Contents

CDR Liquid Index data as at 16 April 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.

Latest European CRE CDO readied

Investec managed deal brings a collateral twist

Preliminary marketing began on Monday for the €300m CREA CRE CDO, which is to be managed by Investec and lead-managed by Bear Stearns and Wachovia. The deal is expected to close in Q2 this year.

Details of the long-awaited deal (see SCI passim) were scant as the manager and leads remained tight-lipped at this early stage of the marketing process. Equally, none of the European CRE CDO investors contacted had yet had a chance to study in depth the transaction details they reported receiving.

It is understood, however, that the deal will involve a mix of underlying assets – CMBS, B notes, REIT debt and whole loans. In the latter case, CREA is believed to include a separate revolving trust for residential mortgage whole loan portfolios. This is intended to add diversity and spread to the deal's collateral, and will also help the manager when asset sourcing in the European market which is still short of CRE supply.

However, the practice of offering such a mix of collateral at this early stage of European CRE CDO evolution has caused concern among some market participants. "The CMBS, RMBS and CDO markets are very different; so a CRE CDO manager looking after such divergent assets will need to demonstrate the ability to manage the whole mix," says one observer.

From one perspective at least, Investec appears to be suitable in this regard. Although it has not yet been confirmed which rating agencies will be involved with CREA, last Friday Derivative Fitch assigned Investec Principal Finance (IPF) a CAM2- CDO Asset Manager rating for European CRE CDOs.

Fitch says the rating is primarily based on the staffing quality of the newly created CDO management platform within IPF and its integration with Investec Bank (UK) Ltd (rated BBB+/F2). The institutional backing provided by IBUK ranges from robust support and control resources to strong credit procedures and established market relationships.

Fitch adds that IPF also benefits from IBUK's experience and capacity in the European real-estate market, principally acquired through its structured property finance division. The rating takes into account IPF's strong commitment to the CDO business, as demonstrated by the depth of dedicated resources, significant co-investment and strong pipeline.

CREA will be the third – by most investors' count – European CRE CDO to be issued following Anthracite Europe (see SCI issue 13) and Glastonbury (see SCI issue 30), although some also include Taberna Europe, which was a REIT only deal (see SCI issue 19). Prior to the launch of Anthracite Europe, a number of observers predicted that as many as 20 European CRE CDOs would be launched in 2007.

Estimates have now been slashed to seven. It is not yet certain who will bring the others – rumours persist that Prudential M&G's offering is nearing launch, but no details are known. Other names in the frame include LNR Partners, Fortress Investment Group and Wharton Asset Management.

For more on European CRE CDOs, see this week's Provider Profile.

MP

Innovative Azur launched

DPPN deal offers investors range of currencies including CZK and HUF

AXA Investment Managers and BNP Paribas have begun marketing Azur notes to be issued by SPV Aquarius + Investments Plc. The deal, which is expected to close next month involves an actively managed multiple currency and multiple underlying-instrument CPPI-type structure.

The transaction utilises a DPPN (dynamic proportion portfolio notes) technique on a portfolio of cash and synthetic credits, managed by AXA Investment Managers Paris. The notes offer investors full principal protection at maturity at a pre-defined 'principal protectected percentage', underwritten by BNP Paribas, and provide returns based on the performance of the managed portfolio.

The deal involves the issuance of a series of Class C and D notes of 7 and 10 year maturities denominated in a range of currencies, including Czech koruna Hungarian forint and Norwegian krone, as well as euros, US dollars and Swiss francs. The principal of all the notes is rated triple-A by Moody's.

The structure involves Aquarius + Investments plc issuing the notes and concurrently entering with BNP Paribas as counterparty into a performance swap in respect of each of the notes; a long-term repo transaction in respect of each of the notes; and cross-currency swap for the non-euro notes

On the issue date, under the performance swap, the issuer pays to the counterparty an amount equal to the issue proceeds of the related notes, less the amount paid through the currency swap. The various payments under the performance swap are thereafter linked to the market performance of a reference portfolio, mainly consisting of long and/or short positions on single name CDS, ABS, leveraged loans or on credit indices, interest rate swaps and futures and bonds (long positions only).

According to specific types of events, the manager will be obliged either to rebalance the reference portfolio or to partially unwind it. AXA will need to rebalance the portfolio if, among other events, there is a breach of the concentration limits; a default has occurred in the reference portfolio or one entity has seen its credit spread exceeding a specified level; or the sensitivity to interest rates of the reference portfolio is in excess of specified limits.

While the usual CPPI technique provides a constant and rules-based leverage, the leverage of the Azur notes is dynamically managed by AXA. Additionally, CPPIs are traditionally structured with exposure to an existing fund, whereas the reference to the portfolio in Azur operates like a synthetic fund managed by AXA.

The DPPN technique is essentially a daily asset and liability management exercise, whereby the assets of the issuer consist of a performance swap and a repurchase transaction. The liabilities of the issuer are the principal protection of the notes at maturity and the reserve (the difference between the asset value and the principal protection value).

The reserve – which constitutes the maximum claim from BNP Paribas to the issuer against losses in the portfolio – is used by AXA to gain a leveraged exposure to a portfolio of credits.

The principles of the technique ensure there is always sufficient cash in the transaction to purchase a zero-coupon at any time, whatever the performance of the credit portfolio. The zero-coupon allows BNP Paribas to pay the principal protection at maturity to noteholders. Such cash will be generated by the unwind of the assets of the issuer (the repurchase agreement and the performance swap) and will be used to match its liabilities: the principal protection at maturity and the distribution of the reserve to noteholders.

MP

Sub-prime impacts spread

US CLOs and CDOs of ABS feel the pain, but it may not be lasting or significant

Sub-prime contagion worries continued last week with spreads in the CLO markets widening. At the same time, concerns remain about the impact on CDOs of ABS. Both factors could be overstated, however.

There has been some spillage from the US sub-prime market turmoil into the US CLO market in the past month, according to Ashish Keyal a structured credit strategist at Lehman Brothers. "US mezzanine liability spreads have softened in the synthetic CLO market with initial knock-on effects on the primary cash market. There has also been a pick-up in secondary trading in the synthetic CLO market with increased BWICS and OWICS," he says.

Lower rated tranches in the secondary market have been most affected on the back of talk of selling pressure from ABS managers trying to offset sub-prime losses. Similarly, double-B and triple-B prices on new issues in the past week have been much wider than the exceptionally tight levels of recent months.

Nevertheless concerns that the impact of the sub-prime turmoil will spread into European CLOs seems overplayed so far, says Keyal. "Because the initial widening in the US has not been significant as yet, there has not yet been any substantial knock-on effect in Europe. If the widening in the US were to pick up pace, we could see investors turning away from the European market towards the US CLO market, which would bring the two spreads closer again. Although we do not expect widening to be sustained in US liability spreads, the robust European CLO pipeline for the summer would be an interesting test of the market's risk appetite," he observes.

Risk appetite is also being tested across the board in the CDO of ABS sector. Sub-prime paper is now held by a variety of market participants, according to Domenico Picone, head of structured credit research at Dresdner Kleinwort. "Currently, dealers – their warehouses are full of weaker collateral – and CDO managers hold the first place," he says.

However, Picone adds: "Conduits, which are likely to have purchased a significant amount of triple-A liabilities, are also now sitting on large mark-to-market losses. As are hedge funds and other CDO equity investors, who should have lost most of the market value in their equity holdings by now. However, cash CDO of ABS are not market value deals; therefore, market price volatility should not be an immediate concern unless either the investor wants to sell the notes, or has to sell them because of downgrades."

Furthermore, he says: "The assumption that all CDOs of ABS have the same exposure to the 2006 HEL vintage is incorrect. Based on data provided by Fitch, we know that the CDOs of ABS – which originated in 2006 – have 25% of their collateral invested in 2006 HEL tranches, while older CDOs have less than 5% invested in 2006 HELs. However, CDOs of ABS are dynamic vehicles, with a high turnover in their collateral, and therefore they may be investing more in 2006 HEL in the coming years."

Even though 2006 HELs experienced the same large cumulative lifetime losses as those of 1999 and 2000, Picone does not believe the losses will be large enough to cause principal losses for triple-B rated notes of CDOs. "There is of course the possibility that the 2006 HEL vintage reaches a double digit loss rate – which is required to cause losses for triple-B CDOs of ABS – and this will depend on a slump in the US housing market, which may trigger further losses in other real estate paper familiar to CDO managers, such as Alt-A, jumbo loans and commercial real estate loans," he adds.

MP

Structured credit hedge funds double

New index indicates significant growth in the sector

A new index tracking the performance of hedge funds that invest in structured credit has become publicly available from today, 18 April. The Palomar SC HF Index is compiled and run by Palomar Capital Advisors and published exclusively by Structured Credit Investor.

The number of hedge funds investing in structured credit and eligible for inclusion in the Index has leapt from 18 to 37 since the index's calculation start date of 31 December 2004 to the end of February 2007. The assets under management included in the index have all but doubled from US$5.8bn to US$10.8bn.

At the same time, the Index shows a cumulative gross return of 18% - equivalent to an annualised return of 8.21%. For more Index data click here.

The objective of the Palomar SC HF Index is to produce an index that represents the risk and return of investable hedge fund investments in the structured credit area. The index aims to provide a monthly measure of the performance of the universe of open, investable structured credit hedge funds. The Palomar SC HF Index is calculated in two formats - as gross asset value and as net asset value.

The Palomar SC Gross Asset Value Index (GAVI) is calculated using the (net) returns from the underlying funds (as reported by them) constituting the index before any costs related to the holding of the underlying funds. The purpose of the Palomar SC GAVI is to provide a benchmark for single manager hedge funds in the structured credit area.

The Palomar SC Net Asset Value Index (NAVI) is based on the Palomar SC GAVI, but is adjusted for the full running costs related to a fund of fund structure. These costs include the costs of a typical fund of funds such as brokerage expenses, management and performance fees, and administration and custody fees. The purpose of the Palomar SC NAVI is to provide a benchmark for multi-manager hedge funds (fund of funds) in the structured credit area.

Palomar Capital Advisors is a financial advisory firm specialising in structuring, managing and placing alternative investment products, specifically credit-related securities. It is an independent firm based in Zurich, Switzerland, owned and controlled by its investment professionals.

MP

Broken Fixings?

Tradable tranche fixings disappoint so far

The development of credit fixings is widely touted as a watershed event in the development of the structured credit market. Banks and intermediaries have progressed from index to tranche fixings, but there is debate from the buy-side on whether they are providing the hoped for greater transparency, investor confidence and improved efficiency.

The first electronic tradable tranche fixing took place on 31 January between sixteen dealers under the aegis of Creditex and Markit Group. Meanwhile, GFI has been conducting tradable tranche fixings for the interdealer market since October last year and on 30 March, the firm combined with ICAP to launch the first multi-broker fixing.

Both initiatives aim to improve liquidity and generate more accurate pricing of the mark to market on the iTraxx tranche series. To this extent, they should benefit buy-side players.

Indeed, investors have always been very supportive of some sort of fixing mechanism for the market as it allows them to more effectively mark to market their funds and the tradability aspect ensures that fixing levels are an accurate measure of market liquidity. Furthermore, tranche fixings could facilitate second generation tranche products.

"This might be a good opportunity to expand the range of activities within the tranche derivatives market, such as options, and improve visibility where we need it most, in the off-the-run market where there is limited daily trading," says Gennaro Pucci, portfolio manager at Credaris in London.

However, to date investors complain of limited activity and not too much interest in providing tranche fixings to the broader market. This may be due to the fact that dealers will potentially have to provide tradable two-way prices for every series of the iTraxx and CDX indices across all maturities and sectors.

Pucci adds that given the volatility this market can experience, the upside for banks is limited as the risk is high compared to potential benefits. "The general opinion in the market seems that banks are against doing this," he says.

There are also concerns over the validity of fixings services when they have no official legal foundation, unlike say the British Bankers Association Libor fixing in the interest rate swap market.

In addition, there can be discrepancies when brokers post prices on a delta-adjusted basis. This means the price of the tranche is based on the price of the underlying portfolios, but the price at which the delta is exchanged does not always equate to the price where the underlying index is trading in the credit market.

"An option investor with no delta exposure is only interested in parts of the tranche not corresponding to the actual market price of the underlying indices. This means that the price you receive in the fixing is useless if this is based on delta and spreads that are not market levels," Pucci says.

Pucci feels that Markit is well placed to provide a valuable service as the firm readjusts the price of tranche to assume the delta. "It is very precise and you can easily spot the differences between tradable delta and market delta," he says.

HD

"Access to collateral is crucial"

In this week's Provider Profile we talk to the legal partnership Cadwalader Wickersham & Taft about European CRE CDOs

Angus Duncan

Cadwalader, Wickersham & Taft (CWT) has extensive experience of the securitisation and derivatives markets in both North America and Europe. The firm's work is as wide ranging as would be expected of a large legal partnership, but it is particularly strong in ABS.

The firm advises on large numbers of CMBS and CDO products and its clients include arranging banks, collateral managers and monolines. CWT sees its understanding of these instruments as a key competitive advantage particularly in the much newer European market.

In the absence of tried and tested European market technology the firm is benefiting from its long term experience of the US real estate markets by adapting its US technology to European deals. Consequently CWT was well-placed to advise on Anthracite the first European CRE CDO (see SCI issue 13) where the firm worked closely with the deal's manager Blackrock.

Angus Duncan, a partner in CWT's London office, is keen for his firm to leverage from the experience of working on the early CRE CDO transactions in Europe and sees a strong long term future for the market. "There are a lot of US investors coming to Europe who will expect to finance their businesses through CRE CDOs. As CMBS in Europe grows, so will the CRE CDO business here," he says.

Neil Weidner, a CWT Partner also with significant experience in both the US and European CRE CDO markets, also recognises growing interest from investors in CDO products. "There is definite appetite from traditional CMBS and RMBS investors in the CRE CDO market in the US and it's the same in Europe; this investor demand comes from both institutional and hedge fund money," he says.

Furthermore, Duncan points to demand for yield being so high generally that it's not just investors with knowledge of the CRE sector that are willing to invest in the asset class but also CDO market investors. "There is so much demand for leveraged loans it's spilling over into other product areas. If you're invested in a manager's CLOs it's not stretching things to see you investing in their CRE CDOs too," he says.

Neil Weidner

However, even with such healthy investor interest structural anomalies in the European market mean that barriers to immediate strong growth exist. Duncan explains: "The underlying collateral if far less uniform in Europe; it's at a less developed stage. Depending on which bank structures the CRE loan, the 'B' note will be structured differently so the issuers and its legal advisors need to investigate the asset more closely than they would in other CDO asset classes."

Equally, the CRE CDO manager's experience is vital, according to Duncan. "Access to collateral is crucial as it's an average of 18 months prepayment on B notes; you need to be able to source collateral for a 5-7 year re-investment period. This is a complex process and only a handful of managers can do this," he says.

Overall, Weidner says: "People are looking for more uniformity on underlying documentation in Europe to drive standardisation and hence liquidity so that the market becomes more CRE CDO friendly. Pressure will come to bear from investors to make the products and their underlyings become more uniform; the rating agencies need to be on side in this respect as well."

Nevertheless, Duncan identifies that diversity in the asset class is already being seen and CWT expects seven or eight European CRE CDO deals coming to market this year. Helped in part by documentation becoming public after each successive deal, which CWT recognises will be used by other firms to build new transactions. Ultimately, this process will serve to benefit the European CRE CDO market as a whole.

JW

DB three set up in private equity

The latest company and people moves

DB three set up in private equity
Three members of Deutsche Bank's structured credit group have left to set up a private equity firm. These include Bertrand des Pallieres, co-head of structured credit, Malik Chaabouni, managing director and Moez Ben-Zid, a member of the structured credit group.

AXA lose two CDO fund managers
AXA Investment Management has lost Stephane Lapiquonne and Virginie Afota, both Paris-based senior portfolio managers. They are currently on gardening leave and understood to be planning to set up their own firm.

Jenkins joins Synapse
Gary Jenkins has joined Synapse Investment Management as a partner and portfolio manager in the firm's Credit Strategy team. Jenkins was previously an md and head of fundamental credit strategy at Deutsche Bank. Prior to that, he was head of credit research at Barclays Capital.

SWIP appoints head of bond product
Scottish Widows Investment Partnership has appointed Gareth Quantrill as head of bond product, a newly created role, within its global bonds and economics team. He will be responsible for implementing the asset allocation of SWIP's high alpha aggregate bond mandates and will be the senior client-facing contact for the bond team in the UK Institutional market.

Quantrill brings over 16 years of fixed income investment experience to the role, joining SWIP from Henderson Global Investors where he was head of credit. He will report directly to Rod Davidson, SWIP's global head of fixed income.

Davidson comments: "Gareth is a highly regarded investor and his knowledge and experience of the areas in which we have been growing will help accelerate our plans. Our fixed income business is expanding rapidly, especially into areas such as Liability Driven Investment, Structured Credit and Absolute Return."

Baccouche joins DB
Deutsche Bank has hired Afif Baccouche from Bank of America, where he was head of credit correlation risk management. He joins as senior correlation trader in the bank's credit trading group in London.

Bristow joins Merrill
It is undersood that Matt Bristow, senior correlation trader, is to join Merrill Lynch from Barclays Capital in a similar role.

Calyon beefs up CDOs
Benjamin Jacquard, who left his position as head of the correlation trading team at Bank of America, is now global head of cash and synthetic CDOs at Calyon. The French bank is also understood to have also hired Arnaud Mounier from AXA Investment Management. Mounier joins as a structurer focusing on cash CDO structuring, marketing and origination in the credit markets and CDOs team at Calyon in Hong Kong.

HD & MP

New Japanese credit fund launched

A round up of this week's structured credit news

New Japanese credit fund launched
Mitsubishi UFJ Trust & Banking Corp and The Master Trust Bank of Japan are in the market with a new Y50bn loan programme. Dubbed Credit Star Investment, the fund is backed by a variety of credit products, including Japanese corporate bonds and structured finance instruments.

Moody's Investor Service has assigned a triple-A rating to the programme, which addresses the expected loss posed to loan borrowers by the final maturity (40 years after the start of the early redemption). The structure allows for timely payment of interest and ultimate payment of principal with respect to the loans.

The fund – which was entrusted on January 15 2007 – benefits from initial subordination of Y20.1bn and pays an undisclosed floating coupon. The borrower on behalf of the trust (as well as acting as trustee) is The Master Trust Bank of Japan.

Fitch and DBRS criticise first generation CPDOs
In a new report on the rating of CPDOs Derivative Fitch has criticised the high level of ratings offered by its rivals on first generation products, but concedes second generation products improve on their predecessors. Meanwhile, DBRS has released research on the model risk in them.

Fitch says that it has been asked to rate numerous first generation CPDOs – defined as those utilising15x initial leverage and referencing on the run investment grade CDS indices for 10 years. The key performance parameters for these traditional CPDOs are spread volatility, roll-down benefit (RDB), bid/offer levels and, to a lesser degree, default risk. In the context of its rating analysis, Fitch has carried out intensive research into these parameters that can influence the performance and hence the achievable rating of CPDOs.

The agency's key findings are as follows:

• First generation CPDO transactions' performance and ratings are sensitive to even a minor amendment of the key performance parameters.
• The sensitivity of a CPDO rating towards change in assumptions increases with higher rating levels and easily leads to rating changes of several categories.
• The leverage employed contributes to the sensitivity to key performance parameters and potential ratings instability.
• Comparison to corporate CDOs showed that they are more robustly structured against worst case scenarios than CPDOs at a comparable rating level.
• Changes to the credit markets, new market participants and the rapid growth of the CDS market may lead to greater spread volatility than experienced historically.
• Scenario analysis through historical back testing showed that many of the more common CPDO structures would probably not have been able to withstand high investment grade stresses.
• As opposed to the 10-year tenor of a CPDO, data on the key performance parameters is only available for a little more than four years.
• For these reasons, first generation CPDOs do not achieve high ('AA'/'AAA') investment grade ratings.

DBRS' research demonstrates the extent to which CPDO performance is highly sensitive to the choice of model and modelling parameters, with a corresponding impact on ratings. DBRS' extensive tests show that credit spread parameters, particularly volatility, term structure and bid-offer spreads, have a significant impact on key risk measures, including probability of default (PD) and loss given-default (LGD). As a result, small changes to assumptions can, in some cases, cause the model-implied rating to vary from triple-A to triple-B.

Kai Gilkes, md, structured finance quantitative group at DBRS, comments: "Given the high sensitivity of CPDOs to modelling assumptions, taking a meaningful view of their investment risk cannot be done without also assessing future liquidity in credit markets. We have tested both optimistic and more conservative assumptions and found that, for example, under a bid-offer spread of 0.25bp, a typical model-implied rating might be as high as AA. But this falls to BBB under a 1bp assumption and even BB under a conservative assumption of 2bp."

Additionally, a detailed back-testing exercise by DBRS reveals that, due to very high path dependence, the performance of CPDOs is very sensitive to timing of issuance and evolution of credit spreads. Over the last credit cycle, this would have led to high levels of volatility in net asset value and model-implied ratings.

Fitch adds that it is currently reviewing several proposals for next, or second, generation CPDOs that seek to address the shortcomings of the first generation. These second generation CPDOs mitigate the risks of their earlier cousins through some combination of: removal of credits from the portfolio if the ratings drop below some (higher) pre-established threshold; limitation of leverage maximum; introduction of a retained asset manager to manage the reference portfolio credits; and mitigation of reliance on achieving an RDB and executing transactions at approximately current bid/offer spreads.

Merrill brings third Asian retail credit product
Merrill Lynch this week launched Jubilee Series 3 – LinkEarner Notes onto the Singapore retail investment market. The notes are credit-linked to five subordinated or senior unsecured obligations of reference entities comprising Lehman Brothers, Macquarie Bank, Morgan Stanley, Overseas-Chinese Banking Corporation and United Overseas Bank.

Jubilee Series 3 - LinkEarner Notes are denominated in both US dollars (USD Notes) and Singapore dollars (SGD Notes). Proceeds from the issuance will be used to purchase synthetic CDOs that are at least double-A rated by S&P or Fitch on or about 25 May 2007.

The interest coupon for the first two years of the transaction will be 5.25% (for the SG$ notes) or 7.00% (US$ notes) per annum based on the note principal amount, providing no credit events occur among any of the five banks and there is no principal loss in respect of the securities. The notes are callable by the issuer after two years, failing which the coupon is stepped up to 6.25% (SG$ note) or 8.00% (US$ note) per annum.

Both notes are scheduled to mature in approximately seven years time, in June 2014. The denominations of the two respective currency offerings are S$5,000 and US$5,000, with minimum investment amounts of S$20,000 and US$10,000.

Credit events include bankruptcy, failure to pay and certain restructuring activities in relation to any reference entity.

The notes will be distributed by CIMB-GK Securities Pte Ltd, DMG & Partners Securities Pte Ltd, Kim Eng Securities Pte Ltd, OCBC Securities Pte Ltd, Phillip Securities Pte Ltd and UOB Kay Hian Pte Ltd.

Limited CDO rating impact from sub-prime RMBS stress
Fitch ratings says that the hypothetical rating impact of simulated deterioration in the credit quality of US sub-prime RMBS on synthetic CDOs is likely to be limited to a downgrade of a maximum of three notches for a small universe of synthetic CDOs. This conclusion follows a scenario analysis undertaken by the agency.

Fitch has run its Default Vector model assuming a three-notch downgrade on each of the US sub-prime RMBS within each CDO portfolio. In this stress, the agency would expect to downgrade approximately 27% of the 72 CDOs exposed to sub-prime RMBS between one and three notches in most cases. A small number of exposed CDOs would have hypothetically experienced a more severe downgrade by up to seven notches; however, this event is highly unlikely due to the heavy concentrations of very high quality ratings of the underlying exposures in these transactions.

The agency observed 203 tranches from 72 synthetic CDOs with exposure to US sub-prime RMBS, equivalent to approximately 9% of the universe of Fitch-rated synthetic CDOs rated out of the US and London. Only one Asian transaction had exposure to sub-prime RMBS, which was limited, and all of the referenced assets are highly rated.

On the 72 exposed synthetic CDOs, the average concentration of sub-prime exposure is 37%, varying between 1% to complete exposure, with a third of transactions having less than 10% exposure. US CDOs average 55% exposure compared to 27% in European synthetic CDOs.

In the affected US CDOs, the exposure varies widely between 9% and 100%, with over half of transactions having greater than 50% exposure. Exposure in European CDOs varies between 1% to complete exposure, with a third of transactions having less than 10% exposure. Managed synthetic CDOs make up the majority of transactions at 72%, while 28% are static synthetic CDOs.

Fitch has identified that the total exposure to US sub-prime RMBS within European CDOs is approximately US$27.5bn, ranging between US$15m and US$1.69bn for individual transactions with the average exposure around US$610m. Within US CDOs, the total exposure is US$10.3bn, with a range of US$20.9m to US$1.2bn and an average of US$396m.

The agency says it will continue to monitor the performance of these CDOs closely and take rating actions when necessary.

Structured finance impairments low in 2006
The credit performance of structured finance securities in 2006 was about what it was in 2005 and remained stronger than historic norms, says Moody's Investors Service in its fifth annual report on the impairment and loss rates for global structured finance securities. Among all the securitisation types covered in the report, CDOs fared the best.

Indeed, global CDOs saw another banner year in 2006, with just 12 newly impaired tranches, compared to 15 in the prior year. The sector's trailing 12-month impairment rate continued to fall from 1.15% in the cohort ending December 2004, to 0.35% and 0.29% for similar cohorts in 2005 and 2006.

CDO tranches in two of the most popular deal types, high-yield CLOs and structured finance CDOs, exhibited solid performance in 2006. HY CLOs remained the best performing major CDO deal type and SF CDOs – after experiencing performance problems in 2004 and 2005 on securities issued in 2000 and 2001 – showed much improved performance in 2006.

If the credit performance of the HEL sector continues to weaken over time, however, some SF CDOs backed by these assets may see a decline in credit quality, says Moody's.

Impaired securities across all securitisation product types on average lost 53% of their original principal. Moody's also finds that the final loss-given-default (LGD) has averaged 53% as a share of the original principal balance for the 425 impaired securities that have resolved (i.e. with no remaining principal balance) as of year-end 2006.

When weighted by dollar volume at issuance, the average credit loss rate across all structured finance has been very low – which Moody's says is unsurprising, given that almost 85% (by dollar volume) of all securities have been rated Aaa at issuance and have demonstrated superb performance.

Fitch launches CCO criteria
Derivative Fitch has published a final version of its criteria for collateralised commodities obligations (CCO), which aims to increase transparency in the market and the understanding of CCO ratings. As part of the release, Fitch has launched a public Vector CCO model to replace the Beta model released in January. The criteria and the model allow market participants to closely replicate Fitch's analysis for CCO transactions.

The criteria report, 'Rating Criteria for Commodities-Linked Credit Obligations', details the methodology behind Vector CCO, which is the main analytical tool for the quantitative analysis of the reference portfolio. It also covers Fitch's analysis of the other risks in a CCO, including structural risks, charged asset risk and counterparty risks, as well as different types of CCO, such as managed CCOs and hybrid CDOs of commodity and credit risk.

"We designed the model to replicate five key risks that we saw in historical data," says Lars Jebjerg, senior director at Derivative Fitch in London. "These are a high frequency of extreme price movements, an occurrence of sudden and large price movements, a tendency for periods of high volatility to follow periods of low volatility, high levels of correlation among similar types of commodities and different levels of volatility across different commodities."

Fitch's quantitative analysis is based on its Monte Carlo simulation of the CCO structure.

Point Nine integrates prime brokers and administrators
Point Nine Financial Technologies this week achieved the full integration of its online financial system with prime brokers and fund administrators for credit derivatives. New credit derivatives trades, corrections to existing trades and novation events are now captured in the firm's offering – FinanceBelt – through its web interface.

Appropriate reports are generated and sent to prime brokers, DTCC and fund administrators. Detailed cashflow reports tracking fee payments, upfront fees, termination/assignment fees, dividends and coupons are also generated for reconciliation with the various third parties and counterparties that firms deal with in connection with credit derivatives trading.

"We have always ensured FinanceBelt can capture all the information an institution could ever need and can output it in exactly the format required by outside parties. The easy integration with prime brokers, DTCC and fund administrators is another example of the advantage offered to our clients by this universal approach," comments Len Fricker, business development director of Point Nine.

MP

Trading ideas - the bitterest pill

Dave Klein, research analyst at Credit Derivatives Research, looks at a positive carry short on Merck & Co

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

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

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

In this trade, we express our deteriorating outlook for Merck & Co (MRK) in a positive-carry short position. Given MRK's bond levels and curve steepness, this is the best trade available and possesses reasonable economics.

Go short
We have scored MRK using our Multi-Factor Credit Indicator (MFCI) along multiple factors. All factors (spread/rating; spread/probability of default; spread/leverage; Gimme Credit fundamental outlook; and LBO-viability) indicate that MRK is trading low in spread terms and it is reasonable to expect the credit to sell-off.

Exhibit 1 charts MRK's CDS performance over the past two years. MRK has rallied significantly since the fall of 2005 and now sits near its historical lows.

Exhibit 1

Given our negative view for MRK, we want to be short the credit. We can take this position either by shorting bonds or buying CDS protection. In order to evaluate opportunities across the term structure, we compare CDS levels to adjusted bond z-spreads, which we believe is the most straightforward way to compare the two securities. Exhibit 2 compares MRK's bond adjusted z-spreads to market CDS levels as well as our fair value CDS levels.

Exhibit 2

MRK's bonds are trading cheap (adjusted z-spreads higher) to their equivalent CDS levels although we find them very close to fair value on a price level. Since we do not have a rich bond available for the trade, we look at buying protection.

In order to offset the protection premium and to hedge against overall market movements, we will sell protection on an index. In order to estimate CDS fair values, we regress each tenor (3s, 5s, 7s, and 10s) against the other tenors across the universe of credits we cover. This results in a set of models with extremely high r-squareds.

In our case, we see that MRK's 3s and 5s are trading below fair value (good for us) and its 7s and 10s are trading above fair value (bad for us). Since we have a negative view on MRK, we base our tenor decision on more than just fair value and consider roll-down and bid-offer as well.

Given the low liquidity in MRK in other tenors, we view the 5s as the best potential maturity, and we drill down and look at the trade economics. Specifically, we look at carry, roll-down and the bid-offer spread of each potential trade. MRK's 5s have a bid offer of 3bp and negative roll-down.

Given the negative carry and roll-down, we choose to hedge with the CDX NA IG Series 8 index, selling less protection on the index given the relative levels of MRK and the CDX. This pushes us into a slightly positive carry trade but still with negative roll-down.

As long as MRK widens by at least 2.5bp relative to the CDX, we expect to unwind this trade profitably in 6 months time. Exhibit 3 outlines the economics of this trade.

Exhibit 3

Risk analysis
This trade takes a positive-carry short position. It is hedged relative to the CDX NA IG Series 8 index but is unhedged against idiosyncratic curve movements. Additionally, we face about 3bp of bid-offer to cross. The trade has (barely) positive carry which protects the investor from any short-term mark-to-market losses.

Entering and exiting any trade carries execution risk and MRK has moderate liquidity in the CDS market.

Liquidity
Liquidity is a major driver of any longer-dated trade – i.e. the ability to transact effectively across the bid-offer spread in the bond and CDS markets. As stated earlier, MRK has moderate liquidity in the CDS market across the term structure.

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

Carol Levenson, Gimme Credit's Healthcare expert, maintains a deteriorating fundamental outlook for MRK. The company faces patent expirations, a weak pipeline of new products and recently had to withdraw Vioxx from the marketplace (and now faces the possibility of huge legal liabilities).

We note that MRK scores a high 3.7/5 on our LBO-viability screen although their size until recently precluded them (perhaps no longer given the ever-increasing size of club deals). While we have not heard any private equity rumours surrounding the name, we believe the credit faces two competing negative event risks, a potential LBO and the potential for large legal liabilities. Additionally, the negative comments about MRK's experimental drug Arcoxia are not encouraging.

Summary and trade recommendation
We take another look at MRK today on the news that an FDA official called approval of the company's experimental arthritis drug, Arcoxia, a 'potential public health disaster'. MRK has rallied significantly since the fall of 2005. Although it has levelled off recently, our deteriorating fundamental outlook, combined with the other factors in our Multi-Factor Credit Indicator model, provides us with ample incentive to short this credit.

Given MRK's tight CDS spreads and a lack of positively-economic curve trades available, we look to take a positive-carry short position. After analysing both the bond and CDS markets for the best opportunity, we have settled on buying 5 year protection on MRK hedged with selling CDX NA IG Series 8 protection.

Reasonable carry and the potential profit of a widening credit strengthen the economics of the trade (although we still face negative roll-down). Given our deteriorating fundamental outlook for MRK and the current tight levels for the company, we feel this outright position presents the best opportunity for trading this name.

Buy US$10m notional Merck & Co. Inc. 5 Year CDS protection at 9bp and

Sell US$3m notional CDX NA IG Series 8 5Y protection at 37.75bp to gain 2.25bp 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).