Contents

CDR Liquid Index data as at 23 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.

Unlocking equity

Early redemption of CDO doubles equity holder value

Pearl Group and NewSmith Financial Solutions have this week completed the early redemption of a CDO, realising enhanced value for investors. The move is likely to herald similar transactions in the future.

Pearl Group, acting through its newly created investment management company Axial, identified a potential value creation opportunity in a portfolio held within its with-profits fund and sought to hire an external advisor to assist in releasing this value. After conducting due diligence on advisors in the market place, Axial appointed NewSmith to advise on its CDO portfolio in July 2006.

The transaction involved the early redemption of Balthazar CSO I, a hybrid CDO issued in January 2003, which was scheduled to mature in 2011 but – in common with similar deals of the same vintage – without an early call option. However, early redemption, completed last Monday 23 April, more than doubled the realisable value for Pearl's with-profits policyholders and other investors in the equity portion of Balthazar.

TJ Lim, ceo at NewSmith Financial Solutions, observes: "This deal could lead the way to many more similar transactions. It is not just attractive to insurers, but also CDO investors of all types – particularly equity holders. It is generally the case that investors start to focus on their underlying investments in a declining market, but when things are good in a rallying one it has usually been less so. I don't think people look so closely at the possibilities of maximising values using alternative routes such as optional redemption, but as this deal shows it can make a huge difference to returns."

The process may not appeal to all, however. Lim says: "The secondary space is beginning to have a lot of traction, but the bulk of the assets coming into the CDO market as a whole are new issues, because it's so easy to print. We spent three months executing this deal, but not all market participants would find that a cost-effective use of their time. In addition, dealers are less likely to offer alternative ways of maximising values as their objective is to buy back positions from investors at the cheapest possible price."

At launch, Balthazar raised €180m from investors, funding a €1bn underlying reference portfolio of mainly investment grade CDS. The transaction included four tranches of notes: €105m of Class A notes rated AAA/Aaa, €25m of Class B notes rated AA-/Aa3, €20m of Class C notes rated A-/A3 and €30m of unrated subordinated notes.

In common with many complex securitisations, the restrictive wording of the trust deed governing the bonds, together with other factors, meant that the optimum value of the equity tranche was not reflected in prices indicated by the secondary market. Pearl held approximately 50% of the equity tranche, as well as a significant amount of the Class C notes.

NewSmith's role in this transaction was to engineer an early redemption of the bond, thus releasing the optimal value of the equity tranche. "Understandably, with four years still to go on the deal the cash bid on an IRR basis was not great – we were getting in the 60s, but our analysis suggested the liquidation was in excess of par, which turned out to be a very conservative estimate," says Lim.

He continues: "We said to ourselves that there had to be a way of crystallising this value. So we really started to look at the indenture and see if there was a way to collapse the deal. There we found a wording that said if you owned 75% of each class of funded note then you can invoke an extraordinary resolution and change the terms of the CDO."

Together with Axial, NewSmith worked with dealers to identify existing investors in Balthazar, offering them a premium for their holdings and accumulating more than 80% of outstanding bonds. Following the extraordinary resolution and acceptance of a supplemental trust deed, the underlying CDS portfolio was unwound and the collateral securities sold.

On completion of the deal, the gross consideration for the equity notes was in excess of €43.65m, or more than 145% of nominal value, compared to the just over 60% of nominal value indicated in the secondary market. For Pearl policyholders, the deal represented a windfall of approximately €12.5m.

MP

CFXOs getting nearer

First rating agency methodology released as FX risk-based CDOs are prepped

Dealers continue to work on the latest evolution of CDO technology – collateralised foreign exchange obligations, or CFXOs. More than five deals are expected this year, but it was only this past week that the first rating agency issued research addressing the product.

On Monday Derivative Fitch published its considerations for analysing and rating CFXOs. The CFXO report, the first to be published by a rating agency, details the structure of the product, the principal risks and Fitch's analytical methodology. S&P expects to publish its CFXO methodology in the next few weeks, while Moody's is understood to be working on its own version.

"CFXOs are the latest evolution in a trend for the repackaging of market price risk into credit-like synthetic collateralised securitisation structures," says Ken Gill, md Derivative Fitch. "Derivative Fitch is working on a number of proposed transactions utilising this structure," he confirms.

Jochen Felsenheimer, head of credit strategy & structured credit global research, UniCredit Markets & Investment Banking, says: "There has been consistent talk about these products being in the pipeline since the end of last year. However, we have not yet seen one and I suspect we won't until the rating methodology has been fully absorbed by the market."

Nevertheless, Felsenheimer believes there is clear evidence of demand for the product. "What has already done well with investors – particularly in the Near and Middle East – is a simplified version of CFXOs involving first-to-default baskets. So, the demand and the credit derivatives technology is already there," he says.

Fitch's report explains that CFXOs combine payoffs linked to FX rates with structural features of synthetic CDOs. Typically, the FX risk is wrapped in a funded structure with credit enhancement and risk linked to a diversified portfolio of FX rates.

The price risk of that portfolio is transferred into the CFXO through notional asset price trigger swaps. Each FX trigger swap is similar to an option on depreciation or appreciation of an underlying FX rate, with a strike level set 'far out of the money', making the probability of triggering each swap relatively remote. A fixed payoff to the swap counterparty is generated if the swap is triggered.

Fitch warns that investors' principal may be impaired if the reference FX rates trigger one or more predefined trigger swap levels. However, the swap counterparty typically provides credit enhancement to absorb a number of initial trigger breaches, and losses will only feed through to investors once credit enhancement has been eroded. The maximum loss is capped at the initial invested amount.

In its analysis Fitch found different levels of historical volatility across FX rates; a high frequency of extreme price movements; potential for the occurrence of sudden, large price movements; and periods of high volatility followed by periods of low volatility (known as volatility clustering).

The agency has found that asymmetric GARCH processes with jumps are able to fit empirically observed features of commodity returns well. The Fitch Default VECTOR Model is used to model the correlated risk of the reference portfolio. Fitch says that it is able to analyse structures that combine FX and credit default swaps using a combination of its model for FX rates and VECTOR.

MP

ABN brings first fully managed CPDO

New deal also offers both triple-A and double-A tranches

ABN AMRO last week launched the first fully-managed and fully-rated CPDO. The deal, which also offers investors two tranches, is managed by Fortis Investment Management France and has been dubbed Degas.

The transaction offers investors a 10-year Aaa tranche and a 10-year Aa2 tranche, rated by Moody's for both principal and coupons in major currencies. This reflects strong investor demand for both triple-A and lower rated CPDOs, according to Andrew Feachem, director in structured credit marketing at ABN AMRO. "Offering two tranches opens up the instrument to a wider set of investors," he adds.

Degas generates returns through an actively managed exposure to a bespoke credit portfolio of single name CDS. The size of the portfolio is adjusted dynamically, so that the CPDO only takes the leverage it needs in order to make the scheduled principal and interest payments.

As well as choosing credits with a range of maturities for the bespoke portfolio, Fortis Investments will have access to the full range of credit indices to effectively balance the portfolio. The manager will have the ability to short names to protect the notes against default risk, downgrade risk or spread jump risk on single names.

Fortis will also have the option of implementing relative value trades and utilising its quantitative expertise developed with CPPI products to manage the leverage and portfolio notional in order to further express its views on the outlook for credit on spreads.

Obviously the manager has some restrictions on what it can do and must ensure that it remains within the confines of the rating model, but Feachem is keen to stress that Degas is the first CPDO to offer a full management capability, which enables it to perform throughout the credit cycle. "The manager has a large degree of flexibility and can manage leverage, maturity profile and a short bucket," he says.

Some other issuers have shied away from fully managed deals on the grounds of cost to investors. However, Steve Lobb, head of credit and alternatives marketing at ABN AMRO, argues: "A fully managed structure doesn't cost significantly more than a partially managed transaction - you're only really talking about bid-offers and managers of these products don't churn their portfolios. They trade as often as required to generate alpha or to defend the portfolio."

The coupon that Degas offers investors will, in part, indicate the inherent costs of the deal. Lobb says that it is still too early for price talk, but it is expected to be in excess of 100bp for the triple-A piece.

Equally, it is too early for the size of the deal to be finalised. Lobb says: "€250 to €350m would be a successful start but, given the response from investors that we have had so far, it could be a lot more - and obviously we will be doing bespoke versions of this structure going forward."

MP

Tetragon attracts investor interest

Potentially huge CLO investor's IPO oversubscribed

Tetragon Financial Group Ltd last week became the latest structured credit investment vehicle to be listed on a stock exchange. Tetragon, affiliated to US hedge fund Polygon Investment Partners, successfully placed 30 million new shares in an IPO with a fixed offer price of US$10 per share. The offering was oversubscribed and the shares were allocated to a broad range of international institutional investors.

Trading of the shares commenced last Thursday, 19 April, on Euronext Amsterdam on an "as-if-and-when-issued-or-delivered" basis. Closing of the IPO is expected to occur tomorrow, 26 April, at which point Tetragon's total equity capital is expected to be US$1.255bn.

According to the offering circular, Tetragon is a Guernsey investment company that invests primarily in residual tranches of CDOs holding interests in broadly syndicated senior secured loans in the US and Europe, as well as middle market senior secured loans in the US and other structured finance instruments. "The company aims to provide stable returns to investors across various interest rate and credit cycles," it says.

Tetragon has already established itself as a key CLO equity tranche investor and the success of its IPO with other accounts has already begun speculation that this is only the beginning of the firm's expansion. Assets under management will increase exponentially in a short period of time, some suggest.

Tetragon began operating on 1 August 2005 and invests substantially all its capital through a master fund. As of 1 March 2007, the master fund had over US$930m of capital under management (exclusive of the offer proceeds).

The company's investment manager, Polygon Credit Management, is affiliated with Polygon Investment Partners and its affiliated management companies, which manage the Polygon Global Opportunities Master Fund. The global multi-strategy arbitrage fund began trading in May 2003 and currently has approximately US$7bn of capital under management (exclusive of its investment in Tetragon). Polygon has participated in the IPO and has been allocated 4 million new shares in the offering.

The presence and success of such a potentially huge investor in the market as Tetragon – and there are rumours of other firms following in its footsteps – will go some way towards reducing concerns over spread widening in the CLO sector (see last week's SCI). In the meantime, tight spreads can clearly still be achieved by the right CLOs able to attract the right investors.

Notably, Babson Capital Management has just closed another significant deal – the US$750m Babson CLO Ltd. 2007-I – at issuer-friendly spreads. This is the sixth CLO closed by Babson Capital in the last two years – all for at least US$500m.

"We continue to see strong investor interest in CLOs," says Thomas Finke, md and head of the firm's US bank loan team. "Babson CLO 2007-I is a continuation of our core CLO strategy. As a result, we continue to get tight pricing on liabilities."

The weighted average cost of the debt for the transaction was 39bp over Libor, with the triple-B and double-B tranches pricing at 125bp and 325bp over Libor, respectively. The fund will comprise at least 95% broadly syndicated senior secured bank loans.

Citigroup arranged the transaction. Buyers included a wide range of US and non-US institutional investors.

MP

Happy to succeed

Investors are sanguine over succession issues

Succession events can result in wild swings in CDS spreads and the cancellation of contracts. However, many structured credit investors feel there is less to fear now than previously.

Asset managers are watchful of succession events as many view them as a market idiosyncrasy that should not be present. Many view them as a technicality where investors can make or lose money and where investment decisions have no bearing.

There was an education process in 2006, according to Jamie Stuttard, credit portfolio manager at Schroders in London, when a host of succession events from Verizon, Alltel, Pilkington to Rentokil blotted the landscape. "The market has gone through a maturation phase and now has a better understanding of the pitfalls, case studies and history," he says.

The variety of succession events and their triggers makes it hard to fully predict what every new capital structure will look like and the ISDA documentation currently does not take into account every type of succession event. However, Jean-Philippe Dorp, senior credit analyst at Solent Capital in London, believes the market is now in a better position to anticipate succession events having gained experience from last year and is able to cope with the vast majority of scenarios.

"The market is perfectly happy with the language the way it is and the reality is that contracts have been written in a fairly clear way and most market participants understand what they are purchasing," adds a US-based credit asset manager.

Some investors have built trading strategies and taken positions on credits before succession events and market re-pricing have occurred; for instance, Solent Capital reduced exposure from its CDO portfolios to Alltel before the firm span off its wireless business.

"We see succession events as an opportunity for sophisticated investors with the necessary expertise to take an educated view on the future CDS price and have a position based upon that," says Dorp.

Banks are offering products to alleviate concerns, such as cancellable CDS or LBO-related structured products like Citigroup's SAILS (see SCI issue 20). However, some view these as having questionable value for investors and see lacklustre interest in the products.

"You have trade-offs for products like these, the biggest issue is liquidity. If you trade SAILS, the bid-offer may be many multiples of the bid offer of a vanilla CDS and even if there is an inkling of a succession event on a credit I can't imagine that being all that economically viable," says the US-based credit asset manager.

Schroders' Stuttard adds that cancellable CDS will not find favour with all fund managers. "You introduce some optionality into the spread duration. For instance, a manager may reach his target maturity profile but a number of succession events and cancelled contracts will immediately take some spread duration out of the portfolio," he says.

Continued high liquidity among private equity firms will keep LBO activity and succession events topical, notes ABN Amro Asset Management's London based credit strategist, Simon Ballard. "There will continue to be concerns over huge swings in CDS spreads and deliverability of debt though banks will naturally be prepared to address these issues," he says.

HD

Walsh exits Dresdner

The latest company and people moves

Walsh exits Dresdner
Bob Walsh, head of cash CDOs resigned from Dresdner Kleinwort on Monday. His destination is not yet known.

Ikhilov heads to BoA
Gregory Ikhilov, real-estate asset-backed securities trader in the MBS/ABS trading syndicate at Merrill Lynch in New York is understood to have moved to Bank of America as a senior ABS trader.

RBC hires Lippman
Stuart Lippman, senior ABS trader at UBS, is believed to be moving to RBC Capital Markets in New York to set up a proprietary ABS trading desk.

Faust switches to Merrill
Paul Faust, a credit trader at Credit Suisse in New York, is understood to have joined Merrill Lynch in a similar role.

Kotecha leaves IXIS CIB
Sima Kotecha has left her role in credit sales at IXIS Corporate & Investment Bank (IXIS CIB). Her destination is not yet known.

Cameron joins Markit
Markit has announced the appointment of Niall Cameron to its executive management team. He joins Markit as an evp and will take responsibility for Markit's index management and equities businesses.

Cameron has worked in the capital markets for over 20 years with experience in fixed income, equities and foreign exchange. Most recently he was global head of traded markets and member of the global markets executive committee at ABN AMRO where he worked for more than seven years.

SL Green reorganises
REIT SL Green Realty and its CDO issuer company Gramercy Capital have announced a series of major organisational moves. The changes include new employment agreements for key personnel.

Notably, this involves the promotion of Andrew Mathias to president in recognition of his long and successful tenure at SL Green, during which he was an integral part of assembling and managing a highly successful and innovative investments group. Mathias has served as SL Green's cio since 2004, responsible for all equity and structured finance investments.

He also serves as cio of Gramercy Capital, which he was instrumental in creating and then spinning off as a separate company in 2004. Mathias has entered into a new employment agreement effective through to 1 January 2011 and will retain the title of cio.

At the same time, Gregory Hughes has been promoted to coo, while retaining his role as cfo. As cfo Hughes has been directly responsible for finance, capital markets, investor relations and administration. He has also served as Gramercy Capital's chief credit officer since its formation as a stand-alone company. Hughes has entered into a new employment agreement with a term extending through to 1January 2010.

ICAP appoints new global head of risk
ICAP has appointed Hervé Geny as global head of risk, reporting to Mark Yallop, ICAP's group coo. He will be responsible for extending further ICAP's risk management framework.

Geny was previously head of the global risk management specialists group at Moody's in New York. Prior to joining Moody's, he was a director of corporate finance for Merrill Lynch.

Phil Moyse, who has combined the role of ICAP's chief risk officer with his other duties, will remain with the group as a consultant for a further 18 months.

State Street hires for derivatives
State Street Corporation has announced the appointments of Kevin Sullivan and Neil Wright to svps with responsibility for overseeing the ongoing development of its derivative processing capabilities.

Sullivan co-founded Eagle Investments Systems in 1989. The company was acquired by Mellon Financial in 2001, and Sullivan remained to serve as Eagle's chief technology officer up until 2006. As a product specialist at State Street, Sullivan will be responsible for building the technology infrastructure to support the company's derivatives processing.

Wright joined State Street from Citigroup where he was a director of derivative operations. Prior to this role, he was svp of asset manager solutions for JP Morgan Chase. As a product expert, he will be responsible for developing strategies to support State Street's derivatives servicing capabilities, working closely with the business leaders, derivative specialists and information technology teams.

HD & MP

First Spanish arbitrage CLO priced

A round up of this week's structured credit news

First Spanish arbitrage CLO priced
On Monday Caja Madrid priced its debut CLO – the €500m Neptuno CLO I. Closing is scheduled for 24 May 2007 and the CLO will invest entirely in European leveraged loans, of which at least 85% will be senior.

The transaction takes a now familiar structure with a super-senior revolver to ensure efficient management of cash balances and a macro hedging FX strategy as a cheaper alternative to perfect asset swaps. As well as attracting a strong domestic following, the transaction was placed more broadly – encompassing 25 investors in 10 countries.

Massimo Carocci, head of global markets at Caja Madrid, comments: "This is the first CLO managed by Caja Madrid and will be followed by at least two other transactions this year. The combination of a fully-ramped portfolio with a very low average price (100.15) and the experience of Caja Madrid in the European leveraged loan market has been the key for a successful transaction. The fact that Caja Madrid outlined during the road-show that this is a long term project in order to create a franchise in managing assets (not only in the leveraged loan space) has attracted quite a lot of investors all around Europe."

Edward Cahill, European head of CDOs at Barclays Capital adds: "This is an incredible start for Caja Madrid. They compiled a strong, almost fully-ramped portfolio which sealed the reputation they had gained on four prior transactions which they contributed assets to. On this, their first solo transaction, and the first Spanish arbitrage CLO, they have also demonstrated their capacity as a manager in their own right, which will serve them well for future transactions"

Barclays Capital acted as sole arranger, bookrunner and underwriter for the transaction. Caja Madrid acted as co-lead and co-placer on the deal.

India announces CDS plans
Dr. Y. Venugopal Reddy, governor of the Reserve Bank of India, this week confirmed plans to establish CDS in India. The confirmation was given in a meeting with chief executives of major commercial banks as Reddy presented the Reserve Bank's Annual Policy Statement for the year 2007-08.

This included the following: "As part of the gradual process of financial sector liberalisation in India, it is considered appropriate to introduce credit derivatives in a calibrated manner at this juncture. The risk management architecture of banks has strengthened and banks are on the way to becoming Basel II compliant, providing adequate comfort level for the introduction of such products."

Furthermore, the statement adds: "The recent amendment to the Reserve Bank of India Act, 1934 has provided legality of OTC derivative instruments, including credit derivatives. Accordingly, to begin with, it is proposed to permit banks and primary dealers to begin transacting in single-entity CDS. Detailed guidelines in this regard will be issued by May 15 2007."

DBRS releases new CDO toolbox
DBRS has recently reviewed its global criteria for CDOs, resulting in an update to the quantitative modelling assumptions within its CDO portfolio model, the "CDO Toolbox".

The agency has published the update in a quantitative methodology report that describes the modelling framework and new assumptions in detail. The updated version of the CDO Toolbox contains new assumptions relating to default probabilities, correlation and recoveries for corporate assets and structured finance securities. DBRS says it welcomes comments from market participants on the methodology and assumptions in the report.

Kai Gilkes, md, structured finance quantitative group at DBRS, comments: "As DBRS's CDO business continues to expand, it is important that we maintain credit standards that are both globally consistent and firmly grounded on empirical research. This update achieves both of these objectives. The CDO Toolbox will allow market participants to see exactly what assumptions DBRS makes when analysing CDO portfolio credit risk. It also provides users with complete control over all modelling assumptions, enabling them to conduct their own sensitivity analysis."

Fitch tackles TABX
A more customised analytical approach is needed in determining the creditworthiness of the underlying assets in the TABX.HE indices, according to Derivative Fitch in a new report.

It argues that the TABX.HE portfolios are less diversified than traditional structured finance (SF) CDOs and reference only 40 RMBS names. This more concentrated nature makes the TABX.HE portfolios' WAL more sensitive to underlying mortgage prepayment and RMBS step-down assumptions.

In responding to numerous requests to express its view in assigning ratings to the TABX.HE, Derivative Fitch's analysis takes into account the key differences between these indices and traditional SF CDO portfolios. Some of the critical areas to consider are asset exposure size and credit quality, amortisation profiles, recovery rates and correlation and servicer concentration adjustments.

For instance, prepayment assumptions and the amortisation of the underlying mortgages are critical in determining the recommended ratings for the TABX.HE indices. The relatively unseasoned nature of TABX.HE assets result in very small amounts of amortisation. Voluntary prepayment rate declines from the weak sub-prime market also need to be taken into account, which is why Fitch draws on the expertise of the RMBS group in addition to using its proprietary Default VECTOR model.

Retail rules suggested
Five industry trade associations have jointly released a draft set of non-binding principles relating to retail structured products. The principles, which would apply to all asset classes including credit, focus particularly on the management of the relationship between providers and distributors from the perspectives of both types of entity.

The principles are issued in the form of an exposure draft, for comment by any interested party by close of business on Wednesday 30 May 2007. The five associations involved are: ESF, ICMA, ISDA, LIBA and SIFMA.

Fitch rating stability examined
Fitch Ratings has released its annual global corporate transition and default study, examining Fitch's global corporate ratings migration and default rates in 2006 and over the long term, capturing the period 1990-2006. The study provides data and analysis on the stability of Fitch's corporate ratings and the ability of its ratings to predict default.

For the third consecutive year, upgrades readily surpassed downgrades in 2006, most notably among global financial institutions and emerging market entities. Overall, upgrades affected 16.1% of Fitch's global corporate ratings universe, while downgrades affected 6.9%.

Low defaults were another reflection of generally improving credit quality supported by favourable funding conditions and robust global economic growth. Fitch-rated defaults totalled just two in 2006, compared with eight recorded in 2005.

Fitch's long-term default rates across the various rating categories continued to show a strong relationship between ratings and default risk. The 1990-2006 average annual default rate across the agency's investment grade corporate ratings, for instance, totalled 0.10%, while its average annual speculative grade default rate was 2.94%.

Furthermore, an analysis of Fitch's rating performance using Lorenz curves and Gini coefficients covering the period 1990-2006 again revealed that its ratings exhibit a strong ability to predict default, producing one-year, three-year and five-year Gini coefficients of 87.5%, 78.2% and 75.4% respectively.

ISDA releases survey data
At the ISDA AGM last week, the trade association released its latest figures relating to credit. These involved post-trade processing, trading volumes and collateral use.
Post-trade processing of privately negotiated derivatives transactions continues to significantly improve, with credit derivatives showing the most progress, according to an ISDA survey. In credit derivatives, outstandings fell from 16.2 days worth of business in 2006 to 5.5.

Meanwhile, the amount of time it takes firms to generate and send credit derivatives confirmations to their counterparties upon completing trades is also showing improvement: among the large firms, over 70% of credit derivatives confirmations are sent out by T+1, up from 50% a year ago.

The results of ISDA's Year-End 2006 Market Survey showed that the notional principal outstanding volume of credit default swaps grew 33% in the second half of 2006, rising from US$26tr at 30 June 30 2006 to US$34.5tr at December 31 2006. This compares with 52% growth during the first half of 2006.

CDS notional growth for the whole of 2006 was 102%, compared with 103% during 2005. The survey monitors credit default swaps on single-names, baskets and portfolios of credits and index trades.

ISDA's 2007 Margin Survey finds that firms continue to increase collateral coverage of the counterparty credit exposure in their credit and fixed income portfolios. On average, 66% of the responding firms' credit exposure related to their credit swap portfolios was covered by collateral, up from 62% last year.

Fitch issues CRE CDO downgrade warning
As the challenges in the US sub-prime RMBS sector continue to play out during 2007, CRE CDOs with exposure to mezzanine sub-prime RMBS have the potential to be downgraded towards the end of this year and into early 2008, though the exposure is minimal, according to Derivative Fitch.

Early vintage deals are static pools, so no rating changes are anticipated due to the seasoning of the underlying sub-prime bonds and the low overall exposure. Additionally, recent issues of CRE CDOs rarely have included any sub-prime RMBS, as investors have expressed a preference for CDOs that do not mix asset types.

13 of the 106 Fitch-rated CRE CDOs have exposure to US sub-prime RMBS – about 12% of the Fitch-rated CRE CDO universe. All were issued between 2000 and 2006. Of the three issued prior to 2003, the average exposure to sub-prime RMBS is only 2.6%.

For the ten issued in 2003 or after, the exposure to sub-prime RMBS ranges from 15.5% to 60.7%. As each of these ten are managed transactions, the vintage composition of the sub-prime RMBS now also includes recently issued deals.

While nine of these transactions are primarily composed of rated bond collateral, Newcastle REL CDO VIII, issued in December 2006, is a managed CRE loan deal that has a maximum 10% bucket for ABS, of which 6.8% is currently invested in double-B plus and triple-B minus rated sub-prime RMBS.

The greatest downgrade risk in RMBS sub-prime assets are in the subordinate part of the capital structure within the 2003 and 2004 vintages in the near term. These RMBS assets are most at risk for default or downgrade due to their position in the capital structure. An increase in expected future pool losses coupled with slowing prepayment speeds is now more likely to breach the thinned credit enhancement levels of these vintages.

In addition, sub-prime RMBS mezzanine assets of the late 2005 and 2006 vintages are at risk of downgrade as well. However, Fitch's sub-prime RMBS group does not expect material negative rating actions for 2005 and 2006 sub-prime RMBS bonds to come until the second half of 2007.

The underlying sub-prime deals of 2005 and 2006 already experienced higher delinquencies than 2004 and prior vintage sub-prime deals of the same seasoning. These trends are expected to result in a more severe rating deterioration for late 2005 and 2006 sub-prime RMBS over the next few years.

The two CRE CDOs with the largest exposure to sub-prime RMBS are G-Star 2004-4 (60.7%) and G-Star 2005-5 (55.7%). Both are managed transactions and, as such, have some exposure to the 2006 vintage.

Their current exposure to 2003 and 2004 vintages is 50.4% and 34.7% respectively. Over 80% of the RMBS exposure is to bonds in the mezzanine part of the RMBS capital structure. However, they have little to no exposure to triple-B minus and below. Fitch continues to closely monitor these transactions.

MP

Trading ideas - WYE LEAPS?

Dave Klein, research analyst at Credit Derivatives Research, looks at a capital structure arbitrage trade on Wyeth

Credit and equity risk are unambiguously linked as the risk of debt holders not receiving their claims is akin to the risk of equity prices falling to zero. Both credit and equity risk are directly tradable with liquid instruments such as credit default swaps (CDS) and equity puts. In this trade, we analyse hedging CDS with specific (deep out-of-the-money) equity put options.

The overall logic is that owning a corporate bond is equivalent to owning a Treasury bill and writing a put option to the issuer. This put option gives the firm's equity holders the right to default on or before maturity of the debt, in exchange for transferring ownership of the firm's residual assets to debt holders. CDR's Trading Technique article – Credit Risk Models – provides significantly more detail on this relationship and can be found on our website (see below).

As perceived credit risk rises, we would expect firm volatility to rise (this would increase the value of the put option) thus increasing the likelihood that equity holders would default on the company's debt. The payoff profiles of an out-of-the-money equity put and a CDS are very similar and thus misalignments in that relationship are potentially profitable.

This trade on Wyeth (WYE) takes advantage of this relationship by selling equity puts and buying CDS protection.

Delving into the data
When considering market pricing across the capital structure, we compare equity prices and equity-implied volatilities to credit market spreads. There are a number of ways of accomplishing this, including the use of structural models that imply credit spreads (through an option-theoretic relationship) from equity prices and the analysis of empirical (historical) relationships between the two markets.

The first step when screening names for potential trades is to look at where equity options (implied volatility) and credit spreads stand in comparison to their historic levels. Exhibit 1 shows the past year's levels for WYE's put implied-volatility and CDS spreads. Notice the high correlation between the CDS levels and implied vol.

Exhibit 1

Comparing market levels over time gives a rough feeling for how each security moves in relation to the other. In order to judge actual richness or cheapness, we rely on a fair value model. Given that our trade is a combination of CDS and equity puts, we consider the empirical relationship between CDS and equity-implied volatility.

Exhibit 2 plots equity-implied volatility (y-axis) vs. 5Y CDS premia (x-axis). If the current levels fall below the trend line, then we view CDS protection as too rich (credit cheap) and/or equity puts as too cheap. Above the trend line, the opposite relationship holds. At current levels, WYE is close to fairly priced although CDS is a bit cheap when compared with puts.

Exhibit 2

We next consider this relationship over time, finding a "fair value" for implied volatility based on the CDS level. We do this for two reasons.

First, we want to assure ourselves that the implied volatility is not too low to fair value. Second, we want to see how often implied volatility and CDS converge to fair value. Exhibit 3 shows the trend for WYE over time.

Exhibit 3

We note that implied vol has consistently moved above and below fair value. Although WYE has recently traded close to fair value, the fact that the implied vol has traded both above and below fair value increases our confidence in the CDS-Vol relationship.

Hedging default risk with equity puts
Our analysis so far has pointed to a potential misalignment between the equity-implied-volatility markets and credit spreads of WYE. It would appear that we should buy protection (sell credit) against a short position in equity volatility. The most suitable way to take this position is to trade CDS against Equity Puts.

As default approaches, we see CDS rates increase (to points upfront) and equity prices fall close to zero. In this situation, an equity put will increase in value as CDS rates increase (and equity prices fall). If we expect equity volatility to rise also, then this will be a double-whammy for the put option value.

However, when a company finds itself under increasing shareholder pressure, credit spreads can widen while share prices increase. This is good news on both legs of a short credit/short equity put trade.

If we can buy CDS protection cheaper than the relative costs of selling equity puts, then we can position ourselves correctly for the trade and benefit from positive carry for the life of the option. This is what makes capital structure arbitrage opportunities difficult – finding the right relationship misalignment with the right economics.

WYE's current price levels across the capital structure, as seen in Exhibit 4, offer us exactly the right combination of positive carry (in the longer-dated options); hedged default risk; and long equity option, short CDS. Translating the cost of our puts into basis points, we find that the trade has positive carry overall for the first two years. We have omitted the details of our calculations in this report but will happily share them with interested clients.

Exhibit 4

The main trade risk here is that the stock price could fall below the put strike without the occurrence of a credit event that triggers a CDS liability. Thus the holder of the long CDS/short put position could potentially be liable for a put pay-off without a proportional change in CDS value.

In our case we like the positive carry of the hedged position until the option expiry. The mismatch in maturities (five-year CDS versus two-year hedge) also provides us with a natural short forward credit position.

This position implies a two-year forward three year long protection position. Additionally, this type of position (selling shorter-dated protection, buying longer-dated protection) is a type of curve steepener, a position we like given our deteriorating fundamental view.

We therefore recommend buying protection in five-year CDS (we'd prefer to trade in 3Y but do not see liquidity there) and selling longer-dated LEAPs (put options) on WYE for positive carry, hedged default risk, and long forward position.

Risk analysis
This position does carry a number of very specific risks.

Recovery and 'Default' Stock Price Assumption: In the default scenario the cheapest-to-deliver CDS obligation may have a higher than expected market value and the stock price might not fall to US$0.75 as assumed.

CDS and Equity Put Timing Mismatch: When the CDS durations exceed that of the put, investors could be exposed to an un-hedged CDS protection payment liability. However, shorter dated CDS may be available that can be tailored to the equity put expiration and/or longer dated puts may be offered in the over-the counter equity options market. Alternatively, at expiry or over the duration of the put contract, the short CDS position may be re-hedged with puts of later expiration. Moreover, the trade may possibly be unwound profitably before the put expiry.

CDS Present Value (PV): The CDS PV is an expected value, but not necessarily a realised outcome. In practice, the CDS may trade on an up-front and/or running basis. .

Corporate Actions: Spin-offs and Private Equity Buyouts, for instance, could force an early settlement of the equity puts, leaving investors with un-hedged long CDS positions. It is our expectation that an LBO would be a positive event for this trade.

Mark-to-Market: In our view, credit and equity derivatives markets operate largely independently and this can lead to trade opportunities. At the same time, however, any relative mis-pricing may persist and even further increase, which could lead to substantial return fluctuations.

Overall, frequent re-hedging of this position is not critical but the investor must be aware of the risks above and balance that with the strong positive carry with minimal default risk over the option's life.

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. 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 WYE and the bid-offer spread costs.

Although WYE is a member of the CDX NA IG 8, it is only a moderately-liquid name. Bid-offer spreads are narrowing to around three basis points. That is a pretty steep bid-offer given the current levels, but the mismatch in price between LEAPS and CDS is the true driver here. We would prefer to buy 3Y protection, given the lower cost, but do not see liquidity at any tenor other the 5Y.

Equity puts are available through LEAPS and from analysing historical volumes it seems trades can be done in reasonable size. A potential alternative is to transact in an OTC trade rather than through the exchange to better tailor positions. The strike we have chosen has had volume recently.

Fundamentals
Carol Levenson, Gimme Credit's Pharmaceuticals expert, maintains a deteriorating fundamental outlook on WYE. Carol notes that WYE faces significant potential litigation liabilities and, although Carol makes no prediction on the ultimate cost of litigation, she would prefer to see management take a more conservative approach to the balance sheet. Carol interprets WYE's new debt issuance as a signal that management believes its litigation risk is minimal and a higher level of leverage is being targeted.

While WYE ranks low on our LBO-viability screen, the trade is driven by the disconnect between the price of equity options and CDS protection. Given our deteriorating fundamental outlook on WYE, we look for CDS spreads to widen while management's shareholder friendly stance is in line with our long put position.

Summary and trade recommendation
We find an equity-credit disconnect in WYE today. With management behaving as if its litigation risk is a thing of the past, the company is undertaking an aggressive share buyback program while relevering.

This feeds our negative fundamental outlook on WYE and leads us to consider a capital structure arbitrage trade that benefits from higher credit spreads and potentially higher stock prices. By selling shorter-dated equity puts and buying longer-dated CDS protection, we bet that equity will outperform credit and implicitly put on a curve steepener. Given the positive economics of the trade, we are happy to take the LEAPS upfront premium and let time work in our favour.

Buy US$1m notional Wyeth 5-Year CDS at 11.5bp

Sell 15,300 Wyeth Jan-09 40 Strike Equity Puts (153 lots) at a price of US$12,240 (US$80/lot, 122bp of notional or 70.1bp of CDS DV01 equivalent) to capture 58.6bp of equivalent carry to option maturity

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).

LCDX - let's get it started in here

Citi's global structured credit strategy team discuss the loan CDS index that will be launched shortly in the US

The loan CDS index will be launched in the US in May of 2007, after having been postponed several times. While the dealers are finalizing the index composition and the last details, we will describe the main index features and compare LCDX to its European counterpart (LevX) and the corporate CDS HY index.

LCDX – the main features
LCDX index will be composed of 100 equally weighted entities, determined by the member committee. The reference obligation for each of the underlying LCDS is a secured first-lien loan, including revolvers and term loans (see Appendix).

Similarly to DJ CDX indexes, the LCDX will be rolled into the new on-the-run index twice a year: April 3 (maturing on June 20th) and October 3 (maturing December 20th). While initially only five-year instruments will be traded, we would expect the emergence of other index tenors in the near future and a robust curve to develop.

LBO-credits are well represented in LCDX (more than 10% of index credits), including HCA, Hertz, Freescale Semiconductor, and SunGard, just to name a few. Also, the index composition is skewed towards the consumer sector (consumer goods and services account for more than 50%), while other sectors account for a much smaller part of the index (see Appendix).

Comparing LCDX to LevX and HY CDX
While LCDX is also a loan index, it is quite different from its European counterpart (LevX). The main difference is that European loan CDSs are callable when the underlying reference obligation is called, while US LCDS are callable only if all the first-lien facilities are called.

Another principal difference is that the US first-lien loan market is much deeper, and consequently it is much easier to come up with a broader tradable loan universe. Hence, LCDX consists of 100 entities, while LevX senior and subordinate consists of 35 names each.

Similar to other CDS indexes, LCDX will be trading with a No R restructuring provision – i.e. a reduction in rate, amount of interest, principal, a change in rankings in priority of payment, a change in the currency, etc., will not constitute a credit event. Also, LevX is settled physically with an option to cash settle, while LCDX is cash settled via an auction process similar to the DJ CDX indexes. This should increase liquidity and alleviate potential credit event-related "short-squeezes" (see Figure 1).

The composition overlap with HY CDX is only about 43% – less than we expected (see Appendix). It is mainly concentrated in the Basic Materials, consumer services, industrials, technology, telecom and utilities – about 50-60%. Consumer goods, financials, health care and oil & gas have a much smaller, if any, overlap.

The spread of the HY CDX8 is about 2.3 times larger than that of LCDX. Equating probabilities of default between the two indexes allows us to project LCDX recovery in default based on the HY CDX8 recovery. Assuming 40% recovery for the HY CDX8 components, one gets 75% for LCDX credits, which is consistent with our expectations.

a - Senior Index b - Facility / Family Rating (Approximation) c - Option to cash settle d - No substitute Ref. Ob. e - All Ref. Obs. Redeemed
Source: Citi.

Intrinsic Values, Index Arb and Single-Tranche CDOs
Index arbitrage strategies have been quite common in the corporate and even the ABX universe. Market participants are salivating about the new potential opportunities in the LCDX. However, there are a few obstacles in the way.

Firstly, single-name LCDS trading has been concentrated on a relatively small group of names, and pricing in all 100 LCDS is sporadic. That being said, we would expect the depth and liquidity of the index names to improve quickly. Secondly, while LCDX will be cash settled, the majority of single names will be physically settled with an option to cash settle.

In the corporate world index arb investors often trade the index versus the underlying: they typically sell the index, buying all its single-name components, whereas in the index, each credit is effectively paying the same coupon (index coupon), no matter what spread it trades at.

However, offsetting single names pay various coupons and the higher the coupon the less likely it is that the name will survive. To fairly value this one needs to calculate DV01-weighted contributions of all the credits, coming up with a theoretical index spread level – the intrinsic value – which should be lower than the average spread of the index composites.

However, there is one fundamental difference between LCDS and CDS, which investors should keep in mind: LCDS unwinds can be quite cumbersome. Firstly, while LCDS unwinds are typically done with a recovery of 75% (CDS assumed recovery is typically 40%) in certain cases market participants have to mutually agree on the recovery assumption. Secondly, LCDS contracts are cancellable. Therefore, projecting a DV01 and calculating the PV of the unwind might be somewhat of a struggle.

For example, if one believes that a given LCDS will be called in the not-so-distant future, one would be much more conservative on the unwind assumptions. This makes closing out index arb trades somewhat problematic.

Investors often prefer to put on an offsetting LCDS position rather than unwinding the trade, but this would create residual duration positions: for example, assuming a three-year maturity and 75% recovery, offsetting US$10 million in LCDS positions at 100bp and 250bp will create a net DV01 of about US$250/bp.

In practice, having a large index (100 names), with most of the components trading relatively tight, diminishes the effects of both average life and recovery on calculation of LCDX intrinsic value. Changing recovery assumption from 65% to 75% and average life from 2.5 years to 5 years only marginally changes index intrinsic value.

Borrowing from our corporate experience, at inception we would expect LCDX to trade at a premium to its intrinsic due to LCDX demand from loan hedgers. However, it is quite possible that despite illiquidity of a number of single-name LCDS, index arb investors will try to sell the index against single-names, pushing its spread down. If LCDX opens at the wide part of the trading range we could also see some outright sellers of protection.

For comparison HY CDX trades nearly 20bp wider than its intrinsic value, and, hence, to assume that LCDX opens 5–15bp wider than its intrinsic seems reasonable to us. So, we project that the index will open at a small premium (3–13bp) to the average spread of index components (currently 122bp) (see Figure 2).

a - Citi's projection
Source: Citi

LCDX index tranches are likely to start trading soon after the index is launched. Compared to LevX, which consists of only 35 names, tranching a 100-name LCDX makes more sense (see Figure 3). The mechanics of a loan CDS tranche product should be similar to the corporate one.

However, one important point still needs to be addressed: what happens when one of the names is called? While this is a relatively rare event (mainly the result of M&A activity or some strategic changes to the company's position), this should be addressed.

Currently, there are two main proposals on the table: a pro rata decrease of all index tranches and a decrease of only the super-senior tranche. While both have their advantages and disadvantages, a pro rata adjustment currently has broader support from the investment community.

Source: Citi.

Conclusion
The leveraged loan index class has developed rapidly and should grow even further this year. The inception of LCDX should be an important development in the US and should help market acceptance of the LCDS product.

The index brings a new tradable instrument, which has all the makings of becoming quite popular amongst various investor classes, including loan hedgers and speculators as well as index arb and synthetic investors. We would expect that the introduction of the LCDX should increase trading volumes and improve depth of the LCDS single-name market.

Appendix

Figure 4: LCDX Index Composition. Data as of 13 Apr 07

Figure 4: LCDX Index Composition. Data as of 13 Apr 07 (Continued)

Source: Markit.

Figure 5: LCDX Sector Breakdown. Data as of 13 Apr 07.

Source: Citi.

© 2007 Citigroup Global markets. All rights reserved. This Research Note was first published by Citigroup Global markets on 17 April 2007.