Contents

New issues

Post-credit crunch originated CLOs emerge

The first CLOs to be collateralised by leveraged loans originated post-credit crunch have hit the market on both sides of the Atlantic. But, given the dramatic increase in liability costs, it is becoming clear that only top-tier managers can price new deals in the current environment.

"Demand and supply dynamics are really only favouring tier-one issuers at the moment," notes one buy-sider. "Differentiation among managers is readily apparent in pricing, but it will also become apparent in performance over the next few months."

Among the post-crunch originated European CLOs, the €495.8m Harbourmaster CLO 10 – through Bear Stearns – is notable for pricing at par across all tranches, albeit at wider levels to some of its peers. Compared to Harbourmaster's 60/150/265/450/725bp spread across AAA/AA/A/BBB/BB tranches, for example, ICG's Eurocredit CDO VIII came at 57/135/200/325/475 but with discounts ranging from 99.7 to 91 across the capital structure.

Similarly, in the US, Highland Capital Management's US$1bn Greenbriar CLO 2007 – through Goldman Sachs – priced tighter than its peers, suggesting that this post-crunch originated transaction was also offered at a discount to par. Dealers say that the discounts are offered to make the deals attractive when compared with prices in the secondary market.

"There is a dichotomy between primary and secondary deals: with secondary being priced tighter than primary at times," explains Lehman Brothers' CDO strategist Ashish Keyal. "However, with lower issuance of primary deals in the next quarter, this may not last. Opportunities can be found by digging deeper into individual deals because they are typically being priced to maturity."

He says that it is possible to pick up assets in the secondary loan market at 96 to 98 that will generate around a 350bp spread – enough to create a decent arbitrage opportunity. "In terms of the deals originated post-credit crunch, arbitrage can be found by realising the spreads on the underlying portfolios – asset spreads have increased in tandem with the cost of the liabilities (in the range of 120-140bp). With close to 20% IRRs, it is still feasible to bring a CLO," he notes.

Analysts at Dresdner Kleinwort point out that over the last few months managers have been holding prepayment proceeds primarily as cash. But, with the leveraged loan primary market opening up now, this cash can be reinvested in higher spread collateral with better covenants and lower leverage. These higher spreads will benefit equity holders, but should also build up a reasonable excess spread cushion for the junior tranches, they say.

In terms of relative value across the CLO capital structure, it is a question of balancing lack of demand with where value lies. For example, the lack of buyers for AA/A paper means that these tranches are exhibiting wider spreads.

Meanwhile, dealers report increasing interest in synthetic CLOs/tranched LCDS. Because synthetic instruments enable a short ramp-up, issuers are trying to quickly take advantage of market moves and the current positive basis.

For example, the Carlyle Group is understood to be prepping bespoke LCDS transactions in Europe and the US that only have triple-A and equity tranches. Other managers, however, are looking to bring full capital structures.

CS

Volatility strikes again

Increased likelihood of cash-out event for financial CPDOs

The unprecedented volatility in financial CDS has hit the CPDO sector once again (SCI passim), with six transactions downgraded by Moody's. Three of the affected CPDOs have already been restructured due to the negative impact of spread widening on their NAVs.

The rating action follows Moody's review of all CPDO transactions exposed to portfolios of financial institutions (representing 20% of all CPDOs it rates) and the placing of eight deals on watch negative (see last week's issue). Average spreads on these portfolios were 30-40bp when the deals closed at the beginning of 2007, but now they are around 150bp, according to Anne Le Hénaff, md in the structured finance group at Moody's.

The €47.5m Series 103, €100m Series 115, €20m Series 117 and an associated €100m CDS of UBS' Financial Basket Tyger Notes were respectively downgraded from Aa3 to Ba2 and from Aa3, Aaa and Aa2 to Baa2. In addition, ABN AMRO's €100m Series 2007-1 and €20m Series 4 SURF transactions issued through the CHESS III and Castle Finance II vehicles were both downgraded from Aaa to A2.

The rating actions are based on the increased probability of a cash-out event, triggered when NAVs drop to approximately 10%. Sensitivity to spread widening varies across each transaction, depending on their leverage mechanism and underlying portfolios.

Series 103 and 115 are levered at 10x and 8x respectively, and their portfolios include FGIC, Radian Group, the PMI Group and XL Capital Assurance CDS. Due to their high weighted average spread and leverage, these Series are very sensitive to the current spread environment.

Series 117 and the associated swap are levered at 9x, with their portfolios including Kaupthing Bank, MBIA, Washington Mutual and XLCA CDS. These notes are also consequently sensitive to the current spread environment.

However, the SURF notes aren't exposed to insurance companies, which have experienced some of the widest spread movements. Their current leverage of 11x nevertheless results in a high degree of sensitivity to the spread environment.

Two of the CPDOs that were put on watch negative have now been affirmed at Aaa by Moody's. Series 104 and 116 of UBS' Tyger notes are exposed to similar portfolios to that of Series 103 and 115, but only have a current leverage of 5x. Although the weighted average spread of their portfolio is relatively high, their low leverage means that they are more robust in the context of spread widening.

Series 104, 116, 117 and the swap were restructured in September by removing some of the names from the portfolio or decreasing the leverage (see SCI issue 56). The affected notes could be restructured again in time, although Moody's hasn't been informed of any such plan.

"Last time the notes were restructured extremely quickly – before we'd finalised any rating actions," observes Le Hénaff.

Meanwhile, CPDOs exposed to corporate names have generally been more stable. Corporate CDS have widened significantly less than financials and the deals are based on the iTraxx/CDX index roll, so have the ability to enter into a new swap with higher spreads. The portfolios affected by Moody's rating actions are static and don't roll (although names that have been downgraded below a certain level are removed).

Le Hénaff says that demand for CPDOs is moving towards bespoke managed transactions, where managers have more flexibility to substitute names and increase/decrease the leverage. "We'll continue to look closely at CPDOs because of the unprecedented market volatility and will review financial CPDOs as frequently as necessary. However, we're currently comfortable with corporate CPDOs," she concludes.

CS

One for all?

Unified indices could spur portfolio innovation

Markit's acquisition of International Index Company (IIC) and CDS IndexCo should bring some standardisation across the two index families. But the move is also likely to spur further innovation in CDS index trading, including the creation of global reference portfolios.

By bringing the North American and European CDS indices under the same roof, it should be open to Markit to offer client-led products that satisfy demand from both liquidity providers and liquidity takers. For example, dealers report growing interest in establishing a global credit index – the benefits of which would include harmonising the index rules across continents and providing price points on a global basis. Such a development would allow market participants to create an international platform for their structured product franchise and facilitate the creation of global reference portfolios.

The acquisition of IIC and CDS IndexCo will also engender standardisation between the iTraxx and CDX indices. As Tom Price, global head of CDS and loans at Markit, notes: "There are a number of discrepancies in the rules between CDX and iTraxx that could be ironed out. But, more importantly, it will enable best practices to be shared between the two indices; for example, the lessons learnt from credit events in the US can be exported to Europe."

Additionally, owning these families of indices will enable Markit to undertake a large number of independent portfolio valuations for its customers' bespoke indices. "Sell-side and buy-side firms are increasingly looking for third parties to manage their bespoke indices and we believe that this will become a major business line for us," confirms Niall Cameron, head of the firm's indices and equities businesses.

There are two main drivers of this trend: efficiency in terms of infrastructure; and increasing demand for external valuations. Markit has been valuing client portfolios for the last 18 months or so, and proactive marketing of bespoke indices will strengthen this service.

The acquisitions were driven by the belief that the index business is at the heart of any asset class or product development. "This was underlined during the summer when the CDX/iTraxx indices became the major point of reference and the liquidity hub for the structured credit market," explains Cameron. "Indices have also become important for many parts of the financial services industry, such as valuations, trading, structuring and modelling."

Dealers were engaged with selling IIC and CDS IndexCo to Markit because they view the firm as being the coordinator of the indices' evolutionary process. According to Brad Levy, md at Goldman Sachs: "[Markit] possess the infrastructure to manage the indices efficiently, and their knowledge of the market and products is unparalleled. Markit is well-prepared and positioned to take on full ownership of the indices, and I'm confident that they will continue to be an engine of innovation for the industry going forward."

As Cameron concludes: "We're seen as being able to bring solutions together in an unbiased manner – although this would only ever be driven by client needs. But the acquisitions were essential from a strategic perspective as well. Markit sees itself at the sharp end of innovation and so, through running the index business, we can create senior dialogues with both the sell-side and the buy-side."

Both iTraxx and CDX index families will now be known as Markit indices.

CS

At a loss

ABX plunges, but is it an accurate reflection of loss expectations?

Despite a brief respite, the plunge in the ABX indices has continued this week. At the same time, the use of the ABX as a loss predictor has been called into question.

A number of ABX index series began last week by posting some positive returns, but then reversed sharply on Friday - although still retaining some of the gains captured during the week. The 07-02 triple-A closed the week at 71.58bp, up 1.65 points, but by yesterday, 20 November, had closed at an all time low of 68.06bp.

The 06-01 saw no respite last week, however, and both the triple-B and the triple-B minus tranches plunged further to close yesterday at new lows of 27.61 and 24.26, down approximately 10bp and 8bp overall respectively. The moves were driven by negative expectations for next Monday's new remittances and the potential evidence of a further increase of delinquencies and foreclosures.

However, analysts at Wachovia Structured Products Research have published a report suggesting that the ABX index may not be the best proxy for loss estimation. "Sub-prime mortgage losses continue to be estimated by too many analysts in a very casual manner, in our view. We believe short-cuts used to come up with bond valuations are contributing to reported losses. The ABX, in particular, is a poor indicator of value, in our opinion," the report says.

The report goes on to observe: "It has been argued that the ABX is predictive. However, the question is predictive of what - price or collateral performance? The answer is that price is the lens through which market participants provide an assessment of collateral performance."

With that in mind, the analysts examine how well ABX market participants have fared. Utilising close of business prices at 13 November, Wachovia calculates that prices and implied losses means that the ABX 06.2 and 07.1 are anticipating a cumulative loss of 49.4%.

However, the report says: "The average cumulative net loss across the indexes to date is 0.73%. This level of losses indicates that 48.6% of the implied cumulative loss for the 2006 vintage still needs to be realised. There is on average 30% credit enhancement, and 27% of the pool balance, on average, has paid off or defaulted. Nearly half of the original pool balance would still need to come through as a loss."

For that to happen, either every remaining loan must default (with each loan incurring a 66.5% severity) or 66.5% of the outstanding loan balance must default with each loan incurring 100% loss severity. "While the underwriting of the 2006 vintage was poor and the current mortgage lending environment is weak, it seems unlikely that such an outcome would actually take place," the analysts conclude.

CS

Kent Kershaw moves to ICG

The latest company and people moves

Kent Kershaw moves to ICG
Dagmar Kent Kershaw is joining Intermediate Capital Group (ICG) to head its CDO & institutional mandate team. She joins from Prudential M&G, where she was the founder and head of structured products for the last seven years.

Tom Attwood, ICG md, comments: "We are delighted that Dagmar Kent Kershaw has accepted to join ICG to lead our fund management team. Her experience will not only be invaluable when Sara Halbard retires in June 2008, but also signals ICG's commitment to further build our investment capability in structured credit funds, asset backed securities and a range of broader fixed income products."

The move appears to be amicable, as Simon Pilcher, head of fixed income at Prudential M&G, says: "We wish Dagmar our best wishes and she leaves behind at Prudential M&G a structured credit business that is in great shape. We have strength and depth within our team and a clear succession plan in which the heads of each discipline – synthetic CDOs, cash CDOs and product development – will now report directly to me."

Under the new structure, the heads of each discipline in Prudential M&G's structured credit team are: William Nicoll, head of synthetic CDOs; Mike Nicholson, head of cash CDOs; and James King, head of product development.

Calyon restructures structured credit
Calyon says it has decided to streamline the organisation of its structured credit business in line with the current market environment. Following the new organisation, Calyon Credit Markets product line is renamed Calyon Structured Credit Markets, gathering 100 professionals located in five main centres – Hong Kong, London, New York, Paris and Tokyo.

Benjamin Jacquard has been appointed global head of structured credit markets for the bank. Based in London, he reports directly to Guy Laffineur, Calyon global head of fixed income markets

Jacquard was previously Calyon global head of credit markets trading, a role he was appointed to in July (SCI issue 48). Prior to joining Calyon, he was at Bank of America where he worked as global head of structured credit trading.

Fund cuts back
Cambridge Place Investment Management (CPIM) is understood to be cutting 20% of its staff. The fund is believed to be reducing its headcount from 140 to around 115, with the 35 losses coming from all levels of seniority as well as front, middle and back offices in both London and Boston.

Staff cuts are thought to be a result of CPIM historically hiring for growth and that expected growth not being achieved in 2007. Certainly CPIM's permacap vehicle Caliber has seen a decline in NAV this year and the manager has had to freeze structured credit funds that invest in US ABS.

Understanding in Singapore
The National University of Singapore Risk Management Institute (RMI) and Singapore Exchange Limited (SGX) have signed a memorandum of understanding to collaborate on financial research. The aim is to create innovative financial products to facilitate risk management and generate additional trading opportunities for investors. Initial research projects include Asian credit derivatives, property derivatives and carbon trading.

This is RMI's first formal research co-operation with a commercial organisation. It is also an important milestone in laying a strong foundation for Singapore to develop as a centre of excellence for risk management and financial innovation in Asia, the two organisations say.

MP

Tapping into transparency

A round up of this week's structured credit news

Tapping into transparency
Two analytics firms last week moved to capitalise on the growing demand for increased transparency. Initially targeting structured credit investors, Lewtan Technologies launched a modelling tool designed to help clients better understand risk and volatility, while Moody's Wall Street Analytics (MWSA) brought a portfolio valuation service to the market.

"The feeling in the market at the moment is that investors can no longer rely on the rating agencies and therefore there is an increasing need for underlying analytics to help them model portfolios independently," confirms one observer. "But the problem in the past has been that technology offerings are typically too expensive for smaller accounts to buy into."

Investors won't have to invest in expensive infrastructure with the new product launches, however. While Lewtan's offering – dubbed Structuring Assistant – is web-based, MWSA runs a client's portfolio for them through its Credit Values DCV service.

Indeed, Structuring Assistant is designed to enable clients without programming backgrounds to quickly and efficiently model all types of structured finance deals. "With Structuring Assistant, we're arming the business user with a powerful yet intuitive new tool for creating, manipulating and stress-testing deal models," says Usman Ismail, evp of Lewtan. "By giving our customers a better understanding of deals, we're helping them get a better handle on risk and volatility."

Transactions can be modelled from scratch, or users can draw on the provided set of deal models as a starting point. Collateral may be represented at the asset level, aggregated into rep-lines or loaded into the software as a predefined cashflow/amortisation schedule.

Investors have typically used Excel to model deals, but this is inefficient and prone to error, according to Ismail. "Structuring Assistant is a web-based product, which means that the model can be shared within a company or with external investors – anyone can use it because it is based on the universal language of finance."

He says that the technology is more straightforward than the typical 'black box' modelling approach, thereby allowing more transparency. "It can be applied to all asset classes and is particularly useful for the more exotic ones. For example, you can't typically project the cashflows of non-performing loans, but you can take the schedule of payments and extrapolate from there using Structuring Assistant," he adds.

Meanwhile, Credit Values DCV (discounted cashflow valuation) utilises both publicly available and proprietary information, including Moody's research and analysis models, components of some rating models, structured finance software and analytics tools from MWSA, and Moody's extensive structured finance monitoring databases and waterfall libraries.

By discounting the value of future cashflows over a set of pre-defined scenarios, the models deliver a number of independent views of the intrinsic value of CDO securities based on transparent assumptions. The service allows subscribers to compare the DCV of their securities to trading values based on pre-defined or user-defined parameters, as well as to calculate the sensitivity of the DCV to different market and credit conditions.

Enquiries regarding analytics to calculate the inherent values of CDO holdings greatly increased over the summer, leading MWSA to begin working on a formal product that would provide investors access to fundamental values, according to Gus Harris, president of MWSA. "The tool provides a framework to script waterfalls and calculate how much an investor is likely to get back at the end of the period in terms of present value. The idea is to enhance transparency: by specifying assumptions, market participants can understand the variability of value under different market conditions. This can be especially useful when there is limited liquidity," he says.

The initiative involves taking the closing spreads from individual tranches over the last 10 years and modelling them relative to term structures and credit spreads in order to establish the worth of underlying assets. As Roger Stein, md of research & analytics at Moody's, notes: "Different assumptions in terms of discount rates, prepayment rates and so on are used for each transaction, which means that there is greater precision when valuing the tranche of a structure. But an important aspect of the analysis is that it includes daily updates, which may allow some market participants to use DCVs as a benchmark."

The product is being launched in a phased manner, beginning with US CLOs and then expanding into other asset classes, including RMBS and ABS CDOs, in Q108. "We envisage it as an evolving process – for example, correlation assumptions will be updated as necessary going forward. The current format is only the first version and will be updated accordingly," concludes Harris.

M-LEC draws closer as ABCP falters
Market rumours suggest that M-LEC has entered the hard marketing phase, with a number of banks and BlackRock reportedly willing to sign up, and a term sheet expected imminently. The super-SIV is likely to be up-and-running by the time the year-end accounting period finishes.

In order to push the vehicle over the line, though, a couple of changes have emerged from the original proposal, according to analysts at RBS. For example, future cap noteholders of M-LEC were apparently not satisfied with the deferral and reward package, hinting that if their income is to be deferred for three months the reward payment should be somewhat higher. Additionally, the vehicle may take more than just the best quality assets; and it may seek either a lower level than the originally-mooted 75% acceptance from senior noteholders in the SIV, or it may not ask permission from noteholders at all.

These developments are, however, taking place against the backdrop of returning weakness in the ABCP market as stress builds in funding over the year-end. The market is preparing for the mid-month time for the CP roll and, after a couple of reasonably successful months, is going into the November roll with an element of trepidation, say the RBS analysts.

Since the middle of last week, the analysts have received increasing enquiries from issuers about levels that will allow them to fund over the year-end. This has proved increasingly problematic, with investors only looking for one month or shorter.

The ABCP conduits that were receiving liquidity are struggling now and spreads are beginning to suffer once again. For example, ABCP spreads in top-quality double-A bank-backed conduits last week increased from +5/8 to +10/15 in short dates (less than 1 month), and for ABCP over the year-end spreads blew out from +8 to +20 over.

With liquidity tightening and earnings pressure in almost every bank, it is questionable whether banks will be willing to refinance their conduits over the year-end (even though it is not materially capital intensive). CP dealers are seeing momentum slow to a crawl in ABCP.

Observers who point towards Libor as being stable as a positive sign are being misled; Libor fixings appear to have little value at the moment with 'real' Libor – i.e. where banks are actually transacting – substantially higher. A better reflection of banks' perception of other banks' credit quality is not Libor, but swap spreads – which is supposed to be the spread for a benchmark double-A rated institution.

Clarity for Fitch's rating review?
Further details emerged last week about Fitch's wholesale review of its rating methodology for SF CDOs. In particular, the agency is seeking to reflect the following:

- Heightened default expectations of US sub-prime RMBS and SF CDOs, in particular for securities issued in 2006 and 2007.
- Reduced recoveries on securities that have migrated to below investment grade categories.
- Increased propensity for credit migration of securities within the sub-prime sector, with the most recent vintages having the highest correlation likelihood.
- Timely probability of default estimates, given the rapidly evolving credit environment in the US residential mortgage sector.

The following adjustments will consequently be made to the VECTOR-defined rating:

- 2007 sub-prime RMBS rated triple-A through single-A will receive a three-notch downward adjustment.
- 2007 sub-prime RMBS rated triple-B plus and below will receive a six-notch downward adjustment.
- 2006/2007 SF CDOs with exposure to US RMBS will receive a nine-notch downward adjustment.
- Pre-2006 SF CDOs with exposure to US RMBS will receive a six-notch downward adjustment.
- All vintage sub-prime RMBS and SF CDOs on rating watch negative will receive a three-notch downward adjustment.
- All other assets on RWN will receive a one-notch downward adjustment.
- The rating used is the lowest of the three agencies after adjustments.
- 2005 and later sub-prime RMBS and all vintage SF CDOs use a 125 probability of default multiplier.

These assumptions, where downward adjustments are applied, will be reviewed as rating agencies update their credit views for the sectors and vintages.

To account for the increased exposure to systemic stress, correlation assumptions have also been increased, and the year of origination of the security is an added dimension in determining the appropriate correlation assumption. Correlation assumptions will be applied in a simple framework of a base level of correlation, with additional correlation penalties based on sub-sector as well as vintage.

For the purpose of reviewing SF CDO ratings, it is assumed that all SF assets are correlated to one another at a base level of 45%. If the assets are sub-prime RMBS or SF CDOs with exposure to sub-prime RMBS, an add-on penalty of
10% will be applied.

Further add-on penalties will be based on vintage, with securities issued in 2004 receiving an add-on of 5%, 2005 at 10%, and 2006 and 2007 receiving an add-on penalty of 20%. For example, for sub-prime RMBS assets issued in 2007, the correlation will be increased to 75% (45% + 10% + 20%). These are the highest correlation assumptions applied in Fitch's CDO modelling, and are deemed appropriate given the level of systemic stress currently being realised.

Meanwhile, Citi's Terra I Mezzanine CLO (see SCI issue 56) appears to have fallen foul of Fitch's 15 November deadline for new issues. The agency stated that it will complete ratings on new issue CDO transactions that were priced on or before the deadline, but will not publish new ratings after that date on any CDOs that could be impacted by the reassessment of its methodology. Fitch has consequently withdrawn its expected ratings on all classes of Terra, which were assigned on 24 October.

New CDPC launched
Fitch Ratings and Moody's have assigned a triple-A issuer default rating (IDR) to Aladdin Financial Products, which addresses the new CDPC's ability to make timely payments as required to counterparties. Aladdin will sell credit protection through CDS on single-name corporate exposures and is managed by Aladdin Capital Management (ACM) and administratively supported by Aladdin Credit Services.

Both Aladdin and ACS are subsidiaries of Aladdin Credit Products, a Bermuda-based holding company. ACM is a credit-focused alternative investment manager with approximately US$23bn of assets under management in CDOs and credit funds.

Aladdin will engage in activities permitted by its operating guidelines, which specify portfolio guidelines, eligible transactions, eligible counterparties, eligible investments and required capital. A proprietary capital model is used to determine the vehicle's required capital. Failure of capital tests and certain breaches of the operating guidelines can lead to restrictions in its ability to sell additional credit protection.

The ratings assigned are based on the financial strength of the structure, standards imposed by the operating guidelines, the experience of the management team, the risk management and operational infrastructure, and the legal terms and structural restrictions of the transaction.

Freddie Mac gives fright
The market was caught off guard by the news that Freddie Mac has posted US$2bn of losses. It has also warned that it is having trouble meeting its regulatory capital requirements and may need to cut its dividend in half to raise capital reserves.

The news cast doubt on the reliability of Fannie Mae's recent earnings release, which showed a US$1.4bn loss. The government-sponsored enterprises (GSEs) lost one-quarter of their value as a result, with Fannie's shares dropping by 25% and Freddie's tumbling 29%.

Freddie set aside US$1.2bn in reserves for Q3 against future credit losses and took a US$3.6bn write-down on its assets to account for deteriorating market values.

Fitch reports on SIV collateral
Fitch says that, during the second half of October, the prices at which SIV collateral was marked decreased slightly, with the largest decreases in the non-prime US RMBS, monolines, CMBS, student loan and investment bank asset classes. As a result, the net asset value of capital of Fitch-rated SIVs fell slightly, but the rate of decline during October was much less than that observed in the previous two months.

The report discusses the most relevant asset and liability parameters for Fitch-rated SIVs. It reveals that the credit quality and composition of SIV portfolios has remained largely unchanged since the publication of the last report on 29 October 2007.

SIVs continued to experience difficultly in issuing CP and they have increased the use of repo funding (see last week's issue). The report provides greater insight into two sources of alternative funding that some SIVs have recently employed: vertical slicing and repo transactions.

Since the previous report, Fitch has downgraded all of Axon Financial's notes and has put Sedna Finance's second priority senior notes on rating watch negative.

Rhineland ABCP affirmed
Fitch Ratings has affirmed Rhineland Funding Capital Corp's ABCP short-term F1 rating on the execution of documentation which effects an immediate CP stop issuance event. This affirmation follows the signing today by Rhineland, the programme administrator (SG), the trustee (Deutsche Bank) and the investment advisers (IKB) of an amendment agreement that leads to an immediate CP stop issuance until further notice.

Rhineland benefits from liquidity facilities, sized at 102% of the performing asset base, that will advance against any security rated above triple-C. The conduit also benefits from dynamic programme-wide credit enhancement (PWCE) sized at a minimum of 4.5% that will advance against securities rated triple-C or below.

Currently Rhineland has, as at 30 October 2007, approximately US$1.5bn equivalent in outstanding CP and benefits from PWCE at the minimum floor of US$427.8m. This recent amendment precludes further CP issuance and therefore the PWCE is only available to support outstanding CP. The CP outstanding has a variety of different maturities with the longest dated being 25 January 2008.

CDO Software integrates Moody's feed
CDO Software, the specialist provider of synthetic CDO management tools, has fully integrated the Moody's RDS ratings feed, CDOROM model and CDOROM Data Feed within its CDO Tools suite.

"Managers and investors can now seamlessly run the CDOROM model within our management tools at a click of a button for prospective deals, substitutions to existing deals and running scenario analysis. Investors can independently monitor deals without being dependent on month-end reports – greater transparency and control is crucial in today's market," says Sunay Shah, ceo of CDO Software.

Ratings are being sourced directly from Moody's so that clients know they are using reliable and consistent data to make decisions. Results are made available much quicker in CDO Director than running the CDOROM model externally; users can capitalise on the efficiency of having one environment to manage deals.

Clients can also benefit from an integrated management platform that takes ratings and market prices automatically via CDO Scheduler. First thing in the morning or intraday within a few clicks, clients can see compliance tests, agency metrics, risks, P&L and exposure to individual deals and across portfolios.

Shah explains: "Timing is everything: if processes are slow and not being managed effectively, this can prove incredibly costly for both managers and investors – especially during volatile conditions."

Moody's and CDO Software are working together to deliver solutions needed by market participants. Head of Moody's international markets strategy, Mario Aquino, says: "This is yet another step to integrate Moody's expertise and data into third-parties' structured finance platforms to provide even greater value to clients and fuller solutions to their needs. This initiative builds on Moody's continued efforts to drive up market transparency and knowledge."

Calypso enables rapid deployment
Calypso Technology, an integrated trading application suite provider to the capital markets industry, has launched Calypso Fast-Track – designed to assist new and existing customers with their rapid deployment of the Calypso application. Calypso Fast-Track quickly familiarises new users with the application in a simulated live environment, providing pre-configured data 'out-of-the-box' within Calypso's front to back office application; including risk management, reporting and accounting.

Calypso Fast-Track covers the discovery, development, implementation and validation phases of projects. During a recent implementation, these phases of a front to back installation for interest rate derivatives, credit derivatives and FX were completed within just 100 working days. Prior to Calypso Fast-Track, this would typically have taken up to nine months.

Designed to reduce the risk of the implementation process, Calypso Fast-Track makes the process as seamless and transparent as possible. As financial organisations face write-downs arising from the credit crunch, critical system replacement projects risk being delayed or put on hold due to the likelihood of unforeseen costs.

These costs can often arise from expanding or inaccurate project scope, unplanned training requirements due to staffing changes mid-project, or a lack of supporting materials to aid implementation. Calypso Fast-Track addresses these issues from the project kick-off, designed to ensure the scope is fully understood, providing static and reference data, best practice workflows and data interfaces to minimise configuration.

"Calypso and IBM have built a strategic alliance to assist Calypso users around the world achieve success in their implementations. IBM welcomes the launch of Calypso Fast-Track as a solution aimed at minimising the inherent risk in system replacement projects – enabling Calypso customers to better realise the benefits of Calypso at an accelerated pace," states Sanny Makki, partner - financial markets at IBM.

"Calypso Fast-Track is the culmination of several years of collective implementation experience from our professional services team, customers, engineering and implementation partners. The solution is unique in that it is an 'open source' configuration," states Gerard Rafie, vp marketing at Calypso. "This initiative, designed for a greater customer satisfaction, is a major priority for our company, supported by a dedicated team of engineers to process feedback from our customers and to ensure quality enhancements and continuous improvement."

Calypso has also leveraged its relationship with Accenture for contributions to Calypso Fast-Track content and testing.

Quantifi upgrades for LCDS
Quantifi, a provider of analytics and risk management solutions to the global credit markets, has released version 9.0 – the fourth major upgrade of its product suite this year – which includes a number of major enhancements, including second-generation models for LCDS, LCDX and LCDX tranches.

Significant activity and interest in the synthetic loan market has resulted in the need for more complex second-generation models for pricing LCDS, LCDX and LCDX tranches, incorporating call risk calibrated from a variety of market inputs. Recent volatility in the market has also resulted in the need for greatly expanded sensitivity and scenario tools, allowing analysis of market value and the unique ability to measure sensitivities of derived values to changes in complex combinations of correlation, credit spread and interest rate scenarios.

Increased trading across asset classes has also driven a demand for more sophisticated relative value and relative risk measures between bonds and credit derivatives. Version 9.0 includes significant enhancements in bond pricing and sensitivity analysis, allowing more complex relative value, spread, interest rate and duration measures for fixed, floating, amortising, step-up and callable bonds.

The new release also includes significant speed improvements to what are already the fastest available models in the market. In total, the 9.0 release includes over 20 new features and enhancements.

"The increased volatility and uncertainty in the market, along with its continued rapid evolution as evident by the growth in synthetic loan products, mean that it is more important than ever for market participants to be able to respond quickly to market changes. Our clients have come to depend on our unique ability to rapidly turn around first-to-market models and respond quickly to their evolving needs," says Rohan Douglas, founder and ceo of Quantifi.

Calyon brings CCO
Calyon is marketing a relatively small commodities-linked credit obligation (CCO) dubbed Amadeus CCO 2007-1. The transaction references a diverse pool of 10 commodities through a portfolio of 75 long and 75 short trigger swaps over a three-year tenor.

Provisionally rated by Fitch, the three-year deal comprises US$30m triple-A rated Class A notes, US$20m double-A rated Class Bs and US$20m single-A rated Class Cs.

Each trigger swap references a specific percentage of price level of a single commodity as specified in the documentation. Investors are exposed to the risk of large negative price movements on the reference commodities.

The principal amount of the notes will be reduced at maturity if the total net loss to the portfolio is greater than the available enhancement. Credit enhancement of 16%, 12% and 8% has been provided for the Class A, B and C notes respectively.

Spanish developer loans reviewed
Moody's is reviewing the main assumptions within the Moody's Real Estate (MoRE) development model – a loan-by-loan approach for Spanish real estate developer loans, from which the expected loss of each loan to be securitised is determined. The agency expects to finalise the process early in 2008; therefore, it will not assign any new rating to this type of transaction until completion of the review.

Moody's expects the revised methodology to pose no likely changes in outstanding transactions, due to the already high seasoning of the deals. In October the rating agency reviewed the four outstanding deals.

In one of these four reviewed transactions, AyT 7 Promociones Inmobiliarias, the final purchasers have already subrogated from the real estate developer loan. As of May 2007, the size of the reserve fund represented 16.24% of outstanding note balance.

Regarding the rest of the reviewed deals, as of July 2007, the weighted average constructed percentage in AyT Promociones Inmobiliarias II was 99.21% and the WA percentage sold was 87.03%. Only six projects have not been fully delivered – out of 131.

The reserve fund was amortising according to its mechanism. As of July 2007, the size of the reserve fund represented 35.16% of outstanding note balance.

As of August 2007, the WA constructed percentage in AyT Promociones Inmobiliarias III was 97.38% and the WA percentage sold was 93.17%. Only 14 projects have not been fully delivered in this portfolio – out of 40. The reserve fund and the subordinated classes were amortising according to their mechanism.

As of July 2007, the WA constructed percentage in AyT Promociones Inmobiliarias IV was 96.71% and the WA percentage sold was 70.85%. Only 35 projects have not been fully delivered – out of 135.

However, the reserve fund was not at the required level and Moody's expects further withdrawals. The size of the reserve fund represented 50.74% of outstanding note balance.

Carador NAV declines
The NAV of Washington Square Investment Management's permanent capital vehicle decreased by 5.35% in October. As at the close of business on 31 October, Carador's unaudited NAV per share was €0.7872.

Calculations for the month include an estimated €688,982.72 worth of net cash flow interest received (to be allocated between capital and income), which equates to €0.013 per share.

The manager referred 13 investments to the pricing committee which it considered were incorrectly priced by market counterparties for the end-October NAV calculation. The pricing committee proposed that, for these 13 investments, the valuations obtained using Washington Square's internal models, adjusted for the price provided by market counterparties, should be the preferred alternative to the market counterparty valuation. This proposal was accepted by the board on 15 November.

As in previous months, only CLO investments were referred to the pricing committee. The average discrepancy between the counterparty quotes and the internal valuation in the month of October was reduced to -0.90% for US CLOs.

The negative discrepancy for the US CLO basket reflects the fact that the internal model is currently, on average, more conservative than the counterparty mark-to-market. In September the discrepancy was at +10%.

Regarding Carador's residual CDO of ABS investments, if these were written off completely, the effect on the NAV would be (assuming current FX rates) a reduction of 2.47%.

OECD reports on structured products
Given the turmoil in financial markets that came into play over the summer, the OECD has released a paper which takes another look at structured products, following up on an earlier paper published in May. Its particular focus is on CDOs and SIVs: how they function, and the mechanisms by which developments in credit markets, in particular the US mortgage markets, have an impact on them.

It also explores how patterns of ownership of these products – by banks and other investors, such as hedge funds – may influence financial market outcomes. An important conclusion of this analysis is that stock adjustment issues are at the very centre of the turmoil.

This means that 'time' is very important, and may indeed be more important than the cost of capital. Work-out vehicles that help provide time for orderly balance sheet restructuring could be helpful, depending on how they are configured.

The main financial market implications are: the potential for instability in the credit supply process as balance sheet factors come into play; the impact on spreads between high and low quality securities; the impact on the dollar, since a good proportion of structured products have been sold to non-US investors helping fund the current account; and economic impacts that may lead to knock-on effects in other markets, such as corporate bonds, credit card receivables and equities.

CS

Trading ideas: retailer reticence

Tim Backshall, chief credit derivatives strategist at Credit Derivatives Research, looks at a pairs trade involving Kohls Corp. and JC Penney Co.

This week's retailer earnings have been disappointing but maybe not so surprising, given our continued view of a pending consumer-led recession. We have recently taken advantage of this view through pairs trades across cyclical and non-cyclical sectors (see last week's issue). Today's pair focuses on the retailer space specifically and picks two recently weak credits that offer significant spread pick-up and idiosyncratic convergence potential if the consumer continues to pull back.

We see three major signs pointing to a consumer-led recession in the US. First, year-on-year growth of consumer spending is in a downward trend.

The American homeowner used easy credit from home equity loans, car loans and credit cards to fight off a recession in early 2002. Year-on-year growth of consumer spending rebounded in mid-2001 and since late-2003 has been on a steady decline.

Second, over the next few years, the American consumer will be hit with over US$800bn worth of adjustable-rate mortgage resets. If homeowners do not default, then they must pay additional money to finance their homes – which will cause a substantial decrease in overall consumer spending in the coming years.

Last, due to the recent credit crunch, tighter lending standards will become the norm, causing refinancing and new loans to be more difficult to acquire than in the recent past. Unfortunately, compared to the 2001-2002 recessions, the American consumer is highly leveraged and does not have the capacity to take on further debt to increase their spending.

We believe the probability of a consumer-led recession has increased, as the consumer has become severely impacted. The retailers are a perfect place to play this perspective and the crossover credits offer the largest differentials and opportunities. Having recently reported, Kohls Corp. (KSS) and JC Penney Co. (JCP) offer a great combination of carry and fundamental divergence.

Shopping stats
The disappointing same-store sales of the retailers recently are consistent with our view of weakening consumer spending. Exhibit 1 shows that the discounters are outperforming (as one would expect when the consumer gets tighter), while department stores are hurt more.

Exhibit 1

Within department stores, SKS and NMG (the highest end) posted strong same-stores sales growth, as opposed to the rest of the sector – which suffered a drop (or negative growth). We do not feel that the worst has come yet and remain bearish on retailers into 2008 and beyond, thanks at the macro level to rising gas prices and a weak housing market and more sector-specifically rising inventory levels and expected heavy promotional markdowns.

The dramatic reductions in earnings and cashflow forecasts have certainly reduced both our and Gimme Credit's views of sectoral credit profile improvements, but the idiosyncratic differences between KSS and JCP remain more prone to JCP outperformance as we feel management is more likely (than KSS) to cut back on buybacks and maintain its investment grade rating (despite the outlook change to stable from positive). Comparing the two firms' leverage (as defined by debt/LTM EBITDA), we find that they both have quite different excess premium to fair-value (albeit at different levels), as seen in Exhibit 2.

Exhibit 2

JCP is clearly considerably cheap to the trendline and almost twice as wide to the trendline as KSS. Leverage measures are always idiosyncratically nuanced and we have seen a number of studies that show KS with a higher net leverage, further reinforcing our views (but we choose to use a more standardised measure in hopes of transparency). So, from a leverage perspective, JCP appears quite cheap compared to KSS relative to their fair-values, and the trendline (though not linear) is not particularly curved and provides some buttress against JCP drifting off into oblivion while KSS has plenty of room to move to the right.

The outlook shift from positive to stable this week was no great surprise, but shifts JCP closer to its rating-implied fair-value. Exhibit 3 shows that KSS is around the same distance from the trendline as JCP, but as JCP's management appears more concerned about maintaining its credit profile and investment grade ratings, we feel KSS should creep up the curve to the right and approach the levels of JCP sooner rather than later. The x-axis is a rating-ordinal derived from a composite rating and outlook model, hence the accounting for JCP's outlook change shifting the data to the right.

Exhibit 3

As same-store sales growth drops and KSS growth fell more than JCP, we feel the pressure will be on continued widening in KSS, and our ratings-implied and leverage-implied views both reinforce the differential as at worst stable, and at best strongly convergent. This is further reinforced by Exhibit 4, as we see that the differential between KSS and JCP's five-year CDS is close to its all-time highs and considerably wider than its historical average since CDS started trading on these names. Obviously both credits are trading at multi-year wides (despite having only traded in CDS land for around two years), but we feel the differential is indicative of too large a premium for JCP over KSS and – while the differential offers good carry – we feel convergence is in order as many of the retailers slip into crossover land.

Exhibit 4

One-stop shopping
While our multi-factor credit indicator (MFCI) model does reinforce our view that KSS underperforms JCP, the scores are not as opposed as one might hope for. But digging into the details a little shows that the spread per unit of default risk (SPD) trends are significantly different.

Exhibit 5 shows that, while KSS is above (therefore possibly cheap to) JCP, it is significantly below its long-run average of around 6175 – indicating a significant level of richness relative to its historical risk premium which seemed to begin around August 2007. JCP, on the other hand, has remained consistently close to its long-run average SPD of 2475 and is close to it currently – indicating that it is close to fair-value (from a risk premium perspective).

Exhibit 5

Combining our leverage and rating perspectives with the weakening macro trend in retailers, the expectation of JCP outperforming KSS seems reasonable. Once we consider the spread differential at its wides and the divergent SPDs, we have further reinforcement of our model-based views.

These model outputs are confirmed by the fundamental views with KSS inventories up considerably and expectations are for a very promotional holiday period (some have argued the most promotional in five years). JCP's liquidity remains solid and, while its more tempered outlook for Q4 and 2008 is a concern, it remains a stable credit with considerably improved credit metrics from a few years ago (and management have repeatedly commented on their desire to remain investment grade rated).

The pair offers great carry, as the differential is close to multi-year wides and the sell-off over the last couple of days offers a generous entry point with solid breakevens. Even if both credits continue to widen, we feel JCP will remain investment grade as KSS slips closer to crossover and the convergence will be profitable.

Risk analysis
This 'pairs-trade' carries a direct risk of non-convergence. In other words, there is the possibility that the names will not tighten and widen as expected. However, based on historical performance of the technical indicators, the cushion provided by the positive carry and the conviction of the fundamental analysts, we believe these risks are well mitigated.

Liquidity
Both JCP and KSS offer good liquidity in the CDS market. JCP is a member of the CDX IG9. They both consistently rank in the top-200 issuers by quoted volume on a daily basis.

They also have tight bid-offer spreads, regularly less than 4bp and sometimes down to 2bp. We see no concerns with the execution of this trade.

Fundamentals
This trade is significantly impacted by the fundamentals. For more details on the fundamental outlook for each of JCP and KSS, please refer to Gimme Credit.

Gimme Credit's retailer industry expert, Carol Levenson, holds a negative view on KSS, citing the following:

Kohls Inc.: [Deteriorating: -1] Just when sales had appeared to be stabilising and LBO risk had waned, management has decided that strong triple -B ratings are good enough. Debt-financed stock buybacks apparently will be the means to this end, but an iffy holiday shopping season might also help management achieve its lower credit quality goal if that's what it really wants. Ironically, S&P just lifted the company from strong triple -B in a rare retailing upgrade in April.

Carol recently downgraded JCP from 'Improving' to 'Stable', but remains somewhat positive on JCP's outlook as an outperformer in the retailer sector, citing the following:

JC Penney Co.: [Stable: 0] After Penney reached its goal of regaining investment grade ratings, we expected debt protection measures to improve at a more modest pace. The recent dramatic reduction in its earnings and cashflow outlook hopefully will cause management to temper stock buybacks, but we no longer see this credit profile as improving.

These fundamental views reinforce our model-based views of JCP outperforming KSS as the consumer cuts back.

Summary and trade recommendation
The dismal same-store sales (SSS) numbers from the major retailers has reinforced our view of an increasingly likely consumer-led recession biting into the credit profile of many 'over-levered' US corporates. It is evident from monthly figures that department stores are struggling (as SSS growth falls) while discounters (SSS growth flat to modestly positive) outperform.

The mid-range department stores have the largest differences in inventory changes and SSS changes, and – looking at JCP and KSS – we see that from both a ratings-implied and leverage-implied perspective KSS looks rich to JCP. Fundamentally speaking, the trend is not encouraging, but JCP's management has been far more cognisant of its investment grade rating than KSS (with its ongoing buyback programmes).

With JCP stable and KSS deteriorating fundamentally, we see further confirmation of our view of JCP outperforming KSS based on the considerable richness of KSS SPD over the past few months compared to its historical average. The spread differential is at multi-year wides and we feel that, as a crossover credit, JCP is at the better end of the scale, while KSS is due for a slide down that scale – and the carry and roll-down offers strong (sector-neutral) breakevens for this retail-weakening bet.

Sell US$10m notional JC Penney Co. five-year CDS protection at 148bp.

Buy US$10m notional Kohls Corp. five-year CDS protection at 92bp to gain 56bp of positive 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).

Equity with principal protection - part 2

In the second part of this series, variations to the basic equity principal protection strategy are examined by Domenico Picone and Priya Shah of Dresdner Kleinwort's structured credit strategy team

To show the early redemption mechanics of equity principal protection, we have so far concentrated on a relatively basic example in which both the zero coupon bond and equity call date were assumed to be five years. In practice, the principal protected note (PPN) strategy has been applied to longer-term zero coupon maturities, to match the legal maturity of the CDO equity piece.

This way the current price of the zero is lower and more of the original investment is allocated to the CLO equity. However, the investor is exposed to the CLO equity for a shorter period of time, as the deal is normally called much earlier, towards the end of the reinvestment period.

Extending the example made in the first part of this series (see last week's issue), let's assume that the legal maturity of the CLO is 15 years. A zero maturing in 15 years is currently priced at 51%, and therefore 49% can be allocated to the CLO equity. Based on the same equity hurdle rate of return of 18% and assuming the CLO equity is called at the end of five years, the no default scenario results in a much higher IRR, with only a marginal increase in duration.

Provided that the deal has performed as expected, application of the formula from the first part of the series allows for the full redemption of the zero coupon allocation when the CLO equity is called – a long time before the actual final maturity (15 years). In Exhibits 1 and 2 we show the IRR and duration sensitivities of this strategy to changing interest rates and defaults.

Exhibit 1

Exhibit 2

PPN and CDS equity (0-3%) tranches
Over the past few years, as a result of a massive growth of trading and investor interest in synthetic CDOs referenced to investment grade indices such as iTraxx and CDX, equity tranches of these indices have also been repackaged into protection strategies. In fact, superior returns can be targeted by utilising the PPN structuring feature that releases the zero-coupon bond sooner as coupons are paid, hence increasing the IRR. Moreover, this structure can easily be replicated with sub-investment grade indices too, such as CDX HY, targeting higher IRR.

The standard arrangement for the 0-3% tranche of the iTraxx or CDX is to trade the tranche with a 500bp running spread and the rest of the return on an upfront basis. The investor (protection seller) receives the upfront coupon at issue and then a running coupon of 500bp based on the outstanding tranche notional throughout the life of the CDS. On the loss leg of the CDS, he must make payments to cover losses resulting from defaults as and when they occur.

Equity tranches, in their standard CDS format, can however be modified into a funded instrument with no upfront payments, which is more suited for the purpose of a PPN. The funded format that is most commonly used in the market is the "all-running equity tranche".

In a PPN structure, the investor funds the purchase of a credit risk-free zero-coupon bond and of a CLN, issued by an SPV and linked to the performance of an equity tranche (0-3%) of the iTraxx/CDX portfolio. The proceeds from the CLN are used to buy collateral, which has virtually zero credit risk.

When a default occurs, part of the collateral is sold to cover the loss, and a portion of the note is written off. In return for the credit risk taken, the investor receives regular interest payments as Libor plus a spread. The CLN is essentially similar to a floating rate bond, in that the investor pays par at issue, receives a regular floating rate coupon based on the outstanding tranche notional and receives back par minus any losses at maturity.

In Exhibit 3, we show the main features of a PPN with an all-running equity tranche. The SPV issues a note at par which pays Libor plus the running spread on the remaining notional.

Exhibit 3

The proceeds from the note are invested in triple-A collateral paying Libor flat. The SPV in addition sells 0-3% equity protection with an all-running unfunded format, so that it receives all coupons on a running basis and pays for losses as they occur.

Additionally, when the coupon is received, part of the zero coupon bond is redeemed according to the aforementioned formula. When a loss occurs, the collateral is sold to pay the loss to the correlation desk and the note is written off for an amount equal to the loss.

In the following period, the coupon payment is calculated on the remaining balance of the note and the zero-coupon bond partially redeems. At maturity, the remaining zero-coupon bond and the CLN are paid to the investor.

What really differentiates the PPN linked to the 0-3% equity tranche IG CDX/iTraxx from the PPN linked to CLO equity is the relatively better credit quality of its reference collateral. CDX and iTraxx are investment grade indices, whereas CLO collateral is primarily made of sub-investment grade leveraged loans.

As a consequence, the equity tranche of IG indices is relatively thinner than CLOs. On the other hand, 0-3% equity tranches are more levered than CLO equity, as they have a higher delta.

Dual currency PPN
The note can also be structured so that the zero coupon bond is placed in one currency and the equity investment in another. Equity cashflows are then converted at the prevailing spot exchange rate and the redemption formula used to calculate the proportion of the zero notional that can be redeemed early.

Basel II-friendly product with small rated coupon
With regard to regulatory capital requirements for a PPN strategy, there is still somewhat a lack of clarity. Interpretation is down to individual regulators; however, we fear that as the PPN does not include a rated coupon in its basic format, it may not be seen as an ordinary 'securitised' product and may be subject to more expensive regulatory capital charges than more traditional ABS products which pay principal at maturity and coupons at regular intervals.

As a solution, the PPN note can be structured in such a way that some of the original investment is used to pay a small rated coupon at regular intervals, with any surplus than being invested in an equity allocation. This may have the regulatory effect of treating the PPN as 'securitisation'.

PPN without market value risk
While the initial principal remains protected, over the interim term to maturity the note value does tend to fluctuate with interest rate changes. For some investors this may result in P&L volatility, which is not always desirable. As an alternative, the note can be purchased via a more efficient market volatility-friendly structure, depending on individual investor requirements and exposure.

Why investors look at these structures
PPNs are, for the majority, buy-and-hold securities – hence suited to investors with medium and long-term horizons. An early exit strategy may appear if the PPN was originally purchased in a high interest rate environment which has subsequently dropped off. In this instance, the investor should consider stripping the PPN into the zero-coupon strips and the CDO equity, and realising profit from the zeros (see chart 'Falling rates, more CF early' from last week).

CLO equity is currently cheap
The recent credit crunch has adversely affected investor confidence in the CDO market. While US sub-prime RMBS and CDOs of ABS securitised with these assets have seen a sharp drop in price due to fundamental issues, the contagion effect on CLOs is more driven by technical factors.

Investors are naturally concerned with the increasing leverage and lower covenants of leveraged loans issued towards the end of 2006 and 2007, and are therefore also reassessing this sector. However, actual corporate defaults do currently stand at historical lows.

In Europe we believe that the corporate environment remains stable and do not expect corporate defaults to increase substantially, but our outlook for the US is more bearish. US growth in recent years has in part been fuelled by a booming housing market and consumer spending, and the continued decline in these sectors is likely to eventually weigh on the corporate sector. We therefore cannot discount the possibility of a US recession.

With investors currently waiting on the sidelines, CLO equity is therefore trading at a discount to par, which we believe offers good value. In particular, CLOs issued prior to the credit crunch benefit from cheap funding costs and, with leveraged loan spreads rising, future collateral reinvestment at these higher spreads will predominantly benefit equity holders, increasing overall IRR.

Defaults
Generally speaking, PPN opportunities are determined by relative value opportunities offered by CLO equities and equity tranches of IG indices. The equity piece of a CDO, cash or synthetic, is very exposed to defaults as it absorbs the first loss, being at the very bottom of the capital structure.

Therefore, the level of defaults (and hence eventual losses post-recovery) is one of the main drivers of the PPN's return. If the investor expects the equity to experience fewer defaults than those priced in by the market, they would benefit from investing in a PPN transaction.

An equity CDO will also be significantly affected by the timing of such defaults. Of course, the absolute size of losses due to defaults is still of prime importance.

Timing of default scenarios
When referring to defaults in a portfolio, we often say that they are 'front-loaded' or 'back-loaded'. For a given number of defaults, we say that they are front-loaded whenever they have tended to occur towards the beginning of the life of a transaction and back-loaded when the defaults occur towards the end of life cycle of a CDO.

The possibility of lost coupons in equity synthetic CDOs
The reason that equity tranche returns will depend on the timing of defaults comes primarily from the possibility of lost coupons. Coupon payments are calculated based on the outstanding principal balance of the CLN. Therefore, if the CLN suffers losses as a result of defaults in the reference portfolio, the investor will receive diminished coupon payments.

If defaults are front-loaded, as opposed to back-loaded, then more will be lost in the way of diminished coupons throughout the life of the deal. Equity coupons are typically quite large in order to compensate for their relatively substantial risk and, as such, the timing of defaults can have a significant effect.

The CLO case
In cashflow CDOs, such as leveraged loan CLOs, some cashflow analysis is required as the combination includes an equity piece of a cashflow product, which is structured to generate a certain level of excess spread. However, as losses are generally not recognised immediately when a loan becomes delinquent, trapping mechanisms are in place to prevent excess spread being distributed to equity when too many loans are delinquent. This way, the losses are crystallised until a later date when the work-out process is completed or the defaulted loan sold.

Returning to our example
To show the effect of the back-loaded and front-loaded defaults, we return to our previous example (see part one). So far we have shown the impact of a zero default scenario and one in which the equity tranche experiences regular annual defaults.

In a zero default scenarios the PPN note returns a higher IRR than the no early redemption strategy, irrespective of the interest rate scenario. However, as the level of annual defaults rises, there is a pivotal point after which the PPN is less superior.

It is also worth examining the timing impact of defaults. In Exhibit 4 we show the IRR impact on our PPN strategy when defaults increase/decrease in fixed increments – again assuming a recovery of 65%. On the x-axis we plot the annual change; therefore, 0.5% means that in an increasing default scenario, year one will experience 0.5% defaults, year two will experience 1% and so on.

Exhibit 4

The pattern is reversed for the decreasing default scenario. As seen, the PPN strategy returns a higher IRR when defaults are more back-loaded. When compared with the no early redemption strategy, once again there is a pivot default rate after which the PPN returns a lower IRR.

No default timing effect on the principal payments
While the timing of equity defaults does impact the timing of the principal cashflow received, defaults will not devalue the principal investment. The strategy is designed to ensure the receipt of all principal originally invested by maturity, irrespective of the interest, credit or default environment over the term.

The principal element is therefore rated triple-A or equivalent by rating agencies. Default timing risk only influences the PPN returns through the effect on running coupons in synthetics and equity cash distribution in CLOs.

© 2007 Dresdner Kleinwort. All rights reserved. This Research Note was first published by Dresdner Kleinwort on 29 October 2007.