Contents

CDR Liquid Index data as at 7 August 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.

Model risk spikes

Dealers and investors search for solution

Typical CDO valuation techniques have been compromised now that liquidity has dried up in both the primary and secondary markets. As the survey of end-July CDO marks is circulated, dealers and investors are searching for a suitable alternative approach – but that is not without its challenges.

"In the current environment, bid for CDO paper has disappeared and any fire sale of assets will result in prices significantly lower than model implied values and also in comparison to what they may actually be worth. Once traded, however, lower market prices will lead to reassessment of model values, leading to substantial write-downs and large paper losses – which is why many dealers and investors have been reluctant to bid on this paper," explains Domenico Picone, head of structured credit research at Dresdner Kleinwort.

Such a reassessment has been reflected in the end of July survey. "Very few banks are marking at bid levels, which are very low as a reflection of lack of liquidity," confirms one CDO banker.

"Most investors don't need an actionable price, but unfortunately because of the way that some of the bonds are being marked as a reflection of those few banks' views on the liquidity premium, clients are forced to sell – and that makes the whole situation worse. So, most dealers and investors are trying to find an alternative approach," the banker adds.

To this end, many deals are being marked to a fundamental model, which is based on analysing the fair value of a CDO's underlying assets and stress testing them at multiples of historical levels. "There are quite a few banks in favour of marking to fundamental or look-through models and, to be honest, if you don't know what the liquidity premium is there is no obviously better way to value the bonds," says one investor.

It is, however, important that such a change in approach is made clear to investors, according to a London-based bank lawyer. "It is OK to do so, provided that it's clear to investors that the valuation of a CDO is as a result of analysis of the fundamental model value, and that valuation is provided in good faith and justifiable."

Nevertheless, utilising a 'fundamental' model approach still has its challenges. "It's difficult to take account of correlation in the model without market prices. For a CDO backed by IG CDS names, it's obviously fairly straightforward because you can use the index correlation market. But for CDO of ABS, there is no equivalent for the ABX market yet, as the TABX is still in its infancy" says Picone.

He continues: "Whether we need some correlation input at all, for these types of assets it is more important to understand how cash flow mechanics driven be each deal's waterfall structures operate under different prepayments, delinquencies, defaults and recovery assumptions. These are cash flow deals and should be treated as such."

However, Picone concedes that utilising a fundamental model is possibly the only current solution. "Once you have one that an auditor or accountant finds reliable, then possibly you can use their model to mark your position," he concludes.

MP

Mixed views on monolines

Opinions diverge over financial strength

Amid CDS market volatility financials have been hit hardest of late – and among them monolines have suffered more than most. However, views on bond insurers remain mixed.

As BNP Paribas' credit portfolio strategy team points out in a recent research note: "Shares of MGIC, Radian, Ambac and MBIA have fallen sharply over the past three months – in some cases halving (Radian). Although their credit ratings currently remain well underpinned, the risk of future downgrades cannot be discounted. This could also affect ratings of those issues that have been structurally enhanced."

Despite a series of reassuring statements over sub-prime exposures in particular and structured credit more generally from a number of monolines, some names in the sector – Radian, Ambac and MGIC – led the way as the market widened on Monday on the back of continued speculation over their financial stability. Radian suffered particularly badly and was forced to make a further announcement over the strength of its balance sheet.

As one banker observes: "Traders are still concerned about the amount of exposure monolines have relative to their equity. If everyone believed everything was fine – as their public statements have suggested – then their CDS would have rallied sharply on Monday. Clearly, the market is still highly sceptical."

Nevertheless, S&P last week published a report saying that the deterioration in the world of sub-prime mortgages does not appear to be a threat to the rating stability of the bond insurers. The agency's conclusion is the result of the insurers' underwriting standards, which typically target deals rated in the single-A category or higher; their sound risk management practices, which have limited the exposure to sub-prime mortgages to typically 1% to 3% of total exposure; and their conservative capital management strategies, which result in cushions that allow for adverse development without jeopardising their capital adequacy.

The agency reports that, as of June 30, the nine primary bond insurers had total direct exposure to sub-prime RMBS transactions of US$36.8bn. Exposure to 2006 and prior vintages was US$30.2bn. Total speculative grade exposure (double-B plus and below) was US$1.5bn, equal to 6.6% of statutory capital as of March 31 2007.

"For many of the bond insurers, the volatility in the sub-prime mortgage market is viewed as an opportunity rather than a challenge", explains S&P md Dick Smith. "Despite the weaker loan underwriting quality in more recent vintages, insurers reportedly have been able to get better structured deals with higher levels of protection and higher underlying ratings and have also been able to get significantly higher premium rates."

This 'opportunity' theme has also carried over into the sub-prime-related CDO markets. A stress test conducted by S&P showed that an estimated amount of sub-prime-related losses and incremental capital charges would not impair the insurers' financial strength ratings.

Furthermore, it is important to note that as part of the stress test, the insurers' capital cushions have not been adjusted for earnings generated in the first half of the year, while exposure includes deals booked in the first half of the year.

MP

Opportunistic fund launched

New hedge fund to capitalise on risk premia compression

New York-based BlueMountain Capital Management has launched a new hedge fund – BlueMountain Defensive Credit Fund (DCF). In a twist on credit opportunities funds, a plethora of which were launched earlier this year (see SCI issue 25), DCF is designed to take advantage of current market volatility.

BlueMountain says that DCF will take positions designed to capitalise on the compression of risk premia between higher and lower quality assets in the credit markets. The manager expects these premia to decompress as the credit cycle moves from technical pressure to fundamental deterioration.

DCF's managers will identify undervalued corporate loans, LCDS and related securities, as well as attractive offsetting shorts in CDS. "We have witnessed a significant sell-off across credit markets in recent weeks and are excited that we have the ability to put new investor capital to work in this space. We have a long-term commitment to high yield, leveraged loans and CLOs, all of which are core parts of our business," explains Jeff Kushner, md at BlueMountain.

"While there are many and varied concerns about the credit markets today, we have proven our ability to sift through the noise and uncover compelling investment opportunities. Now, as in the past, we have tapped into sources of committed capital and will look to execute a series of uniquely profitable strategies in uncertain markets," adds Stephen Siderow, BlueMountain's president.

DCF, which has a five-year lock-up period and is closed to additional investments, is launching with US$160m in investor capital. It will buy corporate secured loans (in the full spectrum of cash and synthetic forms), simultaneously and aggressively hedging via strategic shorting of high-yield CDS. BlueMountain believes that recovery-adjusted returns on secured assets will outperform high-yield, especially as the firm actively manages the ratio over the life of the fund and carefully selects single name assets and shorts.

As with BlueMountain's other vehicles employing long-term lock periods, DCF aligns manager incentives with the interests of investors. In this case, performance fees are calculated and charged only after the expiration of the fund and are relative to a defined benchmark.

"This fund underscores our ability to move quickly and opportunistically in distressed credit markets," Kushner explains. "The recent sell off in the secured credit markets presents a tremendous value opportunity to our investors, which we are prepared to exploit."

BlueMountain Capital Management invests – by going both long and short – in the global credit markets through credit default swaps and other related credit and equity derivatives, as well as cash instruments. The company currently has more than US$4.4bn in client assets under management in its hedge funds and is also the manager of three CLOs with an additional US$1.5bn in assets. BlueMountain Capital Management was founded in 2003.

MP

Asian credit products move

The latest company and people moves

Asian credit products move
Lehman Brothers has appointed George Sun as managing director and head of global credit products sales, Asia ex-Japan, reporting locally to Kirk Sweeney, co-head of fixed income sales, Asia, and globally to Christian Wait, global head of high grade & structured credit sales. He joins from Bear Stearns, where he was head of structured credit products for Asia – a position he took up in April (see SCI issue 34).

In this newly created role, Sun will be responsible for the distribution of all credit products, including money markets, high grade credit, structured credit, CDOs, EMG and high yield. His appointment will enable Lehman Brothers to further extend its strong global franchise in credit products to the firm's clients in Asia. Sun will initially be based in Singapore.

"George's tremendous product knowledge expertise will enhance our existing capabilities and demonstrates our commitment to building a leading credit franchise in the region," comments Sweeney. "We are confident his broad experience – across a variety of roles, locations and organisations – will be invaluable as we move toward greater product specialisation within sales to match the increasing sophistication of our clients in Asia."

Prior to Bear Stearns, Sun was a managing director in global structured credit products, fixed income, for Merrill Lynch covering all markets in Asia, based in Hong Kong.

Emerging market head for similar role
Andrea Vella, head of emerging markets sales and marketing at JPMorgan, has left to join Goldman Sachs in a similar role.

Cash CDO structurer leaves
Gregg Drennan has left Morgan Stanley to join Citi later this month as a senior cash CDO structurer. He will report to David Blackwelder, head of CDOs EMEA.

Hedge fund hires for alternative CDOs
London-based hedge fund Brevan Howard has hired Stephane Diederich to set up an alternative CDO business. He will become a partner at the firm after 13 years at Credit Suisse.

For the past three years, he has been a member of the firm's equity derivatives team, first in institutional sales and, starting this year, as head of equity derivatives product management.

Brevan's planned alternative CDO business is expected to focus on non-credit underlying assets.

Promotions at investment manager
Babson Capital Management has promoted two officials: Clifford Noreen, head of corporate securities, will take on the additional role of vice chairman; while Thomas Finke, head of the US bank loan team and the distribution, marketing and relationship management teams, will assume the additional role of president.

Finke takes over the role of president from Roger Crandall, who remains the chairman and ceo of Babson Capital. The vice chairman role being assumed by Noreen is a new position. Both officials will continue to report directly to Crandall – as will the firm's other senior leaders: Efrem Marder, head of quantitative management; Kenneth Hargreaves, head of the real estate finance group; and Ian Hazelton, chief executive of the London-based affiliate Babson Capital Europe.

Principia hires in global business development
Principia Partners has appointed Mark Kahn as evp in sales. He will be directly responsible for managing global business development and further strengthening the sales pipeline in the rapidly growing structured finance market.

Kahn joins Principia with a highly successful track record in leading business development and managing client relationships in the structured finance trust, administration and servicing businesses at JPMorgan Chase Bank and Deutsche Bank. Most recently, he managed product and client services for Systems and Services Technologies, a wholly owned subsidiary of JPMorgan Chase and a part of its worldwide securities services division.

Kahn also held various executive positions, managing business development for JPMorgan's CDO, SIV and ABCP conduit administration business units. Prior to joining JPMorgan, Kahn managed the ABCP and SIV conduit administration businesses at Bankers Trust Company, where he was responsible for product development, operations, client management, administration and sales.

Bear re-reorganises
Bear Stearns has named Alan Schwartz as the company's sole president, while Samuel Molinaro becomes coo in addition to his current duties as cfo. Additionally, Jeffrey Mayer, co-head of the fixed income division, has been named to the Bear Stearns executive committee.

The moves come after Warren Spector resigned his positions of president and co-coo, member of the executive committee and member of the board of directors of Bear Stearns.

"In light of the recent events concerning BSAM's High Grade and Enhanced Leverage funds, we have determined to make changes in our leadership structure," comments the firm's chairman and ceo, James Cayne. "These promotions reflect and acknowledge the depth of talent in our senior management team. Alan and Sam have demonstrated outstanding judgment and leadership skills during their long tenures at Bear Stearns, have made tremendous contributions to building the firm, and are well prepared to assume greater responsibility."

In a statement Cayne thanked Spector for his significant contributions to Bear Stearns.

E&Y ramps up structured finance services
Andrew Meikle has joined Ernst & Young as director within its structured finance transaction services group. He joins from KPMG, where he was an associate director.

Meikle will be further enhancing the firm's existing services for structured finance transactions, such as MBS, CDOs and other ABS.

MP

Sub-prime manageable for European and Asian banks

A round up of this week's structured credit news

Sub-prime manageable for European and Asian banks
The implications of the US sub-prime mortgage crisis are likely to be manageable for Europe's larger banks but riskier for its smaller banks, and limited for Asian banks because of smaller exposures, reports Moody's.

Moody's remains cautious about the quality of price information available to many banks, as well as their reliance on mark-to-model valuations and the reduced level of liquidity of many structured vehicles that at least partly comprise sub-prime mortgage assets. "Indeed, it is virtually impossible for investors to accurately quantify each firm's credit, market and liquidity exposures within this troubled sector," says Antonio Carballo, London-based team md in Moody's EMEA financial institutions group.

In Europe, the agency expects the financial fall-out of the sub-prime crisis to be manageable for most large banks. "Europe's large banks are able to post solid firm-wide results, despite write-downs resulting from the severe decline in prices and evaporation of liquidity within the sub-prime sector. Also, the size of these banks' overall net position in the sub-prime sector, while generally significant, is modest relative to each firm's capital and liquidity," says Adel Satel, London-based team md in Moody's EMEA financial institutions group.

However, Moody's holds a more cautious view on Europe's smaller banks. "Smaller players that have significant direct or indirect exposures to the sub-prime sector may find that their liquidity, risk management capabilities or financial resources are less adequate to absorb any valuation adjustments and corresponding liquidity requirements," cautions Carballo.

In Asia, the agency expects the fallout from the US sub-prime mortgage market problems to be limited among the region's internationally active investment and universal banks, based on the preliminary results of Moody's survey of Asian financial institutions. "While there are exposures among Asian banks to the US sub-prime market, these have so far proven to be small relative to capital and manageable within the banks' current earnings," says Deborah Schuler, svp and regional credit officer of Moody's Asian financial institutions group.

In fact, the role of Asia's internationally active investment and universal banks in the US sub-prime market is generally limited to the purchase of the structured instruments as part of a large investment securities portfolio or of funds containing those securities. The exposures of Asia's large commercial banks are also minimal, usually involving senior tranches and typically funded by stable deposits. "Moody's therefore sees little risk of contagion," adds Schuler.

The larger exposures are to be found among the largest banks and/or more sophisticated markets – such as those of Japan, China, Korea, Singapore and to a lesser extent Australia. However, the bulk of foreign currency investments at these banks and at the smaller banks in Asia continue to be held in highly rated (single-A or better) government and corporate bonds.

EGMs announced
Two permanent capital vehicles gave notice of proposed extraordinary general meetings this week.

Queen's Walk Investment Limited (QWIL) announced that at its annual general meeting, to be held on 3 September 2007, shareholders will be asked to authorise QWIL to purchase up to 14.99% of its issued share capital (the general authority).

On or about 5 September 2007 and following announcement on 4 September 2007 of its unaudited results for the quarter ended 30 June 2007, QWIL proposes to make a tender offer to buy back at least 10% of the vehicle's issued share capital (the proposed tender offer).

QWIL says it will not seek to buy back more than 24.99% of its issued share capital through any combination of the general authority and the proposed tender offer without first seeking further shareholder approval.

Meanwhile, Caliber has sent shareholders notice today of an EGM to be held on 30 August. At the meeting, shareholders will vote on resolutions to approve a new investment objective for the company, return capital to shareholders and amend certain provisions in the investment management agreement between the company and the investment manager, Cambridge Place Investment Management.

These resolutions follow the statement made on 28 June 2007, where it was announced that Caliber should pursue an orderly return of all its capital to investors over the next twelve months in order to maximise value for shareholders.

Insider information guidance released
Following the publication in April 2006 of its paper entitled 'Dealing with confidential and price sensitive information', the Loan Market Association (LMA) has issued a new paper which provides examples of situations that could arise as a result of institutions receiving information deriving from loan market activities, and comments on how the institution might manage this information flow appropriately.

LMA says that, while the new paper – entitled 'Private and Inside Information in the Loan Market' – cannot be prescriptive regarding measures that might assist institutions in avoiding the mishandling of private and inside information, it does provide guidance on possible ways to manage information appropriately and comments on some of the implications of being in receipt of such information.

S&P holds off on Alt-A CDOs
Following S&P's 7 August placing on credit watch negative of its ratings on 207 classes of US RMBS backed by first-lien Alt-A mortgage collateral, the agency states that the move is not expected to have a significant impact on its global CDO transaction ratings.

S&P rates 398 US cashflow and hybrid CDOs of ABS and 90 US synthetic CDOs of ABS that have exposure to Alt-A RMBS collateral as an asset class. Some transactions have significant exposure: 161 cashflow and hybrid CDO transactions and six synthetic CDO transactions are more than 10% collateralised by Alt-A RMBS assets.

However, CDO exposure to the Alt-A RMBS classes with ratings placed on credit watch negative is moderate; only eight cashflow and hybrid CDO transactions and none of the synthetic CDO transactions saw more than 2% of their total collateral affected. As a result, the agency does not expect recent Alt-A RMBS credit watch placements, or any resulting downgrades, to have a significant negative impact on its CDO transaction ratings.

Trup CDOs analysed
Moody's says it is analysing the exposure of Trust Preferred CDOs (Trup CDOs) to troubled specialty mortgage companies. Out of the 98 Trup CDOs the agency has rated since 2000, only 18 have direct exposure to mortgage companies that are believed to be experiencing financial distress. Among these securities, the exposure ranges from 3% to 16% of the Trup CDOs' underlying collateral, with the largest exposure in REIT Trup CDOs.

Moody's says it is not placing any of the related Trup CDOs on review for possible downgrade at this time because the Moody's-rated tranches of these securitisations are all rated at least single-A (and in most cases, especially for the REIT Trup CDOs, are rated Aa or Aaa), with substantial amounts of credit protection. Most of the collateral securities continue to perform and may not default at all, and, if they do default, they may experience meaningful recoveries.

Codefarm incorporates CDOROM
Codefarm has now fully incorporated Moody's CDOROM model in its Galapagos Structurer product.

Mario Aquino, head of Moody's international markets strategy, comments: "We are pleased that Codefarm has chosen to integrate Moody's CDOROM into its product offering and enable our customers to use our ratings with such an innovative technology."

Galapagos Structurer incorporates market-standard ratings and pricing models with innovative technology to help CDO arrangers create high-yield CDOs in previously unheard-of timescales. By using evolutionary computing on a powerful highly secure compute grid, Galapagos Structurer automates the structuring of CDOs in a fraction of the time traditionally taken.

Ratings explained
Fitch Ratings says that over the past few months discussions with many market participants, including investors, issuers and regulators, have revealed a broad understanding and support of its approach to assigning ratings on the triple-A scale. However, the agency says some market participants have requested further transparency and more detail. In response, Fitch has published a report entitled 'Inside the ratings: what credit ratings mean'.

The study covers a number of topical issues, including the comparability of ratings across sectors, the degree to which loss severity is incorporated in ratings and the time horizons which apply to 'through-the-cycle' ratings. The report also summarises the impact of event risk on Fitch's credit ratings, from wars to changes in tax law.

"Currently, for example, there is a lot of debate about what a triple-A rating means to the investor," says Richard Hunter, regional credit officer at Fitch. "Credit ratings have never explicitly spoken to pricing of an instrument, nor to liquidity of the instrument, but the market has generally formed its own expectations regarding these factors based on historical triple-A rated assets. The expectation that a triple-A rated security would always be highly liquid and price at a very fine level – assumptions beyond the rating – worked well for treasury bills and very low risk institutions, but will increasingly be challenged as the universe of very low-default instruments expands."

Other areas reviewed in the report include local currency ratings, the assignment of rating watches and rating outlooks, and the relationship between rating levels and default statistics.

MP

Trading ideas - over and under

Dave Klein, research analyst at Credit Derivatives Research, looks at a pairs trade involving the CDX IG and CDX HY indices

Given the difficulty in sourcing single-name CDS trades right now, we turn our trade attention to the (relatively) more-liquid CDX indices. We view this as a good time to take advantage of the breakdown of the historic relationship between CDX IG and CDX HY spreads, betting on mean reversion and the relative outperformance of IG.

Systematically speaking
Over the past few years, the ratio of CDX IG spread over CDX HY spread (not price) has hovered around 0.13, as seen in Exhibit 1. This relationship has proven to be fairly robust even through the troubles of 2005 and the long rally of 2006/2007.

Exhibit 1

We use this relationship to calculate a "fair value" for the CDX IG as a multiple of the CDX HY spread, as seen in Exhibit 2. Clearly, the market value for the CDX IG has been both above and below fair value (although we must be careful with this model during periods that the IG has rolled into a new series and the HY has yet to roll). More recently, the CDX has tended to be a bit above fair value.

Exhibit 2

Starting in June, as HY led the sell off, we saw IG drop below fair value. Once the sell-off in IG began in earnest, IG underperformed HY and moved well above fair value. This is the main trade opportunity. The CDX IG has now sold off relatively more than the CDX HY and we expect the spread ratio to drop.

Risk analysis
This trade is weighted to reflect the historical spread relationship between the CDX IG and CDX HY and to ensure positive carry as well. The trade is not duration neutral, rather it is weighted more towards IG than HY. If IG underperforms HY, the trade will lose money.

The carry cushion protects the investor from any short-term mark-to-market losses including the 4bps bid-offer to cross.

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

We do note that with the greatly-reduced liquidity in the market, it has been difficult to trade the indices in size and bid-offer spreads have increased dramatically. It is too soon to tell when bid-offers will tighten back up, but we do expect trading costs to drop back to more 'normal' levels.

Fundamentals
Since this is an index trade, we look at the relationship between IG and HY at a macro level rather than considering single-name fundamentals. We consider three scenarios.

If financing demand returns and HY rallies, we'd expect demand for structured products to pick up and IG to rally as well. We consider this a low probability event given rising global interest rates which has led to the availability of low risk yield.

If volatility in the credit markets drop and levels stabilise, then the trade becomes a positive carry/positive rolldown position. HY spreads are currently close to their long-term historical averages and IG default probabilities are also close to their long-term averages.

Finally, if liquidity stays low, we'd expect a continued flight to quality and HY to underperform IG as occurred at the beginning of the current market sell off (see Exhibit 3).

Exhibit 3

Idiosyncratically, LBOs remain a risk, especially to the IG index. Given the current cost of financing, we are not expecting a return to the days of the seemingly weekly LBO announcement.

Summary and trade recommendation
In our current high volatility, low liquidity environment, we turn to some of the most liquid instruments in creditland, trading the CDX IG 8 vs. the CDX HY 8. With the IG index trading much wider than its historical relationship to HY, we believe this is a good time to sell IG protection and hedge with HY protection.

When considering the possibilities of HY tightening, stabilising and widening, we expect IG to outperform HY in each scenario. With the ever-lower chances of new LBO announcements, we turn to a systemic, mean-reversion trade, betting on a widening of the difference between HY and IG levels.

Buy US$1.3m notional CDX NA HY Series 8 5-year CDS protection at 467bp (Sell at US$93.00) and

Sell US$10m notional CDX NA IG Series 8 5-year protection at 72bp to gain 11.29bp of positive carry

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

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

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

After the turmoil

Challenges and opportunities in the CLO and loan markets are discussed by Mikhail Foux, Ratul Roy and John Fenn of the credit products strategy group at Citi in New York

The leveraged loan problems have been widely publicised in the past several weeks. The news media – ranging from CNBC to the Wall Street Journal to the New York Times – has been focused on them as well. We thought it would be a good idea to discuss the roots of the problem and focus on potential outcomes for the single-name and structured loan markets – notably CLOs.

Based on the drop in prices in the widely watched synthetic loan index (LCDX), one would have thought that the market's default expectations had dramatically increased. This seems counterintuitive because the fundamentals are quite strong: the US economy is still growing at a good pace, the consumer remains resilient, and inflation pressures are slowly fading. Second-quarter corporate earnings have been also relatively strong, despite some notable misses.

Overall leverage is slowly creeping up, but this is a gradual process. The liquidity crunch that we are witnessing could affect the default rate in the future, but currently it is still less than 1%. Hence, we believe that the current market rout is driven by technicals rather than fundamentals, which provides loan and CLO investors with interesting entry points.

A perfect storm
The recent sell-off in the leveraged loan market was a perfect storm. The roots of the problem were already in place, but various forces came together at exactly the worst possible time to punish the already vulnerable markets. In short, we think that there are two main causes of this crisis: imbalances in supply and demand and the abundance of newly introduced structural features of leveraged loans. We discuss these causes in more detail.

Supply is growing
In our view, heavy supply is the primary driver of the sell-off. The recent flood of LBOs was largely financed by leveraged loans (see Figure 1). In the bull market, this worked pretty well. However, with the change in investor sentiment, one has to wonder how the Street plans to distribute more than US$200bn of loans in the fall, with a big chunk of these loans being covenant-lite. The lack of appetite for any of the newly brought deals and expectations for future pricing in the fall is causing investors to lighten up on whatever positions they still have, if they can, or hedge their cash loan exposures with synthetics, driving LCDS spreads even wider.

Recent examples: The US$10bn first-lien deal for Chrysler/Cerberus and a similarly sized European first-lien deal for Kohlberg Kravis Roberts' (KKR) proposed buyout for Alliance Boots plc were cancelled. The syndicate banks that were sponsoring the deals had to honour their lending commitments despite the inability to distribute the deals.

Forced liquidation is another factor that has put pressure on the normally stable prices of leveraged loans. This is caused by various sources: (1) Partially ramped up CLO warehouses that need to be unwound owing to the inability to get lower tranches priced because of greater market uncertainty; (2) certain hedge funds that need to meet their margin calls based on the recent mark-to-market losses in various asset classes – particularly, loan-based total-rate-of-return swaps; and (3) investors that cannot hold on to their longs anymore because of large mark-to-market losses in this normally stable asset class.

Demand is waning
There are several factors hampering investor demand for loans: the loss of investor risk appetite for the asset class caused by volatility, withdrawal of liquidity, and a decrease in buying power.

In the past several years, CLOs have been one of the major investors in leveraged loans, purchasing 60–70% of the total issuance. The sub-prime problems have been hurting the CLO market. Buyers were spooked by their losses and do not show much interest in new deals at the moment – CLO issuance over the past few weeks has slowed to a trickle and many deals are waiting in the wings to close. Tightening of the margin requirements effectively caused deleveraging and a loss in buying power.

Recent announcements by S&P reassessing the recovery values of the covenant-lite structures could cause CLO downgrades in the future, a fact that may also keep some marginal investors away until new criteria are formalised.

Structural features of issued loans
Typical in a bull market, any loan deals brought to market were flying off the shelves. Several bull market loan structures became quite popular with investors because of the additional spread they were providing: covenant-lite loans, toggles, and second-lien loans (see Figure 2). Their issuance has increased dramatically in the past several months (see Figure 3). In default, all these structures should have a lower recovery than the first-lien loans; hence, they provide less security to investors. S&P also emphasised this in its reassessment report.

Here, we provide the main reasons why these structures have a lower recovery:

• In default, the second-lien loans are paid only after the first-lien loans, which are using shared collateral. In certain situations within bankruptcy, the second-liens do not have voting rights, while the first-lien loans and unsecured bondholders do have rights.

• Covenant-lite deals have less restrictive, bond-like covenants (incurrence covenants) that limit the company's ability to dispose assets and issue additional debt, but they are tested only when the borrower has taken a particular action. Typical loans have maintenance covenants that give lenders more control over the borrower and these covenants are tested regularly. With lenders having less control in a distressed situation, they are unable to act quickly and possibly preserve collateral value.

• Pay-in-kind (PIK) toggles provide borrowers with a choice of how to pay accrued interest for each interest period during the first several years of the debt instrument: pay the interest completely in cash, pay completely "in kind," or pay partially in cash and "in kind." Payment in kind normally causes the nominal coupon payment to increase and ultimately results in a further increase in leverage during stressed times.

All of these structures were bull market products. Now that the markets have turned and credit spreads have widened, investors prefer lower spreads but better security. The structures we discussed here will be much harder to place in the future. Covenant-lite provisions provide a good example.

In some situations (like Thompson Learning), the covenant-lite provisions had to be replaced for the deal to get done. Even when such deals get done, investors will be rewarded with wider spreads. We therefore expect loan and CLO investors to get better bang for their buck in the future.

Opportunity in LCDX and CLOs
The timing of the introduction of the LCDX was somewhat unfortunate and to some degree exacerbated the loan crises in our view. Before this index was introduced, the pricing of loans was quite opaque, but since its introduction the recent price erosion has been widely followed by the financial media.

Moreover, the LCDX is widely used as a hedging vehicle for loan portfolios. The index decreased by 7–8 points and at current spreads assumes a breakeven default rate of about 10–11%. This is extremely high, especially in the current benign credit environment (see left-hand graph in Figure 4).

Single-name LCDS spreads have widened dramatically in the past several weeks. In May, spreads were trading much tighter than cash. However, this started to change when investors began using LCDS as a hedging vehicle for loans. LCDX index arbitrage has also contributed to this (see right-pane of Figure 4).

CLO spreads were also under pressure in the past several months. We believe that the magnitude of the recent decline is quite staggering, especially for the BBB and A tranches. Recent deals have seen spreads that were near the all-time high.

The fact that these wide levels are occurring during a period of near-record lows in the corporate default rate is especially striking. This provides an attractive opportunity for CLO investors in our view.

CLO equity arbitrage is still attractive
We believe that CLO spreads are currently quite attractive for investors, and we think that CLO arbitrage is there as well. The increase in liability spreads have been compensated by the increase in leveraged loans spreads.

To prove this, we tracked the difference between the liability and collateral spreads for a typical CLO structure since January 2004, which represents the excess returns available to CLO equity investors in a zero default environment (see Figure 6). Our findings support the view that the CLO market presents attractive opportunities for debt and equity investors, which is contrary to the currently prevailing view.

In fact, growth of secondary market activity following the recent hedge fund sales may even offer investors a wider choice. However, the problem at the moment is investor risk aversion, which could change with time when the overhang of supply is cleared.

Although our arguments are making a case for new issue CLO equity, older deals might still make sense. These deals would have closed with much tighter liability pricing than those available today. Asset spreads would also be lower, but the excess cash will be helped in future by prepayments – these will slow in a declining credit environment, but history shows that even in 2002 repayment rates were close to 20% – and any upward spread revisions following covenant breaches.

We make our recommendation for investors conscious of the fact that volatility is not dead and thus spreads have probably not reached their floor. Investors should still buy the best deals at the risk of some mark-to-market volatility. This is because new issue volume will adjust to the reduced demand and established managers will probably command an even higher premium. We already see a lot of tiering in the lower tranches.

What constitutes the best deals will be a bit subjective. Some investors may focus on the managers' brand image and scarcity of new issues; others may be much more concerned about the quality of collateral pool and absence of riskier buckets such as second-lien loans. For many senior investors, the 1-2bp wider spread for an untested manager will be a price worth paying given the risk seniority.

Our final thought: Get the best and hedge the worst. The secondary market will complement the new issue CLO equity market more than ever before as any distressed funds exit their positions. This will give investors more options to take loan credit risk. Against this, the growing LCDX index can provide a systemic short and still leave the trade with positive carry. This can help the investor to reduce some of the technical volatility, although the correlation is not perfect.

Taking first loss risk of a static portfolio against a portfolio of single-name shorts would probably have better correlation. Single-name CDS can also be used as a hedge against the riskiest names in the CLO portfolio – but investors must keep in mind a typical CLO's dynamic nature.

Looking forward
We believe that CLOs are quite attractive to investors despite the decrease of structuring activity. Structures could also benefit because CLO arb is at its best levels since March. Spread volatility is likely to continue until the overhang of supply is cleared, but the low-default environment should continue to prevail in the medium term, making breakevens quite appealing, especially for investors less sensitive to mark-to-market risk.

Even for those investors put off by large profit and loss swings, greater liquidity of credit default swaps, including indexes such as the LCDX, also allow more targeted long-short trades for investors wanting to protect themselves against systemic risk. We attribute the current absence of structuring activity to risk aversion, which should change with time.

When the market will stabilise is a little harder to determine. With respect to loans and CLOs, there is probably a chicken-or-egg quality as to which should recover first. There is no doubt that the loan market is seeking CLOs to step back in and take some leadership on the demand side of the market. CLOs would want to see the loan market stabilise.

In keeping with the concept that one of the technical hurdles for the loan market is supply (obviously recovery of CLOs would help with respect to demand), we see several things that need to occur before we gain comfort with the level of supply. First, there will need to be some restructuring of the pipeline.

The restructuring could take several forms – including covenants and subordination that takes some of the supply out of the loan market directly – but the most important of the structural issues will ultimately come down to price. Another thing that will help cure the market is simply for some of the market to go away – Chrysler and Alliance Boots help to defer some of that pipeline, and the overhang is lessened as the assumption is that deferred supply should re-emerge in a private market.

Finally, we need to see the market normalise from a pipeline perspective. For loans to gain some traction as well as confidence, investors need to see the distribution process operate as it has in the past. Investors do not want to be concerned that a loan that they bought at 99 will be offered away at 96 several days later because a dealer is moving inventory. Predatory bidding of "hung" paper does not help to build such confidence. A market assured that a jumbo loan was successfully distributed will take a much more optimistic view of the dynamics for the future.

© 2007 Citigroup Global Markets. All rights reserved. This Research Note was first published by Citigroup Global Markets on 31 July 2007.