Contents

CDR Liquid Index data as at 9 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.

Testing times

Sustained broad-based concerns drive market

European indices gapped wider this morning, Wednesday 11 July, following on from both US and European index markets' closing at recent wides yesterday. The iTraxx crossover moved a further 30+bp in early trading and tested the 300bp level before retracing to some extent by mid-day, for example. While the moves appeared to be triggered by RMBS rating downgrades, wider issues are also impacting the markets.

The CDS index market moves over the past few days need to be put in the context of slightly longer-term activity, according to Marcus Schüler, md integrated credit marketing at Deutsche Bank. "Over the past couple of weeks there has been an ongoing consistent repricing of credit," he says.

"Yesterday was a day when we gained some momentum and that momentum is still there today. There is no single piece of news driving it but what you could have been saying for two weeks now – that the market is just pricing in the expectation that sub-prime losses are going to feed through the system, Schüler adds.

"That can happen in many different ways. Whether it is people being forced to liquidate positions in other markets because of losses in sub-prime; or whether it's brokers' results being weaker because they are involved in these markets; or whether it is a general impact on risk appetite and the appetite for structured investments," he explains.

As might be expected the ABX index was hardest hit by the announcement by S&P that it may cut the ratings on up to $12bn of sub-prime RMBS and Moody's downgraded $5.2bn of paper. The ABX triple-B minus 07-1 tranche fell to all time lows as a result, but recovered somewhat to close off those levels. ABX traders attributed the continued presence of overbearing technical factors in the market to its slight recovery in the face of such negative fundamental news.

The ratings on 612 mainly BBB+ to BBB- rated pieces of residential mortgage-backed securities from vintages from Q4 2005 to Q4 2006 were placed on credit watch negative at S&P. Moody's cut the ratings on 399 bonds, including 214 from investment grade to junk, and put 32 on review for downgrade, mainly from the same vintage. S&P also announced that it would review the "global universe" of CDOs that contain sub-prime mortgages (see this week's news round-up).

Schüler says: "You could obviously argue that the rating agency news yesterday was the sole trigger for the general widening, but to be honest I don't think that it was. It is just an indication of what people are concerned about more broadly."

He continues: "While we have seen some capitulation of longs yesterday and today, what strikes me is that many market participants are still holding on to their positions. The thinking behind that is that nothing has changed in terms of corporate credit quality and all that is happening is that we are just finding a new market clearing level for credit exposure – if general risk appetite is lower and the structured pipeline is smaller than we previously thought then logically spreads must be wider."

MP

CDO of ABS haircuts to rise

Increases in margin calls could create forced selling from some hedge funds

Recent woes of some structured credit hedge funds (SCI passim) have generated increasing investor concern about the vulnerability of other funds with exposure to sub-prime and CDOs of ABS. Over the near term, the most significant risk is probably that of forced selling driven by potential margin calls (i.e. haircut increases) or investor redemptions, according to research from Citi's structured credit products strategy group in London.

Citi estimates suggest that typical CDO of ABS haircut levels should have risen significantly – as much as doubled in some tranches – over the past six months. However, it notes that the full effect of these increases has probably not yet been felt.

First, variation margin payments will have been requested earlier this month, in line with end-June monthly CDO valuations. Second, CDO of ABS financing typically runs from one coupon to the next – that is, quarterly.

Although some brokers may already have raised their haircuts some months ago, many more are likely to make a concerted effort to do so at the next coupon date, given the steady slew of negative news out of the US housing market. The next wave of coupon payments will not occur until July 15-20.

However, Matt King, head of Citi's structured credit products strategy group, adds: "It is important to recognise the number of investors affected by these considerations. The vast majority of CDO of ABS tranches are not held on margin, nor even marked to market. The majority of buyers – especially at the senior level – are not hedge funds, but insurance companies, asset managers and banks. What is more, the majority of these tend not to mark to market (with banks, for example, often holding the tranches in off balance sheet conduits)."

Nevertheless, he continues: "The problem of haircuts is very significant, but probably only over the short term and definitely only for a minority of investors. For the longer term, it is increasingly looking as though the absolute level of losses on the CDOs – and, prior to that, associated downgrades from the rating agencies – could be more damaging. Those downgrades, though, could still lie some way off or even not happen at all."

The research also considers how investors could position themselves to benefit from any resultant market movements. It suggests a number of different strategies – revolving around being long high grade, short high yield; short credit, long equities; and putting on shorts in senior synthetic tranches – but warns: "Although there is much to be concerned about, there is also a significant risk of whiplash, given the extent to which spreads have widened already and the number of short positions probably already in the market, as reflected in the index skew."

If haircuts on CDO of ABS tranches rise dramatically, haircuts on other products might rise as well, albeit to a much lesser extent. "CLO levels may move, but their price volatility has not been nearly as great as that in CDOs of ABS," the Citi research concludes. (For more on CLO price movements, see separate news story.)

MP

Brave new world?

European CLO environment undergoing change

Half-year figures from banks published in the past week show healthy CLO issuance volumes and the pipeline looks likely to continue to be strong. Nevertheless, widening spreads in Europe mean that some potential issuers are seeing diminishing arbitrage – and CLO investors are having to consider both structural and pricing issues.

According to research from Dresdner Kleinwort, leveraged loan CLOs remain the leading type of issuance for both the US and European CDO markets. For the first half of 2007, Europe has been dominated by CLOs – representing just under 50% of total H107 issuance. The same is also true for the US, with CLOs contributing 37% to the H107 total CDO issuance.

However, the asset class is currently seeing spread widening at the lower end of the capital structure. In addition, continued high demand for leveraged loans – primarily from CLO vehicles and hedge funds – has seen institutional loans continue to tighten rapidly, even in the US where sub-prime worries dominate. As a result, CLO economics are under pressure, confirms Domenico Picone, head of structured credit research at Dresdner Kleinwort.

"The CLO spread widening could be attributed to a variety of reasons. One possibility is the increasing number of transactions issued to the market, although rising interest rates are expected to slow down refinancing and therefore reduce the flow of new loans to the market – resulting in less collateral availability. Growing number of new managers to the market has also increased competition. Another is fears over a contagious effect spreading from the consumer sector into the corporate space, as there is in the US. But it should be stressed that the European CLO pipeline still looks pretty healthy," adds Picone.

Wide spreads are not being seen across the entire capital structure, according to Ashish Keyal, a structured credit strategist at Lehman Brothers. "Triple-A spreads still trade tight, which has helped maintain the arbitrage for CLO equity," he says.

However, the second half of the year will be a real test for the CLO market when the current pipeline – which would have portfolios ramped up – comes to the market to price, Keyal says. According to S&P LCD, the current pipeline stands at €9.3bn, representing 24 transactions.

A further cause for concern remains the preponderance of covenant-lite deals, although this remains a far more significant issue in the US. Research released last week by Deutsche Bank's securitisation research team in New York notes: "Covenant-lite volume rose another US$24.1bn in 2Q '07, bringing year-to-date total to US$104bn, four times 2006's entire year volume. The cov-lite frenzy has prompted S&P to change its CLO criteria to address increased exposure to these loans." (See also this week's news round-up.)

Lehman's Keyal observes: "Last month finally saw deals being forced to add covenants accompanied by weakness in the secondary trading for covenant-lite loans. In Europe covenant-lite deals constitute only 5% of the new issue loan market so far. The back-up in these structures in the US is a healthy sign for the market, which had been too issuer-friendly, and looks positive for the European market as it would slow the number of deals issued as cov-lites."

Overall, caution appears to be the watchword going forward for European and US CLO investors alike. As the Deutsche Bank analysts conclude: "Given the still-strong fundamentals in the CLO market, we continue to hold that incremental spread widening in this market may offer buying opportunities for investors looking to diversify out of residential real-estate risk. That said, investors should be selective and focus their research on the higher-rated paper of top-tier, experienced managers that have weathered previous economic downturns."

MP

Unusual dynamic CDO marketed

Multiple maturity deal brought with a dynamic bucket

Lead arranger BNP Paribas is marketing an unusually structured synthetic CDO, which will be managed by Crédit Agricole Asset Management (CAAM). Dyneo CDO will be issued by BNP Paribas' Omega Capital Investments and is related to the SPV's multi-maturity Waypoint CDO launched in June (see SCI issue 30).

All firms involved in the transaction were prohibited from commenting because of 144a disclosure rules. However, according to analysts at S&P, the purpose of the transaction is to transfer a portion of the credit risk associated with a long-short portfolio of multi-maturity corporate exposures through one CDS per class of notes.

To collateralise its obligations, Omega Capital Investments will issue notes, the proceeds of which will be invested in bonds (rated at least triple-B minus) under a repurchase agreement with BNP Paribas (for notes that are issued in US dollars, the proceeds will be swapped first into euros under the currency swap). On each interest payment date (IPD), the repurchase counterparty will repurchase the collateral securities at par and pay a price differential to the issuer.

Rated by S&P, the notes are structured so that that there is one series with separate, fully segregated classes. There are four classes of euro-denominated notes: €100m triple-A rated A-1E notes; €80m double-A B-1Es; €50m single-A C-1Es; and €20m triple-B D1-Es.

In addition, there are three classes of US dollar-denominated notes – US$50m triple-A A-1Us; US$30m double-A B-1Us; and US$20m single-A C-1Us – and three classes of Japanese yen-denominated notes. These are split into ¥2bn triple-A A-1Js; ¥2bn double-A B-1Js; and ¥1bn single-A C-1Js.

The manager will apply a long-short strategy, and can affect trading gains and trading losses on the notes threshold; the step-up premium; and/or the trading account. Before each IPD, the manager will be able to monetise or demonetise the threshold or step-up premium into/from the trading account.

The trading account and the step-up premium will be junior to the notes, and will be used to offset any potential loss of principal on the notes. At maturity, the proceeds from each account will be split, with 80% to the relevant noteholders and 20% to the portfolio manager.

Entities referenced in the portfolio can have up to three different maturity dates. The pool will initially comprise 100 long reference entities and 16 short reference entities.

The portfolio will include a 'dynamic bucket', under which the manager will have the option to include further risky assets after the issue date. On the issue date, the dynamic bucket is expected to be 20%.

The portfolio manager will be allowed to engage in discretionary trading, provided that the substitution criteria are satisfied. If, at the discretion of the portfolio manager, the reference entity is a credit-impaired reference entity, some substitution criteria will not need to be satisfied. Available credit support will be adjusted so that each class will benefit from a cushion of 25bp at the trade date.

Substitution criteria include the SROC test being greater than 100%, or improved by the substitution; the number of reference entities must be between 80 and 160; and the replacement reference entity must have an S&P rating of double-B minus or higher for the long bucket and single-B minus or higher for the short bucket. In addition, no ABS or SPE can be referenced in the portfolio; the maximum entities within the same S&P industry classification group must not exceed 20%; and no entity can have a maturity longer than the scheduled maturity date of the notes – 20 December 2015.

MP

Manager-squared

James Smigiel, head of fixed income, Gregory Soeder, portfolio manager, and David Aniloff, portfolio manager, from SEI, answer SCI's questions

Q: When, how and why did you and your firm become involved in the structured credit markets?
A: SEI has participated in the structured credit markets for the better part of a decade with our involvement best characterised as a bottom up, opportunistic approach within our broader credit platform. From a strategic perspective, however, the firm's involvement in structured credit began, in earnest, early in 2005, and was born out of our favourable view of the senior secured bank loan market as an efficient and widely applicable source of excess return.

Helping to shape this view was the remarkably strong characteristics that bank loans exhibit such as a floating rate coupon, capital structure seniority, and relatively low historical default losses. Recognising the bank loan asset class' potential as a natural fit for modest amounts of leverage and the favourable term financing available in the CLO market, structured credit quickly become a growing effort here at SEI.

Another key attraction to the structured credit market has been our ability to leverage our competitive advantage in manager evaluation and selection. As a leader in the manager of managers industry, SEI has built a large and successful business identifying highly skilled investment managers and structuring solutions around their strengths.

Our structured credit platform has allowed us to apply this expertise to a different part of the capital markets and to a broader pool of investment managers. The collateral manager's influence on CDO returns, especially the equity tranche, is undeniably enormous. Therefore, while collateral and structure are key components in CDO analysis, as well as areas we do spend a great deal of time and focus on, we believe that our ability to generate favourable returns for our investors will ultimately be driven through our proven skill in manager selection.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: From our perspective, the institutionalisation of the CDO investor base, particularly the equity investor base, has been the most significant development in the credit markets recently. Over the last three years we have witnessed the laborious necessity of CDO equity placement among a fractured buyer base evolve into an early commitment, investor driven process for the top deals. This has subsequently changed things considerably for the end investor.

First of all, an access point has been established into equity tranche investing with CLO equity oriented funds, such as our own, providing qualified investors with access to diversified holdings in CDO equity. Secondly, the growth of CDO equity-based funds has increased competition amongst buyers to establish solid relationships with top managers in order to get access to their deals. Finally, the development and maturation of the market has led to a more equitable distribution of the economic benefits among all parties involved in CDO space – manager, underwriter and investor.

Q: How has this affected your business?
A: This has affected our business in several ways. Primarily, our efforts in structured credit have enabled us to broaden our relationships among the world's top credit managers and utilise their skills for the benefit of our shareholders.

Furthermore, structured credit has provided our firm with an additional source of excess return which we can utilise in a broader context to further diversify our client solutions. Finally, the exposure to the market participants on both the buy and sell sides has enabled SEI to look at our business in a more creative way, which is a testament to the talent currently populating the structured credit market.

Q: What are your key areas of focus today?
A: The current market environment is a reminder that the more things change, the more they stay the same. The CLO market in particular has experienced massive growth in recent years, tripling in size over the last three years alone.

As such, CDO issuers are rushing to market new deals and more traditional investment managers are entering the fray. This growth has had a material impact on the bank loan market and the end results are obvious: covenant-lite loans and 2nd liens are becoming a larger part of the bank loan market.

Given these developments, combined with where we reside within the current credit cycle, we are more focused than ever on manager selection. Our belief is that credit is primarily a defensive game and we are focusing on those managers who win by not losing.

Q: What is your strategy going forward?
A: We maintain our on-going strategy of identifying top-tier collateral managers as well as continuing to focus on bank loan collateral, however for the reason mentioned above – rapid growth in covenant-lite and 2nd liens – we have moved our focus away from broadly syndicated bank loans and have been finding compelling investment opportunities in the middle market loan space.

We like middle market loans because they offer better covenants, higher spreads and attractive opportunities for skilled investment managers. Unlike the syndicated loan space, middle market loans remain a clubby market and present us with an opportunity to add considerable value for our shareholders.

Q: What major developments do you need/expect from the market in the future?
A: Like most investors in this space, an increase in liquidity would be a welcomed development and one that we expect to be realised over the next few years. Within the area we focus on – CLO equity – we have witnessed flashes of the maturation we expect, most notably, good secondary market activity and investor differentiation by collateral manager. This speaks to the rising level of sophistication among market participants and the broader pool of players. Despite the current volatility, we continue to expect the liquidity characteristics of the CLO market to improve in the coming years.

About SEI
SEI (NASDAQ:SEIC) is a leading global provider of outsourced asset management, investment processing and investment operations solutions. The company's innovative solutions help corporations, financial institutions, financial advisors, and affluent families create and manage wealth.

As of the period ending March 31, 2007, through its subsidiaries and partnerships in which the company has a significant interest, SEI administers US$382.4bn in mutual fund and pooled assets and manages US$190bn in assets. SEI serves clients, conducts or is registered to conduct business and/or operations, from more than 15 offices in over a dozen countries. For more information, visit www.seic.com

Structured credit tops analyst salary survey

The Latest company and people moves

Structured credit tops analyst salary survey
The 2007 Credit and Risk Salary Survey 2007 published by executive search firm HealyHunt finds that overall last year saw a continued demand for credit analysts across all industry and products areas. This was particularly evident in growth areas, such as structured credit (leveraged finance, structured finance and securitisation), commodities and emerging markets, and in areas where specialist knowledge and skills were required, such as hedge funds and languages.

HealyHunt explains that its survey aims to give an insight into the credit risk market (with a focus on counterparty analysis). Over 2000 credit risk professionals were invited to complete the survey, with over 450 respondents doing so.

The survey found that basic salaries increased broadly in line with years' experience, while bonuses were much more varied and linked to the institution or how close the role was to the front office. Benefits as a percentage of base also increased with years' experience.

FI/NBFI counterparty coverage roles paid higher basic salaries, but lower bonuses than corporate counterparty roles at the same level. When taking into account base salary and bonus levels, FI/NBFI professionals were better paid than corporate professionals.

Professionals analysing FI/NBFIs counterparties and structured credit deals were paid similar base salaries for the same levels of experience. However, structured credit professionals were the highest paid when both base salary and bonuses were taken into account.

Capital structuring swap
Franca Jarc, head of regulatory capital structuring at UBS, is understood to be joining Lehman Brothers' CDO team in a similar role.

Rating agency head on the move
Perry Inglis, former head of S&P's European CDO business, is moving to ACA Capital as European head of structured credit.

Cash structurer leaves
Dacil Acosta is understood to have left Dresdner where she was an associate in the cash CDO team. Acosta is believed to be joining an as yet unnamed US bank.

Head of ABS trading appointed
Deutsche Bank has appointed Michael Leung as head of ABS trading, Asia (ex-Japan). From his base in Singapore, Leung reports regionally to Greg Park, head of securitisation, Asia (ex-Japan), and Chetankumar Shah, head of credit trading, CDOs and credit structuring, Asia. Globally he reports to Hyung Peak, md of RMBS at Deutsche in New York.

Leung joins Deutsche Bank from UBS in New York, where he was an executive director in the fixed income division. He was responsible for the bank's non-agency mortgage structuring business and also managed various MBS and ABS-related proprietary trading desks. He has over 14 years' experience in ABS markets in a range of origination, structuring and research-related roles.

Synthetic structurer switches
Michael Malek has joined Credit Suisse as a synthetic CDO structurer from Ixis CIB in Paris. He is now a member of Credit Suisse's synthetic CDO group.

Commerz hires CLO head...
Commerzbank Corporates and Markets (CBCM) has hired Guy Beeston as part of a move to establish a leveraged loan CLO business. Beeston joins CBCM from UniCredit Markets & Investment Banking, where he was a director specialising in acquisition and leveraged finance. In this role he led a team originating and executing large ticket underwrites and participations, and was responsible for UniCredit's buyside activities.

At CBCM Beeston's role as CLO manager will be to concentrate on sourcing and managing the CLO. He joins Frank Netrval, deputy CLO manager, who recently transferred from CBCM's leveraged finance origination desk. Beeston reports to Chris Day, head of leveraged finance. Further hires to the business are expected in the coming months.

...and strengthens ABS trading
Julien Mareschal and David Hoffman have resurfaced at CBCM, having left BNP Paribas together (see SCI issue 41). Mareschal joins as the bank's new head of ABS trading and David Hoffman as a senior trader of the ABS team.

At BNP Paribas, Mareschal was responsible for the past five years for ABS/MBS secondary trading as well as cash CDO trading, while Hoffman worked at the French bank as an ABS trader. His focus will be on ABS derivatives in particular.

Fitch expands emerging markets
Fitch Ratings has expanded its European structured finance emerging markets team. Senior director Jaime Sanz will lead the London-based team, while Andrei Gozia joins as an associate director.

Prior to joining Fitch, Sanz spent five years at Merrill Lynch, initially in the sovereign advisory group focused on emerging markets. He then moved onto the DCM team, marketing DCM products including securitisation to Central and Eastern European clients.

Sanz previously headed the Latin America sovereign rating group and separately the EMEA sovereign rating group at Fitch. Gozia joins Fitch from International Finance Corporation in Washington DC, where he was an analyst in the emerging markets securitisation team.

MP

Sub-prime CDOs reviewed

A round up of this week's structured credit news

Sub-prime CDOs reviewed
S&P is reviewing its global universe of rated CDO transactions with exposure to sub-prime RMBS following its placement on credit watch with negative implications of 612 rated sub-prime RMBS tranches. The agency says it has determined this exposure and will take rating actions where appropriate. (See also this week's lead news story.)

For cashflow and hybrid CDO transactions with material exposure to the sub-prime RMBS on credit watch, S&P will review the results of its cashflow analysis generated for each transaction. The output of this cashflow analysis will be analysed alongside the scenario default rates (SDRs) generated for the CDO portfolios by S&P CDO Evaluator to determine if the credit enhancement can support the tranche at its current rating.

For any cashflow or hybrid CDO ratings that require a credit watch placement or lowering, the agency will issue a press release once the review for the transaction has been concluded. S&P expects that the required cashflow analysis and individual reviews for these transactions should be concluded over the next month.

For synthetic CDO transactions with exposure to the RMBS on credit watch, S&P will be using CDS Accelerator to generate synthetic rated overcollateralisation (SROC) numbers incorporating the RMBS rating actions. These will be reviewed to determine whether the current ratings assigned to the synthetic CDOs remain appropriate after taking the rating actions into account.

Of the US cashflow and hybrid CDO of ABS transactions currently outstanding, 218 (approximately 13.5%) have exposure to one or more of the sub-prime RMBS tranches on credit watch. Of these, 42 are high-grade structured finance (SF) CDOs of ABS and 168 are mezzanine SF CDOs. Of the US synthetic CDO of ABS transactions currently outstanding, 135 have exposure to one or more of the sub-prime RMBS on credit watch. All of these synthetic CDO transactions are mezzanine SF CDOs.

Of the European CDOs currently outstanding, 20 (or approximately 1% of publicly rated CDOs) have exposure to one or more of the sub-prime RMBS tranches on credit watch. Based on its current analysis, S&P does not expect any rating actions to occur for those transactions with exposure to affected RMBS tranches. Exposure to the sub-prime RMBS tranches on credit watch in the Asia Pacific region is limited to two cash transactions.

S&P calls for cov-lite comments
S&P is requesting comments from market participants on its proposed definition of covenant-lite (cov-lite) loans. Given recent trends in the leveraged loan market, the robustness of loan covenants has taken on greater importance as a key analytical factor in determining post-default recovery prospects for loans in CLOs, the agency says.

S&P is initially proposing to establish a means for identifying such loans through the use of a standardised definition. The proposed definition is that cov-lite loans are loans that have only "incurrence tests" but no "maintenance" tests.

Incurrence tests involve a point-in-time review of a specific operating performance measure relative to a predetermined "trigger" level after the borrower has taken a certain action such as debt issuance, dividends, share repurchases, merger, acquisition, or divestiture. A violation of these trigger levels in the absence of such predefined actions does not result in a default.

Maintenance tests, on the other hand, involve regular reviews of operating performance measures relative to the trigger levels without regard to any borrower action, thus providing lenders with greater control over the quality of their investment by requiring the borrower to more strictly preserve its credit quality. This "incurrence test only" proposed definition is the current basis for S&P's cov-lite-related criteria changes for all global CLO transactions closing after August 31 2007.

The deadline for responses to the proposal is 9 August.

Euro media LBO risk limited
Fitch Ratings says in a new report that the LBO risk of European investment-grade media companies is less than media and market speculation suggests, as LBOs in this sector face very significant challenges. These challenges include the uncertainty surrounding the business models of many media companies given technological and behavioural changes to the way media is consumed, improving media company valuations, change of control clauses in bond documentation and cultural factors.

"While leveraged media deals are not uncommon, investment-grade media companies being taken private is a rare occurrence indeed," says Alex Griffiths, director in Fitch's European TMT group. "Where these deals occur they typically involve a combination of an opportunity for a buyer to add value, due to perceived operational underperformance, a depressed share price, and a stable underlying business that can reliably service debt. This is an unusual pairing to find - the worst performing media companies at the moment are generally those facing the greatest threats to their business models. Those with strong business models are typically performing well."

The market for leveraged deals is busy, but these transactions typically arise either through the divestment by companies of businesses, such as Wolters Kluwer's education division, or the refinancing of already leveraged credits. VNU (since renamed Nielsen) is the only instance of an investment-grade European issuer being taken private this century, though a second deal, involving EMI, appears to be in the pipeline.

Markit launches real-time service...
Markit has announced the official launch of Markit Quotes, a real-time quote parsing service designed for the buy-side.

Markit Quotes extracts indicative and live prices from dealer pricing runs and converts them into real-time data, allowing portfolio managers and traders to cut through the thousands of electronic messages they receive daily to gain an immediate view of market levels. The service enables clients to see best bids and offers at a glance, and the parsed data is made available through the website, Microsoft Excel or via a feed.

Unique to the new service, according to Markit, is the display of all parsed data against Markit's clean, consensus closing curves for the broad universe of around 3,300 distinct credits. The combination of intra-day parsed data with Markit's comprehensive end-of-day service allows clients to calculate real-time P&L on all positions. This feature is particularly pertinent since dealer CDS pricing runs often only provide the five year point, Markit says. CDS prices are shown against Markit RED codes, the market standard reference entity and reference obligation identifiers used throughout the CDS market.

Markit Quotes spans bonds, CDS, credit and structured finance indices, index tranches and loan CDS. Markit says it will add loans, convertible bonds and structured finance securities in the coming months.

... And ABS monitoring
Markit has launched the first integrated pricing and performance monitoring service for the European ABS market. The integrated service offers market participants a comprehensive view of European ABS securities and collateral performance information alongside daily independent bond pricing sourced from 27 market makers.

Markit says users will gain access to closing prices, spreads and average lives for over 5,100 European ABS securities; bond and collateral performance data on more than 1,800 European ABS deals; and 17,000 collateral reports. This enhanced dataset allows investors to track pool and loan performance including prepayments, defaults, delinquencies and changes in credit quality.

The new platform builds on Markit's existing ABS pricing service and ABSReports, the deal reporting service that the company acquired in January this year.

Retail principles launched
Five trade associations have released a set of non-binding principles relating to retail structured products (RSP), which follows on from draft proposals issued in April (see SCI issue 36). The principles focus particularly on the management of the relationship between providers and distributors, from the perspectives of firms performing either function.

The principles seek to address issues that financial services firms have in practice found helpful to consider when performing these roles in connection with the process of delivering structured products to retail investors. They are intended to be sufficiently broad in their applicability to provide a reference framework for retail structured products markets globally.

The principles are the product of a working group of firms, taking in the views of both distributors and providers, and supported by a coalition of trade associations: European Securitisation Forum, International Capital Market Association, ISDA, London Investment Banking Association and Securities Industry and Financial Markets Association.

Structured products in this context include a variety of financial instruments that combine various cash assets and/or derivatives to provide a particular risk-reward profile that would not otherwise be available in the market. The exact risk-reward profile varies from instrument to instrument.

MP

Trading ideas - AL aboard!

Tim Backshall, chief credit derivatives strategist at Credit Derivatives Research, looks at a pairs trade involving Alcan and Union Pacific

By combining our fundamental analyst's rankings with a unique debt versus equity implied risk rank model, we recommend a 'pairs-trade' between Alcan Inc (AL) and Union Pacific Corp (UNP).

Armed with two measures of default risk, one from the equity market and one from the CDS market, we can begin to examine any relationships between the two. At first, as has been found by many practitioners, the results appear disappointing. Given the risk neutral nature of the CDS market models and the real-world nature of the equity market models, relating the two is not simple.

Exhibit 1

Exhibit 2

We take a different and unique angle of attack. Instead of comparing absolute levels of default risk, we will compare relative ranks. It is reasonable to expect that an issuer with a high ranking CDS level (wide CDS level) relative to its peers should also have a high ranking equity-implied default probability (high default risk). We compute percentile rank scores for each issuer based on each measure and look for inconsistencies.

In our search for outliers we normally look for rank differences of greater than 40 percentage points between the equity and CDS markets. However, given the current slightly tighter debt-to-equity dispersion, we are forced to revert to a 20 percentage point differential.

We note that there are only a few candidates in each of our 20% differential ranges and highlight that with the number of opposed credits in each segment. This is especially evident in the high-ranked CDS-implied default risks where there is considerable 'capital structure change' and the equity-implied model is unable to cope well with these changes.

More importantly, an analysis of Exhibit 1 also shows that the upper right and lower left corners are seeing more clustering than usual – especially in the upper right.

This portion of the chart (upper right) is where investors in both markets agree that the issuer is a high risk. It is interesting that the tendency for investors across the two markets to agree on the demons but be less in sync on the angels could be simply a reflection of momentum traders in both markets chasing the idiosyncratically risk-challenged issuers and ignoring the stable or low-event risk names.

We also note that in the upper left quadrant there are a number of credits with low equity risk ranks ('good' credits) but high CDS risk ranks ('bad' credits). These reflect the increasing number of LBO-prone names and the divergence that we see in the case of an LBO.

Traditionally we would expect spreads to tighten as equity prices rise and vice versa but in the case of an LBO it is quite different. Equity prices rise due to the premium that private equity will pay to get the deal done but spreads will sell-off dramatically at the merest whisper of an LBO as the company is expected to raise leverage considerably. This raises a critical issue in our selection criteria and one that we will see is very relevant this month.

An equity-implied rank significantly lower than the CDS-implied rank should be interpreted as: the CDS premium is higher than its default risk would deserve, relative to its peers. On a relative basis, we would expect these names to tighten in relative to their peers, based on our historical analysis of this asset selection process.

Exhibit 1 graphically displays the individual issuers, their equity- and credit-implied default risk rank and their fundamental outlook. We look for credits with major rank differentials (top left segment or bottom right segment) that converge with our fundamental outlook, i.e. a green triangle (improving fundamentals) in the green shaded area (tightening expected from quantitative models). The blue dotted line joins the two issuers – notice the improving name is just inside our 20% segment – this remains close to the lowest divergence in six months. 

Exhibit 3

Exhibits 2, 3, and 4 provide the list of the names (Deteriorating, Stable, and Improving fundamental outlooks respectively) analysed in this report and highlight the important next step – convergence between the technicals and the fundamentals. The default probability-implied five-year CDS rate rank and market price five-year CDS rank is displayed.

Each table is sorted by Rank Difference – from most technically deteriorating (at the top) to most technically improving (at the bottom). The investor could use these tables to build a more complete portfolio perspective on their credits or potentially combine in-house scores to select assets.

Notably, many financials pop up in our technically deteriorating outlooks. Financials generally have tight spreads (even with the recent sell-off we have seen) and, as we have discussed in our Trading Techniques features (www.creditresearch.com), they have a higher leverage on a comparable basis to 'normal' corporations. 

While the relative richness of many of the fundamentally deteriorating credits is less than in recent months, AL stands out as a great opportunity (>30%). With the turmoil surrounding the name and entire sector as AA and the rest of the sector battle it out for bragging rights, we feel this won't end well for bondholders here.

The long is more complex and requires us to overlay our LBO Viability Score to ensure we are not getting trapped. While, all too frequently, the cheap credits are simply the credits that are widest based on LBO rumours, we must beware of jumping into these credits for the carry.

Among the cheapest fundamentally improving credits are L-3 Communications (LBO Score of 3.3/5), FDX (LBO Score of 2.8/5 is above average and ongoing LBO chatter keeps us away along with recent comment in Barron's showing good opportunities for PE), Starwood (LBO Score of only 2.5/5 but the ceo's resignation and equity volatility imply larger risk of re-leveraging along with the HLT news last week), and RSG (LBO Score of only 3.4/5 and increased shareholder-friendliness).

UNP offers a modestly high spread level for our long (some upside possible), a low LBO Viability Score of 2.1/5 (even with recent railroad LBO chatter which we feel is overdone due to the unionisation and regulation that is present in that sector), and is still technically cheap to fair-value.

In terms of positioning, we will take the 5Y CDS in AL (as it is tight to fair value and has the tightest bid-offer and roll-down is not too bad). In the case of UNP, we note that the 10Y is a better place to trade (from a fair value perspective) and although 5Y offers a slightly tighter bid-offer (important as this is a short-term trade), we feel the curve steepness also offers some upside in getting long the longer-dated end of the curve. We therefore choose to buy 5Y protection on AL and sell 10Y protection in UNP.

We recommend entering the position duration-neutral, as we have no strong opinion on which credit is likely to strengthen/weaken the most and both sit a few basis points away from fair-value. Given each credit's DV01s, we suggest buying 1.7x notional (DV01s are in the ratio of 1.67:1) 5Y protection in AL against selling 1x notional 10Y protection in UNP.

We are pleased that the relative-value trade has positive carry and remains DV01-neutral. At current levels the sold UNP protection (long credit at 63bp) and bought AL protection (short credit at 31bp) position generates around 6bp of positive carry.

Risk analysis
This 'pairs-trade' carries a direct risk of non-convergence. In other words, there is the possibility that the names will not tighten and widen as expected. However, based on historical performance of the technical indicators, the cushion provided by the positive carry, and the conviction of the fundamental analysts, we believe these risks are well mitigated.

Liquidity
Both AL and UNP offer good liquidity in the CDS market. Both credits are members of the CDX IG8 index. They both consistently rank in the top 100 issuers by quoted volume on a daily basis. They also have tight bid-offer spreads, regularly less than 4bp and sometimes down to 2bp. We see no concerns with execution of this trade.

Fundamentals
This trade is based on the convergence between our fundamental analysts' recommendation and our unique model-based outlook. For more details on the fundamental outlook for each of AL and UNP, please refer to Gimme Credit.

Summary and trade recommendation
A bottom-up analysis of the most liquid (CDS-based) investment grade credits combined the fundamentals with the technical outlook from CDR's proprietary models to highlight anomalies across the market.

The last few weeks have seen equity markets rallying as spreads have continued to push wider, making wider wides and wider tights. As buybacks, leveraged recaps, and LBOs continue to help the equity market and hinder credits, the macro cycle remains divergent with the economy balanced between housing/sub-prime weakness and industrial strength as inflationary concerns loom and Treasuries drift lower.

The tails (extremes of risk convergence) in the debt-equity distribution continue to increase as the body (while converging recently) remains well dispersed (driven by the divergent nature of LBO events/rumours). Spreads have widened as the technical bid support has waned thanks to the domino-effect of sub-prime-defaults, which while pushing HY spreads wider (as supply backs up), has not diminished the LBO risk premia in many credits.

Balancing this apparent cheapness of credits with their LBO risk is critical to performance in this carry-driven market and we look to the extremes of divergence for our credits today. The two most outstanding names, in terms of relative value and strong convergence between technicals and fundamentals, are Union Pacific Corp. (improving credit ratios, favourable industry conditions and oversold LBO risk) and Alcan Inc. (acquisition candidate) – Improving and Deteriorating outlooks. 

Exhibit 4

At current levels, and given our fair-value curve model, we prefer to trade DV01-neutral across UNP 10Y and AL 5Y, generating modest carry and flat roll-down.

Buy US$10m notional Alcan Inc. 5 Year CDS protection at 31bp and

Sell US$5.9m notional Union Pacific Corp. 10 Year CDS protection at 64bp to gain 7bp 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).

Gap risk: structured credit beyond CDOs

The structured credit strategy team at Royal Bank of Scotland provides a primer on gap risk

That the search for yield is driving the rapid growth in structured credit is perhaps approaching the status of a truism, but being so wouldn't make it any less relevant to investors. From our client meetings across Europe in the past few months, it is clear that interest in structured credit is accelerating, perhaps most notably among pension funds seeking more efficient asset-liability management, and traditional asset managers and private banks seeking new products to distribute.

But almost everywhere we go, hovering beneath this interest is scepticism that tight spreads and low risk premiums will not (cannot) continue forever, and that CDOs in particular may suffer if (when) spreads widen and defaults reappear. Underpinning this view, for some, is the concern that there can be too much 'structure' in structured credit (a la CPDOs), or that a one-way structured credit bid in some asset classes can fuel price bubbles (a la the subprime mortgage market in the United States). Moreover, some in the investing community have voiced concerns over a perceived lack of transparency in CDO pricing or risk.

To be clear, we still see ample and compelling opportunities for relative value in CDOs across the board from cash to correlation products. But we also understand why some investors may wish to seek leverage through products that offer returns comparable to CDOs, but on a more bespoke and transparent basis. Many such solutions fall into a category we call 'gap risk' products. This article hopes to provide a useful overview.

The concept of 'gap risk': Limited recourse leverage
At the most basic level, gap risk products can be viewed as an extension of total return swap (TRS) technology into the fixed income space. TRS are a well established tool for hedge funds and other investors to gain exposure to risky assets. While the specifics can vary, most TRS arrangements tend to follow a basic pattern (see Figure 1 below): a total return payer (typically a dealer or arranging bank) offers to pay an investor the ongoing cash return of a reference asset, plus any increase in market value (either at set intervals over the life of the contract, or at maturity). In return, the total return receiver (investor) pays an upfront amount initially, and on an ongoing basis pays the TRS funding cost (typically cost of funds plus a spread).

Most TRS are full recourse, meaning that on an ongoing basis they also require that the investor make payments over and above the initial upfront amount, either in the case of a decline in the value of the underlying(s) (as above) or as a result of a change in the risk of the asset or the investor. For credit assets, TRS also typically include CDS triggers that cause the trade to unwind if the reference asset suffers a credit event akin to a default.

While they are useful tools for credit or funding arbitrage, the mechanics of TRS are not suitable for all investors. For example, some investors may not be able to enter into derivative contracts directly. Others may not be comfortable with full recourse nature of the TRS exposure, preferring to limit capital at risk. Gap risk products can be structured to pay similar returns to TRS, and at the same time overcome these obstacles through the following:

• Limited recourse. While most TRS structures are full recourse, gap risk products typically limit the exposure to initial principal invested (they can also, in some cases, replace the requirement to increase the exposure under TRS arrangements with an option to do so held by the investor, as in some leveraged super senior products). This is an important consideration for credit products, for which the downside can be much more painful than the upside is pleasurable. Gap risk products can also be structured with full or partial capital protection. Moreover, limiting the exposure to the initial amount permits the leveraged exposure to be repackaged in a funded note format.
• Market value unwind triggers. Gap risk products tend to eliminate the capital appreciation/depreciation exchange of cash flows seen in full-recourse TRS. Instead, they embed triggers that would effectively wind down the risky exposure in the event of a severe market value decline of the risky exposure. This changes the nature of the market risk exposure that investors carry vis-à-vis TRS structures.

Let's look at an illustration of the above two features in a basic gap risk product: a single-name credit linked note with an embedded spread trigger (see Figure 2 below). The diagram below provides a generic overview of how such a structure would work: An investor purchases a credit linked note (either issued via an SPV, or through an RBS MTN program) at par, the proceeds of which are placed in an account.

Over the life of the transaction, the investor receives LIBOR on the deposit, plus the spread on the reference asset (say Tesco's 5y CDS) multiplied by a fixed leverage factor (5x), minus the gap risk fee. So, the principal at risk is fixed to the initial amount invested, and the investor receives 37 basis points over LIBOR for taking on 5 yr Tesco risk, compared to an unleveraged spread of just shy of 10 basis points (at the time of writing).

In this example, RBS holds the residual risk of the leveraged CDS exposure should spreads widen to such an extent that the loss on the CDS position exceeds the initial investment. This risk is mitigated in two ways: First, through a spread-related unwind trigger; and second, through the compensation provided by the gap risk fee.

Spread triggers in gap risk products can be structured in conjunction with the risk appetite of the investor. As an example, let's set the spread trigger of our generic example at 50 basis points. Thus, if the spread on Tesco were to widen to 50 bps, the structure would be unwound, and the investor would receive par minus the mark-to market loss from closing out the leveraged CDS (see Figure 3 and Chart 1 below).

However, it is conceivable that in certain stress scenarios, the spread on the reference asset could widen to such an extent that the initial investment would be insufficient to cover the mark-to-market losses on the leveraged CDS position. In this case, the investor's losses are capped, with RBS taking the additional loss.

The gap risk fee is the compensation RBS receives for taking this risk. Chart 2 provides a graphic representation of the loss profile (for incremental moves of 10 basis points) of our single-name credit linked note with an embedded spread unwind trigger if the spread trigger is hit, demonstrating both the first-loss nature of the investor's position and the gap risk protection being provided by RBS. The orange line plots the proportion of principal lost by the investor for a given spread move above the trigger level, the green line plots the loss that would be incurred by RBS if the spread move were such that losses on the position exceeded initial principal.

Overview of product types
The example above is useful for establishing a basic concept of gap risk, but hardly does justice to the breadth and flexibility offered by bespoke, limited recourse leveraged products. Like TRS, gap risk products can be applied to any asset (or assets) with stable and visible prices, and potentially to less liquid asset types. They also can be structured in any number of ways: with or without principal protection; with running coupons, or as capital appreciation products; with bespoke maturities; etc. A convenient (if contrived) way of divvying up the gap risk world is into two camps: static leverage, and dynamic leverage.

Static (i.e. constant) leverage products tend to take the following form:

• Single name CLN: Our example above. Single-name CLNs are typically structured as leveraged CDS positions with spread-unwind triggers, although they can also be offered as products that strip out the CDS, and therefore the default risk. The amount of leveraged permitted, the cushion above the spread trigger, and the leveraged spread payable are structured on a case-by-case basis with a view to the underlying asset risk.
• Basket leveraged CLN: An elaboration of single-name products, where the underlying is a basket with two types of embedded spread triggers: one that refers to the spread on each individual name, and one that refers to the weighted average portfolio spread. The advantages of basket products are that they allow more accommodating spread triggers than single name products, and spread pickup (and more leverage) and a simpler pricing framework compared to first-to-default products. They also can be structured on funded/cash asset positions.
• Portfolio products: A more diversified portfolio than basket products, which allows the spread trigger to apply on a portfolio average basis only. These products can be viewed as being very similar to equity tranches of market value CDOs (with the advantage of bespoke structuring) in that the investor can take the first loss position in the event of an unwind/liquidation event.
• Leveraged super senior products: A leveraged investment in the super senior tranche of a CDO. These have most often been structured on super senior single-tranche CDOs of investment-grade corporates, and to a much lesser extent tranches of CDOs of ABS. They are similar in form to the above: sponsors of LSS products provide limited recourse leverage in exchange for market-value protection (and fees), and as such are taking gap risk. However, these products are priced using an implied correlation framework (unlike the products above where pricing is a more straightforward function of spread and structural features) and as such are complex enough to merit a primer in their own right.

Dynamic leverage products tend to fall into 3 groups:

• CPPI: CPPI is a dynamic asset allocation framework that seeks to maximise portfolio returns within the constraint of providing full or partial principal protection. The basic concept of credit CPPI is to allocate an initial investment between a leveraged risky investment that will produce returns, and an unleveraged 'risk-free' investment that will guarantee principal repayment. The amount of portfolio capital allocated to the leveraged risky investment increases as the value of the total portfolio (risky plus risk-free) increases, and declines as the value of the portfolio declines, hence the total leverage of the initial investment reacts dynamically to portfolio performance. We use CPPI to indicate products for which the amount of leverage is either fixed, or established by algorithmic rules, and for which there is little or no manager flexibility with respect to the underlying exposure. In other words, CPPI can be seen as programmatic trading strategies that seek returns by leveraging market beta. An example of this is early CPPI products, where the reference asset consisted of CDS indices.
• DPI: An extension of CPPI methodology that allows more flexibility with respect to leverage and the underlying exposure. DPI products allow leverage to shift as the riskiness of the underlying portfolio shifts, or according to manager discretion, or both, and can accommodate a variety of management strategies (long, short, curve plays). As such, DPI structures can be viewed as offering leveraged exposure to a manager's ability to outperform the market (alpha). CPPI and DPI products typically are unrated products, or have carried ratings that address only the repayment of principal (with a handful of exceptions).
• CPDO: The latest flavour of gap risk product. CPDOs can be seen as an 'upside-down' CPPI. Whereas CPPI seeks to maximise returns while protecting principal, CPDOs seek to place as much principal at risk as is necessary to achieve a capped upside in the form of a high, and highly rated coupon. The difference in the ultimate aim of the product is reflected in its leverage mechanics: as the value of the portfolio declines (and the strategy becomes further from meeting its yield target) leverage increases, and vice versa. (For this reason, CPDOs have been described as chasing losses.) Moreover, by eliminating the principal guarantee, CPDOs can allocate a greater proportion of the initial investment to the risky exposure, but at the same time expose that initial investment to a greater potential loss. As such, it could be argued that they share more in common with the static leverage products above (in that they pay the equivalent of a fixed coupon and do not provide principal protection) than with CPPI/DPI products. The key selling point of CPDOs is the level of rated spread they can achieve.

For a more extensive version of this paper and detailed discussions on the above products, please contact your Royal Bank of Scotland representative.

Conclusion
Gap risk products are a growing and vibrant area of structured credit, spanning a wide range of products, from leveraged positions on selected assets, to more complex portfolio products that repackage the alpha-generating capabilities of asset managers and hedge funds. While we still see ample opportunity in CDOs, the mainstay of the structured credit markets, gap risk products represent a highly bespoke, transparent, and attractive alternative for investors seeking to increase yield.

© 2007 The Royal Bank of Scotland. All rights reserved. This Research Note was first published by The Royal Bank of Scotland on 20 June 2007.