Contents

Back to basics

Alignment of structure and collateral crucial for US CRE CDO growth

Arrangers report that they have begun working on new US CRE CDOs with the intention of getting them away by the end of the year. But, while the CMBS pipeline may be building up once again, banks are struggling to fill the gap in the investor base left by European SIVs.

Volume in US CRE CDOs vanished over the summer due to the decrease in the buying base: the majority of floating-rate paper was sold into European SIVs, which favoured the vehicles as a way of accessing the US commercial real estate sector. "CMBS deals are now coming through and, given that B-piece buyers use CDOs to finance their businesses, this may well reinvigorate CRE CDO issuance. But the main challenge for issuers is to identify enough investors," explains David Harrison, director at Derivative Fitch in Chicago.

He adds: "Issuers will have to look to real money investors in Europe and Asia, as well as reinvigorate the investor base in the US. There are opportunities across all these investor types, but first there needs to be the right alignment of structure, credit risk and underlying collateral in order to whet their appetite."

Of around 12 preliminary US CRE CDO transactions that Fitch is currently looking at, for example, only a couple have a realistic chance of coming to the market. Those deals are characterised by being lightly managed or having issuers with strong balance sheets which can hold a portion of the deal, and who have identified select investors for various parts of the capital structure.

GKK Manager's US$1.1bn Gramercy Real Estate CDO 2007-1, which closed in August through Wachovia and Goldman Sachs, has been cited as an example of the type of transaction that is expected to be successful in the near future. The manager is known for its involvement with transitional loans and is considered to be a savvy sponsor. But in this deal the portfolio comprises 68.4% triple-A rated CMBS, with the remaining assets consisting of high quality B-notes, mezz and whole loans.

"Most issuers may aim for a similar make-up in terms of collateral and structure going forward," confirms Harrison. "Portfolios may generally transition away from riskier asset types, such as construction and highly transitional loans, for a short time towards more income-producing assets. Such deals may have a better chance of being placed because these speak more to investor sentiment, as do limited revolving components."

Many CRE CDO managers already have revolving loan facilities in place which mean they can continue originating assets and progress their business model – albeit at a much slower pace. But not every manager has the ability to open a fixed-rate issuance platform and so some of the less well-established managers will inevitably drop out of the market.

Nevertheless, US CRE CDOs are generally performing well, with low delinquencies. Harrison remains upbeat about the sector: "We'll see more traditional types of transactions coming through and then, once investors are comfortable with them, the market will begin evolving once again."

CS

Bleak houses

Latest sub-prime rating actions could lead to multi-notch CDO downgrades

2,506 RMBS tranche downgrades by Moody's late last week indicates a bleak outlook for 2006/7 vintage ABS CDOs. Meanwhile, the ABX indices hit new historic lows on the back of the downgrades and decelerating US house prices.

"ABX index prices have continued to head south in the aftermath of last week's downgrades...as an increasing volume of double-A and single-A cash BWICs on the affected bonds keeps up the pressure on the indices," observe analysts at RBS. At the close on Tuesday, 16 October, the ABX single-A 07-1 and triple-B minus 07-1 tranches were at new lows of 37.17bp and 26bp respectively.

Moody's downgrades represent US$33.4bn of single-A to Ba rated securities issued in the latter half of 2006, with 323 of these tranches (totaling US$3.8bn) remaining on negative watch. The agency also placed a further 577 tranches (US$23.8bn) on negative watch, of which 48 are triple-A rated and 529 are double-A rated. In total 396 different deals were affected.

Analysts at Barclays Capital point out that the degree of downgrades was relatively severe this time, with some classes experiencing a ratings slashing of as many as 11-13 notches. Approximately 50% of all tranches that were downgraded were hit with a rating reduction of six or more notches in one stroke.

Moody's says that a combination of performance deterioration and systemic issues were behind the rating actions. The 2006 vintage has experienced an unequivocal rise in early payment defaults, growth in default rates and continuous deterioration in serious delinquencies.

Decelerating home prices across the US are seen as a further indicator of weak systemic performance and Moody's expects a 10.5% peak-to-trough depreciation of nationwide housing values. As weak collateral characteristics persist in the 2006 vintage and are further magnified by high LTV ratios, the agency believes that severe delinquencies will continue to increase. In addition, it said that the expected upsurge of rate resets for the 2006 vintage could significantly affect performance unless severe and proactive loss mitigation practices are put in place.

Analysts at JP Morgan note that house prices in the US could decline by another 15% to 20% – but ABX pricing does not fully incorporate the increased possibility of a severe housing downturn, particularly a front-loaded correction. Government programmes can reduce sub-prime losses, although only if they succeed in reaching at-risk borrowers soon. As a result, the analysts believe it makes sense to short ABX tranches, particularly at the double-A and single-A level.

Globally, 502 CDOs (including 41 from the EMEA and Asian regions) have direct exposure to the sub-prime RMBS downgraded or placed on review by Moody's. In the high-grade sector, on average 13% of 2006/07 SF CDO collateral pools comprise such assets, with exposure ranging from 0.1% to 45%.

Mezzanine SF CDOs are more exposed, however, with an average of 29% of collateral pools consisting of affected sub-prime tranches. Minimum exposures are similar to high grade CDOs (at 0.2%), but the maximum exposure – at 92.5% – is much greater.

"The key takeaway...is that not all ABS CDOs will (nor should they be expected to) act the same; collateral and structural differences matter immensely to the credit and rating performance of ABS CDOs," note the BarCap analysts.

Moody's review of ABS CDOs is expected to be completed by the end of October. The agency stated that some CDOs may be downgraded without a watch-listing if collateral performance warrants.

The prospects for the sector remain bleak, with the other rating agencies due to begin reviews and the 2007 sub-prime and Alt-A cohorts still to be analysed. S&P lowered its ratings on 402 classes (from 138 transactions) of US sub-prime RMBS issued during the first three-quarters of 2005, representing approximately US$4.6bn of original par amount. The agency is also reviewing its rated CDO transactions with exposure to the affected classes, while Fitch is currently reviewing its sub-prime RMBS ratings from Q1 2007.

JP Morgan's loss projections for CDO tranches (incorporating 100% principal writedowns as high as single-A) imply that triple-A and double-A SF CDOs could eventually fall to the BBB/BB area, and single-A through double-Bs to the B/CCC area.

CS

M-LEC to the rescue?

Super fund to support SIV de-leveraging and CP rollovers

A group of banks led by Citi, JP Morgan and Bank of America have established an US$80bn 'super fund' to purchase qualifying highly-rated assets from existing SIVs. The aim of the fund is to help SIVs meet CP rollovers and therefore support a more orderly de-leveraging of these vehicles, but some market participants suspect ulterior motives.

The initiative in principle involves creating a single vehicle dubbed Master Liquidity Enhancement Conduit (M-LEC). It would allow existing SIVs with unimpaired assets to down-size by effectively transferring what analysts at Deutsche Bank describe as a 'vertical slice' of their asset portfolios to M-LEC, in return for cash to finance CP redemption and some equity participation.

M-LEC in turn funds itself via the issuance of ABCP and short-dated MTNs, similar to the debt financing profile of existing SIVs. However, in contrast to existing SIV CP, M-LEC debt will benefit from full liquidity backstops (thus resembling bank ABCP conduit debt), as well as junior layers of capital.

In theory the vehicle will alleviate pressure on SIV sponsors to sell assets at distressed prices and, given the credit quality of the backers, it should be able to fund more cheaply in the ABCP market – thereby broadening the investor base in the sector. SIVs continue to face funding difficulties in the ABCP market, where only the top-tier bank sponsored conduits are financing readily. As at end-September, the US and Euro ABCP markets had shrunk over the preceding quarter by 25% and 35% to US$900bn and US$192bn respectively.

"Our tentative view at this early stage is that this market-wide exercise may significantly diminish the immediate threat of SIV asset overhang (a positive for secondary pricing), but looks unlikely in itself to re-establish the SIV business model – which means that the vacuum in near-term primary market demand is likely to remain," note the Deutsche Bank analysts.

The move was facilitated by the US Treasury and it has been suggested that the UK's Financial Services Authority is considering a similar concept. Alternative structures are believed to have been put forward, including one that pooled SIV sponsors' most risky exposures to CDOs and sub-prime assets.

While the transferal of SIV assets to M-LEC would be at the sponsor's own discretion over a defined period of time, no details have been disclosed about asset bid prices, the right to any valuation or cash upside under the new structure or the form of equity participation (including the position of current SIV capital note investors). Any public pricing mechanism could, however, force a re-pricing of other paper held on banks' balance sheets.

One hedge fund manager describes the proposal as "a massive exercise in evading having to mark to market". "It is an attempt to create a monopoly, so that dealers can offer whatever prices they want to," he adds.

Another buy-sider suggests that the proposal will not appeal to all dealers. "The creation of the super SIV is clearly in the interests of the lead dealers, but it is less clear that those less exposed or comfortable with the way they have marked their holdings will be so keen," he says.

Certainly M-LEC raises some uncomfortable issues. For example, if the vehicle only takes triple-A or double-A assets, existing SIVs will be left with the bulk of lower quality paper – which may trigger automatic sell-downs. The vehicle will also be in direct funding competition with existing SIVs.

A number of investment firms are currently in discussions with the consortium to provide some form of portfolio management to the new vehicle. HSBC and Barclays Capital are also believed to be involved in the initiative.

CS

Capitalising on corporate volatility

Value in super-senior tranche pricing

BlueMountain Capital Management has launched a new closed-end hedge fund aimed at capitalising on recent volatility in the corporate CDS space. The Correlation Relative Value (CRV) II Fund marks the firm's third foray into credit correlation trading, following the close of Timberline and CRV I.

CRV II launched with US$80m in investor capital and immediately closed to new investment. "In our view, the credit markets today present the best relative value opportunities since the spring and summer of 2005," observes Bryce Markus, portfolio manager and managing principal at BlueMountain. "We see excellent value in the synthetic CDO market, particularly in light of the recent volatility in senior and super-senior tranche pricing, and the rolling uncertainty around rating and regulatory action in the structured credit space generally."

The fund features a 6.5-year lock-up designed to help manage co-investor risk and achieve superior dealer margining terms. Despite the 6.5-year lock, however, BlueMountain will unwind the fund after the trading opportunities presented by the current market volatility have ebbed, as it did with CRV I.

CRV I - launched into the 2005 dislocation in the credit correlation market - also had a 6.5-year lock-up. But the firm unwound the fund and returned profits and capital to its investors after just 20 months, delivering 56% returns over the period.

Investors in CRV II include several large institutions and high net-worth individuals, as well as BlueMountain principals and directors who are making a significant co-investment.

As with the firm's other vehicles employing long-term lock periods, the CRV II fund aligns investor and manager incentives. In this case, performance fees are based on cash-out to investors over a 5% hurdle, starting at 20% and graduating up to 30% for a portion of profits above a 15% IRR.

"Today we see parallels to the correlation dislocation of 2005, with the added advantage that the correlation markets are not the centre of the storm - allowing us to scoop up more opportunities as attention is focused elsewhere," says BlueMountain president Stephen Siderow.

He adds: "Moreover, the tranche markets are larger and more liquid today, with more instruments and tenors to trade and find relative value opportunities. We are confident that with our institutional scale and disciplined investment processes, we'll be able to capitalise on the current market volatility and again deliver superior risk-adjusted returns to our investors."

BlueMountain's investment philosophy integrates three vectors: fundamental credit research; quantitative analysis; and knowledge of market technicals. The firm has more than US$4.5bn in client assets under management in its hedge funds and also manages three CLOs with an additional US$1.5bn in assets.

CS

Heads keep rolling

The latest company and people moves

Heads keep rolling
Details of banks' credit-related losses continued to emerge over the past week, swiftly followed by word of structured credit staffing cuts headlined by senior executives moving on and implementation of restructuring plans. While UBS led the way with the exit of James Stehli, formerly global head of CDOs, there is widespread belief that major credit players have more heads to remove – three 'names' at least, so the speculation goes – and Citi's reorganisation is the most extensive move seen so far.

After the departure of Randy Barker – one of Citi's co-heads of fixed-income trading – and his boss Tom Maheras, co-head of investment banking with responsibility for capital markets and trading, the bank announced this week a new appointment for Vikram Pandit. He becomes chairman and ceo of its newly-formed institutional clients group, comprising Citi Markets & Banking (CMB) and Citi Alternative Investments (CAI).

Michael Klein, who Pandit leapfrogs, continues as chairman and co-ceo of CMB, while James Forese has been named co-ceo of CMB.

Pandit was a founding member and chairman of the members committee of Old Lane, a multi-strategy hedge fund and private equity fund manager that was acquired by Citi in 2007. Prior to forming Old Lane, he was president and coo of Morgan Stanley's institutional securities and investment banking business, and was a member of the firm's management committee.

Founder leaves
Alex Graham, co-founder and global head of Winchester Capital, Deutsche Bank's principal finance unit, has left. His destination is not yet known.

RBC reorg
Royal Bank of Canada (RBC) has begun a reorganisation. Head of CDOs, Keith Froggett, has left, as has a junior structured credit trader – Lydia Kerley. Furthermore, Josh Danziger, global head of structured products, is no longer expected to return from sabbatical.

RBC officials declined to comment, but RBC Capital Markets has announced the hiring of Mike MacBain as co-head of its global debt markets business, focusing on financial products and commodities, from 1 November. He will be based in New York and was previously president of TD Securities.

New York move
Mitchell Lench, previously head of structured credit product management at Bank of America in New York, is understood to have moved to Credit Suisse in a similar role.

Schwarz quits ACA
Laura Schwartz, senior md of ACA Capital Holdings, has left the company effective 12 October. Last month she had been replaced in her role as head of CDO asset management at the firm by James Rothman, ACA's new global head of the company's asset management business (see SCI issue 56).

ABS correlation switch
ABS correlation trader Jaime Aldama is believed to have left Citi. He is expected to join Lehman in a similar role.

Synthetic structurer leaves
Rayas Richa, head of synthetic structuring at Calyon, left the bank on Tuesday, 16 October. His destination is not yet known.

Dresdner confirms hires
Dresdner Kleinwort has announced a series of appointments in its credit derivatives business, some of which had previously been reported in SCI.

Tony Main joins Dresdner Kleinwort as md and co-head of structuring and product development (see SCI issue 52). He spent 13 years with Merrill Lynch in London, where latterly he was head of the credit repackaging group.

Maxime Malaure joins as md and head of cash CDOs (see SCI issue 52), replacing Maurizio Raffone, who was the interim head and now returns to the bank's Tokyo office. Malaure joins from Bear Stearns in London where he was a senior structurer in the financial analytics and structured transaction group, which focuses on ABS and structured credit products.

Ed Selby joins from Barclays Capital as director and head of credit exotics (see SCI issue 50). At Barclays, he was a senior trader for the synthetic CDO business. Prior to this, he traded synthetic CDOs for five years at Merrill Lynch.

Michael Coats will start on 2 November as director in credit exotics. He joins from Merrill Lynch, where he worked for the last four years trading synthetic CDO products.

Finally, Steven Price joins as director and head of business technology. He spent six years at Commerzbank, where he implemented the equity derivatives exotics system platform and prior to this a consolidated risk analysis system for the credit trading business.

Correlation trader confirmed
BNP Paribas has announced the appointment of Peter Nowell as head of ABS correlation trading (see SCI issue 50). Nowell joins BNP Paribas from the Royal Bank of Scotland in London, where he was head of ABS correlation trading.

This appointment reinforces the bank's ambitious growth strategy to develop into new markets and underlyings, BNP Paribas says.

Bank ABS restructuring continues
As part of its overall ABS reorganisation, Deutsche Bank has appointed Marzio Keiling and Mark Graham as co-heads of the European securitised products Group (SPG). Keiling and Graham will be based in London and report jointly to Erik Falk and Frank Byrne, co-heads of the global securitised products group.

Graham and Keiling will have responsibility for the origination and distribution of securitisation products and services within Europe. Graham previously ran the European special situations group within SPG, focusing on illiquid securitised financings and whole business securitisation. Keiling was formerly head of institutional client coverage for Europe.

MP

Further rating action on Rhinebridge

A round up of this week's structured credit news

Further rating action on Rhinebridge
S&P has lowered its ratings on the CP, MTNs and mezzanine capital notes issued by Rhinebridge from A-1+, triple-A and double-B minus to A-1, single-A plus and triple-C plus respectively. At the same time, the agency lowered its issuer credit rating for the SIV from triple-A to single-A plus. The ratings remain on credit watch with negative implications, where they were placed 12 September.

Since that date, the vehicle has been in restricted funding mode and has been selling assets to generate funds to meet maturing liabilities. The current rating actions reflect the recent sharp decline in some assets, which led to a significant decrease in Rhinebridge's net asset value (NAV) as a percentage of capital.

This decline in NAV has breached a trigger of 50%, and the vehicle is now failing its major capital loss limit test. If Rhinebridge fails to cure this test within five business days, it will enter enforcement mode, which could lead to an acceleration of all liabilities and a forced asset sale.

S&P's current rated outstanding debt of the vehicle is US$791m in CP and US$130m in mezzanine capital notes. The portfolio is predominantly invested in structured finance assets, the majority of which are US RMBS.

Fitch's SIV performance parameters
Fitch has published the first issue of a regular publication of the key performance parameters for Fitch-rated SIVs. The report is in response to overwhelming investor demand for greater and more frequent updates on the performance of SIVs.

The report displays the most relevant asset and liability parameters for the Fitch-rated SIVs and shall, until further notice, be published on a fortnightly basis. The document will allow investors to monitor the performance of Fitch-rated SIVs over time and to compare SIVs across the market.

Overall, the market price of the underlying collateral of most Fitch-rated SIVs has continued to deteriorate over the last two weeks, with a corresponding decline in net asset value. The credit quality and composition of SIV portfolios has remained unchanged. Additionally, SIVs have experienced limited issuance of CP and increased use of repo funding; the weighted average life of senior funding extended primarily due to continuing redemption of CP.

US CPDO notes withdrawn
Moody's has withdrawn its provisional ratings on two classes of notes previously expected to be issued by the Alhambra CPDO through the Arlo X vehicle. The move relates to the Series 2007 (Alhambra) CLNs and Series 2007 (Alhambra) B1-D CLNs, both due 2017.

While certain euro-denominated notes have been issued, these US dollar-denominated notes are currently not expected to be issued. Barclays Capital arranged the transaction.

LSS ratings remain stable
Fitch-rated European leveraged super-senior (LSS) CDOs have maintained stable ratings, despite recent market turmoil. In a special report, Fitch determines how much deterioration the European LSS transactions can withstand at their current rating levels. Stresses included downgrading portfolio reference entities by three and six notches, as well as simulating credit spread widening.

Given the negative outlook on the US RMBS sub-prime sector, stresses were focused on this sector, as well as on indirectly related corporate sectors. While Fitch-rated LSS transactions have very little direct exposure to the US RMBS sub-prime market, one LSS sub-class – the weighted-average rating factor (WARF) trigger LSS of ABS structures – has significant indirect exposure to US sub-prime through structured finance CDOs. The other two predominate sub-classes, loss trigger LSS and combined spread-loss LSS transactions, only reference corporate entities with little indirect exposure.

The results of the stability analysis show that loss trigger LSS and combined spread-loss LSS transactions enjoy moderate levels of rating cushion. Although the WARF trigger LSS transactions also have cushion, they are the most likely LSS structures to come under pressure if the US RMBS sub-prime market declines further.

In Europe, Fitch has rated 20 LSS transactions with a total volume of US$944m to date. Eleven transactions are still outstanding, while nine transactions have been dissolved by mutual agreement of each party. None of these transactions were called due to a trigger breach, and all called transactions were performing within expectations when they were called.

S&P SROC rating actions
After running its month-end SROC figures, S&P has taken credit watch actions on 49 European synthetic CDO tranches. Specifically, ratings on 16 tranches were placed on credit watch with negative implications; 14 tranches were placed on credit watch with positive implications; and 19 tranches were removed from credit watch with negative implications and affirmed.

These actions do not incorporate the Alliance Boots downgrade on 4 October, which will be taken into account in the October rating actions.

Fitch launches new transparency tool
Derivative Fitch has enhanced its Fitch Research offering with a new service to enhance transparency in the CDO market. CDO Portfolio View provides a snapshot of US structured finance CDO portfolio holdings based on the most recent trustee report from Fitch's CDO database.

"CDO Portfolio View gives institutions access to the same information our analysts use in monitoring CDO portfolios. This is particularly valuable in determining US sub-prime RMBS exposures and relevant risk factors like credit quality. The product also offers an enhanced insight into Derivative Fitch's surveillance methodology during this challenging period in the market," comments Kevin Kendra, md at Derivative Fitch in New York.

Part of Derivative Fitch's CDO SMART surveillance package, CDO Portfolio View offers a granular excel-based report outlining the key characteristics of an institution's CDO portfolio. These include data from trustee reports, the agency's VECTOR model inputs and the current Fitch rating and watch status for both the CDO and underlying assets where available. The initial launch will be restricted to US structured finance CDOs.

Monolines remain under pressure
Q3 results from the major monoline insurers look unlikely to relieve pressure on their CDS spreads (see SCI issue 43).

Ambac has warned that it will make a Q3 net loss due to mark-to-market declines in its credit derivatives portfolio. However, the loss on the portfolio – of US$743m – is thought to be manageable for the monoline insurer.

Importantly, it will not face margin calls and so the decline will not have a cash impact unless losses are realised. In addition, rating agencies do not factor such movements into their calculations of claims paying resources.

But the move is expected to contribute to the negative credit sentiment that still surrounds the industry, in spite of the efforts the monolines have made to reassure investors. Five-year CDS levels at the triple-A level for the four largest monoline insurers on the day of the profit warning (10 October) were: 31 for FSA, 90 for MBIA, 116 for Ambac and 157 for FGIC.

While the absolute levels may reflect a shallow market and short-term trading activity, the relative positions reflect the extent of the exposure each insurer has to problem areas of credit – including US sub-prime and CDOs containing sub-prime collateral – and the depth of their resources. Analysts at RBS believe that downgrades for the monolines are highly unlikely and that the turn in the credit cycle will benefit them in the long term, but they remain wary of the potential for further negative news to hit spreads for wrapped paper in the short term.

MBIA has scheduled a conference call about its Q3 earnings for 25 October, while FGIC held one on 9 October to clarify its exposure to RMBS and ABS CDOs.

Fitch reports on LCDS
The recent launch of tranche trading in the LCDX index highlights the continued evolution of the LCDS market. As LCDS benefit from developments in unsecured CDS as well as from the standardisation of documentation, there are many features that are unique to LCDS contracts that should be considered, according to Derivative Fitch in a new report.

The report describes the growth and evolution of the leveraged loan market and its implications on the portfolio characteristics of CLOs that Fitch has reviewed; examines the standardised LCDS form and the implications for Fitch's rating process for CLOs by discussing the two major components of credit risk, namely default probability and recovery rate; and discusses other CLO structural features that should be considered.

With regard to these factors, Fitch senior director Tania Fago notes: "Fitch may, in certain instances, adjust key assumptions to better reflect differences between the cash loan and LCDS market, including default and recovery assumptions for European structures employing restructuring as a credit event, as well as a discount to Fitch cash loan recovery rates given recovery timing and market liquidity considerations."

With respect to other risks, such as cheapest-to-deliver risk, Fitch senior director Bill May, says: "Based on Fitch's research for which LSTA provided important data and feedback, there appears to be little evidence of systemic cheapest-to-deliver risk inherent in LCDS, as evidenced by the convergence in pricing of term loans and revolvers post-bankruptcy."

According to the report, managers already have the ability to introduce LCDS into cash and hybrid CLO structures, with the majority of US CLOs allowing for synthetic allocations ranging from 10% to 20% of total loan exposure. While these buckets have been unused or underused until now, this situation may change – with many new transactions being structured to allow for synthetic exposure in anticipation of greater opportunity via LCDS.

Basel Committee begins default risk data collection...
The Basel Committee is currently conducting a data collection exercise to evaluate the quantitative impact of its trading book guidelines on banks' portfolios. It has also released a consultative paper which provides additional guidance on how the general principles in paragraphs 718(xcii) and 718(xciii) of the Basel II Framework may be met and contains both guidance on how supervisors will evaluate internal models and fallback options deemed acceptable by the Committee.

The Basel/IOSCO Agreement reached in July 2005 contained several improvements to the capital regime for trading book positions. Among the revisions to the Market Risk Amendment was a new requirement for banks which model specific risk to measure and hold capital against default risk that is incremental to any default risk captured in the bank's VaR model.

The incremental default risk charge (IDRC) was incorporated into the trading book capital regime in response to the increasing amount of exposure in banks' trading books to credit-risk related and often illiquid products whose risk is not reflected in VaR. The requirement for the IDRC was set forth in the form of very high-level standards in paragraphs 718(xcii) and 718(xciii) of the Basel II Framework.

The Basel Committee set up the Accord Implementation Group on the Trading Book (AIGTB) primarily to conduct work on further clarification, as well as to provide a forum for supervisors to share their experience in overseeing banks' implementation of the trading book capital regime. As there is no clear industry standard for measuring incremental default risk for the trading book, the AIGTB has worked closely with industry groups in developing principles for implementing the new charge that build off the principles in banks' internal approaches.

The Committee expects banks to develop their own internal models for calculating a capital charge for incremental default risk in the trading book. Banks are expected to fulfil the principles for the IDRC laid out in the new document to receive specific risk model recognition. Banks that have already received the specific risk model recognition under the 1996 Market Risk Amendment would not be required to implement the IDRC until 1 January 2010.

The Basel Committee welcomes industry comments not only on specific issues in Section VIII but also on all aspects of this consultative paper by 15 February 2008.

... While ISDA IDR Impact Study is released
ISDA has published the results of its Incremental Default Risk (IDR) Impact Study. The study was conducted in conjunction with seven leading international banks in order to assess the impact of IDR guidelines on banks' regulatory capital.

The IDR guidelines represent a major revision to the regulatory regime for trading book activities. If the guidelines are implemented as proposed by regulators, market risk regulatory capital can be expected to almost treble relative to the current VaR-based regime. Failure to align the IDR guidelines with the existing market risk capital rules can inappropriately shift firms' primary attention to managing default risk in the trading book, whereas experience demonstrates that default risk is much less significant than market risk, even in turbulent markets.

The IDR Study complements a technical paper prepared by ISDA for the Accord Implementation Group Trading Book Working Group in January 2007. The paper recommended that the Basel Committee adopt a capital horizon of 60 days for modelling IDR in the trading book and permitted firms to reflect diversification between default risk and market risk.

Participating firms committed considerable time and resources to provide information and technical expertise to inform the regulatory process for the IDR guidelines. ISDA hopes that the study will encourage regulators to improve dialogue with industry participants and gain a better understanding of the technical nature of modelling for incremental default risk. This enhanced dialogue is a pre-requisite for developing a successful framework for this risk, based on sound modelling principles.

New version of RAP CD launched
Derivative Fitch has launched RAP CD v2.0, with the aim of meeting current market needs for the pricing of credit derivatives in a volatile and illiquid market.

"In today's market it is a huge challenge for investors and CDO managers to be able to analyse their market risk exposures on a portfolio basis," says Simon Greaves, md at Derivative Fitch. "RAP CD gives them the pricing information and, importantly, analysis of the drivers of that pricing [which] they require to effectively manage their CDO portfolios."

RAP CD v2.0 offers an excel-based trade interface, allowing trade capture for new trades and substitution analysis for existing trades. The trade interface allows users to analyse trades prior to execution and structure trades from conception to execution. The platform also offers full support for hedge trades.

"An important development for v2.0 is the inclusion of user-defined 3-D scenario stress testing," adds Greaves. "Users can run scenarios to gauge the impact on portfolio market values derived from any combination of stress movements, correlation changes and default rates."

Two versions of RAP CD have been unveiled: 'RAP CD Investor'; and 'Rap CD Professional', which is tailored for CDO managers. Since RAP CD's launch in mid-July 2006, Derivative Fitch has signed up over 40 users and provides daily risk and pricing data for over 120 deals.

GLS-compliant list for Canadian conduits
DBRS has released its first list of global liquidity standard (GLS)-compliant Canadian ABCP issuers, a publication it has committed to publish on a regular basis. Standards for GLS-ABCP were published by DBRS on 12 September to provide transparency to the requirements for liquidity back-stop facilities for GLS-ABCP programmes.

Since that date, a number of Canadian ABCP trust sponsors have been working to meet the criteria outlined for GLS-ABCP by DBRS. Six Canadian and two international banks now meet this standard.

"This is an important step toward ensuring the full and timely repayment of principal and interest for liquidity-backed ABCP," says Jerry Marriott, md, Canadian RMBS/ABS at DBRS. "To have achieved this level of market adoption of GLS-ABCP within a period of less than five weeks makes a strong statement on the commitment by conduit sponsors and DBRS to establishing this new standard for ABCP liquidity."

Meanwhile, the rescue package put together in August for Canadian ABCP issuers under the Montreal Proposal has been extended beyond the original 15 October deadline. While significant progress has been made in terms of establishing normal operations in the sector, an extension to the original 60 day stand-still period may be required in order to complete the restructuring of the affected notes.

iTraxx Australia improves
Fitch Ratings says that the overall credit risk of the iTraxx Australia five-year CDS index Series 8 has slightly improved, following the recent rollover from Series 7. The rollover was effective on 20 September 2007, with a five-year maturity on 20 December 2012.

Fitch provides a credit assessment of each tranche in the index. All the tranches have the same ratings compared with those in Series 7. The weighted average rating factor has improved to 2.76, from 2.92 in Series 7, although the weighted average rating remains the same at A-/BBB+.

Comprising 25 reference entities, the iTraxx Australia five-year CDS index allows investors to gain credit exposure to the 25 most liquid CDS in the Australian market.

The top three industry concentrations in the iTraxx Australia Series 8 index are: banking & finance (28%), real estate (12%) and telecommunications (12%). There are no sub-investment grade reference entities.

CS

Trading ideas - weak appetite?

John Hunt, research analyst at Credit Derivatives Research, looks at a negative basis trade referencing Darden Restaurants

We read that the US new issue market is split in two these days, with familiar repeat issuers having no trouble while untested issues – such as those used to fund LBOs – struggle. We've seen a bit of that, as AES issued debt that went out considerably rich to CDS-implied prices last week, while Darden Restaurants (DRI)'s new 10-year issue – the company's largest outstanding bond, issued after an expensive cash acquisition – went out rather cheap to CDS-implied yesterday. We recommend a basis trade to take advantage of the bond's continuing cheapness.

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 DRI 6.2 of October 2017 bond is trading cheap to fair value. Exhibit 1 presents the price-based term structure of the company's bonds with maturities of two to twelve years and indicates that the October 2017 bond is trading cheap to fair value. Although other bonds appear to be trading cheaper to CDS-implied fair value, the new issue (including the October 2017 bond) is larger than existing issues so we expect greater liquidity.

Exhibit 1

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 2

Exhibit 3 illustrates the projected performance of the trade as a function of bond-CDS convergence over a six-month time horizon. Based on our assumptions that trading costs will remain constant (10-year CDS bid-ask spread equal to 7bp, bond bid-ask spread equal to 10bp over Treasuries), the raw basis needs to converge by about half of its current value over the six-month period to cover trading costs. We believe our trading cost assumption is conservative, as 10bp over Treasuries is a relatively large bond bid-ask spread.

Exhibit 3

The projection is based on the assumption that bond and CDS spreads remain the same except for convergence – that is, that the company's credit does not improve or deteriorate over the six-month time horizon. In the default-neutral construction we recommend, the trade is close to DV01-neutral so overall changes in the firm's credit do not affect the value of the position by much.

Risk
The position is default-neutral. The position is slightly short the firm's credit (1bp of parallel widening in the firm's credit curves benefits the position by about 0.17bp). This is consistent with our view that DRI is a fundamentally deteriorating credit.

We provide a suggested simple, duration-matched Treasury position to hedge interest rate risk. Exhibit 4 presents bond sensitivities in case investors are interested in pursuing more complex hedging strategies.

Exhibit 4

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.

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 10-year maturity, and we have seen good quote flow on this CDS maturity since the liquidity crunch. DRI is a member of the CDR Liquid 50 NA IG series 073 and 074.

The bond, which was issued on 10 October, is being quoted in the market. It is the largest DRI issue and we expect it to be actively traded.

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, our empirical observation is that negative basis trades often perform well when credit deteriorates suddenly. An LBO announcement can cause such sudden deterioration.

Such an announcement frequently causes a "basis spike" that is good for trade performance. We review the firm's fundamentals briefly.

Carol Levenson, Gimme Credit's Consumer expert, maintains a "Deteriorating" credit score on DRI. She notes that DRI raised its leverage target to fund the expensive cash acquisition of RARE Hospitality, announced its intention to abandon its unsuccessful foray into barbeque (the Smokey Bones chain) and nevertheless continues to be a relatively strong LBO candidate based on its fundamentals. Just before the new issue went out, DRI ranked in the top 30% on our fundamentals-based LBO screen.

Summary and trade recommendation
US new issue prices are mixed relative to CDS-implied bond prices, with some new issues going out rich and others going out cheap as the overall pace of issuance remains strong. If it's true, as recently reported, that we're seeing "two markets" – with a strong market appetite for bonds issued by trusted repeat players contrasting with weaker interest in LBO-driven issues – the Darden Restaurants 10-year issue seems to fall into the latter category.

The company's largest bond issue went out on the heels of an expensive cash acquisition that Gimme Credit's Carol Levenson questioned, and the bond sold yesterday considerably cheap to CDS. The bond continues to sell cheap to CDS-implied value, and we recommend a negative basis trade to take advantage of that situation.

Buy US$10m notional Darden Restaurants Inc. 10-year CDS protection at 68bp.

Buy US$10m notional (US$10.01m cost) Darden Restaurants Inc. 6.2s of October 2017 at 100.10 (z-spread of 89.7bp) to gain 22bp of positive carry.

Sell US$9.8m notional Treasury 4.75s of August 2017 at a price of 100.45 (US$9.84m 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).

Bridges open - not under repair

Opportunities in the leveraged loan pipeline are discussed by John Fenn and Panayiotis Teklos, credit strategists at Citi

Perhaps the only good thing to come out of the summer's "credit crisis" – the near abandonment of the ABCP market if one believes the alarmists – is that it finally moved the LBO glut of the high-yield market out of the headlines. As September progressed, we found that there was a receptive audience for LBO paper, albeit for the right structural tweaks and, more importantly, for the right price – with the placement of US$9.4bn of the First Data term loan highlighting the success.

While the activity has been in loans – mostly in term loans, but there has been some interesting activity with respect to bridge loans – we expect that high-yield bonds will follow. This should be the point when we see some real juice hit the market.

Everyone agrees that the size of the pipeline is huge, but the actual numbers are a bit of a moving target. Making things more difficult are the philosophical ways that certain deals are treated.

For example, US$10bn of the Chrysler first-lien term loan is funded and the Home Depot Supply bridge loan is being converted to bonds – but both are undistributed. So does that count as part of the pipeline? We think that it does.

Generally speaking, the backlog of LBO-related leveraged loans was US$250bn to US$270bn (which includes hung deals funded and pulled) and the bond pipeline was believed to be US$80bn to US$100bn as we headed into September. Obviously, there has been a lot of progress between moving deals into the market and other potential deals being challenged, but it strikes us that there is a lot more to be done and that the market remains somewhat vulnerable.

Term loans versus bridge loans: nomenclature tends to get in the way
One of the problems that investors have had with the term "bridge loan" is that it is often misused. The way to think about the difference between term loans and bridge loans is very simple: the term facility is really just a commitment to lend once the deal is closed; the bridge loan will only fund if a bond deal cannot be placed.

Once one or both instruments are funded, they are fair game for trading and, in the market today, LBO loans – bridge or term – represent the most attractive investment opportunities. In our estimation, these loans are likely to become more attractive as we move down the capital structure, provided one has a positive view of the market, economy and the respective credits – the latter point being the most important.

At the time of bidding or entering into an LBO transaction, private equity investors will typically get a commitment for the transaction from their lenders. The commitment from an investment bank (or series of investment banks) will cover both the commitment for the term facility and a bond transaction, which is typically going to be backed by a bridge loan.

Unfortunately, there are too many folks out there who have been using the phrases interchangeably. Of course, getting the terminology right is not going to make the problem go away.

In fact, we would argue that, in normal times, the inflating of the bridge loan number is a problem because bridge loans are perceived as being more risky. So when the folks on CNBC spent the summer telling us that there were US$300bn of bridge loans, the hyperbole got a bit overwhelming. (As the issue got more focus, the actual reporting of the numbers got a lot better.) The funny thing is that the leveraged loan market was dealing with greater structural impediments – such as the loss of the CLO bid, which turned out to be not so disastrous – so the focus on bridge loans has been somewhat misplaced.

The other problem with the language surrounds the notion of what is hung and not hung. In a lot of cases, "hung" simply means "not distributed".

We generally think of bridge loans as being hung and term loans as being not distributed. The US$10bn funded to Chrysler is not a hung bridge, but it might as well be.

We will take it one step further and point out that, in some cases, bridge loans are not drawn; instead, securities are printed and not distributed. Dollar General sub-debt was often cited as a hung bridge, when the reality was that the underwriting banks printed a deal but chose not to distribute it due to market conditions. In other words, it could not be sold.

If one does not think that bidding undistributed paper is attractive, consider that Dollar General sub-debt was reported to have traded at 87 shortly after the deal closed – a yield of 14.36% (without the PIK). Depending on the price one got, Biomet subs were wide of 12%. Part of the undistributed Thomson Learning holdco PIK note was sold wide of 15%.

Up to this point, senior secured debt has been distributed at an IRR of 8.75% to 9% prior to the inclusion of leverage. While many of the bonds associated with the already completed LBO deals have not been distributed, most believe that the senior unsecured will price at around 11% – give or take.

After that, leverage and structure will drive the ultimate pricing of PIKs, toggles and sub-debt. Certainly, yields of 13% or more should be achievable and, since much of the paper will come at a discount, an improvement in market conditions could drive total returns that are even more attractive.

Mechanics make a difference
While bridge loans are different from term loans and high-yield offerings in that they are supposed to be temporary, they have characteristics of both. Structure and seniority tend to mimic the proposed bond structure – unsecured, subordinated, toggle or PIK. Because they are loans, they tend to be floating rate and immediately callable – the better to be taken out, should market conditions improve and a bond deal get done.

When bridge loans were distributed, investors were paid a commitment fee at closing of the LBO transaction and – if it did not need to be funded – that was it. Some investors looked at it as free money or a way to get a better entrée into the permanent financing simply because they were further up the curve once the bond deal was ultimately marketed.

If a bridge loan needs to be funded, there are usually another set of fees for funding and penalties if the bridge remains outstanding for a certain period of time. In addition, the coupon will increase over time after initially funding at some nominal discount to the secured term loan.

The coupon on the floating-rate loan will increase up to a certain fixed cap. Caps are important because they represent the maximum amount that the borrower will ultimately pay under a bond scenario. In fact, if a bond deal can be printed inside of the cap, in most cases the borrower is obligated to accept that bond deal.

The last thing that bridge loan buyers need to know about is Demand Securities. Demand Securities ensure that investors do not wind up in a callable bridge loan for the life of the deal, when the assumption was that there would be a bond takeout.

After a year (or more in some cases), investors can demand to be put into fixed-rate notes, generally with registration rights. The fixed-rate notes will carry a coupon at the cap and will typically have terms as if the note were issued on the day of the LBO closing – timing of the calls, equity claw, etc. Masonite International is the only case of Demand Securities that we know of in the market, but we have to assume that there will be more in the future.

More often than not though, as we have seen of late, bridge loans ultimately get converted into securities immediately. First of all, permanent financing in the form of a bond tends to keep the pricing firmer.

We saw the ServiceMaster Bridge Loan trade in the low 80s during the summer. In contrast, Biomet recently funded US$2.35bn of its bridge in the form of securities and then distributed them (including fees) to investors that had committed to the bridge loan. To other investors, secondary sales were made.

Regardless, pricing has certainly held up better, but that probably has something to do with market conditions. Going back to June, the undistributed Dollar General subs were priced as securities and, more recently, Home Depot Supply's bridge was converted to securities (also undistributed).

Accounting can drive certain decisions
One consideration for investors in bridge loans is that they are loans – not securities – and are governed by different sets of rules (depending on who is holding the paper). Because loans are not securities, they do not necessarily need to be marked to market. These days, with caps out of the money in a fairly notable way, that can make a difference.

ServiceMaster's Bridge Loan was understood to have been fully distributed to investors. That being the case, one would have thought that those investors would have had an incentive to accept a fixed-rate deal at the caps at a discount commensurate with some, if not all, of the fees that would have been paid under the bridge.

Part of the logic would be that investors are not currently getting an interest rate at the cap, since that takes time, and they also move into a callable piece of paper. So, why would investors not bite on a seemingly more attractive deal?

The answer could lie in the mark to market. Depending on the account, investors might not have to mark loans in the same manner that securities would have to be marked if they were thought of as being held for investment.

That could mean a lot if the securities are priced out of the market but at the cap. Is there an appreciable economic difference? There is none from a claim perspective, but the holder of the funded bridge in this case is looking to be taken out by the "subsequent" bond deal.

Another possibility is that the holder of the bridge exposure is actually a bank and, thus, not able to hold securities. As such, the bank cannot be compelled to accept securities (most bridge loans are distributed via participation). In fact, when the Masonite Demand Securities were distributed, there was some subsequent forced selling from banks that were not in a position to hold those notes.

Lastly, the ultimate accounting shift could help explain the focus from the banks. Bridge loans, along with any other type of undrawn loan commitment, used to attract a very favourable credit risk regulatory capital treatment under Basel I.

The rule used to be that any 364-day (or less) undrawn facility was classified as an off-balance sheet item and receives a 0% credit conversion factor (CCF) and, hence, a 0% risk weight (RW). Since most of these facilities have been traditionally undrawn, they have proved an efficient and popular way for banks to provide financing.

However, under Basel II the 0% CCF is substituted with a 20% CCF for less than 364-day facilities, while for facilities maturing in more than a year the CCF remains at 50%. To calculate the RW for any such facility, one has to multiply the notional exposure by the CCF and then the counterparty RW, which itself depends on the rating of the counterparty and the type of the exposure (that is, whether it is classified as bank, corporate, OECD government or retail exposure).

Even under this change in the regulatory capital treatment, the dynamics of LBO commitments are not likely to change. However, the economics and capital allocation do change at a time when banks are looking to free up capital.

Off to a nice start
Why has the discussion of hung term loans and funded bridge loans become so relevant? Well, mostly because it is all anyone in the credit markets has been talking about for the last three months and has the attention of the buyer base, investors in finance companies and management teams across the Street. With the initial success of the first few syndications behind us, we still see attractive opportunities, but some of the panic is out of the market.

The loan deal that used to price at 200bp over Libor at a dollar price of par is now likely to come at 275bp over at a discount that brings the all-in discount margin closer to 400bp. While covenant-lite is still an issue for many buyers, leveraged loans maintain the advantage of being secured at the top of the capital structure. Few investors are arguing about the quality of enterprises to be financed in the near-term LBO wave.

We have already seen that loan and bond deals over the next several months will likely take on a less traditional syndication and marketing process. There has been a significant amount of reverse inquiry of the pipeline and ultimately the issue comes down to what price investors and underwriters will agree upon.

In the realm of possible outcomes, we think that many investors will be able to get to a price that adequately balances risk and reward. For the more heroic investor, funded unsecured bridges could be that much more compelling. On the other hand, given the security of the senior portion of the capital structure, levered term loan returns begin to become interesting even for equity types of investors.

Recommendation: get ahead of the process
We think that the first thing investors ought to do is to start working on the underlying fundamentals of some of the LBO names in the pipeline. Play around with leverage and interest rate assumption, and once one is comfortable with the underlying credit risk, place a call into a favorite loan or bond syndicate representative. Engage in a conversation and see if there can be a meeting of the minds.

However, this is not an advocation of the down-bid philosophy. First of all, there has already been plenty of that out there – and it was not particularly successful. The market is seriously engaging in conversations that can produce a transaction that works for all parties involved.

We bring this up and advise this strategy for really one reason. We have seen several transactions come together very quickly and arrangers are not likely to wait for stragglers when market strength can be promoted with an impressive print.

The second piece of the Allison Transmission term loan and a US$1.1bn block of ServiceMaster are examples of how quickly blocks can get executed. No-one wants deals hanging around too long because they can soon take on some of the characteristics of week-old fish or unwanted house guests.

To an extent, some of the later deals may be more attractive given the theory that waiting is never really a bad idea. However, with the way that things have shaped up over the last four weeks, better deals in the future do not seem likely to come along.

On the high-yield side, we are still convinced that the orderly loan process will result in successful bond transactions. That theory is going to be tested in the near term, but the early indications are positive.

The caveat for investors now is that no-one is sure how deep the capacity is for new paper and what the lingering effects of the leverage unwind and the loss of CLO bid will be. Up to now, the focus has mostly been on the loan market, so we are not fully clear on what the interaction of loans and bonds might be. For example, TXU – with a huge slug of term loans and bridge loans – will be a challenge.

In addition, it is quite possible that market unity could break down and the "prisoner's dilemma" of who blinks first could have a negative effect on marks. However, we would not expect that to break down until year-end or beyond.

So, it still looks like we have an opportunity set that offers attractive rates – certainly in the context of recent market conditions. Yes, things have changed in the credit markets and, although the recovery is in full swing, conditions are not so different that investors should be shunning solid businesses at a reasonable price.

© 2007 Citigroup Global Markets. All rights reserved. This Research Note was first published by Citigroup Global Markets on 12 October 2007.