Contents

Crisis, which crisis?

Lack of certainty over whether 'summer shock' has morphed into full-blown crisis

Now that CDO event-of-default notices have begun to appear as a result of rating agency downgrades, some investors are suggesting that the summer's liquidity crisis could be overtaken by a full-blown credit crisis. "There has already been a deterioration in fundamentals – and further deterioration is likely as the change in expectations regarding asset prices filter through, combined with fewer refinancing options and a tightening in lending criteria," one portfolio manager explains.

A CDO manager agrees that the market is witnessing a sharp contraction in bank lending, but remains sanguine about a potential crisis. He says: "The recent ECB lending survey shows that banks are tightening their lending standards, but it's a bit melodramatic to call it a crisis – it's a cyclical change rather than a crash."

What is clear is that liquidity concerns are driving a new wave of re-pricing in the credit markets – in a steadier and more methodical manner than in the summer. According to analysts at JP Morgan, the market is slowly coming to the view that the weakness in US housing is becoming a broader liquidity event; one that will diminish bank risk appetite for the foreseeable future.

As the losses from securitisation become more visible, the off balance sheet nature of the instrument will increasingly be questioned. "Clearly, if risk is off balance sheets only during periods of low stress but returns to the balance sheet during times of stress, the risk transfer mechanism has not been very effective," note the analysts. "Going forward, there either will be substantially higher capital needs relative to securitisations or, alternatively, substantially lower lending capacity. Either way, the cost to the ultimate borrowers is likely to be higher."

Such capital needs would be in addition to those resulting from housing-related losses that have already been or will be incurred. Estimates of those losses start at around US$100bn and could be as high as US$400bn before this cycle comes to an end.

The CDO manager points out that, against the backdrop of Basel II, banks are incentivised to retain high quality assets on balance sheet and roll off the low quality ones. "Banks will have to evaluate every credit opportunity on its own merit and judge whether they will be compensated by the market for taking on the risk, both in terms of spread levels and covenant packages. There is still a case for lending to BB/B rated companies, but banks will have to be paid appropriately for the risk," he observes.

Performance-related issues have nevertheless already begun to send shockwaves across risk management departments, according to Julien Mareschal, head of ABS trading at Commerzbank in London. "Once rating actions start impacting structured finance CDOs, they become yet another distressed asset on banks' balance sheets and so will serve to widen the number of people becoming involved – risk managers getting involved in such work-outs isn't necessarily productive," he says.

However, as with the shock in the summer, the current 'crisis' is expected to have less of an impact on Europe than on the US. It is now widely recognised that the European market was affected only through the money market squeeze and that a further crisis is likely to be better anticipated and managed.

What is important now is how the market will be reshaped as a consequence of various regulatory bodies and auditors becoming involved. As Mareschal concludes: "It's sad that the market has been impacted by the behaviour of a small minority: the business model was working well for most of the ABS market but has been jeopardised by the abuses of a small minority. Hopefully what we're going through now will add some rationality back to the system."

CS

Long/short opportunities

Revitalised interest in credit CPPI could lead to new underlyings

With many long portfolios having suffered significantly over the summer, a recognition of the need to hedge via shorts – together with the prospect of locking in principal protection – has revitalised interest in credit CPPI structures. Arrangers expect prints to emerge by the end of the year, some of which could include new underlyings.

"CPPI provides a certain flexibility: it is a market-neutral strategy compared to vanilla CDOs and allows value to be found in the current dislocation via various curve trades. In addition, long/short strategies have less sensitivity to market movements," explains one structured credit investor.

Indeed, the summer has proved to be a strong test of the CPPI structure: the credit crunch highlighted one of its shortcomings – negative gamma. As VaR increased, some managers were forced to de-lever their structures to ensure that principal protection remained robust.

However, structures that feature both short buckets and variable leverage were better able to mitigate such convexity. For example, Schroder's Navigator CPPI – arranged by Deutsche Bank – comprises a short bucket of up to 50% (most long/short credit CPPIs have 10%-30% short buckets) and has the ability to de-leverage proactively when spreads are tight.

The transaction was able to weather the summer's dislocation by lowering leverage before the sell-off through buying protection on high yield indices and certain single names in anticipation of the summer volatility coming through. "We implemented single name shorts in the US homebuilder and broker sectors, as well as cyclical shorts by targeting companies that are fundamentally vulnerable to recession risks," confirms Jamie Stuttard, head of structured credit at Schroders.

He says that the challenge in the current environment is to make money in a bear market without giving away carry and rolldown. The credits that typically suffer the most in a recessionary environment often already trade at wide spreads and are therefore expensive to short. It is important to focus short positions on credit direction in order to find names that will experience meaningful fundamental deterioration from a starting point of tighter spreads.

Observers agree that the credit market is being forced to innovate and, given that CPPI is an ideal strategy through which to manage leverage, it is likely that further innovation will emerge in this space. One aspect that is currently being discussed is the potential for new underlyings to be included in CPPI vehicles. LCDS, leveraged loans, funds of funds and even catastrophe bonds have all been touted as possible reference assets.

While it is possible for CPPI product to reference asset classes other than corporate credit, they have to be liquid – therefore synthetic structures stand a better chance of being referenced. "Long/short strategies are necessary for mean-reverting assets because you can't rely on beta to generate value at the current point in the spread cycle. Instead, market dislocation offers long/short alpha opportunities to discriminate between credits," notes Stuttard.

However, this situation could change in three years or so as volatility picks up because there is a chance that the market will see a significant re-pricing of spreads – thereby offering a new beta opportunity at that future point in time.

CS

Deeper and deeper

Expiring ARM teaser rates to drive ABX delinquencies

It is estimated that the isolated effect of expiring hybrid adjustable-rate mortgage (ARM) teaser rates within the next 24 months will result in more than 43% of ABX.HE collateral becoming delinquent. By providing a reasonable reflection of the late-2005, 2006 and 2007 vintage US RMBS sector, new research shows just how significant the sub-prime problem is for the broader financial markets.

Analysis of 30-year mortgages worth US$200,000 has been undertaken by Dresdner Kleinwort structured credit strategists Domenico Picone, Priya Shah and Marco Stoeckle to compare fixed rate mortgages with 2/28 hybrid ARMs comprising common variants for the initial reset cap and interest-only (IO) periods. They used an initial rate of 7.5% and the same constant spread over Libor of 600bp for the floating period following the initial reset – both typical values for hybrid ARMs entered into around 1.5-2 years ago.

For a standard 2/28 hybrid ARM, the strategists calculated monthly payments for initial reset caps of 1.5% and 3%. In addition, they calculated monthly payments for a 2/28 hybrid ARM with two and five-year IO periods, both using an initial reset cap of 3%. In both instances, periodic reset caps of 1% were assumed.

In the first two years, the standard 2/28 hybrid ARM with an initial monthly payment of US$1398 is US$70 a month cheaper than an 8% (US$1468) and nearly as cheap as a 7% fixed rate mortgage (US$1331). If one of the IO versions is considered, the monthly payments fall to US$1250 – which is in the range of the monthly payments for a 6% fixed rate mortgage (US$1199). Using one of these hybrid ARMs therefore enabled sub-prime borrowers to achieve monthly payments comparable to payments under a fixed rate mortgage they would never have qualified for, given their credit quality.

However, if the mortgage isn't refinanced, monthly payment requirements explode after the end of the two-year teaser period. For the 2/28 hybrid ARM with an initial reset cap of 3%, the monthly debt burden jumps from roughly US$1400 to over US$1800 – nearly a 30% increase.

In the case of an IO period of two years, the reset shock is even worse, as there has been no amortisation. The mortgage with an IO period of five years experiences two reset shocks: a US$500 or 40% increase in monthly payments after two years at the end of the teaser period; and a US$145 increase in monthly payments after five years at the end of the IO period.

The strategists moved on to analyse ABX.HE collateral performance to end-September 2007. Aggregated over all four series of the index, the total current balance adds up to US$88.7bn – with hybrid ARMs accounting for US$68.8bn and, more importantly, US$61.7bn of these mortgages still awaiting their first reset.

On a volume weighted basis, less than 25% of the mortgages that are at least 60 days delinquent or worse are non-ARM related. Although the share of hybrid ARM collateral has decreased over the series, even in the 07-02 series hybrid ARMs with an initial fixed period of two years still account for more than 50% of the outstanding balance.

"Under the assumption of no further prepayments or defaults, the volume of hybrid ARMs that will experience their first reset date in the next six months accounts for US$12.5bn. The 06-01 vintage accounts for most of the collateral that will reset within the next two months but has already seen its peak in resets, while the 06-02 vintage will provide the majority of resets for the interval from December 2007 to June 2008," note the strategists.

The reset profiles for the 2007 vintages reflect the fact that a significant number of ARMs have an initial two-year teaser period, as they are either plain 2/28 ARMs or some variation thereof. As the collateral contained in each series has an age of between one and six months at inception, a concentration in resets is expected 18 to 24 months after a series has been launched.

Indeed, there is US$55.6bn of hybrid ARM loans in the ABX collateral facing their initial reset within the next two years. The strategists calculated, for every borrower, the new monthly interest payment for the mortgage and the resulting relative monthly increase as a result of the new interest rate. They then aggregated the new monthly interest payments into bands of monthly increases and totaled the current balance of all loans in each of the bands.

The strategists continue: "The results showed that borrowers with a 20% to 30% increase in their monthly interest payment will experience an average monetary increase of US$400 – bringing their new monthly interest payment to over US$1750. This will affect more than US$20bn worth of hybrid ARM loans referenced by the ABX."

Borrowers falling in the ranges of 30%-40% to 60%-70% will face an additional monetary payment that will take their new monthly interest payment to between US$1700 and US$2500.

The strategists concluded that the increase in monthly costs to ARM borrowers following the reset date will be the main factor driving future delinquency rates. Borrowers facing a monthly interest payment increase of more than 20% account for about US$38bn or around 68% of the US$55.6bn sample of hybrid ARMs that will reset within the next two years. They account for nearly 43% of the outstanding balance of all four series of the ABX.

CS

OC tests under pressure

Interest shortfalls widely expected as CDO downgrades continue

Overcollateralisation tests are increasingly coming under pressure as the rating agency CDO downgrade programme continues. At the same time, the new CDO CDS documentation faces its first challenge with protection sellers preparing to make payments under their contracts.

Moody's downgraded or placed on negative watch a further 100 structured finance (SF) CDOs over the past week. And Fitch began its global review of the asset class by placing 150 transactions – representing US$36.8bn – on rating watch negative (see lead story in news round up).

Consequent rating actions are expected to result in on average three to four rating category downgrades, with even some triple-A bonds being downgraded to below investment grade for the most severely affected transactions. Such severe downgrades are expected to lead to interest shortfalls that breach overcollateralisation tests on some transactions, thereby leaving subordinated classes of notes void of cash flows.

Although event of default provisions vary from deal to deal, in many instances if the senior coverage test falls below 100%, an event of default occurs and the deal enters the acceleration phase. OC tests take into account the haircut value of the reference collateral.

Typically, assets rated double-B are haircut by 10%, single-Bs by 30% and triple-Cs by 50%. Defaulted assets are typically haircut at the lower of market value or rating agency recovery rate.

Analysts at JP Morgan estimate that 2006-vintage mezzanine SF CDO OC test cushions will fall by 8% and 2007-vintage test cushions by 15%. Even senior tests are likely to fail: 40% of recent-vintage single-A rated SF CDOs may defer interest on their next payment date, based solely on current rating actions.

"In mezz SF, given the depth and breadth of downgrades, it would be difficult for any manager to add enough incremental value to overcome such stark test failures," the analysts note. "This is negative for junior investors, since the cash flow stream may now be permanently interrupted in the weakest transactions."

Although high grade CDOs have typically outperformed mezz SF, transactions with large ABS CDO buckets may also begin to under-perform. This scenario particularly impacts financial guarantors, who have sold large amounts of protection on super-senior SF CDOs.

Indeed, super-senior tranches of 2006 and 2007 mezz SF CDOs are believed to be at risk of moderate principal write-downs, while high grade super seniors are reasonably well protected. However, continued deterioration in sub-prime mortgage loss severities will drive losses into A/AA rated RMBS, implying larger losses to super-senior high grade positions.

The anticipated event-of-default notices arising from OC breaches will mark the first real test of the new CDO CDS documentation. Lawyers are expecting a slew of paperwork as protection sellers prepare to pay out under their agreements.

Dean Naumowicz, partner at Norton Rose, confirms that an increasing number of protection sellers have begun looking at CDO CDS documentation in order to clarifying how write-downs and caps are likely to feed through into potential payout scenarios under their contracts. "It isn't entirely clear yet how triggering overcollateralisation tests will impact existing CDS contracts, but clients are certainly clarifying their contractual rights and restrictions with, for example, PIK provisions. They're working out what it would mean in terms of potential pay-outs, as well as the timeframe involved," he says.

CS

Structured credit hedge funds edge up

Latest index figures show small reversal

Both gross and net monthly returns for September 2007 in the Palomar Structured Credit Hedge Fund (SC HF) Index show a positive return for the first time since the April figures. However, three further funds were removed from the index this month as a result of funds either filing for liquidation in August or electing to no longer provide performance data.

The latest figures for the index were released this week and show a gross return of 1.54% for September, while the net return was 1.27% for the month.

As a result of the previous four months showing negative returns, the gross and net indices cumulative returns since calculations began in January 2005 have suffered - now showing at 101.77% and 96.07% respectively. For more Index data click here.

The objective of the Palomar SC HF Index is to produce an index that represents the risk and return of investable hedge fund investments in the structured credit area. The index aims to provide a monthly measure of the performance of the universe of open, investable structured credit hedge funds. The Palomar SC HF Index is calculated in two formats - as gross asset value and as net asset value.

The Palomar SC HF Index is compiled and run by Palomar Capital Advisors and published exclusively by Structured Credit Investor. Palomar Capital Advisors is a financial advisory firm specialising in structuring, managing and placing alternative investment products, specifically credit-related securities. It is an independent firm based in Zurich, Switzerland, owned and controlled by its investment professionals.

CS

ABS CDO team cut

The latest company and people moves

ABS CDO team cut
Following on from its 17 October announcement of poor results, JP Morgan said that it would be making staff reductions in areas where volumes are expected to be lower going forward. This process is now understood to have begun in earnest.

The bank's ABS CDO team in New York is one group that has been affected, although the bank is trying to find alternative roles for some employees.

Correlation head quits
Brian Zwerner has left his US-based role as head of global structured rates and correlation credit at Wachovia. His replacement and future destination, if any, are not yet known.

Meanwhile, over the past week speculation has grown that Wachovia is considering scaling back its European structured credit operations. Officials at the firm declined to comment.

Henderson hires in credit
Henderson Global Investors has appointed Stephen Thariyan as head of credit from 9 November. He joins from Rogge Global Partners and will lead the firm's 17-strong credit alpha team of portfolio managers and credit analysts. For the last three years at Rogge, Thariyan was the portfolio manager responsible for investing in corporate bonds and credit derivatives on a global basis; this followed five years as head of credit research.

Henderson has also recently appointed Leigh Talbot as credit analyst and Colin Fleury as an ABS portfolio manager. Talbot joins from Morley Fund Management where she was a high yield credit analyst, while Fleury was previously director, portfolio manager, ABS at Winchester Capital.

Fleury joins Henderson's existing structured products team, which currently manages £2.8bn in structured credit, including £1.7bn in ABS. The firm has invested heavily in its infrastructure, making it one of the most active buy-side credit derivative investors in Europe. Over the past 12 months it has dealt in excess of £17bn in CDS indices and single names, and is increasingly utilising them across the Henderson product range.

McMunn heads to RBSAM
Royal Bank of Scotland has hired Scott McMunn to a new role in its asset management business. McMunn has been appointed as head of credit investments and, as such, takes overall responsibility for RBS Asset Management's initiatives in the credit markets.

He previously worked for Winchester Capital, part of Deutsche Bank, where he was head of ABS CDOs.

Santander takes on head of solutions
David Behan has joined Santander from AIG Financial Products in the new role of global head of solutions. He will focus on developing derivative solutions offered to Santander's client base in equities, commodities, rates and credit.

Appleyard joins RBC
RBC Capital Markets has appointed Roger Appleyard as head of European credit research, based in its London office. He joins from BNP Paribas, where he was senior credit analyst. Prior to that, Appleyard spent six years at ABN AMRO Bank, where he was global head of credit research.

T-Zero creates head of North America
T-Zero has promoted Clive de Ruig to the newly created position of head of North America. In this role, he will oversee marketing and client services, and will work with the US team to continue the firm's global expansion.

Since joining T-Zero in October 2005, de Ruig has held positions in European marketing and as director of business development, with responsibility for European dealers, buy-side and prime brokers.

DBRS approved
DBRS has been approved by the Governing Council of the European Central Bank as an eligible External Credit Assessment Institution (ECAI) within the Eurosystem Credit Assessment Framework (ECAF). The ECAF defines the procedures, rules and techniques that ensure the Eurosystem requirement of high credit standards for all eligible assets to be used by counterparties in credit operations is met.

The technical go-live of DBRS eligibility will immediately follow the finalisation of the necessary adaptations in the relevant infrastructure of the national central banks. The go-live date will be pre-announced on the ECB's website.

To date, formal ECAI approval has been received from the following countries: Austria, Canada, Denmark, Finland, France, Germany, Ireland, Sweden, Switzerland, the Netherlands and the UK. The other countries that DBRS has initially applied to under the Committee of European Banking Supervisors approach are in process for formal recognition. DBRS will continue to apply to other countries in line with its global strategies.

CMA and Numerix join forces
Credit information specialist CMA and pricing and risk analytics provider NumeriX have announced a strategic partnership. The joint solution aims to provide users with the most comprehensive credit data and richest credit analytics in a single integrated platform.

"This strategic partnership with CMA resulted from increased customer demand for a more complete data set for modelling and structuring derivatives in volatile markets," says Steven O'Hanlon, president and coo of NumeriX.

MP

Further SF CDOs placed on negative watch

A round up of this week's structured credit news

Further SF CDOs placed on negative watch
Following a comprehensive global review of the 431 Fitch-rated structured finance CDOs representing US$300.1bn of outstanding debt, Fitch has placed 150 transactions – representing US$36.8bn – on rating watch negative. This total includes US$4.2bn of SF CDO liabilities previously placed on, and remaining on, rating watch negative.

The agency expects to resolve these rating actions within the next 30 days, having amended its rating methodology to address the performance concerns of the sector, including: heightened default expectations of US sub-prime RMBS, in particular recent vintages; reduced prospect for recoveries on RMBS securities that have migrated to below investment-grade; and the increased propensity for credit co-movement.

The revised methodology also aims to provide the most prospective view of SF CDO credit by identifying the most accurate and timely probability of default estimates for the underlying assets. The methodology will be announced next week, concurrent with the first set of downgrades.

The cash flow model is expected to better reflect current market conditions by eliminating the fast and slow prepay stresses, as well as assigning the 'interest rate up' scenario less weight. As far as Vector primary inputs are concerned: probability of default is expected to be increased across the board, but especially at the triple-B level and below; only the lowest of all three rating agencies' ratings will be considered; recovery assumptions will be lowered so that certain parts of the capital structure are more likely to experience default; and finally correlation assumptions will be increased.

Fitch's rating actions affect US$23.9bn triple-A rated notes from across 83 deals, US$5.4bn double-As from 100 deals, US$3.5bn single-As from 102 deals, US$4bn triple-Bs or lower from 105 deals. Of the transactions affected, 58% are US deals, 41% European deals and the remainder is Asian deals.

Of the triple-A rated securities on negative watch, approximately two-thirds (US$16bn) represent tranches of mezzanine sub-prime deals, as well as CDO-squareds containing these tranches. The ratings from these transactions are expected to suffer the most severe downgrades. While a full analysis remains to be completed, preliminary indications are that a three to four rating category average downgrade is to be expected for most of this group, with the revised ratings in the range of 'triple-B to double-B minus.

The remaining US$7.8bn of triple-A rated notes are from high grade sub-prime RMBS, prime/Alt-A SF CDOs and synthetic SF CDOs of all types. The magnitude of downgrade for these deals is expected to be less severe, averaging one to two categories with revised ratings ranging from double-A to single-A minus.

Classes currently carrying ratings of other investment-grade categories are expected to suffer downgrades to below investment grade.

The primary drivers of Fitch's rating actions are the continued credit deterioration of underlying US sub-prime RMBS and SF CDOs, as well as the agency's expectation of further credit deterioration with respect to 2007 vintage US sub-prime RMBS. SF CDOs were identified as rating watch negative candidates on the basis of exposure to tranches of 2005 to 2007 vintage US sub-prime RMBS which had migrated to a below-investment grade category. In the case of US sub-prime RMBS issued in the second half of 2006 and the first half of 2007, as well as for SF CDO-squareds, exposure to low-investment grade categories was also considered to reflect Fitch's increased loss expectations with respect to collateral originated during this time period.

Mezz CDO exposure to sub-prime analysed
Analysts at Barclays Capital reveal in a recent research note that 2005 and 2006 cash and hybrid mezzanine CDOs have, on average, 55%-65% exposure to sub-prime collateral. They also typically include a 6% CDO bucket, which – for the most part – is comprised of ABS CDOs also referencing sub-prime collateral.

Mezzanine CDOs have a weighted average rating on the underlying collateral in the BBB/BBB- range, and approximately 84% of the collateral pool of such CDOs is rated triple-B or below. Synthetic mezzanine CDOs originated in 2005 and 2006 have even higher exposure to sub-prime, ranging between 80%-90%.

Mezzanine CDO transactions originated in 2006 have, on average, 33.8% and 24.5% exposure to 2005 and 2006 sub-prime assets, respectively. As the bulk of the sub-prime rating downgrades affected tranches rated Baa1/BBB+ or lower, mezzanine CDOs will likely bear most of the impact of the expected downgrades. However, the extent of the exposure of 2006 and 2007 vintage mezzanine CDOs to the most troubled 2006 sub-prime vintage varies greatly from deal to deal, ranging from 0%-100%.

The exposure of high-grade SF CDOs to downgraded assets is significantly lower, due to the higher rated nature of the underlying collateral (high-grade CDOs' weighted average rating typically fall between Aa3 and A1). However, high grade CDOs have second-order exposure to sub-prime through CDO buckets, which are typically larger than those in mezzanine transactions at 15%-25% of the total collateral.

The majority of referenced CDO tranches in this bucket are rated Aa3 or above, and more than 35% are rated Aaa. As such, the impact of RMBS rating downgrades on high grade CDOs will likely be on a lower scale compared to mezzanine CDOs.

BoE comments on credit crunch
The Bank of England has published its Financial Stability Report, providing an initial assessment of the causes of the recent financial turmoil, lessons to be learnt and prospects ahead. The bank suggests that there may be a case for public-sector intervention in structured finance ratings if common market standards don't improve.

The report says that, while it is too early for a full assessment, some lessons are already clear – including the need for improved management of liquidity; more transparency in the composition and valuation of structured products and banks' exposures to off balance sheet vehicles; and better stress testing and contingency planning. In the UK, the authorities also need to strengthen their crisis management arrangements.

It goes on to say that actions in these areas and the strong capital position of UK banks should help restore confidence as risk is re-priced. A period of tighter credit conditions, especially for higher-risk borrowers, should be expected. But in the short term the financial system in the advanced economies remains vulnerable to further adjustments – whether in the credit markets which have been most affected to date or, for example, in the equity or commercial property markets.

The report included some advice for credit rating agencies; namely that it is in their best interest that investors have a good understanding of what ratings mean, so that they retain their important role in the financial system. To that end, the following suggestions to improve the information content of ratings were put forward:
• agencies could publish the expected loss distributions of structured products, to illustrate the tail risks around them.
• agencies could provide a summary of the information provided by originators of structured products.
• agencies could produce explicit probability ranges for their scores on probability of default.
• agencies could adopt the same scoring definitions.
• finally, rating agencies could score instruments on dimensions other than credit risk.

"These actions might occur voluntarily in the light of recent market experience," the report says. "Indeed, there is already some evidence of some of them occurring. Without this market evolution, there might be a case for public sector intervention to specify and encourage higher and common standards of assessment and disclosure. It is still critical, however, that investors carry out their own due diligence and do not become over-reliant on ratings as a summary statistic of risk."

The report also suggests that the introduction of Basel II in Europe 2008 will aid transparency, as additional disclosures are required under Pillar 3 of the framework. "There will be new requirements on banks to disclose information across a number of dimensions, in order to facilitate an assessment of the nature and extent of the risks that banks are exposed to, as well as the capital resources set aside to cover those risks. Under the CRD, all of these disclosures will be required at least at an annual frequency and will typically be made as part of the audited accounts."

Moreover, while some banks might already disclose some of the information voluntarily, the new regime is likely to achieve a greater degree of consistency and uniformity across all banks incorporated within the EU and eventually more broadly. This may enable more meaningful comparisons across banks and strengthen market discipline. If a high degree of uniformity can be achieved, this also holds out the possibility that authorities might be able to use these disclosures for an improved assessment of the size and distribution of risk positions across the system.

Remittance report rout
ABX remittance reports for the October distribution date released last week show that on a month-on-month basis, aggregate 60+ delinquencies increased by 248bp, 240bp, 193bp and 251bp, compared with the 210bp, 190bp, 143bp and 205bp rise last month for Series 07-2, 07-1, 06-2 and 06-1 respectively. These increases represent growth rates of 29%, 14%, 10% and 13% over last month's numbers, according to analysts at Barclays Capital.

ABX spreads plummeted in response, with prices dropping by an incredible 0.78 to 13.24 points, with triple-A and double-A tranches seeing some of the largest declines. TABX.07-1 triple-B minus pricing now indicates that loss-timing will be more front-loaded than previously expected.

Indeed, in a reversal of last month's trend, both the absolute level of delinquencies and the month-on-month pace of deterioration rose across all four series. However, some of the underlying transactions, particularly in Series 06-1 and 07-1, showed slower rates of growth in 60+ delinquencies – although in the aggregate the delinquency pipeline for all index series continues to increase.

Particularly troubling is the fact that the 30 and 60-day buckets are showing signs of accelerated growth, even as increases in foreclosures and ROE held stable or declined – likely providing fodder for future pipeline delinquencies and defaults. The large pipeline of first interest rate resets scheduled in the coming months for Series 06-2 (through spring 2008) and 07-1 (starting in spring 2008) is expected to result in continued performance deterioration, given the current dearth of refinancing opportunities available to sub-prime borrowers (see separate article on ARM resets).

ABX CLNs/CDS downgraded
Moody's has downgraded the ratings of 31 CLNs and two CDS, whose reference obligations are TABX.HE or ABX.HE trades. The downgrades cover transactions that were identified as ABX.HE 07-1, ABX.HE 06-2, ABX.HE06-1 or TABX.HE 07-1 06-2 trades.

The above ABX and TABX indices are static and are 100% exposed to sub-prime RMBS issued in 2005 and 2006, originally rated low investment grade. The rating actions affect securities totaling US$1.1bn and €85m. Previously, US$782.9m and €85m of these securities were rated Aaa.

Moody's rating actions reflect additional downgrades and review for possible downgrades in the underlying sub-prime RMBS announced on 11 October, which resulted in 95% of the ABX.HE 07-1 BBB/BBB- reference obligations and 90% of the ABX.HE 06-2 BBB/BBB- reference obligations being negatively affected.

On average, the ABX.HE 07-1 BBB/BBB - reference obligations have been downgraded by approximately seven notches from their previous ratings, while the ABX.HE 06-2 reference obligations have been downgraded approximately four notches from their previous ratings. Combining these results, currently 35% of the TABX.HE 07-1 06-2 triple-B reference obligations and 25% of the TABX.HE 07-1 06-2 triple-B minus reference obligations are rated Caa1 or below, while 17.5% of the TABX.HE 07-1 06-2 triple-B reference obligations and 20% of the TABX.HE 07-1 06-2 triple-B minus reference obligations remain on review for possible downgrade.

Taking into account its notching convention for reference obligations on review for possible downgrade, Moody's WARF for TABX.HE 07-1 06-2 triple-B is at 3856, while the WARF for TABX.HE 07-1 06-2 triple-B minus is at 5132.

OCC reports on CDS
Insured US commercial banks generated US$6.2bn in trading revenues during the second quarter of 2007, up 30% from a year earlier, according to the Office of the Comptroller of the Currency in its Quarterly Report on Bank Derivatives Activities. Revenues for the quarter were the second highest ever recorded, trailing only this year's first quarter. The strong second quarter trading numbers largely preceded the recent turmoil in the capital markets.

The volume of credit derivatives, the fastest growing product in the derivatives market, increased by 16% during the quarter to a notional level of US$11.8trn – 79% higher than a year ago. The OCC reports that the net current credit exposure, the primary metric the OCC uses to measure credit risk in derivatives activities, rose by US$20bn or 11%during the quarter, to US$199bn.

Credit default swaps are the dominant product in the credit derivatives market, representing 98% of total credit derivatives.

The report also noted that derivatives contracts are concentrated in a small number of institutions. The largest five banks hold 97% of the total notional amount of derivatives, while the largest 25 banks hold nearly 100%. The number of commercial banks holding derivatives increased by 14 in the second quarter to 968.

RBI reports on CDS guidelines
Feedback on the Reserve Bank of India (RBI)'s draft guidelines for the introduction of CDS has been taken into consideration, following their release in February.

The guidelines envisage the introduction of single entity CDS instruments, allowing protection selling and buying to resident financial entities under the overall ISDA framework. SIVs and conduits are not envisaged.

Banks that are active in the credit derivatives market are required to have in place internal limits on the gross amount of protection sold by them on a single entity, as well as the aggregate of such individual gross positions. These limits shall be set in relation to the bank's capital funds.

Banks shall also periodically assess the likely stress that these gross positions of protection sold may pose on their liquidity position and their ability to raise funds at short notice. They are required to determine an appropriate liquidity reserve to be held against revaluation of these positions – especially important where the reference asset is illiquid.

RBI says that learning from the global experience will be of the utmost importance in terms of proper disclosure and reporting framework, accounting and valuation policies, and clearing and settlement systems for these OTC transactions.

SIV asset prices stabilising
Fitch reports that, during the first half of October, the prices at which SIV collateral was marked at have stabilised in most asset classes, with the exception of non-prime US RMBS and CDOs of ABS. As a result, the net asset value of capital fell slightly, but the rate of decline was much less than the comparable fall reported previously.

The credit quality and composition of SIV portfolios has remained largely unchanged. The vehicles experienced an increase in the issuance of CP and increased use of repo funding; the weighted average life of senior funding extended primarily due to continuing redemption of CP.

Since 12 October 2007, Fitch has downgraded all Rhinebridge's notes to default (see last week's news round up). The agency has since then also downgraded Axon Financial's CP and MTNs from F1 to F3 and from single-A to triple-B minus respectively. Rhinebridge and Axon Financial also entered enforcement during this period.

Axon Financial's portfolio currently comprises 31% RMBS (6% prime, 19% near-prime, 1% sub-prime and 5% closed-end seconds), 21% monoline-wrapped securities, 19% CDOs, 17% CMBS, 7% cash equivalents and 5% other ABS. The portfolio has a geographic exposure of 92% to the US and 8% to the UK.

Currently, 96% of Axon Financial's portfolio is rated triple-A equivalent, 3.5% double-A equivalent, 0.3% single-A equivalent and 0.2% triple-B equivalent. Fitch notes the very high credit quality of the portfolio assets but, of late, some of the assets have experienced downgrades and the market values of the assets have come under extreme pressure.

Wrapped paper graded
Against the backdrop of further sub-prime related monoline losses, ABS analysts at RBS recommend that investors should hold wrapped bonds with high underlying ratings over those with low underlying ratings, as well as "natural" triple-A bonds rather than wrapped triple-A bonds.

In addition, they recommend that investors pick bonds wrapped by the better placed monolines over those wrapped by the less well-placed ones. The analysts prefer FSA over MBIA, MBIA over Ambac, and Ambac over FGIC.

While RBS believes that the monolines can survive the credit crunch intact, there is a real risk posed from spread-widening on negative sentiment. If losses in US sub-prime and CDOs containing sub-prime collateral prove worse than anticipated by the rating agencies, it is feasible that some of the monolines may need to raise fresh capital in order to maintain their triple-A ratings.

"Our view is that they would all act to do so, as the consequences of a downgrade would be catastrophic for their ability to write new business in a time of high demand for their services. However, there would be implications for the market's view of the credit quality of wrapped bonds as a result," the analysts note.

Furthermore, the monolines' ability to raise fresh equity is far from certain. The market appears to be distinguishing between different wrapped bonds on the basis of both the monoline insurer providing the guarantee and the credit quality of the underlying paper. In general, the stresses run by the agencies put FGIC as the most exposed of the 'big four' monolines, followed by Ambac, then MBIA, and FSA is a distant fourth – with relatively little exposure to problem areas of credit.

The analysts caution that absolute CDS levels on monoline names are driven more by technicals and an attempt to hedge monoline risk than by fundamental credit views.

Financial institutions' exposure analysed
Inflection points such as Q307 will be testing, but manageable, for most leading financial institutions, according to S&P in a new report. The article considers how collateralised lending markets have expanded in recent years and the implications of this for risk management at large banks and broker/dealers.

In general, S&P continues to consider that investment banks have sufficiently solid risk management, profitability and liquidity to work through temporary dislocation – although weaknesses in risk management have been revealed at some institutions, notably UBS and Merrill Lynch. At the moment, the agency expects a poor 2H07 relative to earlier record results. It may be some time before record earnings levels are regained, but it does not at this stage believe that an extended severe downturn is probable.

"To date, third-quarter results have been characterised by markdowns on structured credit inventory and leveraged loans, but instances of losses arising from collateralised lending have been few. Nevertheless, such activities are not risk free – despite low regulatory capital requirements – and indeed require heavy investment in risk systems, as well as strong legal agreements for the timely perfection of security," says S&P credit analyst Nick Hill.

Recent events serve as a reminder of the importance of establishing prudent margin requirements based on market stresses, rather than purely "expected case" statistical modeling. Such scenarios should consider default risk, as well as spread widening, potential illiquidity, concentration risk, correlations and changes in credit risk and volatility.

Historical price movements, even when stressed, can provide false comfort. Banks should be able to aggregate exposures to client collateral and identify concentrations, as well as correlations with their own risk positions.

"Tighter margin requirements can force leveraged funds to delever and potentially compound liquidity problems. This can affect banks' own trading books too, as can be observed in some of the reported losses incurred by funds following quantitative strategies – which were in some cases also seen on investment banks' own positions," adds Hill.

Financing problems at SIVs can result in credit exposures to such entities at the moment where collateral cover is weakest, leading to increased exposure to its market value, and these may yet result in further, albeit manageable, losses.

iTraxx Asia ex-Japan deteriorates
Fitch Ratings says that the credit risk of the overall iTraxx Asia ex-Japan Series 8 CDS index has moderately deteriorated on an expanded portfolio, with 20 entities added on a net basis, following the recent rollover from Series 7. The weighted average rating factor of the Series 8 index has moderately deteriorated to 6.24 from 5.30 in Series 7, although the weighted average rating remained the same (BBB/BBB-) in Series 8.

The agency notes that the higher weighting of high yield entities on a notional basis in the new roll is reflected in the credit assessment of single-A given to the 9-12% tranche in Series 8 compared with single-A plus in Series 7, and the credit assessment of triple-B given to the 6-9% tranche in Series 8 compared with triple-B plus in Series 7. The weighting of sub-investment grade entities on a notional basis increased to 28% in Series 8 from 22% in Series 7.

The 12-22% tranche rating remains unchanged at triple-A compared to Series 7. For Series 8, Fitch has not assigned a credit assessment to the 3-6% and 0-3% tranches.

Comprising 70 reference entities, the iTraxx Asia ex-Japan Series 8 index allows investors to gain credit exposure to the 50 most liquid CDS referencing investment grade corporates and 20 most liquid CDS referencing high yield corporates in non-Japan Asia. This roll was effective on 20 September 2007, with a 5.25 year maturity on 20 December 2012.

The top three industry concentrations in the iTraxx Asia ex-Japan Series 8 index are: banking & finance (29%), sovereigns (10%) and telecommunications (14%). There are 20 sub-investment grade reference entities on the portfolio of Series 8 compared to 11 of Series 7. The agency notes that two reference entities from Series 7 have been removed and another 22 reference entities added in Series 8.

CS

Trading ideas: Texan callables elate honchos

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

As might be expected from a multi-billion LBO offering amid deteriorating credit markets, the TXU bond issue went out cheap to CDS-implied fair value – though getting it done at all must have pleased KKR and its bankers. The bond's call structure complicates the analysis somewhat, but our callable defaultable bond pricing model indicates that the bond's CDS-implied fair value is well over US$102.

Although the callability feature undermines the quasi-arbitrage nature of the basis trade to some extent (by introducing an event other than default that causes coupon payments on the bond to stop), the bond's cheapness and healthy carry – combined with the relatively low likelihood that the bond will be called during the lifetime of this trade – make a negative basis trade attractive.

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.

In this case, because we expect to hold the position for a fairly short time and because a large credit move in the relatively near future is possible, we construct the position as DV01-neutral to reduce the trade's mark-to-market exposure to credit spread moves.

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 TXU (TCEH) 10.25 of 1 November 2015 bond is trading cheap to fair value, as Exhibit 1 indicates.

Exhibit 1

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

Exhibit 2

Risk
Because of the call feature of the bond, the quasi-arbitrage relationship that underlies the basis trade is undermined to some extent. In the event the bond is called prior to default, cashflows from the bond will cease while the obligation to continue making payments on the CDS will continue.

The callability causes the bond to be worth less than a non-callable bond, but that feature is taken into account in our CDS-implied defaultable callable bond model. If the bond is called, the investor is also subject to reinvestment risk at the call date. That is not modeled and is an additional risk of the trade relative to a basis trade on a non-callable bond.

The position is DV01-neutral. There is a significant maturity mismatch because the bond matures on 1 November 2015 and the CDS expires on 20 December 2012, but we expect to be able to exit the trade with a profit from carry and convergence to fair value before either instrument matures. In any event, the bond's call schedule shortens its effective life and causes it to behave like a shorter-maturity bond, as the tables of interest rate and credit spread sensitivities in Exhibit 3 indicate. They show that the bond's largest interest rate exposure is at the six-year level, and show smaller exposure to post-five-year credit spreads than one would see for a call-free bond.

Exhibit 3

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

The position is overhedged against default, so the investor will gain in the event of a jump to default.

We provide a suggested simple, duration-matched Treasury position to hedge interest rate risk. Exhibit 3 presents a number of sensitivity calculations for the bond for investors who are interested in more complex hedging strategies.

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. The recommended CDS is in the five-year maturity, and it appears that the trade can be executed despite the current liquidity challenges in the market.

The bond is available at the recommended level, according to our pricing sources. The bond issue is quite large and has been trading actively, but the short trading history leaves us without a historical basis for projecting future liquidity.

Fundamentals
Our negative basis trades are based on the assumption that the bond is mispriced relative to the CDS. They are not premised on an expectation of general curve movements.

While the trade is technical in nature and not necessarily affected by fundamentals, we review the firm's fundamentals briefly. Phil Adams, Gimme Credit's Utilities expert, maintained a "Deteriorating" fundamental score on TXU at the time of consummation of the LBO earlier this month. He noted that the key question for TXU bondholders going forward is whether the Texas wholesale electricity generation market will be robust enough for TXU to generate enough cash for debt service.

Summary and trade recommendation
KKR's bankers were able to complete the huge TXU bond offering this week, including the US$3bn issue from Texas Competitive Electric Holdings (formerly TXU Energy Company) that is the subject of this trade. As expected, the bonds did go out cheap to CDS-implied fair value and we recommend a negative basis trade to take advantage of this.

The bonds are trading about US$2 cheap to fair value, according to our defaultable callable bond pricing model (which subtracts about US$0.85 from the bond's fair value to reflect its call schedule). Given the trading costs we're seeing, we estimate profit of about 125bp of bond notional on the trade upon convergence of the bond price to CDS-implied fair value.

One notable feature of the trade is the enormous relative sensitivity to six-year rates, shown in Exhibit 3. This reflects the drop in the call strike price from 102.56 to 100.00 in six years. That weighting makes us more comfortable hedging the bond, which has a nominal maturity of eight years, with a five-year Treasury.

Buy US$11.5m notional Texas Competitive Electric Holdings five-year CDS protection at 435bp.

Buy US$10m notional (US$10.08m cost) Texas Competitive Electric Holdings 10.25s of November 2015 at 100.75 (z-spread of 533.87bp) to gain 34.12bp of positive carry.

Sell US$9.7m notional Treasury 3.875s of October 2012 at a price of 99.35 (US$9.69m 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).