Contents

CDR Liquid Index data as at 30 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.

Concern returns

Index spreads gap out again, but opportunities seen elsewhere

After a dramatic recovery during Europe's day yesterday, 31 July, when Crossover closed at 400bp (having touched 500bp less than 24 hours earlier), the index markets gapped wider during the US afternoon as sub-prime concerns returned following new details of mortgage insurers' and related funds' potential losses. Despite dealers characterising the news as "more of the same", all US indices closed wider yesterday and Crossover was trading mid-day today, 1 August, at 458bp.

Continued index volatility is also having a knock-on effect on the behaviour of individual names. Notably, in the US CDX IG index, the spread blow-up in the housing sector and the higher levels of event risk, have increased the credit dispersion or the tendency of the basket constituents to move in an uncorrelated fashion.

Priya Shah, structured credit analyst at Dresdner Kleinwort, explains: "The US CDX IG basket is currently more heterogeneous than the European iTraxx basket. This has some implications when hedging igamma in long correlation trades, as the delta-hedging with the index or another tranche of the same capital structure, becomes an incomplete tool."

She continues: "Natural long correlation investors have already had an impact on the widest US trading CDS spreads, whose curves have flattened due to increased protection buying primarily on the 5-year maturity. The impact of dispersion on the return of these trades is likely to rise in the CDX basket until it rolls in September, whereas it is likely to have a lower impact in the European index, which has only one name trading very wide – Alliance Boots."

Nevertheless, credit fundamentals remain sound and other credit sectors away from the indices remain attractive. For example, the secondary CLO market offers decent buying opportunities now, according to research published by the Royal Bank of Scotland (RBS) on 31 July.

"While investors will have to handle headlines and volatility, on a three-month plus view these bonds will outperform. We are seeing loans being bought in secondary, Citadel has signalled that hedge fund problems are not uniformly spread, corporate results are hitting or beating expectations and corporates are raising their full year outlooks. This widening is technically driven, and unless corporate defaults rise dramatically, well managed European CLOs will perform," RBS says.

The primary CLO market is expected to be crowded in September and investors will be able to be very selective about the bonds they buy.

Meanwhile, the underlying primary loan market appears to be dividing into two camps at present. Smaller deals are generally progressing through syndication, albeit at a much slower rate and with the assistance of upward flexes and the introduction of original issue discounts. "However, for larger transactions, the markets appear to have shut-up-shop until September, as illustrated by the decision to postpone the syndication on the Boot's senior debt," RBS concludes.

MP

European LCDS documentation published

New template should boost market

ISDA has published a documentation template for credit default swaps referencing European leveraged loans. The move appears to bring to an end more than a year's heated debate over a standard LCDS contract in Europe (SCI passim) and should bring increased liquidity to the market.

The ISDA Standard Terms Supplement for Use with Credit Derivative Transactions on Leveraged Loans is designed to document credit default swap transactions where the reference obligation and the deliverable obligation are a European syndicated secured loan. The form is primarily intended for use in the European market.

ISDA says it has previously published a documentation template for credit default swaps referencing US leveraged loans. The European form differs in several respects from the form published for the US market, reflecting the different market environments.

For example, while the US form is a reference entity-based contract, the European form is a reference obligation-based contract in that it refers to a specific credit agreement rather than all loans of a particular reference entity. Another difference is that the European contract relies on determinations made by the calculation agent, rather than by reference to a trading standard determined by dealer polls.

Even though it relates to a specific credit agreement, the European contract is structured so that it will continue after the refinancing of the reference obligation, referencing instead the new loan (or loans) that refinanced the original reference obligation. The parties may, however, elect when they enter into the loan CDS transaction that the contract will cancel if a refinancing occurs.

The new template appears to have resolved most of the issues that have caused market debate over the past 12 months, according to Shane O'Gorman, director and LCDS trader at Credit Suisse in London. "The biggest problem was that there was no consensus, and consensus has now been reached. Equally, the document that was previously being used was not an official ISDA product, which discouraged some new entrants and therefore liquidity. And the new one also gives more duration to the product, which is what people wanted," he says.

O'Gorman continues: "We start trading next week, but it will probably take a bit of time to feel its way out and gain traction given the current volatile environment. Some of the dealers have been understandably distracted so a few of the new entrants we expect may take a while to come to market. But it's a product that will be here for years, so that's not a key issue."

Indeed, Robert Pickel, executive director and ceo at ISDA, comments: "Volumes continue to grow in US loan CDS, based on standardised documentation produced by ISDA for single-name and index trading. We believe that the publication of this standard document will provide the necessary stimulus for similar success in Europe."

The next stimulus for growth in the European LCDS space will be a revised index contract. As O'Gorman says: "The next big event will be a new LevX contract. There is a bit more work that has to go into that behind the scenes, but it should be in place before the next index roll on 20 September."

MP

Innovative managed CDO launched

First of a kind managed structure and unusual junior notes priced

Wachovia Securities has closed AIG-MezzVest II CLO, which is believed to be the first managed-to-model cash CDO. The deal is also unusual as it offers variable funding notes at the junior level.

The transaction, which was rated by both Moody's and S&P, features a cash CLO structure driven by a dynamic bespoke trading model that is run by the manager for borrowings, paydowns, asset reinvestments and waterfall payment calculations. The collateral portfolio, of up to €1.15bn, is comprised primarily of European leveraged loans, PIK loans, high yield bonds, synthetic securities and equity investments.

AIG-MezzVest II offers five classes of rated notes plus a residual non-rated €296m tranche. The rated notes comprise of €450m triple-A rated Class A1 (variable funding) notes, which printed at 28bp over Euribor when drawn (and at 12.5bp when undrawn); €180m triple-A rated Class A2s at 40bp; €95m double-A rated Class Bs at 60bp; €95m single-A rated Class Cs at 90bp; and €30m triple-B rated Class D (variable funding) notes at 175bp when drawn (and 60bp when undrawn).

The portfolio is dynamically managed by MezzVest Manager II Ltd, a wholly owned subsidiary of CapVest Ltd, a limited liability company organised under the laws of England and Wales. The portfolio was partially acquired at the closing date and can increase in size up to its maximum capitalisation amount as revolving Class A1 and Class D facilities are drawn to the full capacity during the four-year reinvestment period.

Any amount of a credit under a revolving facility which is repaid or prepaid may subsequently be re-borrowed at any time prior to the end of the reinvestment period, subject to applicable conditions. Amounts repaid or prepaid under the facilities that are not revolving facilities may not be re-borrowed.

According to analysts at Moody's, during the reinvestment period the portfolio will be actively managed and the portfolio manager will have the option to buy or sell assets in the portfolio. Any borrowing or repayment under the facilities will be subject to, among other criteria, the coverage test and trading model test verified by the Bank of New York (BoNY) in its capacity as collateral administrator.

The model is run both before and immediately after any amounts of a facility are borrowed, prepaid or repaid to ensure that the facility maintains a computed expected loss compatible with the rating assigned at closing. In other words, the transaction is modelled through time, rather than modelling a worst case scenario at close on the basis of various constraints – which is the case for typical CLOs. No assets will be acquired after the end of the reinvestment period.

S&P's pre-sale report adds that the trading model also incorporates its cashflow stresses and criteria. The trading model must comply with S&P's requirements for the manager to take any action under the portfolio and the facilities.

Following the fifth anniversary of the closing date, the coupon steps up on all the classes of notes. As long as the trading model test and the coverage tests are in compliance, the collateral manager is not in default, and no termination event has happened under the facilities, the issuer can make drawings and repayments under the facilities in a non-sequential order. Following any termination event or a default by the collateral manager, the facilities redeem on a sequential basis.

MP

Structured credit hedge funds suffer

Latest index figures show reversal of fortune

Both gross and net monthly returns for June 2007 in the Palomar Structured Credit Hedge Fund (SC HF) Index dipped significantly. Furthermore, a significant revision of the May SC HF index figures was required, mainly as a result of one fund changing its May returns from a slightly positive initial estimate to a substantially negative one.

The latest figures for the index were released this week and show a gross return of -6.88% for June, while the net return was -7.01% for the month. Meanwhile, the index for May was revised to -2.04% gross and -2.16% net, previously shown as +0.69% gross and +0.51% net.

Nevertheless, both the gross and net indices continue to show positive cumulative returns since calculations began in January 2005, of 108.71% and 103.18% respectively. For more Index data click here.

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

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

MP

Diversification, where art thou?

Cross-market correlation is discussed by Anu Munshi, a partner at B&B Structured Finance

There was a time, not so long ago, when it was relatively easy to observe patterns in markets and to diversify one's investments away from those patterns. Today, not only has the negative correlation between equity and fixed income broken down, but in certain periods, it has inverted to positive correlation.

Consequently, in the search for yield and diversification, investors move to more esoteric asset classes such as emerging markets, real estate, private equity and hedge funds. The movement of money into these hitherto illiquid areas of investment attracts fund managers to set up funds in these asset classes. Not only does this boost their liquidity, but it reduces their returns over time, as more money drives more funds to chase the same opportunities. All of which perpetuates the first-mover advantage.

As alternative asset classes become more liquid, permitting greater inflows and outflows of capital, we need to drill deeper to see if they truly diversify the investor from traditional asset classes. Real estate is cyclical since it is dependent on interest rates. Lower interest rates encourage home buyers to take out mortgages on new or existing homes, which drives up real estate prices. Emerging markets are cyclical, because they are subject to sovereign risk which is dependent on the macroeconomic environment.

Private equity, which is today financed primarily through LBOs, is dependent on low interest rates to minimise the cost of borrowing, and is therefore also cyclical. Hedge funds shouldn't be cyclical, given they target absolute returns and should therefore be uncorrelated to equities and fixed income.

But with increasing capital inflows into hedge funds and subsequently new entrants to the market, it is becoming increasingly difficult for hedge funds to find arbitrage opportunities. Many hedge funds today make their returns by taking outright directional risk. Add to the mix the fact that many hedge funds are active in leveraged structured credit products, and you end up with a return profile that could be as cyclical as a long-only fund manager.

The recent fallout in the US sub-prime mortgage market has only heightened the contagion effect across asset classes. Consider the following chain of events... A few sub-prime mortgage lenders in the US filed for bankruptcy, which caused the ABS securities backed by such sub-prime mortgages to fall in value. Hedge funds that had bought CDOs that referenced these ABS securities consequently suffered losses, particularly because they had bought such securities on margin (Bear Stearns AM's two funds being the most high profile example).

As margin calls kicked in, initial efforts to liquidate the CDOs in hedge fund portfolios caused their prices to gap lower and acted as a stern reminder of the downgrade and liquidity risk to CDO investors, who in turn have started to back away from the product or demand higher returns. This means they have also backed away from, or demanded higher pricing on, CDOs backed by leveraged loan portfolios.

As the CDO bid for leveraged loans has abated, some of the more aggressively priced or structured private equity-driven loan financings have been stalled. And banks that were involved in arranging these deals have now found themselves having to hold millions of dollars worth of high yield loans on their balance sheets.

This cycle covers real estate, structured credit, hedge funds, leveraged loans and investment-grade financials in the space of only six months, and illustrates only too painfully the fact that we are now in a low interest rate-driven playground full of bubbles and dominos. Prick one at your peril.

While it's easy and convenient to blame hedge funds and investment banks for many of the ills we see today, it's important for investors to think about how they can better equip themselves to perform in today's increasingly interconnected markets. They can do this primarily by keeping themselves informed of market trends and developments and by truly diversifying their investments.

On market developments, consider how CDOs have affected the pricing of a variety of asset classes, from triple-A rated ABS to investment grade corporate bonds to high yield leveraged loans. As a long-only corporate bond fund manager, understanding the CDO market would equip you to understand the forces that drive the pricing on the bonds you deal with in your fund, even if you can't or won't ever buy a CDO. An understanding of the mechanics and structure of leveraged loans would help an equity analyst better understand the ultimate structure of the company that he/she is evaluating.

On diversification, the big question is where can one turn to for diversification? To answer that question, we need to ask another simple question: why do investors diversify? Diversification is driven by the need to reduce exposure to directional risks and to therefore smooth returns. But given diversification was traditionally carried out by investing in illiquid but higher-paying asset classes, greed for higher returns entered the equation somewhere along the way.

If a hedge fund pays 1% more than bank deposits, but does so whether the markets go up or down, it is a sound diversification investment. But a hedge fund that pays 5% more than bank deposits is far more attractive. True, but this additional return comes with some additional risk, be that directional risk or leverage. The aggressive fund may provide 5% over deposits for a few years, and indeed some hedge funds do that and better, but most of the time markets will catch up with the fund.

This is not to say that greed is bad. The message is be clear about what you're after, and invest accordingly. You are unlikely to find an investment that pays you better and has less risk and volatility than the comparables. But if you find it, hold on to it. And more importantly, remember that the next thing that comes along that looks and smells like it is unlikely to be the real thing.

If investors are indeed motivated by reducing exposure to directional risks, they need to spread their investments over regions, sectors, maturities and asset classes. This sounds complicated and it is. And it's why fund managers get paid management and incentive fees.

For investors with limited resources, one of the potential areas of diversification is hedge funds. But these are hedge funds that don't necessarily have the highest returns. What they provide is stable cash flows irrespective of the market. The skill then lies in identifying such hedge funds.

The repeated mention of derivatives, hedge funds and leverage in the context of today's troubled markets gets many thinking that they form the financial axis of evil. But the truth is that they provide many benefits to a wide variety of market participants and, in fact, aid diversification – derivatives allow investors to mitigate risk, hedge funds can be a good diversification investment and leverage allows hedge funds to generate good returns while taking minimal directional risks.

However, investors need to realise that they come with risks. And while it's easy to forget those risks in benign markets, the recent volatility across markets acts as a good reminder of those risks. All roads eventually lead to the phrase that is now more relevant than ever: caveat emptor.

©B&B Structured Finance Ltd 2007. All rights reserved. B&B Structured Finance is a consortium of market professionals that provides complementary services of strategic consulting and financial product training, specialising in structured products.

Bank adds to ABS correlation

The latest company and people moves

Bank adds to ABS correlation
Peter Nowell has left his role as ABS trader at Royal Bank of Scotland. He is understood to be joining the ABS correlation trading team at BNP Paribas.

Correlation trader move
Dresdner Kleinwort is understood to have hired Ed Selby from Barclays Capital as a senior correlation trader. He is believed to be joining the firm at the end of September and will be reunited with his former Merrill Lynch boss Neil Walker.

Ratings head switch
R. Ravimohan, md and ceo of CRISIL, India's ratings, research, risk and policy advisory company, has been appointed md and region head in South Asia of S&P. He will continue to be a director on the board of CRISIL.

Ravimohan will be succeeded by Roopa Kudva, currently CRISIL's executive director and chief rating officer. Both appointments take immediate effect. Kudva has now been inducted into the CRISIL board as a full-time director.

Law firms make structured finance appointments
McDermott Will & Emery has hired Kate Lamburn as a partner in its London securitisation and structured finance group, and has added two associates to the same group. Meanwhile, Sidley Austin has appointed three partners to its structured finance and securitisation practice in London.

Lamburn joins McDermott from Ashurst in London, where she was previously a partner in the securities and structured finance group and then subsequently the director of professional development for that group. She specialises in cash and synthetic CDOs, and other structured debt products.

Jonathan Edge, Theresa Kradjian and Paul Matthews have all been elected to the partnership in Sidley Austin (UK) from existing roles within the firm.

Edge represents issuers, underwriters, portfolio managers and trustees in a variety of transactions, including CDOs, SIVs, CLNs, warehousings, accumulation swaps and hedging transactions. Kradjian's practice is focused on a broad range of mortgage-backed and asset-backed securitisation and structured finance transactions.

Matthews' practice, meanwhile, focuses on repos and derivatives – credit derivatives in particular. He has been active in the credit derivatives market, advising portfolio managers and monoline insurance companies, and in the synthetic securitisation market, advising portfolio managers, underwriters and investors.

Moody's creates project finance group
Moody's has announced the creation of a dedicated, cross-disciplinary analytical group focusing on project finance. The agency says it aims to meet the needs of market participants looking to ratings to assess credit quality in support of primary bank and bond distribution, as well as to supplement the risk models of both financial guarantors and arrangers in the emerging project finance CDO sector.

The new group will be led by Thomas Keller, group md. Reporting to Keller are Bart Oosterveld, svp, who has been appointed as chairman of the project finance credit committee, the aim of which is to set policies that govern the rating process for project finance. Three regional project finance team leaders have also been appointed: EMEA – Andrew Davison, vp and senior credit officer; Americas – Chee Mee Hu, svp; and Australia and Asia – Terry Fanous, svp.

Quant software and services firm hire
ClariFI, an S&P Capital IQ business and provider of software and services focussed on quantitative portfolio management and research, has announced the addition of Andrew Hicks to its business development team. Based in the London office, Hicks will be responsible for growing and supporting the client base in that region and expanding ClariFI's presence throughout Europe.

Prior to joining ClariFI, Hicks was an analytics business manager at UBS, where he gained experience in business development, software design, and staff management. He also has a deep knowledge of optimisation, factor analysis and risk management, as well as arbitrage calculation and derivative research, and has experience in equities and fixed income.

MP

Permacap announcements

A round up of this week's structured credit news

Permacap announcements
Three of the London Stock Exchange listed structured credit permanent capital vehicles (SCI passim) made announcements this week.

Washington Square Investment Management's Carador plc announced a proposed dividend and gave some insight into market views, as well as the vehicle's correlation with other asset classes, in its preliminary results. Carador's board says that it intends to pay a further interim dividend of 1.9 cents per ordinary share for the period to 31 March 2007. It is proposed that the dividend will be paid on 28 September 2007.

At the same time, Carador's investment manager report published in the firm's results last Thursday gave its outlook for the CLO and sub-prime sectors. In the corporate CLO sector, it says: "The key risk, in our view, is idiosyncratic risk and access to collateral. In conclusion, we will focus on sourcing CLOs priced last year, with tighter liabilities, which are still priced at attractive levels."

On sub-prime it says: "We will continue to be cautious in this market, as we may only get enough data to quantify the extent of the 2006 sub-prime problems in late 2007. We continue to look at potential opportunities in older vintages."

The report goes on to estimate the correlation of daily returns between the Carador share price – and by inference CDO equity – and several alternative and traditional asset classes. Its findings include: ML Global High Yield & Emerging Markets at 2.31%; ML Global Broad Market Corporate Index at -6.69%; S&P500 at 5.24%; and HFRX Global Hedge Fund EUR Index at 13.69%.

Meanwhile, Cambridge Place Investment Management's Caliber vehicle announced its net asset value per share as at June 30 2007 is estimated to be within the range US$5.40 to US$5.70, against a NAV of US$6.60 at May 31 2007.

"This expected reduction in the NAV reflects the ongoing price deterioration in the US residential mortgage-backed securities market. The company continues to monitor its funding requirements and remains in compliance with the covenants of its funding lines," Caliber says. The vehicle has already announced its intention to unwind over the next 21 months (see SCI issue 46).

Also this week, Cheyne Capital's Queen's Walk Investment Limited announced it had put in place a close period share repurchase programme as part of its ongoing buy-back programme (see SCI issue 49). The company has entered into an irrevocable, non-discretionary arrangement with its brokers, Citi and Goldman Sachs, to repurchase on its behalf for cancellation during the close period commencing on or around 4 August 2007 and ending on or around 4 September 2007 – the proposed date for the publication of the company's quarterly results

As at 31 July, Queen's Walk had reduced its shares in issue to 40,372,216 ordinary shares.

Moody's re-thinks Alt-As and option ARMs
Moody's has refinined its methodology for rating residential mortgage securitisations backed by Alt-A mortgage loans, including Option ARM loans.

The agency says its Alt-A methodology revisions are in response to collateral weaknesses that have surfaced in Alt-A pools securitised in 2006 and that have caused increases in delinquencies for such pools. The changes address the poor performance of sub-prime-like loans, low and no equity loans, and low and no documentation loans present in certain Alt-A transactions.

"In aggregate, our increase in loss estimates is projected to range from an increase of 10% for stronger Alt-A pools to an increase of more than 100% for weaker Alt-A pools. For example, our loss projection for a strong Alt-A pool may increase from 0.50% to 0.55%, whereas our loss projection for a weak Alt-A pool may increase from 1.5% to 3.00%," Moddy's says.

The Option ARM methodology revisions are in response to the current weaker housing and mortgage markets. In addition, the updated methodology refines Moody's credit risk analysis of different Option ARM products. The updated Option ARM methodology is expected to increase the agency's loss estimates by up to 20% and triple-A loss estimates by 10% to 40%.

Jury out on leveraged finance
The weakness in the leveraged finance market in the past few weeks emphasises the risks faced by banks that underwrite and invest in these assets, S&P notes in a new report entitled "Leveraged finance market jitters highlight risks to banks".

"The jury is out on whether the correction marks a much-needed return to more rational risk-based pricing, or the beginning of a severe downturn," says S&P credit analyst Richard Barnes. "Our central expectation is that activity will remain soft at least through the summer, but remain underpinned by the generally supportive economic outlook. We expect a moderate increase in corporate defaults from the current cyclical low, but a harder landing cannot be entirely ruled out," he adds.

The initial change in investor sentiment came as the huge primary issuance pipeline provided an opportunity to push back the most aggressive transactions, particularly covenant-lite and payment-in-kind structures. Further impetus has come from the problems in the US sub-prime mortgage market and the resulting spill-over to other asset classes.

A few high-profile leveraged finance issues have consequently been postponed, and financial sponsors chose to re-price or add covenants to others to get them away. Certain banks have sustained losses on unsold underwriting positions, but the sums involved are not material at this point.

But heightened risk sensitivity among investors has raised the possibility of further falls in prices and liquidity. S&P has therefore stress-tested the impact of a severe downturn on banks' risk exposures and revenues.

"Our analysis shows that this would certainly be a painful scenario, but banks should be able to absorb the effects at their current rating levels," says Barnes. A more widespread deterioration across the credit markets would cause rating pressure, however.

CDO manager best practice identified
Fitch Ratings has identified the best practices of CDO asset managers over the past 12 months in a new report.

Fitch's CAM (CDO asset manager) rating and review programme aims to provide investors with an independent second opinion of the strengths, challenges and differentiating characteristics of CDO asset managers and to provide a forum of best practices for managers. As of June 1 2007, Fitch has rated 56 managers and reviewed over 130. The new report discusses some of the unique needs of each asset class and highlights highly rated CAM managers who exhibit best practices to meet these requirements.

Fitch says it took several key steps in an effort to provide additional granularity to its manager ratings and assessments, including the addition of plus and minus notches to its 'CAM1' to 'CAM5' rating scale. Implementation is in progress, and 2006 ratings are being updated as rated manager's annual updates are completed.

US SROC actions revealed
Following its SROC (synthetic rated overcollateralisation) ratio-based actions in Europe and Asia (see SCI issue 49), S&P has taken the following rating actions on various US synthetic CDO transactions: four ratings (three when pari passu tranches are combined) were raised and removed from credit watch with positive implications; 22 ratings (19 when pari passu tranches are combined) were lowered and removed from credit watch negative; nine ratings (eight when pari passu tranches are combined) were lowered and remain on credit watch negative; and six ratings (five when pari passu tranches are combined) were lowered. At the same time, S&P placed seven ratings on credit watch with negative implications.

Meanwhile, on 31 July S&P placed its ratings on 33 tranches from a further 10 US cash flow and hybrid CDO of ABS transactions on credit watch with negative implications. These tranches have a total issuance amount of $1.025 billion. All of the affected CDO transactions are collateralised substantially by US RMBS backed by first-lien sub-prime mortgage collateral.

CMA offers ASP solution
CMA has announced that its QuoteVision price discovery service is now available as an ASP (application service provider) hosted solution in addition to its installed version. CMA says its ASP solution is superior to web-based systems, as clients still benefit from the richness and real-time nature of QuoteVision's desktop .NET application.

Laurent Paulhac, ceo of CMA, comments: "CMA is continually seeking ways to simplify implementation and reduce cost of ownership for credit market professionals. Our ASP solution can help them to get the proven benefits of QuoteVision more quickly and easily, particularly where their IT departments are tied up on core systems. More than 10 of CMA's QuoteVision customers have chosen to use the hosted ASP solution since its pre-release two months ago."

MP

Trading ideas - hold the phone

John Hunt, research analyst at Credit Derivatives Research, looks at a negative basis trade on Telecom Italia

We look to the telecommunications sector for a rare negative-basis opportunity in a generally positive-basis world in our quest for relatively safe positions at a time of tremendous market uncertainty. In this challenging environment, we identify a trade with good bond liquidity and excellent carry at the CDS levels we show.

Constructing the negative-basis trade position
We generally construct negative basis trades so that they are default-neutral – that is, so that the CDS fully hedges against bond losses in the event of default. This ensures that we are selling the same amount of default risk in the bond market as we are buying in the CDS market.

In doing so, we take account of the fact that the CDS payoff in default is defined relative to the notional amount, while the loss on a bond in default depends on its pre-default price. Thus, a CDS and a bond with the same notional amount will pay off different amounts in default if the bond is trading away from par.

For example, consider a bond and a CDS each with US$100 notional. If the bond is trading at US$110 and recovery value in default is US$40, the bondholder will lose US$70 in default and the CDS protection buyer will gain only US$60, so the investor will have to buy more than US$100 in CDS protection to hedge against default. If the bond is trading at US$90, then the bondholder will lose only US$50 and the CDS protection buyer will gain the same US$60, so less than US$100 notional of CDS protection would hedge against default.

Given that bonds pull to par over their life if they do not default, we typically construct our positions so that the CDS hedges a bond price halfway between the current market price and par, although we may adjust the hedge amount upward or downward if we maintain a bearish or bullish fundamental view on the credit.

Another consideration in constructing the position is that a liquid CDS usually will not be available in an interpolated tenor that matches the maturity of the corporate bond. We construct the trade using a CDS of the closest available liquid tenor. Because CDS premiums vary with tenor (generally, longer-dated CDS have higher spreads), the mismatch between CDS and bond maturity will affect trade characteristics such as carry and rolldown. We generally only recommend trades that have positive carry.

We also present a simple duration-matched position in a government bond to hedge interest rate risk. This risk could also be hedged with an interest rate swap, but we understand that government bonds are the most useful hedging instrument for most investors. We understand that most investors will prefer to hedge interest-rate risk at the portfolio level in any event.

Our strategy for both the CDS and the Treasury hedge is strongly influenced by a desire for simplicity. Perfect hedging would require adjustment of the CDS and Treasury positions over the life of the trade. We are happy to discuss such strategies with clients, and we also provide a set of sensitivities to help clients implement more sophisticated hedging strategies.

Trade Specifics

Bond cheapness
Based on our valuation approach, the Telecom Italia S.p.A. 4.25 of January 2019 bond is trading cheap to fair value. Exhibit 1 presents the price-based term structure of the company's liquid bonds and indicates that Telecom Italia's shorter-dated bonds are trading rich or close to fair value and that the January 2019 bond is trading cheap.

Exhibit 1

Exhibit 2 compares the bond z-spreads with the CDS term structure, and shows that the recommended bonds are indeed trading wider than the closest-maturity CDS.

Exhibit 2

Exhibit 3 illustrates the z-spread and CDS levels basis between the 10-year on-the-run CDS and the bond over the past year. The basis has tightened some over the course of the year, but is not currently trading too far away from its average value over the period. Given the volatility of the basis, we believe it is reasonable to expect some degree of convergence from the current level. 

Exhibit 3

Risk
The position is default-neutral. There is a slight maturity mismatch because the bond matures in approximately 11.5 years, but we expect to be able to exit the trade with a profit from carry and convergence to fair value before the bond matures.

We provide a suggested simple, duration-matched Treasury position to hedge interest rate risk. Exhibit 4 shows the overall and key-rate sensitivities for the bond, which can be used to hedge any residual interest-rate risk. The exhibit also provides other insights into the price sensitivities of the position.

Exhibit 4

The trade has positive carry given current levels, and this carry should cushion the investor from short-term mark-to-market losses.

In its default-neutral construction, the trade is slightly long the firm's credit – the position gains approximately 1bp of notional per 1bp of parallel curve tightening, using the linear DV01 approximation.

Execution risk is a factor in any trade; this risk is discussed in more detail in the "Liquidity" section below.

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

CDS liquidity is a challenge in the current market environment. The 93bp ask that we recommend for this trade reflects our most current information. We recommend working the CDS leg first, purchasing CDS for the best available price up to 120bp ask for 10-year protection.

The Telecom Italia bond shows excellent availability in both directions on Bloomberg's ALLQ screen.

Fundamentals
Negative basis trades are based on the assumption that the bond is mis-priced relative to the CDS. They are not premised on an expectation of general curve movements. While the trade is technical in nature and not necessarily affected by fundamentals, we review the firm's fundamentals briefly.

Dave Novosel, Gimme Credit's Telecommunications expert, maintains a "Deteriorating" fundamental score on Telecom Italia, noting that the company has significant leverage relative to its level of free cash flow. Telecom Italia faces declining margins and deterioration of its wireline business.

Summary and trade recommendation
The Telecom Italia 5.375s of January 2019 are trading cheap to fair value, and we feel a default-neutral negative basis trade is an excellent opportunity to earn positive carry, as well as the potential profit of a return to fair value. We recommend a slightly default-hedged basis package using a single subordinated CDS static hedge to pick up 12bp of carry.

Buy €9m notional Telecom Italia S.p.A. 10-Year CDS protection at 93bp.

Buy €10m notional (€9.7m cost) Telecom Italia S.p.A. 5.375% of January 2019 notes at a price of €95.61 (z-spread of 114bp) to gain 28bp of positive carry.

Sell €10.2m notional DBR 4.25% of July 4, 2017 at a price of €99.33 (€101.8m proceeds) to hedge bond interest rate exposure.

For more information and regular updates on this trade idea go to: www.creditresearch.com

Copyright © 2007 Credit Derivatives Research LLC. All Rights Reserved.

Note: This article is intended for general information and use and does not constitute trading advice from Structured Credit Investor (see also terms and conditions, below, section 12).

Ball in the bowl - part 2

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

If we break the transition data discussed in part 1 of this article into annual upgrades and downgrades by product type, a landscape emerges that is almost unrecognisable compared to our previous analysis. But in many respects the insight is more intuitive.

Figure 1 illustrates the percentage of downgrades amongst outstanding rated deals. Figure 2 is the same only for downgrades, while Figure 3 is the difference between the two.

There are a lot of lines, so we have grouped them by colour. Dark blue shows assets linked to ordinary corporates, with the thin solid blue line showing corporate bonds themselves. Figure 1 shows clearly the wave of downgrades in 2002 and 2003, while Figure 2 shows the wave of upgrades that occurred in 2004 and 2005.

As might be expected, these had a knock-on effect on synthetic IG CDOs and especially on HY CBOs, which both show the same pattern. More surprisingly, both types of CDO seem to have been less stable to the downside (being downgraded more often than corporate bonds), but unfortunately more stable to the upside (being upgraded less). We shall examine the reason for this in a moment.

The red lines show the performance of assets linked to ABS. In this case, the number of downgrades of the underlying peaked in 2003 (one year after corporates), while 2004 (and especially 2005 and 2006) again feature many more upgrades. Once again, the lines for CDOs of ABS follow more or less the same pattern – only in this case although the CDOs were also upgraded less often than their underlying, they were at least also downgraded less often, especially in the particularly weak year of 2003. Unlike CSOs and CBOs, CDOs of ABS have to date proved very stable, in part because of the stability of their underlying, but partly also in their own right.

CLOs have been more stable still, as the single pink line shows. Unfortunately, the rating agencies do not tend to release upgrade-downgrade information for loans (let alone the frequently shadow-rated loans found in CLOs), meaning that we do not have a corresponding underlying set of upgrades and downgrades with which to compare them.

That said, we do know that loan default rates peaked in 2000, remained high in 2002 and 2003, and then fell sharply thereafter. Here too, then, there is a reassuring correlation with the underlying. Yet, the most striking feature of the CLOs remains their stability.

While it would be interesting to have data from 2000, the worst historical year for the underlying, very few CLOs seem ever to have had their ratings changed at all, either to the up- or the downside. These data, therefore, confirm on an unweighted basis what we saw on a weighted basis in Figure 8 in part 1 of this article.

In sum, while all types of CDO have followed the same upgrade-downgrade pattern as their underlyings, some have proved more stable than their underlying, while others have proved less stable. Next, we attempt to make sense of all this.

Why are there such differences in CDO product types?

While the results show often quite startling differences in product types at different points in time, we think they are explicable once we consider a few more of the features of structured credit. Of particular importance are the prevalence (and motivation) of managers, the structural features present in (or absent from) different types of deals, and the transparency of the underlying asset class.

The effect of managers
One characteristic of some of the most volatile CDO subtypes revealed in Figure 3 above is that they all tend to be static rather than managed transactions. CDOs and IG synthetics (in 2001–2003) tended to be predominantly static transactions.

Figure 4 looks at this relationship more closely by breaking out the performance of static from managed transactions. It shows quite clearly that static deals have been more volatile – and in both directions. It is not so much that managed deals have outperformed (as far as the rated tranches are concerned) – indeed, if anything in recent boom years they have often underperformed versus static deals – but rather that they have been more stable.

Figure 5 below shows the importance of this factor. Synthetic corporate CDOs, which were one of our most volatile categories in Figure 8 in part 1 of this article, become as stable as cash ABS CDOs if we strip out the static deals.

The stability of managed deals to the downside is both intuitive and reassuring. The reason for their failure to get upgraded is also explicable, but requires a little further thought.

Many mangers will buy a large proportion, if not all, of the equity tranche. The incentive for the manager is the possibility of highly leveraged exposure to a set of assets in their area of expertise that would be hard to achieve otherwise. This is also attractive for potential debt investors as they see the interests of managers highly aligned with their own, insofar as it comes to avoiding default losses.

However, while debt tranches have fixed coupons, equity tranches receive surplus from the collateral. Therefore, managers have an incentive to maximise returns by increasing the average spread (and hence risk) of the collateral. They should do so within the constraints of the covenants and without putting the rating of the debt holders at risk.

During bear markets these are likely to be the dominant factors, leading them to identify poorly performing collateral and then remove it. But during bull markets, a failure to increase collateral spread levels, while having no effect on debt holders, eats directly into potential equity returns.

On a related point, to the extent that the deal structure permits, managers who are equity holders are likely to want to remove surplus cash from within the deal, rather than allowing it simply to build up as a subordination "cushion." In static deals, such cushions are frequently the cause of rated tranche upgrades.

In sum, an adept manager will avoid downgrades in market downturns and in market upturns exchange upgrades for additional returns for equity holders. So, in other words, managers have incentives to decrease both upgrades and downgrades. The greater prevalence of managed deals on the cash side adds to the historical stability of CLOs and CDOs of ABS; the relative prevalence of unmanaged deals on the synthetic side is the major cause of their lack of stability – but also of their recent outperformance in terms of ratings.

The importance of structure
The second key driver of these trends is deal structure. Some CDO structures tend to enhance the "ball in the bowl" characteristics of a deal. CDO-squared transactions, for example, offer the benefit of huge diversity but have the effect of increasing the binary nature of some of the tranches, as we discussed earlier.

We do have historical statistics on CDO-squared, but there are so few of them, and in particular they have all been issued so recently, that we did not feel it was fair to include them (until now, they have done very well).

The problem here is well illustrated by mezz ABS CDOs. As our numbers above show, these too have historically done very well. Yet so far this year, 10% of outstanding tranches have been downgraded, and we fear a great many more downgrades are to come.

The abrupt departure from the historical statistics is explicable not only in terms of the turnaround in performance of the underlying asset class, but also the deals' structure. Because they contain two layers of tranching, CDOs of ABS are in some respects like CDO-squared: they are more stable (still) in the good times or under moderate shocks, but considerably more vulnerable in the case of a more severe downturn.

Apart from the straightforward effect of extra layers of tranching, ABS and cash CDOs frequently contain structural features such as waterfalls that can both increase and decrease the volatility of certain parts of the capital structure. A trigger that turbos (repays more quickly) the senior note by diverting cash from equity will decrease the volatility of all tranches.

Turboing the senior note increases the effective subordination of other debt holders. Such features may help explain why the fat tail shown for BBB tranches in Figure 5 in part 1 of this article has historically not been seen for AAAs, as Figure 6 in part 1 shows.

Collateral characteristics
The final driver seems to be the nature of the collateral, in particular its transparency with respect to mark-to-market and "rateability." Many investors make the mistake of assuming that high yield collateral means higher volatility.

In fact, in CDOs high yield collateral is balanced with high subordination levels. Yet our rating analysis shows that deals backed with high-yield loans have been the most stable of asset classes. Indeed, if we re-examine our data by collateral type we find that (with the notable exception of HY Bonds) it seems to be the highest yielding collateral that is the most stable and the higher-grade collateral that is the least (see Figure 6).

Yet, as we see it, the real factor at work here is not yield, but price and rating transparency of the underlying. The more opaque the underlying, the greater the historical rating stability (midmarket loans, mezz ABS, HY loans); the more transparent, the greater the volatility (CDS, HG ABS, high yield bonds).

CDS have a highly liquid secondary market that is extremely active, while the secondary market for many commercial real estate whole loans and some ABS will be completely non-existent. This transparency makes it easier for the rating agencies to monitor deals, and ensure their ratings are up to date. Rating synthetic deals (especially static) is much less subjective and much more model-dependent than rating their managed, cash counterparts.

In contrast, SME, MM CDOs and CLOs often have a proportion of unrated collateral in them that is shadow rated by agencies. As many of these processes require complex analysis, the monitoring of assets and therefore tranches will be less frequent than for other asset types.

Moreover, agencies will frequently want to rate "through the cycle" – not downgrading a managed cash deal it they thought it had a healthy cash balance and the manager could trade out of a poorly performing asset. Just as shadow-rated loans are more likely to default suddenly (and abruptly) rather than being downgraded steadily, so we suspect that CDOs containing such assets will tend to be stable, but conceal a larger tail risk that may become apparent in a severe downturn.

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