Contents

CDR Liquid Index data as at 20 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.

Accounting solutions sought

CDO issuers look to create new opportunities

A number of CDO issuers are understood to be looking to utilise accounting treatment to create opportunities in the current market environment. However, there appears to be no obvious quick-fix.

One London-based structurer confirms that his bank is in discussions with accounting experts over ways to generate business and says many other firms are also looking in to similar approaches. One key issue is that assets in issuers' warehouses bought pre-credit crunch are generating a loss - albeit in some cases a theoretical one, given the current difficulties in valuing some assets at present - and clogging up credit lines, while assets bought now could generate a profit far more easily.

The banker says: "The sort of questions we and others are asking are: what if you want to do a structure in, say, six months time on collateral you have warehoused, which - rather than being at 100 - now is at, say, 70? How proactive can you be with your accounting in order not to mark to market collateral losses? For example, that collateral normally goes on your trading book, but if you hold the equity position of the resultant CDO deal, can you transfer the collateral loss to your banking book? And if you hold it to maturity, why should you need to use mark-to-market accounting?"

He continues: "With the sort of deals we're looking at, the bank takes a loss at the very beginning - structuring fees are forgotten about in order to simply get the trade out. The aim is to structure deals and remove existing assets from my warehousing line, in order to free it up for current opportunities."

One accounting specialist concurs that such thoughts are at the forefront of market participants' minds. "We haven't seen anything concrete yet, but many participants are definitely thinking about accounting opportunities. Indeed, we have been focussing on this ourselves too. It's not so much a case of what can be done, but how we approach finding values, because that's ultimately what this is all about - valuing assets. What has to be marked to market and what can be brought in at cost is where the discussion is and where the complex accounting issues are," he says.

Notwithstanding such new-found enthusiasm for accounting, the specialist says that there is no obvious solution to bankers' enquiries. "Rather than coming up with a pure accounting solution (which I think is quite unlikely), our challenge is more about auditing these entities from the audit side of our business - and all accounting firms will have that challenge. Ultimately, it is about ensuring that these entities remain going concerns," he concludes.

MP

Technology spend to increase

Buy-side survey reveals future intentions while processing concerns return

The first annual Structured Credit Investor technology benchmarking survey indicates that buy-side firms' technology spending will increase significantly in the years to come. The results come as unusually high trading volumes, due to recent increased market volatility, have resurrected fears over CDS confirmation backlogs.

The SCI benchmarking survey showed that respondents' spend on credit derivatives technology over the last three years broke down as follows:
18% of respondents spent less than US$0.5m; 23% more than US$0.5m; 32% more than US$1m; 17% more than US$2m; and 9% more than US$5m. However, over the next three years spending is expected to be apportioned as follows: 18% of respondents are expected to spend less than US$0.5m; 9% more than US$0.5m; 9% more than US$1m; 36% more than US$2m; and 27% more than US$5m.

The survey produced data, which was collected with the assistance of Reoch Credit Partners, from 22 exclusively buy-side respondents – 16 banks, three insurance firms and three hedge funds – 18 of which managed credit assets in excess of US$1bn. 95% of respondents traded credit derivatives in Europe, 82% traded in North America and 9% also traded emerging markets.

The breakdown in products traded was as follows: CDS accounted for 91% of trading; tranches for 64%; indices for 73%; cash CDOs for 59%; synthetic CDOs for 77%; managed CDOs for 27%; vanilla structures for 50%; and exotic structures for 27%. These products were traded for three primary reasons: 36% of respondents used them for hedging their bond book; 32% for hedging their CDO book; and 73% for yield enhancement.

Survey respondents were also asked about their expectations for their usage of electronic confirmations over the next 12 months. 23% said they expected it to be the same; 22% expected a moderate increase; but the majority, 55%, expected a dramatic increase.

Such a dramatic increase would appear to be necessary to assist with the current situation in the dealer community. A number of major banks are understood to be struggling to cope with processing trades, given enhanced CDS volumes seen in recent months.

As a result of market volatility, CDS volumes for August have not dipped as they typically would in a normal summer lull. These figures have followed on from treble the previous year's volumes in both June and July. The concern is that dealers will not be able to catch up prior to the index rolls in September, which produce their own processing challenges due to heightened trading activity.

Until recently the CDS confirmation backlog had looked to be on the way to being resolved. In July, for example, a US Government Accountability Office (GAO) report concluded that the 14 largest credit derivatives dealers dramatically reduced the number of total confirmations outstanding more than 30 days to 5,500 trades – which represented a 94% reduction from the previous backlog of more than 150,000 unconfirmed trades that had accumulated between 2002 and 2005 (SCI passim).

MP

SIV-lites suffer

Downgrades follow wind-down

SIV-lites have become the latest structured credit vehicle to be impacted by market volatility in general and commercial paper illiquidity in particular. London-based hedge fund Solent Capital's Mainsail II vehicle has had to wind down and it – along with four other SIV-lites – have received rating agency scrutiny.

A statement from Solent Capital concerning Mainsail II published last Friday, 17 August, explains: "Current market volatility and lack of market liquidity with respect to sub-prime lending markets have caused adverse conditions with respect to the liquidity and market risk exposures on the company's underlying portfolio of investments. In particular, the company has not been able to raise commercial paper pursuant to its Euro CP note programme and its USCP note programme, which has resulted in the company drawing under certain back-stop liquidity arrangements (at a higher costs of funds which could have a material negative impact on the company's earnings) and liquidity funding may cease to be available under such back-stop liquidity arrangements."

As a result of such adverse liquidity and market conditions, a market value coverage test wind-down event has occurred. Following the confirmation of a wind-down event and for so long as such a wind-down event continues, the issuer (acting on the advice of the collateral manager) must comply with specified wind-down management procedures. This has resulted in the forced sale of investments and the closing out of hedging instruments at a loss, which may materially impact principal and interest repayments on the programme notes.

Consequently, this morning, 22 August, Moody's downgraded the US CP and Euro CP programmes issued by Mainsail II from Prime-1 to Not Prime. The agency says its rating action reflects the breach by Mainsail II of the P-1 capital adequacy test, declines in the market value of its assets and the inability of the vehicle to draw under its liquidity facility. Moody's notes that no security in Mainsail's portfolio has experienced a rating downgrade.

Meanwhile, yesterday, 21 August, S&P took the following credit rating actions on the five SIV-lite transactions it rates: the notes issued by Sachsen Funding I and Cairn High Grade Funding I were placed on credit watch with negative implications; its ratings on the notes issued by Mainsail II were lowered and placed on credit watch negative; and S&P lowered its ratings on the notes issued by Golden Key and retained them on credit watch negative; while the agency affirmed its ratings on the notes issued by Duke High Grade II Funding/EGAM 1.

S&P says that its actions are the result of its review of various factors relating to the vehicles. First, whether a vehicle has actually entered a wind-down that causes a liquidation of assets. Second, the portfolio composition and specifically the amount of the portfolio invested in US sub-prime assets. Third, the capital structure – which varies from structure to structure – and finally, the liquidity available to each vehicle.

MP

Japanese REITS to rise?

Latest CDO could presage further such issuance

Aozora Bank has issued a to-date rare synthetic CDO that references Japanese real estate investment trust (REIT) assets. However, Moody's has released a report suggesting that the volume in such transactions is likely to grow going forward.

The ¥24.5bn (US$207m) Aozora Bank transaction - dubbed Godo Kaisha Acorn One - has an expected maturity date of 25 February 2010. It has been rated by Moody's, which assigned triple-A ratings to the deal's ¥23.2bn and ¥2.7bn Series 1 Senior notes, as well as A2 ratings to its ¥1.3bn and ¥1.4bn Series 1 Junior notes.

Aozora Bank acts as the CDS counterparty and calculation agent, while Tokyo Kyodo Accounting Office will be the credit event determining agent and independent valuator for the deal.

On the back of this transaction Moody's has released a report offering the agency's initial thoughts on the notable issues when it rates corporate CDOs, structured finance CDOs and CRE CDOs incorporating Japanese REIT obligations. Notably, the agency says that it expects to see more REIT obligations as underlying or reference assets of CDOs, as various types of structures and portfolios emerge.

The report notes that the number of Japanese REITs has continued to increase since their emergence in 2001, while the balance of loans made to and bonds issued by REITs (REIT obligations) held by banks and investors has also grown. "While we have seen structured finance transactions backed by REITs in the US market for years, we are now seeing CDOs backed fully or partly by REIT obligations structured in Japan as well - for risk management, funding and other purposes," note analysts at Moody's.

These Japanese REIT obligations can be incorporated not only in corporate CDOs or structured finance CDOs, but also in CRE CDOs normally backed by commercial real estate-related assets, including non-recourse loans and CMBS. Moody's says it normally uses its CDOROM model when rating Japanese CDOs and CRE CDOs. However, the assumptions used in CDOROM for Japanese REIT obligations differ from those for US REIT obligations, due to factors characteristic of Japanese REITs.

Furthermore, the agency's correlation assumptions between Japanese REITs assume higher correlations than that for Japanese corporates within the same industry, including the real estate sector. "This is warranted because REITs are focused on real estate, and are not as diversified as real estate companies in terms of their business strategies. In addition, this is especially the case among REITs focusing on the same property types, where Moody's assumes a relatively higher correlation," the analysts explain.

Moreover, the agency may assume higher correlations - compared to inter-industry correlations for corporates - between REIT obligations and certain real estate corporates, non-recourse loans secured by real estate, or CMBS.

MP

All in the timing

Christiane Elsenbach, a managing partner at Mayflower Finance, answers SCI's questions

Q: When, how and why did you and your firm become involved in the structured credit markets?
A: Mayflower Finance was set up as a company in July 2006, but the founding partners have been involved in the structured credit markets since their inception. There are three founding, and now managing, partners – Dirk Röthig, Enno Balz and myself.

Dirk Röthig was previously at IKB as global head of securitisation and co-head of treasury and financial markets. Enno Balz, also from IKB, previously held the position of head of portfolio management, while I most recently worked as a director in structured credit marketing, at Dresdner Kleinwort in London.

We all knew each other through our involvement in the market and decided to leave our previous employers to set up Mayflower because all three of us had aspirations to work beyond the very strict and political investment banking hierarchy. In particular, the two partners that worked for IKB felt they were not able to take on further challenges given that the firm was unwilling to implement proposals on how to further improve its structured credit business to address expected negative market developments

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: The creation of a synthetic ABS market, which has advanced the overall ABS market significantly. On the one hand you can now go short and take a view on specific sectors or hedge single assets. That is very useful when you run portfolios and see potential problems, but don't want to sell whole positions, for example.

On the other hand, synthetic products allow you to go long and ramp portfolios that are not available in the cash market much more effectively. They also enable CDO managers to execute the ramp up process more quickly. Not only does it mean that it is now a much easier and shorter process, but you also can often pick up opportunities to benefit the structure as a result of the basis between the cash and synthetic instruments.

Furthermore, the development of synthetic ABS enables the introduction of other instruments. The advent of the correlation market means you can create single tranche ABS transactions, for example.

Q: How has this affected your business?
A: As I've already indicated – we can use it to manage our portfolios with exactly the exposure we would like to have and we can manage and monitor the risk exposure of those portfolios more efficiently.

Q: What are your key areas of focus today?
A: Given current US market volatility, which we had seen coming for some time, we are primarily focussing on buy and hold Euro ABS transactions at the moment. We are also looking at corporate indices in the context of managed capital guaranteed structures such as long-short CPPI for our network of high net worth individuals.

However, we obviously continue to monitor all assets, but overall think that the timing isn't right for US ones. While there may be a lot of value in certain transactions we also need to consider out investors' views and most are in favour of caution with US assets at the moment.

Q: What is your strategy going forward?
A: We intend to manage a number of European CDOs with high grade assets and also plan to launch a CDO that references mezzanine assets later this year. We currently have a warehouse open with a bank (which wishes to remain anonymous, but will remain our strategic partner for CDO issuance). We are currently ramping high grade assets only, but when the market is a little more receptive to the relevant underlying we will look to offer mezz transactions as well.

We will also continue to work on the capital guaranteed fund I mentioned for our high net worth individual clients. Our founding shareholders have given the project approval and we are creating the structure. It will be a closed end fund with a fixed maturity aimed exclusively at buy and hold investors.

This should therefore avoid the mark to market volatility problems of some other funds. Equally, the investors it will attract are those who are used to investing in similar styles of vehicle – private equity funds for example, which are typically far from liquid.

Q: What major developments do you need/expect from the market in the future?
A: Obviously the market is very choppy and we expect it to remain so. But we are very happy about this correction in US sub-prime and to be in a position to start operations post correction – our timing is very fortunate.

About Mayflower Finance
Mayflower Finance was formed in 2006 by Dirk Röthig, Enno Balz and Christiane Elsenbach to be a progressive structured Finance asset manager specialising in CDOs, Hedge Fund activities and other investment vehicles. With a European focus the group operates out of offices in London and Düsseldorf.

Mayflower Finance is owned by the founding partners and a group of institutional investors as well as ultra high net worth individuals. In addition to their investment, this group of investors will support Mayflower Finance to develop distribution channels for its CDO and Structured Credit fund products through their relationships with financial institutions, high net-worth individuals and family offices.

Bank makes senior hires

The latest company and people moves

Bank makes senior hires
Dresdner Kleinwort is understood to have made two senior structured credit hires. Tony Main, formerly head of credit repackaging at Merrill Lynch, is expected to become the latest former Merrill colleague (see SCI issue 50) to rejoin Neil Walker, now Dresdner's head of credit trading.

Meanwhile, Dresdner is also believed to be hiring Maxime Malaure as head of cash CDO structuring. Malaure was formerly at Bear Stearns in London, where he was a senior cash CDO structurer.

CDO head back in business?
Following his exit from ABN AMRO where he was head of Cash CDO structuring (see SCI issue 42), Ian Robinson is rumoured to be joining Nomura in London. Further speculation was that some of his former team will be joining him there. Neither suggestion could be confirmed.

Correlation exits
James Boyle, correlation trader, and Marc-Albert Hamalian, a junior correlation trader, have both left Barclays capital. Their destination or destinations are not yet known.

Trading head confirmed
Matt Reader has not after all rejoined UBS from RBS (see SCI issue 38). Instead he has joined JP Morgan as head of structured finance trading.

Middle East sales move
Fiona Lui, formerly in structured credit sales at SG is understood to be moving to Lloyds TSB. Lui will have similar role covering the Middle East.

Credit structurer surfaces at bank
Dacil Acosta has now surfaced at Merrill Lynch, having previously left the credit structuring team at Dresdner Kleinwort (see SCI issue 47).

BNP Paribas grows emerging markets
BNP Paribas has hired Vlad Galea as head of emerging markets structuring in Europe. The bank says this appointment demonstrates its continued investment in aggressively building its presence in emerging markets, in particular Russia and the CIS.

Galea is based in London and reports directly to Kara Lemont, European head of FX and interest rates structuring and Herve Besnard, head of credit derivatives structuring. He joins from JP Morgan in London, where he spent five years, most recently within the emerging markets structuring & marketing team.

PIMCO adds product managers
PIMCO has appointed Ilan Heimann and Ryan Blute as product managers in its European product management group. Both will be based in London and report to Craig Dawson, head of the European product management group.

Heimann is responsible for structured products and joins PIMCO from Goldman Sachs Asset Management where he was an executive director. He will be responsible for product development and positioning across the company's structured products client base.

Blute is responsible for European credit products following his relocation to London from PIMCO's headquarters in Newport Beach. He joined PIMCO in 2000, and has nine years of investment experience, including high yield and investment grade corporate bond research.

Coffman joins Lewtan
Lewtan Technologies, provider of asset-backed securities surveillance, analytics and content has taken on Don Coffman as vp of professional services. Coffman will be responsible for leading the organisation in ensuring customer satisfaction with the consulting and implementation of Lewtan products. He joins Lewtan from Dell, where he served as director of financial services consulting, with responsibility for engagement management, leadership, client relationship management, and systems-integration initiatives.

Lewtan also announced that long-time Lewtan executive Paul Arvidson, senior vice president of sales and services, will assume management responsibility for Lewtan's professional services organisation.

MP

More CPDO moves

A round up of this week's structured credit news

More CPDO moves
Moody's announced yesterday that it was reviewing its rating on a CPDO as a result of recent market volatility for the first time. Meanwhile, two new deals have been launched in the past week.

Moody's has placed under review for possible downgrade the various series of UBS's TYGER Notes, currently rated triple-A. The agency says this review for downgrade is the result of the recent spread widening on financial names underlying this CPDO, negatively impacting the NAV of the deal.

Meanwhile, Deutsche Bank and Natixis have launched €100m of managed CPDO notes issued by Coriolanus Limited under Series 92, due September 2017.

The rating of the Notes addresses the expected loss posed to investors by the legal final maturity. The scheduled maturity date with respect to the Notes is 20 September 2017.

The Coriolanus Limited Series 92 CPDO notes apply the CPDO technique on a portfolio of credit exposures (the Reference Portfolio) managed by ("Natixis").

The deal's reference portfolio, which is managed by Natixis Asset Management, is comprised of long credit default swap exposures referencing single name corporates. Natixis will change the composition of the portfolio through time investing into long and short single name CDS exposures. In addition to the criteria on the portfolio profile to be fulfilled, a portfolio change is allowed only if it passes a model test based on the publicly released Moody's CDOROM model completed by an add-on.

Natixis will have some ability to manage the leverage subject to a maximum which is initially at 5 then increases to 15. The deal pays a coupon of Euribor plus 105bp to noteholders.

At the same time, Nomura has launched an A$28.9m CPDO in Asia –PHOENIX Secured Portfolio Index-Linked Floating Rate Notes due 2017 issued by Aphex Pacific Capital Limited. The notes are exposed to a leveraged portfolio of 250 corporates.

The portfolio is comprised of the on-the-run 5-year iTraxx Europe Index Series (initially 5-year iTraxx Europe Index Series 7) and the on-the-run DJ CDX.IG 5-year Index Series (initially Series 8 DJ CDX.IG 5-year). Each of the indices represents 50% of the total portfolio on a notional basis; the portfolio size is dynamically adjusted following rules defined in the documentation; and the current portfolio size is adjusted to equal the target portfolio size, subject to a maximum leverage constraint.

SIVs weathering volatility
SIVs appear to be coping far better with current market disruption than SIV-lites (see this week's main news section for more). A new report from S&P says that several key structural aspects of SIVs and the ratings analysis that go beyond a simple asset price volatility analysis have led the agency to maintain its ratings on 30 SIVs.

"We are reviewing reports on a daily and weekly basis and, thus far, all SIVs are passing their tests. In addition, we have been looking at net asset value to capital rations and portfolio concentrations to further evaluate each SIV," says credit analyst Nik Khakee, an md in S&P's structured finance group.

"Given that SIVs are structured so they don't have to liquidate immediately due to the liability profile and are structured with liquidity facilities to address market disruptions, we believe that the structure, in conjunction with the actual portfolio level detail, enable us to maintain these ratings and communicate to the market that we will provide updates if and as appropriate," he adds.

"SIVs have weathered various crises over the past 19 years, including the difficult credit conditions of 1990-1991, the Long-Term Capital Management collapse, and the Sept. 11, 2001, terrorist attacks," Khakee notes. "They have responded by diversifying into multiple funding markets, such as Europe and the US, and by maintaining access to the best available liquidity sources, including banks and easily traded assets."

Global banking fears exaggerated
Fears of a global banking systemic crisis remain exaggerated, despite the most recent events, given that the "core" of the system is still comfortably shock-resistant. However, the ongoing resilience of the system may remain more dependent on episodic liquidity assistance from central banks than originally thought, according to Moody's in a new report.

The events of recent weeks – which featured some small-size bank casualties in Germany and large scale interventions by several central banks to restore orderly conditions on money markets – potentially cast into question Moody's contention, outlined in a report published last month, that fears of global banking systemic risk were exaggerated.

Nonetheless, Moody's believes that the intensity of the crisis will depend whether or not the "core" financial institutions – the pillars of the system – are shock-resistant. "Notwithstanding the possibility of a severe depression of earnings attributable to asset impairment, higher funding costs and lower business volumes, our long-held view that the largest and most sophisticated US and international financial institutions have a high pain threshold remains unchanged," explains Pierre Cailleteau, Moody's chief international policy analyst and author of the report. "Isolated casualties, if they happen, are therefore much more likely to occur at the periphery, among smaller institutions that may or may not be assisted depending on their respective countries aversion to bank failures," he adds.

That said, Moody's acknowledges that the nature of today's global financial system – in which risks are dispersed – while it has favourable implications in terms of the solidity of the pillars of the system, also fuels anxiety at times of stress – and results in a system as a whole that is vulnerable to confidence shocks and, by extension, liquidity shocks.

"Therefore, although systemic risk is very likely to be avoided because the core financial institutions are able to absorb losses, the system may remain dependent on episodic market "peace-keeping" operations carried out by central banks – which may become an enduring feature of our global financial system," Cailleteau says. "The anxiety over where risk coagulates in a largely opaque and leveraged system may have made the system more prone to confidence shocks, sometimes affecting banks indiscriminately, and therefore requiring more frequent market-stabilising operations".

Fitch revises SF CDO methodology
Derivative Fitch has introduced revised methodology for rating structured finance (SF) CDOs to reflect the increased risk associated with sub-prime RMBS as portfolio collateral. The agency reiterates its methodology change announced on 12 July 2007 and further identifies additional criteria changes as follows:

• Increased assumed default probability for US sub-prime bonds issued since 2005 by 25% (announced July 12);
• Modified methodology for treatment of US sub-prime bonds on rating watch negative to assume a three-subcategory downward rating adjustment for purposes of the rating definition used in Fitch's Default VECTOR model;
• Fitch will take into consideration, in conjunction with input from Fitch's RMBS ratings group, additional risk factors, such as those affecting recently issued sub-prime RMBS, Alt-A performance, closed-end second lien RMBS, and overlap with other SF CDOs as collateral, that may further increase the 25% default probability adjustment or otherwise modify modelling assumptions.
This revised rating methodology will apply to all SF CDOs immediately. This includes the issuance of initial ratings on new transactions, as well as maintaining accurate ratings on existing CDOs.

CMA adds ABX to QuoteVision
CMA, the credit information specialist, has announced a new release of QuoteVision, its price discovery service for the OTC credit derivatives market, with the ability to handle (accurately parse and validate) the Asset Backed Securities Index (ABX) along with other new features.

Laurent Paulhac, ceo of CMA, comments: "The latest version, just released, contains many enhancements in addition to ABX pricing, such as a rapid search facility, new portfolio functions, and performance enhancements. It is also optimised for CMA's recently released ASP version."

Markit enhances ABX calculator
Markit has launched an enhanced ABX Calculator, designed to aid settlement of ABX index trades. In response to the increased focus on the synthetic ABS market over the last several months, Markit has enhanced its ABX Calculator to allow clients to understand the impact that credit scenarios can have on ABX index trade economics.

The new functionality of the ABX Calculator enables users to input their own prepayment, delinquency, default and loss assumptions. Enhancements include: ability to add index-level credit assumptions and project cash flows dynamically for each constituent deal underlying the ABX indices, which includes functionality for determining the cumulative default rate of collateral by including annual collateral default rates in calculations; ability to input percentage of losses on defaulted collateral and use proprietary delinquency percentages; and ability to run historical scenarios to calculate values for back-dated trades.

Fitch exposes new insurance-linked criteria
Fitch Ratings has published an exposure draft detailing the agency's proposed methodology for rating insurance linked securities (ILS). Fitch believes this is a time of innovation and rapid change for ILS, with new hybrid structures and variations on traditional structures being introduced to the market almost monthly.

Therefore, this methodology presents Fitch's approach to rating ILS in broad terms. It describes the core principles Fitch applies to all ILS.

In a notable change from prior methodology, Fitch's new methodology proposes rating all ILS using a probability of loss (PL) benchmark. While Fitch historically has rated many ILS based on PL, non-investment grade catastrophe bonds have been rated based on an expected loss (EL) methodology which also considered the level of expected recovery given default. Fitch specifically solicits comments on the change from an EL benchmark for non-investment grade catastrophe bonds to a PL benchmark.

No rating changes are anticipated as a result of the new criteria. Additionally, this methodology does not cap the ratings of ILS at the rating of the sponsor in all cases. While a cap may exist for some transactions, the methodology recognizes structural mitigants may be in place in other transactions that reasonably permit ratings above the rating of the sponsor. Fitch is also interested in market participants' opinions on this aspect of the methodology.

Fitch will be publishing a series of more detailed criteria pieces tailored to specific transaction categories. In the supplemental criteria, Fitch will illustrate how these broad principles are applied to those transactions and describe aspects of the rating process unique to those assets. In addition, transaction-level presale and new issue reports will describe Fitch's approach to the analysis of the risks unique to those specific transactions.

Comments should be sent by 7 September 2007. Following this review period, Fitch expects to publish a final ILS methodology report that incorporates the feedback received where appropriate. This new methodology report will supersede and replace 'Rating Guidelines for Catastrophe-Linked Bonds.'

Caliber NAV drops again
Cambridge Place Investment Management's permacap vehicle Caliber released its quarterly report and accounts to 30 June this week. They showed a net loss for the third quarter of US$30.1m (31 March 2007: net loss was US$8.8m) after an impairment charge of $37.1m, a result of sustained market weakness during the period.

As a result Caliber's NAV was US$5.55 per share at June 30, 2007, compared with US$6.30 at 31 March. Furthermore, reflecting further severe market disruption since the period end, Caliber's NAV (estimated and unaudited) at 31 July 2007 is expected to be in the range of US$1.50 to US$2.50.

The report and accounts go onto note that following a strategic review, as previously announced (SCI passim), an extraordinary general meeting is to be held on August 30, 2007 to approve resolutions authorising the return of invested capital to shareholders. In the meantime, financing facilities have, or are in the process of being, restructured post period end, stabilising the portfolio.

"Caliber does not believe that recent declines in market pricing are a fair reflection of fundamental credit performance," the report and accounts adds.

MP

Trading ideas - positively golden

John Hunt, research analyst at Credit Derivatives Research, looks at a positive basis trade on Goldman Sachs

Although Goldman Sachs does not seem to be perceived to have as much sub-prime exposure as some of its peers, the bank's benchmark five-year credit spread has nevertheless rocketed upwards from the mid-30s at the beginning of July to the low 80s as at 17 August. As we expected, this deterioration in perceived credit quality has gone along with an increase in the cash-CDS basis – for the bond we recommend here, the basis has gone from around zero to the 20s-30s since early July.

At current levels, a positive basis trade is attractive for those who are willing and able to take on the risks attendant to shorting bonds. Although the high volatility of the basis at this time suggests that either joy or pain is possible in the short term, the quasi-arbitrage nature of the basis trade makes us confident that bond and CDS spreads will converge eventually.

Positive basis trade basics
The underlying idea of the positive basis trade is that credit risk is underpriced in the bond market relative to the CDS market. The investor sells a risky bond – and thus pays the buyer for credit risk on the issuer – while being paid to take credit risk in the CDS market by selling protection on the issuer.

Eventually, the prices for credit risk in the two markets should converge, resulting in an arbitrage-like profit. In the interim, the investor should earn positive carry, because the credit spread that is collected in the CDS market is greater than the spread that is paid in the bond market.

The credit risk implied by market prices in the CDS market can be inferred in a fairly straightforward fashion from the CDS spread curve, as discussed in the Trading Techniques section of the CDR Website. The price of credit risk in the bond market is sometimes measured by the "z-spread" – the amount that must be added to the risk-free curve to cause the discounted present value of the bond's promised cash flows to equal the bond's current price.

While the z-spread often is a good measure of how the market prices a bond's credit risk, the z-spread approach implicitly makes the incorrect assumption that all the bond's promised cash flows definitely will be received, and received on time. The z-spread is not a good measure of credit risk price when bonds are trading at or near distressed levels and/or are trading away from par. For that reason, we prefer to extract the probabilities of default implicit in CDS spreads and use those probabilities to arrive at a CDS-implied bond price.

Because bond and CDS maturities usually do not match exactly, interpolation is usually required to perform the comparison. The details of this computation are explained in the Trading Techniques section of the CDR website. We then compare the market price of the bond to the CDS-implied bond price to determine whether the bond is trading rich or cheap to the CDS-implied level.

Constructing the positive basis trade position
We generally construct positive basis trades so that they are default-neutral – that is, so that the bond position fully hedges against CDS losses in the event of default. This ensures that we are paying the counterparty in the bond market to take the same amount of default risk as we are being paid to take 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 recommend only 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 richness
Based on our valuation approach, the Goldman Sachs Group Inc. 5.125 of April 2013 bond is trading rich to fair value. Exhibit 1 presents the term structure of prices of the company's bonds with maturities near five years and indicates that all the Goldman Sachs bonds with maturities of approximately five years are rich to fair value.

Exhibit 1

Exhibit 2 compares the bond z-spreads with the CDS term structure, and shows that the recommended bond is indeed trading tight of the closest-maturity CDS. 

Exhibit 2

Exhibit 3 illustrates the basis between the 5-year on-the-run CDS and the bond over the past year. The basis has been negative for most of the period and has become significantly positive only during the market sell off as Goldman's credit spreads have increased. Basis volatility also has increased recently, but the quasi-arbitrage nature of the positive basis trade gives us confidence that spreads will converge despite any short-term pain the trade may suffer.

Exhibit 3

Risk
The position is default-neutral. There is a maturity mismatch because the bond matures on April 24, 2013 and the five-year CDS expires on September 20, 2012, but we expect enough convergence to enable us to exit the trade with a profit from carry and convergence to fair value before either instrument matures.

Positive basis trades require the investor to take a short position in a bond and typically expose the investor to the special risks of the repo market, such as the risk that the bond will go "special", causing the carrying cost of the short position to increase dramatically in a short period time. Such an event could force the investor to exit the position prematurely.

We provide a suggested simple, duration-matched government bond position to hedge interest rate risk.

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 short the firm's credit – the position gains approximately 0.35bp of notional per 1bp of parallel curve widening, using the linear DV01 approximation. If Goldman's credit improves uniformly across the credit curve, then the position will lose; if Goldman's credit deteriorates uniformly, then the position will gain.

Exhibit 4

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, but for many large names the 5-year tenor remains liquid. That appears to be the case for Goldman Sachs, which is generally one of the most liquid CDS names.

The Goldman Sachs 5.125 of April 2013 bond shows strong availability and high current trading volumes.

Fundamentals
As explained, our positive basis trades are based on the assumption that the bond is miss-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.

Kathleen Shanley, Gimme Credit's Financials expert, maintains a "Stable" fundamental score on Goldman Sachs. Kathleen notes that although the company has been more aggressive than some of its rivals, its leading size and market shares in equity and M&A have enabled it to take on bigger bets while maintaining credit quality.

Summary and trade recommendation
The basis between the Goldman Sachs 5.125 of April 2013 bond and the on-the-run 5-year CDS has been moving steadily more positive for months, but in the last two weeks it has reached record positive levels while its volatility has jumped, all against a backdrop of extreme behaviour across the credit markets.

At 17 August 2007 levels, a positive basis trade offers attractive carry (20bp), plus the potential for profit if the basis reverts in the near term. Our computations indicate that if the bond re-prices to the level implied by the CDS, the trade will yield profit of approximately 290bp (€290,000 on a €10m notional).

Sell €10m notional Goldman Sachs Group, Inc. 5 Year CDS protection at 79.5bp

Sell €10m notional (€10m proceeds) Goldman Sachs Group, Inc. 5.125 of April 2013 bonds at a price of €99.97 (z-spread of 59.8bp) to gain 20 basis points of positive carry

Buy €9.3m notional Bundesrepublik Deutschland 3.75% of July 4, 2013 at a price of €97.94 (€9.07m cost) 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).

Liquidity facilities as a credit enhancement tool?

The impact of recent events in the Canadian ABCP market are examined by Domenico Picone and Priya Shah of the structured credit research team at Dresdner Kleinwort

The US sub-prime crisis has become a global event as the Canadian ABCP market is the next to suffer the consequences of the credit market turmoil. With ABCP conduits and SIVs now finding it difficult and expensive to roll existing CP contracts, they are increasingly turning towards their liquidity providers. However, how many sponsors will be willing and able to take on the resulting increased credit exposure without challenging their commitment?

As liquidity continues to fall it is now the turn of the short-term CP sectors to suffer the consequences of the recent deterioration within the credit markets. In particular it is the asset-backed commercial paper (ABCP) sector which has come under pressure as a number of conduits and SIVs are finding it difficult and expensive to roll these contracts forward as investors remain concerned and worried about the programmes' exposure to the US sub-prime market.

Volume of commercial paper
US commercial paper issuance has increased significantly in the past few years with a total outstanding volume of US$2.13tr of which US$1.15tr is ABCP. In its Q107 ABCP update S&P reported that while conduit mortgage allocation has fallen marginally this year they continue to be the largest asset type backing US$ ABCP, accounting for 26% of the total portfolio, with the rest comprising of CDOs and consumer and commercial lending assets such as trade receivables, credit cards, student loans etc.

For the CP market, S&P expect to see continued growth with total CP projected to grow at 18% for 2007 and 21.7% in 2008. The table below shows the volumes in the CP market and what is expected for the future. ABCP is currently the largest sector. However, with the recent uncertainty within the credit market these predicted forecasts could alter and we could be looking at a different set of numbers by the year end.

What is an ABCP conduit?
ABCP conduits are generally sponsored by financial institutions and established to finance the sponsor's own assets or to provide financing alternatives to the sponsor's clients. Additionally, they may also provide warehousing facilities, where assets accumulate until a sufficient portfolio size is reached and sold via a term securitisation.

An ABCP conduit programme comprises of a bankruptcy remote SPV that invests in high quality, high yielding assets, predominantly structured finance securities. Some common assets financed through ABCP conduits include RMBS, CLOs, CDOs, CMBS, trade receivables and other commercial and consumer assets. While assets are generally of long maturity they are funded by short-term CP borrowing, with maturities typically between 30 to 90 days and usually no longer than a year. The structure generally includes transaction/asset specific and program specific credit enhancement features, providing CP providers' protection against asset default.

In addition, a financial institution also provides a liquidity facility, usually equal to the amount of CP outstanding, which can be drawn to assist the timely repayment of CP. In particular, liquidity facilities can be used as an alternative funding source if disruption in the CP market makes it difficult to roll the CP contracts. The credit risk faced by an ABCP investor is therefore limited to a shorter period of time.

Comparisons within the ABCP market and CDOs of ABS
ABCP conduits are in many aspects similar to cash flow CDOs of ABS, as they manage a diversified portfolio of assets, and their activity is constantly monitored by rating agencies. They are different as they are funded by short-term liabilities.

Comparing the portfolios of ABCP conduits with CDOs of HG ABS, ABCP have a more diversified portfolio of assets, through investment in a variety of collateral types and not only mortgages but other consumer and commercial lending assets as well. CDOs of ABS primarily comprise at least 75% or more of RMBS and HEL with a small amount of CDOs and CMBS making up the remaining assets.

Another difference between the two vehicles is the unusually large proportion of NA/NR rated collateral (42%) within the conduit. However, for those investors closer to the ABCP world, this is not surprising as conduits provide finance on a revolving basis for businesses whose assets will never been sold via a term securitisation.

US sub-prime crisis hits commercial paper
The US sub-prime crisis has become a global event and the Canadian ABCP conduits are the latest casualty of the sub-prime crisis. Some Canadian ABCP vehicles have been unable to place new ABCP to fund the rollover of maturing paper and are now requesting funding from their liquidity providers.

On 13 August DBRS stated that Canadian conduits were providing the first notices to their liquidity providers following Coventree's announcement of an ABCP "market disruption event". As a result DBRS was requested to affirm the asset rating of these conduits, which DBRS have since confirmed to be performing in a manner that is consistent with the ratings that were originally assigned. However, liquidity providers still remain concerned about their resulting credit exposure and regulatory concern that will arise and DBRS has warned that some liquidity providers may therefore try to get out of their liquidity commitment by legally disputing the market disruption criteria.

The scope of Canadian liquidity lines
In Europe and in the US, liquidity providers are obliged to make available funding in three circumstances:
? market CP disruption,
? lack of investor demand for ABCP,
? collateral performance triggers are breached and the assets cannot be further financed by CP.

The actual amount that is then "liquidity" financed varies and depends on the risk appetite of the bank providing the liquidity. As a result, there is a wide range of non-credit events but also temporary credit events which are under the protection of the liquidity provider.

However, the liquidity facility is not available for defaulted assets or to compensate for a drop in market value, and some conduit programmes restrict the use of liquidity to fund only IG assets. The definition of defaulted assets varies amongst transactions but it tends to include elements such as: number of days delinquent, credit rating of the asset, or loan obligor.

Alternatively, the scope of Canadian ABCP liquidity lines has been confined to market CP disruption. Ambiguity regarding the real meaning of a disruption event has raised concern regarding the stability of these vehicles under the current credit market conditions.

Domino effect in the correlation market resulting from Canadian ABCP
Canadian conduits have been dominant buyers of leveraged super-senior synthetic CDOs. Faced with liquidity concerns these conduits may be forced to unwind these trades and as a result we may see further widening in super senior credit tranche spreads and credit indices, with demand for senior protection buying increasing.

Recent credit concerns has already resulted in a relatively high amounts of value being priced into the super senior credit tranches and any LSS unwinding will push these tranches wider still.

Liquidity sponsors
The chance that conduits could be hit by the current broad market volatility will also continue to put pressure on the CDS spreads of the financial institutions involved in the ABCP market as liquidity sponsors. We also anticipate that most of the ABCP conduits will roll into more expensive CP programmes, when available, challenging the economics of their operations.

Conclusion
Although the majority of ABCP vehicles have a lower exposure to US sub-prime RMBS and CDOs, in contrast to CDOs of ABS which rely on more stable funding tools via credit enhancement techniques, they are more exposed to the current market liquidity volatility.

Liquidity lines cannot become permanent credit enhancement tools and thus if the Structured Finance turmoil continues to persist, it is likely that several European and US conduits will end up in a similar position as their Canadian cousins, and be forced to sell assets to meet the CP/liquidity payments. In such a fire-sale of assets, despite the higher rating, pricing will drop further resulting in even more collateral losses, and continued credit contagion.

© 2007 Dresdner Kleinwort. All Rights Reserved. This Research Note was first published by Dresdner Kleinwort on 17 August 2007.