Contents

CDR Liquid Index data as at 30 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.

CMBX.3 gaps wider

New version of the US CMBS index driven by technicals

The latest version of the CMBX index began trading last Wednesday 25 April. Since then, dealers report heightened shorting activity which is pushing spreads ever wider.

One trader explains: "Right now, CMBX is trading purely on the basis of technicals. You have had people from the ABX world, who know nothing about CMBS, piling in because they made a decent amount of money by shorting ABX. They're saying 'spreads look tight versus ABX, so let's buy some protection'."

Existing CMBX investors have been buying protection too, according to another dealer. "Before the introduction of the third series, the whole credit curve had steepened and people were buying protection on the 06.2 as the latest and greatest that they could short. So, when the circulation of the names in series 3 came out, a number of firms started trading on a 'when issued' basis."

Consequently, those shorting series 2 rolled their shorts to the when-issued version and subsequently actual series 3. As a result, the spread differential between the series has been forced ever wider over the past two weeks.

It has, however, begun to stabilise since the start of this week, with the triple-B minus tranche of series 3 trading late yesterday (1 May) around 100bp wider than series 2. "When series 3 was first discussed people were anticipating a 30-40bp differential on the triple-B minus sub-indices," says the dealer.

A number of other factors are also driving the widening, according to the trader. "The whole ABX issue has driven us steeper in the first place and then a couple of weeks ago Moody's came out with a report that says it may need to require extra credit support on future CMBS it rates – and that caught the market a bit by surprise. At the same time, this series obviously references the most recent deals and is perceived by the market to be the most levered in terms of underwriting," he says.

Nevertheless, the dealer expects the market's strong fundamentals to hold sway eventually. "When the triple-B minus coupon was set at 320bp it caused some people to think that maybe this was all a bit overdone now. Furthermore, I think that the difference between ABX and CMBX is that with ABX the fundamentals support shorting activity – performance has deteriorated in recent months. But underlying performance in CMBS has been stellar so far, so the fundamentals for CMBX should begin to drive more two-way flow."

Meanwhile, plans for the proposed four European CMBX indices (see SCI issue 28) are moving forward. ECMBX is still targeting completion of negotiations by the end of Q2, with a public announcement hoped for in early June.

The US CMBX index represents a standardised basket of CMBS CDS that references a basket of CMBS reference obligations, and a new issue is released every six months. The index is currently comprised of six sub-indices: triple-A, double-A, single-A, triple-B, triple-B minus and double-B. Each sub-index, in turn, is comprised of 25 equally-weighted single-name CMBS CDS that refer to the like-rated tranches from 25 newly issued fixed-rate CMBS transactions.

MP

Re-leveraging returning?

First signs of credit-equity decoupling appear in the US

Investors looking for potential indications of a turn in the credit cycle need not look further than the current divergence between the CDX and the S&P 500 indices. It is, however, early days for the US market - and Europe is even further behind.

Hans Peter Lorenzen, a credit strategist in Citi's credit products strategy group, explains: "The whole debt-equity story is basically about leverage. The last time we were at a similar stage in the cycle was 1997. In 1995 and 1996, as between 2004 and 2006, there was strong correlation between debt and equity markets. However, in 1997 there was a big divergence - equity markets continued to perform very well but credit spreads started widening; corporates were increasingly using the financial flexibility they had built up to reward shareholders, with the result that leverage rose."

He continues: "We think that 2007 and beyond could follow a similar pattern. We are not saying that there has to be a sudden and sharp decoupling, but from our perspective it is hard to paint a scenario where equity does badly without credit following. Yet we can see a scenario where shareholder-friendly corporate actions sustain the momentum in equities but increasingly with more leverage. This would be a problem for credit holders."

Recent signs suggest that the strong correlation between equity and credit markets of the last 3-4 years could be coming to an end. In the US, the equity market is now at higher levels than before the sub-prime crisis hit, but credit spreads have struggled to keep up and are still wider than they were in late February.

In Europe it is a different story, however. The equity index has recovered even faster than in the US, but credit indices have followed and are now inside the levels seen in late February.

The disparity between Europe and the US can be explained by the fact that, while superficially there are similar levels of event risk - there is plenty of LBO talk, for example, either side of the Atlantic - far fewer deals have come to fruition in Europe. "What we are seeing is a tendency that the US market is pricing in some event risk that is not being priced in Europe yet," says Lorenzen.

This scenario makes sense, as the US has led the European cycle over the last few years. But Lorenzen's expectation is that Europe will follow at some point in the future.

Nevertheless, Lorenzen is keen to emphasise that the decoupling between S&P 500 and CDX is still not definitive. "Our US strategists are still quite bullish near-term about US credits, so it's quite possible that we will see over the next couple of months that the divergence will start to narrow again. Yet, we still think that current divergence will prove symptomatic of a long-term trend," he concludes.

MP

Queen's Walk attracts renewed interest

Share price rises on the back of buying activity

Cheyne Capital's Queen's Walk Investment Ltd (QWIL), the closed-end investment company listed on the London Stock Exchange that invests in and manages a portfolio of subordinated tranches of ABS, has seen some renewed interest in its shares in recent days. QWIL withdrew its dividend forecast as its share price plummeted in March (see SCI issue 33) to around €6, but it closed yesterday at a shade over €7 on the back of healthy buying volumes.

Investors put forward a range of suggestions as to what may be behind the share buying. These varied from speculation that a new management team of former investors might now be trying to buy up a significant holding in the vehicle to force a re-think of its strategy, to the manager conducting a share buy-back, to hedge funds seeing value in the current price or using QWIL as a hedge for their business more broadly. For its part, Cheyne declined to comment.

Whatever is behind the share buying, it remains clear that a portion of QWIL's investments are not faring well – which elicits some sympathy from one hedge fund manager at least. "Much of Queen's Walk's underlying has suffered high volatility. We do not dabble separately in the sub-prime market in either the US or the UK, but we do have a very small position in UK near-prime. And so I can understand when Cheyne says that its UK positions haven't suffered any high default risk but nevertheless have suffered from higher pre-payments than expected – that's what we have seen as well in our investment," he says.

"But on the US side, who knows? ABX.HE has been range-bound for the last couple of weeks, but a sting in the tail is to be expected. Ultimately for these guys, there's not much they can do," the hedge fund manager adds.

The fund's structure itself is not without its difficulties either, according to one structured credit investor. "QWIL is managed by a company that also has a hedge fund who's objectives may very well be different from those of Queen's Walk. I'm sure they have certain safeguards in place, but there is a clear conflict of interest – and if you look at the portfolio there is more than one transaction sponsored by the manager's other operations," he says.

Nevertheless, he adds: "I'm sure all the guys there are professionals and doing their damnedest to sort this out, but the fact remains that there are some oddities about the selection of assets and the fundamental conflict. The difficulty in managing that conflict is, for example, the major reason why every time we considered launching a CDO we rejected the idea."

Meanwhile, listed structured credit fund Carador announced its results for March last week. The investment manager's report says: "Carador's NAV performance continues to be resilient. In particular, Carador's secured loan positions have performed well. Carador's NAV was unchanged, month on month, during March. The NAV calculation excludes interest receipts from the CDO portfolio and other current period revenue items (after expenses)."

During the month, Carador received five additional interest payments from its CDO portfolio. The fund completed a small investment in Mizuho's Harvest IV, a euro-denominated seasoned CLO in March. This takes the total number of its positions to 34, and the number of underlying single credits to 2260.

MP

Wachovia preps synthetic auto deal

Second synthetic three years after the first could foreshadow others

Wachovia Securities is marketing a US$461m portion of a synthetic balance sheet securitisation of auto loan receivables. HELIOS 2007-S1 is only the second such transaction to come to the market and follows Wachovia Corp's acquisition in March of WFS Financial, which included a US$12bn portfolio of auto loans.

The acquisition more than doubled the size of Wachovia's indirect auto finance business, making it one of the US's 10 largest auto loan originators. HELIOS will enable the firm to transfer part of the associated credit risk to the capital markets, thereby freeing up capital on its balance sheet to be deployed elsewhere in the business.

The transaction references a US$6.2bn portfolio, but only the mezzanine notes (Classes B-1 to B-4) will be offered via a 144a deal. The remainder of the notes will be retained by Wachovia Bank.

Capital structure comprises US$4.99bn triple-A rated Class A-1 notes, US$249.4m double-A Class A-2s, US$249.4m single-A Class A-3s, US$249.4m triple-B Class B-1s, US$93.5m double-B Class B-2s, US$93.5m single-B Class B-3s, US$20m single-B minus Class B-4s and US$291.8m unrated Class B-5s.

The reference portfolio comprises 448,847 prime and non-prime auto loans secured by new (accounting for 31% of the pool) and used vehicles, of which 62% have already been securitised across 13 deals dating from 2003. HELIOS has a significant concentration of receivables originated in California (33.55% of the pool), resulting from Wachovia's strong dealer network in the state. The next four largest state concentrations are Washington (5.28%), Arizona (4.99%), Texas (4.67%) and North Carolina (3.26%).

The overall performance of Wachovia's auto loan portfolio has seen improvements since 2001, attributable to improved origination, underwriting and servicing practices, including better collection practices and improved collateral quality. However, in 2006 performance softened slightly versus prior years: total delinquencies were 3.21% through to December 31 2006, up from 3.09% the previous year.

Analysts at Fitch note that this is in line with the overall industry trend of improving performance and is consistent with the performance of certain of Wachovia's peers. They point out, however, that the condition of the wholesale vehicle market remains pressured as a result of the ongoing use of incentives and supply-and-demand factors, which may negatively affect loss severity in the case of vehicle repossession and disposition.

The cashflow generated from the reference portfolio will not be used to pay down the noteholders but instead will determine the principal reduction schedule of the notes. Any losses in the referenced portfolio will be first allocated to the class B-5 retained tranche until completely depleted. Thereafter, losses will be allocated from the lowest rated tranches to the higher rated tranches sequentially, resulting in the impairment of the principal amount of corresponding notes.

A potential impairment of the notes will trigger a cash settlement amount to Wachovia under the CDS agreement, which will be paid from the eligible investments – thereby decreasing the principal available for repayment of the notes. Any amount recovered from a charged-off vehicle in excess of net losses for a collection period on an aggregate basis will then be used to decrease the impairment amount for the related class of securities, starting with the most senior class.

Bank of America brought the debut synthetic auto ABS in 2004 – CARS 2004-A. Analysts expect further such deals to hit the market in the near future as lenders reassess their funding needs and the consolidation trend continues in the auto sector.

Wachovia's last auto transaction – WALOT 2006-2 – featured a US$39m triple-B rated tranche that priced at 40bp over swaps.

MP

Trading migration

This week, Maple Securities (UK) answers SCI's questions

Q: When, how and why did you become involved in the structured credit markets?
A: Maple has been trading proprietary strategies since our inception in 1986. From proprietary trading we developed a successful structured products business. Credit trading was an opportunity for us to employ intellectual capital acquired from our proprietary trading experience and structured products capabilities. So, when a credit team with a track record became available we employed them to set up our credit trading desk in January 2002.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: The introduction of commoditised index and index tranche trading. Prior to the introduction of industry accepted credit indices and tranches of these indices there was no common view of correlation in the market.

The introduction of credit indices and common tranches forced a common view of credit modelling and implied correlation in the market place. It also hastened the demise of full capital structure CDO's since it became possible for investors to have tranches tailored to their requirements without the need to place the unwanted parts of the capital structure.

Q: How has this affected your business?
A: Commoditised indices and tranches have made it possible for us to invest in structured credit tranches without having to find investors. The ability to invest in these tranches has made it possible for us to run various trading strategies which take relative views of the risk in credit tranches of differing subordinations and maturities. This would have been impossible to implement if the full capital structure had to be placed each time we wished to invest in a tranche.

A further advantage that stems from the commoditised indices is improved liquidity. The reduction in bid/offer spreads of structured credit tranches allows us to take advantage of relative value trades without the need for large mispricings to be observed.

Q: What are your key areas of focus today?
A: Our focus is currently on exploiting mispriced credit migration. Traditional credit trading has focused on the mispricing of default risk. Trading the mispricing of defaults generally requires a buy and hold type strategy and its subsequent exposure to spread volatility. The success of this type of strategy is determined at maturity by how many defaults have occurred.

Since the advent of commoditised structured credit tranches it has been possible to trade tranches by going long or short risk at various maturities with various subordinations on a range of portfolios with a high level of liquidity. This improved liquidity in the structured credit market has enabled credit migration trading. Credit migration trading focuses on the continually changing credit quality of a portfolio rather than on waiting for defaults to occur. This type of trading makes money if the degree of credit deterioration within a portfolio in a given time period is less than the degree of migration priced in by the capital markets. Credit migration trading is less volatile than waiting for defaults, which are binary in nature, have large impacts on profits, and are rare.

Furthermore default trading usually involves taking significant credit spread exposure, although credit migration trading does involve some degree of exposure to market spreads, forward spreads and correlation it is possible to greatly reduce this exposure. A further advantage of the improved liquidity in credit markets is the ability to tailor hedges cheaply and easily hedge out unwanted exposures.

Q: What is your strategy going forward?
A: Credit migration remains a central plank in our credit strategies. We continue to look for mispricings in terms of forward spreads and correlation when compared to predicted levels of credit migration within a portfolio. Once these mispricings are determined we look for methods to extract this mispricing whilst remaining hedged to general market spread and correlation levels.

Credit migration has been very successful for us and we are also considering ways to expand the business either through the issuance of credit migration notes or using a credit migration fund.

Q: What major developments do you need/expect from the market in the future?
A: Credit trading has always been interested in rating arbitrage. This is really an expression of the difference between the capital market view of risk – as expressed by prices from which default probabilities and downgrade paths can be implied – and the rating agency view of risk.

We expect many market participants to continue to focus on this area, and new styles of products like CPDOs are arriving to fulfil this demand. Liquidity in Far Eastern credit indices is expected to increase. Also credit options on both single names and credit indices and derivatives on ABS structures are gaining in popularity.

One problem recently highlighted by the Delphi default is the shortage of bonds required to fulfil a CDS contract on a defaulted entity. The shortage occurs because the process for enforcement of CDS contracts requires delivery of bonds to monetise the contract. A mechanism to avoid these squeezes on bonds is required and we expect such a mechanism to become market standard.

Another problem associated with structured credit trading is the need for name give up. CDS contracts contain within them implicit counterparty credit risk, hence the requirement for name give up. A mechanism to remove this requirement, such as exchange traded contracts, is required to continue to fuel the growth of the market. The recently introduced index contracts on Eurex are a step in this direction. However, such movement is likely to be opposed by the big market maker banks, which would see a reduction in their business.

One area of credit derivatives that has improved greatly and will continue to improve is the control and standardisation of swap documentation. A few years ago it could take months for documentation to be finalised between counterparties following a structured credit trade. This has been reduced to weeks and we expect the imposition of standard docs and procedures to reduce this even further.

About Maple Securities (UK) Ltd
Maple Securities (UK) is the London based, FSA regulated subsidiary of Maple Financial Group Inc ('Maple'). Maple is a privately held, global financial organisation headquartered in Canada. It provides banking, securities, trust and financial services to financial institutions, corporations and individuals throughout the world.

Maple was founded in 1986. Today, it has over 250 employees, assets of US$19bn with a bank, Maple Bank, in Frankfurt and offices in Toronto, Jersey City, NJ, London, Milan and Amsterdam.

Maple Securities' credit derivatives desk is currently led by Paul Hiob, and co-managed by Marc Verlet and Roy Bottomley. The desk is a small yet multi-disciplined team that brings years of experience in financial structuring, credit analysis and computer science to this highly technical business line. The desk seeks to create synthetic portfolios that are better quality and lower risk than those typically available from investment banks.

Chapey leaves Citi

The latest company and people moves

Chapey leaves Citi
Fred Chapey, global head of structured credit derivatives at Citi in New York has resigned from the bank. His destination is not yet known

Blake to UBS
Martin Blake, an illiquids trader at Barclays Capital, has left the bank and has joined UBS in a similar role. He reports to Damon Cooke.

BarCap adds Borrin
Stan Borrin has joined Barclays Capital from Lehman Brothers as a high yield CDS trader.

Croxson to WestLB
WestLB is understood to have hired Katie Croxson to work on the structuring desk. She joins from Merrill Lynch where she was a cash structurer.

Van der Linden exits ING
Guillaume van der Linden is understood to have resigned from his position as head of credit at ING. His destination is not yet known.

Fortis Investments appoints new duo
Fortis Investments has appointed Peter Branner as its new cio for multi-management and Charles Janssen as head of institutional sales, Netherlands and UK. Both joined yesterday, 1 May.

As cio for multi management, Branner will be responsible for a twelve-strong team including analysts, portfolio managers and portfolio constructors currently located predominantly in London, plus Amsterdam and Luxembourg. He reports to the company's global cio, William De Vijlder.

As head of institutional sales, Netherlands and UK, Janssen is responsible for the nine-strong institutional sales teams currently located in Amsterdam and London. He reports to Thomas Rostron, md and head of marketing & business development.

Branner joins Fortis from the IKANO Group where he has worked for the last 12 years, most recently as cio and md of IKANO Fund Management in Luxembourg. Janssen joins with 22 years experience in the institutional asset management arena; his last five years were spent at Barclays Capital in London where he was country manager Netherlands, and head of the Dutch structured solutions desk.

JP Morgan hires in structured solutions
Gareth Davies and Mark Dyson have joined JP Morgan, as md and vp respectively, in the firm's structured solutions group for EMEA. The structured solutions group provides investors with bespoke solutions across all asset classes to all client sectors in the region.

The bank says the hires serve to reinforce the strength and breadth of JP Morgan's structured solutions business and further demonstrate its commitment to continue to invest in this area. Davies joins from Bank of America where he was an md in global structured products. Dyson joins from Barclays Capital where he was a manager in the resource team, which is part of the structured capital markets division.

Both Davies and Dyson will be based in London and report to Nick Woolnough, md and head of the structured solutions team for EMEA at JP Morgan.

DBRS Appoints Fekete
DBRS has appointed Aloysius Fekete as an svp of its structured finance group. His appointment further strengthens DBRS's EMEA team in London and Paris, which has now grown to 21 people.

Fekete, who joins from Lewtan Technologies, will be developing and leading the structured finance deal surveillance platform in the EMEA region. Based in London, he will report to Apea Koranteng, md and head of structured finance EMEA.

Gooch joins Markit
Markit Group Limited has appointed Jeff Gooch to its executive management team as an evp and head of Markit's portfolio valuations and trade processing businesses. Prior to joining Markit, Gooch worked at Morgan Stanley for eleven years, most recently as md, global co-head of fixed income operations and global head of OTC derivative operations.

He was formerly the European co-chair of the ISDA operations committee, and served as Morgan Stanley board director of Markit in addition to being a member of the Markit RED advisory board.

DTCC adds chief risk officer
DTCC has named Douglas George to the new position of md and chief risk officer. In his new post, George will lead DTCC's Enterprise Risk Management (ERM) efforts, including the management of credit and market risk associated with all DTCC subsidiaries' clearing, settlement and depository activities, as well as assessing operational and strategic risk issues for DTCC and its growing involvement in the delivery of global services. He will also oversee the planning of new technology to support enterprise-wide risk analysis and the development of new strategies to mitigate risk for DTCC and its member firms.

Most recently, George has served as md and head of payment systems risk management for Citi, a position he's held since 1996. In this capacity, George oversaw the development of a firm-wide programme for identifying, measuring, monitoring and managing Citi's credit, legal, market, operational, sovereign and cross-border risks.

HD & MP

First CFXO announced

A round up of this week's structured credit news

First CFXO announced
Merrill Lynch has announced that it will launch the first collateralised foreign exchange obligation (CFXO), with an as yet un-named deal managed by Crédit Agricole Asset Management (CAAM). It will offer investors five-year notes in all major currencies, with rated tranches – from triple-A to triple-B by S&P – and equity.

A press release from Merrill and CAAM states that the CFXO product allows institutional investors, for the first time, to gain exposure to currency while also benefiting from maturity and a yield and rating corresponding to the chosen tranche. Because of its very low correlation with traditional asset classes, this innovative structure provides a very efficient tool for diversifying investors' portfolios, the release adds.

The underlying portfolio reportedly references around 10 FX pairs, combining G10 currencies with a number of emerging market currencies. The triple-A notes are expected to carry an 80bp to 100bp coupon, with the return for the equity piece in the region of 20%.

A global roadshow for the deal is scheduled for the coming weeks. For detailed information on Emerging Market local currency CDOs, see this week's Research Notes section.

BoE highlights wider sub-prime issues
In its latest Financial Stability Report, published last week, the Bank of England suggests that problems in the US sub-prime sector may give insights into potential problems in other markets, such as corporate credit and commercial real estate (CRE).

BoE says: "Structured credit markets have expanded rapidly in benign conditions and their resilience in less favourable conditions has not been severely tested. Although both the sub-prime and corporate credit markets do exhibit significant differences, the common factors suggest there is merit in risk managers examining carefully lessons arising from the recent sub-prime episode."

It goes on to discuss those similarities and differences. For example, BoE argues – given that risk is transferred to other market participants – there are concerns that the 'originate and distribute' model might dilute incentives for the effective screening and monitoring of loans in the corporate market, as appears to have occurred in the sub-prime market.

Furthermore, it says, the structured credit market is characterised by new types of investors and a concentration of credit risk in lower-rated tranches. CDO managers are typically the main distribution channels for mezzanine tranches of both sub-prime ABS and corporate credit deals.

There are also some hedge funds which purchase the higher risk equity tranches of both. Any fall in demand from these investors could cause a sharp rise in the cost of debt to firms.

Equally, the embedded leverage in CDOs is common across sub-prime, CRE and corporate credit markets and could magnify the market response if there was a particularly sharp deterioration in the performance of underlying assets.

The differences between the sub-prime and other structured credit markets that BoE highlights include the fact that corporate loan prices do not appear to have been driven by demand to the same extent as MBS. And corporate credit securitisations tend to be more diversified than sub-prime MBS, with greater differentiation across the risk factors that corporates are exposed to.

In addition, BoE says credit analysis may be more extensive in corporate credit and CRE lending than sub-prime lending, due both to the size of the individual deals (which are often rated) and the fact that the arranging institution usually retains at least some exposure. Moreover, in the case of sub-prime mortgages, although tranches of the subsequent securitisations are rated, the underlying loans are not. As such, they cannot be individually downgraded and early warning signs arise only from delinquencies.

Due to their size, some CRE loans are not individually rated, although larger single-name deals tend to be. The speed of transmission from the cash market to the securitisation and structured credit markets may be faster in corporate credit, since the underlying assets are rated and so any downgrades can quickly affect the ratings of tranches.

US CRE CDOs continue to evolve
In a new report, Moody's notes the continued evolution of US CRE CDOs in terms of their structure, collateral and the agency's approach to them. During 1Q 2007 Moody's rated nine cash CRE CDO transactions totalling US$5.6bn. By balance, this is an increase of 50% from the same quarter one year ago.

The agency says that while the overall composition of cash CRE CDOs can vary significantly from one quarter to the next depending on just a handful of transactions, collateral composition continued its general trend toward including a greater share of uncertificated assets such as whole loans and B notes. This trend should continue as portfolio lenders such as banks and insurance companies increasingly find the CRE CDO structure to be efficient for risk management and financing, Moody's suggests.

The report continues: "With significant attention currently being focused on the sub-prime residential mortgage sector, it is important to note that CRE CDOs have extremely limited direct exposure. Only a handful of CRE CDO transactions permit residential exposure at all, and in those cases it is typically investment buckets limited to 5%."

Moody's adds that it has seen an increased use of the pro-rata pay structure in CRE CDOs. Pro-rata pay structures allow for principal payments to be made to each class in proportion to its size, subject to some limitations based on collateral performance and diversity.

However, the bulk of CRE CDOs continue to use sequential pay structures, where all principal payments are directed to the most senior outstanding class until it is fully retired, and then additional principal payments work their way down the capital stack in a similar manner.

The report notes: "Sequential pay structures build up more credit support for senior bonds than pro rata structures, which helps offset adverse collateral developments over time. As Moody's models WARF, diversity and other factors for possible credit drift, we perform additional analysis to determine the credit impact of the pro-rata pay structure."

Fitch reassesses iTraxx in Asia
Fitch Ratings reports that the credit risk in the iTraxx Asia Ex-Japan series 7 index is broadly stable. However, credit risk had deteriorated slightly in the iTraxx Australia series 7 CDS index

The agency says the credit risk of the overall iTraxx Asia ex-Japan series 7 CDS index remains broadly stable, following the recent rollover from series 6. The weighted average rating has remained the same (triple-B/triple-B minus) in series 7, although the weighted average rating factor has deteriorated slightly to 5.30 from 5.06 in series 6.

Meanwhile, Fitch confirms that the overall credit risk of the iTraxx Australia five-year CDS index series 7 has slightly deteriorated, following the recent rollover from series 6. Fitch provides a credit assessment of each tranche in the index.

Apart from the 12%-22% tranche that has the same rating at triple-A, all the remaining tranches in series 7 were lower by one to two notches compared to those in series 6. The weighted average rating factor has deteriorated to 2.92 in series 7 from 2.48 in series 6, although the weighted average rating remains the same at A minus/triple-B plus.

EHYA calls for restructuring re-think
The European High Yield Association (EHYA) has submitted a paper to the UK Treasury that reviews the current restructuring climate in the UK and suggests areas to reform insolvency legislation to improve the efficiency and fairness of corporate restructurings. The document cites a number of high-profile restructurings that have occurred in the UK and Europe in recent years, including those of British Energy, Eurotunnel, Marconi, Jarvis and Polestar, which the EHYA believes could have benefited from these reforms.

The EHYA submission recommends a limited addendum to the Insolvency Act of 1986, addressing three principal issues. First, an all-encompassing stay on actions should be available to prevent value destruction, as this is currently seen as an inevitable consequence of filing for insolvency in the UK.

In other jurisdictions, notably the US and France, contractual termination provisions are not enforceable. The current stay deployed by English law does not go far enough in protecting failing businesses and allows customers and suppliers to terminate contractual relations just when their continued commitment is most crucial to the rescue.

Second, a framework should be created for fast judicial resolution of valuation disputes in restructurings, short of administration proceedings. This will enable practise and precedent to develop in restructuring valuations, thus providing stakeholders with relative certainty of outcome, while avoiding the value loss that arises through administration.

Third, creditors or shareholders with no economic interest in the revalued enterprise should not be able to block restructurings or force full insolvency proceedings. A mechanism is needed to deal fully with 'out of the money' claims in restructurings.

US structured finance shows upside
US structured finance rating activity was again strongly skewed to the upside in 2006, according to the latest study of Fitch-rated US structured finance securities, which looks at market performance both in 2006 and over the long term period from 1991-2006. The upgrade-to-downgrade ratio across the universe of Fitch-rated ABS, RMBS, CMBS and CDO tranches was 5.3:1, an improvement from the 3.2:1 ratio recorded in 2005.

Overall structured finance upgrades increased 47.5% year over year, totalling 2,571, compared with 1,744 in 2005 – while downgrades declined to 482, down from 549 in 2005. Fitch-rated US structured finance bonds exhibited either a high degree of rating stability or improvement in 2006, with 98% of credits maintaining their rating or being upgraded.

The CDO sector also saw its best performance in several years, experiencing substantially more upgrades (up 68.3%) and fewer downgrades (down 33%) than in 2005.

CMA enhances DataVision
CMA has announced major enhancements to CMA DataVision, its same day consensus based price verification data service for CDS, indices and tranches. To provide the best possible evaluation of less liquid entities, CMA has developed a sophisticated multi-step modelling process, in conjunction with several clients and a team of industry experts, to enable CMA to derive price points and generate a full term structure with a high degree of accuracy.

Using this process, CMA has more than doubled the number of data points that can be confidently provided by CMA DataVision. Laurent Paulhac, CMA's ceo, comments: "By delivering full term structures using our state-of-the-art methodology, we can now enable more middle office professionals to use DataVision for end of day mark-to-market."

Principia offers SIV functionality
Principia Partners has released Principia SFP Version 5.1. The new release provides extensive standardised compliance reporting and accounting functionality for the rapidly expanding SIV and securities arbitrage conduit markets.

"As market requirements and practices have become more standardised, we are able to package a complete SIV management solution that covers a wide range of compliance reporting and operational needs out of the box," states Douglas Long, evp - business strategy at Principia. Using an intuitive interface, SIV managers can select and edit the standard suite of compliance reports covering cash outflows, portfolio composition, liquidity, market risk and capital adequacy and stress tests. The packaged SIV chart of accounts accommodates a broad range of accounting treatments, requiring little or no customisation."

The added functionality integrates with Principia's deal capture, portfolio management and risk capabilities. This continuous end-to-end processing is critical because SIVs do not require costly liquidity backup facilities to guarantee shortfalls in settling maturing liabilities.

SIVs qualify for this capital efficient approach by marking their portfolios, testing cashflow adequacy and monitoring credit and market risks on a daily basis. Thus they require far more robust and analytic portfolio management capabilities than other less dynamic vehicles.

Thomson launches Credit Analysis
Thomson Financial has launched of Thomson Credit Analysis, which is integrated into its Thomson ONE platform. The solution aims to provide an end-to-end workflow package to aid credit analysts, risk managers and managers of multi-asset funds.

The solution's cross-asset class capabilities offer a link between the corporate bond, CDS and equity of an issuer, giving a relative value perspective across the complete capital structure of the firm. Thomson Credit Analysis is initially available in Europe and will be rolled out in the US this month and to clients in Asia in early 2008.

LaSalle adopts SIFMA CDO format
LaSalle Bank has become the first firm to adopt SIFMA's recommended standardised format for data files related to the performance of CDO transactions that are disseminated on a regular basis by the trustees of the deals.

"The recommended data file format offers a way to standardise the multiple formats currently used by trustees of CDO transactions, allowing users to more quickly and efficiently process the vast amount of data that are provided in reports on CDO transactions," says Robbin Conner, vp and assistant general counsel at SIFMA. "We believe this has benefits for the CDO market and expect that other trustees will adopt the standardised format as well."

TriOptima launches portfolio reconciliations service
TriOptima, the service provider for early terminations of OTC derivatives portfolios, has launched a new service – triResolve – for proactive portfolio reconciliations. A group of major dealers, including Barclays, Goldman Sachs, Morgan Stanley, UBS Investment Bank and Wachovia, are now using triResolve on a regular basis. Over 1.2 million unique trades were reconciled through triResolve in the first quarter of 2007.

triResolve is a web-based service where participants submit their entire bilateral portfolios comprised of all transactions covered under their collateral agreements. Portfolios are compared and the results of the match are immediately available on the triResolve website, showing all trade details and valuations.

Counterparties research and resolve their differences online through the triResolve GUI. The solution maintains previous data submissions and matches, so that only incremental discrepancies need to be addressed.

The triResolve service provides functionality for resolving portfolio discrepancies, including on-line highlighting of issues and trade level chats between counterparties, as well as a range of management reports for tracking progress and analysing root causes generated from regular submission of data.

MP

Trading ideas - full speed ahead

Dave Klein, research analyst at Credit Derivatives Research, considers a default-neutral curve flattener on Cisco Systems

In this article we consider a special type of curve flattener – buying shorter-dated CDS protection and buying a longer-dated bond. With the ongoing volatility in the markets, it is easy to be a bear these days and ignore bullish trades altogether. Occasionally, the stars align and we find relative value in a technically sound, positively economic trade on a credit we like. In this case we consider a 5s-9s curve flattener on Cisco Systems, Inc (CSCO), buying 5-year CDS protection and the CSCO 5.5's of Feb 2016 bond.

Looking better
To estimate the fair value of the 5s-9s flattener, we model the 10-year CDS mid level as a quadratic combination of the 5-year mid levels. We do this across 10-year CDS since the 9-year CDS is not a liquid tenor. This is undertaken across the universe of credits whose 5's are close in value to CSCO.

For each issuer, we produce an expectation of the five-year CDS mid level. This is compared to the current market five-year CDS mid level in Exhibit 1.

Exhibit 1

Ignoring the difference in maturity (10-year CDS vs. a 9-year bond), the 5.5's of 2016 is about 8bp steep to fair value according to the model. If we interpolated the bond z-spread out to a 10-year maturity, we would expect to see an even wider differential. Our CDS-implied bond pricing model, our preferred pricing method, assigns the 2016 bond a fair z-spread of 13.01bp, implying the bond is even wider of fair value than the CDS market indicates.

Differentiated differentials
CSCO has reasonable liquidity in the CDS market at the five-year maturity. As spreads have moved over the past year, the curve differential (between five-year CDS and the 2016 bond) has ranged between 3 and 26bp, as seen in Exhibit 2. We have interpolated the CDS level to match the decreasing maturity of the bond (that is, we used a constant maturity date of June 20, 2012 to match the current 5-year on-the-run maturity date).

Exhibit 2

Mid-to-mid absolute differentials are currently high compared to the past year, sitting at about 21bp. The differential has widened and tightened regularly over the past year which further boosts our confidence in the trade.

The real deal
While we maintain a stable fundamental outlook for CSCO, we are bulls on the 2016 bond. Given this positive view, we could take an outright position and purchase the bond without a hedge.

However, we like the fact that our relative model value shows the bond to be away from fair value and the 5-9 curve (with the bond providing the 9-year level) too steep. Given that a default-neutral 5-9 flattener is positive carry and provides a hedge against default, we'll prefer the flattener over an outright.

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

Risk analysis
This trade is default-neutral to ensure positive carry as well as to reduce our exposure to roll-down effects. However, we are not duration-neutral.

We choose higher carry and better roll-down over exposure to short term shifts in the credit curve. We are comfortable with this trade-off, especially given our view that the curve is much too steep.

We do understand that many investors would still prefer to understand the interest rate risks associated with this position. Exhibit 3 shows the overall and key-rate sensitivities for the bond that can be used to specifically hedge any residual interest rate risk and offers the investor some more insights into the price sensitivities of the position.

Exhibit 3

The carry cushion protects the investor from any short-term mark-to-market losses. This trade has negative roll-down which we have minimized by going default-neutral rather than duration-neutral.

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

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

CSCO is a moderately liquid name. Bid-offer spreads have narrowed to around five basis points in five-year CDS respectively and the 2016 bond has good availability in the cash market. While we'd like to see lower bid-offers, the positive economics of the trade allow us to recommend the flattener.

Fundamentals
This trade is significantly impacted by the fundamentals. The technical steepness of the credit and positive economics are helped by a potentially positive systemic outlook which, in our view, overwhelms the stable idiosyncratic performance of the credit.
Dave Novosel, Gimme Credit's Technology expert, maintains a stable fundamental outlook on CSCO and is a buyer of the 5.5's of 2016. Dave believes that CSCO offers above-average top-line growth while generating massive free cash flow. Dave notes that leverage on CSCO is very low and liquidity is outstanding.

Summary and trade recommendation
We consider a bit of a hybrid trade here with a CSCO bond-CDS default-neutral curve flattener. CSCO shows outstanding fundamentals with excellent top-line growth and free cash flow.

While we could easily take an outright position in CSCO's 2016 bond, we prefer to capture relative value in a default-neutral (not duration-neutral) curve flattener and are buyers of 5-year protection as well. This results in a positive-carry flattener on a curve that we believe is much too steep. Good carry and the potential profit of a return to fair value strengthen the economics of the trade and offset negative roll-down.

Buy US$5m notional Cisco Systems, Inc 5-year CDS protection at 13bp and

Buy US$5m notional (US$1.014m cost) Cisco Systems, Inc. 5.5% of Feb 2016 bonds at a price of US$100.374 (z-spread of 26bp) to gain 13 basis points of positive carry

For more information and regular updates on this trade idea go to: www.creditresearch.com

Copyright © 2007 Credit Derivatives Research LLC. All Rights Reserved.

Note: This article is intended for general information and use and does not constitute trading advice from Structured Credit Investor (see also terms and conditions, below, section 12).

Emerging market local currency CDOs

Michael Hampden-Turner, a director in the credit products strategy group at Citi, looks at the increasing popular product class

With spreads at historic tights and yields on structured credit products offering diminishing returns, many investors are looking at alternative investment classes to diversify risk and obtain spread pickup. Despite tightening spreads, emerging market debt offers an attractive risk/reward profile for investors relative to loans or high yield.

In comparison to these other collateral types, emerging market debt has not been as extensively used in structured credit. As a result, emerging market debt has not experienced spread compression to the same extent.

The asset class would, at first glance, seem the ideal candidate for the diversification and structural credit protection CDOs offer. However, emerging market structures have historically been restricted by a lack of liquidity/availability of suitable debt instruments or CDS.

The increase in structured demand has helped to improve the standardisation and liquidity of EM debt. However, some of the new generation of credit derivates have gone a stage further and created their own collateral in the form of credit-linked notes (CLNs).

A CDO made of CLNs bypasses idiosyncratic local market features, maturity mismatch, and problems of liquidity. Global investment banks used their expertise and local knowledge to create a standardised product, providing liquidity and absorbing risks between the standardised note and the local market debt instruments.

These innovations have made emerging market sovereign risk accessible to a new audience. Investors can more easily take a G3-denominated, investment-grade, diversified exposure to the whole sector with all the benefits of structural credit protection. Many of the new generation of EM CDOs allow investors to buy a dollar-denominated investment that has both local debt and local currency exposure, nicely matching the needs of both investors and borrowers.

Solid emerging market fundamentals
Citi economists forecast solid performance in emerging markets for the next few years. The key components of this forecast include the trend towards better economic policies, growing financial depth and sophistication, and a benign global economic backdrop.

Major emerging market economies like China, India, Russia, and Mexico all showed higher GDP growth in 2006, with only modest deceleration expected in 2007. Continued solid gains in output measures such as industrial production, exports, and GDP has been coupled with moderate or falling inflation and steady fiscal positions.

Key economic variables in EM countries have become much more stable in line with the United States and Europe. For example, CPI and GDP volatility is much reduced in CEEMEA and Latin America in particular.

This may be due to financial innovation, high G3 GDP growth, capital flows, and the lack of external economic shocks, but some portion of it seems likely to be due to a general improvement in local policy decision making.

Structural vulnerability is decreasing in EM countries as well, which should improve their resilience going forward. Government debt-to-GDP ratios are falling, and international reserves are rising. Reserves have increased despite the prepayment of external debt.

Positive economic performance has some reinforcing political effects, encouraging the continuation of market-friendly policies. However, years of tight adjustment policies in areas like central Europe might well result in waning popular support as "reform fatigue" sets in.

This political vulnerability in select areas seems unlikely to spill over into a larger crisis. Geopolitical events seem more likely to provide shocks, although the timing and severity of these are much harder to forecast. This underscores the need for an experienced collateral manager to monitor and react to such risks.

Interest in EM CDOs
There are a number of features of the new generation of EM CDOs that investors have found particularly appealing.

Enticing spreads
The spread compression that European and US High Yield and crossover credits have undergone has not, by and large, been reflected in EM credits. One of the primary reasons for this is a combination of a low default environment and the popularity of including high yield and crossover assets in structured credit, which has driven tights far beyond historic levels.

This can be seen in Figure 3, which illustrates the spread compression in the iTraxx Crossover Index relative to a basket of corporate and sovereign EM credits. EM credits are at tights relative to historical levels, but they have not experienced spread compression to the same extent.

Figure 1 illustrates the pickup available in local currency EM sovereign credit spreads relative to G3-denominated corporate EM CDS spreads. The table compares iTraxx € corporate credits to G3-denominated EM corporate and sovereign spreads and local currency sovereign debt by rating.

Investment diversification
CDO investors who already have substantial exposure to more traditional structured credit collateral, such as ABS CDOs and CLOs, value portfolio diversification.

Figure 2 illustrates the correlation of emerging market collateral relative to other forms of collateral, such as ABS and leveraged loans and other products such as rates.

The global nature of the credit and FX exposure provides considerable diversity compared with CDOs and CLOs that focus on narrower markets. Regional defaults and geopolitical events have yet to provoke widespread EM contagion.

Spread pickup relative to CDOs/CLOs
Despite the fact that EM sovereigns are at historic tights, local currency EM CDOs still offer a substantial spread pickup relative to CLOs and ABS CDOs of an equivalent rating. The pricing on Evolution, a three-year local currency EM CDO, illustrates how spread pickup is available across the capital structure with a particularly large and volatile equity tranche.

Structurally, because Evolution contains EM FX risk, subordination levels are much higher compared to deals like Eurocredit, even though the average rating of the loan collateral is also low. This is even more extreme for the Euromax CDO of ABS, which has an attachment point for the AAA tranche of 21.6%, whereas the equity tranche for Evolution II is 0–25%.

Emerging markets performance has been strong
This has been the case in terms of spread and rating performance. Declining default rates, positive structural changes, abolition of fixed-exchange rates and increased foreign reserves have boosted investors' confidence.

Upgrades have outstripped downgrades, both for corporate and sovereign credits, and there has been spread tightening and currency appreciation in emerging markets generally (against US$). EM CDOs issued in the last few years have performed well and crucially have retained a low correlation to other investments.

The following bar chart illustrates how EM sovereigns have benefited from upgrades in the last few years. This is especially marked since 2000.

Market access
Emerging market credit investment has long been seen as a specialist investment area. In the last few years CDOs have become the largest buyers of emerging market debt in synthetic and cash form and have become one of the easiest ways for generalist investors to take exposure to the market.

While liquidity and transparency has improved in EM credit, specialist managers working with global investment banks are capable of increasing the breadth of EM credit investment beyond what would be available to generalist investors through the creation of local currency CLNs.

Specialist managers
Diversified exposure to a large pool of EM credit requires a huge quantity of due diligence and analysis of globally diverse credits, particularly challenging in the sub investment-grade area. The volume of information and close monitoring of political and legislative changes that might be harmful to investors' interests would typically be beyond the means of many non-specialists.

Precision risk taking
Although EM CDOs differ in structure, they allow investors to take diverse credit risk exposure to emerging markets with some precision. CDO technology allows investors to take deleveraged or leveraged exposure to credit while remaining remote from interest rate, currency, taxation, and structural anomalies of local markets.

G3-denominated EM CDOs with EM FX exposure
Figure 7 illustrates the process of creating an EM CDO from local currency debt instruments. One of the challenges in creating EMCDOs is the limited universe of liquid names available for inclusion. An innovative way to overcome liquidity issues of EM names is to create a basket of proxy assets.

For each EM name, traders with knowledge of local debt markets create a local currency CLN. It is up to the CLN market makers to create a suitable investment vehicle that smoothes idiosyncratic differences such as maturity mismatch, custodian arrangements, local taxation, and repatriation of funds' rules to make a generic investment note. Each bank-issued CLN is, therefore subject to both local currency and credit risk.

A basket of such notes can then be created for use in a CDO. The first CDOs issued of this type have been short dated (three years) and managed by a specialist emerging markets manager who retains large portions of the equity tranche (aligning interests with investors).

The manager instructs the arranger about changes to the investment portfolio and regional market makers buy or sell local assets to create suitable amounts of each CLN to fulfil the manager's instruction. Cash flows are then swapped into euros or dollars and paid to note holders.

Unlike other CDOs this form of EM CDO has an FX and a credit component. If the dollar value of the basket of local currency investments falls, this erodes the value of the notes sequentially up the capital structure. Unlike credit loss in a CLO, however, it is possible for a note to be written down and for coupons to be curtailed in one period and then be written back up again in the next.

CFXO (collateralised foreign exchange obligations) have a dominant FX component as well, but this risk comes in a much more binary form. A CFXO is a basket of digital put options that pay a fixed amount if an FX rate drops to a certain level. This is different to deals with multicurrency collateral that have an equity tranche that benefits from profit and loss due to foreign exchange moves. (Protracted loss can eat progressively into the rest of the capital structure as well.)

Emerging market credit events
Credit events that trigger default payments in emerging markets are not standardised in the way that investment-grade corporate and PAUG loan CDS are standardised. Additional triggers are required to capture events that are particular to emerging markets. While these are not standard across every deal, the main additions are extensions of the moratorium/repudiation clause found in CDS contracts.

• Inconvertibility/non-transferability of debt. Emerging market debt often has to be held locally or by a custodian. If political events mean that debt held by foreign parties cannot be sold/repatriated/transferred then market makers have three months to effect that transfer or a default event is deemed to have occurred.
• Adverse change of law. If a change of law results in a loss to local currency debt then this is deemed to constitute a credit event.

EM FX risk in EM CDOs
Emerging market FX risk is a novel feature for most CDO buyers. A few key factors to bear in mind. The most important is the dampening caused by a large basket of even quite volatile FX risk.

Diversification provides considerable advantage for EM FX risk because the currency pairs are characterised by low levels of correlation, although certain regional pockets are exceptions to this rule. The correlation table in Figure 8 illustrates this.

Consider the following example that compares a basket of 30 names to €/US$ risk. The graph on the left shows all 30 currencies (indexed to 100 for comparison).

The graph on the right shows the average level of the same 30 currencies compared to the euro. Annualised volatility is 5% for the basket of currencies and 7% for the euro.

Figure 10 also illustrates how emerging markets have been appreciating relative to the dollar in the last few years.

Conclusion
Liquidity in EM credits has historically hindered the creation of CDOs. The new generation of local currency CDOs has increased potential coverage and liquidity by the creation of local currency linked CLN.

As a result, collateral selection based on a wider choice is possible and limits on availability/liquidity have been removed. The largest global investment banks have a substantial advantage in the creation and maintenance of local currency-linked CLNs.

Emerging market fundamentals suggest a solid period of growth and low volatility of economic indicators. An increased structural resilience in many EM countries is supportive of this view. Citi economists highlight a few high-risk countries, but do they do not anticipate that problems would spill over into a more general crisis that would see a retreat from the asset class.

Early investors have benefited from wider spreads relative to US and European names with equivalent ratings. Therefore, demand for the first few structures offered in the market has exceeded expectation with deals being upsized. If the collateral and currency continues to perform, CDO spread compression is almost certain to continue.

Some of the new structures are likely to continue to change and adapt. But local currency CDOs match the needs of borrowers and lenders with the result that the CDO type is likely to continue to prove popular.

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