Contents

Alternative assets?

Lack of new issue HEL RMBS threatens index roll

Insufficient deal flow and originator diversification in the US home equity loan sector over the last three months has sparked concern that the ABX.HE index will be unable to roll in January. However, some market observers believe that it will take the demise of ABX before ABS valuations begin to properly reflect credit fundamentals.

Although a trickle of new issue US first-lien sub-prime RMBS is finally emerging post the credit crunch, the transactions are typically small at around US$100m. An ABX.HE-eligible deal needs to be over US$500m and include a triple-A tranche worth at least US$15m (together with the requisite double-A, single-A, triple-B and triple-B minus tranches).

Indeed, of the 26 HEL deals that have been brought to the market since July, only three would qualify for the index, according to analysts at Wachovia Securities. The transactions are the US$964m Ellington Loan Acquisition Trust 2007-2, the US$1.3bn CWABS Asset-backed Certificates Trust 2007-12 and the US$1.3bn Saxon Asset Securities Trust 2007-3. The remaining issues are characterised by having too small a deal and/or triple-A tranche size; being private placements; having too short an average life; being fixed rate; or lacking an S&P rating.

Among the rumours about potential ABX rule changes currently circulating the structured credit market are the inclusion of Alt-A collateral as index constituents and allowing smaller deal sizes to be eligible. Another potential course of action would be to simply postpone the roll until more new issuance has come through.

But one ABS correlation trader suggests that even more drastic changes may be needed in order to reflect the different primary market reality that is now emerging in the US. He says: "Different mortgages are being written these days, with FICO scores of between 650 to 700 (the average FICO score for reference entities in the 06-1 index was 600), and lenders seem to have stopped offering adjustable-rate mortgages. Furthermore, there has been a significant increase in fixed-rate RMBS issuance recently. If the US mortgage sector goes back to being a fixed-rate market, it begs the question of whether an entirely new index should be created to replace the ABX.HE, given that a supply of comparable securities would no longer be available."

It appears that the Wachovia analysts at least would welcome the demise of the ABX index. "Our hypothesis is that before valuations can begin to reflect credit fundamentals, the creature (ABX) must be driven from the market (with torches and pitchforks if need be)," they note in a report entitled 'Frankenstein's monster must die'.

Their theory is that global macro momentum traders (GMMTs) – attracted by the current thin market – have unrelentingly shorted the index and driven valuations well below fair value, especially at the single-A level and above. But, with a lack of ongoing dealer support due to the demise of ABX, GMMTs would likely unwind their shorts, thereby relieving the technical pressure on ABS valuations.

Meanwhile, the current market environment offers a mixed picture for ABX-related indices. As a result of the losses experienced by the underlying bonds, TABX tranches are trading at similar prices and so there is little incentive to trade the index. "It is possible that the index might be tranched up to the double-A level because triple-Bs are too close to defaulting," the trader comments.

But, on the other hand, wider spread levels could revitalise efforts to launch the long-awaited ECMBX. Current volatility in the European CMBS market has led to an increasing need to buy protection.

Flexible investment

New hedge fund to focus on synthetic CDO equity

Credit-specialist asset manager Credaris is preparing to launch an Irish-regulated hedge fund that aims to capitalise on the current dislocation in the market. But unlike some of its peers – which have recently come to the market with distressed/credit opportunity funds – the firm is focusing on the high grade correlation space.

The fund aims to build on the track record that Credaris has in the performance of the €130m long-correlation fund it has been managing as a segregated strategy since June 2005. "The strategy has proven itself to be flexible and profitable through the very distinct phases we've experienced in this credit cycle since June 2005, and has weathered both the near-euphoric structured credit market in 2006 and the market dislocation/rally in correlation from July 2007," explains the firm's ceo Andrew Donaldson.

He adds: "It is an opportune time to launch the fund because credit is at the forefront of most people's minds and the dislocation has allowed us to position the fund well. It has a highly competitive 27-month track record which has provided annualised returns in excess of 30% per annum."

Investment in synthetic corporate CDO equity forms the core of the fund's strategy. The high carry of these positions pays for the flexible leveraging or hedging of the three key risk dimensions that the fund aims to exploit: single name credit risk, portfolio spread sensitivity and, critically, default correlation.

While other investment managers have chosen to launch distressed or credit opportunity funds to capitalise on the current market dislocation, Credaris preferred to remain transparent to its clients by taking its risk management tools and quantitative understanding of the underlying to perform well, even in periods of intense illiquidity. Given recent spread widening and the continued low default environment, the firm believes that it can produce superior risk-adjusted returns without having to compete for distressed and often highly illiquid exposure.

"Our experience proves that investment grade correlation is a sound and flexible way of positioning in the credit market," argues Donaldson. "Structured credit can sometimes appear counter-intuitive, but in essence it's just risk and how much you get paid to take it. Returns generated by senior and super-senior portfolios have probably disappointed in comparison to our spread-hedged equity portfolios, and some investors have struggled with that concept."

He says that 2008 will be an interesting period for the structured credit market. "After the trauma of this year subsides, investors will be more objective about their positioning in and capital allocation to structured credit. We feel that once again derivative-based markets have proved more flexible and probably more liquid than traditional cash markets. We're launching a product that has shown great performance through distinct periods in this fascinating credit cycle and will continue to be relevant once confidence in structured credit has been restored."

CS

Urgent action required

Investors step up call for transparency in losses and valuations

A general feeling of investor frustration pervaded the European CDO Summit in Monte Carlo last week, as it appeared that time was running out for some buy-siders. One investor speaking privately summed up the feelings of many attendees: "We really need investment banks to step up and start providing indicative levels from which we can model our own portfolios – and this really needs to happen before year-end."

One much-discussed issue is the lack of a common standard for valuations. Valuation metrics vary from bank to bank, and the level of liquidity premium/haircut depends on individual counterparties. "The market is in its infancy in terms of after-sale support, whether it be the provision of valuation tools or ongoing reporting," the investor added.

Another part of the problem is that there is so little secondary trading occurring at the moment that it is difficult to find levels in an organised fashion. This is compounded by the fact that every CDO is unique and each tranche may be held by only one or two accounts at a time.

"Dealers are happy to provide marks, but many of them may be client marks and so there is a confidentiality issue: the holder of a given tranche may not want people to know he is selling," explained Sharif Anbar-Colas, a director in secondary CDO trading at UBS, during the CDO secondary market session.

Nevertheless, he agreed that what is needed is a bid. "The market needs to come to terms with the fact that a lot of paper was sold as triple-A when it wasn't really. Investors need to look at what they have bought and ask why they're bidding at a particular level; banks need to look at what they are leveraging and distinguish between asset classes. For US ABS CDOs, it is simply a modelling exercise and they should accept that they are probably going to have to write their holdings down. But it's a different situation for CLOs."

Indeed, much of the criticism was aimed at the lack of transparency surrounding investment bank losses, SIV losses and banks' exposures to SIVs. As Armand Pastine, md and coo at Maxim Capital Management, observed: "The market will need to de-leverage before the situation gets better: bonds aren't worth zero and the mortgages backing them certainly aren't worth zero. SIVs are black boxes – how about opening the hood and finding out what they own and let the market decide the solution?"

No-one knows what SIVs hold and even banks aren't sure of their exposure to the vehicles, concurred Omicron Invest Management md Marcus Klug during the investor roundtable. "Most press releases issued recently by banks don't provide proper statements on losses and only confuse the message. As long as this remains the case, investor confidence in the sector won't come back," he says.

The other panellists at the same session agreed that the market wants to see banks closing their books. Having accounted for a large part of demand, they are likely to be the cornerstone for a recovery in the CDO sector.

"Over the next three to six months, banks need to clear out what they hold so that they can begin underwriting new transactions," noted David Reilly, managing partner at Indicus Advisors. "The market needs to revisit how deals are marketed and syndicated. How can investors be sure that paper is being sold at the right price? How deals are cleared is pretty confused at the moment – banks can engender confidence by marking to market and providing more information."

It is likely to take longer to resolve the current crisis than previous ones experienced by structured credit investors because it has a global reach. As long as there is little transparency regarding losses, a recovery will take longer to emerge – as the losses are distributed globally, it is even more difficult to discover where they lie. But investors now have the power to set terms and simplify structures in an environment where assets increasingly need funding.

CS

Missing out the mezz

Unusual CLO structure launches

Harbourmaster Capital is roadshowing an unusual arbitrage CLO dubbed Global Senior Loan Index Fund (GSLIF) 1. The €650m low-levered transaction – via Goldman Sachs – comprises triple-A and triple-B minus tranches only, and allows for partial optional redemption at the discretion of the junior noteholders.

Low-levered transactions are regarded by some analysts as being the 'next big thing' for the CLO sector. As one European CDO structurer explains: "Issuers are currently choosing not to lock in liabilities at their most expensive levels: low levered structures can provide more flexibility until mezz reaches an equilibrium and confidence is restored in CLOs."

Rated by Fitch, GSLIF's provisional capital structure consists of €451.75m triple-A rated Class A1 notes; €42.25m triple-A rated Class A2s; and €156m triple-B minus fund notes – all due in 2023. Some of the proceeds from the subordinated notes will be used to pay certain initial expenses of the issuer and will therefore not be available as subordination.

The transaction features overcollateralisation, interest coverage and reinvestment tests, with the ratings of the Class A1 and A2 notes addressing ultimate repayment of principal at maturity and timely payment of interest. For the fund notes, however, the rating addresses the ultimate repayment of the rated balance (from all available funds, including principal and excess interest) and a stated coupon, including any deferred interest until the rated balance is reduced to zero at maturity.

Analysts at Fitch note that the rating on the fund notes may be withdrawn once the rated balance is reduced to zero from the application of all available funds. Further to this, the rating does not address any investor action, including optional redemption and direct liquidity redemption on the called fund notes.

Any fund noteholder has the option to call the notes, or part of the notes, on any payment date after the initial direct liquidity redemption date (June 2009) at the then current market value, provided that certain conditions are met. The purpose of the conditions is to mitigate any negative impact on the noteholders who remain invested in the transaction.

Direct liquidity redemptions are limited to a maximum of 50% of the initially issued fund notes. The mechanism provides for the proportional redemption of the Class A1 and Class A2 notes at par, including any accrued and unpaid interest. It also allows whole payments to be made for any foregone margin payments for a period of up to four years after closing.

Alternatively, on any payment date after the end of the non-call period in December 2010, the issuer – acting on behalf of the majority of the fund noteholders (66.33%) – may call the transaction, provided that all the term notes and applicable senior fees can be repaid in full.

The net proceeds from the note issuance will be used to purchase a portfolio of at least €638.8m primarily European senior secured loans. At the closing date, the issuer is expected to have purchased at least 80% of the target portfolio; the remaining 20% is expected to be purchased over the subsequent 180 days.

However, amortising proceeds will only be reinvested for a period of six years starting from the closing date (the reinvestment period). Unscheduled principal proceeds can be reinvested for a further two years, subject to compliance with certain criteria.

From the closing date, the issuer may invest up to 20% of the portfolio notional into non-euro obligations denominated in an applicable currency. This collateral will be asset swapped with one of the hedging counterparties (subject to rating requirements); a further 20% of US dollar exposure may be hedged via a cancellable cross-currency basis swap. However, in certain situations, this hedge will not fully cover the FX risk.

Harbourmaster may, at any time, sell defaulted or credit-impaired assets. In addition, the manager may sell assets whose value has appreciated since purchase to lock in the profit and trade up to 20% of the aggregate collateral balance during any calendar year at its full discretion. Any sales proceeds (including purchased interest) are classified as principal, except accrued interest sold, which is counted as interest proceeds.

CS

Bonus doubts revealed

The latest company and people moves

Bonus doubts revealed
London-based headhunters Credent polled 240 front office credit market professionals earlier this month on their 2007 bonus expectations. The results were mixed – on average there was hope for a slight increase on 2006's bonuses, but negative expectations were strongest.

Headline numbers from the survey are: more than 25% expect a downturn in their bonuses; approximately 35% expect their bonus to be flat on last year; and less than 40% of respondents expect their bonus to be up on last year, compared with 83% in Credent's survey in 2006. The poll shows the average expectation to be a 10% increase on 2006 bonuses.

Credent comments: "As our poll shows, there are likely to be both winners and losers. One group of winners have to be those that negotiated sizeable guaranteed bonuses in the first half of the year. Our survey has not been able to pick up the impact of this factor on expectations. We suspect that the significant amount of hiring that took place in the first half of the year will have positively skewed the results."

Bank reviews Europe
Morgan Stanley is understood to be reviewing senior positions in its London-based European CDO and structured credit trading groups. Meanwhile, Darragh McCarthy has been appointed European coo. His previous credit sales duties have been amalgamated into an enhanced role for Suzanne Cain, formerly in charge of structured credit sales, who has become overall European head of credit sales.

More RBC fallout
Jean Dulude, co-head of structured credit, has left RBC Capital markets in London. The move appears to be part of the ongoing credit reorganisations at the bank (see SCI issue 60).

Trader swaps
Senior structured credit trader Colin Stewart has left Morgan Stanley in New York. He is rumoured to be joining Merrill Lynch in a similar role.

Structured products head exits
Chris Hentemann, formerly head of global structured products, left Bank of America last Friday. He is replaced by George Ellison, BoA's head of global structured finance.

ISDA expands in Asia
ISDA is expanding its presence in Asia-Pacific by opening a regional headquarters office in Hong Kong and has named Keith Noyes as regional director, Asia-Pacific. Noyes will serve as ISDA's primary Asia-Pacific representative, heading both the Hong Kong office and ISDA's existing office in Singapore. He will coordinate with the Association's ceo, Board of Directors, staff and members to develop and lead ISDA's activities and strengthen its relationships with key constituencies in China, Hong Kong, Singapore, India, Australia and other countries in the region, ISDA says.

Noyes is a veteran of the global derivatives markets and has spent the past two decades working in Asia for such firms as Taiwan Securities (HK), Bear Stearns Asia, S.G. Warburg and Merrill Lynch.

Wilmington hires Traynor
Wilmington Trust has hired corporate trust professional John Traynor to fill a new London-based position on the client development team for its Corporate Client Services (CCS) business. He will be responsible for presenting Wilmington Trust's trust and administrative services to new and existing corporate clients throughout Europe.

Traynor joins Wilmington Trust with 17 years of financial services experience in European markets. Most recently, he served as a global corporate trust vp in the London office of The Bank of New York, where he was responsible for developing new trustee, agency and administration business for CDOs and ABS/MBS transactions.

MP

SIVs default

A round up of this week's structured credit news

SIVs default
The Cheyne Finance and Rhinebridge SIVs have been downgraded to single-D, as the operating states of the vehicles came under even further pressure this week. Meanwhile, Axon Financial Funding suffered more negative rating actions.

S&P lowered its ratings to single-D on Cheyne Finance's CP, MTNs, capital notes and issuer credit rating. Moody's downgraded the vehicle's mezzanine capital notes to Ca from Caa2 and its combination capital notes to Ca from Caa3.

These rating actions follow a statement from the receiver (Deloitte & Touche) on 17 October that the vehicle is in breach of solvency tests and that it will cease to repay CP as it matures (thereby avoiding a fire-sale of its assets). Instead, the outstanding unpaid CP will be grouped pari passu with other senior debt and the entire class will be paid pro rata at the same time. CP notes that matured following the receiver's announcement have not been paid.

A receiver was appointed on 4 September to oversee the disposition of the portfolio for the benefit of the noteholders in accordance with the terms of the security trust deed. Following the declaration of the insolvency event, as provided in the security trust deed, the funds available to the SIV will be used to pay, after satisfying administrative expenses, all senior obligations pari passu and in equal proportion at a date to be determined. Following the full repayment of all senior liabilities of the SIV, any remaining funds will be used to pay senior capital notes and finally any outstanding junior obligations.

The current amount of outstanding debt consists of US$7bn of senior liabilities (comprising US$1.3bn of CP, US$5.4bn of MTNs and US$275m of liquidity facility to be repaid) and subordinated to the senior liabilities are US$720m of mezzanine and junior capital notes. The book value of the portfolio is currently US$6.2bn (excluding cash equivalents of US$948m). Additionally, there are sale proceeds of US$487m.

Based on the outstanding liabilities and current portfolio, the minimum amount of sale proceeds from the SIV's current portfolio would need to be approximately 90% of the par value of these assets to repay senior debt in full and would need to achieve par to repay all rated liabilities in full. It is assumed that any cash available would be used to repay the senior liabilities first and then the liabilities would be paid by proceeds from asset sales.

The current weighted-average market value of the portfolio is 93% of its par value, based on the mark-to-market prices reported to us by the manager. The portfolio proceeds and the amount of cash available to the SIV (after payment of expenses) are the main sources of funds for repayment of the liabilities. Therefore, the ability to repay all rated liabilities will depend on the ability of the trustee to realise on the collateral consistent with the mark-to-market prices reported by the manager.

The portfolio comprises 56% RMBS, 6% CDOs of ABS and 38% corporate CDOs and CMBS. Of the assets, 52% are triple-A rated, 22% double-A plus, 15% double-A, 8% double-A minus, 1% single-A plus and 1% single-A.

Four institutions are understood to be in restructuring negotiations with Deloitte over the Cheyne portfolio, including RBS. A restructuring will see CP and MTN noteholders much more likely to be paid out in full – although mezz noteholders may suffer principal loss on their positions.
The SIV has experienced severe declines in capital net asset value (NAV) since July 2007: NAV dropped from 91% on July 27 to 30% on October 18.
Meanwhile, Derivative Fitch and S&P have downgraded Rhinebridge's CP, MTNs and senior, mezzanine and combo capital notes to single-D.

The rating actions are based on failure to pay when due the US$65m CP maturing on 18 October and failure to pay any CP following the mandatory acceleration event on the same day, due to a revaluation of its CDO of ABS assets, which represented 35% of the portfolio notional. Rhinebridge also declared a senior creditor payment event in light of a rapid decline in portfolio value such that the manager has determined that the market value of the remaining assets within the portfolio may be insufficient to meet the amount of outstanding senior liabilities in full.

Rhinebridge drew upon committed liquidity on 7 September to honour maturing liabilities. This caused the vehicle to breach an NCO liquidity test and it immediately entered a restricted investment operating state.

The SIV again drew upon committed liquidity on 10 September to honour further maturing liabilities. Failure to cure this breach after five business days resulted in Rhinebridge entering a restricted funding operating state.

On 11 October Rhinebridge failed its major capital loss test due to more than 50% of the value of capital being eroded. This test remained in breach for five business days, leading to an enforcement event on 18 October resulting in the security over the assets becoming enforceable.

A senior creditor payment event results in a mandatory acceleration event, whereby any time subordination between senior creditors is removed and all notes are immediately due and rank pari passu. However, the timing of portfolio unwind is at the discretion of the security trustee whom is expected to try to maximise the final payment to senior creditors.

Outstanding CP stands at US$791m and the book value of the portfolio is US$1bn. The portfolio market value required to repay all CP would therefore be approximately 70% and to fully repay all rated liabilities approximately 92% of book value.

The current market value of the portfolio is 63%, based on mark-to-market prices updated and reported to us by the manager. It is assumed that any cash available will be used to repay CP and that the remaining balance will then be repaid with proceeds from asset sales.

This represents a significant erosion of collateral value of US$69m since 16 October. The portfolio comprises 63% RMBS and 37% CDOs of ABS. Of these assets, 89% are rated triple-A, 5% double-A plus, 4% double-A, 1% double-A minus, 1% single-A plus and 1% single-A.

Rhinebridge has low levels of cash in the vehicle and no detailed refinancing plans have so far been presented to the rating agencies. On this basis, and because the CDO of ABS assets have re-priced so dramatically, proceeds from assets – if they were to be sold in the short-term – are likely to be below the amount required to make full payment on senior liabilities.

Finally, Moody's has downgraded Axon Financial Funding's CP to Not Prime from Prime-1. Its Euro and US MTN programmes have respectively been downgraded to Ba3 and Not Prime from Aaa/Prime-1, while the mezzanine capital notes have been downgraded to Ca from A1. All ratings remain on review for further possible downgrades.

The SIV has experienced severe declines in capital NAV since July 2007, dropping from 96% on 27 July to 39% on 18 October. This precipitous drop resulted from the vehicle's exposure to US RMBS (57%, 22% of which is wrapped by monoline insurance companies) and CDOs of ABS (6%) that have themselves experienced severe price declines during this period.

Movie Gallery auction completed
The first credit event auction for the LCDX index was conducted successfully yesterday, 23 October, with the final price for Movie Gallery loans fixed at 91.5%. The US video store chain failed to make a 10 September interest payment on its first-lien loan, which triggered a 'failure to pay' credit event on LCDS contracts referencing the company (see SCI issue 57).

Markit and Creditex, in partnership with 11 major credit derivative dealers, conducted the auction to generate a cash settlement price for contracts referencing Movie Gallery loans. The two firms are the official administrators of credit event auctions.

Movie Gallery was a constituent of the LCDX index and the auction enabled institutions to cash settle LCDS and LCDX index trades (or cash settle and exchange physical loans) at the final auction price. The auction was run in accordance with the LCDS Settlement Terms published by ISDA on 22 May 2007.

During the auction, dealers submitted orders electronically on the Creditex platform. The auction submissions were delivered to Markit electronically which calculated and verified the results.

Synthetic trade finance deal launched
Moody's has assigned provisional ratings to four classes of credit-linked floating rate notes issued by Sealane (Trade Finance). The proposed transaction is a synthetic trade loan deal sponsored by Standard Chartered Bank (SCB), and jointly arranged by Lehman Brothers Asia and SCB.

The provisional capital structure comprises US$50m triple-A rated Class A notes; US$50m Aa2 Class Bs; US$50m A2 Class Cs; and US$25m Baa2 Class Ds – all due in Nov 2012.

The ratings address only the credit risks associated with the transaction; other non-credit risks have not been addressed, but may have significant effect on yield to investors.

The deal involves SCB entering into a CDS with the issuer relating to a portfolio of trade financing obligations that meets certain criteria as to creditworthiness and diversity. There will be a replenishment period of three years, in which SCB can – subject to the replenishment criteria being met – replenish loans or other exposures that have been paid or reduced with new exposures.

Interest on the notes will be paid quarterly, while principal repayments can occur prior to the initial termination date depending on (i) amortisation of the underlying loans, (ii) occurrence of early redemption date, or (iii) occurrence of enforcement date.

S&P CDO rating actions
S&P has taken credit rating actions on 41 European synthetic CDO tranches. Specifically, ratings on: 20 tranches were lowered and removed from credit watch negative; eight tranches were lowered and remain on credit watch negative; and 13 tranches were raised and removed from credit watch positive.

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, S&P has modeled recovery rates in accordance with its criteria and assessed portfolio quality based on its credit quality today.

These rating actions follow two reviews. The first review was of the credit watch placements made on 12 October after running the September month-end SROC figures. The second review was of the ratings on tranches that have been on credit watch negative for more than 90 days.

Separately, S&P has placed 590 tranches from across 176 US ABS cashflow and hybrid CDOs on rating watch negative for a total issuance amount of more than US$20bn. Out of the 176 ABS CDOs, 163 are US mezzanine ABS CDOs and 13 are US high grade ABS CDOs.

The structures are all exposed to recently downgraded US sub-prime RMBS collateral. Out of the 590 ABS CDO tranches put on negative watch, 13 are single-B rated, 83 double-B, 218 triple-B, 127 single-A, 109 double-A and 40 triple-A.

IIF launches best practice initiative
The Institute of International Finance has launched a major initiative to refine best practices for market participants. The organisation has established a committee to produce recommendations by the spring of 2008 that reflect the views of industry leaders and that will enjoy strong support from financial services firms across the world.

The committee's agenda will concern: risk management, credit underwriting practices and pricing of risks; conduits and the contingent liquidity risks that firms have been exposed to by using off-balance sheet instruments; valuation questions, especially where markets are thin or absent; ratings – interpreting and evaluating them; and transparency, disclosure and communications to define appropriate standards.

Ottimo SLNs downgraded
Moody's has downgraded the secured liquidity notes (SLNs) and extended notes issued by Ottimo Funding, currently rated Prime-1 on watch for possible downgrade, to Not Prime. The Ottimo Series 2007-A and Series 2007-B subordinated term notes are downgraded from B2 on watch for possible downgrade to C, while Series 2007-C are downgraded from Caa2 on watch for possible further downgrade to C.

Ottimo uses the proceeds from the issuance of the notes to invest in a portfolio of Aaa rated RMBS. Following the extension of SLNs during the first week of August, the conduit's overcollateralisation fell below the required amount as a result of market value deterioration of the assets in the portfolio.

The programme sponsor and administrator Aladdin Capital Management and its investors have since agreed to postpone the liquidation of the securities as required by the programme documents. However, they have not been able to reach an agreement regarding a long-term extension of the notes or restructuring of the conduit. Some of the extended notes have reached their legal final maturity.

Moody's rating action reflects the current market value of the assets held by the programme relative to the required enhancement and likely continued price volatility.

DBRS comments on Canadian ABCP trusts
DBRS has provided investors with additional information on the nature of the transactions within the trusts affected by the recent turmoil in the Canadian ABCP market. Since 13 August a number of Canadian ABCP trusts have been unable to refinance their obligations and were unsuccessful in drawing on their liquidity facilities.

Approximately 77% of the transactions, calculated by funding amounts, within the affected trusts consist of CDOs. The remaining 23% of transactions consist of traditional assets, such as mortgages and auto receivables.

DBRS believes that the vast majority of transactions in the affected trusts continue to exhibit strong credit characteristics consistent with previously assigned ratings. However, approximately 7% of the CDO transactions comprise US RMBS assets that are principally rated by other rating agencies.

In contrast to the above, approximately 85% of the CDO funding amounts in the affected trusts reference only corporate credits. DBRS does not consider these corporate exposures to be at risk for downgrade and believes that their credit characteristics are solid and consistent with originally assigned ratings.

Moody's reports on EMEA ABCP
In light of current market conditions, Moody's has received a number of enquiries regarding the exposure of ABCP programmes in the EMEA region to the US sub-prime residential mortgage loan market. In a new special report, the agency describes how EMEA ABCP programmes are designed to protect investors against exposure to declines in the market value of the underlying assets and provides an update on the assets that these programmes hold, based on reports received from programme sponsors dated July 2007.

The report explains that most ABCP programmes are classified as either "credit arbitrage" programmes or "multi-seller" programmes. Credit arbitrage programmes generally invest in ABS, while multi-sellers are primarily used to fund receivables.

Other programmes, known as "hybrids", have material holdings of both securities and receivables. Of the 68 Moody's-rated EMEA ABCP programmes, 12 are credit arbitrage programmes, 27 are multi-seller programmes and 14 are hybrid programmes.

"As of July 2007, the overall direct exposure to prime and sub-prime US residential mortgage loans in Moody's-rated credit arbitrage and multi-seller programmes (in each case including the respective portions of hybrid programmes) in EMEA was approximately 16% and 1.4%, respectively (by outstanding assets). Of the US RMBS held by credit arbitrage programmes in EMEA as of July 2007, 79% were rated Aaa, 7% were rated Aa1-Aa3 and 4.3% were rated Ba1 or below, in each case as of 12 October 2007," says Edward Manchester, a Moody's svp and co-author of the report.

"Taking into account the rating actions on 2006 first-lien sub-prime RMBS published on 11 October, Moody's has downgraded or placed on review for possible downgrade only a few securities held in EMEA ABCP programmes in connection with the difficulties experienced by the US sub-prime residential mortgage loan market and the affected securities are held in a very limited number of programmes. Furthermore, as of this date, no ABCP programmes have been downgraded or placed on review for possible downgrade in connection with exposure to sub-prime residential mortgage loans," adds Paul Kerlogue, vp-senior credit officer and report co-author.

As of the date of the report, Moody's anticipates that downgrades of certain tranches of CDOs of ABS may follow from the downgrades of US sub-prime RMBS announced on 11 October 2007. As shown in the report, the vast majority of CDOs of ABS held in EMEA credit arbitrage conduits are rated Aa2 or higher. All CDOs of ABS rated Aa3 or lower are held in two conduits, one being a fully supported conduit.

Stable iTraxx Japan
Fitch Ratings says that the credit risk in the iTraxx Japan Series 8 CDS index is stable, following the recent rollover from Series 7. Series 8 was launched on 20 September 2007, with a five-year maturity.

The credit risk of the iTraxx Japan Series 8 index is almost the same as that of the Series 7 index. The weighted average rating factor has shown little deterioration, reaching 4.98 at the BBB/BBB- level from 4.96 in Series 7.

Consisting of 50 reference entities, the index comprises the 50 most liquid Japanese CDS. The top five industry concentrations are: banking & finance (20%), transportation (14.0%), metals & mining (10.0%), industrial/manufacturing (10.0%), business services (10.0%), and computers & electronics (10.0%).

On the other hand, in Series 7, top five industry concentrations were: banking & finance (20%), transportation (12.0%), metals & mining (10.0%), industrial/manufacturing (10.0%), business services (10.0%), and computers & electronics (10.0%). There have been three reference entities removed and another three added to reflect recent dealer liquidity polls.

Enhanced CDO Suite released
Deloitte & Touche has release of an enhanced version of CDO Suite – a portfolio tracking, collateral compliance calculation and reporting system – that will meet new data format standardisation guidelines from the Securities Industry and Financial Markets Association (SIFMA).

The latest version of CDO Suite will improve the efficiency, transparency and usefulness of CDO reporting for investors by supporting SIFMA's recently introduced standard for consistent CDO data file formats that are disseminated by CDO trustees/collateral administrators.

"The use of CDO Suite by the majority of the global CDO market's trustees and collateral administrators will accelerate the acceptance and use of SIFMA's standardised CDO data file," says Hillel Caplan, a partner with Deloitte & Touche's securitisation services group in New York and the global leader for its CDO Suite practice. "We are proud to contribute to improving transparency and efficiency in the CDO market by supporting this SIFMA-sponsored initiative."

CDO Suite also includes detailed tracking capabilities for CDOs and other types of portfolios that invest in a variety of asset classes including ABS, bonds, CDS and loans, and can be used to perform scenario analysis around hypothetical trades and changes in collateral characteristics. Known for its flexibility and ease of use, CDO Suite empowers business users to model compliance calculations, rating notching rules and other deal-related details without the need for programming.

CDS Deliverability launched
Allen & Overy has launched CDS Deliverability, a tool that will offer the CDS market an indicator of deliverability for the growing universe of frequently traded reference obligations. The online service will bring greater transparency and efficiency to the credit derivatives markets by providing rigorous legal analysis of deliverability, made available in a one-page report for each obligation.

Historically market participants have conducted this analysis on a unilateral basis, duplicating effort and cost without the benefit of a recognised market standard.

CDS deliverability has been developed in association with Markit. Mutual clients of Markit RED and CDS Deliverability will be able to access deliverability reports directly through the Markit website.

Simon Haddock, head of Allen & Overy's derivatives and structured finance practice, comments: "Quick and efficient mechanisms for delivery of both legal and market data are an integral part of the commoditisation of the credit markets. The market has long sought a cost-effective and timely indicator of deliverability for frequently traded obligations. CDS Deliverability has been produced to satisfy that demand, based on feedback from a number of leading dealers in the credit markets."

Ed Chidsey, director of Markit RED, adds: "The launch of CDS deliverability is a welcome next-step in the move towards greater legal and operational efficiency in the credit derivative markets, and we are pleased to have partnered with Allen & Overy in this initiative. The CDS Deliverability tool will provide our clients with valuable information that will add clarity and confidence to CDS trading."

The solution covers the iTraxx Europe index series 7 and 8 at present, and will include future rolls to this index. The product will be expanded to cover the weekly rolls to the Markit Preferred Reference Obligations list shortly.

Manageable sub-prime impact on Japan
Moody's says that the impact on Japan of the sub-prime problems in the US and subsequent market turmoil has so far been manageable. The country's major banks have already disclosed their exposures and some have recorded valuation losses, the agency says in a new report.

Corporates are also in good shape, as strong banking relationships are helping Japanese companies maintain strong liquidity. Furthermore, Japanese structured finance deals are unlikely to be affected directly, as their characteristics and the conditions surrounding structured finance products in Japan can diverge significantly from the US market.

The report provides Moody's assessment of the credit markets with a broad overview of the crisis, risk implications and scenarios, as well its impact – real and potential – on Japan. Globally, the report says that the most likely scenario remains one of robust worldwide growth with temporary slowdowns in large, mature market economies.

"This should help the healing process – with the largest part of the losses being absorbed in the next couple of quarters. The resolution of central banks and public authorities to protect banking systems from liquidity stress will succeed," the report concludes.

CS

Trading ideas: fizzy fizzle

Dave Klein, research analyst at Credit Derivatives Research, looks at an outright short on Cadbury Schweppes

When we have a fundamental outlook on a credit, we prefer to put on positive-carry, duration-neutral curve trades. In general, this means putting on flatteners when we are bullish and steepeners when we are bearish.

Flatteners can be difficult to put on simply because their roll-down often works against us. With the current lack of liquidity across tenors, positively economic curve trades have been positively difficult to find recently.

Of course, we can always put on an outright trade (long or short a credit) and accept that we are not hedged against parallel curve shifts. Indeed, if our fundamental view is strong enough, an outright trade might be preferable as we expect to capture plenty on the upside.

In this trade, we make an event-risk play on Cadbury Schweppes (CBRY) in an outright short position. Given CBRY's CDS curve steepness and the volatile gyrations of credit indices, this is the best trade available and possesses reasonable economics. We would love to find a positive carry position, but we believe the upside of a naked short on CBRY (going long protection) outweighs the benefits of hedging with a credit index at this time.

Go short
First, we consider CBRY from a historic and technical perspective. Exhibit 1 charts CBRY's CDS performance since the beginning of 2006.

Exhibit 1

CBRY sold off considerably this summer and has since rallied past its one-year tights. Given the event-risk surrounding this name, discussed below in the Fundamentals section, this looks like an opportune time to short CBRY.

Given our negative view for CBRY, we want to be short the credit. We can take this position either by shorting bonds or buying CDS protection. In order to evaluate opportunities across the term structure, we compare CDS levels to adjusted bond z-spreads, which we believe is the most straightforward way to compare the two securities.

Given the lack of opportunity in CBRY's bonds, we choose to express our view by buying CDS protection. Exhibit 2 compares CBRY's market CDS levels and bond z-spreads to our fair value CDS levels.

Exhibit 2

In order to estimate CDS fair values, we regress each tenor (3s, 5s, 7s, 10s) against the other tenors across the universe of credits we cover. This results in a set of models with extremely high r-squareds.

Since we have a negative view on CBRY, we base our tenor decision on more than just fair value and consider roll-down and bid-offer as well. Specifically, we look at carry, roll-down and the bid-offer spread of each potential trade.

We view the 5's as the best potential maturity given liquidity, and we drill down and look at the trade economics. CBRY's 5s have a bid-offer of 3bp and negative roll-down. Although we are facing negative carry and roll-down, we choose not to hedge with a credit index at this time.

Risk analysis
This trade takes an outright short position. It is un-hedged against general market moves, as well as against idiosyncratic curve movements. Additionally, we face about 3bp of bid-offer to cross, which is significant given CBRY's current levels.

The trade has negative carry, which means we face a double challenge of paying carry and fighting curve roll-down. We believe that the challenge is worthwhile, given CBRY's current levels and our outlook for the credit.

Entering and exiting any trade carries execution risk, but CBRY has good liquidity in the CDS market at the 5-year tenor.

Liquidity
Liquidity is a major driver of any longer-dated trade – i.e. the ability to transact effectively across the bid-offer spread in the bond and CDS markets. CBRY has good liquidity in the CDS market at the 5-year tenor. Given that we have over two months until the next roll, we do no anticipate that liquidity will be an issue for this trade in the near term.

Fundamentals
This trade is based on our negative outlook for CBRY CDS. Taking a short protection position by its nature means we are placing a lot of faith in our fundamental view of the credit. While we have chosen a security and tenor that we believe offers the best opportunity for profit, our bearish view on the credit is the driver of this trade.

Craig Hutson, Gimme Credit's Food & Beverage expert, maintains a stable fundamental outlook on CBRY but recommends buying CDS protection at current levels. He notes that there is considerable uncertainty surrounding CBRY's credit profile as the company demerges its Americas Beverages unit.

Craig further notes that CBRY can only improve its leverage to meet targets if it uses the dividend it receives from the demerger to repay debt. Furthermore, he is not dismissing the possibility that the company will sell the unit instead. Finally, with activist shareholders in the mix and a dropping stock price, Craig is concerned that the company will find it more difficult to meet its leverage targets.

Summary and trade recommendation
With CBRY's businesses performing well, it might be surprising that we are recommending shorting the credit. However, our fair value model for CBRY CDS shows it trading too tight, and the uncertainty surrounding the fate of the company's Americas Beverages unit leads us to believe there is more downside than upside to this credit.

With CBRY trading near its one-year tights and the potential loss of its investment grade rating, we believe this is an opportune time to buy protection. Given our negative view of CBRY, we feel an outright position presents the best opportunity for trading this name.

Buy US$10m notional Cadbury Schweppes 5-year CDS protection at 35bp to pay 35bp of carry.

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

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

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

More questions than answers at this stage

The M-LEC 'super conduit' is discussed by Andrea Cicione and Olivia Frieser, credit strategists at BNP Paribas

If there were any remaining doubts that the strain SIVs are facing has reached unbearable levels, Cheyne Finance, the structured investment vehicle managed by hedge fund Cheyne Capital Management, is since 16 October effectively insolvent. Deloitte, which was appointed in September to oversee the liquidation of Cheyne Finance's assets, said that the SIV would not repay any commercial paper falling due. Instead, the short-term obligations will be pooled together with debt of different maturities and repaid as the SIV's assets are eventually sold and liquidity realised.

In this context, the news that Citi, JP Morgan and Bank of America have committed to pool together between US$75bn and US$100bn to create a fund aiming at improving liquidity in the ABS market (see SCI issue 60), should be welcome. Generally, this has not been the case: the M-LEC (Master Liquidity Enhancement Conduit, as the fund is called) at best has been discounted as no-news by market participants. In most cases it has been heavily criticised.

SIVs: structurally unsound
SIVs are funds that invest in highly-rated securities ranging from ABS to bank bonds. They finance the assets by selling commercial paper with a maturity of 270 days or less, and medium term notes, falling due in nine months or longer. Despite being sponsored by a bank or a financial institution, these vehicles remain off balance sheet and, differently from their close cousins conduits, they do not benefit from liquidity lines made available by the sponsor in case of liquidity needs.

There are several concerns regarding the structure of SIVs, but two are particularly worrying – and are at the root of the distress the vehicles are experiencing now. First, being off balance sheet entities, they have the advantage that there are no regulatory capital requirements for the sponsoring institution; however, they are opaque and it is difficult for investors to know how many there are and what assets they hold.

Second, the duration mismatch between asset and liabilities may not be an issue at times of ample liquidity, but can easily turn into a nasty problem when liquidity dries up.

This is exactly what happened at the beginning of the summer. As concerns regarding the sub-prime mortgage market resurfaced in June, liquidity quickly evaporated, leaving in distress those banks, financial institutions and SPVs that were heavily reliant on it: Libor jumped to abnormal levels, the commercial paper market collapsed (see Chart 1) and scenes no-one was expecting to see, such as the Northern Rock bank run, have shocked the world.

As most of the ABCP falling due is not rolled over by the investors, SIV managers are left with no other option than liquidating assets to meet the payments – or default. About US$75bn worth of assets have been dumped since July in a market in which liquidity was already very thin due to the credit crunch.

This is a small amount compared to the combined size of the SIVs, which in the US alone is about US$400bn. Since the market cannot possibly absorb in an orderly manner such huge amounts of paper, the only way to avoid a fire sale would be for the sponsoring institutions to take the SIVs back on their balance sheet.

Enter the Super Conduit
Banks have a clear incentive in trying to avoid taking the SIVs back on balance sheet, as additional assets would require an increase of regulatory capital. Besides, sponsoring banks would have to raise funds in order to make up for the withdrawals of ABCP investors.

This would prevent them from using their balance sheet for other purposes and, in an economy so dependent on credit, that would be bad news for everyone. This is probably why the US Treasury decided to get involved, "encouraging" banks to team up and find a solution to the problem.

What the consortium of banks (three so far, but they are looking to get more peers involved) has come up with is the M-LEC. While not much detail about the vehicle has as been made available yet, what is clear is that its purpose is to create a heavy-weight buyer able to absorb the supply of ABS and bank securities that the SIVs will have to sell as more ABCP matures. The banks will inject about US$100bn in the capital structure, and fund the rest via the ABCP paper market.

This Super Conduit, as it as been dubbed, will be operational within the next 90 days and will agree to purchase "qualifying highly-rated assets" from "certain existing SIVs", for "a set period of time". Similar measures have been used in the past to help the market overcome times of critical illiquidity.

In 1989, the US Congress set up the Resolution Trust Corporation to facilitate the sale of assets held by failed Savings & Loan companies. In 1998, the Fed urged sixteen major US banks to inject US$3.5bn into LTCM to facilitate an orderly unwinding of the mother-of-all-hedge-funds' positions. Therefore, at face value, the Super Conduit seems a reasonable solution.

Will it fly?
Until the full details of the fund are disclosed, however, it is difficult to say whether the M-LEC will be successful in bringing liquidity to the market and restoring investors' confidence. At this stage, there are more uncertainties than clear answers. We highlight some of the questions we have, as well as the potential risks.

• Why now? The Cheyne Finance example mentioned earlier, although not necessarily a precedent for other SIVs, is indicative of the amount of stress under which SIVs are at the moment. Considering the short maturity of ABCP and when the crisis began, it is clear that the clock is ticking and, if something has to be done, the time is now.

• What's the banks' motivation? The question is easily answered for Citi, which – with about US$100bn of assets in the SIVs it sponsors – is easily the biggest player in this space, and the one with the most at stake. As for Bank of America and JP Morgan, the benefit, though indirect, is twofold. First, a fire sale of ABS and similarly highly-rated securities would cause prices of these assets to collapse, and potentially spill over to other asset classes. This would not be good for any bank's books. Second, if the M-LEC purchases assets from the SIVs at a fair price, there is room for a profit, should the market to recover. Besides, fees will be earned in the process.

• What will the M-LEC's capital structure be? The name suggests the fund will be a conduit, but other information suggests it will be more like a SIV, with a tiered capital structure – with ABCP holders senior to the banks' capital. Crucially, a typical conduit has the possibility to draw liquidity lines from the sponsor, an option not available to SIVs. It seems, however, that the sponsoring banks will provide back-up lines should the M-LEC fail to re-finance maturing ABCP.

• What will be the time horizon for the M-LEC? In the press release announcing the Super Conduit it is clearly stated that the fund's commitment is only for a "set period". We do not know what will happen at the end of this period, but chances are that if the market has not yet normalised, the funds' life will be extended.

• Which assets will the Super Conduit buy? According to the press release, the fund will only accept the option of purchasing highly-rated assets. Unofficial reports state that it will not buy sub-prime MBS, and that the minimum accepted rating will be double-A. If this were the case, SIVs' asset quality would be diluted: this would likely trigger further ABCP unwinding, potentially creating a vicious circle. The opposite strategy, namely buying low-quality assets, would not make sense, in our view, as it would lead to crystallisation of mark-to-market losses for the SIVs.

• Who will buy ABCP from the M-LEC? The question is a fair one: if investors do not buy SIVs' ABCP, why buy M-LEC paper? There are several possible reason: (i) the M-LEC is backed by a consortium of banks committed to provide liquidity, making the possibility of insolvency more remote; (ii) it will, as it seems, hold only the better quality assets; and (iii) it will probably offer returns high enough to attract ABCP buyers.

• Who will set the price at which the assets are transferred? This is the major concern whenever schemes such as the Super Conduit are established. According to a senior executive at one of the banks involved, the pricing process will be very transparent and will require getting quotes from dealers for "normal size" (as opposed to "fire-sale size") transactions. Although this sounds reasonable in theory, the reality is that for many of the securities there will simply not be a market price, hence the brokers' quotes will be entirely indicative – and potentially subject to manipulation. The good news is that two of the three banks involved are not SIV sponsors. Therefore, they will not be on both sides of the transaction as Citi will be in many cases, and will not be willing to pay an artificially inflated price that would turn into a definite loss. The presence of both sponsoring and non-sponsoring banks should guarantee a minimum degree of fairness in the pricing process. Additionally, we can expect regulators to be watching closely.

Moral hazard
Some have stated that the M-LEC is nothing more than a concerted bail-out of the troubled SIVs and, as such, raises concerns of moral hazard. Although we acknowledge the risk, we do not think that this is necessarily the case.

We would entirely agree with the moral hazard case if the Super Conduit bought assets from SIVs at artificially inflated prices. But, as we have seen before, the presence of non-sponsoring banks in the consortium and the involvement of the US Treasury alleviate this risk, in our view.

If, on the other hand, the fund pursues its stated objective – which is to avoid the liquidation of assets in the market at artificially depressed prices – then we do not see anything immoral with it. Then the scheme would look like less of a bailout and more of a measure to address a (hopefully temporary) market dysfunction.

It is clear then that the difference between a bail-out of banks that have simply taken too much risk and an attempt to correct a "market failure" is thin, and depends primarily on the price at which the transactions take place. Whatever this price, only time will tell if the M-LEC will have overpaid for the assets it buys.

The root of the problem
The real problem with the M-LEC, however, is that it attempts to cure the symptoms rather than to address the causes of disease. What produced the current lack of confidence and liquidity in the ABS market, which the Super Conduit tries to mitigate, is the fact that ABS asset quality is deteriorating, due to falling house prices, rising delinquencies and creditors increasingly under strain (see Charts 2 and 3).

On this front, US Treasury Secretary Henry Paulson called on 16 October for an aggressive response from both the government and financial institutions to deal with an unfolding housing crisis that, he said, presents a significant risk to the economy. He also called for an overhaul of laws and regulations governing mortgage lending to halt abusive practices that contributed to the current crisis, including off balance sheet vehicles.

This will prove more difficult to pull off than setting up a rescue fund: the spreading of risk allowed by credit derivatives does not provide players in the mortgage food chain (from origination to servicing, to securitisation and tranching, to the end investor) the right set of incentives to co-operate and work out a solution to the problem.

M-LEC: impact on banks
If press reports are confirmed and the M-LEC will commit to buy only SIVs' most liquid and higher quality assets, we assume that this includes bank debt – senior and LT2. According to Moody's, 43% of SIVs' assets, on average, are invested in financial institutions debt – largely LT2.

To the extent that the M-LEC indeed buys the SIVs' bank debt and therefore prevents a fire sale, this would be a positive technical for senior and especially LT2. Expectations that LT2s would be fire sold by SIVs in difficulty has been weighing on spreads over the last couple of months; if the M-LEC is set up some of that pressure should be relieved.

However, too many details are missing for us to draw clearer conclusions. For example, how much of an impact the M-LEC will have on bank debt and ABS would also depend on its size.

The fact such a solution is being considered shows how serious a possible SIVs' fire sale would be. Therefore, we may get negative headlines before the situation calms down.

Reports are that the M-LEC would be created and operational within three months; however, press articles also say that SIVs may be facing significant debt maturities in November. If this is the case, then we could have more selling before M-LEC is ready.

Another potential impact for the banks is that preventing a fire sale of assets at distressed levels will help minimise mark-to-market losses for assets they own on their books. It remains to be seen how much of these assets will have to be marked-to-market depending on which accounting bracket they fall into.

Finally, European banks are not exposed to SIVs as much as some of their US counterparts. While it is often said that banks would have a reputational incentive to support SIVs they sponsor, we believe it will be considered on a case-by-case basis.

© 2007 BNP Paribas. All rights reserved. This Research Note was first published by BNP Paribas on 19 October 2007.