Contents

CDR Liquid Index data as at 20 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.

New CPDOs begin to emerge

A variety of structures now coming through

Details of the first second-generation CPDOs to be issued since the rating agency re-think on the structures (SCI passim) have emerged over the past week. A number of deals are now being marketed, offering an array of structures aiming to improve on first-generation products – despite having to offer lower leverage as a result of stricter rating methodologies.

Only two genuine CPDOs are known to have received public preliminary triple-A ratings from Moody's so far: the first is the €100m TYGER notes issued by UBS' ELM vehicle. The structure is a static one, but offers a move away from the index-based deals of the past by referencing a portfolio of 50 equally-weighted 10-year single name CDS, all of which are in the financial sector.

Moody's has also assigned preliminary ratings to a managed CPDO – the €135m Ulisse Capital through Lehman Brothers' Ruby Finance vehicle. Here, the underlying portfolio is the on-the-run five-year iTraxx main and CDX IG indices, but the manager – Pioneer Investment Management – is able to manage a variety of aspects of the deal, including changing the leverage multiplier.

Managed deals appear to be the bulk of CPDOs currently being marketed – ranging from those where the manager simply manages the timing of the roll to an actively managed structure with a mix of index and single names where the manager can make substitutions. One deal, expected to be rated by Moody's shortly, bucks that trend however.

Société Générale Corporate and Investment Banking (SGCIB) is marketing a CPDO called Stelaris. The deal is index-based – referencing the iTraxx main and CDX IG indices – but, unlike first-generation products, is not long-only.

Stelaris incorporates a steepener position, whereby it takes leverage on a position that is long the risk on the five-year indices and short the risk on the ten-year indices in a ratio that is dynamic and formula-based. This ratio has been optimised so that the structure has positive carry and, unlike earlier CPDOs, does not suffer heavy mark-to-market losses when spreads widen.

Marc Pantic, director structured credit team at SGCIB in Paris, explains: "The rationale behind Stelaris is that we wanted to keep it transparent and simple, but we wanted it to be more robust in scenarios of spread widening than standard CPDOs. So we put together this steepener strategy because we have observed that historically when spreads widen the curve tends to steepen as well – so we expect that the steepening will mitigate the mark-to-market loss on the CPDO when the spreads widen."

Pantic goes on to say that offering a non-managed deal made sense to SGCIB from its perspective. "At this stage, given that spreads are where they are at the moment and that rating agency methodology is still evolving, we thought that it may be too early and a bit too expensive structurally to offer a fully managed deal for the timebeing," he notes.

Meanwhile, more CPDO deals of an increasingly wide variety are set to be launched over the coming weeks. Notably, the third SURF structure from ABN AMRO is expected and is believed to be a new structure utilising a step-up in leverage.

MP

Residual risk realised

A clearer picture is appearing of firms' exposure to sub-prime residuals

Although thousands of column inches have been written about sub-prime in the last few weeks, the effect of the meltdown upon the value of residuals in the asset-backed market has been overlooked, according to some market experts. And the loss could be very substantial.

"We think that there is something in the region of US$1.5bn of market loss in sub-prime and affordability product residuals. A lot of this stuff is worthless or worth only cents on the dollar," says Tom Priore, ceo and president of ICP Capital in New York.

The losses are likely to have been borne most heavily by those shops that were the biggest originators of sub-prime asset-backed securities. These, according to ABS dealers in New York, were houses such as Credit Suisse, Bear Stearns, Citigroup, Deutsche Bank, Lehman and Royal Bank of Scotland.

These shops might have off-set their sub-prime residual exposure by shorting the triple-B and triple-B minus tranches of the ABX Index – which have suffered heavily in the recent sell-off of sub-prime related assets – but even this might not provide much balm to these shops. There are very few natural long positions in the ABX market, so although trading desks might be the right way around in this trade they can't cover the position and realise the paper gain.

"Who is the seller of protection? Who goes long in this market? They are left with a short they can't cover and can't monetise the profit. Even if they've been sensible and taken a one to one short – which most guys haven't – there is no natural taker of the upside," explains Priore. Moreover, as is usually the case in situations of this kind, everybody with short positions would be rushing for the same exit at the same time, distorting the market price.

The exposure that banks have to sub-prime residuals is a direct one, resulting from the packaging of a loan into an ABS securitisation. Residuals refer to the difference between the interest earned through the loan portfolio and the cost of the ABS liabilities used to finance it. As defaults occur in the sub-prime sector, the residual income will be diminished.

As positions are marked to market on a daily basis, this loss must be covered sooner or later. The difficultly of hedging in the ABS market means that the losses will only gradually be revealed over the next 90 to 120 days, suggest dealers in New York.

To date, most of the attention has focused on possible mortgage losses at the major broker-dealers. At the end of last week, Lehman printed at a high of 46bp in the CDS market – more than double its price seen at the beginning of the month. Bear Stearns also endured a widening of around 100% to 42bp/44bp, though both later narrowed from the wides. Meanwhile, Merrill traded at over 40bp recently.

These broker-dealers are all strong single-A or double-A names, and most bankers in New York feel that the recent widening has been overdone. "Pretty soon it will be business as usual and spreads will tighten again," said an asset manager in New York.

RV

Orderly but active roll

Crossover takes the brunt as CPDOs make little impact

The first day of trading in the new iTraxx indices yesterday saw strong activity, but no sign of the much-talked about CPDO impact. Instead the focus was primarily on the Crossover index.

The market was pretty orderly as it was with the last roll, according to Marcus Schüler, md integrated credit marketing at Deutsche Bank. "It was very active in the first hour as you would expect because people were trying figure out where everything was. Then, every 20 minutes increasingly large trades were being put through. It was certainly a high volume but I'm not sure if it set a new record," he says.

Volumes were high though not spectacular, says Gregory Venizelos, structured credit strategy at Royal Bank of Scotland. "We estimate somewhere in the €40bn region - where rolling a dollar of position counts as two dollars. Accounts were predominantly buyers of the roll, with prop desks and hedge funds rolling over short risk positions. Given the dominance of roll activity, we estimate the change in net risk exposure to have been rather marginal yesterday," he adds.

"We've seen significant rolling of shorts in the Crossover, which explains why it's trading 10-14bp above fair value [as at late Wednesday morning]. The same is also true of the Crossover curve with 5-10s 10bp up on fair value as the differentials between series 6 and 7 make the switch attractive," says Schüler.

Hivol also saw some short rolling activity meaning that the HiVol roll was trading at 2bp above fair value, in contrast to the iTraxx main roll, which was trading slightly below FV.

Schüler observes: "With Europe S6 and S7 both trading 2bp below FV it seems as if so far CPDOs have had little impact in this roll. However, I suspect that the series 6 leg of such trades happened last week."

Tranche markets were busy due to the roll too, with a lot of trades on rolling equity and junior mezz positions. Venizelos says: "The iTraxx market was a little choppy in the morning, with 10Y equity pricing, interestingly, coming out at a higher base correlation than the old series - the norm is lower base correlation - this was promptly arbed-out. The market became more liquid with the US coming in. The old series 5 and 7Y equity and junior mezz outperformed the new series, as expected, and the 10Y equity was almost unchanged."

Previously, International Index Company had announced that the roll had taken place satisfactorily from its perspective. Furthermore, it has added three new market makers - HSH Nordbank, LBBW and Standard Chartered - since the previous index roll in September 2006, bringing the total number of market makers to 41.

MP

Bank rating revisions

Moody's announces JDA changes as Fitch issues support rating floors

Following investor outcry (see SCI issues 29 & 30), Moody's Investors Service has formally announced that it will refine the application of joint default analysis (JDA) to its bank rating methodology. Meanwhile, Fitch Ratings has published its financial institution specific Support Rating Floors, which it stresses will not result in any rating changes.

In its revised plan, Moody's says that it will: limit the impact of systemic support assumptions in the determination of bank debt and deposit ratings; review the notching component of the JDA methodology for hybrid securities and other capital instruments issued by banks; reassess under the refined methodology all bank ratings that have already been revised according to the JDA approach; and issue a revised country-by-country schedule for those countries to which JDA-informed ratings have not yet been released.

The agency says that its next update on the matter will be no later than 30 March, followed by the release of its reassessment of JDA-related rating adjustments already made by 10 April and it expects to complete its implementation of the JDA approach for all rated banks worldwide by 18 May. The move has been given a lukewarm welcome by market participants.

For example, analysts from Royal Bank of Scotland say: "We certainly expect there still to be widespread ratings upside on the banks not already re-rated, albeit less absolute in terms of notches upgraded. Where the agency will come out on bank capital notching is sadly still anyone's guess. So all told, the positive is a welcome break while the agency reviews the next stage of the process but the negative is that the poor guys who have been Aaa or Aa1 rated – from previously very lowly ratings – have got to wait until April 10 before they hear what's going to happen to them, which may restrict their funding plans and technically, although maybe not in reality, will offer some rating arbitrage opportunities."

Meanwhile, as noted above, Fitch Ratings has published institution-specific Support Rating Floors on all Fitch-rated financial institutions in Western Europe, North America and Japan/Australasia for which potential support is sovereign-derived. "The publication of these Support Rating Floors does not result in any changes to Fitch's existing ratings. Indeed, most major banks are currently very strong credits and their ratings are well above their Support Rating Floors," the agency says.

Fitch's Support Rating Floor is expressed on the traditional 'AAA' long-term scale. It indicates the level below which Fitch would not lower its issuer default rating (IDR) in the absence of any changes to the assumptions underpinning the bank's support rating.

In addition to the 'AAA' scale, there will be one additional point on the scale - "No Floor" - which indicates that, in Fitch's opinion, there is no reasonable likelihood of potential support being forthcoming. In practice this approximates to a probability of support of less than 40%.

MP

SF CDOs avoid sub-prime contagion

New report examines short-term impact and long-term outlook

A wide array of investors are concerned about the impact of potential CDO losses (actual or mark-to-market) on the broader structured finance (SF) market, according to a new report from JP Morgan CDO Research. The bank says that it has fielded many questions in recent days on the matter – as well as on how sub-prime declines will affect the full spectrum of SF CDO investors across the capital structure.

SF CDO first-loss investors, for example, are typically hedge funds and prop trading desks which have been active relative value players, going long equity and short higher CDO tranches or HEL single names. "Such strategies are likely to have been quite profitable recently, although anyone incompletely hedged may have market value losses," says the report.

But investors at the triple-B level are most often other SF CDOs. "Some senior and mezzanine investors (triple-A through single-A) may be market value sensitive (SIVs, guideline sensitive, etc.); however, it is difficult to quantify the extent of this," the report notes.

Overall, the report argues that thus far, the problems in the sub-prime sector appear to be contained and unlikely to pose large risk to broader economic growth. Furthermore, SF CDOs are designed to take credit risk and are not exceptionally market value sensitive.

Forced sales usually result only if a bond has not paid interest or has been Caa/CCC rated for an extended period (1-2 years). Even then, the manager usually has one year to sell the asset "if, in his opinion, doing so would benefit the trust".

Equally, OC ratios primarily reflect realised credit or trading losses (although ratings and market value haircuts play a role). An OC test failure diverts interest otherwise due to junior classes to senior classes as early principal. Unlike market value CLOs – where deleveraging can be rapid and severe – SF CDO deleveraging would be gradual and modest, and need not result in the sale of collateral.

"We estimate a typical mezz SF CDO can withstand 2-4% of principal losses before a subordinate OC test would trip, and about 8-10% before the triple-B tranche would realise a principal loss," the report confirms.

In any event, the report notes that SF CDOs have temporarily stepped away from the sub-prime mortgage market while waiting for stricter underwriting standards and optimal timing in terms of valuation. "Liquidity may remain challenged near-term, reducing 2007 HEL volume drastically. We think that ultimately this step-back is temporary, although it may last longer than many anticipate (late 2007, 2008)," it adds.

However, the report concludes: "At re-priced collateral spreads, CDOs are likely to step back in (offering wider liability spreads to debt investors). Given the plethora of SF hedge funds, prop desks and other institutional investors waiting for a significant price dislocation in sub-prime, we do not foresee the type of extended market turmoil/drying up of liquidity observed from 2001-2003 in IG corporate CDOs."

MP

Conference call

Details of SCI's Exotics '07 conference revealed

Structured Credit Investor has announced initial details of its groundbreaking one-day conference - Exotics '07. The investor and manager led and focussed event will take place on 5 July 2007 at Claridge's in London's Mayfair - the heart of the UK's hedge fund community.

Conference sessions cover developments and opportunities across the full range of cash and synthetic structured credit products. Buy-side experts speaking include representatives from Alpstar, AXA Investment Managers, Babson Capital Europe, Cairn Capital, Credaris, New Bond Street Asset Management, NewSmith Capital Partners and Prudential M&G.

Discussion panels also feature: BNP Paribas; Cadwalader Wickersham & Taft; Goldman Sachs; Moody's Investor services; Morgan Stanley; Principia Partners; Quantifi; and Reoch Credit. A full line up will be announced in due course, but for regular updates and reservations visit: www.structuredcreditinvestor.com/exotics07

The programme commences with a main session on constant proportion technology, before splitting into two strands. Strand 1 covers: CLOs; real estate in Europe; structured credit ABS; 'all about equity'; and an advisor led forum on secondary CDOs. Meanwhile, strand 2 covers: CDPCs and SIVs; synthetic loans; alternative assets; managed CDOs; and risk management technology.

JW

Infrastructure LCDS proposed

New loan instruments could be led by CDPCs

Basel II is expected to boost opportunities for entities looking to offer CDS contracts on new asset classes and help manage regulatory capital requirements. Some firms, notably credit derivative product companies (CDPCs), could find a unique opportunity in infrastructure and project finance loans.

"Basel II is obviously a very important development for CDPCs as it recognises CDS contracts from any highly-rated entity," says John Ryan, md, Greengate Loan Services in Jersey City.

Tom Jasper, ceo of Primus Guaranty in New York, adds: "It has an incrementally important impact. The more European banks that manage to an economic capital model is good news, as that will encourage them to be more active in the credit space."

A synthetic loan alternative would certainly increase liquidity in a broader variety of names and boost secondary market activity. And GLS' Ryan believes that, now with Basel II in force in Europe, developing single-name CDS for infrastructure loans would be timely.

However, Primus' Jasper feels the jury is still out on whether loans make sense for a CDPC model, due to the fact that a disproportionate amount of capital is required to support these lower-rated instruments. "They eat up a significant amount of a CDPC's regulatory capital and it is doubtful that project finance or infrastructure loans will make sense from a risk-return perspective," he says.

Ryan argues that contracts could be specifically designed to assist banks in managing the regulatory capital requirements of senior secured infrastructure loans. He notes that many European banks involved in infrastructure lending are actively developing and executing capital management plans for the asset class. "A CDPC considering infrastructure loans would certainly get a good, even enthusiastic, reception among bank portfolio managers," he says.

Such lending could benefit greatly from a single-name CDS capital management product for a number of reasons. The synthetic format obviates the assignment and relationship issues associated with outright sale. Loans are low-risk and the risk and return profile of long-term secured construction bank debt generally decreases over time.

"A CDPC could act as a risk transfer mechanism between originating banks – who undertake development and construction financing – and other long-term credit investors, who want passive low-risk, low volatility assets at the post-completion stage," says Ryan.

He expects that CDPCs will naturally look towards new approaches, including considering less liquid and non-traded assets, as long as the credit fundamentals can be properly assessed. "Post-completion infrastructure loans that have a few years of operating history fit this bill very well," he says.

There are challenges associated with writing CDS contracts and risk assessment on unrated illiquid loans, but Ryan points to precedents in the commercial mortgage real estate markets.

"CRE mortgages are privately assessed by rating agencies and included in CMBS conduits all the time," he says, adding that developing these fundamental procedures for a synthetic context would fit easily into the CDPC framework, perhaps as a sub-portfolio or defined bucket. More importantly, the quantitative depth of the Basel II framework allows a bank portfolio manager to precisely assess the regulatory capital impact of a CDS contract on a single loan exposure.

According to GLS estimates, the average rating on a diverse infrastructure loan portfolio is triple-B but with a recovery rate of almost 85%. This compares favourably to an unsecured public debt obligation with a rating of single-A and a significantly lower recovery rate, which is the type of obligation that a successful CDPC like Primus writes protection on.

"The numbers for infrastructure loans suggest that these assets could work well for a CDPC. With high recovery rates, the portfolio could have a pretty reasonable impact on incremental required capitalisation," notes Ryan.

What's more, pricing for infrastructure loan credit protection is not transparent, since the underlying loans are not generally traded – which leaves the door open to above-market returns for the risk. "Fundamentally, this asset class should be of interest to all sorts of synthetic investors, including CDPCs," Ryan concludes.

HD

"How soon, how soon, how soon?"

In this week's Provider Profile, SCI talks to outsourced buy-side technology provider Sky Road

Sky Road, founded in 2005, describes itself as a custom hosted technology solution for hedge funds and asset managers. Built on top of Calypso technology, the firm says it aims to provide hedge funds with "the next generation of ASPs".

Sky Road's co-founders, chief technology officer Joe Clifford and president John Borse, first worked together when they built an interest rate platform for NationsBank CRT (now part of Bank of America) in the mid 1990s. They subsequently joined hedge funds Citadel and Ritchie Capital. At Ritchie Capital, they were to build a multi-strategy trading infrastructure. "This was built using Calypso at the core and I really liked the extensibility of the technology," recalls Borse.

Borse recognised that Calypso had also become the leading credit derivatives trading platform, and saw an opportunity to support hedge funds' trading of credit and other asset classes via a hosted platform based on Calypso. The concept of using Calypso and building it out for the specific purposes of each client seemed "a great business model" to Borse and so in 2005, with an amicable split from Ritchie Capital whereby the new firm would continue to support Ritchie Capital's operations, Sky Road was formed.

The new Sky Road platform, described by Borse as "standing on the shoulders of Calypso" also connects hedge finds to administrators, prime brokers and other intermediaries. "Funds that wanted to get hold of this great platform via the Internet and adapt the technology became the basis of our business model," says Clifford. "No two clients are alike; we take a real partnership approach with clients to support each fund's individual requirements."

This individuality is further underlined by Clifford. He says: "The way that hedge funds put strategies together is different from sell-side firms, and the view of risk demanded from investors in hedge funds is also different from the sell-side. Our adaptation has been to match operational and risk strategies of buy-side clients, including SIVs and CDPCs, using a common platform. Managers need to see asset classes in one system, not silo'ed across different systems. So we evolved the platform with our clients."

Sky Road is keen to foster this approach to appeal to all styles of trading in the hedge fund community, through the strength and adaptability of the Calypso platform. "Our first client was a global macro fund, but recently the demand has been predominantly in credit, although fixed income arbitrage and global macro are coming back. So the strength is in the cross-asset capability of the platform," explains Borse.

Part of the demand for technology to deal with structured credit trading derives from the complexity of the asset class, says Clifford. "The technology provides CDS, index and tranche transaction processing. As the fund ramps up, the processing of market data and the intra-day calculation of market shocks on P&L, and associated mark-to-market risk management becomes crucial."

A familiarity with techniques used in each individual client's trading environment is therefore vital to supporting each effectively, especially those trading bespoke structured credit, according to Borse. "Knowledge of assumptions in the models used, such as CDOs, is important," he says.

This expansion of trading coupled with investor demand for greater transparency means that such intra-day reporting is increasingly necessary. Sky Road provides a solution that allows all market players to report in real-time. "We spend a lot of time with market data providers to foster better reporting, such as our relationships with Markit Partners and Reuters," says Clifford.

Another of Sky Road's advanced functions is to bring together the fund's existing infrastructure and connectivity and link all the components to allow the fund to trade competently by providing a fully outsourced technology function. "Once the fund is up and running we interact and advise them as a virtual team pretty much daily. We let the fund leverage off their in-house technology teams and allow them to stand on our shoulders in the same way as we stand on Calypso's shoulders," says Borse

Similarly the technology required to support today's credit trading leaves old techniques behind; funds can get away with spreadsheet management to manage their books in equity trading, but trading and connectivity issues makes this impossible in credit derivatives, argues Clifford. "An ability to trade is the simplest requirement of the system, but then there's connectivity to market intermediaries such as T-Zero, SwapsWire and the DTCC; the strong derivatives background of Calypso's technology makes this possible," he claims.

Today's markets therefore demand a great deal from technology providers. As Borse explains: "We help them get their arms around the myriad complex products they trade. But time has been compressed. People need problems solved yesterday and will not settle for a six month installation as they would have done so previously. The overwhelming question our clients ask is 'how soon, how soon, how soon?'"

"The pace of evolution in the market is such that many of the smaller teams we support actively avoid building proprietary technology, especially as commoditisation emerges more," says Clifford. "It's very important to get the technology decision right."

Borse concurs by concluding with a warning shot to firms under prepared for a market down turn. "At some point the credit cycle will change and the tight credit environment we've had will change with it. Then we'll see who hasn't been employing good risk management."

JW

Calyon sues over staff defections

The latest company and people moves

Calyon sues over staff defections
Calyon is suing Mizuho Securities over the defection of the French firm's New York-based cash CDO staff in December (see SCI issue 20). Calyon is understood to be seeking US$150m in compensatory damages and US$600m in punitive damages. In addition, it is aiming to block Mizuho from disclosing confidential information and soliciting CDO business from anyone who was in talks to do the same with Calyon in the past year.

The complaint – filed in the US District Court, Southern District of New York (Manhattan) – alleges Mizuho behaved improperly in the staff defections. Furthermore, Calyon says its reputation and potential future profits have been damaged by Mizuho's actions. Mizuho Securities is understood to be planning to fight the lawsuit, believing that the allegations by Calyon are unfounded.

In December, Alexander Rekeda joined Mizuho Securities along with ten colleagues from Calyon, where he was head of cash CDOs. In his new role as head of structured credit, Americas at Mizuho, Rekeda's mandate is to build a US structured credit operation to originate, warehouse, structure, trade, underwrite and globally distribute cashflow and synthetic CDO products including CLOs, ABS CDOs and CRE CDOs.

DK's gardeners
It is believed that two structured finance bankers have left Dresdner Kleinwort. Chris Allen, who worked in product management, is understood to have left the same team as Darron Weinstein, who joined RBS from DK in February. Also, Regino Boti Llanes is believed to have left the bank's European securitisation group. They are both on gardening leave and their destinations are not yet known.

Lees to syndicate CDO
Chris Lees has joined Citigroup's CDO syndicate as director. He moves internally from his position as head of frequent borrower syndicate in London.

Jananayagam leaves ABN
Suthan Jananayagam, head of emerging markets credit trading and structuring at ABN Amro is understood to have left the Dutch investment bank. His destination is not known.

Lehman gets Moore
Patrick Moore has left his synthetic credit structuring role at BNP Paribas and is moving to Lehman Brothers to work as a product marketer. He will report to Raj Dhown, head of UK institutions for fixed income sales.

Guerrero becomes ceo of NIBC Credit Management
Fernando Guerrero has been appointed md of NIBC and ceo of NIBC Credit Management in New York. He will also serve on the firm's board of directors as co-head of NIBC Credit Management and as a member of its investment committee.

Guerrero has over 20 years of experience in the structured credit markets and has worked on a number of first-of-their kind transactions in the ABS and CDO markets. Before joining NIBC he was head of the global structured products team at Merrill Lynch Investment Managers.

ABN AMRO appoints global head of financial markets
ABN AMRO has announced the appointment of John Nelson as global head of its financial markets business. Nelson – previously head of global markets Americas for ABN AMRO and executive committee member of the LaSalle Bank Corporation – will now have global responsibility for the sales and trading of all derivative, foreign exchange, credit, interest rate and treasury products.

He continues to sit on the global markets executive management team and report to Gary Page, head of global markets. He will be based in London.

Markit partners with Quintillion
Markit Group and Quintillion, a Dublin-based fund administration services company, have announced a partnership to provide mutual customers with integrated fund administration services and independent OTC derivatives valuations.

Quintillion is a full service hedge fund administration specialist that provides its clients with back office, fund accounting and investor services. Quintillion's systems, technology commitment and operations expertise ensure that all portfolio investment strategies and fund structures are accommodated in a single location, allowing clients to manage a range of funds with the support of a single administration partner.

The firms say that the partnership will allow Markit and Quintillion to work together to provide mutual clients with independent valuations on their complete portfolio of derivatives positions, including commodity, credit, equity, currency and interest rate swap instruments.

HD & MP

Asian role for Solent's Centris

A round up of this week's structured credit news

Asian role for Solent's Centris
HSBC has closed US$200m-equivalent worth of Centris notes, a principal-protected long/short credit CPPI managed by Solent Capital Partners. The transaction is noteworthy for being structured and coordinated out of Asia.

The deal references mezzanine tranches of the iTraxx Europe and DJ CDX investment grade credit indices and comprises notes denominated in US dollars, euros and New Zealand dollars with maturities of seven to eight years. The US dollars-denominated paper pays a contingent coupon with a modeled return of approximately 9.25% per annum.

The aggregate of the long and short positions is credit-event neutral on a cash basis, while having the benefit of substantial positive carry and roll-down. This feature is expected to result in an attractive risk/return profile for investors.

In addition to the core index tranche strategy, there is flexibility for the manager to use single name CDS, indices or tranches – thereby allowing Solent access to more efficient hedging tools to capture return for investors. HSBC assumes the gap risk by providing principal protection within the dynamic leverage framework.

Jamie Spence, head of structured credit product marketing Asia Pacific for HSBC notes: "Centris offers investors the opportunity to participate in a managed strategy that captures the relative value currently available in the credit curve between the five-year and 10-year indices, together with the comfort of principal protection. In partnering with Solent, we provided our client base with the combination of a top-tier credit manager and an investment with enough flexibility to allow the manager to perform under differing market conditions."

"Given the nature of this opportunity, Centris is ideally suited to Solent's management style," adds Ray O'Leary, partner at Solent Capital. "By understanding the factors driving changes in the price of protection in investment grade indices alongside traditional management of synthetic CDOs, Centris allows investors to access the structural alpha offered through this construction with the benefit of a manager to police potentially hazardous events which could impair the monetisation of that value."

HSBC's client footprint in Asia, where a significant part of the transaction was sourced, proved to be an ideal springboard to distribute the structure.

More CDPC activity
Cournot Financial Products (see also SCI issue 28) has been rated by Fitch and Channel has teamed up with Principia in the past week.

Fitch has assigned a triple-A issuer default rating to Cournot Financial Products, addressing the credit derivative product company (CDPC)'s ability to make timely payments as required to counterparties.

Cournot is expected to sell credit protection mainly on highly-rated tranched corporate exposures. At least 50% of the company's aggregate notional exposure with respect to all outstanding CDS transactions will be allocable to reference tranches that meet a triple-A threshold. The vehicle will be managed by Cournot Capital, a subsidiary of Cournot Holdings – which is in turn a subsidiary of Morgan Stanley.

Cournot will only engage in activities permitted by its operating guidelines, which specify portfolio guidelines, eligible transactions, eligible counterparties, eligible investments and required capital. A proprietary capital model is used to determine Cournot's required capital. Failure of capital tests and certain breaches of the operating guidelines can lead to restrictions in Cournot's ability to sell additional credit protection.

On Tuesday it was announced that Principia Partners had joined up with Channel Capital Advisors. Principia's SFP system will manage transactions from deal capture and risk management through compliance reporting for new CDPC Channel Capital plc.

The CDPC will principally write credit protection on AAA rated tranches of portfolios of corporate and sovereign obligors. Channel Capital plc is expected to be efficient even in current tight credit spread market conditions due to its use of a multiple-tranche capital structure, a low velocity business model, and other operational and structural enhancements of its business model.

REIT TruPS CDOs to withstand HEL volatility
The latest chapter in the sub-prime mortgage market slowdown is likely to present a fairly minor problem for US REIT-specific TruPS CDOs since the majority of their collateral comprises residential mortgage loans, according to a new report by Fitch Ratings.

Though research by the rating agency shows that REIT TruPS CDOs account for approximately 13% of the entire TruPS CDO arena, Fitch md and REIT group head Steven Marks says that the inclusion of residential mortgage obligor TruPS in portfolios has actually declined over the last two years. "Spreads have tightened and the yields on the TruPS are not cost-effective for issuers," he explains.

Exposure to sub-prime residential mortgage lenders represents only 8.4% of total residential mortgage lender exposure within REIT TruPS CDOs and hybrid CDOs. Furthermore, exposure to sub-prime residential mortgage lenders represents only 1.8% of total REIT TruPS collateral included in REIT TruPS CDOs and hybrid TruPS CDOs.

Nonetheless, Derivative Fitch senior director Nathan Flanders notes that the agency continues to actively monitor the sector and how it may affect transaction risk. "There have been no deferring or defaulted residential mortgage company entities in any Fitch-rated TruPS CDOs to date," he observes.

Banque AIG in SIV launch
S&P has assigned preliminary A-1+/AAA ratings to the senior European and US CP and MTN programmes of Nightingale Finance, the latest SIV to come to the market. Banque AIG sponsors the vehicle and will provide it with investment services; certain aspects of treasury execution and operational support will be provided by QSR Management.

Nightingale can issue up to US$25bn senior US and European CP and MTN notes, as well as US$5bn triple-B rated capital notes. The vehicle will use the proceeds of the issuance of the notes to purchase a portfolio of securities following predetermined portfolio guidelines.

Lion Capital Management brings CDO pair
Singapore-based asset manager Lion Capital Management is in the market with two synthetic CDOs – the US$30m Sukhothai CDO 1 and the A$112.7m Zircon Finance Series 2007-1.

The triple-B plus rated Sukhothai transaction will be issued via Calyon's Queenstown CDO vehicle and comprises a funded single tranche referencing a US$3bn portfolio of 115 investment grade global obligations, with an average rating of A minus. The US and Western Europe account for the majority of the portfolio, with 60.1% and 31% of the exposure respectively.

Meanwhile, Zircon Finance (also known as Coolangatta) comprises A$84.05m double-A rated Class A notes and A$28.6m triple-B rated Class Bs. The deal references a 7.5-year portfolio of 150 predominantly investment grade corporate entities, with a weighted-average rating of A-/BBB+.

Arranged by Lehman Brothers, the notes are callable in March 2011. Should this occur, the collateral securities will be delivered by the issuer to the swap counterparty in return for a cash settlement, thus shielding the noteholders from market risk on liquidation of the portfolio.

CBOE to launch listed credit default options
The Chicago Board Options Exchange (CBOE) plans to launch credit default options based on credit events during the second quarter of 2007, followed by credit default basket options soon. The instruments will provide the opportunity to hedge the risk of adverse credit events, such as bankruptcy and failure to pay.

"CBOE's credit default options will bring great benefits and tremendous cost-savings to a market that has exploded into a US$26trn business. CBOE's product will provide investors with the advantages of a standardised, exchange-traded options contract, including the assurances of SEC oversight, triple-A rated clearing, increased price transparency and reduced trading costs. In addition, CBOE credit default options will trade on our highly successful hybrid trading system," comments CBOE chairman and ceo William Brodsky.

The instruments are cash-settled binary call options that pay US$100,000 when the exchange confirms that a credit event has occurred. If no such credit event occurs, the option expires with no value. Special procedures would apply in the event of a succession or redemption.

Derivative Fitch launches Vector 3.1
Derivative Fitch has launched an updated version of its VECTOR default model for CDOs, focusing on ease of use and including enhancements to the automated data loader for corporate reference entities.

The new version of VECTOR includes a CDO comparator, which enables users to quantify the impact of portfolio substitutions on the rating loss rate, default rate and recovery rate of the initial portfolio. In addition, a more sophisticated matching engine has been added to the Vector Reference Entity Feed to facilitate better communication between the Fitch feed and users' proprietary feeds.

MP

Trading ideas - pick it up

Dave Klein, research analyst at Credit Derivatives Research, looks at a curve flattener on JC Penney Company

With the ongoing volatility in the markets, it is easy to be a bear these days and ignore bullish trades altogether. However, occasionally (lately very occasionally), the stars align and we find relative value in a technically sound, positively economic trade on a fundamentally improving credit. Here, we consider a 3s-5s curve flattener on JC Penney Company (JCP).

Looking better
To estimate the fair value of the 3s-5s flattener, we model the 5 year bid level as a quadratic combination of the 3 year offer levels. This is undertaken across the universe of credits whose 3's are close in value to JCP.

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.

Exhibit 1

JCP is about 7bp steep to fair value and has nice roll-down which further bolsters our confidence in the trade.

Differentiated differentials
JCP has good liquidity in the CDS market across the curve and now trades actively in five-, ten-, three- and seven-year maturities. Additionally, JCP is an in-coming member of the DJ NA IG CDX Series 8. As spreads have moved over the past year so the curve differential (between three- and five-year CDS) has ranged between 15 and 30bp, as seen in Exhibit 2.

Exhibit 2

Mid-to-mid absolute differentials have remained modestly high (compared to JCP's peer group) at around 18-20bp. This differential has made the 3s-5s flattener a positive carry trade. At present, JCP is in the middle of its 3s-5s differential, leading us to expect (when combined with out fair value model) that the name is a good candidate for a flattener.

The real deal
While we maintain an improving fundamental outlook for JCP, any positive view could obviously be implemented with an outright long, but, as we have stated before, we prefer positive carry trades (and relative-value opportunities) that are somewhat market neutral. At these levels we see a little too much downside for the naked long although we could potentially hedge with some exposure to the CDX IG 8. We still prefer the flattener as our positively economic long trade (especially when our market bias is to the tightening and flattening side) when we are concerned on downside and so investigating the 3s-5s relationship provides us with both relative-value and positive carry.

One more item of note with the flattener is that it buys us time (at these maturities) – if we are modestly positive on the credit but do not expect a major move soon, it does not cost us to maintain a position that benefits from over-performance. The position provides us with a cushion on our timing of any positive view and offers good upside from just rolling down the steep curve (if nothing happens).

Moving from the mid-to-mid (rough) curves to the bid-offer adjusted curves in Exhibit 3 paints a much clearer picture of where JCP's curve is trading. JCP has regularly moved from being too steep to being too flat according to our fair value model.

Exhibit 3

As stated earlier, JCP is now a bit too steep. Combined with our improving fundamental outlook, we expect the curve to continue to flatten.

Risk analysis
This trade is duration-weighted to ensure positive carry as well as to reduce our exposure to absolute levels. We are therefore hedged against short-term movements in absolute spread levels, profiting only from a curve flattening between the threes and fives.

The carry cushion protects the investor from any short-term mark-to-market losses. This trade has positive roll-down thanks to the curve shape and tightness of bid-offer.

Entering and exiting any trade in these maturities carries execution risk, but this is not a major risk with this credit in these maturities as they are increasingly liquid.

Given that we believe JCP faces only a minor probability of default during the lifetime of this trade, we also recommend putting on a third leg of selling 1Y JCP protection (US$5m worth) to monetise our improving fundamental outlook. While this moves the trade away from DV01-neutrality, it keeps the trade default neutral.

We have not added this leg to our trade position because we do not see liquidity in the 1Y tenor. However, we would not expect to unwind this leg if indeed it was put on, so if your dealer can quote you 1Y bids, we recommend considering adding the leg to the trade. As the 1Y's expire, continue to sell protection in 1Y maturity to keep the trade default neutral and to pick up an extra bit of short-dated carry.

Liquidity
Liquidity is a major driver of any trade – i.e. the ability to transact effectively across the bid-offer spread in the CDS markets. Our data on liquidity, created from the volume of bids, offers, and trades we see each day, provide us with significant comfort in both the ability to enter a trade in JCP and the bid-offer spread costs.

JCP is a member of the new CDX NA IG Series 8 index. Bid-offer spreads have narrowed to around four and five basis points in five- and three-year CDS respectively. While we'd like to see lower bid-offers (especially in the three years), the positive economics of the trade allow us to recommend the flattener.

Fundamentals
This trade is significantly impacted by the fundamentals. The technical steepness of the credit and positive economics are helped by a potentially positive systemic outlook which, in our view, overwhelms the stable idiosyncratic performance of the credit.
Carol Levenson, Gimme Credit's Retailing expert, maintains an improving fundamental outlook on JCP. Carol notes that JCP has posted six years of positive same-store sales and has a strong national brand. Carol believes the company can exploit the trouble competitor Federated currently faces with its May integration. JCP has reached investment grade status, Carol does not expect debt protection measures to improve as rapidly as in the past but the company's fundamental outlook is positive even in a highly competitive environment.

Summary and trade recommendation
As the CDX IG rolls from Series 7 to Series 8, we turn to one of the new members of the index. With the company's movement to investment grade, positive same-store track record and competitors facing tougher challenges, we like JCP as a credit.

Given the relative steepness of the 3s-5s CDS curve, we believe a positive-carry flattener trade is the safest way to express our improving fundamental outlook on JCP. Good carry, roll-down and the potential profit of a return to fair value strengthen the economics of the trade.

Buy US$15m notional JC Penney Company 3 Year CDS protection at 21bp and

Sell US$10m notional JC Penney Company 5 Year CDS protection at 39.5bp to gain 8bp 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 future of iTraxx

Michael Hampden-Turner and Michael Sandigursky of the European quantitative credit strategy and analysis group at Citigroup, look at the iTraxx index futures contracts due to be launched on Eurex next week

The 27 March 2007 will see the launch of the new 5-year iTraxx Investment Grade, High Volatility and Crossover index futures. For CDS indices this marks the final stage of a remarkable three year evolution from exotic OTC credit derivative to exchange traded security.

The British Bankers Association estimates that index credit derivatives such as CDX and iTraxx make up at least 30% of the US$26tr credit derivative market. For more details about the CDS and index market, please see the Citigroup publication "Credit Default Swaps, the Invisible Hand" (republished in SCI issues 28 and 29).

Summary points
Futures on these indices will build on this success by making index credit derivatives accessible to a much broader audience than could have used the OTC contract. The future has an identical risk profile to the index credit default swap but the fact that it is margined has a significant impact.

• No credit lines are required for futures, which is a significant advantage for investors who have high demands on their capital or limited access to credit.
• No ISDAs have to be in place between counterparties, which removes a significant administrative burden.
• Margined products have no counterparty risk. The cost of trading futures is, therefore, considerably lower as counterparty risk costs money in terms of capital usage and administration costs.
• Index credit default swaps require a sophisticated booking and risk management system. CDS are typically closed out with an offsetting CDS with another party, which means that over time a CDS book can grow to be quite large.
• Futures are completely fungible; with the result that managing them can be done on a net basis.

Another advantage of trading on exchange is the degree of confidence that the market has in a product that is completely standardised. The underlying OTC index CDS is also standardised but for many investors the simplicity of a futures contract will prove popular.

• iTraxx futures will trade on a price basis (which means convexity will not play a part) and daily P&L can potentially be calculated without a calculator. Ticks move x contracts x tick value. This will suit 'futures orientated' investors while investors who prefer a spread-based product can convert the price to spread and view the contract in this way.
• Exchange traded contracts have complete order book and trade transparency which will help to give investors confidence.

Futures will trade on a contract size of €100,000 notional which is a much smaller granularity than is available for the OTC contract, again opening up trading to a whole new potential category of small investors.

Contract Mechanics
So how has Eurex managed to commoditise an OTC credit derivative?

Eurex has chosen to reference the most liquid index CDSs, the front or on-the-run contracts. There will be three active six-month futures trading on the investment grade, high vol and crossover indices. At the time of the roll there will be a brief period (five exchange trading days) of futures overlap when both the vintage and new indices trade together to enable market participants to roll into the new future before the old one expires.

The CDS contract has been transformed into a bond, the future trades on that bond price, i.e. essentially on the PV of the CDS. To clarify this it is helpful to think of it in four components:

• Par is 100 at inception for all the indices and will reduce proportionally as defaults occur in the underling index. It will reduce by 1/n for each default, where n is a number of equally weighted constituents in the reference index. For example, if a default were to occur in the iTraxx investment grade index the par value would drop to 100 - 1/125 = 99.2. This mirrors the change of notional in the OTC index CDS.

• PV of the underlying spread change reflects the change in the market's view on credit quality of the reference basket since the inception of the index. Each new series of iTraxx indices have a standard coupon. This coupon is roughly equal to an average spread of the index basket at a time of issuance. In order to standardise trading, this coupon is fixed and doesn't change with credit quality of the underlying basket. The current series (S6) of iTraxx Europe was issued with 30bp coupon, while a current market quote is around 24bp. Therefore the protection buyer needs to be compensated by the seller for this 6bp in the PV of the contract. More formally for a protection buyer:

where 

contractual coupon – current spread and DV01 is the present value of a single basis point (DV01 is a non-linear function, a model is required for accurate pricing, by convention the market uses the model on the CDSW, but Eurex will have their own model for this calculation.)

• Accrued coupon represents a portion of the iTraxx index coupon due to the protection seller, similar to the "dirty price" of a bond. The accrual is based on fixed coupon paid by the underlying index CDS. It is calculated as a daily 'straight-line' accrual on an ACT/360 basis. Unlike OTC indices, which pay coupon quarterly, future coupon will be only settled at maturity. For example, the accrued coupon on a future with a contractual coupon of 30bp on the 10 October 2007 would be 20 days/360 * 30bp * Par = 0.0167

• Default component if a credit in the index defaults then the future may contain a component that is equal to the recovery value of the defaulted name(s) in the index. In the case of a default a new index will spawn and there will be two indices – one with a default component and a clean one.

Once the future starts trading, iTraxx spreads will change from the inception level and the future will trade away from the par to reflect the value of the upfront payment now embedded into the price. If spreads tighten, the future will trade above par, while the opposite is true when spreads widen.

This closely resembles price behaviour of a fixed coupon bond. In fact, thinking of the future as a bond is useful to understanding it in terms of risk, dirty/clean prices and its relationship to the OTC index CDS.

Since futures prices are observable and the P&L of a future is a simple function of the number of ticks made and the number of contracts held no model is required. However it is inevitable that market participants will want to break the futures price into its constituent parts and to know what iTraxx spread is implied by a given futures price. Also, at expiry Eurex will cash settle futures using a 'closing' iTraxx spread.

For both of these purposes a model will be required to be able to move between futures price and index spreads. Eurex will use Bloomberg's CDS model, which is based on a standard methodology accepted by the market. The model will be available through CDSW screen and also via new FCDS function currently being developed by Bloomberg.

Treatment of Defaults
When it comes to treatment of defaults, iTraxx futures mimic the OTC index contract. In case of an anticipated credit event, International Index Company, which oversees the administration of iTraxx indices, may publish a separate version of the index that excludes a name that is on the edge of bankruptcy. In the case of iTraxx investment grade, this means a 124-names basket. If that happens Eurex will also list a 124-name future, which will trade without the defaulted credit and whose par component will be 99.2. Both 125 and 124-name futures will trade until future expiry or until another credit event occurs.

The announcement of a CDS protocol will be used as a sole trigger of an actual trigger event. The following day, the par of the contract will be reduced by 1/n. Both the accrued premium and PV of spread change will be now calculated based on the reduced par.

Additionally, the price of the future will contain "expected recovery" of the defaulted name. For instance, 40% expected recovery would contribute 0.32 (40% times 0.8 units of par).

Actual recoveries are determined by an ISDA recovery auction and until that day the recovery component remains variable. This allows investors to create a synthetic recovery swap by trading 125 versus the 124-name future.

The only complication arises when recovery auction is scheduled after the expiry of the future. When recovery is still not fixed at expiry of the future, 125-name future will be split. The non-defaulted part will be settled based on 124-name contract, while a recovery component will continue trading as a single name future until the auction date.

Next Steps
The success of the iTraxx future will be largely dependent on it gaining enough liquidity to become a mainstream method of taking a credit view. Market makers have few incentives to entice investors to stick with OTC markets, as bid/offer spreads are already quite tight and the operational costs of maintaining a large CDS book relatively high.

A successful launch of the future in March will almost certainly be followed by an isomorphic CDX future launch by one of the US exchanges before the end of the year.

Beyond this, we see futures extending into longer maturities. A one year future referencing static 5Y index will help investors to express their views on credit transition more efficiently.

The next logical step will be to trade exchange traded options on futures. Liquid OTM options will satisfy a current demand for cheap "crisis" hedge attracting more investors' interest than the moribund OTC swaption market.

© 2007 Citigroup Global markets. All rights reserved. This Research Note was first published by Citigroup Global markets on 7 March 2007.