Contents

CDR Liquid Index data as at 26 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.

A difference of opinion

Buy- and sell-side divided over Eurex futures

The world's first credit derivatives futures launched yesterday amid some controversy. Sell- and buy-side market participants appear to be taking opposing views on the contracts.

Some dealers are complaining that the new futures listed on Eurex rely directly on the ISDA auction process to determine a recovery rate in the event of a default, but the interrelationship between an exchange-traded product and an OTC process is far from clear. It is even being suggested that, given futures are outside the auction process, it could be possible that a firm might be tempted to manipulate the auction price to benefit its futures position.

However, fund managers are sceptical of such arguments. As one observes: "It all seems a bit self-serving to me. Only two or three of the major dealers are driving these complaints and for them there is still plenty of premium in the OTC index markets, but far less in futures. Equally, the futures best suit smaller funds such as ours, but that's who the banks make proportionately the most money out of."

The issue is beginning to involve larger funds as well, however. AXA Investment Managers in London has written an open letter to all its bank counterparties urging them to support the contract.

"We accept that the contract is not perfect – for example, we would prefer a longer maturity than five years, but that will come in time – but overall are very keen that it succeeds, because it enables us to take directional views in credit without the need for signing an ISDA master agreement," says Jamie Grant, investment manager at AXA IM.

He continues: "We know from painful experience that it is difficult to get acceptance from clients to enable us to use OTC instruments – they are receptive to knowing more about it, but it just takes time. Whereas about two-thirds of our accounts already give us authorisation to trade futures and so we are effectively already able to trade the Eurex contracts on their behalf."

Not all dealers are against the products, however. "I understand the arguments about margins being eroded and the importance for firms of staying in the flows, but in some cases you have to look at the bigger picture. Futures are an additional product that could bring more participants to the market and greater transparency – and that can only be a good thing," says one.

Nevertheless, he warns the fact that only one market maker has so far been named for the contracts – Societe Generale – could prove crucial. "The contracts could easily fail if the banks don't support them and create liquidity, because instruments such as structured products and the hedging of CDOs require such big volumes."

The divergence in opinion of the contracts illustrates a classic difference between the buy- and sell-sides, according to Grant. "Bankers don't fully understand all the nuances of running large amounts of money against a benchmark and the need to take short-term views within an overall portfolio. We use gilt futures to do this with sterling fixed income funds, for example. Now it's possible in credit – and that's ideal," he says.

For its part, Eurex appears to be unconcerned by the issue. "We have structured our product so that it very closely mimics the OTC market and do not see that there is an issue," a spokesperson for the exchange says.

MP

Standard and Poor's releases CPDO model

Flexibility is the word going forward

S&P has publicly released its modelling tool and quantitative framework for static index-based CPDOs. The agency's strategy indicates the way ahead for the rating of all such products, structurers say.

S&P last week released a beta version of its CPDO Evaluator, which is the primary model it uses for rating the instruments. The beta model has been published specifically for arrangers and dealer brokers who wish to evaluate and execute CPDO transactions with an S&P rating, according to the agency.

Together with the launch of CPDO Evaluator, S&P has published its quantitative modelling framework and criteria for rating index CPDO structures, including detailed technical criteria of its modelling approach. The criteria also include a description of the rationale behind and the mechanics of the CPDO structure, the formulae for calculating the inputs to the model, and a working example showing how these inputs interact.

In its analysis S&P ran numerous sensitivity scenarios on each of the main variables driving a CPDO's NAV – credit defaults and spreads on the underlying reference assets, the depth of liquidity in the CDS market and the interest rate – to understand the net effect of changes on the NAV and therefore the rating. Such sensitivity analyses were performed on each variable in isolation as well as in combination with the other variables. The size of the impact of each variable and the timing of the imposition of the stress in the transaction are central in determining the suite of stresses used to arrive at a base case scenario for rating these structures.

The analysis also had to take into account transition risk below triple-B minus. Upon an asset's transition below investment grade, the affected entity is removed from the indices at the next roll date, typically resulting in a mark-to-market loss for the portfolio in which it is referenced.

As mark-to-market changes are not directly captured in S&P's modelling, stressed default curves are used to account for this risk. The agency's model generates on average 6.8 defaults over the life of a transaction.

"This external version of CPDO Evaluator is pretty much the same as the internal model we have been using since the outset," says Cian Chandler, credit analyst at S&P's structured finance ratings group in London. "We are still working on the internal version for second-generation CPDOs, which will encompass all of the new twists to these products being considered, such as managed deals and bespoke portfolio structures."

Chandler continues: "There has been a huge amount of queries coming through for some time, but the key is knowing which ones are going to actually turn into deals. To be honest, over the last couple of months there were quite a few enquiries coming through, about which you would be sceptical whether they were going to happen or not. But recently there seems to be an awful lot of concrete demand for CPDOs in a wide variety of forms. So the challenge is to be able to reflect all of that functionality in our models."

That challenge will best be met by taking a flexible approach in the future, according to one credit structurer. "The rating agencies need to adopt a more generic framework than they have been used to and ensure that it is flexible enough to adjust for these quickly-evolving products if they do not want to make the same mistakes again as they did in the past," he says.

Another structurer believes that the lessons have been learned. He concludes: "We really get the sense that all the rating agencies now are on the same page and are prepared for their methodologies to continuously be improved going forward as the different types of structures in the pipeline start coming through."

MP

CDO of ABS sub-prime exposure assessed

Double-A tranches more vulnerable than triple-Bs

A new report by Citigroup's European quantitative credit strategy and analysis group suggests that investors should be considering the ramifications of current market volatility on higher rated US CDO of ABS tranches. Furthermore, investors should be considering hedging their exposures via CDS on CDOs of ABS.

"Sub-prime has been one of the main focal points during the recent sell-off, if not necessarily its cause. But we reckon the effect on CDOs of ABS may be more interesting than that on sub-prime itself - and considerably less priced in," explains Matt King, a director in the group.

The report argues that, unlike CLOs, US CDOs of ABS seem to be relatively undiversified. The individual triple-B and triple-B minus ABS tranches within CDOs of ABS are actually quite well diversified, but when incorporated in CDOs the effect is reversed.

Rather than being concentrated in particular regions, ABS tranches tend to span several regions - even if there is still a preponderance of exposure to 'hot' states like California. This renders the individual ABS more stable. But from a CDO perspective, it actually makes the collateral more similar - thus reducing diversification.

"As we see it, this creates a classic 'ball in bowl' phenomenon, in which either no ABS tranches get downgraded, or a great many do," King says.

The report argues: "Translated into the CDO space, widespread downgrades would, relatively speaking, be far worse for senior tranches than for junior ones. Indeed, preliminary analysis of some cash CDO of ABS deals confirms this: if 25% of triple-B ABS tranches fall to single-B, for example, then on one deal we analysed the double-A tranches would fall to single-A minus, while the triple-B tranches would only move to triple-B minus."

It continues: "Such findings already seem comfortably priced into TABX - and indeed help to explain the otherwise absurd levels reached by its super-senior tranches. But the more liquid (if less transparent) CDS of CDOs of ABS market does not seem to share that pattern at all: to judge from new issues, triple-B tranches have suffered far more than double-As have."

Consequently, the report recommends that existing investors in high quality tranches switch out in favour of smaller allocations to, say, triple-B tranches instead, or consider using CDS on CDOs of ABS to effect the package.

The report notes that levels will depend on the specific deals and may differ significantly as many tranches are being sold at discounted prices. In addition, it warns that on some deals the bid-offer is very wide.

MP

Sputnik launches

First rated CDO of CIS corporates comes to market

Deutsche Bank, in conjunction with VTB Bank Austria and VTB Bank (Moscow), has closed Sputnik CDO I – the first-ever rated CDO of CIS corporates. The deal follows on from Red Square, the debut local un-rated Russian CDO (see SCI issue 20), and is expected to herald the arrival of more deals of both kinds involving collateral from the CIS region.

The five-year US$400m synthetic CDO references a diversified portfolio of Russian, Kazakh and Ukrainian bank and corporate credits. The transaction is managed by VTB Bank Austria.

The capital structure of the CDO includes unrated equity (accounting for 0-10% of the risk) and senior equity (10-20%) tranches, as well as mezzanine tranches rated Ba2, Baa3 and A2 by Moody's – each issued by a special purpose vehicle domiciled in Ireland. The portfolio contains 43 credits, each of which are rated and are issuers of publicly traded external debt.

Sourcing credits for a CDO portfolio in the CIS region is not always the most straightforward task, as previous issuers have found. However, that task does appear to be getting easier – even given that Sputnik's arrangers made matters more difficult by aiming for a rated transaction.

Praveen Bhandari from emerging markets structuring at Deutsche Bank in London, says: "We were always very sure that we wanted to do a rated transaction, so, in the portfolio, we sought to put in names that have an explicit rating and we, in conjunction with the manager VTB Austria, constructed a portfolio of 43 names."

All of the credits selected for the portfolio did not have the same level of liquidity in CDS. However, the CDS market for CIS-based bank and corporate credits has become much more active in recent times.

Nevertheless, Bhandari explains: "All of the names in the CDO's portfolio have external debt available – either in the form of bonds or hard currency loans. On the back of that we, in conjunction with VTB Bank Austria, have been able to source CDS in all of the reference names, making this landmark deal possible."

The deal has now closed, having attracted orders from investors in Europe, the US and the CIS region. "The majority of the deal has been sold and we are in the process of syndicating the residual tranches over the coming days," Bhandari confirms.

He is equally confident that more CIS-related CDOs will follow. "You might see more rated or more unrated deals denominated in hard currency or even local currency. But generally I think that this sort of theme will continue – either focused purely on Russia or the CIS, or broadened to cover, say, Eastern Europe," Bhandari says.

Furthermore, supply will meet demand. As Bhandari concludes: "The CIS will remain a hot area for investors. Last year there was a record level of bond issuance from this region and all the bonds were oversubscribed, illustrating strong investor interest – and there is increasing investor appetite for structured risk such as CDOs."

MP

"It's a moving target"

Algorithmics is the subject of this week's Provider Profile

Algorithmics has been providing the market with risk management systems for almost 18 years, constantly developing its product suite to offer a variety of in-house and hosted services to both sell and buy-side institutions. The firm, founded in Toronto in 1989, is now owned by the Fitch Group.

'Algo Risk' is the firm's module that provides a holistic solution to credit derivatives market participants. Designed for both 'buy and hold' and 'fast money' investors, Algo Risk, the firm says, assists portfolio managers by providing an integrated view of market and credit risks and returns in both absolute and relative contexts.

Diane Reynolds

Reynolds continues: "The real appeal of our approach is to provide information in an easily accessible format. Our reports are fully customisable, and cover the entire portfolio, not just a single asset class. The analytics in the software similarly provide full cross-asset asset pricing and risk/return optimisation."

This system flexibility, explains Reynolds, allows clients to choose the deployment option that best meets their needs. For example, Algo Risk can be deployed at a client site giving the client full flexibility to configure the system to meet its specific needs.

Alternatively, it can be deployed as a "managed service", where Algorithmics operates a dedicated production environment on the client's behalf. Finally, it can be deployed as an ASP offering where a number of customers share a single configuration of the system, which further reduces total cost of ownership, according to Reynolds. "The size and complexity of the client's business determines which solution they adopt," she adds.

To complement this structure and ensure each client is supported to their individual requirements, Algorithmics uses a multi-tiered approach that ensures consistent development of each module employed. Users can not only import modules built in-house, but can also connect to other in-house systems through Algorithmics' software, a framework the firm terms 'Open Mark-to-Future'.

"Open Mark-to-Future allows the portfolio manager to assess risk and forecast reward for the entire portfolio by facilitating complete coverage of the portfolio; for complex, new or low-volume deals you can price in your trading system and send results to the risk management system. We then combine this with the more standard parts of the portfolio and provide the user with the advanced analytics needed to perform lifetime risk management of the trade," says Reynolds.

Having a comprehensive risk management system such as this serves not only experienced structured credit investors well, but also the steady flow of new entrants attracted by the apparent promise of the additional returns from an outperforming sector. There is also however an element of caution noted among investors, according to Reynolds.

Chief among the concerns of newer investors is the pace of growth in the market and consequently the sustainability of profits. "Investors are inevitably concerned about products they have little experience with. 'Can this product really be as profitable as it looks?' and 'What are the longer term consequences of investing in this product?' are the principal questions we hear," Reynolds explains.

Naturally the complexity of the market can also have serious implications for a firm's infrastructure. Reynolds cites issues surrounding trading, settlement risk, management oversight, and the ease of tying a new portfolio in with other aspects of the trading infrastructure. And all these issues need to be managed in a fast developing sector. "It's a moving target", she claims.

Reynolds believes that more market data might help to ease investor concerns over the market's complexity. "It's the responsibility of the market to provide more data and greater transparency so that risks can be better assessed and so that cost/benefit analyses can be performed quicker and more often."

The last few years have in fact seen a better flow of data that has attracted the deeper liquidity that the market has benefited from, says Reynolds. "The deeper traded CDX and iTraxx indices have added to liquidity and we'd like to see that matched by managers providing the market with more of their own data, although indications are that the process is improving."

This wider supply of data is in part required to improve the general understanding of market risks, which will be essential should the market experience a downturn, observes Reynolds. "Even if there is a downturn the market will have learnt important lessons from experiences such as the fall-out after downgrades to the likes of General Motors and Ford, and more recently the US sub-prime market, in how to handle risk," she concludes.

JW

Fuhrmann to join Lehman

The latest company and people moves

Fuhrmann to join Lehman
Lehman Brothers is understood to have hired Dorothee Fuhrmann to head up syndication in its European CDO business. Fuhrmann, previously co-head of European CDOs at Morgan Stanley, will report to Sridhar Bearelly, global head of CDO syndication, when she starts in May.

Hershkovitz set for Bear
Ilan Hershkovitz has left Dresdner Kleinwort where he was an LCDS trader. He is expected to join Bear Stearns in a similar role.

Zuberi leaves UBS
Adnan Zuberi, head of American correlation structuring at UBS resigned from the bank last week. His destination is, as yet, unknown.

BlueMountain launches new credit fund
BlueMountain Capital Management this week launched its BlueHorizon II fund with US$88m in assets. The fund, which is closed to new investment, began executing trades on 1 March and has already deployed more than 65% of its capital.

The firm began immediately investing BlueHorizon II into the recent volatility in credit spreads and implied correlation levels, which BlueMountain believes offered excellent entry points for the core long correlation/long credit trade.

BlueHorizon II is the sixth fund managed by BlueMountain, and the fifth focused on structured credit and correlation strategies. Investors include institutional investors, such as US and European pensions, endowments and banks, as well as select family offices.

BlueHorizon II employs a buy and manage investment strategy similar to that of BlueHorizon I, with an identical structure: long "BlueMountain" bespoke synthetic 7- and 10-year CDO equity tranches referencing a portfolio of over 500 predominantly investment grade or high-quality double-B credits; selective single name hedging; 10-year lock-up; and regular monthly cash distributions to investors. In addition, the Fund has a private equity like fee structure, in which BlueMountain earns back-ended performances fees only after exceeding a 5% IRR hurdle.

LaSalle offers European fund services
LaSalle Global Fund Services has launched the European arm of its international fund services operation. The announcement comes just weeks after the decision by LaSalle Bank, a North American subsidiary of ABN AMRO Bank, to further expand its global structured finance services business with the launch of LaSalle Global Fund Services in the US.

Based in Dublin's International Financial Services Centre, LaSalle Global Fund Services provides a range of services to the European alternative investment industry including fund administration, custody and treasury services.

"As the leading global Commercial Mortgage Backed Securities (CMBS) trustee and the second largest global provider of Collateralized Debt Obligation (CDO) trustee services, LaSalle Bank is already a market leader in the structured products and securitization industry. The addition of LaSalle Global Fund Services further extends the bank's comprehensive service offering to alternative investment managers," the firm says.

Codefarm opens US office
Codefarm, the structured credit technology company, has opened offices on Broadway in New York City to provide local support for its rapidly growing North American customer base.

With offices in London and New York, Codefarm now has a presence in the two main global hubs of CDO issuance. "The opening of offices in New York is an important step in our growth," explains Jeremy Mabbitt, md of Codefarm. "Since four of the world's top ten CDO arrangers are based in the US and two of them account for more than one-third of total global CDO issuance, Codefarm's presence in New York is key to our strategic objectives."

Calypso attains partner status
Calypso Technology has received Certified Alliance Partner status under Markit's certification programme, which was launched in January 2007. Calypso is the first provider of trading and trade processing solutions to successfully complete the certification program.

In order to receive certification, Calypso's product management team for credit derivatives had to demonstrate that the completed integration of CDS, CDS indices, Markit RED (Reference Entity Database) and tranche data met the integration standards defined by Markit. The certification means that joint customers of Calypso and Markit can be assured of a high quality of integration, the firms say.

HD & MP

Citi and Fortis bring Botticelli

A round up of this week's structured credit news

Citi and Fortis bring Botticelli
Citi and Fortis Investments have launched a managed equity programme called Botticelli. The programme includes a variety of equity tranche-linked notes, each of which offers different risk/return characteristics, with a projected internal rate of return of up to 21%.

The initial portfolio is composed of 80 equally-weighted credits. The aim behind the product is to defend the carry typically provided by the equity tranche by managing the portfolio against defaults and credit events. Fortis Investments' bottom-up credit-picking investment style and the deep resources behind it – dedicated structured credit portfolio managers, credit analysts and quantitative and risk specialists – aims to allow it to meet that goal.

The seven and 10-year fund-linked transaction is available in either funded or unfunded format. The three core products are principal protected notes (PPN) (Citi-guaranteed), combo notes (with a different mezzanine portfolio) and straight equity-linked notes.

The PPN and combo notes can achieve principal and interest rating (AAA/AA) with a small guaranteed coupon paid. The structure offers modelled internal rate of return of Libor + 16% on a straight equity transaction and Libor + 200-250bp on the PPN/combo structures.

Citi and Fortis Investments will market the transaction in Europe, Asia, the Middle East, the US and elsewhere. The first pricing will be in mid April.

Strong Taiwanese structured credit issuance expected
Fitch Ratings expects Taiwanese CBO issuance backed by structured bonds or principal-only notes to remain strong, with more than NT$110bn in term liabilities or ABCP in the pipeline for 2007. The agency says the majority of this issuance represents bespoke transactions for insurance firms that are flush with liquidity.

"The major local insurance companies have exhausted their capacity for US$ (or the other foreign currency) denominated investments. They are buying the equity tranches of the bespoke structured credit transactions that are backed by NT$ bonds with a remaining maturity of two to five years and 'selected' US$ assets with a maturity greater than five years. This enables them to get 'indirect' exposure to foreign assets whilst holding a NT$ liability."

Additionally, domestic originators view arranging such transactions as a lucrative source of income, particularly given that issuance of corporate bonds and commercial paper is expected to decrease when compared with 2006. Meanwhile, the agency adds that CLO issuance is expected to continue on a steady path in the region, with Fitch anticipating a number of balance sheet CLOs and primary CLOs to come in 2007.

Regarding cross-border CDO issuance, Rachel Hardee, head of Asia Pacific structured credit, Derivative Fitch, says: "In the short term, I do not think that CDOs backed by NT$-denominated assets can be sold to the global market given their relatively tight credit spread and the very tight currency basis swap level. Securitising US$ assets owned by Taiwan institutions may in principle be feasible, but the majority may find it difficult to achieve a suitably diversified US$ portfolio. By way of contrast, fully-hedged US$ assets will look attractive from a yield perspective for Taiwanese investors."

Carador remains resilient
Listed structured credit fund Carador announced its results for February this week. Its NAV has dropped slightly, but the fund has again (see SCI issue 26) successfully avoided the worst of the sub-prime market turmoil.

Carador's monthly report from manager Washington Square Investment Management says: "Carador's significant underweight position in the ABS market in general and the sub-prime market in particular has meant that our NAV performance has been resilient. Carador's NAV decreased by 0.36 cents, or 0.37%, month on month, during February."

The report explains that this reduction in NAV is due to a conservative mark-to-market in the manager's CDOs of ABS positions and expenses for the period. The low impact is due to its minimal exposure to the sub-prime sector.

Washington Square adds: "The current portfolio continues to be overweight senior secured loans, and underweight transactions backed by structured finance securities. This has been a view we have highlighted since our initial monthly report back in May 2006. At the time of launch, we took a view opposed to the consensus on the corporate market, in the belief that senior secured loans offered significant value, particularly given the very low funding rates we could achieve in CDOs backed by these assets. Similarly, we decided to underweight CDOs backed by ABS securities."

FSA lobbied over EEPE
ISDA and LIBA have written a letter to the UK's FSA hoping that the regulator can lend its backing to their views on the correct approach to Effective Expected Positive Exposure (EEPE) within the Capital Requirements Directive (CRD). The associations say that the CRD indicates EEPE must be computed at the level of the netting set.

However, the letter argues that this definition is not consistent with the level at which firms manage credit exposures, which is that of the counterparty itself. "Calculating EEPE at netting set level will therefore require upgrading systems and internal validation practices, at a significant cost, and for no clear purpose other than to abide by a regulation divorced from firms' practice. The change will cause a rift between exposures used for risk management purposes and those calculated for regulatory capital purposes, causing system differences and a dichotomy in user/senior management understanding," it says.

Furthermore, the associations report that their member firms do not believe that computing EEPE at the level of the counterparty would substantially change the size of their total counterparty credit risk capital.

New SIV rated, another issues euro paper
SIV activity continued apace this week, with Axon Financial Funding receiving provisional ratings and Cortland Capital issuing euro-denominated CP and MTNs.

Both Moody's and Fitch have assigned preliminary Prime-1/F1+ and Aaa/AAA ratings to Axon Financial Funding's new European and US CP and MTN programmes, which can issue up to US$20bn in securities. In an usual move, the agencies have also assigned provisional A1/AA- ratings to the SIV's US mezzanine note programme, which sits above its capital notes.

The SIV is sponsored by Axon Financial Services, a wholly owned portfolio company of TPG-Axon Capital Management. According to analysts at Fitch, Axon's key strengths include its very well staffed and experienced management team, strong asset surveillance and liability management team, and large secured capital commitment.

It also has a large and diverse ramped-up portfolio and its investment purchases are restricted to 100% triple-A rated structured finance assets. Maximum deal size for any security is limited to the amount of capital in the structure (or 50% of capital if asset-weighted average life is greater than five years).

Meanwhile, Moody's has assigned definitive P-1 and Aaa ratings to the euro CP and MTN programmes of Cortland Capital, up to a US$20bn limit. The vehicle currently issues US CP and MTNs under P-1/Aaa rated programmes that closed on 17 October 2006 (as well as unrated capital notes). The ECP and EMTN programmes will share exactly the same risks and interests in Cortland's assets as the US programmes.

The management of Cortland has been delegated to Natixis Securities North America, which has in turn delegated certain administrative functions to QSR Management – a wholly owned subsidiary of The Bank of New York.

Cortland differs from several other SIVs in that it has a reversible restricted funding state instead of the irreversible defeasance state found in many other vehicles.

Fitch Launches SME CDO VECTOR model
Fitch has published a new rating methodology for European SME CDO transactions and simultaneously launched its new rating tool, Fitch Default VECTOR SME Model.

The Fitch Default Vector SME model (VECTOR SME) will be the primary quantitative tool in the agency's analysis for European SME CDO transactions and is based on the same theoretical framework as VECTOR 3.0. It is a multi-risk factor model that takes as input default probabilities or ratings, recovery rate assumptions and correlations to produce default and loss distributions using a Monte Carlo simulation.

The criteria report, European SME CDO Rating Criteria, outlines the theoretical framework behind VECTOR SME, explains the generation of necessary input assumptions into the model, and gives guidance on how to read and interpret the model's output. It also briefly introduces various transaction types securitised in European SME CDO structures, explains the qualitative analysis carried out at the originator and servicer level, and describes Fitch's cashflow modelling assumptions.

Rating agencies tackle sub-prime concerns
Reports released in the past week from both Moody's and Fitch look at the effects of sub-prime stress on two structured credit sectors. Moody's suggests that the impact of sub-prime RMBS is manageable for many structured finance CDOs, while Fitch says ABX-HE referenced sub-prime loans may see continued stress.

The effects of potential performance deterioration of sub-prime RMBS should be mild to moderate for the average SF CDO, says Moody's Investors Service in a new report. But the agency also notes that the average deal is beginning to show significant credit deterioration, especially for the lower investment grade tranches, in cases where the sub-prime market exhibits severe underperformance.

The 2003 to 2006 vintages of SF CDOs have exposures to sub-prime RMBS averaging around 45% of total collateral (by par), ranging from almost zero to nearly 90%, says Moody's. Well-diversified SF CDOs hold a range of assets from other sectors, including prime RMBS, CMBS and securities backed by auto loans and credit cards.

The structural protections in some SF CDOs – including calculating the par coverage ratio with ratings-based haircuts and treating securities on watch for upgrade or downgrade as if they have already been upgraded or downgraded – will mitigate some of the portfolio deterioration that may occur in the sub-prime RMBS sector.

Rising delinquencies and resultant price declines have been felt most acutely in the ABX-HE 06-2 and ABX-HE 07-1 CDS indices due to their heightened exposure to a slower home price appreciation (HPA) environment and riskier low documentation loans to sub-prime borrowers with piggyback second loans, according to Fitch Ratings. And, according to a new report by the rating agency, continued problems in the sector are likely.

Sub-prime loans underlying the indices could face more stress in the future since most of the underlying transactions contain hybrid adjustable rate mortgages that have not yet experienced a rate adjustment, says Fitch. It is too early in the life of the underlying RMBS transactions to determine exactly which bonds may underperform, and to what degree.

However, the agency believes that 2006 sub-prime vintage delinquencies and losses could continue their relatively high trajectory, increasing downgrade risk for the lowest-rated investment grade bonds backing the index. Fitch notes that there are important risk mitigants, such as low unemployment and relatively solid economic growth that may help contain the loss rates. Any decline in short-term interest rates could also have a positive impact.

MP

The sell-off, CDS, and the credit cycle

Tim Backshall, chief credit derivatives strategist at Credit Derivatives Research, discusses the four constant themes that have enabled the continued rally in credit and evolved the credit cycle to its current critical balance point

There are four major themes that have enabled funding costs (the cost of corporate borrowing) to fall so aggressively over the last few years – corporate fundamentals, derivatisation, globalisation, and regulation. One-by-one these are starting to show signs of negative sentiment and the cornerstone of it all will be the credit derivative market and its higher volatility, transparency and efficiency.

We expect credit to be much more pro-cyclical than many believe and CDS to exaggerate any weakness but still provide many opportunities. The two-step unwind that we envision (see Exhibit 1) will be driven by these four factors, and their inevitable conclusions.

Exhibit 1

Corporate fundamentals have been on a charge over the last few years – profitability at highs, cash at highs, leverage at lows BUT recently as management has started to turn more shareholder-friendly so cash is being burned on buybacks and dividends. Capex is also up and this expansionary phase is definitely more credit negative than positive as leverage ticks up modestly, FCF falls, and cash piles drop.

Derivatisation of the credit market has enabled not only a flood of new entrants to join the market but also, thanks to lower marginal costs of transacting, has enabled spreads for any given level of credit risk to be significantly lower. The transparency and efficiency of the CDS market allows investors to trade in any part of the curve (even without bonds) very quickly and at low cost.

While this has indeed helped drive spreads lower and lower (helped by the CDO/CPDO technical bid), it may also in our view exaggerate any credit concerns in a systemic manner – recent examples among the major financials such as Morgan Stanley and JPM show idiosyncratically how quickly spreads can jump as well as CSX and HD on LBO rumours. As this concern moves from idiosyncratic to systemic, CDS are likely to widen much more than bonds due, in part, to the ease of shorting.

Globalisation has meant that we have all become comfortable with the idea of a deflationary boom going on for years. The combination of technology and a global economy is conjectured to result in a large upward revaluation of all risky assets against the backdrop of a more profitable, less capital-intensive and less volatile world.

While we are not economists, recent upticks in inflation and concerns on corporate growth trajectories may raise more than one eyebrow with regard to this and certainly the increase in corporate bond issuance is a signal that companies are willing to take on more risk which inevitably must encourage the credit cycle to re-appear.

Regulatory changes are generally seen as bad for markets but in the case of Basel II, regulatory changes enabled banks to more optimally and more profitably build huge loan/credit portfolios. Basel II's main tenet is the more granular analysis of regulatory capital requirements for lending/credit – that in many cases was the under-pinning of regulatory arbitrage among the CDO/CLO community. The net effect was a drop in capital charges in most cases and combined with the ability (thanks to CDS) to hedge these risks, banks were able to make loans cheaper (lower cost of funding for corporates) and remain profitable.

The other side of the Basel II coin is the fact that the capital charges are reflective of a default risk measure that is tied to equity markets – if equity markets falter, then implied default risk will rise, leading to higher capital charges and banks will reduce their lending volumes. This is the classic 'pro-cyclical' effect that has been discussed many times with regard to Basel II.

Pro-cyclicality and the credit downturn
This pro-cyclical effect is what worries us the most in the current market. As we sit in an expansionary phase (see Exhibit 1) – on the verge of a downturn in the credit cycle perhaps – it is the ease of shorting in CDS, high degree of leverage, and amount of 'fast money' that means that any weakness is reacted to very quickly and in our view will inevitably lead to a more pro-cyclical credit cycle than many believe.

The naive view that CDS will help dampen volatility due to their efficiency is flawed – one only has to look at the ABX market for an example of more money chasing a falling market to see the effect of leverage and one-way trading in an OTC market. If we see more volatility spikes this year (as we have done in the past few weeks and expect to in the future) then the likely result will be more of an exaggerated sell-off as investors rush for the exits and use the CDS market to bet/hedge rather than the expected gradual decompression.

With the NAHB index falling and continued sub-prime weakness, lending standards are starting to tighten and homebuilders are largely weaker in credit – significantly more credit risky than a few weeks ago. As the already high degree of correlation between equity, volatility, and credit markets picks up, we are likely to see any sell-off in one market immediately impact the others and although we expect equity to outperform credit in the short-term (Step 1 of Exhibit 1), we see both ending up cyclically weaker as the downturn (Step 2 of Exhibit 1) evolves from a harder than expected landing... helped in no small part by the massive growth of the CDS market's tail wagging the entire business cycle's dog.

Outrights ordeal
While we remain systemically bearish, we still see great opportunities for outperformance this year in both micro- and macro-trades. Recent volatility is in line with our previous forecast but we still expect a more gradual spread decompression for the rest of 2007.

We feel that only HY will offer enough to cover roll-down and carry costs for any outright position. We prefer the HY steepener, and note that IG curves have steepened (as investors shorten up duration) but for only a modest cost (2-3bp) offer DV01-neutral, positive roll-down bearish trades that, in our view, will significantly outperform any outrights – wait to enter CDX8 steepeners as dealers front-run the CPDO flow.

Idiosyncratic exposure is where we feel the greatest (relative value) opportunities lie and combining curve trades and basis trades seems to offer the best breakevens at the moment and positive convexity.

For other credit market strategy articles such as this, 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).