series 1 to be issued by Blue Wings via Swiss Re. The SPV was created for the sole purpose of issuing one or more series of notes from a US$1bn natural catastrophe shelf programme sponsored by Allianz Global Corporate & Specialty.

The objective of the transaction is to provide fully collateralised protection against high severity losses incurred from earthquakes in Canada and in the US (excluding California), and river floods in the UK.

DTCC triples volume and rebates US$3m
The Depository Trust & Clearing Corporation's (DTCC) Deriv/SERV business has announced a record year of performance with transaction volume tripling in 2006. The clearer is to provide a first-time rebate of US$3m to its global derivative dealer customers.

The Deriv/SERV platform processed a record 2.6 million in transaction volume in 2006 – a nearly three-fold increase from the 945,000 handled in 2005. It has also increased matching and confirmation rates for credit derivatives trades to more than 80% in 2006, up from 15% in 2004. This increase has played a key role in addressing regulators' concerns about improving efficiency and managing risk in the marketplace.

Deriv/SERV's global customer base has grown to 753 global derivatives dealers and buy-side firms from 207 in 2005, with service extended to include additional OTC credit, interest rate and equity derivative products. In addition, the DTCC launched its Trade Information Warehouse to provide an automated central repository for tracking OTC derivatives contracts over their life cycle.

MP

Trading ideas - room for reservations

Dave Klein, research analyst at Credit Derivatives Research, looks at a positive-carry short trade on Marriott International, Inc

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

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

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

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

Go short
Given our deteriorating fundamental outlook for MAR, 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 adjusted bond z-spreads, which we believe is the most straightforward way to compare the two securities. Exhibit 1 compares MAR's bond adjusted z-spreads to market CDS levels as well as our fair value CDS levels.

Exhibit 1

MAR's bonds are trading significantly cheap (adjusted z-spreads higher) to their equivalent CDS levels. Since there are no rich bonds available, we choose to express our view on MAR 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 MAR's 3's, 5's and 7's are trading very close or 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. MAR's 5s have a bid offer of 3-4bp and negative roll-down.

Given the negative carry and roll-down, we choose to hedge with the DJ CDX NA IG Series 7 index (of which MAR is a member). This pushes us into a positive carry trade but still with negative roll-down.

As long as MAR and the CDX 7 tighten relative to each other by at least 1.4bp, 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 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 MAR 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. MAR has good liquidity in the CDS market at the 5Y tenor with a bid-offer of 3-4bp.

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

Carol Levenson, Gimme Credit's Lodging expert, recently changed her fundamental outlook for MAR from stable to deteriorating. Carol believes the lodging industry's outlook is improving but remains volatile and she likes MAR's "asset light/fee heavy" approach.

However, Carol is concerned that the company is continuing to borrow to fund share buybacks, especially given the potential cash needed for taxes and penalties related to an ESOP transaction currently undergoing a federal audit. Carol also believes the family ownership stake in MAR reduces event risk.

Our LBO-viability screens rank MAR a low 2.0 out of 5.0. LBO-likelihood is held back by high capex intensity and proposed valuation when compared to EBITDA and free cashflow.

However, IRR ranks medium and free cashflow is stable, both positive signs for an LBO. A look at the options market ranks MAR at 2.1 out of 5.0 in LBO-viability, in agreement with our fundamentals-based score and in-line with Carol's outlook. Overall, the driver for this trade is our deteriorating fundamental outlook for MAR and not the expectation of an LBO.

Summary and trade recommendation
As the credit market rallies after the previous week's sell-off, we have seen MAR tighten a bit more than the CDX IG 7. Although we do not view MAR as an LBO candidate, our deteriorating fundamental outlook provides us with ample incentive to short this credit. Given MAR'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 MAR hedged with selling CDX 7 protection. Reasonable carry and the potential profit of a widening credit strengthen the economics of the trade. Given our deteriorating fundamental outlook for MAR 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 Marriott International, Inc. 5 Year CDS protection at 29bp and

Sell US$10m notional DJ CDX North America IG Series 7 5Y protection at 35.75bp to gain 6.75 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).

The road to recovery

Jean-Baptiste Gaudemet, senior consultant at Sophis, takes an in-depth look at recovery rates and argues that structured credit investors should be doing the same

The emergence of credit derivatives such as credit default swaps (CDS) has lulled many credit investors into a false sense of security, causing them to abandon more complicated risk calculations based on recovery rates. However, ignoring recovery rates and taking a deceptively simple route to mitigating risk may be causing many credit investors to pay over the odds for protection or leave themselves overexposed.

The recovery rate on a debt instrument (the percentage of investment that investors can expect to recover in the case of default) is dependent on a range of factors, such as the kind of default involved (full bankruptcy, failure to pay, restructuring etc.), and, in most cases, cannot be easily calculated until well after the default becomes a reality. For investors, because CDS contracts that protect against default can be bought at a low price long before a default is on the horizon, the temptation is to use a very generic, industry-wide recovery rate, e.g. 35% for the entire oil sector.

The ability to offset default risk through CDS contracts has led to the emergence of a credit market that places a priority on spread. However, while spread may be simpler to analyse compared to, say, default risk and recovery rate, it does not convey a complete picture of the market. For example, relying on spread to calculate risk on a basis trade is not sufficient because in most cases, the value of the bond being traded is not the same as the nominal value on which the CDS contract is based.

As a result, the amount of hedging required on that investment depends on the estimated recovery rate. It is therefore crucial for the recovery rate to be calculated to a reasonably accurate level, to ensure that the hedging is not under- or over-evaluated and avoid either over-exposure to risk or an under-profitable trade.

The recovery rate is also an important element when modelling structured products such as synthetic CDOs, a process that requires, among other things, an analysis of the issuer as well as the issuer's default probabilities and issuer's recovery rate. From the simple to the most complicated credit instrument, recovery rates are essential.

Ignorance is not an excuse
So, why is the merit of recovery rates underestimated? Many are put off by the fact that recovery rates are complicated and can only be calculated accurately in the case of default. Furthermore, since the advent of the CDS market, defaults have been few and far between, causing players in the credit market to rely on a market consensus based on a global historic average which does not reflect the financial structure of the issuers nor the default events applicable in the CDS contracts.

The actual recovery rate can vary greatly depending on the type of default and the organisation's individual circumstances. Additionally, recovery rates can vary greatly according to the currency in which the bond is denominated. As a result, it requires a huge amount of effort to come to an accurate estimate.

Ignoring recovery rates completely amounts to going into the market 'blind'. One prime example of the widespread failure to factor the recovery rate into credit risk calculations is the overpricing of CDS contracts in emerging markets.

Recent episodes of financial distress, beginning with Argentina in 2002 and followed by similar crises in Uruguay and Brazil, showed that despite an estimated recovery rate of between 20% to 25%, the actual recovery rate was somewhere between 35% to 70%. Because of this miscalculation, the contracts were overpriced based on low predicted recovery rates.

The current situation is comparable to that of equity index arbitrage in the early 2000s. At the time, dividend risks were not properly taken into account by traders, despite the fact that they had a crucial impact on the profitability of the trades being booked. By choosing not to ignore a vital risk factor, today's credit investors can demonstrate that they have learnt from past mistakes and avoid suffering similar losses.

A renewed interest
These facts have not gone completely unnoticed. Of late, an increasing number of industry voices have been re-emphasising the importance of the recovery rate after a period in which it received little interest from financial modellers or empirical testers. By paying more attention to recovery rates, loss estimations can be greatly improved – and with far less effort than is deployed in refining other metrics which have far less impact on the total risk banks face.

The issue of recovery rates is finally beginning to attract research interest, with a number of initiatives in the market showing an increasing awareness of the issue. Credit rating agency Standard & Poor's, which pioneered recovery ratings in 2003, analyses the behaviour of recovery rates in an econometric report, The Relationship Between Default Rates and Recovery, released in January 2007. Based on its historic data, the Standard & Poor's report asserts that there is a negative relationship between the probability of default and speculative-grade post-default recovery values (i.e. the higher the default rate, the lower the recovery rate, and vice versa).

Leveraging such research, credit derivatives teams are working on quantitative models of recovery rate behaviour. For example, establishing a link between the bond's default probability, the probability of a particular default event and the recovery rate associated to this default event.

Calculating the cost
Clearly, the recovery rate needs to be considered in risk calculations. But how can investors avoid the risk of paying too much for CDS contracts without opening themselves up to the risk of a low real recovery rate?

One solution is to use recovery rate swaps, effectively digital swaps designed to enable firms to trade recovery rates (see also SCI issue 17). In a similar way to dividend swaps which were developed to take into consideration the impact of dividends on equity index arbitrage, recovery rate swaps help offset the unpredictable effect of recovery rates by enabling investors to recover a pre-defined fixed amount. These instruments are still not very liquid, but they have the potential to enable basis trading desks to perform perfect arbitrage.

However, the most important step credit investors must take is to develop an accurate understanding of risk. In the complex credit derivatives market, it is essential to use risk management and modelling tools that can take into account crucial factors such as recovery rates as well as spread.