Contents

CDR Liquid Index data as at 17 September 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.

Manager rankings

New tools could clarify tiering

New bank research shows that the average percentage of underlying RMBS and CDO collateral downgraded in 2006/7 vintage US mezz ABS CDOs is 13%. The research, which attempts to rank CDO managers by portfolio quality, could facilitate the emergence of manager tiering in the sector.

On average, the results show that 24% of collateral was downgraded in the worst quartile and 4% in the best quartile. Compiled by analysts at UBS, the research surveys 144 transactions (managed by 68 managers) up to the end of August whose portfolios are exposed to RMBS bonds that have either been downgraded or negative watch-listed by Moody's or S&P. Intex is used as the source for the CDO collateral.

The exposure of a CDO to downgraded/watch-listed collateral is an indication of the likelihood of the transaction being downgraded and provides a way of differentiating between two deals that may be trading at the same level but have differing asset quality. "It could help in the process of manager tiering," explains one structured credit investor. "Investors holding CDOs issued by some of these managers may be getting bad marks at the moment. This kind of information could help them justify their decisions to their credit committees."

Zais Group tops the UBS manager rankings with an average of 0.4% of the total collateral par in one CDO subject to a downgrade/watch-listing. AXA Investment Managers are next (with 1.6% across one deal), followed by Rabobank New York (2.2%/one), Babcock & Brown Securities (2.8%/one), Bear Stearns Asset Management (3%/one), New York Life Investment Management (3%/one), Duke Funding Management (3.6%/three), Cairn Financial Products (3.8%/three), Ivy Asset Management (4.2%/one) and Peloton Partners (4.3%/one).

At the other end of the spectrum, Fischer Francis Trees & Watts are last in the rankings, with 25.2% of the total collateral par in one CDO subject to a downgrade/watch-listing. Above them are Seneca Capital Management (with 23% across one deal), ACA Management (21.8%/four), NIBC Credit Management (20.6%/two), Putnam Advisory Co (20.4%/one), MKP Capital Management (19.8%/two), TCW Asset Management (19.7%/seven), PIMCO (19%/one), State Street Global Advisors (18.8%/two) and Church Tavern Advisors (18.5%/one).

The investor isn't surprised by the overall ranking and believes that it is reasonably reflective of managers' performance. "The results are interesting: they are exactly as you'd expect for some managers but for others they look poor. There are also some one-offs which are perhaps reflective of bad financing decisions."

Meanwhile, Zais Investment Grade 8 (which closed on 23/3/06) is the CDO least exposed to downgrades, according to the UBS research, at 0% of total collateral par. Cairn Mezz ABS CDO III (29/3/07) and Duke Funding X (12/4/06) are next with 1%, while Opus CDO (19/1/06), Bayberry Funding (15/2/06), Barramundi CDO (12/12/06) and Nordic Valley 07-1 (2/8/07) follow with 2%. At 3% of total collateral par exposed to downgrades, Euler ABS CDO (27/3/06), Vertical ABS CDO 06-1 (25/4/06) and Buchanan SPC (9/11/06) come after them.

The CDO most exposed to downgrades out of the sample, on the other hand, is ARCA Funding 06-II (which closed on 19/12/06), with 38% of total collateral par affected. Above this in the rankings are ARCA Funding 06-1 (11/10/06) with 37%, TABS 06-5 (5/10/06) and Static Residential CDO 06-B (22/8/06) with 35%, ACA ABS 06-2 (29/11/06) with 33%, GSC ABS CDO 06-4U (6/10/06) with 29%, South Coast Funding IX (9/3/07), ACA ABS 06-1 (27/4/06) and Gemstone CDO VII (15/3/07) all with 27%, and Commodore CDO V (25/9/06) with 25%.

A number of other banks are understood to be exploring whether to publish similar CDO manager rankings in the hope of expanding the range of comparative tools for investors.

CS

Market risk re-evaluated

Rating agencies set to explore ratings volatility

The traditional disclaimer for rating agencies is that they are only concerned with credit risk. But the current credit crunch – combined with the rise of market value CDOs – has forced them to re-evaluate their position on market risk too.

"Perception of rating accuracy can impact price volatility, as well as the liquidity of the underlying," argues Kai Gilkes, md at DBRS. "Rating volatility establishes a causal link between a rating and market prices, as it leads to regulatory capital volatility. Basel 2 underscores the importance of rating performance, which in turn is the impetus for rating agencies to provide more information on rating performance."

He says that rating agencies should provide timely and accurate surveillance, allowing them to identify likely sources of pressure over the next 12 months as well as to look at rating transitions retrospectively (and therefore update their methodology accordingly). "Rating agencies have been quite backward-looking: you can use both directions of the analysis to inform the market."

Most investors now accept that there has been an over-reliance on ratings to the detriment of doing their own fundamental analysis on transactions. For buy-and-hold investors, the majority of European ratings have proved to be relatively reliable over the years. However, progress still needs to be made in terms of transparency around what ratings address, which analysis the rating is trying to capture and the future performance of the portfolio.

"Rating agencies compete to get business: they present the idea that they're proactive and innovative, while forgetting that structures evolve and so their methodologies need to adapt," observes one European portfolio manager. "We haven't seen a full cycle yet in Europe, so it's hard to assume negative amortisation when there is little information on historical default rates or underlying borrowers. Ratings should be based on asset quality, as well as the quality of the manager and servicer of the deal, but these other dimensions seem to have been ignored."

A further issue – which was highlighted recently by the downgrade of a number of SIV-lites from triple-A to triple-C seemingly overnight – is that if there is significant deterioration in the credit quality of a deal, how quickly and how severely should a rating be adjusted? It is clear that investors don't want long delays and large adjustments in rating actions – they prefer to see smaller adjustments made more frequently.

One of the issues that has come to light in the current market environment is education. Richard Hunter, regional credit officer for Europe at Fitch Ratings, agrees that, while there is sufficient transparency surrounding approaches to default risk, there isn't enough transparency around the other aspects of risk. To that end, Fitch recently introduced a stability score for CDOs which aims to identify transactions' migration prospects.

Moody's, S&P and DBRS are also exploring whether to introduce a ratings volatility measure to provide a better idea of the chances of a given rating moving up or down.

One proposal in the frame for DBRS is a "3-D view of risk", in which ratings remain one-dimensional (addressing default risk) but the other two dimensions (recovery risk and volatility) are analysed separately and communicated to the market in parallel as separate pieces of information (see SCI issue 55 for more). "There is a feedback loop: as you measure changes in credit quality, modeling assumptions should be reflective of that new information," explains Gilkes.

CS

CPDOs restructured

Move highlights impact of spread leverage

UBS has restructured two of the three series of Financial Basket TYGER CPDO notes issued by its ELM vehicle that had their ratings withdrawn by Moody's last month (see SCI issue 53). The move is in response to recent spread widening on financial names underlying the notes, which has negatively impacted their net asset values.

The motivation behind the restructuring was partly driven by the deals' exposure to financials – financials widened much more than the rest of the market, and the portfolios contained names that widened the most thanks to their exposure to US sub-prime. But, says Mehdi Kheloufi-Trabaud, associate analyst at Moody's, it was also driven by the concept of spread leverage – which is the leverage of the deal (note notional) multiplied by the duration of the contract.

"The duration of the standard TYGER transaction is approximately eight years (ten year contracts) and the leverage 10x, which equals a spread leverage of 80x – compared to, say, a standard rolling Globoxx deal which has one of 60x (15x leverage multiplied by a duration of approximately four years). The original TYGER deal is then the most leveraged CPDO at a triple-A rating we've seen," he adds.

The €80m Series 103 notes have been partially restructured into triple-A rated Series 116 and 117 notes. €7.5m of Series 103 has been cancelled and restructured into Series 116, for which the leverage has been halved from 10x via a €7.5m notional increase from the noteholders. The notes consequently have a notional amount of €15m and pay a coupon of 50bp over Euribor.

Similarly, €20m of Series 103 has been cancelled and restructured into Series 117, following the removal from the portfolio of five names that have showed the greatest spread widening recently (Ambac, CIT, Radiant, MGIC and PMI). As a result, the leverage of the transaction has been reduced by 10% from 10x to 9x, with a notional amount of €20m and an unchanged coupon of 100bp over.

With €5m also having been bought back by the issuer and cancelled, €47.5m of Series 103 remains unaffected by the various restructurings and has been downgraded by Moody's from Aaa to Aa3.

Additionally, Series 104 has been fully restructured, with the leverage halved via a €45m notional increase from the noteholders. As a consequence, €90m of triple-A rated notes are now outstanding, paying a coupon of 37.5bp.

Moody's notes that the Aa2 rated CPDO CDS entered into by UBS has also been fully restructured, with the leverage halved from 18x via a €50m notional increase from the noteholders and the removal from the portfolio of Ambac, CIT, Radiant, MGIC and PMI. The swap now amounts to €100m and pays a coupon of 125bp.

However, the €100m Series 115 notes have not been restructured and have consequently been downgraded by Moody's from Aaa to Aa3.

The initial rationale behind the deal was to benefit from the stability of financials, but the spread widening on such names seen in August is considered by Moody's to be exceptional. At closing in April 2007, the average spread of the original portfolios were approximately 30bp; at one point in mid-August they had more than quadrupled, going over 120bp and driving the NAV of the deals as low as 40%. They are now in the range of 90bp.

The transaction was in danger of hitting its cash-out trigger, so investors preferred to halve their principal and move the deal away from the trigger level rather than run the risk of losing their investment. None of the transactions were forced to crystallise these mark-to-market movements and so, as spreads returned to more moderate levels, their NAVs have improved accordingly.

Moody's has been discussing the concept of spread leverage with investors because it often isn't clear where leverage levels are. As Kheloufi-Trabaud explains: "The duration effect is neglected often, but it's important because it is possible to re-leverage the portfolio in some transactions by increasing the maturity of the CDS contract. Certainly we've seen this feature being used in some CPPI deals."

The agency doesn't expect to conduct a review of the sector in the near future, but will continue to monitor transactions outstanding – particularly in light of the forthcoming index roll and potential volatility on financial spreads due to the news flow expected on this market over the next few weeks.

CS

European CLO sector returns

Two innovative transactions lead the way

The European CLO market has returned with a flourish. Citi has structured what is thought to be the most granular emerging market CLO yet, while Merrill Lynch has priced an innovative variable leverage deal for Mizuho Investment Management.

Citi's €2.5bn Terra I transaction references a portfolio of over 800 corporate credit facilities across 32 jurisdictions. "We have kept the structure quite simple in order to broaden its appeal. The innovation is in the portfolio: to our knowledge no-one has brought a trade referencing as many emerging market names before," explains Olivier Renault, director in global structured credit products at Citi.

The portfolio references senior loans made to large corporates which have gone through Citi's credit approval process. The five-year synthetic balance sheet CLO will allow the bank to further grow its business in the underlying emerging markets.

The equity and junior mezzanine tranches of Terra – both structured as CLNs – have already been placed with Dutch pension fund PGGM. Most of the underlying companies don't have bonds outstanding, so the transaction provides diversification for PGGM.

"We were looking for a partner with a long-standing leading position in EM and where it is a core activity well embedded in the DNA of the organisation," comments Mascha Canio, head of infrastructure, private equity and structured credit at PGGM. "We have found that commitment at Citi and so have worked closely together to tailor and optimise the transaction. It gives us access to assets that don't normally trade in the market."

Citi plans to market the rest of the capital structure – which is expected to be rated by Moody's and Fitch – to traditional CDO investors. But it may also appeal to ABS accounts because there is no residential exposure in the portfolio.

"While there were efficiencies to be gained by negotiating the terms of the trade with one core investor, we bore in mind that it needs to appeal to others, so portfolio composition and replenishment criteria should make the trade attractive to rated-note investors as well," says Renault.

Meanwhile, Merrill Lynch appears to have found a re-entry level for investors in the European cashflow CLO sector with Windmill CLO I – albeit for a top-tier manager. The senior triple-As of Mizuho Investment Management's sixth European transaction printed at 40bp over Euribor, while the junior triple-A piece came at 65bp over. The Aa2/AA, A2/A–, Baa2 and Ba3/BB– tranches priced at 85bp, 175bp, 375bp and 650bp respectively. Marketing of the transaction is likely to have been aided by investors' familiarity with the manager.

The proceeds will be used to purchase a portfolio primarily comprised of senior loans, second lien loans, mezzanine loans and principal-protected equity obligations issued by companies with a primary place of businesses located in some EU member states, Norway, Switzerland, the US, Canada, Australia and New Zealand. These assets will be mainly denominated in euros, but up to 30% of the portfolio can consist of non-euro obligations subject to the entry of the issuer into perfect asset swaps.

The transaction features an innovative variable leverage mechanism – via the Class A-1R revolving notes – which allows Mizuho to alter the asset mix, thereby ensuring it can be efficiently managed through the credit cycle. The amount that can be drawn depends on the riskiness of the portfolio: the leverage of the equity piece is 11.5x if the revolver is fully drawn and 7.7x when undrawn.

The available commitment of the Class A-1R notes will vary up to a maximum of €200m throughout the reinvestment period, in increments of €50m. The target par amount will vary accordingly from €400m to €600m, resulting in five different levels of leverage. A different set of collateral quality tests, coverage tests and portfolio profile tests will need to be satisfied for each leverage scenario.

Any evidence of tiering between CLO managers – widely expected to be given impetus by the current credit crunch – should emerge with the close of the next few transactions in the pipeline. One such deal is Ares Management's €400m Ares Euro CLO II, for which JP Morgan is understood to be marketing the equity.

CS

CDO management as nature intended

Applying Mother Nature's laws to the jungle of CDOs may help managers evolve in the current climate according to Onur Cetin, business analyst at Codefarm

The art of effectively managing CDOs in these turbulent markets is becoming more complex by the day. Adjustable subordination, which allows managers to replace credits while dealers simultaneously adjust their hedges, means considerable leverage – leverage of credit picking skills that is.

Lately one would expect to see many substitutions in the underlying portfolio, especially for a deal that is in its early life. Managers, suddenly bearish on some names or sectors, look to replace them with higher quality credits to avoid further deterioration, leading to a loss in subordination. Initial good picks will ideally have rallied by then, resulting in a MTM gain for the portfolio, which can be used to re-build subordination.

Right up until the point of execution, the decision making process involves dealers, who provide bid/offers, deltas and subordination adjustments. As the dealers have different models and different positions in the market, they can come up with different substitution suggestions, leading to different subordination levels. There will also be transaction costs, individual delta hedges and correlation hedges to take into account – and possibly a change in the calibration, i.e. mapping of index base correlations on to the evolving portfolio.

Complying with the covenants (or constraints) of the deal is another issue. One might have the ideal set of substitutions, but S&P's SROC and Moody's Metric tests (measures to quantify closeness to a rating boundary), or removal limits, might just not allow the manager to go ahead. Add to this some rapidly moving spreads during the day, LBO rumours, liquidity squeezes, updates from rating agencies and things get even more hectic. Some tranches could be sensitive to jumps in only a few names, which leaves managers in an anxious defensive position to keep the ratings stable.

All this chaos might not only mean missing opportunities, but can also cause an operational risk when trying to integrate all these information sources. One can only hope for a common language to communicate effectively with all parties and a platform to make robust decisions based on accurate data.

* * *

The concept of optimisation has been familiar to many for a long time, perhaps since Markowitz's Modern Portfolio Theory gained popularity. However, the original idea relies on numerous assumptions – and more advanced, non-linear and multi-stage versions of Markowitz optimisation require painful tweaks to adapt to realistic situations.

Any practitioner of real-life optimisation tools knows that if one is talking about a shared communication tool or a common platform to solve a complex problem, optimisation should be an integral part of that system. When it comes as an afterthought, it becomes a time-consuming, tedious and inflexible process; making everyone's life harder rather than easier.

Traditional optimisation methods rely on gradients, which basically involves making a best guess on the optimal step and direction to take in the search space in the vicinity of the current solution. This is a natural starting point, but unfortunately discrete problems such as substitutions, coupled with simulations, makes this direction finding hardly feasible. Think of following every slope in an unfamiliar but almost certainly uneven terrain through a thick fog.

Looking at how nature deals with complex optimisations is a good way to search for innovation. Evolutionary algorithms, a smart blend of informed search and randomness that has no reliance on gradient calculation, can bring efficiency and flexibility to CDO optimisation problems. In this context, as a simulation of 'survival of the fittest', many candidate portfolios go through mutations (substitutions or notional amount changes) to adapt to sudden changes in the market or credit opinions, while strict laws of nature (covenants) fine-tune the evolution.

* * *

An effective CDO management platform needs to continuously evaluate and re-optimise deals by integrating pricing and rating models and data feeds. Substitution suggestions have to take a wide range of factors into account, including prices, ratings, compliance tests and trading costs, as well as SROC targets, loss triggers and removal limits. Such a platform gives the user a one-stop shop for constraint satisfaction.

In the usual CDO management practice, analysts pick up a good name and a bad name, and keep trying different combinations until they meet the constraints. The key in effectively implementing evolutionary algorithms is designing the appropriate operators to drive the search and to find the right combination from the immense number of possibilities incorporating managers' picks and reflecting their current credit opinions. Optimising for a single substitution is very likely to get stuck in local optima, whereas the search for a larger set of substitutions may lead to innovative solutions that are closer to the global optimum.

In fast-moving markets, managers need to find and execute the trades rapidly, before they become sub-optimal. Again inspired by how nature works, industrial evolutionary systems perform the optimisation as a parallel search on a compute grid, significantly improving the efficiency.

Maximising value, protecting and improving credit quality and ensuring rating stability in volatile markets, while working on more deals – these are the characteristics of a 'natural' platform for CDO management that will benefit all market participants.

© Codefarm Software Limited 2007. All rights reserved. Codefarm is a technology company providing products and services to help investment banks and financial organisations achieve better returns in the structured credit market, in part by utilising evolutionary computing techniques.

What goes around

Mark Gold, senior partner at Hillmark Capital, answers SCI's questions

Q: When, how and why did you and your firm become involved in the structured credit markets?
A: I first got involved in structured credit as an adjunct to the credit and loans business of the firm I was working for in 1990 – Chancellor Capital Management, formerly CitiCorp Investment Management – when we put together one of the first CLOs managed by an asset manager. At that time, the market was at the phase of the credit cycle where there was a massive supply of leveraged loans due to an LBO boom, much like now, and the deal was aimed at taking advantage of that environment.

Back then CLOs had a three tranche structure – a triple-A note, a single-A note and 20% equity. That equity usually paid 500bp over Libor and investors would basically back-leverage their equity investment to get their desired return.

So, from a structural perspective they had a very stable return, albeit not a high one, but the investor was able to dial in the amount of leverage or return that they wanted based on their risk appetite. That may well turn out to be a structural concept that will again prove to be very popular in today's market.

Another type of CLO structure I first worked on could also see a return to popularity. In the mid-1990s I managed a number of deals using a structure that permitted banks and other ratings sensitive institutions to repackage a portfolio of bank loans into an investment grade-rated income note that served as the first-loss tranche. We have heard market chatter that some arrangers are considering resurrecting that type of structure right now as a way of addressing some of the balance sheet considerations that investors currently face.

In March of 2006 I, along with Hillel Weinberger, started HillMark Capital. We wanted to establish a single platform that had the ability to execute strategies in cash and synthetic format with the expertise of looking at each obligor's entire capital structure, from bank loans to bonds down to equities.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: Several developments spring immediately to mind – all of which, we believe, contributed to the current market conditions.

First is the additional leverage built into the CLO structure, with the equity tranche comprising 20% of the capital structure in the first third-party managed CLO, to the current environment where the equity tranche makes up 8% or less of the capital structure.

Another is the disintermediation of the banks in the loan market. When we started out, the non-banks accounted for 5% of the leveraged loan space; now they account for 60% to 70%.

This disintermediation has given rise to the acceleration of bank loan issuance because capital markets have tremendous capacity to absorb new issuance. At the same time, the market has seen an inflow of new non-specialist investors searching for yield. Both of these factors, combined with a low default rate for the past couple of years, have provided the fuel for the dramatic growth in the leveraged loan market until recently – one where mega deals were seen regularly and sponsors were able to push the envelope in terms of financing structures.

Q: How has this affected your business?
A: The market currently provides us with plenty of opportunities. Today you have a non-specialist market dealing with a liquidity panic and loans that are trading down, despite a very low default rate environment, because people are concerned about what evil lurks there. CLO investors are asking themselves if bank loans or covenant-lite loans are the next sub-prime.

Given the panic, some investors are 'throwing the baby out with the bathwater', which presents us with opportunities to pick up very attractive names at some pretty steep discounts. That panic, overlaid with the continuing market uncertainty, means that new leveraged loan deals should appear with stronger structures, more robust covenants and investor-friendly features such as call protection all being offered at higher than pre-adjustment prices.

Q: What are your key areas of focus today?
A: We had our first closing on our credit opportunities fund on 7 September. This clearly positions us to take advantage of not only what we believe are attractively priced names in the secondary market, but also permits us to take advantage of some of the hung bridge loans on both senior and subordinated basis that may be coming into the market.

The fund also permits us to be actively involved in the distressed market once that manifests itself.

Q: What is your strategy going forward?
A: To continue to look for opportunities that we believe the market will offer. Notably, the aforementioned distressed market that we expect to pick up in the next couple of years.

Furthermore, we certainly see the LCDS market as an area for opportunity as it continues to develop. We have a team with extensive credit derivatives experience and we are actively investigating funded and hybrid capital structures that can take advantage of the LCDS market.

Q: What major developments do you need/expect from the market in the future?
A: The market has an amazing mechanism for self-correction and we believe that a rationalisation of the marketplace currently taking place is to some extent inevitable. After a period of market excess as we have seen in recent years a correction has to follow. That doesn't mean it's not painful, but it is certainly healthy for the capital markets in general.

About HillMark Capital
HillMark, founded in March 2006, brings together the complementary skill-sets of a team of experienced investment professionals. The firm offers investors a range of credit-based investment products with a philosophy focused on: a credit-intensive culture; risk adjusted return; and active management.

HillMark leverages off extensive industry contacts and credit expertise developed by its three Founding Partners: Mark Gold, formerly of TCW, Hillel Weinberger and Kevin Cuskley, both formerly of Loews Corporation, and each with over 20 years in the industry. The firm currently manages two CLOs and a credit opportunity fund.

"People should distinguish more between assets"

In this week's Provider Profile we talk to Morrison & Foerster about recent market volatility and the future for structured credit products

Recent market volatility has brought structured credit into the mainstream headlines for the first time. Morrison & Foerster (MoFo) has been advising clients on the structures in trouble and shared with SCI its thoughts on the possible future shape of the structured credit markets.

Peter Green

Peter Green and Jeremy Jennings-Mares were brought into MoFo from Freshfields in April 2007 to expand the firm's debt capital markets expertise. Their main emphasis for the London practice is structured finance, and within this the structured credit focus is on CLNs, cash and synthetic CDOs, ABCP, conduits, SIVs and constant proportion technology. MoFo advises several tier one investment banks; Bank of America amongst them.

The funding requirements of SIVs are foremost in the news, with a catastrophic shortfall in the availability of funds for many of these vehicles through the ABCP market bringing the sector to its knees (SCI passim). MoFo outlines a bleak market for such products: "There are very likely to be further unwinding of SIVs and SIV-lites – and many of those that aren't liquidated will likely be restructured, depending on the view taken on the strength of the underlying assets," says Green.

He continues: "Right now there is no appetite for paper issued by SIVs or other CP conduits, even though they are triple-A rated vehicles; the major problem being the changes in assumptions in liquidity for funding. People will want to know how this happened before the market progresses again. One solution may be to syndicate liquidity wider in future and to consider other funding arrangements."

Another new scenario for SIVs and other CP conduit structures may be a product which bears some resemblance to existing vehicles but that has new assumptions and structures, and that still has triggers and unwinds to enable investors to exit.

As Green explains: "It is necessary to build in triggers to allow the investor to exit, but at present it's actually not necessarily in their best interests given the high quality assets and low asset prices. So there are undoubtedly some collateral managers licking their lips right now with so many cheap assets on the market. Investors should remember that the lack of liquidity in commercial paper is the major problem here."

To better protect investors' interests in the future, regulators are also likely to have their say. They may impose further controls over the market directly and increasing focus is likely to be given on the role of the rating agencies (see rating agency story).

Green cites the example of IKB's reported potential US$17.5bn exposure to its Rhineland Capital Funding conduit and Rhinebridge SIV. "We may see regulators imposing further controls on the level of exposure one bank or institution can have to any one product. Although exposure may be split between various unconnected entities, if those vehicles are all invested in similar underlying pools of assets there is a question to be asked as to whether these should be aggregated in calculating exposure limits."

With banks moving to a ratings-based approach under Basel II, it is likely that in future the market will see similar products but with new structures in place.

"The need for banks to move assets off balance sheet will not disappear and may in fact mean a spike in issuances in certain types of CDOs as short-term funding via CP for SIVs dries up," explains Green. "We could see a greater focus on higher rated assets and longer-term debt to make the process easier. But we may well see a fall in the volume of CDO issuance generally."

Underpinning all exotic structures is the demand for yield not accessible elsewhere – and new technology, such as constant proportion structures, has been at the top end of exotic issuance in the last two years. CPPI, CPDO and DPI product has been issued, each with varying amounts of protection imbedded. These products are also likely to be reviewed in the new market paradigm, according to MoFo.

Jeremy Jennings-Mares

"CPPI draws from the familiarity of CDO structures, so really there is not too much difference from an investors' perspective," says Jennings-Mares. "You still need to know what the assets are, and how they are managed but also understand how and when the principal protection kicks in. The question over the balance of risk is paramount. A great deal of discretion is needed by the portfolio manager, within certain parameters, and the investor needs to understand when the portfolio can ramp up on riskier assets and when it must ramp up on highly-rated zero coupon bonds, for instance."

Recently the quest for higher yields has meant less protection has been required by investors; therefore, changing risk appetites now means that the dynamics of these products will change. "And pressure for such change will come from many angles; possibly from Government – witness French President Sarkosy and German Chancellor Merkel's recent comments on the need for more financial market transparency," Jennings-Mares adds.

Changing perceptions of risk will therefore bring in a new investment landscape. But overall MoFo believes its clients are confident that structured products have a solid future.

"Banks are bullish on credit and equities generally – and the markets for more exotic categories of structured notes including commodity-linked products may witness further issuance, as some of these assets could be seen as safe havens. Additionally, the demand for corporate debt via CLOs is still very strong. Investors are likely to distinguish more between assets," comments Green.

There is, however, no complacency and there has of course been genuine concern, he adds. "There will always be risk – otherwise we'd have no attractive products. So the point should be made that you must fully understand the product under consideration."

"There has been a knee-jerk reaction to CDOs generally. Slower growth in the sector is likely to continue, but there is general optimism in spite of the sub-prime fallout. The result is likely to be a changing price of assets," Green concludes.

JW

Fund adds five

The latest company and people moves

Fund adds five
SPQR Capital the fund manager set up by three former members of Deutsche Bank's structured credit group (see SCI issue 35) – Bertrand des Pallieres, Malik Chaabouni and Moez Ben-Zid – has hired five new members of its structured finance team. Virginie Afota and Stephane Lapiquonne who left AXA Investment Management in April (also see SCI issue 35) are, together with Malik Chaabouni, the three Portfolio Managers in charge of the new SPQR Structured Credit Opportunity Fund.

Emilie Blehaut and Brice Tomassone have joined as structured credit analysts from Moody's and Natixis respectively. While Bedis Gharbi, a correlation trader from RBC, has been taken on as a risk manager.

ACA shuffles
ACA Capital Holdings has announced the appointment of several senior managers to new positions. Specifically, James Rothman, senior md and previously responsible for the company's structured credit business, has been appointed as the global head of the company's asset management business, including CDO asset management.

Laura Schwartz, senior md, will report to Rothman and continue to support the Company's CDO asset management segment. Brad Larson, md and prior head of the US based structured credit business, will succeed Rothman as global head of the structured credit business.

Additionally, Simon Meers, md and prior head of ACA's Singapore office, will be relocating to New York and assuming the role of head of alternative investments strategy. Rothman, Larson and Meers will all report to Alan Roseman, the company's president and ceo.

Correlation specialist resurfaces
James Boyle has joined Deutsche Bank's CDO team as an associate for correlation CDO distribution and reports into Fritz Thomas. He was previously at Barclays Capital (see SCI issue 52).

Senior trader exits
Neil Murray, formerly a senior CDS trader at UBS, has left the bank. His destination is not yet known.

Flow trader goes
Senior credit flow trader Paul Grimsey has left his role at Royal Bank of Canada. His destination is not yet known.

ISDA names new general counsel
David Geen has been appointed general counsel for ISDA. Geen has served as ISDA's European general counsel since November 2006.

Following a transition period, he will take over the position of general counsel from Kimberly Summe, who leaves ISDA at the end of 2007 to take up a position in prime services with an ISDA member firm.

Caplan made partner
Hillel Caplan was recently admitted as a partner in the Securitisation Services group at Deloitte & Touche. Caplan is based in New York, and is the global leader of Deloitte & Touche's CDO Suite practice, a software solution for collateral managers and trustees in the CDO market.

CDO lawyer switch
Assia Damianova has joined Cadwalader, Wickersham & Taft's London office as special counsel in the law firm's capital markets department. Prior to joining Cadwalader, Damianova was a solicitor at Sidley Austin Brown & Wood in London, where she focussed on synthetic structured transactions, including CDOs, CLOs, CDO-squareds, CDOs of ABS, correlation trades, credit derivatives, total return swaps, and various innovative synthetic structures.

She has advised arrangers, collateral managers, monoline insurers, and other protection sellers and investors, on a variety of derivatives, insurance, banking and securities and cross-border collateral issues.

DBRS appoints
DBRS has appointed Rupal Patel as a vp in its structured finance group in London. Reporting to Kai Gilkes, md, structured credit group in London, she will be responsible for the analysis of structured credit transactions.

Patel joins DBRS from UBS, where she was European head, structured credit derivatives valuations, managing a team of six. Her appointment continues the growth of DBRS's EMEA team, which has now grown to more than 25 people.

Calyon takes prop loss
Calyon has announced that it will bear a loss of €250m from an unauthorised prop trading position managed by its New York office. The position was in diversified credit indices and had been built up in the last days of August in excess of internal authorised limits, the bank says in a statement.

The position has been brought back within Calyon's normal trading activities and security controls have been strengthened to avoid a repeat of the incident. The bank was only willing to say that appropriate disciplinary action had been taken, but it is understood that around six people were involved and have all left the bank.

Calyon's statement adds that taking into account the cost of unwinding the position, the overall impact on its Q3 results will be €250m. The bank's Q3 net income is likely to be significantly lower than in 2006, but will remain in profit, it says.

MP

Northern Rock presents conundrum

A round up of this week's structured credit news

Northern Rock presents conundrum
Northern Rock – Europe's largest ABS issuer in 2006 (at €29.6bn) – was forced last week to ask the Bank of England for emergency funding. Just as ABCP conduits and SIV-lites fell short as a result of reliance on one form of funding (CP), Northern Rock's excessive dependence on securitisation funding – as opposed to retail deposits – left the bank particularly exposed to a rising spread differential between Libor and the UK base rate.

The news precipitated further spread widening and consternation in the structured credit market amid concern over the fate of Northern Rock's securitisation programme.

Indeed, research from RBS presents an interesting conundrum: does the Bank of England support extend to allowing a private institution to continue originating mortgage collateral at a pace sufficient to sustain Northern Rock's Granite master trust? The assessment by analysts at RBS indicates that the possibility of breaching a master trust trigger has jumped considerably.

The effects of a so-called non-asset trigger in the master trust would cause investors some more possible economic loss if bonds extend their weighted average lives. The market does not appear to be fully incorporating this possibility into spreads at this point, say the analysts.

Rating agencies have announced a new series in the Granite master trust programme (which the analysts believe will be used to collateralise Northern Rock's borrowings at the Bank of England). Moody's careful wording of its press release to say that its rating only addresses credit risk is notable, and the agency also said that the portfolio yield had materially decreased.

Resulting from Moody's downgrade of the bank, the lender faces breach of swap agreements used to hedge basis risk in the trust and may be required to collateralise the swaps, find a co-obligor or shift the swap. Fitch stated that Northern Rock expected to take no action with respect to the breach, given its liquidity support arrangements with the Bank of England.

The analysts note four scenarios for the future of the lender: sale to a foreign buyer; a 'rescue' by a UK bank; insolvency; or recovery as a standalone entity.

Could Northern Rock's problem spread to other UK banks? Certainly other UK banks use wholesale funding and there are real issues as retail customers withdraw deposits from some of the smaller banks as part of a general flight to quality.

But Northern Rock had certain unique attributes that have led to this situation: very rapid growth with net new mortgage lending up 43% in the first eight months of the year and mortgage lending up 55%; and very heavy reliance on the wholesale funding market. The bank had less than half the ratio of deposit funding compared to peers at the mid-point of this year. This doesn't apply to any other UK lender apart from Paragon.

New DPI launches
Dresdner Kleinwort has launched a new DPI through its Thebes Capital vehicle – the US$25m Artemis Series 2007-1. Moody's has assigned a triple-A rating to the deal.

The notes' performance is linked to the performance of a credit reference portfolio split equally between an iTraxx Europe index CDS and a CDX NA.IG index CDS. The indices will be rolled-over every six months, limiting negative credit migration and default risk.

The reference portfolio notional amount will be dynamically adjusted according to pre-defined management guidelines. In addition, the structure includes a cash-in mechanism such that indexation to the reference portfolio stops whenever the transaction's net asset value is higher than the present value of all future liabilities of the issuer. Notes also include a cash-out mechanism such that the transaction will unwind at market value when the net asset value of the strategy represents a small proportion of the notes' notional.

Moody's reports on credit crunch
The credit crunch initiated by the ongoing sub-prime woes began as an overdue and disorderly risk reappraisal but ballooned into crisis due to a combination of too much leverage, financial innovation, price-sensitive accounting rules and opacity, says Moody's in a new report.

"This cocktail has proved explosive," says Moody's vice chairman Christopher Mahoney, co-author of the report – the second in a series on the global sub-prime fallout – with Pierre Cailleteau, Moody's chief economist. "The credit crisis has imposed a major stress test on the modern disintermediated financial system while also offering the possibility of corrective reforms."

Among the causes of the panic identified by Mahoney and Cailleteau include: an extended period of credit risk under-pricing due to a temporary shift in the balance of power between lenders and borrowers; a pervasive illusion of liquidity; the bursting of the US housing price bubble; and very poor performance of sub-prime mortgage securities that imposed market losses on many institutions and cast a shadow over the valuation of certain classes of structured securities.

The rating agency's report draws some tentative but important lessons for the "post-disintermediation" financial system "in which an arm's-length financial model now has precedence over the traditional relationship model centered on banks".

In the report, entitled "Stress Testing the Modern Financial System," Mahoney and Cailleteau argue that, while credit crunches in earlier days resulted from tight monetary policy, modern credit crunches are caused by psychological shocks to market confidence. This leads to a flight from risk and liquidity stresses for financial actors dependent upon confidence-sensitive funding.

"The problem is that central banks were designed to handle bank runs, not market confidence crises," says Mahoney. "The challenge is to ensure not just 'liquidity' but 'fluidity' throughout the system, ensuring that systemically important non-bank financial institutions obtain vital funding."

Most of the deficiencies exposed by the current episode were identified in the aftermath of the Long-Term Capital Management Crisis in 1998. These include the modern financial system's over-reliance on the presumption of liquidity; increasingly difficulty localising risk; increase of asset correlations in times of stress; and leverage which changes the scale of market dynamics, on the upside as well as on the downside.

"We expect market and official pressure to require greater transparency from financial actors, to introduce larger liquidity buffers into the system, and to consider ways to introduce automatic stabilisers to counter some of the pro-cyclicality inherent in an increasingly market price-sensitive accounting system," says Mahoney.

LCDX removals announced
CDS IndexCo, a consortium of 16 investment banks licensed as market makers in the ABX, CDX and CMBX indices, and Markit Group have announced which companies will be removed from the LCDX North America Index, which is set to roll on 3 October. The portfolio selection process was conducted by Markit, the index administrator, with input from the member banks of the CDS IndexCo consortium.

The companies to be removed are: ADVANCED MICRO DEVICES; ALTIVITY PACKAGING; Boise Cascade; Chiquita Brands; Emmis Operating Company; HLI Operating Company; Huntsman International; Movie Gallery; Mueller Group; and Reynolds American. Those that will be added to the index are expected to be announced tomorrow 20 September.

Permacaps report
Carador has declared an interim dividend of 6.9 cents per ordinary share payable on 28 September 2007 to shareholders registered as at the close of business on 21 September 2007. The dividend includes the 1.9 cents for the period to 31 March 2007, as announced by the company on 27 July 2007, and a further 5 cents in relation to the current period ending 30 September 2007.

Additionally, as of 31 August 2007, Volta Finance Limited's gross asset value per share stood at €8.53, down 3% from 31 July 2007, according to its latest monthly report. But the company emphasised the absence of impairment to any of the assets it holds, allowing it to firmly maintain its initially anticipated dividend, to be announced in the third week of October and paid in the fourth week of November.

The mark-to-market value of Volta Finance assets is nevertheless down 3% month-to-month. The company believes that such a mark-to-market change in gross asset value is not a guide to the expected cash flows from its assets, but rather a reflection of the present scare with everything structured credit-related.

Volta Finance firmly maintains its target dividend for its first financial year (at least 3.5% of the IPO price of €10), given that all its assets' cashflows have been in line or higher than the initial expected cashflows. The whole portfolio also benefits from term financing and over three-quarters of the portfolio has an imbedded leverage that is not directly sensitive to mark-to-market valuation.

Meanwhile, Queen's Walk Investment Limited (QWIL) has sent a circular to eligible shareholders detailing its proposed tender offer to purchase up to 24.99% of its ordinary shares and thereby to return a maximum of €25m in cash to shareholders. The tender offer will be open from 13 September to 3pm on 27 September 2007 and is being made at a price per ordinary share of up to €6.30. This price represents a premium of approximately 34% over the middle market closing price of €4.70 per ordinary share on 11 September 2007.

The tender offer is conditional on the approval of shareholders at the extraordinary general meeting of the company to be held at 12.30pm on 8 October 2007.

Finally, following the approval of its new investment objective, Caliber has terminated its interest in Amber Funding Limited. This is expected to result in an increase in net asset value per share of approximately US$0.60 to US$0.80 that should be reflected in the NAV for September 30 2007, expected to be published in mid-November with the full-year results.

Amber is one of four special purpose vehicles that holds Caliber's investments. This transaction is expected to result in a reduction in the size of the company's overall portfolio by approximately US$120m (portfolio size at June 30 2007 equalls US$824m) and a reduction in associated indebtedness of approximately US$140m.

At June 30 2007 approximately 63% of the assets held in Amber were US RMBS. At June 30 2007 US RMBS accounted for 52% of the overall Caliber portfolio. As a result of this transaction the company's exposure to US RMBS is expected to fall to approximately 49% of the overall Caliber portfolio.

Rating action for Axon
Fitch has downgraded Axon Financial Funding's US$890m of mezzanine notes to double-B minus from double-A minus, remaining on rating watch negative. In addition, it has placed the SIV's US and Euro CP and MTNs on rating watch negative.

The rating action reflects: the continuing challenges of Axon Financial to access the CP and MTN markets to refinance maturing debt; the fact that Axon Financial is in a restricted investment operating state; the accumulating losses realised from the continued sale of assets to meet maturing debt; the continued deterioration in the net asset value of capital and mezzanine notes, which now stands at 57%; and the increased likelihood of entering into a restricted funding operating state.

Restricted funding operating state could be triggered if the NAV of capital and mezzanine notes fell below 50% of their notional amount. Axon Financial would not be permitted to issue further senior notes, and would have to sell assets or draw upon liquidity to redeem maturing funding.

Moody's has also placed on review for possible downgrade Axon's US and Euro MTN and CP programmes, reflecting further significant deterioration of the market value of its portfolio. During the agency's review, it will focus on the ability to issue new debt, the future evolution of market prices and the potential crystallisation of losses following any asset sales.

Axon Financial's portfolio currently comprises 25% RMBS (6% prime, 17% near-prime and 1% sub-prime), 21% monoline-wrapped securities, 18% CMBS, 17% CDOs (including 9% leveraged-loan CDOs and 4% CDOs of ABS), 11% cash equivalents, 4% closed end seconds and 4% other ABS. The portfolio has a geographic exposure of 87% to the US and 13% to the UK.

Currently, 96.7% of Axon Financial's portfolio is rated triple-A equivalent, 3% double-A equivalent, and 0.3% single-A equivalent. Fitch notes the very high credit quality of the portfolio assets but, of late, some of the assets have experienced downgrades and the market values of the assets have come under extreme pressure.

Rating action for Rhinebridge
Moody's has placed on review for possible downgrade the ratings of Rhinebridge's Euro and US MTN and CP programmes.

The rating action reflects the further deterioration of the market value of Rhinebridge's portfolio since placing the subordinated debt on review, its continuous inability to fund as well as a breach of its net cumulative outflow (liquidity) test. Moody's notes, however, that the quality of the asset portfolio remains high, with a weighted average rating of Aa1.

During its review, the agency will focus on the ability to issue new debt, the future evolution of market prices and the potential crystallisation of losses following any asset sales. A further factor that Moody's will review is the relatively short weighted average remaining term of senior liabilities.

Rating action for Duke Funding
Moody's has put Duke Funding High Grade II's Class A-2, B-1, B-2, C and D mezzanine term notes on review for possible downgrade.

The rating action reflects a reduction in the number of counterparties to repo transactions, a deterioration of the market value of the SIV-lite's portfolio and the potential impact of crystallised losses on the notes following asset sales. Moody's review will focus on the liquidity of the remaining portfolio supporting the note ratings.

The rating action takes into account the current stressful market conditions. While the underlying assets of Duke Funding remain highly rated, the unprecedented illiquidity in the market for MBS has created a high level of uncertainty around the valuation of the assets, which makes it difficult to assess the probability of the manager achieving certain prices.

Fitch affirms Rhineland Funding's ABCP
Fitch has affirmed Rhineland Funding Capital Corporation's ABCP short-term F1 rating and removed it from rating watch positive. The action follows a further review of Rhineland's securities portfolio, the conduit structure and discussions with the sponsor.

On 30 July 2007 all the committed liquidity support previously provided by IKB was novated to KfW. With KfW's accession, all liquidity support providers are rated F1+. The liquidity providers for Rhineland are: KfW (approximately 55% of the total), the Royal Bank of Scotland (approximately 20% of the total) and Calyon (approximately 12.5% of the total), as well as Wachovia Bank, Deutsche Bank, Citibank and Kommunalkredit Austria – each of which provides under 5% of the total.

Fitch has reviewed Rhineland's portfolio in light of recent rating migrations in its securities. The securities portfolio is by far the largest portion of the conduit, making up approximately 95% of the total programme.

Rhineland benefits from programme-wide credit enhancement (PWCE) sized at a fixed 5% for client transactions and a dynamic amount subject to a minimum floor of 4.5% for the securities portfolio. The PWCE for the client transactions, totalling approximately US$49m, is provided by IKB.
Fitch's modelling assumes any securities on rating watch negative (or equivalent by any rating agency) are downgraded by four notches.

As of 7 September, 18 securities were on negative watch or equivalent. Fitch also increased the default probability of securities with real estate exposure by 25% above its standard assumptions.

Over 99% of Rhineland's securities portfolio is made up of CDOs, and approximately 83% of the CDOs have real estate exposure. Much of this indirect real estate exposure is related to sub-prime RMBS and hence is subject to additional stresses by Fitch.

The agency also carried out further stresses, which assumed that in addition to the above assumptions all securities currently rated below double-A minus were downgraded by three notches. Approximately 14% of Rhineland's security portfolio is rated below this level.

The client transactions portfolio consists of 21 trade receivables transactions, mostly with German-based originators. Of these transactions, 19 are wrapped by trade insurance. The remaining two are credit-enhanced on a standalone basis to a sufficient level to support the F1 rating on the CP.

Japanese deals distanced from sub-prime debacle
Japanese structured finance transactions have features that distance them from the US sub-prime debacle, says Moody's in a new report, "US Sub-prime Crisis: Impact – or Lack of – on Japanese Structured Finance Market".

The increase in defaults in sub-prime mortgages in the US has prompted a global credit crunch and liquidity crisis, as well as concerns regarding negative effects on the US and global economies. Japanese structured finance securities, however, differ from those in the US and Europe. In fact, the conditions surrounding, and the characteristics of, structured finance products in Japan can diverge significantly from the US sub-prime market.

As such, Japanese structured finance securities have thus far exhibited strong performance overall, reflecting the state of Japan's macro-economy and corporate results.

Nevertheless, the globalisation of credit markets has led to widening spreads for certain types of securities in Japan's structured finance market; hence, the impact of a global credit crunch should not be underestimated.

Moody's notes that it is currently difficult to determine exactly how the US sub-prime crisis will play out and how events may impact the Japanese market. However, the rating agency will continue to make thorough efforts to take rating actions on a timely basis and disclose rating methodologies, as well as provide information on rated structured finance securities to enhance transparency.

LMA launches German law document
The Loan Market Association has launched a new German law investment grade facility agreement. The document has been drafted with input from the major German banks and a number of law firms active in Frankfurt.

It conforms the LMA investment grade facility agreement to the relevant provisions of German law, while maintaining the overall commercial balance set out in the English law facility agreement.

Clare Dawson, LMA executive director, comments: "This has been an important project for the LMA to further promote its work and the use of its documentation in the German market. We hope that market practitioners will welcome this document for use in the cases where English law documentation is not considered appropriate."

CS

Trading ideas - lock, stock and two smoking Bear-els

Dave Klein, research analyst at Credit Derivatives Research, looks at a "wings" trade on Bear Stearns

Credit and equity risk are unambiguously linked, as the risk of debt holders not receiving their claims is akin to the risk of equity prices falling to zero. Both credit and equity risk are directly tradable with liquid instruments, such as credit default swaps (CDS) and equity puts. In this trade, we analyse hedging CDS directly with equity.

The trade exploits an empirical relationship between CDS and equity, and an expectation that equity drops precipitously in the case of default. For certain names, equity and CDS levels are such that buying CDS protection and buying equity provide a straddle-like payout.

If equity sells off, we expect CDS to sell-off more in dollar terms. If CDS rallies, we expect equity to rally more (again in dollar terms). This is also the basis for the so-called "wings" trade, where CDS is financed using equity dividends.

In this example, we choose our hedging ratios based on a fair-value model that incorporates equity prices in distress (near default) situations. Given the straddle-like payout, we are going long volatility and taking advantage of a non-linear relationship between CDS and equity.

This trade on Bear Stearns (BSC) takes advantage of such a relationship by buying equity shares and buying CDS protection.

Delving into the data
When considering market pricing across the capital structure, we compare equity prices and equity-implied volatilities to credit market spreads. There are a number of ways to accomplish this, including the use of structural models that imply credit spreads (through an option-theoretic relationship) from equity prices and the analysis of empirical (historical) relationships between the two markets. We refer the reader to a CDR Trading Technique article – Capital Structure Arbitrage – for more detail.

The first step when screening names for potential trades is to look at where equity and credit spreads stand in comparison to their historic levels. Exhibit 1 shows the past year's levels for BSC's equity and CDS spreads.

Exhibit 1

Until recently, equity tended to be more volatile, while 5Y CDS held steady in the 20bp to 30bp range. Since the beginning of the summer, both equity and credit have sold off dramatically.

Comparing market levels over time gives a rough feeling for how each security moves in relation to the other. In order to judge actual richness or cheapness, we rely on a fair value model.

Given that our trade is a combination of CDS and equity, we consider the empirical relationship between CDS and share price. Exhibit 2 plots 5Y CDS premia versus an equity-implied fair value over time.

Exhibit 2

If the current levels fall below the fair value level, then we view CDS as too rich and/or equity as too cheap. Above the trend line, the opposite relationship holds.

At current levels, BSC CDS is rich (tight) to fair value. We note that this empirical relationship has been extremely volatile over the summer, with CDS alternating between being rich and cheap at short intervals. This bolsters our view of taking on volatility using the two securities.

Taking equity price in distress into account, we build a hybrid fair value model that again estimates CDS levels based on equity share prices. Exhibit 3 charts market and fair CDS levels (y-axis) versus equity prices (x-axis).

Exhibit 3

We note that BSC clearly has traded under two regimes. Before the stresses of the sub-prime crisis, BSC CDS hovered in the 20bp to 30bp range as equity rose. Since May, both equity and CDS have sold off. Given the current state of the market, we do not expect BSC to return to the 20bp to 30bp range anytime soon and note that, according to our model, CDS currently sits about 30bp to 40bp too tight.

Hedging CDS with equity
Our analysis so far has pointed to a potential misalignment between the equity markets and credit spreads of BSC. It would appear that we should buy protection (sell credit) against a long equity position.

As default approaches, we see CDS rates increase (to points upfront) and equity prices fall close to zero. In this situation, our equity position will drop in value (bad for us), but this loss should be more than offset by our gain due to the CDS sell-off.

If equity rallies, we expect CDS to rally as well. Exhibit 4 charts the straddle-like payoff structure of the trade, taking transaction costs and six months worth of protection paid into account. For simplicity, dividends are ignored.

Exhibit 4

The longer we hold the trade, the more difficult it will be to make money, given the negative carry/negative rolldown we face. However, given the volatility BSC is currently exhibiting, we believe we can exit profitably in a reasonably short time period. The main trade risks are that BSC volatility drops and we are unable to unwind the trade profitably or that BSC returns to its previous equity-CDS relationship with a major credit rally that is not accompanied by an equity rally.

Risk analysis
This position does carry a number of very specific risks.

Recovery and 'default' stock price assumption: In the default scenario the cheapest-to-deliver CDS obligation may have a higher than expected market value and the stock price might not fall to US$0.75 as assumed.

CDS present value (PV): The CDS PV is an expected value, but not necessarily a realised outcome. In practice, the CDS may trade on an up-front and/or running basis.

Corporate actions: Spin-offs and private equity buyouts, for instance, could radically change the equity-CDS relationship, leaving investors with a mis-hedged position. It is our expectation that an LBO (however unlikely) would be a positive event for this trade, as we would expect CDS to sell off and equity to rally.

Mark-to-market: In our view, credit and equity markets operate largely independently and this can lead to trade opportunities. At the same time, however, any relative mis-pricing may persist and increase even further, which could lead to substantial return fluctuations.

Additionally, the trade faces a fairly substantial bid-offer to cross in CDS. The negative carry and rolldown hurt us the longer we hold the trade. Given our view that BSC credit will underperform and that CDS is too tight to fair value, we are willing to take on the carry and rolldown. Overall, frequent re-hedging of this position is not critical, but the investor must be aware of the risks above and balance that with the strong positive carry with minimal default risk.

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 BSC and the bid-offer spread costs.

BSC, a member of the CDR Liquid 50 NAIG index, is a liquid name and bid-offer spreads are around 5bp to 10bp. BSC is also quite liquid in the equities market.

Fundamentals
This trade is more a bet on volatility than a bet on a credit improving or deteriorating. As long as the debt-equity relationship holds and prices move sufficiently, we should make money.

With that said, we do see CDS as being too tight to fair value (or equity too cheap). Our expectation of a CDS sell-off is based on an empirical model and we turn to the company's fundamentals to see if that view is supported.

Kathleen Shanley, Gimme Credit's Financials expert, maintains a stable fundamental outlook on BSC but expects the company to underperform given its current levels. Kathleen believes that BSC will be able to weather the current storm it finds itself in, but sees "no immediate catalyst for credit markets to rebound." She notes that "though BSC was historically known for its conservative risk management culture, that image has been tarnished by the recent collapse of several hedge funds managed by Bear Stearns Asset Management."

Summary and trade recommendation
We inaugurate a new capital structure "wings" model in this trade, buying equity and buying CDS protection. With BSC due to announce earnings this week, we place a bet that the company will continue to show both equity and CDS volatility.

Our fair value debt-equity model shows BSC CDS as trading too tight, so a negative surprise in earnings should result in a CDS sell-off. Given CDS is tight to fair value, high equity and CDS volatility and the current alignment of debt and equity, we believe a long equity, long CDS protection is the best way to capitalise on BSC's current predicament.

Buy US$10m notional Bear Stearns Companies Inc. 5-Year CDS at 141bp

Buy 24,000 Bear Stearns Companies Inc. shares at a price of US$109.30/share to pay -141bp of 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).