Contents

CDR Liquid Index data as at 7 May 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.

Washington Square readies opportunistic CDO-squared

Innovative combined CLO-squared and CDO of ABS deal being prepped

Washington Square Investment Management (WSQIM), as manager, is putting together a CDO-squared, the underlying of which will comprise mostly CLOs.

The deal will invest in the mezzanine tranches of its target underlying, aiming to capitalise on opportunities presented there. Miguel Ramos Fuentenebro, managing partner at WSQIM, explains: "The idea for the deal came about as a result of the performance of our listed fund, Carador, and the effective asset allocation we implemented."

He continues: "Certainly value has shifted there currently in US CLOs, thanks to large numbers of hedge funds shorting the mezzanine area for paper profits. At the same time - also on the back of the noise from the sub-prime market - we have decided to include a bucket for CDOs of ABS because we see the market is not differentiating enough there either. We see some portfolios that we expect to underperform significantly, but at the same time we see other portfolios that are quite healthy and still being priced at extremely wide levels."

WSQIM has an advantage in this space due to its wider investment remit, Ramos Fuentenebro argues. "If you only invest in triple-B you typically don't have that much time to assess the paper before a deal closes, but as we invest across the capital structure and need to assess every transaction as a potential equity investment we get information significantly in advance, and get full access to the manager and details of the portfolio. From our perspective it works really well because at the end of the day we have to do the work anyway and gives us the opportunity to invest where we see the value," he says.

The transaction also attempts to diffuse the potential impact of defaults on the basis that defaults tend to occur in specific sectors or clusters of sectors rather than across the whole market. CLOs offer significant sector diversification, but by utilising a CLO-squared format, the deal extends this still further and will run across a large number of different sectors.

Overall, Ramos Fuentenebro says: "We want to provide a structure that is very stable. So we are targeting a thick equity tranche. This, combined with an average investment grade portfolio and significant sectoral diversity means that investors will benefit from a strong breakeven point."

MP

Projected LCDX spreads tight

Expectations for US loan CDS index spreads have narrowed, while discussions over tranches continue

Dealer projections for LCDX spreads have got tighter in the weeks running up to the launch of the new US index – now expected in the next couple of weeks. At the same time, market participants are attempting to resolve the two major issues surrounding standardised LCDX tranches.

A report published by Citi's credit products strategy group last week notes: "After widening in March and early April as a result of sub-prime contagion, LCDS spreads have tightened a bit in the last several weeks, especially for some of the high-beta credits. In the rally, LCDS outperformed loans by about 10–15bp, decreasing the average basis to about minus 60–70bp. Our projections for the average LCDX spread also decreased to 113bp. The tighter spreads could cause extra buying interest from the index hedgers, hence, a larger premium of the LCDX spread to its intrinsic value at inception."

Mikhail Foux, a credit strategist at Cit in New York and co-author of the report, adds: "That projection is effectively unchanged in the last week or so. Today [Tuesday 8 may] the average is still about 113bp."

The tightening of dealer-projected LCDX spreads, is understandable according to another New York-based banker. "We are getting so much interest in the index now that it is so close to launch – it's just a question of getting everyone ready to go simultaneously now," the banker says.

Attention has now turned to finalising the two major outstanding matters on the proposed standardised LCDX tranches, which are expected to be set at 0-5%, 5-8%, 8-12% 12-15% and 15-100%. First, and foremost, is the process to be adopted when entities within the index are called.

The banker says: "The debate is between whether a call is treated on a pro-rata basis across all the tranches, or it just reduces the super senior tranche. I think the market is leaning towards the simple approach, which is to treat it as a default with 100% recovery and write down the top. But there are some consequences to that approach and so the market still needs to talk it through and the issue is being addressed right now."

The second issue is one of timing. Some market participants are suggesting that launch of the tranches should be held back to allow liquidity to build in LCDX. A delay of a month is being mooted, but others disagree.

"I think the market will be trading standardised tranches well before that month is out. No one is going to want to wait to do trades and I think liquidity on the index is going be very robust from the outset," says the banker.

Liquidity in the European LCDS index, LevX, has been far from robust, but there are grounds for optimism that this will emerge. New widely accepted European LCDS documentation is likely to be in place for LevX's first roll – now scheduled for this month – and at that point the number of names it covers is expected to increase to around 50, which should encourage the introduction of tranching in Europe as well.

MP

Credit ETFs planned

Two platforms to offer iTraxx-based exchange-traded funds

Deutsche Bank and a joint venture between BNP Paribas and AXA Investment Managers will both shortly launch the first-ever CDS exchange-traded funds, having been granted licences to do so by the International Index Company.

The two organisations' ETF platforms - Deutsche's db x-trackers and EasyETF, the ETF platform co-managed by AXA IM and BNP Paribas Asset Management - will offer funds based on three indices: iTraxx Europe, iTraxx Europe HiVol and iTraxx Europe Crossover.

Fiona Bassett, co-head of structured funds at Deutsche Bank, says: "There is real demand from clients to have liquid access to the credit derivatives markets and to trade in a way that is efficient, transparent and cost effective. We believe that the new db x-trackers iTraxx ETFs are the ideal delivery tool to achieve those aims."

The products take the form of UCITs III open-ended funds which are intended to perfectly replicate the underlying index. They will be listed on all the major European exchanges.

"The beauty of ETFs is that they are both tradable on exchange or OTC, so customers can transact them readily. Equally, clients can trade in small size or large depending on their requirements - it's a far more easy-to-use product than, for example, a futures contract would be," explains Bassett.

EasyETF adds: "ETFs on iTraxx indices will enable asset managers, insurers, corporate treasury, hedge funds and bank proprietary desks to hedge a credit portfolio, achieve relative value credit trading or maximise credit views. These ETFs will enhance access to diversified European credit risk for all investors willing to address credit markets."

Not everyone is convinced about the initiative, however. Bankers at other houses suggest that ETFs may prove to be more use as a precursor for other credit derivatives products by maintaining name awareness. The argument is that buy-side firms are as likely and able to invest in other products - vanilla CLNs, for example - as buy ETFs.

Equally, while credit ETFs might ultimately target the retail market as ETFs with other underlyings already do, the spreads on the iTraxx main index at least may not be sufficient to attract enough interest from private banks to ensure success in this area either.

ETFs are passive investment funds that replicate the performance of indices and trade on stock exchanges in the same way as other exchange listed securities. ETFs were first introduced in the US in 1993 and in Europe in 2000.

According to Deutsche Bank, in December 2006 there were 769 ETFs listed globally with over €445bn assets under management, with equity-based ETFs showing an increase in volumes of 18% for the year.

In Europe ETF assets grew 19% to €67.9bn. By 2011 it is widely forecast that assets in ETFs globally will exceed €1.5tr.

MP

First publicly rated microfinance CLO launched

Number of similar deals expected to follow this year

BlueOrchard Finance and Morgan Stanley have launched BlueOrchard Loans for Development 2007-1 (BOLD 2). The transaction is a CLO of unsecured loans to 21 microfinance institutions (MFIs) based in 13 different developing countries – Azerbaijan, Bosnia, Cambodia, Colombia, Georgia, Ghana, Kenya, Mongolia, Montenegro, Nicaragua, Peru, Russia and Serbia.

BOLD 2, which is expected to close at the end of this month, will be rated by S&P – marking the first time such a deal has been assigned a rating from a major rating agency. The transaction follows a similar but unrated transaction brought to market by BlueOrchard and Morgan Stanley in 2006, which was the first-ever MFI CLO to be arranged by an investment bank.

Like its predecessor, BOLD 2 funds unsecured loans to a diverse portfolio of microfinance institutions globally. These funds will be on-lent by the MFIs to approximately 70,000 low-income borrowers in the developing world for entrepreneurial activities.

While MFIs have largely existed on the fringes of the securitisation market, the BOLD transaction is expected to pave the way for future institutions to harness these financing techniques to aid economic development. S&P says it expects to rate a further two to three transactions in the months ahead, with issuance levels potentially reaching US$500m by the end of 2007.

"As the existing microfinance institutions become adept at handling this new inflow of funding and further MFIs enter the market, securitisation volumes could reach between US$1bn and US$3bn annually over the next decade. Less sophisticated MFIs will also benefit from this development, as they become the new focus of NGOs and government agencies who have historically been the main providers of microfinance credit to the upper tier MFIs," adds the agency.

The loans to the MFIs in relation to BOLD 2 will be denominated in a number of local currencies, including Ghanaian Cedi, Mongolian Tugrik, Colombian Peso, Peruvian Sol and Russian Rouble, as well as US dollars and euros. Denominating loans in local currency is intended to assist MFIs with their risk management and micro-entrepreneurs with their ability to match the currency of their liabilities and revenues.

At the same time, all the currencies will be swapped back to the currencies of the notes in order to protect investors. BlueOrchard and Morgan Stanley say that BOLD 2 offers investors the opportunity to invest in a new asset class, with the unique combination of attractive financial returns and effective social benefits.

The resultant US$108m-equivalent CLO is expected to include two tranches of rated notes and three tranches of unrated notes. The rated classes consist of US$42m Class As rated double-A and US$16m Class Bs rated triple-B; the unrated notes will total US$50m.

An US$8m Class X note is understood to be included within that US$50m, repaid by excess interest. A reserve fund is expected to also use excess spread to build to 1% over time.

The Class A notes will have an average life of 4.94 years and the other notes an average life of five years. Notes will be offered in different combinations of US dollars, euros and sterling on a fixed/floating basis.

The aim of microfinance is to provide financial services to poor and low income people, who have been hitherto excluded from traditional commercial banking. Over the past 25 years, microfinance has become an effective way to promote economic and social development by aiming to build inclusive commercial services for the poor.

MP

Looking to the future

Buy-side firms are holding off from entering the credit futures market, but are watching it closely

The failure of credit futures volumes to take off on Eurex is both an indication and a cause of the product's hitherto strongest advocates, fund managers, to delay entering the market. While managers may not now view futures as a current priority, they still suggest that credit futures will become more important and the market requires monitoring.

Mario Hooghiemstra, fund manager at F&C Netherlands in Amsterdam, notes that at present the asset manager feels no urgency to enter the credit futures market. "We are able to do whatever we need to in the cash market and so do not have a need to use credit futures. The market is still pretty new and also has to prove itself, to see if all the technicals are right, but we have no plans yet to enter it in the short term," he says.

He adds that F&C is involved in the iTraxx indices as it is a more mature market and can be used in the day-to-day management of the firm's funds.

Others still need to do their homework or already have ISDA agreements in place allowing them access to the OTC credit derivatives market. "It is index-based and not single name and I don't see what the credit future hopes to achieve, other than not hanging up counterparty limits," says one London-based portfolio manager.

Equally, the liquidity in iTraxx could pose a developmental issue for credit futures, suggests Jamie Stuttard, credit portfolio manager at Schroders in London. "The iTraxx is cheap to trade, it's deep and liquid and there is almost a circular problem with the futures market: it will become liquid when it becomes liquid," he says.

He notes that Jeci, Tracers and Trac-x, the precursors to iTraxx, became more liquid over time and further funnelled liquidity and believes it is possible to change what seems like a Catch-22 situation into more of a virtuous circle.

He draws comparisons to the government bond market that offers basis opportunities between cash bonds, swaps and futures, while the credit market can only offer the first two. "You have had that triangle of development in the govvie market but not in the credit market as of yet. That does suggest it is possible," he says.

Stuttard feels it is still worthwhile monitoring the situation and considering credit futures, if they start to provide an edge to current investing. "If one market offers a better way to implement ideas, analyse and extract value and is better for our clients, then we will be involved," he says.

There are some fund managers that have a greater need for credit futures. For example, those that have mandate, legal or regulatory constraints preventing them from using CDS or those managers less experienced in credit derivatives.

"It perfectly suits small/mid-sized clients who want to hedge small exposures and larger clients that may have regulatory or organisational issues with credit derivatives," says Jochen Felsenheimer, head of credit and credit derivatives strategy at Unicredit Markets and Investment Banking in Munich.

He adds that a number of large German asset managers that currently do not use credit derivatives due to regulatory constraints will be able to immediately hedge their credit portfolios with futures as there is no additional work or counterparties required.

Though there are forces trying to stop the market's development and the product is not as liquid as it should be, Felsenheimer believes there will be rising pressure from the client base to implement the contracts.

"The current problems will not be solved in one or two months and investors need to have liquidity, which will take time. The contract does have a future as there is a widespread need for a standardised hedging instrument that can easily be implemented and exchange traded," he says.

HD

"A total risk picture spanning many different markets"

This week's Provider Profile looks at OpenLink's cross-asset trading, risk and operations processing management software solution Findur

OpenLink started trading in 1992 as a front and middle office interest rate derivatives system and after working with partners such as JP Morgan, they gradually extended their coverage to other asset classes including commodities, fixed income and cash management products.

Subsequently, OpenLink has continued to pursue strategic partnerships to develop functionality for new asset classes. The result today is Findur a multi-asset class suite with 81 installations across 120 client sites worldwide.

Phil Wang

Inevitably, demand from client banks in recent years has meant the product's coverage includes credit derivatives. "In the last three to four years, we have built upon existing derivatives capability in Findur to increase coverage in synthetic CDOs, credit notes, tranched indices etc.," says Phil Wang, the firm's vp for product management. "And so we now have rich coverage in the sector, and full front-, middle- and back-office functionality."

This functionality includes a suite of pricing models, links to third party vendors for live and static data; workflow; STP; affirmations, confirmations and novations capability, together with event management. Links to DTCC, SwapsWire, Markit and T-Zero are now being built, and according to Mark Sappol, the firm's global director of Findur, OpenLink has also developed its own grid to accommodate the complexity in commodity trades, which helps in dealing with pricing and hedging of complex structured and hybrid instruments on the capital markets side of the business.

One of the key strengths of Findur is its ability to aggregate risks across several desks and products. "The risk management capability is already proven across many sectors. As the market expands to take in other asset classes, true risk monitoring is needed – Findur can show these risks from a holistic perspective to give a total risk picture spanning many different markets," says Wang.

He continues: "Credit derivatives are evolving so rapidly that from an operational stand point, this requires a system capable of supporting a new survival probability curve; developing interfaces; and an extensive capability to customise, in order that the customer can link, for example, to a new confirmations system."

OpenLink understands the demands that are placed upon an institution's entire trading infrastructure, and so provides an enterprise-wide product, according to Wang. "We always develop as a true front-, middle- and back-office product accommodating all developments in the space we are working in," he explains.

Findur allows clients to develop the system and build it out with their own technology teams. "Clients can develop interfaces to new systems and their own workflows, for example," says Wang.

Mark Sappol

"We also now offer an ASP solution for buy-side, mainly hedge fund clients. We have a function called RiskPak that allows one to upload risk positions remotely into the system. Findur is a trading solution not a product specific package. This is ideal for buy-side firms looking to trade across assets," Wang adds.

Given the flexibility and the cross-asset nature of Findur, a key advantage is seen in structured credit emerging trends, according to Wang. "We are seeing some of the main developments take place in the hybrid space and also when combining aspects of different markets into tradable products – cross-asset structures issued as credit-linked notes, for example" says Wang.

As with the introduction of any new product stream, one of the main challenges with hybrids is having a system capable of satisfying the demands of structurers and traders. As Wang observes: "Many banks are definitely not happy with what they have – whatever it is, it's never fast enough for banks; they don't want to be behind the curve."

Nevertheless he adds: "Inevitably there's a reliance on spreadsheets as systems play catch up. Banks are not going to roll out spending on a brand new area until it proves itself."

However, there are external drivers that change this situation. As Sappol concludes: "Regulations such as Sarbanes-Oxley, MIFiD, and Basel II require that banks audit their work, which is difficult to do with spreadsheets. A solution is needed to develop future products as far more complexity will come from all areas."

JW

UBS re-hires Reader

The latest company and people moves

UBS re-hires Reader...
Matt Reader, global head of correlation trading at RBS, has left the UK investment bank to rejoin UBS after only a year. He will now be global co-head of structured credit within global credit strategies and will report to Vincent Mistretta who is head of global credit strategies

...and re-integrates DRCM
UBS has announced that the proprietary funds currently managed by Dillon Read Capital Management (DRCM) within its global asset management operation will transition to the investment bank. DRCM's principal finance, credit arbitrage and commercial real estate businesses will be merged with relevant business lines within the investment bank. DRCM's third-party funds will be redeemed.

UBS says it intends to work with DRCM investors to identify alternative investment opportunities for them. DRCM will continue operations until the transition period is complete, which is anticipated to be in Q3 2007.

Pascucci joins Rose Grove
Hope Pascucci is joining credit hedge fund Rose Grove Capital Management as principal after resigning from Deutsche Bank. Her departure will not lead to any reorganisation at Deutsche Bank due to her only having an advisory role. Her husband, Mike Pascucci, set up Rose Grove in December last year.

JP Morgan hires Uzuner
Tolga Uzuner, a credit hybrids trader at CSFB, has moved to JP Morgan and is understood to have been hired to build out the bank's credit hybrids prop business.

Sadler to BarCap
Greg Sadler has left his position as trader at Citigroup and will join Barclays Capital in August in a similar role.

Structured credit pays
According to Credent Partners' second annual salary survey, average total compensation for structured credit bankers is on the rise. Managing directors in structuring took home $2.5 million in pay in 2006, a 147% increase from $1.01 million the previous year. Average pay for directors and analysts rose roughly 10% last year, while associates and VPs saw a similar percentage drop in total compensation packages.

Across all markets, those with 20 years of market experience based in Asia on average received the highest total compensation of between $1.5 million to $3.5 million. New York is the next best paid followed by London and Asian structurers with up to four years' experience.

Being employed in structured credit trading also pays more than credit trading. Managing directors in structured credit trading received salaries and combined bonuses of $3.2 million versus $3 million for mds in credit trading.

Dresdner Kleinwort appoints head of credit trading
Dresdner Kleinwort has appointed Neil Walker as its new head of credit trading. His responsibilities span structured credit products – comprising structured credit solutions, cash CDOs, ABS and exotics – as well as the bank's credit flow products business. He reports to Mark Richardson, head of equity & credit derivatives, and is based in London.

Walker's background includes time spent at Bear Stearns and Chase. Most recently he was at Merrill Lynch, which he joined in 1999. At Merrill he was responsible for initiating and developing several different credit trading desks – including flow, cash CDO and synthetic CDO business lines. From late 2004 until he left in mid-2006, he was co-head of Merrill Lynch's global exotics credit derivatives business.

BlueMountain enters synthetic ABS market
BlueMountain Capital Management has launched an asset-backed securities platform as part of its BlueMountain Credit Alternatives Fund. Managing the portfolio is newly-hired David Burt, who joins BlueMountain from his previous firm, AlderTree Capital Partners, where he was co-founder and chief investment officer.

Erik Larson, also formerly of AlderTree, will act as primary ABS credit analyst at BlueMountain. Both began their tenures with BlueMountain on May 1.

BlueMountain says it will focus on the RMBS segment of the broader ABS market, believing that there is significant opportunity there, particularly with the advent of synthetic ABS. The firm will be trading RMBS cash and synthetics, but will not actually structure products.

In addition, BlueMountain will acquire AlderTree's proprietary analytics and technology platform, which will provide the fundamental and quantitative backbone of BlueMountain's entry into RMBS.

HSAM hires Fernandez
Halcyon Structured Asset Management has hired Isidro Fernandez as co-head of European research. Fernandez will be based in London and work alongside Khing Oei, who is heading the firm's European research effort.

Before joining HSAM – an affiliate of US$10bn hedge fund firm Halycon – Fernandez was the head of credit products and trading at Caja Madrid, where he specialised in structured credit products and leveraged loan/credit derivatives trading.

Lehman names fixed income head
Lehman Brothers has promoted Roger Nagioff to the position of global head of its fixed income division, based in London. His responsibilities include high yield and high grade credit, structured finance, CDOs, research and real estate.

Nagioff succeeds Michael Gelband, who has decided to leave Lehman to pursue other interests. In addition, Benoit Savoret will assume the role of chief operating officer of Europe.

Junior structurers leave
Dresdner Kleinwort has lost Rishi Pabari while Anis Khedher has left Société Générale. Both are junior synthetic structurers and their destinations are not yet known.

HD & MP

Fitch outlines approach to European real estate CDOs

A round up of this week's structured credit news

Fitch outlines approach to European real estate CDOs
Fitch has released a report outlining its general approach to rating real estate CDOs in Europe. The agency says the report's aim is to provide greater transparency on the CDO aspects of the overall modelling of this asset class.

While the market is yet to flourish in Europe, Fitch says it still expects to see several transactions in the course of 2007. Underlying changes in lending practices as well as pending regulatory reforms may hasten the growth of capital market financing of subordinate real estate debt.

"Investment banks have been able to claw market share away from the traditional subordinate lenders in Europe, particularly commercial banking institutions, and to sell-on the junior slices of debt to clients lacking a platform to originate and service mortgage loans but eager to assume credit exposure to previously unavailable real estate products," says Euan Gatfield, senior director, commercial mortgage-backed securities, Fitch Ratings. "In this bracket, one can place the myriad entities now turning to RE CDOs as a possible source of term funding."

Fitch says it has developed a methodology capable of analysing these transactions that incorporates analysis from multiple asset classes. The twin pillars of Fitch's RE CDO analytical framework are a fundamental real estate analysis and an evaluation of the diversity benefit brought about by aggregating numerous real estate positions into a single managed pool. The specifics of the real estate markets demand a modelling of the underlying investment property income and value that is entirely consistent with and road-tested by Fitch's analysis of CMBS over several years.

"While CMBS analysis is a necessary component, it is not sufficient in modelling European RE CDOs since it does not assign credit to loan diversity at the CDO level," says Andreas Wilgen, director, Derivative Fitch. "Unlike European CMBS, RE CDOs are structured with features supportive of diversity credit such as restrictions on borrower concentrations and sequential principal pay structures, and these are afforded by an initial reinvestment period as well as the high-yielding nature of the underlying assets."

ISDA publishes 2007 Property Index Derivatives Definitions
ISDA has published its 2007 Property Index Derivatives Definitions, which are intended for use in confirmations of individual property index derivatives transactions governed by agreements such as the 2002 ISDA Master Agreement, the 1992 ISDA Master Agreement (Multicurrency - Cross Border) and the 1992 ISDA Master Agreement (Single Currency - Local Jurisdiction).

Working with its members, ISDA says that it has developed these definitions to assist the smooth and efficient functioning of the property index derivatives market by providing a common set of terms for parties to use in documenting such transactions.

In conjunction with the release of the Definitions, ISDA also published new confirmation forms for common types of property index derivatives transactions, including total return swaps and forwards. An options confirmation template will be developed over the summer.

An Annex to the Definitions contains Index Descriptions. It is anticipated that Index Descriptions will be added or changed from time to time as transactions involving property indices not included in the Definitions become more prevalent and to reflect market practice. Currently, indices in North America and Europe are included.

Basel to boost credit portfolio models
A new report from Fitch Ratings suggests that the increasing use of credit portfolio risk models by financial institutions will accelerate with the establishment of Basel II.

"Basel II adapts many of the concepts and techniques used by large financial institutions in their own internal credit risk models for supervisory purposes," says Gary van Vuuren, senior director in Fitch's financial institutions team.

"Fitch believes that the anticipated convergence between economic capital and regulatory capital frameworks has been a positive impetus to further refine and more broadly spread advanced risk measurement and management practices, such as credit portfolio risk modelling, amongst financial institutions," he adds.

In the report – How much Credit in Credit Risk Models – Fitch outlines the factors that influence the degree of comfort the agency derives from an institution's credit risk models in the assignment of ratings.

To be effective, models should be chosen that provide a strong fit between their capabilities, assumptions and the properties of the portfolio, Fitch says. For example, some contemporary credit risk models employ a single-factor model framework that may be appropriate for highly diverse portfolios as found in retail banking or SME divisions, but can only rarely be applied to corporate portfolios. Thus it is essential to ensure that the model is appropriate for the underlying business.

MP

Trading ideas - down the property ladder

Tim Backshall, chief credit derivatives strategist at Credit Derivatives Research, looks at a long-short basket trade

With the significant tightening that we have seen in homebuilder credits in the last few weeks (against our view and market indicators), we decided to put our money where our mouth is and find an attractively economic trade that would benefit if the housing market turns out to be as bad as the now ubiquitous numbers suggest, but still protects modestly from the downside of any recovery.

As opposed to the outright short, which is both risky and expensive (roll-down and carry costs), we look to make a basket pairs trade between a group of IG names and a select threesome of HY names. This decompression trade is designed to be approximately beta neutral, carry positive, roll-down neutral, and still provide good upside if things continue to go badly for the housing market.

After last week's weak GMAC/RESCAP numbers, rating agency outlook changes, and the poor outlook for mortgages that they offered, we feel this is an excellent time to instigate this convergence/decompression trade and, given the richness of IG homebuilders, also offers us more attractive terms than in recent times.

Building the basket
The basic approach is to cherry-pick credits from the HY and IG homebuilder credits and instigate a basket pairs trade that will payoff if one or more of the IG credits is downgraded to junk.

The asset-selection process is based on a number of criteria. These criteria are different for the long and short legs of the trade.

In the case of the short IG names, we prefer to find credits that trade rich to their 'spread-per-rating' with the view that this will discourage any further structured credit technical bid from driving spreads against us in the short-term. We also look for credits with relatively low scores on our Multi-Factor Credit Indicator (MFCI). The MFCI is constructed from a number of relative-value models including spread per unit of default risk, spread per unit of leverage, distance from fair-value, LBO Viability, rating-based rich-cheap, and fundamental outlook.

The selection process identifies four credits that stand out – these are Toll Brothers Inc, MDC Holdings Inc, Lennar Corp, and DR Horton Inc. These names also have the benefit of tight bid-offers at around 5bp in 5Y CDS and solid liquidity (high number of runs per day). This final criteria (liquidity) means that we reject credits such as NVR Inc and American Standard (even though they trade considerably tighter and therefore richer than the others).

In the case of the long credits, we are choosing from HY credits, so a slightly different approach is necessary. We do not screen on spread-per-rating as there is little technical bid here, but leave our screen based on MFCI and liquidity. Choosing credits with the highest MFCI scores (given that they are all negative), means that we select KB Home, Meritage Homes Corp, Standard-Pacific Corp, K Hovnanian Enterprises Inc., and Beazer Homes USA Inc.

We drop BZH due to its accounting and options issues (too much potential downside on that event risk). We also drop MTH due to its minimal liquidity and wide bid-offer (around 20bp compared to between 6 and 10bp on the remaining names), leaving us with KBH, SPF, and HOV.

Having selected our basket of four shorts and three longs, we move on to construction of the trade.

Better beta
The first step in construction is to analyse historical behaviour of the two baskets. Exhibit 1 shows the two baskets having traded significantly wider recently and notably having diverged in the last few months (dark blue triangles) to over 250bp differential. This differential has pulled back modestly in recent weeks, and it is much of this momentum that we hope to play as an IG downgrade seems increasingly likely from rating agency comment and market sentiment.

Exhibit 1

The differential, both absolute and ratio, has fallen recently, but the ratio has shown a more marked trend having begun its decline in January. Better late than never, we feel that jumping on this trend is valid currently as the spread behaviour has us back to mid-summer 2006 levels in IG and when compared to the weakness we have seen since then, we are surprised.

From an optical analysis of Exhibit 1, it is clear that the two baskets have a solid correlation (or at least some dependence) as they rise and fall together. Obviously the HY credits have a higher beta or more volatile nature than the IG credits and Exhibit 2 illustrates this relationship.

Exhibit 2

The dark and light blue points and trend-line indicate weekly- and daily-based changes in the basket's spreads. The lower frequency (weekly) deltas show a beta of approximately 1.9 over the past two years, which drops to approximately 1.6 when we move to the higher-frequency daily data. The r-squared on the weekly figures is around 70% (which is high) but drops a bit when we move to daily (which is somewhat expected given the volatility in the sector).

Exhibit 3 shows that the relationship has been anything but stable over the past two years. The rolling three-month beta based on weekly and daily data have generally risen consistently since early 2006 and seemed to have peaked in mid to late March 2007.

Exhibit 3

The peak could be explained by the earnings announcements, BZH's issues and the contagion inherent in HY, and (although spreads have tightened) an emerging convergence between the two baskets as investors begin to see less to discriminate between the good homebuilders and the bad. The distribution of betas can be better understood from Exhibit 4 which shows that the weekly –based betas show a much more 'normal' distribution, approximately centred around 1.5. The daily-based data is skewed to the left due to the period from July to October in 2006 following a significant jump in spreads (see Exhibit 3) but still shows a similar pattern to the weekly data.

Exhibit 4

The choice of beta in this case (that is the choice of weighting between the IG and HY basket) is a trade-off between carry, duration, payoff, rolldown, and risk. The higher the beta, the worse the carry as the short leg costs us more money.

The higher the beta, the more skewed the duration is to IG under-performance as opposed to convergence (making the trade more and more like an outright position). The higher the beta, the better the payoff if IG does get downgraded.

The higher the beta, the worse the overall one-year roll-down of the position if curves stay still. The higher the beta, the higher the risks of serious underperformance if convergence does not occur, or if the beta of the basket drops to more historically consistent levels.

So, our choice boils down to wanting more carry to protect us over time from being wrong, trying to minimise the duration differential with a view that the beta of the baskets will fall to more historically consistent levels, and still getting paid well if an IG downgrade occurs. Exhibit 5 shows the trade-off between carry and duration-skew and seems to suggest a weighting of approximately 1.6-to-1 as a balance between carry (don't be too greedy) and performance (we don't want an outright short). Notably, roll-down on the trade is also skewed to the downside as we increase the beta.

Exhibit 5

Comparing Exhibits 4 and 5, we feel that a ratio of 1.6-to-1 of the IG to HY baskets compares well with historical betas, is a goldilocks number from the risk-return perspective (not too much DV01 skew, not too little carry, but just right!). If we sum carry and roll-down, we find that the lower the beta, the better the overall performance of the basket if nothing happens but the more exposed we are to the relationship of the two baskets not converging. The 1.6 beta remains a solid balance between roll-down and carry (leaving us net positive unwind in one-year if nothing happens, which we see as unlikely).

The total package, as illustrated in Exhibit 6 generates approximately 120bp of carry, is duration-skewed (IG to HY) around 1.76 to 1 (modestly above historical average but below current betas), has tight bid-offers, and roll-down is not too painful. The position performs well if an IG name gets downgraded to junk, or if HY improves further while IG remains stable and given the carry, we have time to be right.

Exhibit 6

Risk analysis
The basket beta of 1.6 means that we are likely to suffer some MTM volatility if the current beta remains high. Obviously there is risk that the spreads do not converge, or that an IG name does not get downgraded, but we feel that the relationship between the baskets is strong and cyclical, mitigating the significant outperformance of one group over the other.

Duration is skewed to IG widening as opposed to HY tightening (which also makes sense from our fundamental view) but introduces risk, which we feel is mitigated by the carry and only slightly negative roll-down which should help.

Liquidity
All of these names offer good liquidity in the CDS market. As members of the CDX IG8 and XO8 indices they consistently rank in the top 200 issuers by quoted volume on a daily basis. They also have relatively tight bid-offer spreads, regularly between five and ten basis points. We see no concerns with execution of this trade.

Fundamentals
This trade is based on our view that the US housing market will continue to weaken (even with rate cuts) as sub-prime mortgage issues, tightening lending standards, high inventory, prices falling, and rising foreclosures continue. For more details on the fundamental outlook for each of the credits, please refer to Gimme Credit.

Summary and trade recommendation
The recent dichotomy between IG homebuilder spreads and housing and consumer-spending-related statistics offers us a great opportunity to enter a bearish skewed basket trade betting on downgrades to junk. With prices falling, inventories rising, foreclosures rising to their highest levels as a percentage of loans underwritten since 2002, tightening lending standards, and a seeming deterioration in consumer credit generally, the future does not look bright.

Specifically, we feel the ratings agencies willingness to move RESCAP to negative outlook shows their readiness to take action in the housing/lending markets which seem so intricately linked currently. Even with rate cuts, we feel the froth has come off the housing market (flippers, investors, and occupiers) and that we are unlikely to see this spur any real growth, rather just delay the seemingly inevitable recession or possibility of stagflation.

With that cheery thought in mind, we construct a long-short basket of HY and IG homebuilders to capitalise on the likelihood that downgrades to junk are on their way. Asset selection, based on liquidity, relative-value, and technical bid attractiveness, was followed by an analysis of historical betas between the two markets.

Balancing the trade-off between carry, roll-down, risk, and return, we arrive at a 1.6-to-1 weighting for our basket that generates considerably carry, offering us time to be right, while paying well if an IG credit gets downgraded.

Buy US$4m notional Toll Brothers Inc. 5 Year CDS protection at 109bp and

Buy US$4m notional MDC Holdings Inc. 5 Year CDS protection at 110bp and

Buy US$4m notional Lennar Corp. 5 Year CDS protection at 110bp and

Buy US$4m notional DR Horton Inc. 5 Year CDS protection at 126bp and

Sell US$3.5m notional KB Home 5 Year CDS protection at 217bp and

Sell US$3.5m notional Standard-Pacific Corp. 5 Year CDS protection at 340bp and

Sell US$3.5m notional K Hovnanian Enterprises 5 Year CDS protection at 315bp to gain 123 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).

Dynamic portfolio insurance - part 1

In this first of a three part series, DPI is explained and compared to CPPI and CPDO by Alessandro Muci, Domenico Picone, Emiliano Formica, Richard Huddart and Shreepal R Alex Gosrani of the structured credit research team at Dresdner Kleinwort

Dynamic Portfolio Insurance (DPI) is the latest innovation in synthetic credit markets building on the technologies of the now well-established CPPI and the relatively new CPDO. Comprising a mixture of features from both CPPI and CPDO structures, DPI similarly offers rated coupons and rated principal payment by taking a leveraged position in liquid, diversified, investment grade credit indices that generates enough income to pay its cash flow obligations.

Compared to CPPI, DPI does not offer any principal guarantee but both coupon and principal are highly rated (by incorporating the CPDO-type cash-in feature) for timely repayment. In the leverage mechanism, the reserve is not multiplied by a fixed number but by a dynamic quantity, which is an inverse function of the overnight maximum possible loss.

An additional feature of DPI is the flexibility in customising the product to incorporate investors' preferences: leverage can be made dependent on spread evolution, passage of time, note value or a combination thereof. Indeed, DPI with a spread-dependent cap can replicate the 'sell high, buy low' property of the CPDO and yet mitigate its pitfalls thanks to its target exposure's (TE) positive dependence on the note value: a DPI de-leverages less aggressively in a spread tightening environment (which translates into earlier cash-in times) and re-leverages less aggressively during spread widening (therefore having a better capacity to withstand subsequent shocks) than a CPDO. A typical DPI structure is shown below.

As shown in the chart above, the proceeds of the notes are held in a deposit that grows at LIBOR. The strategy then enters an unfunded leveraged position (by selling protection) in liquid on-the-run credit indices. The premiums collected, as well as realised MtM gains, are added to the deposit, from which the periodic coupons and possible losses (due to either defaults or spread widening) are paid.

Cash-in feature
The main difference between CPPI and DPI (and CPDO) is the cash-in feature: when the strategy accumulates enough income to pay its future obligations (i.e. PV of future liabilities < note value), the risky credit portfolio is unwound and its value transferred to the cash deposit where it will grow at LIBOR. The product becomes a risk-free investment and changes its nature from a total-return product to a bond-like one.

A cash-in feature entails taking only as much risk as necessary, which helps reduce the downside but also limits the upside potential. In other words, by incorporating a cash-in feature we are giving up some upside in exchange for a reduced downside. Below, we have prepared four charts where the contribution of the cash-in feature to the final rating of the product is analysed. We compare the performance of the DPI base case relative to, DPI without cash-in, CPDO and CPPI.

Internal rate of returns
At this point, we highlight that as part of our CDO research we have developed a proprietary model to measure the IRR of the DPI strategy. The main inputs of our model are listed in the section 'DPI Model'.

Indeed, the DPI and CPDO strategies show a very narrow distribution around the promised return (LIBOR + 175bp) and the low IRR volatility is simply due to interest rate risk: after the cash-in, both strategies remain exposed to the changes in interest rates. The differences between the two strategies appear to be almost negligible, even if the DPI is superior since it achieves the AAA rating whereas the CPDO rating is AA.

DPI with no cash-in clearly offers almost twice the mean-return as the standard DPI and the CPDO; however, this comes at the expense of a higher volatility of return and thus a lower rating (we estimate one/two notches down). CPPI looks similar to DPI with no cash-in, but offers a lower return since it guarantees principal at maturity.

DPI exposure
As alluded to above, the DPI exposure is dynamically adjusted so that trading gains and premiums collected from the risky exposure are sufficient to cover the liabilities. As such we define a dynamic multiplier, M_t , which is derived by the following equation:

The multiplier is the minimum of two dynamic quantities: the Control Leverage (CL_t) and the Cap.

CL_t serves to limit the instantaneous gap risk of the structure. It works as a function of certain, pre-specified, "worst case" scenarios for spread moves (as per rating category) and as such controls the risky exposure, so that DPI can survive and not cash-out under an extreme, worst case, evolution. CL_t in particular, is a function of the following quantities:

? A daily spread risk (SR_t). Each name in the portfolio is assigned an overnight maximum spread movement according to its rating category and then a weighted average calculated. This quantity is finally multiplied by the portfolio duration to obtain the overnight maximum (percentage) variation in the index value.
? A daily default risk (DR) that represents the percentage index loss (considering recovery) due to a conservative number of defaults.

First generation dynamic strategies on credit indices included a static definition of cap. In essence, a fixed cap on the maximum allowable leverage was set to limit the risk of the strategy. DPI strategies use a dynamic cap concept in order to manage the risk of the strategy. Cap_t is a function of the market's evolution (value of the reserve, spreads and time), essentially aiming to minimise losses in adverse situations and to maximise gains under positive evolutions of the market.

Finally, the target exposure (TE) is the product of the reserve (R_t) and the dynamic multiplier:

This may seem similar to the CPPI exposure but presents two crucial differences: (i) the multiplier (M_t), as already mentioned above, is dynamic rather than fixed, and (ii) the reserve (R_t) is the whole note value instead of being only a part of it, since there is no principal protection and therefore no bond floor.

Buy low sell high
The reserve makes the target exposure dependent on past performance (R_t increases after MtM gains and decreases after losses). However, as the DPI contains a spread-dependent cap definition (i.e. a cap that increases as spreads increase), the multiplier would move in the opposite direction to the reserve after a spread move.

Since the cap tends to dominate in the dynamic multiplier formula (see M_t), the DPI exposure would tend to behave like a positive function of the spread levels (capturing the 'buy low, sell high effect' of the CPDO). In addition, the presence of the momentum component (the reserve) mitigates the more aggressive re-leveraging during spread widening (resulting in higher rating) and the rapid de-leveraging during favourable market conditions (bringing earlier cash-in time) of the CPDO.

Finally, to minimise transaction costs, the actual exposure is rebalanced only if it falls outside a given range, say [90%, 110%], of the target exposure TE.

Risk management: cash-out and caps

Cash-out
As per CPDO and CPPI, a cash-out feature is also included in order to limit losses when the strategy suffers in an extreme scenario (following either severe spread widening or a high number of defaults). When a threshold – typically set around 5% of the notional amount invested – is reached the credit risky portfolio is unwound, leaving the investor with severe capital losses. Therefore, the cash-out aims to prevent losses beyond 100% of the notional, reducing the gap risk for the issuer: if losses exceed the notional invested the arranging bank will bear them.

Caps
The presence of maximum caps – as in CPPI and CPDO – is a further mechanism to mitigate gap risk. The presence of the spread-dependent cap in the multiplier (as described above) is thus to permit a narrower cash-in distribution of the structure (as described below) than would otherwise be achieved by the global maximum cap on its own.

The charts below show the effect of moving from only a global maximum cap to adding a spread-dependent cap. With such a change, we can obtain a lower volatility for the cash-in time distribution, even if it means a later expected cash-in time (4.7 years vs 3.9 years).

Indeed, this specification of the cap is able to achieve a lower probability of losses (0.09% vs 0.18%) and potentially provides a higher coupon given the same rating: we give up some upside (a later average cash-in time) in return for some downside protection (lower probability of losses) with the addition of the spread-dependent cap.

Credit CPPI – momentum-based strategy

Credit Constant Proportion Portfolio Insurance (CPPI) was introduced about three years ago and is now well established among investors looking for a synthetic, dynamic exposure to the credit market whilst preserving a minimum guaranteed payoff (usually the capital invested). Unrated coupons may be paid, but the strategy focus is on maximising returns over the investment horizon. A typical CPPI strategy is shown below:

The CPPI strategy dynamically allocates capital invested to two different components: risky (credit exposure) and risk-free assets. The proceeds of the issued notes (net of any fees) are held in a cash deposit, which accrues interest overnight, and is dynamically split across:

? A risk-free asset that grows over time – like a zero coupon bond – and returns the guaranteed principal at maturity. At any time, the price of such an asset is called the bond floor and is evidently exposed to interest rate risk.
? A risky asset that is a leveraged, synthetic position in a credit risky portfolio. The leveraged notional is set by multiplying the reserve – the remaining part of the note value after subtracting the bond floor – with a fixed number, called the multiplier. The reserve represents the excess value in the portfolio that can absorb any credit exposure shocks without risking the guaranteed payoff. The deposit will also hold the periodic premiums received from selling protection on the credit portfolio as well as any realised MtM gains. In addition, potential losses – due either to defaults or unfavourable MtM moves – would be paid from it. Then, by adding all unrealised gains and losses to the cash deposit, we obtain the note value.

The risk-return profile of CPPI can be easily summarised by the multiplier: The higher its value, the greater the credit exposure, the greater the CPPI returns (and risks). However, the leverage is also a positive function of the reserve; for example, when credit spreads widen or default losses arise, the note value decreases and so does the reserve and leverage. The opposite happens when spreads tighten. Moreover, the reserve tends to shrink over time because of the increasing bond floor.

CPPI, therefore, follows a momentum strategy: the leverage is reduced after MtM losses and increased after MtM gains (subject to a fixed cap). Contrary to DPI and CPDO, there is no cash-in event since the aim is to maximise returns.

CPDO – contrarian-based strategy

Like CPPI, a CPDO strategy maintains a leveraged exposure to the credit market, by selling protection on both iTraxx Europe and CDX IG portfolios (typically 50% on each – 250 liquid IG names) by way of an efficient synthetic transfer. However, the CPDO is structured in a similar fashion to a traditional fixed income instrument, and is rated both for regular coupon payment and principal redemption. The leverage mechanics for a CPDO therefore target a credit exposure which is sufficient to meet these promised cash flows, and thus returns achievable from a CPDO are capped at the stated coupon, in contrast to a CPPI strategy that offers total return and no regular coupon.

Leverage mechanism
As a result of these different aims, CPDO leverage mechanics work opposite to those of a CPPI strategy. For a CPDO, leverage increases when spreads widen, aimed at achieving sufficient returns by way of more carry to meet the liabilities. Correspondingly, when spreads tighten, the CPDO note value increases 'ahead of schedule', such that the leverage (and hence risk/volatility) is reduced.

Cash-in feature
The CPDO benefits from a cash-in feature which results in the credit risky strategy being unwound if sufficient returns have been achieved to meet all subsequent liabilities. Crucially, for the remainder of the contract the investor is then only exposed to the risk-free asset whilst still earning the enhanced yield. A typical CPDO strategy is shown in the chart below (see table on page 9 for a CPPI/CPDO comparison).

Shortfall
The difference at any time between the target redemption value (TRV, the value of the liabilities to be paid) and the note value (NV, the value of the strategy) is known as the shortfall. This shortfall is what the strategy needs to make up to meet the TRV, and thereby cash-in and revert to a risk-free exposure. Reducing the shortfall to zero (net of a cushion that exists for protection from interest rate volatility) is therefore the objective of the strategy. The size of this shortfall drives the (uncapped) target exposure (TE – to the credit risky assets) that needs to be maintained. This can be seen in the formula shown below.

The shortfall, on the right hand side, is multiplied by a gearing factor (G – that is fixed at the outset), which allows the strategy to lever the exposure to the risky assets in order to generate enough premium income (IPPV – see below) to cover any MtM losses and, target a cash-in occurrence. Hence, G is strictly greater than 1. If this were not the case, the strategy would be unlikely to generate sufficient income to yield a cash-in event.

If we consider the equation on the previous page, there is a tendency in the structure for the exposure (TE) to rise if the shortfall increases and, since TRV is fixed, the shortfall rises in the event of negative performance (NV falls, hence TRV minus NV increases). The exposure to the credit index is increased under such evolution of the market. Similarly, when good performance is realised, the NV increases and the shortfall is reduced, meaning the structure needs less exposure, so TE falls.

The net tendency is for the exposure to rise when the performance is negative (i.e. leverage increases), and for exposure to fall when the performance is positive. The aim of increasing exposure under negative performance (i.e. spread widening) is to sell more protection at a higher spread in order to earn more income to offset MtM losses and reduce the shortfall. For this reason, we say that CPDO is a contrarian-based strategy.

Comparison of DPI, CPPI and CPDO strategies

DPI, CPPI and CPDO share a number of similar features as well as some important differences. We provide a comparison table below.

DPI benefits

A DPI strategy allows investors to achieve a dynamic leveraged exposure to a highly diversified and transparent investment grade credit portfolio linked to iTraxx and CDX indices.

? Rated coupon and principal: Like CPDO – but different from a CPPI, which has only a minimum guarantee payoff – a DPI provides full rating for both principal and coupons, making it more Basel II friendly. Moreover, by giving up the principal protection and the potential higher upside of a traditional CPPI strategy, a DPI structure achieves a AAA-rating for both coupon and principal, a lower average leverage and a potentially shorter exposure to the risky portfolio (the cash-in feature).
? Enhanced yield: A DPI provides a higher yield than similarly rated instruments. Currently a AAA-rated DPI strategy can return a coupon of 50-60bp higher than a comparable CPDO.

? Lower default risk: The six-month index roll mechanism, like in CPDO, reduces the risk of default by removing downgraded names and replacing them with higher rated ones. No default has occurred in the on-the-run iTraxx and CDX induces since their creation.
? No correlation risk: Like CPDO strategies and unlike bespoke CDO tranches, DPI does not have any exposure to correlation.
? Cash-in feature: Similar to a CPDO (unlike traditional CPPI), the cash-in event reduces the period of exposure to credit risk whilst still fully paying the investor the promised yield.
? Leverage mechanics: DPI captures the 'buy low, sell high' feature of the CPDO, but with a less aggressive re-leveraging during spread widening (better rating) and less hasty de-leveraging in favourable market conditions (earlier cash-in time).
? Credit curve roll down: Like a CPDO, DPI generates gains by rolling down the upward-sloping credit curve: selling protection on a 5.25 year maturity on-the-run index and buying it back it when it has 4.75 years left.

DPI risks

DPI retains some of the same risks of a CPDO – though it tones down its more aggressive rebalancing. We briefly mention them below.

? Spread risk: The primary risk driver of DPI – as with a CPDO – is the spread risk. While the product recovers from a few spread jumps, a multiple series of them could impair it, even in the absence of any defaults. Moreover, higher volatility causes more frequent rebalancing and, therefore, higher transaction costs. However, contrary to a CPDO that has a high starting leverage, the more flexible DPI cap (spread and/or time dependent) may shield the strategy from higher initial spread volatility due to expected spread widening from the current low levels.
? Default risk: Although investors are exposed to potential defaults, this risk is limited by the roll to a new IG portfolio every six months.
? Liquidity risk: The popularity of CPDO/DPI strategies may significantly increase the buying pressure on the off-the-run series and the selling pressure on the new-on-the run index at the roll. This may weaken the roll down.
? Model risk: Naturally, rating and promised coupons are based on a model and, therefore, on its assumptions (e.g. mean long-term spread, volatility, default rates).
? No principal protection: DPI does not offer principal protection, unlike a traditional CPPI.
? Cash-out trigger: If the note value falls below a pre-agreed threshold, a cash-out event is triggered and the investor suffers capital loss.
? Secondary market liquidity: The secondary market in DPI notes may not be liquid and the investor should therefore be prepared to hold the investment until maturity.

© 2007 Dresdner Kleinwort. All Rights Reserved. This Research Note was first published by Dresdner Kleinwort on 27 April 2007.