Contents

CDR Liquid Index data as at 23 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.

Uncertainty prevails

Structured credit investors sit it out

The European indices edged slightly inward by mid-morning today, 25 July. However, investors look set to stay on the sidelines of the market, particularly for more structured products, as uncertainty still prevails.

Following on from a slight move wider overnight in the CDX NA.IG and almost no change on the day in the high yield index as US equities fell, traders reported some surprise over the European indices opening wider this morning. The Crossover index began the day 7bp wider at 372bp, but quickly traded down to 357bp before settling at around 360bp mid-morning.

One dealer explains: "It now looks like one market leading another. We've had a severe credit correction in the last few months while equities continued to go up and now equities are reacting to the correction in credit. There are, therefore, limited reasons for us to go wider right now. I do think that at these current levels more and more people will look at the market and think there is some fundamental value after trading below fair value for a long time."

Nevertheless, shorts continue to hold sway in the US property-related CDS indices, with the ABX index hovering around its lows and the CMBX widening out – particularly in their triple-B minus tranches – on the back of negative sentiment. Even the new series of ABX has been impacted, which analysts at BNP Paribas note indicates that "the sub-prime problem did not stop with the 2006 vintage but continued right through H1 2007, even after several thinly capitalised vendors had gone under because the loans in the warehouses had to be packaged and sold".

Away from the index markets, activity is subdued as investors – unsure of where the market is heading – are sitting on the sidelines waiting, according to the structured credit research team at Dresdner Kleinwort. "We are seeing hedge funds putting on gamma trades in tranches – long the equity short the mezz so they can profit from any moves – but you need the other side of the coin to stabilise the market, which comes from dealers hedging bespoke issuance and that pipeline seems to have dried up," says Domenico Picone, head of the team.

Priya Shah, structured credit analyst at Dresdner Kleinwort, adds that the current market situation is likely to lead to further widening. "In the past, complex CDO structures have been priced based on models and market participants have generally accepted model prices for risk management and collateral calculations due to the illiquidity of these securities. However, models are not always efficient at capturing tail and liquidity risks – and in the current market environment bid prices, when available, are significantly lower than model prices. The collapse of the Bear Stearns funds has also resulted in many creditors requiring larger collateral requirements," she explains.

Shah continues: "This combination of bigger collateral margin requirements, suppressed prices, increased illiquidity and heavy sub-prime losses is likely to lead to more hedge funds freezing investor redemptions, in a similar manner to the Australian fund Basis Capital [see also this week's News Round-up]. To meet collateral margin requirements hedge funds unable to sell their illiquid exotic assets are also likely to start selling the liquid collateral, in particular credit tranches, leading to further credit market widening."

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Cross-asset strategy

Non-credit instruments offer hedging solution

At current market levels being short iTraxx Europe Crossover is proving expensive for investors. As a result, some are looking for alternative means of hedging their portfolios.

Geraud Charpin, head of credit strategy at UBS, says: "The sub-prime issue is a fundamental one with real losses, downgrades etc. and could therefore force unwinds in an illiquid and nervous market. If the negative news flow dries out for a week, however, the high cost of being short credit could force shorts to be covered again. Given this relatively elevated risk of going through a large scale technical sell-off, investors should consider cross-asset solutions to hedge credit exposure."

Indeed, Meyrick Chapman, head of fixed income derivatives strategy at UBS, observes: "Despite Crossover moving wider, credit investors have not reached a point where they are willing to get out of their long positions. So managers are increasingly looking across asset classes to hedge risk, especially in light of liquidity and correlation issues within their main asset class."

Consequently, new research from UBS looks at a hypothetical solution to hedge a credit portfolio against a 'flight to quality' type event using Bund options. The research examines the four sell-offs experienced by credit markets over the past two years – March 2005, May 2006, February 2007 and June 2007 – and finds that they have been accompanied by a degree of flight to quality at some stage.

The research states: "We tried to identify these periods (not the entire sell-off but rather the period over which risk aversion developed) and compared the total return of a 10Y bund future versus that of the Xover index. Our observations give a total return ratio between the two assets in the range of 1x to 1.4x."

Charpin explains: "This is our best estimate of the hedge ratio to use when credit and government moves are correlated. It is important to note that in most of the recent credit sell-offs, credit spreads and 10Y bunds were only correlated for short periods of time over the actual duration of the sell-off."

The hedge is not intended to protect against every spread widening but only those associated with global risk aversion. The 2005 sell-off is the closest the market has been to this and a good directional correlation between 10-year rates and credit spreads was observed then over several weeks.

The UBS research paper goes on to say that hedging a three-month credit position has historically cost around 120cts, which is roughly equivalent to six months of Crossover coupon or about 28bp of spread movement on the index.

As a result, Charpin says: "The hedge is expensive and cannot be used as a 'permanent' hedging strategy. Moreover, the hedge essentially needs 28bp of index widening to pay for itself. This has two main implications: it will only be a mitigating factor to losses occurring in a credit portfolio in the event of a sell-off; and we ought to try and get in the trade relatively early without being too pre-emptive, given that we are only taking three-month options. Timing is therefore a relatively critical issue."

Nevertheless, UBS notes that it is possible to structure protective strategies that minimise its costs, while still protecting against a flight to quality and a rise in bond yields. The hedge can be structured to be zero-cost or in variants that are more or less aggressive compared to spot prices.

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Smoothing structure?

New CDO of ABS could lead the way

Deutsche Bank is marketing an innovative CDO of European mezzanine ABS CDS - Galileo 1 CDO. The deal seeks to take advantage of the significant positive basis currently available to synthetic deals, combined with the lack of ramp-up time required for such structures. The transaction also attempts to underscore the fundamental difference between European and US ABS, and - if successful - could lead to a number of similar deals launching into the European market.

The €730m Galileo 1 CDO, which will be rated by Fitch and S&P, references a pool of 73 equally sized CDS contracts on European ABS. The weighted average asset spread on the pool is reported at 142.6bp and the weighted average rating on the underlying names is triple-B minus.

The portfolio is expected to include both CMBS (accounting for 19% of the pool) and RMBS (81%) - mostly in UK non-conforming (38%), Spanish prime RMBS (33%), Irish RMBS (5%) and UK prime RMBS (5%). The portfolio is static without any redemption or substitution and so does not require a manager.

Galileo is mostly driven by the positive basis between cash and CDS, according to Hans Vrensen, head of European securitisation research at Barclays Capital. If launched successfully, it will take advantage of the recent widening of the European ABS CDS basis and should have an overall calming effect on both the European CDS and cash ABS markets, he says.

"The key point is that this structure is attractive to the originator. When considering various spread scenarios, we note that the excess spread remains positive, even if equity spreads widen to 1500bp. This attractive base case excess spread provides compensation for the originator's risk, but at the same time can be expected to attract more originators," Vrensen explains.

Given the current status of the European ABS market, such excess spread might prove sufficiently attractive that other trading desks and asset managers might want to copy this type of transaction. However, if many other desks follow Deutsche Bank's lead, the working of the markets might reduce the arbitrage or make it less attractive.

But in the short term Barclays Capital believes the transaction will provide a boost to further CDS of European ABS trading, as it would provide efficient funding for sellers of protection. "We believe that this might also dampen the widening of the CDS basis and steady the nerves of the small number of desperate investors that have been buying protection at high spreads," concludes Vrensen. "Finally, this could have a calming effect on the overall cash markets as well, as market participants would be better able to understand the CDS pricing signals. Of course, all this will depend on whether this first deal will sell at sufficiently interesting levels."

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More permacap moves

One vehicle explains NAV dip and another begins share buy-back

Washington Square Investment Management's listed structured credit fund Carador plc announced a 2.5% drop in NAV for June, but pointed to technical pressures and says it is happy with its exposure. Meanwhile, Cheyne Capital's Queen's Walk Investment Limited (QWIL) began a share buy-back programme.

On Tuesday, 24 July, Carador said that as at the close of business on 30 June 2007, the unaudited net asset value per share was €0.9448 – translating into a 2.5% drop in NAV on the month. The investment manager's monthly report explains: "We believe that the round of ABS downgrades by S&P and Moody's which took place at the beginning of July put pressure on month end valuations (which in many cases are produced during the first two to three weeks of the following month). Although the downgrades should not have come as a surprise to any investor, they led to a dramatic trade off in the ABX indices, which was exacerbated by a lack of liquidity. This pressure affected valuations across the board, including loans and CLOs, regardless of fundamental factors."

It goes on to say that the key focus on the ABS market in June was the liquidation of assets held by Bear Stearns' hedge funds and the June remittance data for the components of the benchmark ABX index. "We believe that the Bear Stearns situation highlighted the dangers of financing illiquid assets with short term funding. One of the reasons Carador does not use leverage is this clear mismatch which can exacerbate losses based on margin calls and forced liquidation," the manager adds.

The report continues by looking at the underperformance of the new LCDS indices (LevX and LCDX) versus the cash market, which it suggests is driven by investors using the products to position for potential contagion from sub-prime. "These shorts have, in turn, forced the closure of long loan/short bond spread trades," it says.

Carador believes that this volatility in the loan and CLO market will have a number of positive effects – namely the reduction or disappearance of cov-lite loans in Europe, as well as more conservative lending standards and pricing; increased CLO manager due diligence in terms of team, resources, access to suitable loans and motivations to enter the CLO market; increased investor due diligence on CLOs; and additional transparency.

Overall, Carador's investment manager concludes: "We are still comfortable with our corporate exposure. Moody's reported that the Q207 speculative grade default rate was down to 1.4%, its lowest level in more than 12 years (issuer weighted) and 1.1% (dollar volume basis)... A year ago, Moody's leveraged loan default rate was 1.5%. According to Moody's report, there have been eight defaults in the first half of 2007. We are pleased to report that none of these issuers were present in portfolios owned by Carador."

Meanwhile, following QWIL's announcement of a four-year revolving €135m financing facility (see SCI 48), the vehicle last week held an EGM that enables it to begin a share buy-back programme.

A QWIL statement explains: "The company is now in a position to effect a buy back of its ordinary shares in accordance with the company's existing buy back authority and with chapter 12 of the Listing Rules. As long as the company experiences extremely low liquidity in relation to its ordinary shares, any buy back of ordinary shares on any trading day may be up to 50% of the average daily trading volume of such ordinary shares over the previous 20 trading days."

Since then QWIL has been buying shares on a daily basis. As at close of business yesterday, 24 July, it had bought back 104,125 shares, which have been cancelled – leaving the fund with a total of 40,516,631 ordinary shares in issue.

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Investment manager grows CDOs

The latest company and people moves

Investment manager grows CDOs
Solent Capital, the specialist investment management group, has appointed Desmond Dundon as its cfo and Genia Diamond as investor relations director to support the growth of its hedge fund and CDO businesses.

Dundon has 19 years of finance and operations experience in investment and commercial banking. He joins from Merrill Lynch where he worked for 10 years in London, Tokyo and New York. His roles included that of cfo for the hedge fund development and management group.

Diamond was previously marketing director for global equity at hedge fund manager BlueCrest Capital Management. Prior to this she worked as a research analyst and institutional relationship manager at fund of hedge funds Pacific Alternative Asset Management Company.

Global structuring head hired
Samuel Migus is understood to be joining Unicredit as global head of credit derivative structuring. He joins from ABN AMRO.

Fund manager strengthens fixed income
AXA Investment Managers (AXA IM) has strengthened its UK fixed income team with the appointments of Mark Benstead and Philip Chow as portfolio managers. Based in London, the pair will report to Denis Gould, head of fixed income UK & Asia.

Benstead will join the team responsible for credit strategy and portfolio management. He joins from Royal Bank of Canada Capital Markets (RBCCM), where he spent over 20 years, most recently as md and head of syndicate.

Chow will join the team responsible for rates strategy and portfolio management. Previously at F&C Asset Management as director, UK fixed income, he spent two years managing UK and global fixed income. Prior to this, Chow was head of UK and global spread product at WestLB Asset Management London.

Asset manager adds md
Frederick Horton has joined Cohen & Company the firm as an md, where he will oversee the development of new strategic business opportunities. Horton will be based out of Cohen's New York office and report to Chris Ricciardi, the firm's ceo.

Horton brings 24 years of experience, primarily in asset management, in the structured finance industry. Most recently, he served as a senior md at GSC Group, an alternative asset investment manager focused on credit-driven strategies, where he founded and led the company's structured finance group.

Bank appoints securitisation head
Calyon Credit Agricole CIB has appointed James Siracusa as global head of debt capital markets and Securitisation as of today, July 25th 2007. Based in London, he will report to Guy Laffineur, global head of fixed income and member of the Calyon executive committee.

Siracusa joins from Dresdner Kleinwort where he was a member of the executive committee and of the operating committee for global banking. In his new role, he will be in charge of origination for classical debt capital markets across all asset classes, including emerging markets and will also be responsible for securitisation, debt principal finance and client solutions (covering both hybrid capital and capital structure advice for the bank's clients).

Technology firm takes on credit manager
SuperDerivatives, the multi-asset derivatives solutions provider for real time option pricing, independent revaluation, derivatives data, trading and risk management systems, has appointed Sasha Rozenberg as product manager for credit derivatives.

In his new role, Rozenberg will lead the strategic planning and development of credit derivatives pricing, analytics, trading and risk management for the company's credit derivatives platform, SD-CD. He will be responsible for the credit derivatives component of SD-Funds, the cross-asset pricing and risk management solution for hedge funds; SD-Banks, the multi-asset and cross-asset platform for banks; and SD-Revaluation.

Rozenberg joins SuperDerivatives with over 10 years of experience from Wall Street. His most recent appointment was at Morgan Stanley, where he was a key player in the credit derivatives structuring group. Earlier in his career he worked at JPMorgan as part of the FX and interest rate derivatives research group and at Goldman Sachs in the FX and commodity cross-asset structuring group.

Bank bolsters Asia structuring
The Royal Bank of Scotland has appointed Stanley Ng as md, head of structured investor product development and marketing. Ng joins RBS from Schroders Investment Management, where he held the position of head of structured investments, Asia Pacific.

Ng is joined by Paul Chan as senior director, structured investor products, and Sharon Tan, associate – both formerly with Schroders Investment Management.

Ng will report jointly to Water Cheung, head of treasury and emerging markets for Asia Pacific, and to Robert Begbie, global head of structured investor products in London.

ISDA hires deputy ceo
ISDA has hired George Handjinicolaou as deputy ceo and regional director for Europe, Middle East and Africa. He reports to Robert Pickel, ISDA's ceo and executive director.

Handjinicolaou has held senior management positions in the derivatives and fixed income markets in Europe and the US at several global financial institutions. Most recently he was founder and managing partner of Etolian Capital Management, where he provided consulting services to asset management firms with a focus on initiatives related to municipal derivatives and distressed credit derivatives.

LMA appoints new board members
The Loan Market Association has announced a number of new board appointments. David Slade, md and head of European syndicated loan group at Credit Suisse, was elected LMA Chairman at the board meeting on 18 July 2007.

Meanwhile, the following were elected as new directors at the AGM on 11 July 2007: Chris Porter, head of european loan sales and trading at Bank of Scotland; Matthew Smith, director and head of loan trading at Deutsche Bank; and David Zell, md and head of debt finance and loan syndication at Glitnir Bank.

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Australian funds take further action

A round up of this week's structured credit news

Australian funds take further action
Troubled Australian fund Basis Capital has appointed Blackstone Group to act as financial advisor. Meanwhile, Sydney-based Absolute Capital has suspended two of its funds.

Basis Capital announced on 24 July that the Blackstone Group has been appointed to act as financial advisor to its Basis Yield Alpha and Basis Pac-Rim Opportunity Funds. Both funds have recently suffered from an adverse reaction by some investment banks to a downgrading of US Sub-Prime Assets and CDO's, whereby prices were marked down, negatively effecting valuations, despite continued performance of the underlying assets, Basis Capital says.

Blackstone, a global alternative asset manager and provider of financial advisory services, recently advised Bear Stearns Asset Management on its Sub-Prime Asset Investment Funds. Basis Capital says: "Blackstone's role will include negotiating with investment banks to prevent adverse pricing and selling of assets, as well as add to the international experience of the Funds' investment management and advisory teams."

Today, 25 July, Absolute Capital, a boutique specialist structured credit fund manager, announced that it has temporarily suspended its Yield Strategies Funds, due to the current lack of liquidity in global structured credit markets. The decision relates to the Absolute Capital Yield Strategies Fund (Classes A & C) and the Absolute Capital Yield Strategies Fund NZD. Together the two Funds have approximately A$200m in funds invested.

Absolute Capital's Yield Strategies Funds have investment exposure to structured credit assets including CDOs, credit opportunity funds and Australian ABS. Absolute Capital says: "While the Funds maintain a diversified portfolio of credit investments and do not invest in higher-risk equity tranches of the CDO market, the general lack of liquidity in the market and in particular the CDO debt market backed by senior secured loans where we invest, led to the decision to temporarily close the Funds to ensure equity for, and to protect investors. The credit funds and Australian ABS components of the Funds are performing well."

The manager explains: "We have taken this proactive step as other managers, who have larger exposures, are unwinding positions in the market at this time and we believe it would negatively impact the Funds' investors to become a seller in this market, particularly given the lack of market liquidity.

It adds that there have been few redemption requests in respect of the Funds so far, however, given the reduced market liquidity Absolute Capital believes the Funds are not placed to adequately satisfy or price withdrawal requests. In the event that withdrawal requests are made, withdrawals will not expect to be processed until 25 October 2007.

Absolute Capital says it believes that the long term fundamentals of the segments of the credit markets where it specialises and to which the funds are exposed, such as senior secured loans, remains healthy, with low default rates and a reasonably positive outlook for the economy and corporate earnings.

Systemic false alarm, but continued concerns
The recent turbulence on financial markets associated with the US sub-prime lending crisis has led to some risk reappraisal across credit markets. While it does not reach systemic levels of intensity, there are still serious reasons to worry, according to Moody's in a new report: "Another false alarm in terms of banking systemic risk but a reality check".

The report concludes: "This episode does not trigger systemic concerns at this stage for at least two reasons. First, the core of the system – the financial firms that ensure an orderly flow of financial intermediation – have the ability to withstand the shock. Most of the key financial institutions have a pain threshold considerably higher than even a few years earlier."

The second reason is that the world economy is still extraordinarily dynamic and yet stable with the US economy, while perhaps weaker than in recent years, remaining robust and companies' profitability at very high levels. "Far from being a global margin call as in 1998, this re-pricing is salutary: it instils a more realistic perception of risk. It will restore a steadier balance between lenders and borrowers, and, within lending firms, between risk managers and front offices," Moody's argues.

However, the agency warns that many imperfections of global financial markets are unlikely to disappear. It says that the current global financial system is affected by several structural features or imperfections, which, when combined, trigger or amplify adverse dynamics: the inability of tracking risk accurately and knowing ex ante the distribution and size of losses within the system; recurrent lapses of market depth; the challenges of valuing highly customised financial products; and the difficulty of assessing correlations at times of stress.

LCDS protocol published
ISDA has announced its publication of the 2007 LCDS Protocol. The trade organisation explains that the purpose of the LCDS Protocol is to facilitate the amendment of documentation for loan CDS transactions that reference the Syndicated Secured Loan Credit Default Swap Standard Terms Supplement (the Old LCDS Terms), which were published on 8 June 2006.

For transactions documented under the Old LCDS Terms, adhering to the LCDS Protocol will effect amendments to conform to new documentation standards under the Syndicated Secured Loan Credit Default Swap Standard Terms Supplement (the New LCDS Terms) published on 22 May 2007.

ISDA says adherence to the LCDS Protocol will achieve the following: (1) incorporating the New LCDS Terms in place of the Old LCDS Terms; and
(2) adopting the new form of Syndicated Secured Loan Credit Default Swap Physical Settlement Rider published by The Loan Syndications and Trading Association as of 18 June 2007.

The Protocol is open to ISDA members and non-members alike. The adherence period for the Protocol runs from 24 July to 24 August 2007.

SIVs offer stability
Structured Investment Vehicles (SIVs) have key features that should enable their ratings to remain stable at this time of turbulence in the US sub-prime housing market, says Moody's Investors Service in a new report.

According to the Moody's report, entitled "SIVs: An Oasis of Calm in the Sub-prime Maelstrom", market participants – including SIVs and related hybrids – have conducted re-underwriting exercises across their portfolios following the recent wave of downgrades and watchlistings of securities backed by US sub-prime mortgages. Such exercises are to ensure that there are no hidden pockets of sub-prime exposures within the vehicles.

SIVs and SIV-lites that invest in US RMBS and CDOs of ABS do so predominantly at the Aaa and Aa levels, notes the report. Meanwhile, the strict pricing and reporting discipline observed by the vehicles ensures that net asset values (NAVs) are reflective of asset market values within the funds.

Furthermore, the vehicles are not structured to forcibly liquidate assets in times of crisis. "Even in the face of a rapid and dramatic deterioration in NAV that results in an inability to roll liabilities, SIVs and SIV-lites may, prior to liquidating the portfolio, draw down on committed liquidity, withdraw breakable deposits and extract asset-based liquidity," says Henry Tabe, a Moody's md. "This obviates the need to liquidate large buckets of assets at potentially the worst period in the life of the vehicle."

Tabe concludes: "We therefore expect ratings in the SIV and hybrid SIV sectors to remain stable amid the current maelstrom surrounding the US sub-prime housing market."

DBRS undertakes mid-year review
DBRS has announced its mid-year review for 2007, which identifies a number of topical issues in structured finance, including the relevance of the US sub-prime market for the UK; leverage and volatility in the structured credit market; and structuring corporate assets and arbitrage.

On leverage and volatility in the structured credit market, Kai Gilkes, md, EMEA structured finance quantitative group, comments: "DBRS believes that the true extent of the sub-prime problem will take some time to fully emerge, but credit fundamentals are still solid in many areas, most notably the corporate sector. That said, while credit problems may still be some way off, there are real concerns about a near-term reduction in market liquidity."

Rating volatility is a key concern for investors right now, due to the impact of the US sub-prime market. The crucial requirement for ratings agencies is to be transparent about the leverage and the risk it entails – and that is what DBRS says it intends to be.

New SME CDO performance tracker
Fitch has announced a new format for its pan-European SME CDO performance tracker report. The main report is in PDF-format, highlighting issuance and performance trends on all public European SME CLOs rated by the agency. In addition, to provide increased transparency to the market, this report is accompanied by an extensive performance data file which provides the underlying analytical data and additional information on each transaction.

From January to May 2007, SME performance remained strong; however, some specific trends can be noted in particular for the Spanish balance sheet segment and German mezzanine SME CLOs. The Spanish SME CLO segment is under close surveillance due to the strong concentration of loans from the real estate and construction sector in most collateral pools.

However, default and delinquency levels have remained generally stable to date. On new Spanish balance sheet transactions, the collateral pools include new, riskier loan products.

This change has caused Fitch to re-consider the level of expected recoveries. Further defaults in the German mezzanine SME CLO segment threaten performance, but ratings have been stable to date due to structural protections holding up. So far only one tranche – StaGe Mezzanine Societe en Commandite Simple's Class B – has been placed on rating watch negative, in January 2007.

Sub-prime rating actions...
On 19 July S&P placed its ratings on 17 tranches from eight US cashflow and hybrid CDO of ABS transactions on credit watch with negative implications, following the downgrade of 418 classes of US RMBS backed by closed-end second-lien mortgage collateral. All but one of the eight CDO transactions with ratings placed on credit watch were issued during 2006; the remaining transaction was issued in 2003. Two of the eight are high-grade SF CDOs of ABS and the remaining six are mezzanine SF CDOs of ABS.

On the same day, S&P lowered its ratings on 93 tranches from 75 US CDO of ABS transactions. The downgrades follow a review of all of Standard & Poor's rated synthetic CDO transactions with exposure to US RMBS backed by sub-prime first-lien collateral that saw ratings lowered on 12 July (see SCI issue 48).

Then on 23 July S&P placed its ratings on 33 tranches with a total issuance amount of US$1.76bn from a further eight US cashflow and hybrid CDO of ABS transactions on credit watch with negative implications. All of the affected CDO transactions have exposure to US RMBS backed by first-lien sub-prime mortgage collateral.

In addition, all eight transactions are mezzanine SF CDOs of ABS. Seven of the eight transactions were originated during 2006, and the remaining CDO was originated in 2007.

Meanwhile, Fitch Ratings has placed 26 classes from 12 SF CDOs on rating watch negative for potential downgrades. The agency also maintains 41 classes of 23 SF CDOs on watch negative. These actions affect approximately US$603m of CDO notes issued from US$4.8bn of mezzanine SF CDOs issued between 2001 and 2006.

To date the cumulative tranches placed on rating watch negative resulting from sub-prime RMBS credit deterioration by Fitch total approximately US$1.4bn of CDO notes from US$16bn of SF CDOs.

...And SROC changes
Following its June 2007 SROC (synthetic rated overcollateralisation) review, S&P has taken credit rating actions on 32 European synthetic CDO tranches.

Specifically, the agency has taken the following actions: ratings on five tranches were removed from credit watch negative and lowered; ratings on nine tranches were lowered and remain on credit watch negative; the rating on one tranche was removed from credit watch negative and affirmed; ratings on 16 tranches were removed from credit watch positive and raised; and the rating on one tranche was removed from credit watch positive and affirmed.

S&P also announced its review of its SROC June numbers in Asia. There, it lowered its ratings on two Asia-Pacific CDOs (both of which remain on credit watch with negative implications) and raised the rating on one other CDO. In addition, the ratings on five CDOs were affirmed and removed from credit watch with negative implications, while the ratings on two other CDOs were affirmed and removed from credit watch with positive implications.

MP

Trading ideas - bonds out of line

John Hunt, research analyst at Credit Derivatives Research, looks at a Vodafone Group bond switch

With markets widening amid continuing uncertainty on a number of fronts – from sub-prime to LBOs – we recommend a narrowly focused, technically driven trade.

Vodafone's CDS indicate that the VOD 5.375s of January 2015 are trading cheap to fair value while the 5.35s of February 2012 are trading rich, so we recommend buying the 2015s and selling the 2012s, collecting 5.4bp of positive carry on a US$10m notional, and awaiting a return to fair value, which we would expect to bring in 27bp of profit.

Trade Rationale:

Bond cheapness and richness
We can judge fair value for bonds by looking at the probability of default implied by the issuer's CDS of the same maturity of the bond. (Because an issuer usually will not have liquid CDS trading with exactly the same maturity as the bond under examination, the comparison usually requires some interpolation of CDS spreads.)

This information can be combined with the term structure of risk-free interest rates and the bond's coupon to determine the fair price for the bond implied by the CDS market. Based on this framework, we recommend a cheap-rich pair of bonds to trade against one another.

As Exhibit 1 shows, Vodafone Group plc. 5.375s of January 2015 are currently trading cheap to the price implied by the Vodafone CDS term structure, and the Vodafone Group plc 5.35s of February 20212 are trading rich to their CDS-implied value.

Exhibit 1

Exhibit 2 compares the z-spreads of each bond to the spread of the CDS for the same maturity. (Because there are no liquid CDS trading with exactly the same maturities as the bonds, this exercise requires interpolation.) 

Exhibit 2

The z-spread is defined as the additional amount beyond the risk-free rate by which each cash flow of the bond must be discounted to arrive at the bond's market price, and serves to some extent as a proxy for the bond's credit risk. The z-spread of the 2015 bond is greater than the interpolated credit spread of the equivalent maturity CDS, and the z-spread of the 2012 bond is less than the interpolated credit spread of the equivalent maturity CDS.

Time series
Exhibit 3 presents the time series of the two Vodafone bonds and of their differential since issuance of the 2012 bond in February of this year. This widening of the differential reinforces our view, based on CDS spreads, that the 5.375s of January 2015 have become cheap relative to the 5.35s of February 2012. We would expect the difference to converge over time to a level consistent with the differences in CDS spreads for the two maturities.

Exhibit 3

Trade economics
The trade has carry of 5.4bp (relative to a US$10m notional, i.e., carry of US$5,400 in the recommended size) at current levels. If there are no changes in the credit curve, the position will experience rolldown gains. The position also will benefit if the bonds converge toward the fair values implied by the CDS curve.

As discussed above, the position benefits if the credit curve flattens over the range of maturities of the two bonds and is harmed if the credit curve steepens over that maturity range.

Specific trade issues:

Risk analysis/hedging
The trade is constructed to be duration neutral, so it is hedged against parallel shifts in interest of credit curves, but it is a natural flattener because it consists of buying a longer-maturity bond and selling a shorter-maturity bond. Thus, the trade position will suffer if the risk-free yield curve or the Vodafone credit curve steepens in the range of 4.5 to 7.5 years.

Execution risk is present in every trade, but the bonds here appear liquid, with good quantities and bid-ask spreads showing on our pricing sources.

The trade is not neutral with respect to default, but at current pricing we expect the position to benefit from a jump to default, as the bond we recommend shorting is of equal seniority to the bond we recommend buying but trades at a higher price. If both bonds converge to the same recovery value, the short position will gain more than the long position loses.

Liquidity
Vodafone's bonds show strong liquidity. Both issues are sizable (US$900m outstanding for the cheap 2015s, US$500m for the rich 2012s) and show good availability in dealer inventories. Both bonds regularly trade in size – 30-day average volume is US$4.4m for the 2016s and US$3.4m for the 2013s.

Fundamentals
Although the trade is technical in nature, changes in Vodafone's overall credit may have different effects on different bonds, so we briefly review the company's fundamentals.

Dave Novosel, Gimme Credit's Telecommunications expert, maintains a "Stable" credit score on Vodafone. Vodafone faces pricing pressure, especially in Europe, issued a large special dividend during the last year, and has been pursuing an aggressive campaign of emerging-market acquisitions that could harm the company's credit profile in the short term. In Dave's view, these negatives are offset by the company's dominant international position in the critical wireless segment.

Deterioration of the credit may lead to steepening of the credit curve, which would hurt the recommended position.

Summary and recommendation
We recommend another narrowly focused, technically driven trade – buying VOD bonds that are cheap relative to what the CDS market implies and selling bonds that are rich compared to the CDS level.

Buy US$6.7m of Vodafone Group plc 5.375s of 1/30/2015 and

Sell US$10m of Vodafone Group plc 5.35s of 2/27/2012

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).

Ball in the bowl - part 1

In this two part series, the tail risk of CDOs is examined by Matt King and Michael Hampden-Turner of the credit products strategy group at Citi in London

Investors have long struggled to understand the risks on structured credit relative to plain vanilla corporate bonds. Spreads on many structures – or even on plain old ABS – are typically higher than those of corporates of the same rating. Where does the extra spread come from? And what does having the same rating really mean?

Recent rating activity in sub-prime ABS has brought these questions into the spotlight. The prospect of widespread, and in some cases dramatic, downgrades is liable to leave investors complaining that the rating agencies have not been doing their job. But are agencies to blame, or are unpredictable shocks an inherent feature of structured credit products?

This report aims to shed light on the issue, not only by considering the fundamental nature of the risks in structured (and in particular tranched) credit, but also through an empirical analysis of historical rating transitions on different types of structured credit relative to corporate bonds.

We argue that the best way to understand the risks on structured credit is through an analogy: that of a ball in a bowl. Nudge the ball gently, and structured credit turns out to be considerably more stable than its plain vanilla equivalent. Nudge it harder, though, and at a certain point the ball falls out. The greater the number of layers of tranching, the more abrupt (and harder to predict) that transition tends to be.

What is more, the nature and location of this tipping point varies considerably from one type of structured credit to another, and between managed and static deals. A proper understanding of these characteristics and reconciliation with investors' risk appetites can ensure that structured credit returns are superior to those in ordinary corporates. A failure to appreciate these characteristics increases the risk of financial losses.

Same rating different spread
In a risk-neutral world we would expect assets with identical risk profiles to carry similar spreads. In practice, spreads vary significantly between assets with identical ratings, especially between cash assets such as corporate bonds or ABS and structured credit products such as CDO tranches. Figure 1 gives an idea of the huge variation in AAA spreads on different product types. The spreads on corporate bonds or CDS are much tighter than those on securitised products such as RMBS, ABS, and CMBS. These in turn are much tighter than structured credit products such as CLOs and CDOs.

One often sees arguments that this is a complexity premium or that it is due to the fact that there is a smaller universe of investors that can invest in structured products. However, significant differentials can be observed within the set of structured products. AAA CLOs in Figure 1, for example, have half the spread of optimised CSOs, even though CSOs are much less intricate structures. Some investors are unable to buy synthetics, but we are still left with the feeling that such an explanation is, at best, incomplete.

This quick comparison of these spread differences prompts the question: Are there fundamental characteristics of structured credit that warrant higher spreads?

Understanding the characteristics of structured credit
The schematic diagram above in Figure 2 illustrates the difference in risk profile between a BBB mezzanine tranche (3-6%) of a CDO and a large portfolio of BBB credits. As losses occur, the portfolio of vanilla credits suffers instantly, while losses to the CDO are buffered by the equity tranche. The 3–6% tranche takes no loss until the 3% of losses have been absorbed by the equity tranche. So, in the graph we can see that the return of the tranche is more stable than the vanilla credit portfolio – up to a point – after which loss occurs more rapidly.

Figure 3 above illustrates the same concept, but for different tranches. Junior tranches offer a high return, but a small increase in the default rate of the underlying portfolio means that they reach their tipping point quite quickly. In comparison, more senior tranches are deeper out-of-the money and will not be affected in the same way if the realised default rate turns out to be higher than the initial assumed default rate. In addition, they tend to be larger, meaning that the rate at which losses eventually accrue is also slower than for a typically narrower mezzanine tranche.

Conversely, Figure 3 also illustrates that a CDO-squared will have a faster rate of loss, making it almost binary. Although it will normally take a greater number of defaults for it to take any losses at all, as mentioned above, a larger number of layers of tranching does tend to make the point where the ball "falls out" all the more sudden. We might expect such tail risk not only to help explain the higher spreads on structured credit, but also to manifest itself in terms of greater volatility.

Are CDOs more volatile than comparable assets?
Empirical analysis of MTM and rating volatility of CDOs lends support to such a hypothesis. CDOs are less volatile in normal market conditions but can be more volatile than bonds or ABS in infrequent stress periods.

For example, the graph in Figure 14 is a histogram of the daily MTM moves of a pool of 5yr iTraxx BBB CDS relative to a 5yr iTraxx BBB tranche. The graph illustrates how, in general, the BBB tranche is less likely to make a small MTM move but is more likely to have large MTM moves; that is, it has fatter tails.

This analysis is a little limited in terms of scope and the available history. What if we extend it to the rest of the CDO market? Unfortunately, observing MTM volatility is difficult in cash CDOs, but it is possible to observe rating volatility. Rating upgrades and downgrades are a reasonable proxy for MTM volatility, and for many cash CDO investors are probably more important.

We have therefore gathered together information on a large number of CDO rating transitions and compared them with both ABS and ordinary corporate bonds. We have collated it by rating type as well as by product type to gain a picture of the relative volatility of different types of investment. We have also divided the data by year so we can see how performance has varied through good and bad years.

As there is a lot of information we have tried to summarise it as a series of trends. In the next section, we provide our observations.

CDOs are less likely to suffer small downgrades than bonds, but more likely to suffer big downgrades
This stability is illustrated by the graphs in Figures5 and 6. Figure 5 illustrates the probability that a AAA tranche or bond is downgraded to AA, A or beyond in the course of a year. Similarly, Figure 6 illustrates the probability that a BBB tranche or bond is either upgraded or downgraded in the same time period. At first glance it seems that CDOs have been more stable than bonds. However, when we truncate the graph to make it easier to see what is going on in the tails, a more complex relationship is revealed.

The graph on the left illustrates the way in which BBB tranches are less likely to move a single grade, but the probability of a larger move (down or up) is greater than it is for bonds. This is precisely what is predicted by the "ball in the bowl" hypothesis: tranches are more stable for small market shocks, but have a greater capacity to fall out of the bowl; in other words, they have more tail risk.

Figure 6 illustrates the same analysis for AAA CDOs. The graph shows that the probability of a downgrade to AA is lower for CDOs than for bonds. However, in the two decades that make up our data there has not been a push hard enough to completely knock a AAA ball out of the bowl. It is hard to see, but the BBB point probably does indicate the beginning of a fatter tail for the CDO data.

Relative rating volatility between different CDO types
Comparing rating volatility between product types adds greater depth to this analysis and provides a framework for thinking about the inherent risks in certain types of structures. We use these comparisons to see how tail risk has manifested itself historically for different collateral types.

Figure 7 illustrates how synthetic CDOs tend to have greater rating volatility relative to cash CDOs. The bulk of this volatility comes from synthetic single tranches (CSOs), which have historically been the least stable CDO category.

Figure 8 breaks these rating stability figures down further. It illustrates that cash CLOs and ABS CDOs have been the most stable category of CDOs. The structural credit protection that CLOs and mezz ABS CDOs provide has created one of the most stable asset classes from pools of poorly rated debt.

However, it is worth stressing that these statistics are misleading and they certainly do not seem to strengthen our ball-in-the-bowl hypothesis. Standard & Poor's has compiled the numbers using weighted averages. Although this is methodologically sound, it results in a significant bias towards very recent performance, as we shall see in the next section.

Recent issuance dominates statistics on CDO stability
The huge volume of deals issued in the last few years dominates the statistics. Consider the chart in Figure 9. The blue line illustrates how in the past three years issuance has doubled every year. Therefore, any sort of weighted average – and hence the stability figures shown above – are dominated by the bull market in credit, characterised by tightening spreads and corporate upgrades.

However, an unweighted analysis is also biased to the different state of the market in the period 2000–2003. The graphs in the table below illustrate the way in which the structured credit market has changed over the last seven years. Figure 10 shows the growth of the CDO market, and Figure 11 the change in the nature of the underlying collateral. In Figure 11 we can see the way in which there has been a transition from primarily high-yield to high-grade assets. For example, HY CBOs, which were a dominant feature of the landscape at the start of the decade, have almost completely disappeared from view.

The significance of this transition is that any study of rating stability is analysing a moving target, as the nature of deals changes significantly. Therefore, it is important to break the market down into sub-categories and analyse these separately to gain a better understanding, which we will do in part 2 of this article. One insight this process provides, for example, is how certain types of structured credit perform in a credit downturn.

© 2007 Citigroup Global Markets. All rights reserved. This Research Note was first published by Citigroup Global Markets on 18 July 2007.