Contents

CDR Liquid Index data as at 2 July 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.

Short-term respite

Slight reversal unlikely to hold

Moving in to the US public holiday there was some longed-for relief in the main CDS markets as spreads in the indices either side of the Atlantic exhibited a tightening bias on Tuesday and ABX closed the day up from all-time lows plumbed in the preceding days. However, as further bad news hit the market, a further sell-off was expected.

"The recovery on Tuesday looks to me just like a typical bounce after a major sell-off," observes one CDS of ABS trader. "I don't really think that it is over," concurs another dealer.

He continues: "What we are seeing is very different from what we saw in February when there was a shock to the market, but 80% of participants regarded it as a buying opportunity. Today, it's more about an ongoing re-pricing of the market - taking into account many factors, including losses on sub-prime, falling risk appetite and hedge fund concerns."

The latter was underscored by the confirmation on Tuesday that United Capital Asset Management (UCAM) had temporarily suspended redemptions on its Horizon funds. "Over the past 10 days we have received an unusually high number of redemption requests, including a request from our largest investor that accounts for nearly one-quarter of our assets under management," a statement from the firm says.

"We wish to emphasise that UCAM and Horizon are not liquidating and intend to continue in operation... Horizon has taken the step to suspend redemption requests in order to protect the interests of our investors... We expect to resume processing these redemptions as soon as it is prudent, which we hope will be in the very near term," the statement adds.

It goes on to explain that in light of recent volatile market conditions UCAM reduced many cash bond and all synthetic positions in June. "We have greatly lowered Horizon's leverage. We sold a large amount of cash securities into the market without issuing bid lists or conducting auctions. Horizon lost money in closing down its positions in the ABX. We view the synthetic markets as highly volatile and, at this time, have stopped trading them entirely."

Another potential driver for credit market concern also emerged last week in the form of heightened regulatory interest. In a response to a question at a House committee hearing, SEC chairman Christopher Cox stated that the commission's enforcement division has undertaken about a dozen investigations involving CDOs and CLOs.

However, this may prove to be a longer-term issue. As a report from Nomura's fixed income research team in New York observes: "While we do not foresee any immediate changes to the valuation of CDO assets, it will be a topic to watch closely as the investigation furthers."

MP

Products for all?

New research examines structured credit investment patterns

As the range of structured credit investors expands seemingly exponentially, some suggest that the similarly rapidly expanding numbers of products are attractive to all. However, new research seeks to look beyond such generalisations.

The research, published by the structured credit products strategy group at Citi in London, uses data from the firm's internal databases to reveal trends about each type of investor in their investment choices in structured credit products. "Our large market share and long history of data give our findings considerable statistical significance and make them representative of the trends in the entire market place," observes Citi's Panikos Teklos.

He continues: "The first and most striking determinant of who buys what is the type of investor. While there is considerable variation at individual institutions, banks tend to buy senior, while insurers, asset managers and hedge funds tend to dominate as we move towards equity."

The research reveals that banks tend to buy senior paper for two reasons. First, the new regulatory framework favours highly rated investments. Second, banks typically like to buy through conduits or SIVs, so as to keep investments off balance sheet and have the ability to hold them on a non-mark-to-market basis. This is easier to achieve if they buy senior (and typically triple-A) tranches.

Hedge funds, insurers and asset managers, meanwhile, seem to have been driven by the broader move towards 'alternative assets'. The report notes that structured credit is most alternative (and has the lowest correlation with instruments such as government bonds) when bought in equity format.

In addition, Matt King, also a director in Citi's structured credit products strategy group, says: "Even when hedge funds make outright investments in equity, it is worth noting that it is often done in the context of long lock-up periods of up to ten years. This should go some way to allaying liquidity crunch fears surrounding such investments, even if the practice is by no means universal."

The second key determinant of investor choice is the variation of regions resulting from jurisdictional and regulatory differences along with the maturity of the investor base in the structured credit markets. European investors are mostly banks and buy more senior risk as they face tighter regulatory constraints and the implementation of Basel II.

But Asian investors, although also mostly banks, have a higher risk appetite and buy more equity risk relative to both Europe and the US. The US investor base falls somewhere in between that of Europe and Asia/Australia.

In terms of product preferences, the research does find that all investor types buy across the whole range of products. In relative share terms, though, the research identifies that: asset managers buy more CDOs of ABS, followed by synthetic CDOs and CLOs; banks buy synthetic CDOs, followed by CLOs and CDOs of ABS; hedge funds buy predominantly synthetic CDOs and CDOs of ABS; and insurance companies buy mainly CLOs and CDOs of ABS.

Citi argues that the fact that all investors are represented across product types provides some comfort relating to overcrowding of certain types of underlying, such as leveraged loans and high yield assets. "The larger the number of investment vehicles in each product the smaller the concentrations of each individual participant and the smaller the impact of a blow-up – especially when there is bi-directionality and the market for synthetic structured credit is a two-way street: there is almost as much protection buying as selling," Teklos concludes.

MP

European CRE CDO relative value emerges

Comparisons become clearer as more deals price

With two transactions currently being priced and two more new deals from Citi alone expected in the reasonably near future, the European CRE CDO market appears at last to be springing into life. As such, it is now possible for analysts to put together a relative value framework for the asset class.

The first such analysis was published by Barclays Capital last week. The report notes that since the pricing of the first European CRE CDO – Anthracite Euro CRE CDO 2006-1 – two more deals have priced (Taberna Europe CDO 1 and Glastonbury CRE CDO), and two (CREA CDO I and Duncannon CRE CDO I) are currently being marketed with guidance out.

However, Hans Vrensen, head of European securitisation research at Barclays Capital, says: "We excluded Taberna Europe CDO 1 and Glastonbury CRE CDO from our analysis because the collateral is not as mixed as for the Anthracite, CREA and Duncannon transactions. We scored the remaining deals based on three fundamental criteria."

First was the CDOs' legal structure in the context of enhancement and the complexity of the transaction. In general, Vrensen says that the framework prefers structures that offer adequate built-in liquidity, more enhancement over less enhancement and transactions that provide a straightforward pay-down structure and additional support to bond investors. It also prefers ratings from two or more agencies to ratings from a single agency.

Second, the framework considers the quality and strategy of the CDO manager in relation to management and company experience, systems, staffing, processes and performance, as far as possible. In addition, some recent performance data is included in the evaluation.

Third is the quality of the initial collateral pool and the ability of the manager to change the portfolio. Barclays reviews the pool as of day one, but more importantly looks in detail at the portfolio reinvestment criteria and the different tests set out in the structure, under which the manager needs to operate.

Vrensen observes: "Based on these criteria, Duncannon is the highest-scoring CRE CDO deal compared with the other two deals. CREA scores marginally higher than Anthracite. Furthermore, after taking into account current price guidance, we see good relative value in Duncannon at the triple-A and single-A minus levels, and in the CREA transaction at the double-A, triple-B and double-B levels."

Meanwhile, there is potentially negative news for Anthracite Euro CRE CDO 2006-1 following the downgrade by S&P and Fitch of the Class E notes in Deutsche Bank's DECO 2005-UK1 CMBS to triple-C and double-B, respectively, from triple-B minus. "From disclosures related to the Anthracite CRE CDO transaction, we note that 100% of the Class E was included in the original asset pool. Unless Anthracite was able to trade out of these bonds after issuance in November 2006, this will likely result in a loss on the €66.5m subordinated equity tranche, which was retained by BlackRock," explains Vrensen.

Officials at Anthracite's manager, BlackRock, and arranger, Morgan Stanley, declined to comment. As a result, the magnitude of any loss could not be determined, although it is thought to be relatively insignificant at around £1.4m of the deal's equity tranche.

MP

Listed funds revisions

Amended approaches seen from four structured credit vehicles

Four more permanent capital vehicles have reassessed their positions over the past seven days following on from those the previous week (SCI issue 45). Caliber is to close, Carlyle capital's IPO has been reduced, Carador may offer new shares and ACA has pulled its planned share offering.

Cambridge Place Investment Management's Caliber structured credit vehicle announced on Thursday that it would unwind. "In making this decision the board and its advisers recognise that there is insufficient demand currently for investment through listed investment companies exposed to this asset class," a statement from the company says.

Current expectations are that Caliber's assets will be realised over a period of approximately twelve months, with interim distributions to shareholders during the period. The company will hold an Extraordinary General Meeting, most likely in August, to seek shareholder approval to these proposals and their implementation.

Caliber's net asset value (NAV) per share is estimated to have risen between April and May 2007, reflecting a modest improvement in market conditions over that period. Since the announcement of the interim results to March 31 2007, Caliber has not been subject to any margin calls and remains conservatively and fully funded, it says.

The company confirmed on Tuesday 3 July that, as at the close of business on May 31 2007, Caliber's unaudited NAV per share was US$6.60 against a NAV of US$6.38 at April 30 2007.

Also on Tuesday, private equity firm the Carlyle Group's Carlyle Capital Corporation (CCC) confirmed the final number of Class B shares actually sold in its global offering as 15,962,673. The initial offering price was US$19.00 per Class B share, pared down from the originally targeted US$20 to US$22 as a result of sub-prime market turmoil.

The shares began trading on Euronext Amsterdam today, 4 July. CCC primarily invests in triple-A rated RMBS, but also has some structured credit exposure including CDOs. Of the 15,962,673 Class B shares CCC sold in the global offering, an aggregate of 4,501,648 shares were sold directly to investors in a private placement.

Also on Wednesday, 4 July, Washington Square Investment Management's Carador issued an investment update. The company states: "In view of the ongoing difficulties faced by the US sub-prime mortgage sector and the performance of other structured finance listed vehicles, the board of Carador Plc considers it appropriate to update investors on the current portfolio and strategy."

The company has made clear in its monthly reports its significant underweight position in CDOs backed by portfolios composed primarily of 2006 sub-prime mezzanine ABS collateral. The rationale behind this view, which was originally taken against market consensus, was a negative fundamental view on the assets and also the belief that the correlation assumptions used in the analysis by the market were too aggressive. As at 2 July 2007, Carador's portfolio has only one transaction with exposure to 2006 mezzanine sub-prime ABS, representing 2.01% of the overall portfolio.

However, Carador says: "The board and the manager believe that the current market may provide Carador with an opportunity to take advantage of dislocated market conditions to selectively identify attractive investment opportunities. As a result, the board is exploring the potential for a further issue of Carador shares to exploit such opportunities."

Meanwhile, ACA Capital Holdings announced that it has withdrawn its registration statement on Form S-1 that had been filed with the SEC in conjunction with a proposed offering of approximately 3,944,473 shares of common stock by certain selling stockholders. ACA Capital is a holding company that provides asset management services and credit protection products to participants in the global credit derivatives markets, structured finance capital markets and municipal finance capital markets.

MP

Structured credit hedge funds up again

Latest index figures show continued upswing

Both gross and net monthly returns for May 2007 in the Palomar Structured Credit Hedge Fund (SC HF) Index showed a better than average monthly return for the year to date. The latest figures were released this week and show a gross return of 0.69% for the month, while the net return grew by 0.51%.

Both the gross and net indices are therefore continuing to show positive cumulative returns since calculations began in January 2005, of 120.01% and 113.99% 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

"The feedback is very good"

In this week's Provider Profile we talk to European derivatives exchange Eurex

When Eurex launched a credit event futures contact earlier this year many buy-side market participants expected it to be a further extension of the deep liquidity that the main iTraxx index offers and upon which the exchange based its new contract.

The lack of a requirement for ISDA paperwork, the inherent mitigation of counterparty risk that an exchange offers, combined with the success and expansion of the credit derivatives markets generally should make the contracts attractive to a range of users. At the same time, Eurex's first-mover advantage in exchange traded credit derivatives, coupled with its market leading status and global distribution lead many to believe the contract could be an unqualified success.

The reality since launch has not reflected this hope, with just one bank offering a market making service, and only modest trading volumes so far. The reasons for the lack of support from the main dealers are complex and varied, but many assume that the erosion of margins that an exchange traded contract might eventually bring to bear is chief among them.

There are, of course, other factors that have resulted in the less than spectacular start to futures trading. Eurex argues that from a development perspective, the asset class is a complex one, which is exacerbated by the lack of a comparable exchange traded product to learn from. Equally, the OTC credit derivatives market is a highly innovative, rapidly changing one that offers a very competitive product in the form of the indices.

Then there are more fundamental factors that have also held the futures contract back. Notably, many credit desks do not yet have connectivity to Eurex, and with such approval to connect taking time, immediate additional support has been held back.

Mehtap Dinc

Eurex however is not daunted by the task facing it. "We are concentrating our efforts on increasing asset management and hedge fund participation in these products. Not just our traditional client base that has traded on the exchange for many years, but funds that have traded CDS and CDOs over the counter and who possibly don't yet realise the opportunities of an exchange traded credit product," says Mehtap Dinc, product manager responsible for credit futures at Eurex.

"We are also approaching those that do not have the capability to trade OTC Credit Default Swaps due to regulatory constraints, and for whom the benefit of credit derivatives must therefore be realised through an exchange," she adds.

The exchange also claims that many banks and hedge funds are pro an exchange traded contract. "We have approached a lot of institutional investors, and the feedback is very good; they like the design of the product and it fits into their strategy well. For example the lack of a requirement for credit line management appeals; there is no counterparty risk, and there is less administration than with an OTC contract," says Dinc.

Despite few contracts having being traded thus far and a 'wait and see' policy being adopted by potential new entrants, Eurex claims that from its point of view the contract is suitable already.

The exchange is working hard to add liquidity providers and remains confident that the long term success of the product remains bright. Eurex cites research released by Merrill Lynch in April 2007 showing that 80% of investors plan to trade iTraxx credit futures, either alongside OTC credit derivatives or in isolation.

The reasons for trading futures listed in that research validates Eurex's approach, the exchange says. Those reasons include: familiarity with futures, lack of counterparty risk and being unable to trade OTC derivatives were all chief among the reasons why credit contracts on Eurex and elsewhere may yet see real success.

Furthermore, when asked if Eurex had considered allowing other exchanges to launch ahead of it, in order that it could learn from their experiences, Dinc was clear on the Eurex's strategy. "There are other contracts in launch phase at the Chicago futures exchanges, but their product set is different and what's more important is that Eurex was ready to go," says Dinc.

JW

Senior structurer joins Barclays

The Latest company and people moves

Senior structurer joins Barclays
Pamela Winchie has resigned from Dresdner to take up a position at Barclays Capital. At Dresdner, she was the senior cash CDO structurer working most recently under Stratis Hatzistefanis.

Winchie is understood to be joining Barclays as a director, reporting to Edward Cahill, European head of CDOs in London.

Credit head leaves
David Cohen is understood to be leaving his position as global head of credit trading at Calyon. His destination is not yet known.

Trader exits
Peter Furlong has resigned from RBS' credit trading business to pursue other interests.

Synthetic structurer on the move
Alain Forclaz has left Credit Suisse, where he was a synthetic credit structurer. It has been speculated that he will be moving to RBS to team up with his old boss Marc Freydefont, but the move is not confirmed.

BSAM changes
Jeffrey Lane has been appointed as chairman and ceo of Bear Stearns Asset Management (BSAM). Richard Marin, former BSAM chairman and ceo, will remain with BSAM as a senior advisor to Lane.

James Cayne, chairman and ceo of the Bear Stearns Companies comments: "Our focus is on restoring investor confidence in BSAM, serving our clients with excellence and assuring them of our commitment to provide them with the highest quality asset management products and services. Jeff's experience and leadership combined with his successful track record make him an outstanding candidate to lead our asset management business at this time. We are extremely pleased to welcome him to Bear Stearns."

Before joining BSAM, Lane held a number of roles at both Lehman Brothers and Neuberger Berman, including serving as a vice chairman of Lehman Brothers, a member of the office of the chairman, chairman of the investment management division and co-head of asset management, as well as chairman of Neuberger Berman. Lane was previously with Travelers Group as vice chairman, where he worked closely with the chairman and chief executive officer in the management of the company's various administrative functions and operating units.

Senior sales hires at JPM
Ante Razmilovic and Billy Cormier have joined JP Morgan as an md and executive director respectively, in sales and marketing for EMEA.
Razmilovic will be head of Dutch and Scandinavian institutional sales and derivatives marketing. He joins from Goldman Sachs, where he was head of credit structuring.

Cormier will be an executive director in European credit hedge fund sales. He joins from RBS, and prior to that he worked at Barclays as a trader and at Lehman in credit sales and trading.

Razmilovic and Cormier will report to Ian Slatter and Marc Badrichani, co-heads of north European sales and marketing, and will be based in London.

Law firm adds CDO partner
Mayer, Brown, Rowe & Maw has announced that Elana Hahn, a structured finance and capital markets lawyer specialising in securitisation, has joined the firm as a partner in its London finance group. She joins the team from the London office of Milbank, Tweed, Hadley & McCloy.

Hahn's practice has a particular focus on CLOs, CDOs and specialised funds-related structured finance transactions, whole-business securitisations and mortgage- and other real estate-based securitisations.

Fitch hires Brigo
Derivative Fitch has hired Damiano Brigo as an md to lead the rating agency's Global CDO risk modelling efforts as part of Fitch's quantitative financial research group. Brigo is based in London and will focus on Fitch's efforts regarding modelling of innovative and complex CDO transactions.

Prior to joining Fitch, Brigo was the head of the credit models department at Banca IMI, after previously working on cross-currency and interest-rate derivatives and smile modelling. He joined Banca IMI in 1998.

Isla's role confirmed
BBVA has confirmed that it has hired Lorenzo Isla, formerly Barclays Capital's head of European structured credit research (see SCI issue 44). Isla will be responsible for credit derivatives structuring, reporting to Justo de Rufino, who runs BBVA's credit business globally.

A BBVA spokesperson says: "In his new role Isla will be in charge of developing BBVA's credit derivatives platform across asset classes, including CDOs, ABS leveraged loans options and exotics. This integration is, in BBVA's view, the best way of giving its clients the ability to better access the opportunities associated with increasing disintermediation in credit markets."

The spokesperson continues: "This initiative also highlights BBVA's commitment to consolidate its leading position in the Spanish and Latin American credit derivatives markets and a key building block of BBVA's plan to increase its presence in European capital markets."

MP

Dealers stand firm on CDS of ABS

A round up of this week's structured credit news

Dealers stand firm on CDS of ABS
ISDA hosted a meeting last Thursday to discuss concerns initially raised by hedge fund Paulson & Co over the potential for market manipulation in CDS on ABS (see SCI issue 42). It was decided that no amendment to existing documentation was necessary, however.

Over 100 investors and dealers attended the meeting. According to ISDA, the possibility that sellers could attempt to manipulate these products to their economic advantage was articulated, but the universal view was that firms are committed to the integrity of the market and that fraud and manipulation are unacceptable.

Furthermore, the trade association reports, other investors expressed the view that it would not be possible or fruitful to attempt to define by contract specific forms of fraud or manipulation. These are fact-specific determinations and existing legal prohibitions were specifically designed to deter a broad range of misconduct that constitutes fraud or manipulation.

In addition, it was noted that further proposed restrictions in the documentation would artificially inhibit legitimate market activity, favouring the position of one side of the market at the expense of the other, and would therefore not be prudent.

The consensus view at the meeting was that current ISDA documentation preserves existing legal protections against fraud and manipulation, and in no way endorses or is permissive of illegal conduct. ISDA documentation also preserves the balance between the rights of buyers and sellers of these products, as well as the rights of entities that service the underlying securities.

The association says it recognises that successful markets depend on rules of engagement which are not only fair but are also perceived to be fair and that engender the confidence of all market participants. To this end, ISDA has in previous years published a series of principles for the guidance of market participants in the conduct of their credit derivatives business. Based on discussions at the meeting, it was agreed that a similar statement of principles would be developed over the course of the coming months.

Market implied ratings launched
Fitch Ratings is introducing a new suite of market implied ratings based on CDS spreads and equity prices. The models, utilising derivative and equity market valuations as inputs, cover all corporate, financial institution and sovereign entities with liquid or mostly-liquid CDS prices (around 2,250 entities globally) and all non-financial corporate entities with listed equity (around 20,000 entities globally).

Designed to summarise the market's perspective on an entity's credit risk, market implied ratings distil market information into the common language of credit ratings and can be used as a primary input for a multitude of portfolio management and optimisation, and valuation and risk management purposes.
Fitch's current offering of market implied ratings consists of a CDS implied ratings model, as well as an equity implied ratings and an equity implied probability of default (PD) model.

"In building our models we felt it was very important to distinguish idiosyncratic from systemic market movements, as well as predict potential ratings migrations and event risks, such as default – thus accurately reflecting fundamental ratings behaviour," says Ahmet Kocagil, md of Fitch's quantitative financial research group.

The CDS-Implied Rating Model uses daily consensus CDS inter-dealer prices from Fitch's CDS Pricing Service to derive an implied rating. Based on a reduced form framework, the model considers the CDS quotes, term structure and credit information to determine spread ranges for each rating category.

The model is also calibrated to filter-out market noise to reduce the number of false positives and negatives, as individual CDS spreads on any given day may be influenced by technical market factors.

The Equity-Implied Rating and Probability of Default Model is based on a framework which fortifies a structural model (a barrier option model) with an econometric approach, while the rating model and Equity-Implied PD uses the market value of assets (derived from market capitalisation), historical equity price volatility and debt to quantify the likelihood that a firm will default. The equity-implied probabilities of default are then mapped to ratings on a daily basis.

European banks well-positioned for upgrades
The number of entities poised to benefit from upgrades stood at 382 in June, according to an article published by S&P. The article – 'Upgrade potential across credit grades and sectors' – says that this is 13 fewer than the number reported in May, but 16 more than the number reported 12 months ago.

"Financial companies maintained their pre-eminent position among sectors most likely to benefit from upgrades, which is in line with previous months," says Diane Vazza, head of S&P's global fixed income research group. "They also displayed a high percentage of issuers listed with a positive bias."

Within non-financials, the high technology and utility sectors appeared especially well placed. European banks are particularly well positioned for potential upgrades, as they are expected to demonstrate resilience, despite a less-favourable economic environment.

In most of these sectors, the proportion of issuers with a positive bias is more elevated than has been recorded historically, highlighting the likelihood that companies within these sectors will be upgraded in the relatively near future. The highest potential for upgrades were issuers rated single-B, accounting for a sizeable 14%, followed by single-B plus rated issuers, with a 12% share of total potential upgrades.

Strong 2006 ESF performance
Fitch Ratings says in a new study that rating performance remained strong in European structured finance (ESF) in 2006, based on rating transition data up to the end of that year. However, the agency notes that the rate of improvement eased back from the extraordinarily positive performance recorded in 2005.

CDOs in the region continued to outperform their long-term averages, with SME and structured finance CDOs especially strong. However, the asset class also saw the most downgrades, accounting for 39 of the overall 48 downgrades to a new rating category. This activity was focused in particular among synthetic corporate CDOs forming the inner level of CDO-squared transactions.

The growth of 15% in the number of observations in the study for 2006 was all accounted for by net increases in the numbers of tranches outstanding in the European RMBS and CMBS sectors, although CDOs remained the largest sector overall in 2006.

Transition performance in 2006 is consistent with the pattern shown by Fitch's ESF index of rating change, which measures changes in the estimated weighted-average probability of default. The index grew by 2.1% across 2006, after recording an increase of 5.2% during 2005.

DataVision integrates CDO Software
CMA, the credit information specialist, has announced that CDO Software has integrated the CMA DataVision same-day CDS pricing data into CDO Software's CDO Tools suite of products.

DataVision is sourced from CMA's Data Consortium of 30 buy-side firms, including leading global investment banks, hedge funds and asset managers, who continuously provide average CDS spreads (single name CDS, indices and tranches) 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.

MP

Trading ideas - Wa(t)ching and waiting

John Hunt, research analyst at Credit Derivatives Research, looks at a negative basis trade on Wachovia Corp

Against a background of widespread uncertainty over the state of the credit markets and the stage of the credit cycle, here we recommend a conservative, positive-carry trade that does not take a directional view on the underlying high-quality name. Based on our survival-based valuation approach – see SCI passim and www.creditresearch.com – the Wachovia Corp (WB) 4.375 of November 2018 note, which is denominated in euros and is a subordinated obligation, is cheap to fair value.

Exhibit 1 indicates the 'price-based' term structure of WB subordinated bonds and indicates that WB's shorter-dated bonds are trading rich to fair value and that the November 2018 bond is trading cheap. (For simplicity, we refer to WB's bonds and notes collectively as "bonds.") WB is active in the credit derivative markets and the 4.375s of November 2018 is a relatively liquid instrument.

Exhibit 1

Based on our analysis of bond cheapness and market activity, the 4.375s of November 2018 is viable for the long cash 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.

Exhibit 2 compares the bond z-spreads (for subordinated bonds) with the subordinated CDS term structure, and shows that 4.375s of November 2018 are indeed trading wide of WB's subordinated CDS. We note that the bond is trading wide of its extrapolated maturity-equivalent CDS, a CDS with maturity between 11 and 12 years. This reflects the second basis adjustment discussed above.

Exhibit 2

The WB CDS curve is fairly 'well-behaved' and has no serious inflection points. Additionally, we see solid two-way pricing on Bloomberg's ALLQ screens for the 4.375s of November 2018.

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 consider the bonds' and CDS relative performance in recent months.

As seen in Exhibit 3, the basis between June 2017 CDS and the February 2016 bond has stayed steadily negative over the past year, and has become more negative in recent days. Positive carry and rolldown are the main drivers of this trade, and the potential for gains from short-term convergence of bond z-spread and CDS spread is a sweetener.

Exhibit 3

Over the hedge
There are two significant risks that need to be hedged in a bond-CDS negative basis trade. The first is default and the approach most frequently used by practitioners is to hedge based on the price of the bond.

A bond trading at US$110 would mean we buy 1.1 times the notional protection as we bought face value of the bond. A bond trading at US$90 would mean we buy 0.9 times the notional protection as we bought face value of the bond. This approximation is, somewhat surprisingly, close to optimal in terms of a single CDS static hedge.

This default risk hedge amount – based broadly on the bond price change – is important to understand in that if the bond is trading at a premium (over par) then we will be over-hedged in the CDS as the bond pulls 'down' to par over time. Correspondingly, if the bond trades at a discount (under par) then we will be under-hedged as the bond pulls 'up' to par as maturity approaches.

We have seen different approaches discussed as to how to solve this dilemma but we prefer to 'keep it simple'. A practical approach is to hedge the bond's default risk with the most liquid (and closest in maturity) CDS according to the average of current and final bond price adjustments. Our initial hedge amount should be based on a minimisation of expected loss in default– we calculate the initial hedge as (Bond Price – Recovery)/(Par – Recovery). For a bond trading at US$110 and assuming a 40% recovery, the initial hedge amount should (110-40)/(100-40)=117%. We should buy US$11.7m protection for each US$10m of face value bond we buy.

This hedge will, obviously, be over-hedged as the bond pulls to par at maturity. We would want to hold a 100% weighting in the CDS as we get close to maturity. So we simply average our initial and final hedge amounts – (117-100)/2= 108.5% - to arrive at our 'simple' initial hedge. We therefore buy US$10.85m protection for each US$10m of bond face value we buy. This hedge is, on 'average' our most optimal hedge.

We sometimes take a slightly more directional perspective on this hedge. Given that we are basically hedging the impact of default on our position, if we felt strongly that the credit was unlikely to default, then we would prefer to receive more carry for more default risk. Vice versa, if we felt that fundamentals were weakening and the credit was more likely to default, then we might prefer to be slightly over-hedged.

Utilising Gimme Credit's Credit Scores – which reflect the fundamental outlook for the issuer, we adjust our single CDS hedge. If the outlook is improving then we will prefer to hedge only 100% of face value to maturity. If the outlook is deteriorating then we would hedge at our maximum current hedge amount (117% in our example). If the outlook is stable then we will choose our mid-point optimal hedge (108.5% in our example).

Once this hedge is put on, we will monitor bond price levels and default risks to ensure that our hedge is still 'close' to default neutral. This is more reasonable than adjusting frequently and paying the bid-offers, and even more importantly can often provide more carry in the short-term on a credit that is a low default risk.

In this specific trade, at the time of writing, 28 June, the bond is trading at €91.98 (best ask) and so our maximum hedge would be (91.98 – 40)/(100-40) = 85%. We do not adopt a directional view on Wachovia's credit, so the "optimum" hedge is 93% - halfway between 87% and 100%.

Adding in mid-dated CDS to balance the hedge is possible and we are happy to discuss the use of a second CDS position with any investors who prefer to be more 'perfectly' hedged. We suggest the single CDS to bond 100% hedge and a less frequent but vigilant re-hedging program. We can generate a forward-based price projection for the bond based on the CDS curve – to show how we expect the bond price to drop (premium) or rise (discount) until maturity – which may help some investors with their hedging strategies.

The second (and often overlooked) hedge is the simple interest rate hedge on the bond. Our basis trade is positioned to benefit from any convergence of the credit risk perspectives of the cash and CDS markets and further, the bond is cheap on the basis of its CDS curve (only credit-risk based). We therefore must ensure that our bond is hedged against interest rate movements and the impact these will have on the price of the cash instrument. Note that the CDS is exposed to interest rate movements but only in the discounting of cashflows and this interest rate sensitivity is minimal (and we ignore it in this case).

Investors could choose to asset swap the bond to minimise the interest rate sensitivity but we suggest otherwise. The asset swap has a number of shortcomings (not the least of which are lack of liquidity, premium/discount bond price errors, and default cash flow timing mismatches). We suggest buying the bond outright – benefiting from the most positive carry – and hedging interest rate risk on a portfolio basis. However, many clients have asked for an interest rate hedge to be integrated into our negative basis trades and so we incorporate a duration-matched government bond hedge. This type of hedge, while good, is not perfect since we are still exposed to changes in swap rates.

Given the cheapness of the bond and relatively wide basis, we suggest this negative basis trade (long bond and long protection) as a default-neutral way to pick up positive carry and potentially to realise the bond's relative value differential.

Risk analysis
This position is default-neutral for the life of the CDS. There is a slight maturity mismatch since the bond matures in between 11 and 12 years. This does not concern us as we expect to be able to exit the trade with a profit from carry and rolldown before the bond matures.

We do understand that many investors would still prefer to understand the interest rate risks associated with this position. Exhibit 4 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. For a simple duration-matched interest hedge with a German government bond, we recommend selling €10.6m of the DBR 4.25s of 7/4/2017.

Exhibit 4

The trade has significant positive carry and rolldown 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 on the CDS side of this trade because the WB subordinated CDS in this maturity is fairly liquid. Our largest concern is execution in size in the bond markets.

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

WB subordinated CDS shows good liquidity in the ten-year maturity and bid-offer spreads are around three basis points.

Recent bids and offers for the November 2018 WB notes have shown good availability in both directions. We recommend the bond leg of the basis be worked first, looking for a price below €92.30 (our model fair value).

Fundamentals
Generally, our negative basis trades are based on the assumption that the bond market is mispriced relative to the CDS curve, rather than an expectation of general curve movements. While this trade is technical in nature and not necessarily affected by fundamentals, we must consider whether surprises in the short term could cause adverse movement in the cash-CDS basis.

Kathleen Shanley, Gimme Credit's Financials expert, maintains a neutral view on Wachovia, observing that the company has pursued an aggressive acquisition strategy and has improved risk management since its merger with First Union. In her most recent comment, Kathleen assessed the effect of the firm's planned acquisition of A.G. Edwards and reiterated her "stable" opinion on Wachovia's credit.

Although this trade is not driven by an assessment of idiosyncratic risk to which Wachovia is exposed, our research into the effect of LBOs and other dramatically negative credit developments on negative basis trades suggests that such an event would benefit the position recommended here.

Summary and trade recommendation
With the WB 4.375s of November 2018 trading a bit cheap to fair value, we feel a default-neutral negative basis trade is an excellent opportunity to earn positive carry and roll-down, as well as the potential profit of a return to fair value. We recommend a slightly over-hedged basis package using a single subordinated CDS static hedge to pick up 16 basis points of carry.

Buy €9.3m notional Wachovia Corp. 10 Year subordinated CDS protection at 31 bps and

Buy €10m notional (€9.2m cost) Wachovia 4.375% of November 2018 notes at a price of €91.98 (z-spread of 45bps) to gain 16 basis points of positive carry

Sell € 10.6m notional DBR 4.25% of July 4, 2017 at a price of €97.62 (€10.4m proceeds) 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).

CLO call options

Options in pre-2004 euro CLOs and the rationale for equity investors to exercise them are analysed by Ashish Keyal, a structured credit strategist at Lehman Brothers

Most CLOs issued in 2003 or earlier are now nearing or have crossed their non-call dates and a few have reached the end of the re-investment period. Equity investors in these transactions can exercise the option (upon a majority vote) of calling the deal by repaying the debt tranches and refinancing the collateral by issuing a new CLO.

Below, we detail why it can be profitable in the current market environment for equity investors to exercise the call option as and when it becomes available.

Liability spreads have compressed
Over the past three years CLO liability spreads have compressed significantly. This has led to a notable fall in the weighted average funding cost of the debt tranches. Figure 1 shows the weighted average cost of debt for a typical 2003 and a 2007 vintage CLO.

With the cost of CLO debt reduced to almost a third (47bp from 131bp) of the 2003 level, there are significant benefits for seasoned vintage deals to be called by subordinate note holders. Moreover, despite prepayments in the loan portfolio that require managers to replenish old loans, most of the loans in vintage portfolios earn higher spread when compared to new issue loans. This provides further motivation for equity tranche holders to continue with the same assets in a "refinanced CLO" as opposed to liquidation.

Structural constraints: weighted average spread test
CLOs have weighted-average spread tests, as required by rating agencies, which dictate the new investments that a manager may make. Given the tightening in spreads, vintage CLO managers are finding it increasing difficult to abide by these. Rating agencies incorporate a spread requirement for the collateral in the portfolios as follows:

• Moody's: For every combination of spread, recovery and diversity score, Moody's specifies the maximum WARF (weighted average rating factor) that is allowable.
• S&P: For every combination of spread and recovery estimate, the portfolio must pass the break-even default rate (BDR) as specified by the S&P CDO Monitor.

In effect, the rating agencies set requirements for the returns or spread that the collateral must achieve based on every unit of risk (measured by means of ratings/WARF/default rate). With leveraged loan spreads for all ratings declining, the older vintage deals would struggle to pass these tests. Hence, it would provide a lot more flexibility to the manager if the deal were to refinance with new spread requirements.

Enhanced IRR for equity investors
It is interesting to note that equity IRRs have also improved in the past few years. If we use 2003 as a point of reference, the following have driven higher returns to equity.

• Increased leverage: From 12-14% equity in a CLO in 2003, current euro deals are structured with 10% equity.
• Reduced liability spreads: As Table 1 shows, the weighted average cost of debt has fallen from 131bp to 47bp. This is the key factor enhancing IRR for equity holders.

On the other hand, loan spreads (weighted average institutional spreads) have also compressed in this period, from 300bp in 2003 to 260bp currently. However, the reduced liability funding cost has more than compensated for the spread compression. To analyse the net effect we plot the CLO funding gap (Average portfolio Loan Spread – Weighted average cost of liabilities - Expenses), which denotes the unlevered net return to the equity investor in a zero default scenario for new issue deals.

Given the above economics it is apparent that there are more than enough reasons to motivate equity note holders to exercise the option to call a vintage deal. However, timing of the call option may not be as simple a decision.

When should the deal be called?
A CLO can be called by the majority of the equity holders at any point after the non-call period. Hence the deal may not be called promptly after the end of the non-call period. The two important factors in deciding the call timing are the re-investment period and the expected net asset value (NAV) of the portfolio.

Re-investment period
The end of the re-investment period is a key factor in deciding the call timing of a deal. The re-investment period of the deal ends either simultaneously with the non-call period or a couple of years thereafter. After the re-investment period, the deal starts deleveraging. This is not ideal for the equity investor because returns fall as a result of the following:

• The excess cash from the principal proceeds is used to pay down sequentially the senior tranches on the deal, which are also the cheapest source of funding for the CLO.
• Higher rate of loan prepayments is more challenging for the manager post the re-investment period leading to large cash balances.
• Because of the reduced maturity of the transaction the manager may struggle to find adequately yielding shorter maturity assets.

To illustrate the above with an example, we take the Jubilee II CLO which was issued in June 2002. This deal has a non-call period until July 2007. The re-investment period also ends with the non-call period.

Figure 3 shows the expected half yearly equity coupons (as a % of the outstanding equity) for the remaining life of the deal. We assume a 0% CADR under different prepayment rates to illustrate the impact of high prepayment rates on the return for equity. After the reinvestment period even in a low prepayment environment we can observe the decline in equity returns as the structure deleverages.

Alternatively, we compute the IRR at various points, assuming investment in equity at par. Figure 4 demonstrates the decline in IRR following the re-investment period. Again, the equity IRRs decline at a faster rate as prepayment rates rise.

Expected Net Asset Value (NAV)
Another important consideration for evaluating the call timing is the underlying loan portfolio's NAV. If the deal has experienced a large number of defaults or has assets trading significantly under par, it may not be ideal to call the deal for the following reasons:

• The assets may not be enough to pay all the debt tranches and leave enough to pay the equity tranche
• Because over collateralisation (OC) tests are computed using a par notional value, the deal may be passing the tests even though the NAV is trading below par.
• "Make whole" provisions for fixed rate tranches are generically in the money as liability spreads have compressed and swap spreads are lower. This cost at times could lower the effective NAV left for the equity holders.

The expectation of the NAV value at various points after the call date also determines the call timing, as a higher NAV in the future would result in a greater exit value for the equity holders. Expected default rates, loan prepayment rates, re-investment capacity and change in mark-to-market of the assets help determine the expected NAV of the portfolio. Once this has been set, it is possible to compute the expected IRRs at each point, based on modelled cash flows and the expected exit value.

Euro CLOs refinanced and those nearing call dates
In 2006, the bulk of the euro CLO deals issued in 2001-03 (when CLO issuance started in Europe) had non-call periods coming to an end. There were many deals refinanced, with refinanced deal collateral comprising that of the old deal. Figure 5 lists deals that had non-call periods ending in 2006. Most of the deals have been refinanced.

Given the rally in the leveraged loan market, with nearly no defaults, most deals have performed well over the past three years. Given that most collateral would be trading above par, it would be expected that most deals would be refinanced as liability spreads compressed. However, deals may not be refinanced for the following reasons:

• Administrative difficulties in managing multiple deals. At times a manager may have a couple of deals outstanding that have crossed their non-call periods but the manager has been able to accept the refinancing of only one of the deals.
• Equity owners may not be easily contactable. Most deals require a two-thirds majority of equity holders to consent to calling a deal, but it may be difficult to secure such a majority. Asian holdings of euro CLO equity are a case in point.
• The deal may be suffering from defaults or distressed assets. The equity investors may rather have the manager hold on to the assets and go through the workout process for the loans and receive recovery value than "monetise" the lower NAV value of the assets by calling the deal.

Figure 6 lists the deals with call dates ending in 2007. Since issuance in the euro CLO market ballooned in 2005/6 there should be many deals available for refinancing in the coming years.

Maturity extension of deals: an alternative to refinancing
Another alternative to refinancing a CLO is simply to extend the maturity of the transaction. From an equity holder's perspective this is very effective for the following reasons:

• Saves on structuring fees and other expenses which is paid out to the investment bank (typically €8-10m on a 400m deal which translates into 2%- 2.5%)
• Reduces the cost of liabilities as the debt holders agree to reduced coupons with increase in maturity as alternatively they would have to face refinancing of the deal.
• Extends the re-investment period, providing the manager the ability to re-invest the principal prepayments and maintain adequate returns for the equity holders.

From a debt holder's perspective this is acceptable, as the coupon on the new bonds with increased maturity are typically wider than those in the new issue CLO primary market. This motivates them to accept the maturity extension with reduced coupons rather than face redemption with only the new issue CLO market as a resort for investing the released cash.

One recent deal to opt for this alternative was the Leveraged Finance Europe Capital II (LFEC II) deal managed by BNP Paribas. This reduced the coupons of the AAA, AA, BBB and BB tranches by 20bp, 55bp, 90bp and 200bp to 40bp, 70bp, 200bp and 500bp respectively. It was the first European CLO to reduce margins across all tranches, although Babson reduced its AAA tranche from 52bp to 42bp when it extended the maturity of the Duchess I CLO in 2005.

In deciding between calling a deal and refinancing it or extending the maturity, the manager/equity tranche holders weigh the saving on the structuring of a new CLO versus the increased coupon paid to the debt holders compared to the new issue CLO market.

Potential opportunities for debt and equity investors
Given the economic rationale for deals being called after the non-call period, there are implications for investors holding the debt as well as the equity tranches of the CLO. This also has implications for trading in the secondary market where pricing is dependent on the assumed maturity of the transaction.

Implications for debt investors
With coupons paid on seasoned deals being significantly higher than current deals, all secondary CLO debt is priced above par. Also, these positions are typically priced to the call date rather than to the maturity of the instrument, given the high probability that the deal will be refinanced and the bonds repaid at par.

This has a significant impact on the price of the bond. For example, Adagio 1 AA's would be valued at 100.14 if priced to the call date (Nov 07) for a discount margin of 40bp Vs being valued at 101.83 if priced till maturity (Figure 7). Hence it is important to bear the call date in mind.

On the other hand, if a deal is not called on the call date, the bonds valued to the call date may be cheap. With reinvestment periods ending a couple of years after the call date, there may be a possibility of the deal not being called if the manager has been able to deliver satisfactory returns to the equity holders. Thus if these nuances can be spotted, there may be opportunities in the secondary market.

Implications for equity investors
The equity of a CLO can be valued using two techniques.

• Liquidation value, i.e. the NAV (Net asset Value = Market value of the assets – Liability Notional – Expenses/other costs)
• Present value of future cash flows: Projecting the future cash flows to the equity holder under certain prepayment and default assumptions and then discounting these by the required IRR to determine the fair value of the equity.

The NAV of the equity is a minimum threshold price for the equity tranche. Future expectations of the NAV do affect the IRR achieved by the equity investors. Considering the portfolio and assumptions on spreads, market-to-market, prepayments etc investors can have differing views on the NAV.

Deals nearing their call dates would be expected to trade closer to the NAV and the pricing would be influenced significantly by the NAV expectations. Such deals may provide opportunities for investors to put money to work, based on their views. Deals that are not expected to refinance would trade closer to the present value of future cash flows.

Conclusion
With the performance of leveraged loans and the compression of liability spreads, most deals have been refinanced after the end of the non-call period. This has implications for debt as well as equity holders. Investors should analyse the probability that the deal will be called after the non-call period, which would have implications for the secondary pricing of both debt and equity tranches.

© 2007 Lehman Brothers. All rights reserved. This Research Note was first published by Lehman Brothers on 15 June 2007.