Contents

CDR Liquid Index data as at 14 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.

CDS skew UK RMBS

Derivatives pricing misleading cash market?

Spreads in the primary UK non-conforming (NC) RMBS market have pushed dramatically wider in the past week or so, following in the footsteps of those for CDS on RMBS. Suggestions that the CDS market is mature enough to be used as a price discovery tool appear to be premature, however.

"Some firms are using CDS as a reference to where market levels should be, but while CDS on ABS are now liquid in the US, they aren't over here," says one London-based RMBS investor. "The CDS market in the UK and Europe is becoming more liquid, but still pretty much a beast on its own - cash should theoretically be trading where the CDS trades, but because the investors in each market move in different circles cash is trading 20bp tighter."

Laila Kollmorgen, head of ABS, MBS & CDO trading at BNP Paribas, concurs: "It's an unbalanced market - there are six or seven banks in the market that are looking to start up their own platforms for UK NC RMBS and their risk management groups have told them to go out and hedge future issuance. So they are all bidding single-A and triple-B classes from non-conforming deals, and the only people at this early stage of the CDS market capable of selling protection are other dealers who don't have NC platforms, hedge funds and CDO managers."

However, she continues: "Right now there are probably only two CDO managers that are able to trade CDS - all the other real money accounts in the market are only able to trade the cash bonds, because CDS are not yet approved products under the terms of their mandates. If they were able to trade CDS then this market would not be as illiquid or grabbing the headlines it is, which are a direct result of a fundamental misunderstanding."

The current disparity between the cash and CDS markets is understandably causing real money accounts to ask questions. The stock response from syndicate desks is that the CDS is pulling the cash wider on the back of sub-prime contagion fears.

"The CDS is pulling the market wider, but it's those same banks' fault because they've been out hedging their forward pipeline. So it's a vicious circle: the banks perpetuated the widening themselves and now they are trying to say it's based on investors' concerns. But investors are only concerned because they are seeing the CDS go wider, otherwise nothing has changed," argues Kollmorgen.

The situation will only truly rectify itself if more real money investors enter the CDS market, which Kollmorgen suggests is likely to happen. "Real money investors will have to get CDS as an approved product, because if you are a portfolio manager you would be doing your clients a disservice if you didn't," she concludes.

MP

Long-short evolution

Manager builds programme of new synthetic CDO strategies

Washington Square Investment Management (WSqIM) is in the process of rolling out a series of innovative long-short managed synthetic CDOs. The third such deal is currently being prepped, with a fourth expected shortly.

"We are planning on building on the programme we started in May 2006 so that we complete a couple of deals of this nature every year. Each one will utilise the technology we see in long-shorts to try to make them more flexible in terms of how we invest the short bucket and what is appropriate given prevailing market conditions," says Karan Chadha, md at WSqIM.

The first transaction, Silver Square, had a traditional structure and was one of the more commonly marketed managed long-short synthetic transactions currently offered in the market – a co-mingled structure. While such deals have proved popular and can work well, WSqIM felt that the structure was too restrictive given the limitations imposed by rating agencies and therefore the firm resolved to improve upon this format.

Chadha adds: "In our second long-short deal, Kingly Square, we kept the short bucket outside the structure so it wouldn't be subject to rating agency restrictions and therefore provided us with much more flexibility. With the third deal that we are currently working on, Schweden Square, we have taken that flexibility still further and are able to express our credit views not only in terms of CDS markets, but in other credit markets as well."

The idea is to be able to leverage the views of the entire research team at WSqIM so that the long-short manager can take advantage of various idiosyncratic opportunities. For example, to play secured versus unsecured debt; or loans versus bonds; or the basis between loans and LCDS; or other strategies that the manager thinks are appropriate.

"Most market long-short transactions tend to be co-mingled, so the long and the shorts are put on at the same time and therefore if the shorts do really well, all you get is extra subordination and a more stable tranche. Doing it our way means that if we do well the investor also gets some spread in the form of an increased coupon down the road," explains Chadha.

The current WSqIM long-short deal is only being selectively marketed because most interest has come via reverse inquiry from investors. The transaction is not suitable for all, according to Chadha.

"Investors in these structures are comfortable with a more trading-oriented strategy and understand the complexity and risks involved in managing a short portfolio of this kind. The typical co-mingled strategy is more of a macro play in my view – it works well in times of systemic widening because weaker names widen disproportionately to the long names. But in a market that has seen three years of tightening, you need to be more selective and not be forced to put all your longs and shorts on at the outset," he says.

Furthermore, Chadha expects his firm's long-short deals to continue to evolve. "As markets evolve and provide more opportunities, we will try and incorporate them in future deals. For example, now that we see pricing being offered by banks on CDS on tranches of ABS we might possibly take advantage of that on particular deals where we feel the tranche price is not adequately pricing in risk," he concludes.

MP

CRE CDOs attract non-CMBS investors

CDO-focused buyers may settle for less specific issuance, but European asset class expected to grow

As Citi and Lehman Brothers announced the preliminary details of the fifth European CRE CDO, analysts have begun to look at the investor base for previous transactions. It remains to be seen whether the new deal – the €800m Duncannon CRE CDO managed by Fortress Investment Group – will attract a similar set of CDO-focused buyers.

The pricing of the lower-rated tranches of the four European CRE CDOs launched to date (SCI passim) strongly reflects the disparate nature of their underlying portfolios – triple-As have seen pricing in a relatively tight range, but triple-Bs and double-Bs have seen much wider differences. The disparity in portfolio assets has contributed to a wider than expected range of investors in the instruments.

Investors consequently need to have the expertise to review each of the different underlying asset types, as well as the quality and resilience of the CDO manager, according to a report published last week by Barclays Capital's securitisation research team. As a result, most buyers of CRE CDOs to date are not CMBS-focused investors.

"We think it likely that CMBS-focused investors would be concerned about an overlap with their own CMBS holdings, as well as a lack of good relative value opportunities compared to CMBS deals available in the primary market. As a result, we think most investors are more CDO-focused," says Hans Vrensen, head of European securitisation research, at Barclays Capital.

Furthermore, he adds: "Issuance growth in this emerging sub-sector has been disappointing so far, compared to expectations of 10 to 20 deals in 2007 that were voiced by rating agencies at various conferences last year. The main reasons for this disappointing growth, in our opinion, is the lack of appropriately yielding commercial property assets, strong competition for assets from other non-CRE CDO buyers and high asset pre-payment rates."

Both the CDO-focused investor base and the dearth of commercial property assets could perhaps lead to increased growth in less property-specific CDOs, such as Prudential M&G's recently launched Panther CDO IV, which allow for significant B-note and CMBS buckets. However, Vrensen says: "On balance, we remain optimistic about CRE CDO issuance in the future. Given the problems potential managers have had to overcome, it might just have taken them a bit longer to ramp up a sufficiently sized and diversified portfolio."

The report goes on to say that European CRE CDOs have also provided investors with a slight improvement in the transparency of junior debt prices. While such prices are not typically disclosed in the public documentation of the related CMBS, they can be disclosed in the documentation of CRE CDOs that include B-notes and mezzanine loans. But of the four such transactions to date, only one – Anthracite Euro CRE CDO 2006-1 – provided complete details on B-note prices and sponsors.

The report adds that Barclays Capital has reviewed the pricing patterns of European B-notes, following the purchase of four B-notes by Investec's CREA CDO I Limited. Based on these junior debt pieces, prices appear to have tightened slightly from approximately 400bp to 375bp, although there is considerable variation around this average.

However, Mark Nichol, CMBS and corporate securitisation research, at Barclays Capital, concludes: "In our opinion, junior debt spreads should have tightened more significantly than implied by this limited sample, as demand for B-notes has increased with other CRE CDOs looking to ramp up. For example, CREA CDO I Limited expects to receive margins of between 300bp and 350bp for seven of the further nine B-notes it intends to purchase during the ramp up phase."

MP

Everquest IPO planned

Details emerge of Bear and Stone Tower permanent capital vehicle

Bear Stearns Asset Management and Stone Tower Debt Advisors filed papers with the US SEC to initiate the process towards becoming the latest listed credit company. The permanent capital vehicle, dubbed Everquest, is seeking to raise up to US$100m.

The purpose of the IPO is to restructure existing hedge funds managed by BSAM and Stone Tower, which comprise almost entirely third-party money, and add capital to pay down existing credit lines and to invest in existing investment strategies along the same guidelines as the approximately US$720m that is already under management.

BSAM and Everquest declined to comment on the deal given its impending IPO status, but the company's filing says: "We generate earnings primarily through a diversified portfolio of CDOs in which we beneficially own all or a majority of the equity. Our CDOs are special purpose vehicles that hold a range of cash-generating financial assets, such as corporate leveraged loans, asset-backed securities and securities issued by other CDOs."

Everquest plans to continue increasing its holdings of CDOs, primarily through the formation and acquisition of additional CDO subsidiaries in which it will hold all or a majority of the equity. To a lesser extent, it will also acquire and hold minority equity positions in CDOs.

The filing continues: "We expect to form and hold CDOs structured by our managers, as well as to help structure and opportunistically acquire CDOs sponsored by third parties where we believe we can do so on attractive terms. We may also form or hold, from time to time, other structured finance assets."

Everquest has received some public criticism following its SEC filing, but experienced investors are sanguine about the vehicle. "There has been some talk about the deal offloading Bear Stearns risk on retail investors. This is clearly not the case if you look at the SEC filing – it's just about all third-party hedge fund money," says one hedge fund manager.

However, he points to the lack of third-party appraisals of the underlying collateral which has been an issue in other listed vehicles. "I would therefore view it somewhat warily, although I have some faith in a company like Bear – it's active on the exchanges and aware of the issues connected with a public listing of any kind. In any event, it has so many sources of liquidity, so why choose this one if they're thinking of passing a spivvy customer-cheating trade through? I think we're talking about a tempest in a teacup here," he adds.

But another hedge fund trader observes: "I hear that there will actually be some kind of voluntary third-party valuation – Everquest doesn't want to be associated with other vehicles that don't have this. There is, of course, a concern that this stuff will be available to retail investors – but that's the nature of the beast and no one is being forced to buy it."

As of December 31 2006, Everquest says: "Our CDO holdings consisted of 19 CDOs, including 11 CDOs in which we own all or a majority of the equity, one in which we own 50% of the equity and seven in which we own a minority interest. In addition, at that date, our largest CDO subsidiary – Parapet CDO – a CDO of CDO securities, held a portfolio consisting of preference share or income note tranches of 15 CDOs and mezzanine debt securities of 22 CDOs. The aggregate fair value of our CDO and related holdings as of that date was US$719.7m."

MP

Structured credit hedge funds stay steady

Latest index figures indicate a quiet March for the sector

Both gross and net monthly returns for March 2007 shown in the Palomar Structured Credit Hedge Fund (SC HF) Index showed little movement. The latest figures were released last week and show a gross return of just 0.08% for the month, while the net return dropped 0.04%.

However, the gross and net indices are both showing positive cumulative returns since calculations began in January 2005 of 118.94% and 113.33% respectively. For more Index data click here.

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

The Palomar SC HF Index is compiled and run by Palomar Capital Advisors and published exclusively by Structured Credit Investor. Palomar Capital Advisors is a financial advisory firm specialising in structuring, managing and placing alternative investment products, specifically credit-related securities. It is an independent firm based in Zurich, Switzerland, owned and controlled by its investment professionals.

MP

Troubling times

Sub-prime contagion may be contained, but investors expect further volatility

The US housing market's turmoil and how it will affect the wider financial markets is a concern. Though many believe its impact is limited to the sub-prime sector, structured credit investors still need to be vigilant, as it may take time before all the problems are fully recognised.

The market is still awaiting the catalyst that will cause a change in the credit cycle and push spreads wider at last. The sub-prime market has the potential to instigate this change, but is yet to extend its impact beyond the US mortgage market.

Gary Jenkins, partner at Synapse Investment Management in London, believes it is hard to find a valid reason for the cycle to turn. "Risk appetite remains strong and when you look at the global economy, credit quality, default rates and ratings trends; none of them seem to suggest that the cycle will turn any time soon," he says.

Others believe the affects of the sub-prime turmoil are gradually diminishing and observe the market entering a cleanout phase. "A lot of the surprise has come out of the marketplace and though it is likely we'll see continued pockets of problem and further revelations, I do not see that this will be a catalyst at this point that will cause a major disruption to the corporate credit cycle," says Cam Albright, director of fixed income research, Wilmington Trust Company in Wilmington, Delaware.

He adds that the market has entered a rational discovery process, determining the level of exposure that companies have and the extent and breadth of problems. Albright cites the first quarter earnings season as providing a good gauge of the market's current state; in particular, the case of RESCAP which despite announcing over US$900m charges related to the underperforming mortgage market, saw spreads on its bonds hardly move. "The market at that point was focussed on where the problems were and priced a lot of this in," he says.

There is an element of timing too, adds Albright, as the process for loans to move from delinquency to a loss situation is a matter of months and so it will take time to show up in CDO structures. Also, loans held by firms that have gone out of business still need servicing, which is another lengthy process. "It takes a while for this to catch up and fully recognise and ascertain the quality of a portfolio," he says.

Tighter credit and underwriting standards have led to a healthy correction in the market. Though this may have alleviated some of the problems caused by overcapacity and overly aggressive loan pricing and loose underwriting standards of 2005/2006 vintages, risks are still present, says Dominique Dijkhuis, portfolio manager, global credit and CDOs at F&C Asset Management in Amsterdam.

"It is a micro crisis, and for now we do not see it turning into a macro crisis, but the worse is yet to come. Defaults and foreclosures are likely to pick up and there is the risk that the 2005/6 vintages may have to be reset to worse conditions," she says.

Dijkhuis notes an additional concern is the lack of visibility in sub-prime issuance and caution among investors, which could lead to sub-prime lenders finding it difficult to securitise their loans. "Valuations are becoming more attractive but it is very tough to sell subordinated tranches, because that is where the losses have been focussed," she adds.

Investors are now closely scrutinising not just collateral but other factors, such as the financial strength of the issuer, track record of the servicer and trustee. Alexandra Gropp, ABS analyst at F&C Asset Management in Amsterdam, expects tiering to increasingly come into play in the market. "It is quite likely that there will be strong tiering among CDO of ABS managers and potentially only deals from very strong players in the sub-prime market will be successful," she says.

"A form of tiering will occur over time, with people viewing differently the quality of ABS collateral issued between 2005 and 2006 versus new collateral that is issued under tighter credit conditions and has better pricing," adds Wilmington's Albright.

HD

Bearelly heads to Zais

The latest company and people moves

Bearelly heads to Zais
Sridhar Bearelly, global head of CDO syndication at Lehman Brothers is understood to joining Zais Group's CDO business. Bearelly's departure follows the retirement of Mark Zusy, global head of Lehman's collateralised debt obligation banking group, earlier this month.

Ford joins Synapse
Rob Ford, the veteran ABS trader from Barclays Capital, has joined Synapse as a partner in portfolio management. Ford, an md and head of European asset-backed securities trading, leaves Barclays after 21 years' service.

Ford's hire takes the Synapse ABS trading team to three. Ben Hayward and Eoin Walsh joined Synapse in March from Citigroup, where they managed four structured investment vehicles.

Synapse's Mark Holman says: "We are obviously delighted to have Rob on board with us. He has one of the most consistent track records of any trader that I have worked with. His knowledge and market profile coupled with his incredible enthusiasm are going to be a tremendous asset to us in the coming years".

Pimco beefs up in Asia
Pimco is growing its Asian structured products business and is understood to be transferring Showbhik Kalra from New York to aid this development. Kalra is expected to be in position by the end of the year. Also, it is understood that Rob Mead, head of credit for Europe, has moved from Munich to Sydney to manage the firm's Asian credit portfolio.

F&C appoints structured credit head
F&C has recruited Teimuraz Barbakadze to the new senior position of director, head of structured credit. He will be based in London and report to Jacob De Wit, head of fixed income.

Barbakadze joins from the investment banking division of Societe Generale where he has been md, head of cash CDOs in Europe since 2004. At F&C he will be responsible for structuring, marketing and distributing structured credit products – F&C having announced that the development of a CDO platform would be one of its eight key initiatives launched in 2007 as part of its three-year accelerated growth plan.

UBS' global CDO shake-up
UBS has reorganised its collateralised debt obligation business in an effort to grow the business and better serve clients' needs. Lirenn Tsai becomes head of all US CDOs, from his position of head of the New York CDO team. He reports to Jim Stehli, global head of CDOs.

Robert Morelli, previously head of syndicate for structured finance CDOs, now heads the residential ABS CDO business and reports to Tsai, while Bruce Steinberg joins from RBS Greenwich Capital Markets as global head of CDO product management, reporting to Stehli. Steinberg and the respective heads of Europe and Asia-Pacific product management, Paul Heyrman and Yugo Yamamoto, will market and develop CDO products. All three teams will cover all CDO products including ABS CDOs, commercial real estate and collateralised loan obligations.

Meanwhile, Fred Engle and Ji-Mei Ma, co-heads of CLOs, have left UBS. Their destinations are not yet known.

DB hires Cornut
Antoine Cornut is joining Deutsche Bank as head of European credit trading, reporting to Derek Smith, the firm's New York-based head of US flow credit trading. Cornut was previously head of European flow trading at Credit Suisse.

Lips leaves WestLB
Hans-Jurg Lips, head of European structured credit has left WestLB. His destination is not yet known.

Walsh joins HVB
Robert Walsh, who left his position of head of cash CDOs at Dresdner Kleinwort, is understood to be joining HVB.

BofA's sales growth
Bank of America is growing its structured credit products sales force and is in the process of making a number of hires to build up the team.

Michael Furtado will join the bank at the end of this month in a senior structured sales position covering UK institutions. Furtado joins from RBC Capital Markets, where he was head of UK structured credit products sales.
Vincent Moge, co-head of structured credit products sales at Bank of America, expects further hires to be announced shortly.

"We are making a number of hires to the structured credit products sales team over the coming months and Michael's appointment is key in the context of strengthening our sales coverage," he says.

Serge De Bruyn was added to the team last month as senior structured credit salesperson for the Benelux, also joining from a similar role at RBC CM.

Swell at GSAM
Michael Swell is understood to have joined Goldman Sachs Asset Management as md and head of structured products. He joins from Friedman, Billings, Ramsey Group where he headed up the firm's institutional asset- and mortgage-backed securities trading unit.

Eggenschwyler joins CS
Basil Eggenschwyler, a financials trader at Barclays Capital has left the bank and is understood to be joining Credit Suisse in a similar position.

CIFG hires two for Europe
CIFG has hired Richard Lumley and Louise van der Boon to its European structured finance team.

Lumley joins CIFG after three years at Rabobank International, where he served most recently as head of structured credit and securitisation, risk division. In his new role he will be a director, European structured finance, and will focus on a variety of asset classes including consumer ABS, RMBS and whole-business securitisations.

Van der Boon joins CIFG as an associate from Fitch Ratings, where she was a performance analyst for European structured finance. Both Lumley and van der Boon report to European structured finance head Charles Gundy, and are located in CIFG's London office.

Randolph to Jefferies
John Randolph is to join Jefferies & Company as svp in the firm's fixed income division, focusing on trading distressed ABS, including MBS and CDOs. He will be based in Austin, Texas, and officially joins Jefferies on 1 June.

Randolph has over 17 years of analytical and trading experience in various ABS-related sectors. He comes to Jefferies from Cantor Fitzgerald, where – as the firm's director of ABS trading – he focused on residential ABS, including subordinated and distressed ABS, as well as CDOs.

TSI acquisition and alliance announced
In a move to capitalise on the anticipated growth in loan-only credit default swaps (LCDS), Creditex Group has acquired a minority stake in privately held Trade Settlement Inc, a provider of settlement services to the global primary and secondary syndicated loan markets. As part of the transaction, the two firms also announced a partnership between TSI and T-Zero, a leading credit derivative processing platform which is an independently managed subsidiary of Creditex Group.

The investment by Creditex Group comes as TSI prepares to expand its post-trade platform for primary and secondary syndicated loans to the European market. TSI already has gained rapid adoption among participants in the US loan market and will provide significant post-trade benefits to European market participants later this year.

The companies say that the partnership between TSI and T-Zero will benefit LCDX and LCDS market participants by bringing together T-Zero's affirmation platform and extensive credit derivative expertise with TSI's settlement platform and extensive loan expertise. The two firms will work together to provide an integrated solution for accurate trade capture, STP and settlement of loan credit derivatives.

CMA appoints sales vp
CMA, the credit information specialist, has appointed Peter Vitale as vp sales for its credit market pricing data (CMA DataVision) and intra-day services (CMA QuoteVision). Vitale, based in New York, will be responsible for sales and account management globally.

Vitale joins CMA from GFI, where he was head of sales at GFI's data & analytics North America division. Vitale has more than 20 years' experience in the OTC credit and financial services markets.

Four for BNP Paribas' FI structuring
BNP Paribas' fixed Income structuring team has made four key appointments to its Interest Rates and FX structured products platform in London, to focus on developing new business lines, such as strategy and property derivatives, and to strengthen existing product capabilities.

Francois-Xavier Chevallier joins the bank from BNP Paribas Asset Management in Paris and brings more than 10 years of experience in fund management. In his new role, Chevallier will further develop a recently-started business of devising and marketing algorithm-based strategies with interest rate and FX underlyings to clients, who are looking for more actively managed investments.

Andrew Jeyarajah will spearhead BNP Paribas' structuring activities in property derivatives. BNP Paribas has been active in property derivatives for the past nine months and is adding a dedicated structuring resource now that the business is gaining momentum in the market. Jeyarajah joins from Tulletts, where he has been focusing exclusively on property derivatives for the past 18 months.

Meanwhile, Javier Quiros Garcia joins BNP Paribas from Banco Santander in Madrid, and has seven years of experience as a derivatives trader and structurer. He will strengthen the bank's hybrids and local markets structuring capabilities.

These three hires all report to Kara Lemont, head of interest rate and FX structuring in Europe.

And finally, Wojciech Herchel will focus on ALM modelling within the structuring team. He joins from WestLB and previously worked at Ernst & Young. He reports to Vincent Berard, deputy head of interest rate structuring in Europe.

HD & MP

Moody's warns on ABS CDO tranche correlation

A round up of this week's structured credit news

Moody's warns on ABS CDO tranche correlation
Increasing overlap in the securities underlying ABS CDOs may have increased correlation between these CDOs' debt classes in recent months, says Moody's Investors Service in a new report. In light of these developments, the agency is re-examining its correlation assumptions for ABS CDO tranches forming the underlying of other ABS CDOs and CDO-squared transactions.

"The increase in asset overlap can be traced to the concentration of exposures to the residential mortgage-backed and home equity loan sector, a growing proportion of synthetic transactions, and the introduction of tradable HEL-based credit indices, such as ABX," says Yvonne Fu, Moody's md and co-author of the report.

These factors, plus the advent of standardised tranches based on the ABX indices, have made it possible for large numbers of CDOs to purchase (or, if synthetic, to reference) a common set of structured credits.

If it were possible to look through to the underlying assets of every CDO included in a CDO portfolio, along with every underlying CDO structure, Moody's could explicitly model the correlations. But in practice, the many structural layers that may affect the top-level CDO and the dynamically managed nature of the CDO portfolios often make such a look-through approach impossible, says Moody's report.

Moody's expects to complete its correlation analysis over the next couple of months. In the meantime, the ratings agency will continue supplementing its standard analysis on the current deal pipeline with various scenarios based on the preliminary findings from this study. Additionally, Moody's will continue to discuss these findings and possible new correlation levels with market participants.

Japan sees increase managed synthetic CDOs
S&P says it assigned ratings to ¥61.9bn of CDO transactions in Japan in Q1 2007. The majority of synthetic CDOs continue to be arbitrage transactions comprised of CDS on global corporates and financial institutions. With regard to public deals, there is a burgeoning trend for managed transactions that allow a third-party manager to substitute the reference entities of the portfolio, the agency reports.

The overall issuance figure represents just one-third of the total issuance amount of Japanese CDO transactions rated by S&P in the first quarter of 2006. The decline was attributed mainly to a decrease of more than ¥70bn in the issue amount of CBO deals geared toward SMEs under the Tokyo Metropolitan Government's initiative to establish a bond market for SME credits.

The reporting quarter saw only one such transaction. In March, ratings were assigned to Excellent Collaboration Tokutei Mokuteki Kaisha's ¥16.39bn note issuance. This deal was arranged by Mizuho Bank and is the eighth in the series. In addition to the Tokyo Metropolitan Government, the transaction was jointly originated with regional Japanese authorities, including Osaka prefecture and the cities of Chiba, Kawasaki, Yokohama, Shizuoka, Osaka, Sakai and Kobe.

Munich Re securitises hurricane risks
Munich Re has issued US$150m Series 2 Class E principal at-risk variable-rate notes under its shelf programme, Carillon Ltd. This is the second series of notes issued under this programme.

Through the issuance of the notes, Munich Re has bought further fully collateralised protection against high severity losses incurred from US hurricanes over the next four hurricane seasons.

The transaction relates to hurricanes in 26 eastern and southern US states and Washington D.C. causing a market loss in excess of US$35bn each (Hurricane "Katrina" in 2005 caused an insured market loss of more than US$40bn). From the US$150m already deposited by investors, Munich Re will receive – in the risk period from 9 May 2007 to 31 December 2010 – payments on the basis of this plan if, and to the extent that, the insured market loss exceeds US$35bn.

The transaction was arranged by Morgan Stanley together with Munich Re's business unit Munich American Capital Markets. In view of the loss probability of approximately 4% on the basis of the risk modelling prepared by Applied Insurance Research (AIR), the securities were given a single-B rating by S&P. The notes pay 15.25% over three-month Libor.

This is the largest catastrophe bond ever to be placed on the market in a comparable risk category. It triggered considerable demand and has been subscribed to by institutional investors around the world.

S&P revises criteria for single-event cat bonds
S&P has revised its ratings cap on natural-peril catastrophe bonds that can experience a loss of principal because of a single event. The change is in response to the evolving structures in the natural catastrophe bond market.

S&P says it has recently seen some transactions with attachment points that are significantly higher than in earlier transactions, which makes the probability of a first-dollar loss to the principal much more remote. The new criteria will allow these bonds to be rated as high as triple-B plus if the one-year probability of attachment is less than or equal to 20bp and triple-B minus if the one-year probability of attachment is less than or equal to 40bp.

The modelled probability of attachment based on the tenor of the transaction must also be consistent with the rating level. For example, a note with a term of three years with a three-year modelled probability of attachment equal to 70bp would not be rated triple-B plus.

In addition to the modelled probability of attachment, other transaction-specific factors could contribute to – or detract from – the ability to achieve an investment-grade rating. These might include the parties to the transaction (e.g., the ceding insurer and the total return swap counterparty and their respective ratings) and the peril modelling output.

Biggest European credit opps fund to launch
Park Square Capital, the London-based credit products investment adviser is to launch Europe's largest credit opportunities Fund by equity commitments. The Fund will be leveraged and is expected to total approximately €1.25bn once fully invested.

Caisse de dépôt et placement du Québec, Ontario Teachers' Pension Plan and a third Canadian institutional investor and the Park Square team have committed €315m of equity to the Fund. These institutions are existing investors in Park Square's first mezzanine fund.

Given the fund's ability to draw capital as needed, it has limited pressure to ramp-up and has the ability to alter investment strategies over time to take advantage of changing market conditions. The fund will provide first lien, second lien, mezzanine, high yield and equity financing and also has the ability to invest in distressed debt.

Park Square, established in 2004, raised the largest independent European mezzanine fund of €1.05 billion in 2004, which is now more than 50% invested. The credit opps fund, together with Park Square's first mezzanine fund and its limited partners, will have the ability to invest up to €500 million per transaction.

CFTC proposes credit options exemption
The US Commodity Futures Trading Commission (CFTC) is proposing to exempt the trading and clearing of certain credit default options and credit default basket options from applicable provisions of the Commodity Exchange Act (CEA). It is proposed that these products be traded on the Chicago Board Options Exchange and cleared by the Options Clearing Corporation.

The CEA gives the CFTC the ability to promote economic or financial innovation and fair competition by exempting certain transactions that are consistent with the public interest. The proposed exemptive order would facilitate bringing such products to the marketplace, allowing market forces to determine their viability, while ensuring that appropriate public, market participant and financial protections are in place, the regulator says.

The proposal will be open for public comment for 14 days following its publication in the Federal Register.

Strong start to 2007 for CDOs of leveraged loans
Traditionally, the first quarter is quiet in terms of CLO issuance. However, a report by S&P shows that it assigned preliminary or final ratings to 27 transactions during the period, compared with 33 in the last quarter of 2006.

"Throughout the world, investor demand for CLO paper remains strong, despite growing concerns from many market participants about the credit quality of the underlying assets," explains S&P credit analyst Claire Robert. "Spreads on these loans, although they continue their downward trend, are still high enough to make the arbitrage transactions profitable."

S&P expects the pipeline for the second quarter of 2007 to be extremely busy, with approximately 30 transactions to either close or reach the market by the end of the second quarter. This would make it as active as the fourth quarter of 2006. Following this trend, S&P expects over 100 transactions to be structured by the end of 2007.

Calypso unveils version 9.0
Calypso Technology has unveiled version 9.0 of its suite of solutions. The company says enhancements in all solution areas build upon its innovations in trading, risk management and processing for derivatives, treasury and securities.

The Calypso credit derivatives solution now includes a CDO structuring and analysis tool that enables the creation of a bespoke portfolio, pricing of the complete capital structure, enables substitutions and manages the trades affected by substitutions. In addition, credit contingency features have now been added to all OTC products.

The new Calypso asset management module adds functionality to the leading sell-side capital markets solutions to meet the specific requirements of asset managers. The module enables fund and strategy configuration and associations, the ability to trade funds, position configuration and look-through analysis.

Furthermore, Calypso says its underlying infrastructure has been modified to ensure it remains at the cutting edge of software development. The use of clustering for data servers ensures maximum availability of the solutions, and the Calypso database schema is now defined in XML to simplify the upgrade process. Additions of new server-side components thin the Calypso client applications further.

S&P releases April SROC figures
After running its month-end SROC (synthetic rated overcollateralisation) figures, S&P Ratings Services says it has taken credit watch actions on 76 European synthetic CDO tranches. Specifically, ratings on 62 tranches were placed on credit watch with negative implications and ratings on 14 tranches were placed on credit watch with positive implications.

The SROC levels for the ratings placed on credit watch negative fell below 100% during the April month-end run. These SROC figures will be published in the imminent SROC report covering April 2007.

Correction
In the News Round-up in SCI issue 29 under the heading 'Smart PFI 2007 launches' we incorrectly stated that Sumitomo Mitsui Banking Corporation Europe was sole arranger of the deal. In fact, the deal was co-arranged by Deutsche Bank, who also acted as lead manager.

MP

Trading ideas - shareholder FrienDly

Dave Klein, research analyst at Credit Derivatives Research, looks at a negative basis trade on Federated Department Stores

Basis trades are often seen as the bread and butter of many credit traders. The systemic rise and fall of credit quality often exhibits itself quite differently in each of the cash and synthetic credit markets.

The basis, or cash-CDS differential, tends to move on the back of a number of technical and fundamental factors. The most notable, over the past few months, are the impact of the structured credit technical bid (driving supply for CDS protection) and loan issuance and its hedging (driving demand for CDS protection).

Neither of these major forces impacts the bond market directly – but clearly there is an arbitrage-based relationship between the two that needs to be kept in line. In this case, we look at a negative basis trade on Federated Department Stores, Inc (FD).

Based on our survival-based valuation approach, the FD's 6.625's of Apr 2011 bond is priced roughly at fair value with a negative basis (against 3Y CDS). Normally, we would look for a cheap bond with which to enter a negative basis trade to get the extra pop of a return to fair value. However, FD ranks fairly high on our fundamental LBO-viability screen and, although we have not heard any recent rumours, our research indicates that bonds outperform CDS when an LBO announcement or rumour becomes public.

Exhibit 1 charts the CDS-bond basis for 9 names pre- and post-LBO rumour/announcement date. None of the bonds had change of control provisions.

Exhibit 1

Clearly, the basis swings from negative to positive which would be good for our negative basis trade. While the negative basis is the driver of the trade and we are not placing a specific bet on an LBO, we would be happy to benefit from the potential upside from such an event.

Exhibit 2 indicates the 'price-based' term structure of FD and indicates that FD's shorter-dated bonds are trading cheap to fair value while longer-dated bonds are trading rich. FD is active in the credit derivative markets and the 6.625's of Apr 2011 is a moderately liquid bond. We note that, unlike the FD 12's, the 11's do not contain change of control provisions. 

Exhibit 2

Based on our analysis of bond cheapness and market activity, the 6.625's of Apr 2011 is viable for the long bond leg of our negative basis trade. We must now look at the actual spreads to judge whether we are actually trading at a negative basis, and, maybe more importantly, can position ourselves with positive carry.

Comparing the bond z-spreads (for the active bonds) with the CDS term structure, Exhibit 3 shows that the bond is indeed trading wide of CDS. Importantly, we must note that the bond is trading wide of its interpolated maturity-equivalent CDS (three-year) which reflects our second basis adjustment discussed above.

Exhibit 3

The FD CDS curve is fairly 'well-behaved' and has no serious inflexion points and we see liquidity in the 3Y tenor. Additionally, we see solid two-way pricing on Bloomberg's ALLQ screens for the 6.625's of Apr 2011.

Given that we have identified the bond as trading cheap to the CDS market (from our survival-based framework) and its z-spread as being wide of on- and off-the-run CDS levels, we must ensure that we account correctly for any premium or discount at which the bond is trading.

As seen in Exhibit 4, the basis between June 2010 CDS and the Apr 2011 bond has stayed negative over the past year. Given the mismatch in maturities, we are implicitly putting on a curve flattener (which works against our LBO-viability rating for FD but the maturities are close enough that we do not expect this to have a major impact). Since our CDS and bond are mismatched in maturity, we alter our hedge strategy a bit, looking to duration hedge the package rather than attempt a more standard default-hedged negative basis package.

Exhibit 4

Over the hedge
Given the almost one year difference in bond and CDS maturity, we build a duration hedge for our package rather than the more traditional default hedge. As noted earlier, we are putting on a curve flattener (very roughly it is a 3-4-year flattener).

Given current DV01's for the bond and CDS, this results in buying US$1.20 of protection for each US$1 bond (face) purchased. In the (remote) event of default, we will be over-hedged and gain an extra US$0.12 on every dollar of bond exposure assuming a 40% recovery rate.

The main drivers of this trade are the negative basis, FD's high LBO-viability rating and FD's negative score in our Multi-factor Credit Indicator (MFCI) model. We do not believe that FD poses much of a default threat. However, we do believe there is a reasonable possibility that FD could be taken private. In that case, we would expect the CDS to widen more than bond spreads and benefit our trade.

Given the fair value pricing of FD's bonds, the company's LBO-viability and the slightly positive carry of our overall position, we suggest this negative basis trade (long bond and long protection) as a duration-neutral way to pick up positive carry.

Risk analysis
As noted earlier, this position is a bit away from default-neutrality but close to spread duration-neutral. There is a maturity mismatch since the bond matures in a bit less than four years. We have constructed the trade to be duration-neutral, betting on CDS-bond basis to move from negative to positive.

We do, notably, understand that many investors would still prefer to understand the interest rate risks associated with this position. Exhibit 5 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 5

While the ideal interest rate hedge would employ an interest rate swap, clients have asked for an equivalent Treasuries hedge on our basis packages. Hedging with Treasuries eliminates much of the interest rate exposure of the bond leg but still exposes the position to swap spread movements. For this trade, the FD bond is quoted against the US Treasury 4.5% of Apr 30 2012 bond and we enter a duration-matched hedge with them.

The trade has minimally positive carry – given the current levels. This carry cushion protects the investor from any short-term mark-to-market losses.

Entering and exiting any trade in these maturities carries execution risk, but this is not a major risk with FD 3Y CDS in this maturity as it is increasingly liquid. Our largest concern is execution in size in the bond markets.

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

FD shows good liquidity in the three-year maturity and bid-offer spreads are narrowing to around 5 basis points.

Recent bids and offers (seen on Bloomberg's ALLQ) for the Apr 2011 FD bonds have shown good availability in both directions. We recommend the bond leg of the basis be worked first, looking for a price not far above US$104.06 (our model fair-value) if possible.

Fundamentals
This trade is technical in nature but, given how close to fair value the bond already trades, is impacted by fundamentals.

FD rates a high 3.3/5 on our fundamentals-based LBO-viability score. In the event of an LBO, we would expect bonds to outperform CDS and send the negative basis positive, benefiting our trade.

Summary and trade recommendation
We look again at LBO-viability and the behaviour of bonds and CDS in this negative basis trade. Although we are not reacting to any current rumours, FD's high LBO-viability rating motivates the trade. In the event of an LBO, we expect bonds to outperform CDS based on our empirical research and the possibility of a tender offer.

We feel a duration-neutral negative basis trade is an excellent opportunity to earn modest carry and potentially benefit from the basis moving from negative to positive. While FD's 2012 bond contains CoC language and enhanced protection against an LBO, we believe it is priced rich to fair value and prefer the 2011 bond for its combination of positive carry and potential LBO benefit. We recommend a slightly over-hedged basis package using a single CDS static hedge to pick up 3.6 basis points of carry.

Buy US$12m notional Federated Department Stores, Inc. 3 Year CDS protection at 27bp and

Buy US$10m notional (US$10.43m cost) Federated Department Stores, Inc. 6.625% of Apr 2011 bonds at a price of US$104.28 (z-spread of 36bp) to gain 3.6 basis points of positive carry

Sell US$8.1m notional (US$8.0m credit) US Treasury 4.5% 4/30/12 at a price of US$99.7344 to hedge bond interest rate exposure

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 2

In this second of a three part series, DPI strategy is discussed by Alessandro Muci, Domenico Picone, Emiliano Formica, Richard Huddart and Shreepal R Alex Gosrani of the structured credit research team at Dresdner Kleinwort

This section introduces our base case DPI strategy. Following a brief description of a generic DPI strategy, we analyse its performance in different scenarios.

Base case strategy

We list below the main contractual specifications of our 'base case'. This is a generic product and does not represent an actual DPI offered by Dresdner Kleinwort.

Static scenario analysis
A single deterministic path has been used for the index spread and default processes to isolate the impact of each on the strategy's performance. By removing any stochastic behaviour from the scenario, we assess the performance in terms of the cash-in-time achieved: the earlier the cash-in time, the better the performance.

In all static scenarios, we have assumed no fees.

Changes in spread levels

We examine how different index spread scenarios affect the timing of the cash-in event. Interest rates are kept constant at 4% throughout the life of the contract and we assume no defaults. Each scenario shows two charts: on the left, the spread and the evolution of the exposure over time, and on the right, the target redemption value (TRV) and the note value (NV), where the difference makes up the shortfall.

Flat index spread
If we keep the index spread constant at 35bp, we find that the cash-in event occurs at the end of year 6.

With a constant index spread and in the absence of defaults, the value of the note grows linearly toward the TRV. This is because there are no MtM losses and no gains from a constant index. In addition, the premium received remains unchanged throughout the life of the contract.

Increasing/decreasing index spread
When the index spread moves, we have two opposite effects that partially offset each other:

? A higher index spread generates MtM losses that reduce the NV and, as a consequence, the possibility of a cash-in event.
? On the other hand, a rising spread also leads to a higher carry from the protection sold, which increases the NV at a faster rate going forward.
The end result of these two contrasting effects depends on the particular spread evolution under consideration: for some paths this leads to a later cash-in event while for others the opposite may be true. The reverse occurs when spreads decrease producing MtM gains and a lower carry.

In the charts below, we show the performance of the structure when the index spread increases or decreases linearly over time.
? The first two charts display the impact of linearly increasing spreads from 35bp to 85bp over 10 years. Although the strategy initially suffers MtM losses, it is still able to recover through the higher positive carry. However, the cash-in now experiences a delay of about one year when compared to the constant spread case above.
? On the contrary, an index spread declining from 35bp to 20bp leads to an earlier cash-in with the MtM profits more than offsetting the lower future carry derived from having sold protection on a declining index.

Index spread jumps
Below, we assume a sudden spread jump from 35bp to 55bp at the end of year 1. In this scenario, the strategy suffers a large MtM loss, which is later recovered with the higher carry that accelerates the growth of the NV. The structure does not default and the cash-in occurs before year 5. Similarly to the CPDO, we also notice that the exposure jumps together with the spread. As expected, when a spread jumps from 35bp to 25bp (not shown below) the strategy initially records an MtM gain, but later on suffers from a lower leverage and the cash-in event is delayed.

Worst case two and five defaults with low flat spread

We analyse here the impact of defaults on the DPI strategy. This way, we compare the DPI performance relative to the 'zero default-flat spread' scenario we illustrated before.
The defaults are assumed to happen on day 100, 200, 700, 900 and 1200. The index spread is kept flat at 35bp.

As in the CPDO case, a default decreases the DPI note value since the resulting losses are paid out from the cash deposit. Therefore, defaults delay the cash-in event and, in some cases, even cause a principal loss on the note.

The assumption that the index spread does not widen after one or more defaults is unrealistic. Nevertheless, we think it is important to see how the DPI strategy performs in extreme economic scenarios. Later on, we will look at the combined effect of defaults and changing spreads.

Timing of defaults: back vs front-loaded

The timing of defaults is equally important. To further investigate this we ran two scenarios with the same total number of three defaults, and with the index spreads kept constant at 35bp. In the first scenario, we assume that all defaults are clustered at the beginning of the strategy (front-loaded), whilst in the second we cluster the defaults at the time when the strategy is about to cash-in (back-loaded).

Though the monetary losses are similar in both cases, their impact on the reserve is different. With back-loaded defaults, the reserve will continue to accrue interest until a later date, whereas front-loaded defaults penalise the returns gained from the reserve at an early stage of the strategy.

The situation is similar to a comparable CPDO strategy, though the dynamics of performance are rather different. For example, in the front-loaded case, the CPDO initial loss is large, since its leverage is greatest at the beginning. The CPDO then recovers more quickly than DPI since the leverage will jump back to its maximum level instead of increasing over time.

Negative gamma
In the front loaded case, the defaults cluster when the CPDO leverage is set at its maximum cap (set at 15). In this case, the CPDO may not be able to make up for the loss, as there is no room for further leverage in the strategy. This effect is described as 'negative gamma'.

The event of defaults clustering together at an early date can be interpreted as a single big shock (rather than a sequence of them). In this case, the CPDO outperforms the DPI. Alternatively, when defaults/shocks are spread out over time, the DPI outperforms the CPDO. We will investigate further this point in the following section.

Spread and defaults together: DPI vs CPDO

The scenarios illustrated before were kept unrealistically simple for ease of exposition. For example, when defaults occur, we would expect a spread widening. In this section we analyse such situations by looking at some examples of possible spread-default co-movements.

Single shocks
In the charts below we analyse the DPI performance when a single shock occurs. A single shock is defined as either the spread widens or there is only one default, or both.

We assume the index spread rises by 15bp in anticipation of a single default after year one. The index spread gradually drops to 40bp over a period of two months. Both DPI and CPDO strategies display a cash-in event. However, whilst DPI cautiously increases its leverage, the CPDO leverage jumps straight to its maximum (i.e. the cap level).

The above results rest on the assumption that there are no more shocks to follow the first one. This is exactly the philosophy behind the CPDO strategy and it does not come as a surprise that it does better than the DPI.

Multiple shocks
Consider instead the case where we have a sequence of defaults followed by spread widening (the defaults are assumed to happen on day 100, 200, 700, 900, 1200 and 1250). The CPDO leverage is like a double-edged sword: whilst in the case of single shocks it helps to speed up the recovery by re-leveraging more aggressively, in the event of sequential shocks it may even end up wiping out completely the value of the note. The DPI, on the contrary, has a more cautious and intuitive profile by taking more risk when it can afford it.

Stable environment
Assuming a constant spread at 35bp and no default, the CPDO cashes in after 4.1 years compared to 6.7 years for the DPI.

Favourable environment
In favourable markets (with no defaults and spreads declining from 60bp – see also backtesting in the next section), the DPI outperforms the CPDO, reaching the cash-in date sooner.

Conclusion
The CPDO performs better after single shocks by re-leveraging more and therefore recovering losses faster, and in a stable environment.

The DPI outperforms when a sequence of shocks occur. DPI also displays both a mean-reversion feature (due to the spread-dependent cap which allows investors to implement the 'sell high and buy low' strategy of the CPDO) and a momentum-chasing behaviour (thanks to the reserve which increases upon a good performance and avoids the rapid de-leveraging of the CPDO strategy).

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