Contents

Downgrades hit market value CDOs

Liquidation fears could be overstated

Downgrades of three US market value CDOs have renewed fears that the market may be swamped by liquidated structured finance collateral. While the move underscores the sensitivity of market value structures to current depressed prices, asset sales are nevertheless currently being undertaken in an orderly manner.

One way of restructuring market value deals is to term them out, according to Miguel Ramos, managing partner at Washington Square Investment Management. The advantage of such transactions is that they have conservative capital structures and thick equity tranches, so there are more options in terms of restructuring or adjusting different parts of the capital structure to attract a variety of investors.

Given depressed market prices and thin liquidity, there is a chance that once one market value structure is liquidated, other transactions will be triggered. It is estimated that around US$3bn to US$5bn of agency and highly rated MBS could potentially be liquidated if market values stay at current levels or deteriorate further.

However, the market is seeing orderly sales of liquidated assets rather than panic selling – albeit with increases in bid-list activity following the liquidation of CDO portfolios. Certainly there are buyers out there who are willing to take positions at the right price.

"Sellers are acting with more constraint because they realise these are illiquid positions and so are taking their time in negotiations. They are typically discussing fair price and what kind of information is needed in order to get the buyer comfortable – it is a much more open discussion now," says Ramos.

Moody's downgraded six classes of the US$602.2m Westways Funding X transaction on 20 September, while Fitch downgraded five classes the day after. The rating actions follow the failed attempt to restructure the TCW-managed deal after it breached its overcollateralisation tests.

Then on 25 September Moody's put on watch negative one class each of Enhanced Mortgage-Backed Securities Funds III and IV, and downgraded three classes of notes between them. The move reflects the deterioration of the market value of the collateral pool and the transactions' structures, including liquidation parameters.

All three transactions are backed by highly rated MBS. Although the portfolios haven't experienced any delinquencies or credit performance issues, the decline in asset prices was sufficient to cause NAVs to fall below the critical threshold.

On the loan side of the market, many warehouses have been liquidated and some are still being marketed, with managers taking down either equity/mezz or senior notes. One way that the market has absorbed such paper is through multi-managed CLOs.

"Investors seem to be more comfortable with CLO positions and there is more confidence that the market will return," explains Ramos. "Loans are a tangible asset, whereas structured finance assets are more difficult to understand. This is reflected in the indices: there has been lots of hedging activity and volatility on the ABX lately, whereas the LCDX has found some stability."

CS

Loan indices face new tests

LCDX settlement mechanism to be utilised

The default of Movie Gallery is set to test the LCDX settlement mechanism for the first time. Meanwhile, despite the delay in the forthcoming LCDX and LevX rolls, US tranche trading is scheduled to begin on 10 October.

Following on from Movie Gallery's failure to pay a coupon due this month, the first credit event for the LCDX index has been declared. The event determination date has been set as 19 September 2007 for all institutions who sign the related 'Uniform Settlement Agreement'.

The settlement process now moves to a credit event auction that is expected to be run in the next three to four weeks. This approach was agreed when LCDX was launched and requires dealers to vote in favour of a credit event resulting in an auction, which they have done in this case.

"There are strong reasons to have an auction in the loan space: trading loans is a complicated and involved process – transactions can be outstanding for weeks, even months. Having a process which allows for both cash or physical settlement is also compelling," explains Nishul Saperia, director at Markit.

While Movie Gallery is the first major credit event since the launch of LCDX, the market appears to be confident about the process. Although Movie Gallery isn't a particularly liquid name, dealers have decided to continue trading it in the Series 8 index because there was little demand from clients to remove it. In addition, says Saperia, removing it would have hindered more than helped operationally – although it will be removed by the auction date and won't be included in Series 9.

Dealers are equally sanguine about the delay of the LCDX roll to 3 October, as it is seen as part of the agreement to stagger the rolls of the various CDS indices to more evenly spread pressure out on the Street. The roll date of LCDX was originally set for a week later than that of CDX.HY, which was delayed until today, 26 September, due to market volatility.

Instead, traders are now looking towards the formal launch of LCDX standardised tranche trading, which is scheduled to begin on 10 October. Citi, Deutsche Bank, Goldman Sachs, Lehman Brothers and Merrill Lynch are understood to have already begun trading tranches informally, but a further three to five banks are expected to enter the market post-roll.

Meanwhile, the roll of the European LevX indices will be delayed until some time after 3 October because dealers are still working through a number of issues, including name selection – the number of reference obligations is likely to be increased from 35 to 40 – and making the new ISDA European documentation (see SCI issue 50) compatible with the index format.

The new documentation is nevertheless working well, according to one LCDS trader in London. "There has obviously been some disruption in the broader market, which has made it hard for traders to begin working with any new product. But the loan market finally seems to be settling down now and stocks are trading up, thanks to the Fed's liquidity injections," he says.

Indeed, LevX liquidity is expected to increase dramatically after the roll. "The new ISDA documentation will attract more participants to the sector who are put off by the cancellability of the existing index," the trader concludes.

CS

Subordinated MFI structure debuts

Status as Tier 2 capital achieved

Deutsche Bank has launched an unusual microfinance CLO. The €60m VG Microfinance-Invest deal is thought to be the first-ever securitisation of fully subordinated debt issued by microfinance institutions (MFIs).

The transaction securitises subordinated credit risk against 21 MFIs located in 15 different countries, the main activity of whom is lending to small entrepreneurs in developing countries. While Deutsche Bank sold its claims that arose under 20 of the loans via true sale, it has bought credit protection in respect of a locally granted loan to a Kenyan-based MFI.

The motivation behind extending subordinated loans to the MFIs was to achieve status as Tier 2 capital in accordance with local banking regulatory requirements, according to Michael Hölter, director at Fitch Ratings. "Over the past years authorities in these countries have either developed a dedicated regulatory framework on MFIs or extended general banking regulations to these entities, although they are not necessarily fully licensed financial institutions," he says.

The Fitch-rated issuance involves three disbursement dates, whereby notes will be sold to investors and the proceeds used to acquire further receivables arising under existing loans or new pay-outs. "This follows funding plans of the participating MFIs as to when they need the money and manage interest expenses. While this avoids negative carry, the final disbursement was underwritten by Deutsche Bank and KfW from day one, mitigating the risk of portfolio changes," explains Hölter.

The first disbursement date was 17 July, when €17.6m triple-B rated senior, €9.7m unrated mezzanine and €1.9m unrated junior notes were sold. The second issuance fell on 17 September, with €11.3m senior, €6.3m mezzanine and €1.3m junior notes being sold. Finally, the third issuance is expected on 17 December and will see €7.2m senior, €4m mezzanine and €0.8m junior notes being issued.

The arranger has retained the junior notes, while the mezzanine and senior notes were offered to KfW, as well as churches, foundations and wealthy individuals that passed Deutsche Bank's internal investors guidelines. The transaction was not aimed at the typical structured finance investor base: participating accounts either already supported the MFI sector in the past or were motivated by the mixture of an economically and ethically attractive investment.

The issuer can call the transaction until 17 December 2007 if it determines that the portfolio composition of loans will cause a shortfall of cash available to serve the payments due under the notes which is higher than the junior investor's claim for interest payments over the term of the transaction.

Fitch has performed its own credit analysis on each of the underlying MFIs. The ratings assigned to the borrowers take into account the agency's view on sovereign risk, namely the possibility of transfer and convertibility restrictions. Due to the subordinated status of the loans, the bullet repayment structure and the legal uncertainties regarding the enforceability of loans within the respective countries, it was assumed that no recoveries could be obtained after default.

In Fitch's view the key risk factor in respect of the MFIs as debtors in this transaction are event risks, such as shocks to the local economies or governmental intervention – including expropriation of property or redenomination of the currency in which the loans are denominated. The agency has taken these aspects into account when analysing the quality of the collateral.

In terms of portfolio composition, Azerbaijan shows the highest concentration with 21.59% outstanding. The top three countries combine to create a share of 51.57% of the outstanding balance related to eight loans. The highest concentration against a single obligor stems from Microfinance Bank of Azerbaijan, a joint-stock corporation the majority of which is owned by KfW (24.96%), IFC (25.55%) and EBRD (18.25%).

CS

Manager impairments to rise

Investors urged to continuously vet their CDO managers

The long-predicted shakeout among CDO managers has begun. An increasing number of manager impairments are expected, driven by secular changes in the market and heightened investor discrimination.

Sixteen out of 52 CDO managers that Derivative Fitch rates have been identified as potentially having similar liquidity risk profiles to Bear Stearns Asset Management and C-BASS, according to the agency in a new report. Following interviews with these managers, however, Fitch concluded that none are exposed to discernable and material short-term liquidity risk at this time.

But the agency nevertheless believes it possible that manager impairment rates may reach 20% for all CDO asset managers across all collateral types and as much as 40% for managers focused on ABS collateral, should the CDO market downturn persist. The market may come to regard CDOs backed by RMBS as unattractive, depressing future prospects for managers specialising in the structured finance sector.

"One consequence of manager impairments would be consolidation of collateral assets with unimpaired managers," says Fitch senior director Vincent Matsui. "Manager tenure is not necessarily an indicator of future manager success or failure, as the impairments to date have involved seasoned managers. That said, newer entrants will be under pressure should the new issue CDO market take time to return."

The agency defines manager impairment as any substantive diminution of a manager's capacity, as evidenced by material staff reductions, cutbacks on critical resources such as data and technology, and financial stress.

Fitch's manager universe comprises two types: the classic arbitrage manager, which manages CDO collateral as a means of earning fees; and the strategic funder, whose primary focus is to obtain long-term matched funding for their fixed income and loan portfolios. Among managers of arbitrage CDOs are companies specialising in CDO management, as well as multiline fixed income managers.

Specialist companies – specifically those focused on ABS CDOs – appear most vulnerable to a sustained slowdown in the CDO market. Many managers are seeing reduced fee income due to the diversion of subordinate management and incentive fees caused by credit deterioration in the underlying collateral. With diminished prospects for growing out of this problem through additional CDO mandates, managers with a high fixed-cost base will need to make difficult cost-saving decisions.

Whereas many CDO asset managers often diversified their fee revenues with high-leverage vehicles such as ABCP conduits and SIVs prior to the market downturn, downsizing or closure of such operations may further compound a manager's loss of income and reputation. "Even if the CDO market were to recover completely, specialist managers with poor or mediocre absolute performance may be completely shut out of new mandates as investors opt for managers with strong prior performance and good long-term business prospects," adds Fitch md Shaun Baddeley.

Multiline fixed income managers have the best prospects for managing through the financial stress of a prolonged downturn in the CDO market because they benefit from diversified sources of revenue.

Strategic funders, meanwhile, may find themselves in a double bind should there be a sustained slowdown in new issuance. A prolonged closure of the CDO market will lead to an interruption of various growth strategies as these issuers seek long-term financing alternatives.

The second aspect of their dilemma is their reliance on short-term financing to support their origination and warehousing of assets prior to match-term funding through CDO issuance. With their two main sources of financing reduced, strategic funders may be confronted with a slow- or no-growth reality until short-term liquidity and the CDO market recover.

Fitch warns that in the case of manager impairment investors are confronted with a slow dissolution of the manager, where the effects of a weak financial condition will take time to manifest themselves in portfolio performance. "Investors must take responsibility for continuously vetting their CDO managers if they wish to preemptively manage this risk of manager dissolution," the report concludes.

CS

Portfolio manager swap

The latest company and people moves

Portfolio manager swap
Patrick Janssen has joined Prudential M&G as a portfolio manager for the firm's CDOs of ABS. He previously held a similar role at Fortis Bank in Brussels.

Calyon loses its heads
Following the announcement of a €250m credit trading loss at Calyon in New York (SCI issue 56), three senior managers are understood to have left the bank. Loïc Fery, global head of credit markets & CDOs, together with Zain Abdullah, head of credit markets & CDOs Calyon Americas, and Jérôme Le Jamtel, head of the credit and debt markets division of Calyon Americas, are believed to have departed last week.

ICG opens in New York
Intermediate Capital Group (ICG) has expanded its global network with the opening of a New York office and the recruitment of five New York-based investment executives. ICG America will be managed by Jason Block, who joins from AlpInvest Partners, where he was a partner responsible for mezzanine investments. The senior investment team also includes Gerald Chaney and Charles Rosse, also from AlpInvest, Mike Anderson from ICG London, and Jon Marotta who has joined from York Street Capital Partners.

RBC reshuffle
RBC Capital Markets has appointed Chuck Powis as head of institutional sales for US financial products and fixed income & currencies, Mike Quinn as head of US credit trading and Eric Olson as head of emerging markets trading, US. All positions are part of RBC's US fixed income & currencies platform and are based in New York.

Quinn retains his role as RBC Capital Market's co-head of structured credit, financial products. Powis was formerly RBC capital markets' head of US structured credit and rates.

GFI appoints for e-commerce
GFI Group has made Jurgen Breuer senior md – head of e-commerce. He will be responsible for executing GFI's global e- commerce strategy, including the continuing development of GFI's CreditMatch, ForexMatch and other electronic platforms.

Breuer has been with GFI since 1998, most recently as senior md – head of Asia. GFI has appointed Scott Tatham to the post of md of Asia to replace Breuer.

RBS adds co-head
The Royal Bank of Scotland (RBS) has announced the appointment of Roberto Silvotti as joint head of exotic credit derivatives, alongside Vincent Dahinden.

Silvotti joins RBS from Dresdner Kleinwort, where he was head of multi-asset derivatives structuring, and prior to that co-head of credit derivatives at Calyon.

RBS says that Silvotti and Dahinden will each focus on specific areas, with Dahinden directly responsible for cash CDOs, principal investments and structured client solutions, while Silvotti will head trading and structuring in the areas of synthetic products and index strategies. Both will report to Matteo Mazzocchi, head of structured debt derivatives, RBS global banking & markets.

TSI gets Biggar
Trade Settlement Inc (TSI), an electronic loan settlement services provider, has hired Stuart Biggar as general manager of the Dublin office, part of its expanding European operations. Biggar is a 20-year veteran of Merrill Lynch International Bank, having worked in all facets of post-trade operations in loan trading.

Most recently, he served as loan administration manager at Merrill and, earlier in his career, worked in such areas as derivatives settlement and service management.

MP

CRE CDO-squared closed

A round up of this week's structured credit news

CRE CDO-squared closed
NIB Capital has closed Scute 2007-2, a US$1.3bn-equivalent CDO-squared backed by US CRE CDOs and CMBS. The majority of the assets in the semi-private deal were previously held on NIBC's balance sheet.

Rated by Fitch, the capital structure comprises €882m single-A minus rated Class A-1 notes (which priced at 60bp over Euribor), US$0.25m Class A-2s and a US$91m unrated equity tranche.

The transaction is static at closing, but may become managed at the option of 66.67% of the Class B noteholders. There is little anticipated amortisation in the portfolio in the first four years, according to one market source, but the option is available to begin managing the deal if there is value to be added in doing so.

In such a case, the reinvestment period can last until September 2011 and the manager will be NIBC Credit Management. If managed, discretionary trading will be limited to 20% per annum and in addition any credit impaired, defaulted or credit improved asset and any asset that appreciated in price since purchase can be sold throughout the life of the transaction.

Asset disposals, apart from credit impaired and defaulted asset sales, are subject to certain conditions. Reinvestments will be subject to the guidelines outlined in the collateral management agreement and limit the collateral manager's portfolio allocations with respect to obligor, manager, asset type and rating concentrations.

The current portfolio has a WAL of 7.8 years and consists of 190 assets from 92 different issuers. About 83% of the assets were originated in 2006 (61.2%) and 2007 (22.2%).

The transaction is callable by the Class B noteholders at all times, subject to the repayment of the rated notes in full. Additionally, there is an auction call that begins in 2014.

Fitch updates CCO criteria and downgrades deals
Derivative Fitch has updated its criteria for collateralised commodities obligations (CCO) to include a scenario stress test overlay. The agency has also released an updated version of its Vector CCO model, which will improve market understanding of the risk dynamics of CCOs, bringing more flexibility and transparency to the sector.

The latest Vector CCO allows for analysis of transaction tenors between six months and seven years in six-monthly intervals, and provides enhanced functionality to calculate 'what if' scenarios on future price movements and for the surveillance of existing CCOs.

The scenario stress test overlay reflects the possibility of a structural break in commodities price behaviour since 2003 that might not be captured in the historical data. Specifically, the test is designed to protect CCO investors against the possibility that recent price increases of some commodities might reverse themselves.

The test introduces a minimum level of credit enhancement so that a CCO structure can withstand a significant decline in the price of several reference commodities from their current price towards their long-term mean price over a short period. The scenario stress test is differentiated according to target rating and tenor of the transaction, as detailed in the criteria report.

The higher of the rating loss rate simulated in Vector CCO and the loss rate determined by the scenario test overlay will be considered in the agency's CCO rating analysis.

Ratings are assigned by ratings committee and the quantitative results are only one input into the rating process. Fitch's analysis, through the rating committee process, also considers additional factors such as historical price movements, the correlation between commodities prices, and structural features of the transaction including the number and level of the commodity price triggers, in addition to the quantitative analysis.

Fitch's quantitative analysis is based on Monte Carlo simulation of the CCO structure using Vector CCO, the agency's simulation tool for analysis of a commodities reference portfolio, and a scenarios stress test.

Following the amendment of its rating criteria for CCOs and the respective introduction of an additional scenario stress to address the structural break in historical price movements in commodities, Fitch has downgraded a number of classes of notes across three CCO transactions. The deals affected are Sirens Series 2007-2 (which has had four tranches downgraded), Cargo III (two) and Cargo IV (three).

The transactions reference a diverse pool of commodities through a portfolio of long and short trigger swaps. Since the closing of the transactions, the price of several base metals has declined.

In particular, the price of nickel has dropped to approximately 55% to 60% of the price at closing, increasing the likelihood of breaching at least some of the long triggers on this metal. In addition, aluminium, zinc, corn, silver, and natural gas prices have all dropped in value by about 10% to 20%.

Continued CP disruption puts SIVs under pressure
Derivative Fitch says in a report that a continuing disruption in the CP market will keep putting SIVs under pressure. The agency does not expect a short-term improvement of either the current CP funding environment or the current illiquidity and re-pricing of credit risk in the market. SIVs with little to no US sub-prime RMBS exposure, a relatively long liability structure and in particular good access to alternative sources of funding will be the ones best able to withstand these adverse market conditions.

"Some SIVs have already come under pressure, reflected in rating actions in the form of rating watch negative and downgrades executed by Fitch," says Stefan Bund, md in Derivative Fitch's European structured credit team. "If the current lack of liquidity continues and if asset price declines do not moderate, further rating actions may be warranted."

SIVs, the business model of which is based on the short- and medium-term financing of long-term investments, are doubly hit – both on the asset and the liability side – by the current credit-triggered liquidity crisis in the global structured finance markets.

"The fact that SIVs to a large extent rely on short-term funding through the issuance of CP makes them even more vulnerable to the current situation," says Patrick Clerkin, senior director and head of Derivative Fitch's SIV rating team. "They currently have to refinance much of their debt through CP or asset liquidation in very hostile conditions."

The report, entitled "SIV's Rating Performance in Times of Diminishing Liquidity for Assets and Liabilities", provides market participants with a clear picture of the threats to which SIVs are exposed in the current market environment, and the parameters driving the level of vulnerability of individual SIVs. Throughout the report Fitch also explains the type and magnitude of rating actions it has taken to date, and gives an indication of what future rating actions can be expected in a continuing stressed environment.

Sachsen Funding files restructuring plan
Sachsen Funding has become the latest SIV-lite to undergo a restructuring. The restructuring plan allows the SIV to seek interim funding from LBBW via a 90-day financing facility to term out the vehicle's short-term paper as it falls due.

The vehicle holds 74 US RMBS securities with a notional value of US$2.3bn which are rated mostly triple-A or double-A with an average spread of around 30bp over Libor. The plan's disclosure notes that the likely mark-to-market of the book would have wiped out the mezzanine and capital noteholders.

The move will also allow the vehicle to return to its day-to-day operations in the short term and pursue a permanent restructuring.

Monoline exposure explored
In a recent report, Moody's lays out scenarios involving US sub-prime mortgage cumulative losses on the financial profiles of rated financial guaranty insurance companies. The report reviews the guarantors' risk exposure to sub-prime RMBS transactions and ABS CDOs that contain sub-prime exposure, and points to the following conclusions.

The risks presented by the direct insurance of sub-prime RMBS transactions will likely be well contained. This should be so because the credit enhancement levels (that is, the cumulative losses assumed by third parties before the guarantors have to pay claims) are generally well in excess of Moody's current estimates of the ultimate cumulative losses these transaction may suffer.

Using a stochastic model that relates sub-prime cumulative losses to claims on insured ABS CDOs, Moody's shows that most of the guarantors would experience zero expected claims on their insured ABS CDOs, in the base case – at 10% average cumulative losses – and none would incur material claims. Further deterioration in the US sub-prime residential mortgage market, however – up to 14% cumulative sub-prime losses on average – could have significantly different net effects on individual guarantors, given their unique risk and franchise profiles.

Under the more stressful scenario modelled above, of those guarantors with sizable notional ABS CDO exposure, MBIA would remain adequately capitalised for its rating, but AMBAC, FGIC, SCA and CIFG would all need to undertake capital strengthening measures to maintain their Aaa ratings. FSA, Assured and Radian Asset have not insured meaningful volumes of ABS CDOs in recent years.

Stanislas Rouyer, svp and author of the report, emphasises that Moody's stress model results are highly sensitive to the underlying inputs, some of which are based on broad assumptions about specific CDO collateral composition and performance. Moody's md Jack Dorer states that "we will continue to refine our ABS CDO analysis while monitoring the impact of any changes to sub-prime cumulative loss expectations, as well as any underlying rating actions, should they occur, on the credit profile of the guarantors".

Because ratings are so important to the monoline industry's value proposition, the rating agency believes that a highly rated financial-guarantor with a strong ongoing franchise would likely take whatever action is feasible to preserve its rating during times of stress.

According to Dorer: "Beyond the immediate disruption to the guarantors' business opportunities due to chaotic conditions within the global credit markets, these events are likely to be a positive catalyst for financial guarantor business growth over the medium term, as credit re-prices to levels that increase demand for their core product."

Fitch confirms approach to ABCP programmes
Fitch has confirmed that the treatment of sub-prime RMBS in securities-backed ABCP programmes will be consistent with its updated criteria introduced on 15 August 2007 for CDOs in a report called "Global Criteria Change for US Structured Finance CDOs Reflects Heightened Sub-prime Risks".

In accordance with the revised methodology for CDOs, the agency will implement the following adjustments when applying the VECTOR CP analysis to securities-backed programmes. First, the default probability for any US sub-prime RMBS security issued since 2005 is increased by 25%. The second change is with regards to securities placed on rating watch negative (RWN) or equivalent by any other rating agency.

Any US sub-prime RBMS security placed on RWN by any rating agency is now assumed to be downgraded by at least three notches, regardless of vintage. These adjustments to both the default probability and RWN may be increased by Fitch for certain transactions. Conduit sponsors that run the Vector CP model are expected to apply the same adjustment.

Vector CP is a Monte Carlo simulation model used by Fitch to help size programme-wide credit enhancement (PWCE) for securities-backed ABCP conduits. Vector CP is populated with information on each security in a portfolio, such as the ratings, asset type and country of risk. Using these inputs the model can calculate the correlation between securities and the probability of default.

The above criteria may be applied to any relevant security with US sub-prime RMBS exposure. This could include direct exposure via RMBS or indirect exposure via residential mortgage CDOs. Fitch has applied the updated criteria in its recent review of conduit ratings.

Moody's modifies assumptions on sub-prime RMBS
In light of expectations for continued ratings deterioration among recent vintage sub-prime RMBS, Moody's has modified its assumptions to the expected loss inputs of certain first-lien sub-prime RMBS assets going into new structured finance CDO transactions effective immediately.

Also, for the purpose of Moody's CDO analysis, "sub-prime" will encompass all non-prime assets, including those assets that would have previously been classified as "mid-prime" in the agency's CDOROM model. These assumptions will affect the base case expected loss inputs to the SF CDO model; however, Moody's has reiterated that the ultimate ratings on CDO tranches are determined by its rating committees who may ask for additional scenarios in which the underlying ratings and other inputs may be stressed in order to make their final decisions.

The agency stated that the stresses are meant to be broad-based assumptions that will allow for the SF CDO market to continue operating in an orderly fashion. These guidelines are intended solely to account for future ratings volatility on the underlying RMBS assets in Moody's analysis of SF CDOs and are not meant to be reflective of any specific future rating actions. Its rating analysis on RMBS assets is performed on a tranche-by-tranche basis, taking into account the specific characteristics of and circumstances around each security.

S&P takes rating actions on 22 CDO tranches
S&P has taken credit rating actions on 22 European synthetic CDO tranches.

Specifically, the agency has taken the following actions: ratings on 11 tranches were removed from credit watch with negative implications and lowered; the rating on one tranche was lowered and remains on credit watch negative; ratings on eight tranches were removed from credit watch positive and raised; and ratings on two tranches were raised.

For those transactions that have been on credit watch negative for longer than 90 days, where the agency has either not received material levels of information or relative portfolio credit quality has not improved since the credit watch placement to a level sufficient to affirm the rating, it has modelled recovery rates in accordance with its criteria and assessed portfolio quality based on their credit quality today.

These rating actions and the credit watch updates follow two reviews: the credit watch placements made following the month-end SROC figures; and the ratings on tranches that have been on credit watch negative for more than 90 days.

Where SROC is less than 100%, scenarios are run that project the current portfolio 90 days into the future, assuming no asset rating migration. Where this projection indicates that the SROC would return to a level above 100% at that time, the rating is maintained, but placed on credit watch negative. If, on the other hand, the projection indicates that the SROC would remain below 100%, the rating is immediately lowered.

Fitch places 14 SF CDOs on watch negative
Fitch has placed 48 classes from 14 structured finance (SF) CDOs on rating watch negative. Additionally, 29 classes from 10 SF CDOs remain on rating watch negative.

The actions affect approximately US$1.2bn of CDO notes issued from US$7.7bn of mezzanine SF CDOs and US$67m of CDO notes issued from US$4.5bn of high-grade SF CDOs issued during 2006 and 2007.

These actions are a result of Fitch's ongoing collateral portfolio review of SF CDOs where significant portions of the portfolio have been downgraded or placed on rating watch negative by either Fitch or the other major rating agencies. In addition to public rating actions, this collateral portfolio review identified concentrations of sub-prime RMBS bonds issued in 2006 where expected losses may be significantly higher than the ratings suggest.

New Moody's report on CDO rating action
Moody's has launched a new monthly publication which summarises its actions regarding CDOs. This report is part of the agency's continuing efforts to improve rating transparency for the asset class.

In the first issue of 'Structured Finance CDO Ratings Surveillance Brief', Moody's reports that the sub-prime mortgage fallout continues to put pressure on CDO ratings. According to the report, downgraded tranches currently account for a small percentage of the rated CDO market.

However, if home price appreciation continues to decline and losses accumulate on mortgage loan collateral, there may be further weakness in SF CDOs backed by RMBS assets.

In August report Moody's downgraded 25 tranches from 19 CDOs and placed 73 tranches from 27 CDOs on review for downgrade. About 5% (239 by count) of all outstanding Moody's-rated SF CDOs continued to be on review for possible downgrade, with around 60% of them on tranches rated Baa or below.

The new publication will be produced monthly to update the market on rating actions taken during the previous month on CDOs, including CDOs backed by pools of structured finance assets such as sub-prime RMBS, as well as summary market commentaries describing reasons, trends and potential outlooks for these actions.

CS

Trading ideas - unbalanced reaction

John Hunt, research analyst at Credit Derivatives Research, looks at a negative basis trade referencing Dow Chemical Co.

We recommend a negative basis trade on the Dow Chemical Co. 6s of October 2012, based both on Dow's relatively underpriced bond and on the company's relatively high event risk. We've found that CDS usually underperform bonds when a credit-unfriendly event happens, and negative basis trade positions benefit as a result.

Dow faces higher-than-usual event risk. That sweetens what would be an attractive negative basis trade even without the event risk.

Basis trade basics
The underlying idea of the negative basis trade is that credit risk is overpriced in the bond market relative to the CDS market. The investor buys a risky bond – and thus is paid to take credit risk on the issuer – while paying for credit risk in the CDS market by buying 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 credit market is greater than the spread that is paid in the CDS 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 cashflows to equal the bond's current price.

A "quick and dirty" comparison of how the bond and CDS markets are pricing a bond's credit risk can be done by simply looking at a bond's z-spread and the CDS spread for an instrument of matching maturity. In fact, the "basis" is defined for our purposes as the CDS spread minus the bond z-spread.

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 cashflows 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. If the bond trades in the market below the CDS-implied price, we say it is "cheap" compared to its CDS-implied market value. If the bond is trading above CDS-implied price, we say it is "rich".

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

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

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

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

Another consideration in constructing the position is that a liquid CDS usually will not be available in an interpolated tenor that matches the maturity of the corporate bond. We construct the trade using a CDS of the closest available liquid tenor.

Because CDS premiums vary with tenor (generally, longer-dated CDS have higher spreads), the mismatch between CDS and bond maturity will affect trade characteristics, such as carry and rolldown. We generally 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 cheapness
Based on our valuation approach, the DOW 6 of August 2012 bond is trading cheap to fair value. Exhibit 1 presents the price-based term structure of the company's bonds with maturity near five years and indicates that the August 2012 bond is trading cheap to fair value.

Exhibit 2 compares the bond z-spreads with the CDS term structure and fair bond z-spreads, and shows that the recommended bond's market z-spread is wide of the closest-maturity CDS and its fair z-spread.

Exhibit 3 illustrates the basis between the matching maturity on-the-run CDS and the bond over the past year. The bond follows a familiar pattern – the basis moved dramatically towards the positive over the summer and has now reverted back to a more negative-than-average level.

Risk
The position is default-neutral. There is a slight maturity mismatch because the bond matures on 1 October 2012 and the CDS expires on 20 December 2012, but we expect to be able to exit the trade with a profit from carry and convergence to fair value before either instrument matures.

We provide a suggested simple, duration-matched Treasury position to hedge interest rate risk. Exhibit 4 presents a number of sensitivity calculations for the bond for investors who are interested in more complex hedging strategies.

As with any bond-CDS basis trade, investors should ensure that the bond is a deliverable obligation for the CDS.

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 position is very slightly short the firm's credit on a DV01 basis. A small parallel tightening in the firm's bond and CDS credit curves will hurt the position to the tune of approximately 0.02bp for each basis point of parallel tightening. In our view, the trade is effectively DV01 neutral.

The default-neutral construction is based on the assumption that the bond will trade at US$40 upon default. Although this is a conventional assumption, the post-default trading value could be different. That would lead to a gain or loss on the position.

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.

The recommended CDS is in the 5-year maturity, which is the most liquid tenor. We are seeing good quote flow on Dow, and bid-ask spread is 5bp.

The bond is currently available in large size and should be obtainable at the recommended level with a reasonable bid-ask spread.

The cheapness of the bond to fair value is significantly greater than the trading costs we see, leading to a calculated profit of approximately 110bp to 120bp of notional on full repricing of the bond to its CDS-implied price.

Fundamentals
As explained, our negative basis trades are based on the assumption that the bond is mispriced 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.

Carol Levenson, Gimme Credit's chemicals expert, maintains a "Deteriorating" credit score on Dow Chemical, noting that the firm is subject to event and legal risk, and is also engaged in a chemicals/plastics business that is at its core highly cyclical. Although LBO concerns have receded for the moment, we do not believe that such risks are gone for good, and Carol notes that Dow appears in every major M&A rumor in its sector. Dow's fundamentals-based LBO score is above average for our universe.

Summary and trade recommendation
Bond mispricing and event risk come together in this negative basis trade. As we pointed out in our outright short recommendation on Dow earlier this week, the company faces significant event risk:

It is the perennial subject of merger rumors and also scores negatively on many of the indicators incorporated into our multifactor credit model. Because credit-unfriendly events usually cause CDS to overreact relative to bonds, that event risk is also a good reason to put on a basis trade.

At the same time, Dow's bond-CDS basis has dropped as credit markets have come out of the summer's liquidity crunch, and the basis is now below pre-crunch levels. The recommended bond is now trading almost US$2 cheap to CDS-implied fair value, and our computations indicate total trade profit of around 90bp of notional after trading costs on full convergence of the bond to fair value.

Buy US$10.4m notional Dow Chemical Co. 5-year CDS protection at 24.5bp.

Buy US$10m notional (US$10.24m cost) Dow Chemical Co. 6s of October 2012 at 102.44 (z-spread of 46.1bp) to gain 20.5bp of positive carry.

Sell US$10.5m notional Treasury 4.125s of August 2012 at a price of 99.16 (US$10.42m proceeds) to hedge bond interest rate exposure.

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

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

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

What doesn't kill you makes you stronger

The difference between the synthetic structured corporate credit market and the structured sub-prime ABS market is discussed by the RBS structured credit strategy team

Bespoke synthetics
Along with all markets using the acronym "CDO", bespoke synthetics have come under increased scrutiny as participants try to establish who holds what risk. However, we continue to make the distinction that it is the collateral that defines an investment, not the manner in which that collateral's risk is transferred to the investor – a CDO of RMBS is quite different to a CDO of corporate credit risk.

The corporate correlation market has remained open during the recent turmoil and valuations have been feasible. We focus on the advantages that synthetic tranches have over their full capital structure predecessors and we think this technology is suited to solving the problem of wide triple-A CLO liabilities.

We see the following as being key advantages of synthetic corporate tranches in these market conditions:

• Single-tranche structures (STCDOs) have no need to place liabilities. One of the biggest stumbling blocks to the resumption of the CLO market is the ability to find investors prepared to take on triple-A risk at spread levels that make the structure economical. Whereas these tranches once printed at around 20bp, we have heard anecdotally of some secondary paper trading as wide as 100bp. Given that triple-A makes up in excess of 70% of a typical CLO, it is too expensive to fund a structure at those levels. Synthetics do not have this problem.
• STCDOs have inherently matched funding – they are unfunded swaps overlaid on a par cash collateral account. They have no "assets" to fund, so are not reliant on the money markets which have caused so much distress at the moment.
• Superior collateral relative to other asset classes, especially RMBS.
• Managed structures stand a better chance of avoiding any potential landmines that a more volatile future is likely to bring.
• They are highly bespoke investments. Unlike most other investments, it is possible to tailor STCDOs on a per client basis.
• Managed synthetics allow a manager to make relative value decisions through a short bucket. The ability to do this should prove valuable in a deteriorating credit environment.

Given the above advantages of the synthetic approach, it is possible that single-tranche CLOs may appear (we note that full capital structure synthetic CLOs are not new). This would alleviate the problem of placing liabilities and also eliminate warehousing risks, which have hurt arrangers recently.

This is predicated on an LCDS correlation market developing, which should happen as soon as tranched LCDX and LevX begin trading in the next few months (see news story on LCDS). The recent widening of LCDS spreads relative to cash loans removes a further obstacle (read lack of spread) to their CLO use.

With regards to non tranched products, we think that principal protection may become more popular, if only for its psychological benefits, while we also expect investors to treat ratings with more caution. High levels of implied spread volatility also create fertile conditions for structures accessing spread volatility risk, especially at the index level. Improving liquidity in the index options market should help facilitate pricing.

Standardised index and tranche markets
Correlation has repriced upwards through the credit turmoil. We see value in senior tranches, especially leveraged super senior if suitable unwind triggers can be arranged. We anticipate demand for tranched loan indices from arrangers of STCLOs, as this goes some way to solving the funding problems in full capital structure deals.

The summer of 2007 will be remembered as the time the mainstream press took iTraxx Crossover and elevated it from a niche market interest topic to front page material. Huge intraday swings whipsawed dealers and investors alike as everyone from FX traders to CLO arrangers tried to use Crossover as a hedge. Many of these "macro" hedgers have since departed and some semblance of calm has returned to the iTraxx indices, but what next for these standardised markets?

Our overall theme for the next six months or so is one of consolidation of existing products in the index space rather than a renewed drive for ever more exotic instruments. Any innovation will occur in bespoke products. We are of the opinion that transparency and liquidity will be key.

In the list of 'liquid' products we include the new loan derivative indices – LCDX in the US and LevX in Europe. As many of the credit concerns revolve around leveraged loans, trading in these indices should remain brisk.

We expect LevX liquidity to catch up with LCDX, as the next roll will see it adopt the new ISDA documentation allowing contracts to remain in force following refinancings. This development will bring to the product more participants who are put off by the cancellability of the existing index.

The investment grade tranche market (aka correlation trading) hasn't received a great deal of attention recently, with most people focusing on indices and CLOs in addition to anything ABS related. As real money stopped buying structured deals, trading in index tranches slowed to a crawl, characterised by wide bid-offers on most tranches.

This is not to say the market has lacked action, because we have in fact seen substantial upward movements in correlation. This has been driven by four factors:

• Systemic risk to the fore. The sell-off was about the financial system in general and everything has been dragged wider. Increasing systemic risk tends to increase correlation.
• Gamma traders piling into delta hedged equity. In a volatile index environment, positive convexity is a valuable asset. In combination with a delta hedging strategy, index volatility will earn an equity-risk holder money. This kept the price of equity protection down and lifted correlation higher.
• Macro hedgers buying X-100% protection. Large, senior tranches typically offer sensitivity to the index (delta) that is cheaper to buy (lower spread per delta) than simply shorting the index risk. Therefore many macro hedgers have been buying protection on, say, 3-100%. This is equivalent to selling equity protection, therefore driving up correlation.
• Fears of leveraged super senior (LSS) unwinds. Canadian conduits were big buyers of highly rated LSS notes. Failure to find short-term financing led to the fear that large quantities of LSS would be unwound as part of a mass liquidation. Dealers and investors have been positioning themselves accordingly by buying SS protection, again driving up correlation at the most senior parts of the structure.

We see value currently in the senior and super senior parts of the capital structure, due to the historically high levels of correlation there. We think conditions are ideal to buy LSS notes again and lock in those spreads, albeit with a couple of provisos.

All LSS structures have an element of "gap risk" because the notional amount of protection written is several times the notional of the underlying note (the "leverage" in LSS). For this reason they contain triggers which will unwind the trade at a MTM loss before any hard dollar losses can be incurred.

The definition of these triggers is key. We believe that the LSS notes purchased by the Canadian conduits had triggers referencing the spread of the SS tranche.

SS tranche spreads have jumped, not only because of wider index spreads but also because correlation has moved against them. Therefore it is possible that they are near their unwind triggers.

An alternative trigger would be on the spread of the underlying portfolio rather than the tranche. While this would also be wider, the moves in correlation would be irrelevant and we think no portfolio would be close to a trigger level. We therefore would recommend LSS notes with portfolio spread triggers set to be as remote as possible.

© 2007 The Royal Bank of Scotland. This Research Note was first published by The Royal Bank of Scotland as part of 'Structured Credit Market Outlook' on 20 September 2007.