Contents

CDR Liquid Index data as at 21 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.

LCDX launches

US Loan CDS index begins at last as further progress is made with standard tranches

The long-awaited launch of LCDX (SCI passim) met with enthusiastic trading on its first day, 22 May. Dealers report significant two-way volume and quoting up to US$250m markets with bid-offers as tight as a sixteenth.

The previous day dealers held a conference call to discuss proposed standard tranches for the LCDX, which will initially, at least, be set at 0-5%, 5-8%, 8-12%, 12-15% and 15-100%. Further conference calls are expected over the coming weeks and no timeframe has yet been set for the start of tranche trading, but dealers say that significant progress was made this week.

One says: "We moved further along on how the standard contracts should work to the point that we have now only got one trading issue that needs to be dealt with. The predominance of the work now has to move over to the legal side and getting the documentation done, which will, of course, take some time."

That trading issue is to be determined by investors. "We want to see what clients prefer to do, so we and the other firms will be asking them whether they want everything to trade on a spread basis or on a dollar basis, or on some combination thereof. It will be interesting see what the response will be, but my guess is that it is most likely to be a preference for trading on a spread basis for all the tranches except the equity tranche, which would trade on an all upfront basis. So it would be like high yield," the dealer says.

LCDX comprises a basket of 100 credit default swaps referencing first-lien loans. Deliverable obligations will consist of first-lien loans as defined by Markit RED Loans in accordance with its Syndicated Secured List for North America. RED Loans confirms reference entities and the key identifying information for credit agreements, loan facilities and loan tranches.

As with the CDX and iTraxx credit derivative indices, the LCDX index will roll every six months. It will trade with a five-year coupon, and additional maturities will be added in due course. Only failure to pay and bankruptcy will be treated as credit events.

To coincide with the launch of LCDX, both the Loan Syndications and Trading Association and the International Swaps and Derivatives Association have issued new documentation.

LSTA published a physical settlement rider that is intended to be used in conjunction with the Syndicated Secured Loan Credit Default Swap Standard Terms Supplement as published by ISDA and the LCDX untranched transactions standard terms supplement as published by ISDA and CDS IndexCo, together with the LCDS standard terms. LSTA says in the event of any inconsistency between the LCDS Rider and the applicable Swap Standard Terms, the LCDS Rider shall govern.

For its part ISDA launched trading documentation and auction rules relating to LCDX. The association also published revised documentation for the North American (Single-Name) Loan Credit Default Swap (LCDS), which was originally published on June 8 2006 to facilitate LCDS transactions.

The documentation was modified to conform to the LCDX documentation in terms of the settlement standard. ISDA is also preparing an LCDS Protocol regarding legacy LCDS trades to conform to the new standard set forth in the revised LCDS documentation.

MP

Asian firsts

Malaysian synthetic debuts as initial regional LCDS is traded

The past week has seen two landmark deals in Asia, both of which are expected to be followed by significant numbers of similar transactions. Malaysian national mortgage provider Cagamas yesterday, 22 May, launched the long-awaited first synthetic securitisation in the country – Cagamas SME – while the debut regional LCDS trade was executed.

The RM600m (US$176.5m) Cagamas SME is the first rated synthetic transaction in Malaysia and its first securitisation involving loans to small and medium enterprises. The deal is a partially funded synthetic CLO, referencing a portfolio of loans granted by Malayan Banking (Maybank) to SMEs. Maybank will enter into CDS agreements with various parties – including Cagamas SME – to transfer the credit risks of the reference portfolio.

Rating Agency Malaysia has assigned respective preliminary ratings of AAA, AA3 and BBB3 to the deal's five-year Class A (worth RM75m), B (RM30m) and C notes (RM45m). The agency says the ratings are supported by the senior-subordinated structure of the notes, together with the first loss protection provided by Maybank in the form of a threshold amount and the guarantee extended by Corporate Guarantee Corporation Malaysia.

Market participants suggest that the deal is likely to be followed by other Malaysian SME CLOs. At least two other deals are in the pipeline awaiting investor reaction to Cagamas SME.

Meanwhile, Morgan Stanley is believed to have executed the first loan-only CDS in Asia. The trade is understood to have been a hedge for a customer transaction involving A$25m worth of six-year loans to PBL Media.

Now a precedent has been set, dealers are optimistic for LCDS in the region. A pipeline of underlyings in excess of US$10bn over the next quarter means that there will be no supply issues and expectations of increasing interest for credit derivatives that can genuinely reflect local markets could provide demand.

Both Asian LCDS and the launch of synthetics in Asia can only help to reinforce the continuing growth in structured credit across the region. That growth has been highlighted in a series of conferences held by Derivative Fitch over the past week.

The rating agency believes that as the Asian structured credit market continues to develop, new types of assets will be referenced in CDO structures. In particular, it highlights CLOs referencing Asian assets and commodities-linked credit obligations.

Rachel Hardee, head of Asia Pacific structured credit at Fitch, notes: "The Asia Pacific CDO market is growing at a rapid pace and the investor base continues to expand. Synthetic CDOs continue to be the dominant product and these typically reference global assets. However, market participants are all looking at CLOs of Asian assets and we expect a number of such transactions this year."

At the same time, Atsushi Kuroda, director in Fitch's structured credit team based in Tokyo, observes that Japan is the first country in Asia to show a strong interest in CRE CDOs – though the number of such deals is still limited. He also identifies four key drivers for the development of CRE CDOs in Japan – diversification of real estate finance, issue trends in the primary market, development of the secondary market and transparent historical data.

MP

Munis on the rise?

Municipal CDO issuance expected to become a more regular event

The US$2tr municipal securities market is attracting increasing attention from structured credit investors. Deals have been few and far between to date, but increasing issuance is expected.

Research from Derivative Fitch observes: "CDOs that reference US municipal bonds and loans are hitting CDO arrangers' and investors' radars. Fitch has rated two of these transactions to date and a few more preliminary proposals are in the pipeline."

But it is still too early to tell whether municipal CDOs will be a sustainable and active slice of the structured credit market. The transactions are emerging as the appetite for CDOs of ABS has ebbed due to the downturn in the US sub-prime residential mortgage sector.

The rating agency continues: "Skittish investors may be flocking to safer havens, such as municipal bonds that carry investment grade ratings, as they are supported by the full faith and credit of their respective issuers. At the same time, those investors seeking better yields and searching for newer types of collateral may also be setting their sights on unrated municipal assets."

One New York-based asset manager is not entirely convinced about the asset class, however. "Muni CDOs is a bandwagon that everyone is now trying to jump on. You just have to look at how far down the chain the banks are that are hiring in this area to realise that the story has been told too many times," he says.

However, he adds: "While the CDO pitch may have been overdone by some players, the actual issuance of the securities themselves of course remains attractive. So, the addition of new index-based products might prove to be of interest – particularly to non-US investors."

Indeed, Deutsche Bank has launched a new index, dbMAST, which is linked to the US municipal market. The index aims to extract arbitrage value by leveraging the inefficiencies that exist due to the issuers' preference for long-term financing and investors' demand for US tax-exempt municipal bonds at shorter maturities.

Deutsche says that investors can gain access to the index via funds, notes, certificates and OTC derivatives or by a number of different wrappers. The product is available in both principal-protected and leveraged formats.

Carlos Rodriguez, head of municipal derivatives in the US at Deutsche Bank, comments: "db MAST offers clients the opportunity to generate alpha from the US municipal market via an innovative indexing solution, presenting European and Asian investors with an exciting alternative to their traditional fixed income markets."

The first municipal CDO was issued by UBS in 2004, but the transaction was a synthetic one. More recent deals have been issued as a structured tax-exempt pass-through (STEP) to achieve tax-exemption from the underlying municipal bonds.

For example, Republic Funding Trust I is currently being marketed by UBS and manager FSI Capital. The deal consists of US$415m senior, mezzanine and residual interest certificates.

The proceeds from the sale of the certificates will be invested in a static portfolio of tax-exempt bonds issued by government entities and issuing authorities. The bonds are issued on behalf of for-profit and not-for-profit obligors under section 501(c)(3) of the tax code of the Internal Revenue Service. The majority of the obligors in the collateral pool are in the health care and education sectors.

Municipal securities are typically issued by states, cities, counties and other government entities, as well as other issuing authorities such as not-for-profit institutions and other service sectors to help finance specific projects. Municipal securities typically enjoy a tax-exempt status.

MP

Tables turned on ABX shorts

Hedge funds left holding positions as market moves away

The past few weeks have seen a gradual tightening of the ABX index, save for a slight reverse yesterday, 22 May, as the market anticipates remittance reports due on the 25th of the month. The market movement has left those hedge funds, which first guessed correctly over the sub-prime spread explosion and then accelerated the process (see SCI issue 26), holding diminishing positions.

One ABS CDS trader observes: "Single names have retraced enormously over the past month or so - they're completely back to where they were last year. The ABX has been steadily tightening off the back of that and those huge mark-to-market gains that hedge funds saw in February and March are becoming an increasingly distant memory. They have kept those positions on and given back a big chunk of their gains over the past month."

The hedge funds have deliberately been left holding their positions, according to a New York-based hedge fund manager. "It looks like the dealers haven't been much help in the face of the market rally - they must have really been hurt on the way down," he says.

The trader suggests that it is simply a question of circumstances. "Dealers are putting on shorts at what are, in my opinion, very tight levels and nobody wants to pay large sums of money to take shorts off hedge funds' hands. So they are kind of stuck looking for some way to finance these shorts or having to wait until they have some resets or real deterioration in the underlying before spreads go out again," he adds.

Another banker observes that it can be difficult for hedge funds if they put on a billion or two in shorts in single names because it is unlikely that they will be able to trade out of them in a hurry. Equally, the CDOs that are now returning to the market and looking to ramp up and go long have reserve levels to meet, so will remain relatively choosy about the price they pay - even though it may be quite tough to find decent bids on more seasoned bonds at present.

For the hedge funds, there appears to be no permanent respite currently in sight. "It's only today, Tuesday, that we are starting to see some reversal of the tightening trend and I would expect to see a little more of a decline until people see how the remittance reports look on Friday, but that may well be it," the trader concludes.

MP

Keeping tabs

Subordinated investors mindful of key-man risk

The performance of a CDO portfolio is, to a certain extent, dependent on the expertise and skill sets of an individual or a team. So it is natural that some investors will take into account key-man risk when making their investment decisions.

However, investors should be mindful that the departure of key personnel from a CDO manager does not necessarily result in a lower quality portfolio management team or a change in investment style. Nevertheless, key-man risk does become more important further down the capital structure of a CDO and for investors that are reliant on the expertise of a select number of individuals; in particular, mezzanine and equity CDO investors.

Those focussed on more subordinated tranches have an increased focus on who is managing the money and it is common for their investment management agreements to incorporate key-man provisions. This is particularly true when newer and/or smaller investment managers are involved.

"The lower you are in a managed cash transaction, the more sensitive you become to the asset manager. And particularly at the equity level, having the key man provision is very important to us. We need to know what will happen and that we are protected in the event that a key manager leaves," says Olivier Gozlan, co-manager of Crystal Fund in London.

"It is definitely a large risk, and investors have to be comfortable that if one person was to leave, there are others around for the ongoing business and that the asset manager is committed to finding the right calibre person as a replacement," says Philippe Jodin, partner at Alegra Capital in Zurich.

The stability of portfolio management teams is also important for Crystal Fund, which places a higher consideration on the individual, rather than the institution involved in the management of CDO portfolios," adds Gozlan.

The firm's due diligence process does take into account the track record of a company to gauge the sourcing power behind a transaction. And Gozlan adds that it is important to closely analyse the statistics – not only the annual default rate of the asset manager, but also his par loss figures since he can sell a few days before default at a loss.

Gozlan believes that equity tranche investors will focus more attention on the track record of a person behind the deal than the company. "It is more a qualitative than quantitative analysis," he says.

Having good working relationships with managers is also key. "We do not invest in a transaction in the primary market without meeting the asset manager and you need to have a good relationship with the company and the people themselves," adds Gozlan.

Although Alegra Capital's Jodin agrees investors need to pay close attention to the strengths of provisions, he feels some may be only as good as the paper they are written on. "You have to know the asset managers you deal with and be comfortable they have the right strategies in place, no matter who is there," he says.

HD

Centerline hires for CLOs

The latest company and people moves

Centerline hires for CLOs
Centerline Capital Group has hired John Trentos as an md and senior portfolio manager in its credit risk products group. Trentos joins the firm to lead its new initiative into the CLO business and reports to Nicholas Mumford, executive md and head of the credit risk products group.

"Our strategy is to accumulate a highly diversified portfolio of non-investment grade commercial and industrial loans and securitise them through a series of CLOs," explains Mumford. "With Centerline's purchase of ARCap in August 2006, we currently monitor over 300 companies in 25 industries in connection with tenant credit. In combination with our experience as a highly-rated servicer, the CLO strategy is a natural overlay of our core competencies."

Centerline expects to begin aggregating loans on the company's balance sheet in the third quarter of 2007, with the potential for the first CLO issuance in the first quarter of 2008. Once the Company has gained market acceptance as a CLO issuer, it expects to retain only a small portion of the CLO equity.

Trentos comes to Centerline Capital Group from Sandelman Partners, where he was senior portfolio manager of a US$3bn credit book. Prior to that, he was with GE Capital Corporation in capital markets structuring for 11 years.

Stewart joins Standard Asset Management
Standard Asset Management has announced that Fiona Stewart, previously coo of hedge fund firm Sofaer Capital and more recently of Plutus Capital, will be joining the firm later this month as its coo. Stewart also currently co-chairs the AIMA Hedge Fund cfo/coo committee.

At Standard her role will include the oversight of the asset manager's overall operations, risk management and compliance functions. She will report into Ian Gibson, Standard Bank International's md of wealth management, and will be based in London.

Lehman adds Willis
Ian Willis, previously in CDO Trading at Dresdner Kleinwort, has moved to Lehman Brothers. He joined as a CMBS trader and reports to Alex Maddox, head of ABS trading at Lehman.

Singer departs
Sally Singer has left BNP Paribas where she was a credit derivatives structurer under Herve Besnard, head of product development, credit derivatives, BNP Paribas.

DK loses Grobman
Alex Grobman is understood to have left Dresdner, where he was responsible for structured credit sales for Germany.

Brightwater replaces management team
WestLB has replaced much of the senior management of its Brightwater Capital Management CDO and SIV business. Neil Colverd has been named as the firm's president and ceo, reporting to Graham Light, vice chairman of Brightwater Capital Management and global head of WestLB's investment management unit.

"To accommodate the recent and anticipated growth of the Brightwater business, and to strengthen the operational infrastructure of the firm, WestLB's board decided unequivocally to bring in a new management team," comments Light. "We're very pleased to have Neil run the Brightwater business along with the appointment of George Suspanic as cio and Gerri Alfino Egler as coo, both reporting to Neil."

Colverd has been with WestLB for 10 years, most recently as ceo for its APAC region, as well as acting cio for the Bank's investment management unit, a position he has held since 2001. In addition, he is chairman of the Dublin-based WestLB covered bond bank.

Suspanic is an md at Brightwater, responsible for leveraged finance asset portfolio management. Prior to joining Brightwater at the end of January 2006, he was an md in the portfolio management unit of WestLB's New York Branch.
Egler joined WestLB in 2004 as an md to spearhead the development of certain special projects. Previously, she was general counsel at Assured Guaranty Corp. and CGA Investment Management.

Deutsche expands China credit trading
Deutsche Bank has expanded its global credit trading platform in China, with Jianyi Zhu appointed as md and head of global credit trading for Greater China, along with three other senior hires.

Zhu joins from Goldman Sachs where he was previously an executive director in the Asia special situations group, based in Hong Kong. As a founding member of the group's China team, he was responsible for sourcing, evaluating, executing and managing a broad range of investments in China across numerous asset classes and industries.

Zhu will join Deutsche Bank on 13 June 2007. For CDOs and credit trading-related activities he will report to Chetankumar Shah, head of credit trading, CDOs and credit structuring for Deutsche Bank in Asia. For all other activities, he will report to Sajid Javid, md and head of global credit trading Asia.

Deutsche Bank has also made three senior hires to join Zhu and the existing Greater China global credit trading team, which is based in Hong Kong.

Sun Yong Hong joins as director, global credit trading, from JP Morgan Chase in Beijing, where he was an executive director in the Asia special situations group. Rowena Yue also joins as director, global credit trading, from Standard Chartered where she was a director in the corporate finance and advisory group. Meanwhile, Gavin Xing arrives as a vp, global credit trading, from HSBC in Hong Kong where he was a director in the project and export finance group.

Merrill buys GSO stake
Merrill Lynch has agreed to purchase a minority stake in GSO Capital Partners, a New York-based registered investment management firm. As part of the transaction, Merrill Lynch will invest capital in a number of GSO's strategies. Financial terms were not disclosed.

GSO is a registered alternative investment manager with approximately US$8bn in assets under management and offices in New York, London, Houston and Los Angeles. The firm invests in a broad array of public and private securities across multiple investment strategies. Key areas of focus include leveraged loans, distressed investments, special situations, capital structure arbitrage, mezzanine securities and private equity.

HD & MP

Natixis brings DPI

A round up of this week's structured credit news

Natixis brings DPI
Natixis and BNP Paribas Asset Management have launched a first series of DPI notes, dubbed Parflex. The notes offer a dynamic exposure to credit markets through investments in five credit asset classes: corporate bonds (investment grade and high yield), asset securitisation (ABS and CLO) and emerging markets sovereign securities.

The performance of the notes will be linked to a leveraged portfolio selected and managed by BNPP AM. The two firms say that active allocation between the different credit asset classes aims at providing flexibility in a changing credit environment, throughout the lifetime of the notes.

The notes are issued by Chrome Funding Limited, a special purpose vehicle, based in Jersey. The structure offers various coupon features and provides full capital protection through Aaa rating by Moody's (and AAA by S&P for certain series of notes), as well as attractive returns.

The first issue of Parflex notes amount to a total of €174.7m offered in three different series (ten-year and seven-year maturities with a contingent coupon; and ten-year in a total return format). The size of the transaction may increase through a tap or issuance of new classes of notes in various currencies, in the coming weeks.

India publishes CDS guidelines
The Reserve Bank of India has issued draft guidelines for the trading of credit defaults swaps in the country. RBI explains that the move is part of the gradual process of financial sector liberalisation in India and it is therefore considered appropriate to introduce credit derivatives in a calibrated manner at this juncture.

"Accordingly, to begin with, it has been decided to permit commercial banks and primary dealers to begin transacting in single-entity credit default swaps," RBI says. However, it adds that it will consider allowing insurance companies and mutual funds to trade the instruments as and when their respective regulators permit them to do so.

The draft guidelines state that the Reserve Bank has decided to initially allow only plain vanilla CDS that satisfy a number of requirements. These include that reference entity, the protection buyer and the protection seller all have to be resident entities; the underlying asset, the reference obligation and the deliverable obligation shall be to a resident and denominated in Indian rupees; the reference obligation shall be identical to the underlying asset; and the underlying, reference and deliverable obligations shall be those which are rated and that rating is current and maintained by the rating agency.

RBI explains that in view of the complexities involved it has been decided to initially issue the proposed guidelines for implementation as a first draft for comments and feedback from various stakeholders. Comments are requested by 16 June.

First Danish SME CLO launched
Danske Bank and its servicing subsidiary Realkredit Danmark are marketing the €357.6m Prime Bricks 2007-1. The transaction is noteworthy for transferring credit risk on loans granted to SMEs across Denmark.

A major part of the loans in the reference portfolio are granted to cooperative housing companies and individuals for financing mortgages for letting purposes. The transaction is structured as a synthetic, partially funded transaction.

The collateral backing the notes will be certificates of indebtedness (Schuldscheine) issued by KfW. The ratings on the notes will be dependent on the credit quality of KfW.

Losses will be allocated to the notes for the outstanding amount of a reference loan minus the foreclosure proceeds received by Danske Bank, plus related enforcement costs during the foreclosure process.

The deal is rated by S&P and offers six series of notes: €0.1m triple-A rated Class A+ notes; €166.4m double-A rated Class As; €51.7m single-A plus Class Bs; €69.7m triple-B rated Class Cs; €33.7m triple-B rated Class Ds; and €36m double-B Class Es.

Mild synthetic CDO environment in 2006
With only three new reference entities yielding 60 credit events in the face of continued auto sector deterioration, 2006 was a mild credit environment for synthetic CDOs – and this year is off to a similar start, with no credit events reported, according to the latest annual study by Derivative Fitch.

Credit events last year were predominantly in the automotive (98.3%) and commercial ABS (1.7%) industries, with Dana Corp. representing approximately 77.6% of the 2006 credit events by number and approximately 79.1% by notional balance. However, Derivative Fitch's synthetic index showed an 11.7% decline in exposure to the automotive sector from 2001-2005, while energy, transportation and telecommunications sector reference entities experienced much larger decreases of 48.7%, 36.9% and 41.2% respectively over the same period (following peak years of credit event activity from 2001-2003).

Fitch expects this trend to continue in 2007, when exposure to the automotive sector is likely to decrease as the industry works through its credit cycle. The study focuses on credit events in Fitch-rated synthetic CDOs and incorporates data from January 1 2000 to April 3 2007.

CDS market keeps expanding
The market for CDS continued to expand at a fast pace in the second half of 2006, according the latest figures from the Bank for International Settlements. At 42%, the rate of growth was only somewhat below the 46% recorded in the first half of the year.

At a cumulated US$1.7tr between July and December, multilateral terminations of CDS contracts were of a similar volume as in the first half of the year and shaved approximately 8% off the rate of growth in the market.

The increase in the notional amounts of multi-name CDS (54%) again outpaced growth in single name contracts (36%). Positions in multi-name CDS of non-financial institutions increased by 131% between July and December 2006, although at US$1tr – split roughly evenly between protection bought and protection sold – they remain relatively small compared to the size of the market as a whole.

BIS says that activity in the CDS market was in part driven by issuance of synthetic CDOs and other structured products that use CDS to obtain credit exposure. "The impact of such issuance on positions in the CDS market could be considerably larger than suggested by nominal amounts, since hedging structured credit products may involve selling a multiple of their face value, in particular in the case of more junior tranches whose prices are very sensitive to market conditions," it says.

BIS adds: "The multiples of more complex products, such as constant proportion portfolio insurance (CPPI) and constant proportion debt obligations (CPDOs), may be even higher. That said, it is impossible to disentangle the effect of structured issuance on CDS volumes from other factors."

S&P warns over Basel II
Many banks, even those perceived as the most sophisticated, may not yet have sufficiently transparent, auditable or replicable systems in place to efficiently allocate regulatory capital among individual business units and will face challenges implementing Pillar 2, according to S&P Risk Solutions.

Until recently, for most banks adopting an internal ratings based approach, the focus of Basel was Pillar 1, the solutions provider says. "But now, Pillar 2 looms large and has the potential to undermine investment to date. Of course, for those banks that work through Pillar 2 successfully, the regulatory hurdle it represents for others can be a profound source of competitive advantage," it adds.

Executing an enterprise-wide, transparent risk capital system and firm-wide portfolio approach were among the key challenges faced by banks as they move to adopt Pillar 2, explains S&P Risk Solutions' Paul Waterhouse.

"The irony for some of the more sophisticated banks that moved early to more complex economic capital management is that business unit or department-specific execution may actually now challenge meeting Pillar 2, as central to Pillar 2 is firm-wide, transparent and consistent implementation of risk capital management," he adds. "Internal ratings based banks will need to demonstrate a robust and objective approach to an integrated risk capital calculation. This includes having an effective, codified and transparent system for evaluating the impact of guarantees, group structures, inter-asset class correlations, pricing and limit setting and management."

Waterhouse continues: "While process has been key for Pillar 1, much of it is related to the technical execution of executing and validating probability of default (PD), loss-given default (LGD) and exposure at default (EAD) measures. With Pillar 2's focus on firm-wide overall capital adequacy, the focus switches to ensuring a 'top down', integrated risk position and a strategy around this. Issues such as liquidity risk and legal risk become much more central and, hence, so do the processes for managing and calculating these."

FSF issues hedge fund recommendations
The Financial Stability Forum (FSF) has issued a report recommending action by financial authorities, counterparties, investors and hedge fund managers to strengthen protection against potential systemic risks relating to hedge funds and other highly leveraged institutions (HLIs).

Given the importance of strengthening protection against systemic risks, the FSF makes the following five recommendations to support and – where relevant – build upon ongoing supervisory and private sector work:

1. Supervisors should act so that core intermediaries continue to strengthen their counterparty risk management practices.
2. Supervisors should work with core intermediaries to further improve their robustness to the potential erosion of market liquidity.
3. Supervisors should explore and evaluate the extent to which developing more systematic and consistent data on core intermediaries' consolidated counterparty exposures to hedge funds would be an effective complement to existing supervisory efforts.
4. Counterparties and investors should act to strengthen the effectiveness of market discipline, including by obtaining accurate and timely portfolio valuations and risk information.
5. The global hedge fund industry should review and enhance existing sound practice benchmarks for hedge fund managers in the light of expectations for improved practices set out by the official and private sectors.

The FSF says it will monitor work on these recommendations, as well as other areas relevant to the potential systemic risks associated with hedge funds. It will report to the G7 finance ministers and central bank governors on the progress made, new developments and any judgements that the FSF makes about the need for further updates of its overall assessment and recommendations.

Fitch looks at CES RMBS in CDOs
Though sub-prime closed-end second-lien (CES) RMBS transactions represent a small sub-sector of the overall sub-prime RMBS universe, these transactions are proving to be some of the worst performers through the first four months of 2007, prompting Derivative Fitch to take a closer look at the potential impact of sub-prime CES RMBS on the CDOs it rates.

Fitch rates a total of 116 US CDOs with exposure to sub-prime CES RMBS transactions, though only 35 US CDOs have exposure to the 2006 vintage sub-prime CES RMBS transactions that are experiencing the greatest stress. These US CDOs include 16 mezzanine SF CDOs, 11 high-grade SF CDOs, four synthetic SF CDOs, three commercial real estate (CRE) CDOs and one market value SF CDO.

CES exposure in European CDOs is isolated to eight transactions with relatively mild exposure. Seven of the CDOs are synthetic and one is a cashflow transaction. The highest total exposure in the European CDOs is approximately 2.2% of the reference portfolio.

Fitch has reviewed these CDOs and the underlying exposures to gauge the potential impact on the rated CDO notes. At this time the cumulative exposure to sub-prime CES RMBS transactions in these CDOs is not sufficient to cause Fitch to place any tranche on rating watch negative. However, as Derivative Fitch expects this negative performance trend to continue, the potential for negative actions on both high-grade and mezzanine SF CDOs increases dramatically where there are significant exposures to 2006 sub-prime CES RMBS and limited asset manager flexibility to sell assets.

Sub-prime CES deals differ from sub-prime first-lien deals in the timing of collateral loss. Defaulted first liens go through a foreclosure and liquidation process that can take many months, often over a year, thus delaying loss realisation. Defaulted CES are typically 100% charged-off 180 days after default, due to the poor prospects for recovery on a junior lien.

Loss-given default on CES is therefore recognised much earlier in the life of a deal than is the case for first-lien sub-prime mortgages. Thus, to the degree that collateral is underperforming, rating actions may also occur earlier in the life of the RMBS transaction in which it was securitised.

Markit launches CDS of ABS service
Markit Group has launched the first independent, daily consensus spread service for CDS of ABS. Markit says the service provides independent spreads for mark-to-market, research and valuation purposes and will help satisfy the accounting requirements of the Financial Accounting Standards (FAS) 157 which requires a market-based measurement in order to recognise trading book profit and loss.

Markit's CDS of ABS spread service receives daily feeds from the leading market makers' books of record. Spreads are cleaned and validated overnight before publication the following morning. A minimum of three contributions is required for a mark to be published to ensure only the highest quality, most accurate mid-point composite spreads are delivered. Clients of the service can view and analyse spread changes over a day, week or month and sort data by rating, issuer, sector or region.

The service covers the two largest asset classes: RMBS and CMBS. Additional instruments such as CDS referencing collateralised debt obligations, student loans, auto loans and credit cards are expected to be added to Markit's CDS of ABS spread service according to demand.

CMA adds equity tranches
CMA, the credit information provider, has announced enhancements to its same day price verification service, DataVision, by including equity tranche pricing data. CMA says the move comes in response to customer demand.

DataVision is a same day consensus based price verification data service for CDS, Indices and Tranches. It is sourced from 30 leading buy-side firms who continuously provide average CDS spreads based on indicative observed quotes. DataVision is delivered by 5pm London and 5pm New York time, giving customers a timely market view and enabling more accurate mark-to-market and flash P&L analysis, the company says.

MP

Trading ideas - lead trial balloon

Dave Klein, research analyst at Credit Derivatives Research, looks at a positive carry short position on the Sherwin-Williams Company

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

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

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

In this trade, we express our deteriorating outlook for The Sherwin-Williams Co. (SHW) in a positive-carry short position. Given the lack of liquidity in SHW's bonds and its CDS curve steepness, this is the best trade available and possesses reasonable economics.

Go short
We have scored SHW using our Multi-Factor Credit Indicator (MFCI) along multiple factors. While some factors (spread/rating, spread/probability of default, or spread/leverage) indicate SHW is trading too wide, we place more trust in Gimme Credit's fundamental outlook and our LBO-viability rating which indicate that SHW is trading tight in spread terms and it is reasonable to expect the credit to sell-off.

Exhibit 1 charts SHW's CDS performance over the past two years. In February 2006, SHW lost a lead-paint public nuisance case in Rhode Island, sending spreads wider. Since then, CDS levels rallied until this February. Last week SHW rallied by about 10bp and is the biggest tightener among CDX NA IG 8 names.

Exhibit 1

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

Exhibit 2

In order to estimate CDS fair values, we regress each tenor (3s, 5s, 7s, 10s) against the other tenors across the universe of credits we cover. This results in a set of models with extremely high r-squareds.

In our case, we see that all SHW levels are trading very close to fair value. Since we have a negative view on SHW, we base our tenor decision on more than just fair value and consider roll-down and bid-offer as well. Specifically, we look at carry, roll-down and the bid-offer spread of each potential trade.

Given the lower liquidity in SHW in other tenors, we view the 5s as the best potential maturity, and we drill down and look at the trade economics. SHW's 5s have a bid offer of 4bp and negative roll-down. Given the negative carry and roll-down, we choose to hedge with the CDX NA IG Series 8 index, of which SHW is a member, selling a bit more protection on the index given the relative levels of SHW and the CDX.

To calculate an appropriate level, we regress SHW's absolute levels against the on-the-run CDX. Given the major disruption in CDS levels caused by the Rhode Island court decision and the fact that SHW has rallied so much, we underweight our CDX hedge a bit. We still maintain a positive carry trade (but with negative roll-down). As long as the difference between SHW and the CDX widens by at least 3.3bp, we expect to unwind this trade profitably in 6 months time. Exhibit 3 outlines the economics of this trade.

Exhibit 3

Risk analysis
This trade takes a positive-carry short position. It is hedged relative to the CDX NA IG Series 8 index but is unhedged against idiosyncratic curve movements. Additionally, we face about 4bp of bid-offer to cross.

The trade has positive carry which protects the investor from any short-term mark-to-market losses. Entering and exiting any trade carries execution risk and SHW has reasonable liquidity in the CDS market.

Liquidity
Liquidity is a major driver of any longer-dated trade – i.e. the ability to transact effectively across the bid-offer spread in the bond and CDS markets.

As stated earlier, SHW has reasonable liquidity in the CDS market across the term structure and is a member of the CDX 8.

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

Carol Levenson, Gimme Credit's Chemicals expert, maintains a deteriorating fundamental outlook for SHW. Carol notes that SHW's business model makes it look like a retailer but it faces legal issues that are manufacturing-based. While SHW has stable cash flow and excellent brand equity, Carol believes litigation uncertainty and shareholder-friendly cash distributions will continue to be a drag on the credit.

We note that SHW scores a relatively high 3.6/5 on our LBO-viability screen although we have not heard any private equity rumours surrounding the name. Litigation risk may prevent a near-term LBO but presents its own challenges to SHW.

Summary and trade recommendation
SHW popped up as one of last week's biggest tighteners within the CDX IG8 universe, possibly on news that the rating agencies were taking them off negative credit watch (after a year of waiting). Given the litigation risk the company still faces and the recent rulings (indicating that we may be getting closer to determining costs) we believe this is an opportune time to short the credit.

We also note that if the litigation is dropped or settled reasonably, then SHW's high ranking in our fundamentals-based LBO-viability screen combined with a look at pre-litigation-concern spread levels provides a solid floor on downside. Given SHW's tight CDS spreads (three month tights) and a lack of positively-economic curve trades available, we look to take a positive-carry short position.

After analysing both the bond and CDS markets for the best opportunity, we have settled on buying 5 year protection on SHW hedged with selling CDX NA IG Series 8 protection. Good carry and the potential profit of a widening credit strengthen the economics of the trade (although we still face negative roll-down). Given our deteriorating fundamental outlook for SHW and the current tight levels for the company, we feel this outright position presents the best opportunity for trading this name.

Buy US$10m notional The Sherwin-Williams Co. 5Y CDS protection at 43.5bp and

Sell US$15m notional CDX NA IG Series 8 5Y protection at 35bp to gain 9bp 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 3

In this last part in the series, the DPI model is discussed and tested 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 sees us make use of our research proprietary model based on a Monte Carlo Engine (MCE) to assess the performance of DPI under different stochastic scenarios. Our model allows us to calculate an indicative rating for the DPI note, based on the concept of 'first cent loss'. At this point, we wish to emphasise that these ratings do not represent actual ratings that would be provided by rating agencies for similar strategies. Nevertheless, they are useful to compare the risk profile of the different dynamic strategies analysed in this report.

The DPI contractual specifications are the same we used in the previous section. Several paths are simulated for each stochastic process (index spread, rating migration, defaults and interest rate) in order to obtain the cash-in time probability distribution, and a rating estimate. We test the sensitivity of the structure to changes in spread volatility, the default rate and the impact of different entry points. For details on the model used in this analysis, please refer to the Appendix of CPDOs, 11 December 2006.

Model inputs
We list below the parameters used in our model. By changing some parameters we assess their impact on the strategy. Some (e.g. index spread and interest rate process) are inspired by S&P assumptions, whilst others reflect conservative market assumptions.

Model results
We present below the main simulation outputs (after 10,000 simulations) for the DPI:

The cash-in distribution is right-skewed (rather than fairly symmetric like in the CPDO case); however its mean is 4.7 years (eight months earlier than a comparable CPDO).

Sensitivity analysis

Index spread volatility
The following table shows the results obtained in terms of expected loss and "first cent" loss probability of a DPI structure for different levels of index spread volatility. In particular we have run some scenarios varying the volatility of the index from 15% to 75%.

As in most dynamic structures, the performance of DPI does not benefit from higher levels of index spread volatility. As for CPDO, with increasing volatility, the probability of experiencing considerably high MtM losses increases as well. Moreover, a high level of spread volatility can lead to frequent rebalancing of the underlying portfolio with a consequent increase in transactions costs. The chart below clearly demonstrates the effect of the volatility in terms of expected loss and loss probability.

As we increase the spread volatility, we have a higher probability of experiencing high losses but also significantly large MtM profits that may cause an earlier cash-in event. This effect is clearly illustrated in the cash-in time distributions presented below.

As observed for a CPDO, higher values of spread volatility tend to shift the distribution to the left while increasing the probability of the structure not cashing in. Conditional on the occurrence of the cash-in event, the mean of the distribution tends to move towards lower levels. This means that the strategy is expected to cash-in earlier: from 5.1y with 15% volatility, to 4.3y for 50% volatility.

In summary, spread volatility has the same effect on DPI that we observed on a CPDO: high spread volatility can generate large MtM losses that can impair the DPI, but favourable moves in the spread can also produce large profits that can quickly cover the shortfall in the structure.

Default rate
The effect of changing default rate assumptions on the rating of a DPI structure is illustrated in the following table and charts.

As with a CPDO, the performance of DPI is sensitive to the number of defaults that occur through the life of the structure. The greater the number of defaults, the lower the probability of covering the shortfall and cashing in before maturity. It is worth noticing that the different leverage mechanism and the lower exposure typically used for this type of product make this structure more robust than a CPDO to persistently weak credit market evolution.

While for a CPDO, a default is likely to trigger an increase in the leverage to compensate for the loss, for DPI this event would probably lead to de-leveraging as a result of a lower reserve. The lower exposure to credit risk will then mitigate the impact of any further defaults (in the case of clustering) on DPI while the CPDO would experience significantly higher losses.

In terms of cash-in time distribution we notice that a higher default rate leads to a fatter right tail and therefore a higher probability for the structure to default (see chart above). The expected cash-in time varies between 4.5 years with the 75% default rate and 5.5 years with 200% default rate.

Entry point spread level
The value of the index spread at the outset constitutes an important variable as it has a significant impact on the performance of DPI. The table below lists the results obtained by running several scenarios with an initial index spread varying from 20bp to 50bp.

As expected, the probability of the structure defaulting tends to rapidly decrease when the strategy starts with a higher entry point.

Moreover, a higher initial index spread tends to bring forward the expected cash-in time (see chart below). This is not surprising as a wider spread means collecting a higher premium for having sold protection on the index. Moreover, at a higher entry point, the DPI is likely to start with a higher initial leverage that would boost the benefit of a wider index premium. In this way, the value of the note would cover the shortfall at a faster rate, reducing the time for the strategy to cash-in.

Back-testing: DPI vs CPDO

The following charts show how DPI would have performed if a hypothetical investor entered the contract on 1 April 2004 with a coupon of 175bp.

From the chart on the left we can see that, for this particular scenario, the exposure was always at the cap. As the index spread widened, the strategy reset the cap at a higher level and therefore the risky exposure was increased as well. This is a concrete example that shows that the (uncapped) TE may stay above the cap throughout the life of the contract and therefore the actual exposure is mainly driven by the presence of the cap. Despite the May 2005 correlation dislocation that generated substantial losses, the strategy was able to recover and cash in after just two years.

Assuming the same strategy with a coupon of 120bp, DPI reduces the shortfall to zero after only 10 months, thus avoiding the rapid deterioration of the credit environment observed just few months later. We also back-tested the CPDO with a coupon of 120bp: as the strategy de-leverages faster, the cash in event is delayed relative to the DPI.

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