Contents

Structural alterations

SIV and CDO restructurings step up a gear

HSBC's move to consolidate the two SIVs it sponsors has given impetus to restructuring activity in the sector. At the same time, the restructuring of CDO investments continues apace.

The current SIV model of buying long-term assets and borrowing short has ceased to be attractive, according to TJ Lim, partner and ceo of NewSmith Financial Products. "Most of these SIVs had average returns of 30bp to 50bp over Libor prior to the crisis and, with the re-pricing and risk aversion in the ABCP markets, they are no longer viable as an on-going concern."

He adds: "As such, we believe the key here in any restructuring solution is not to term out the senior debt – which will likely result in the structure bleeding to death. We're advocating short-term restructuring solutions. For example, two-year with call features that will help stabilise the SIVs and allow the vehicles to work out the assets in a measured manner, while offering optionality to take advantage of any capital market takeouts, should the opportunities arise."

For income noteholders who have the ability to fund themselves, one strategy is to acquire a vertical slice of the assets in their SIVs as a way to protect their positions. For those who can't, there is a risk that once a SIV enters into enforcement their income notes could be severely impaired, if not wiped out in a fire-sale situation.

HSBC is set to absorb US$45bn of assets from the Cullinan and Asscher SIVs by providing 100% liquidity support, with the added protection of a third-party first-loss layer. The restructuring will involve exchanging income and mezzanine notes for rolling CP or CDO tranches. Cheyne Finance is understood to be following a similar strategy, while MBIA is unwinding its Hudson-Thames vehicle with the nine holders of the capital notes taking a proportional share of the assets onto their balance sheets.

Although there are many issues and challenges associated with the vehicles, Lim points out that good opportunities can still be found by investors – especially in the super-senior tranches of a SIV restructuring. "The majority of the underlying assets of SIVs are of very high quality, despite some exposure to the ABS sectors. As such, the super-senior tranches (say 50-100%) are extremely safe – assuming one gives very little credence to the market values of ABS securities," he says.

Before the liquidity crisis these tranches would trade at around 5bp, but in today's environment it is not uncommon for investors to obtain spreads of around 100bp – which offer significant value for little risk. However, risk aversion and concern about super-senior losses from bank write-downs have led investors to shy away from these opportunities.

Meanwhile, arrangers report increasing restructuring activity in the CDO sector. Ally Chow, global head of product management and origination at Calyon, confirms that an increasing number of asset managers are being appointed to static CDOs to help investors manage the risk of the underlying assets. This could involve restructuring of a deal into a managed format, or having the asset manager act as an outside consultant to monitor the deal.

According to Serge Crevecoeur, head of structured credit product sales at UniCredit: "Certainly banks are focusing more on restructuring deals that have gone sour than trying to invest into new transactions at the moment. Investors are willing to restructure their portfolios because of credit quality issues; for example, by looking to substitute assets to increase portfolio quality or through innovative delivery mechanisms for regulatory capital and other purposes."

But, he says, restructuring is being undertaken on a case-by-case basis and is typically a long process. "Each restructuring is unique, and it takes time for investors to mobilise and receive the necessary credit-committee approval."

Investors are also concerned about the sensitivity of their portfolios to mark-to-market volatility. In this context restructuring typically involves repackaging an asset with a loan or guarantee to create a different accounting treatment (see SCI issue 52).

In addition, some CDO restructurings have been undertaken to gain regulatory capital benefits under Basel I. Assets that are consuming too much capital can be stripped out of a portfolio, leaving only the risks that the investor prefers.

CS

The harder sell

Investors well supported, but more work needs to be done

Banks are stepping up their support of investors in the current buyers' market. An issue that has been ignored so far, however, is extension risk.

One structured credit investor points out that arrangers are certainly trying harder to accommodate the needs of buy-side accounts during the marketing process. "Every bank is feeling the pressure to sell, so they are offering more services."

He adds: "They are more willing to talk with investors and change the legal documentation where appropriate; for example, in terms of callable features and voting rights. There is more emphasis on this area because it is no longer a sellers' market. Whereas in the past the level of demand meant that accounts simply bought deals without differentiating between managers or underlying assets and so on, now there is much more scrutiny surrounding these issues."

Shammi Malik, portfolio manager in Henderson Global Investors' structured products team, says that buy-side research departments have gone into over-drive of late and begun covering areas that would typically have been overlooked before the liquidity crunch – such as the SIV, CP and covered bond sectors. "However, arranging desks generally only enhance their after-sales support when an issuer gets into difficulties – as, for example, occurred last week when Paragon announced its funding problems," he notes.

Investors nevertheless report that most issues are performing well, with good opportunities to be found in short-duration seasoned paper – typically offering higher credit enhancement due to revolving periods ending and sequential pay-down higher up the capital structure all offered at wider spreads. But the big change and unknown in the current market is that of extension risk. Typically it is not in the dealer's interest to highlight this issue and it is left, if noticed, to the investment community to negotiate.

According to Malik: "Most issues of late have been structured with a step-up in margins as the stimulus for repayment and refinancing. Against the backdrop of current spreads where we've been through a 10-15 standard deviation event, it is not in the issuer's interest to refinance and, as a result, many issues will face extension risk."

Each transaction has to be examined on its own merits, with some issues stepping up from the typical 12bp to 100bp. In other instances investors are even more exposed buying in secondary, as the traditional first call date is no longer the appropriate point to which to price the security.

"A good example is French MBS, where issuers have bought protection from the issuing vehicle via the CDS until the 10% clean-up date or it is now open to the discretion of the issuer to exercise after the first call date. As there has been a significant increase in margin, it makes economic sense for such issuers to leave transactions outstanding rather than call them. Some of the more sophisticated bank issuers may exercise their regulatory call, depending on the cost of capital at that time," continues Malik.

As most deals don't include puts, investors will consequently end up holding a bond for a longer period. The precise extension window and additional risk compensation required is a subjective point, depending on prepayment assumptions used and when an investor expects the market to normalise. One potential solution, however, may be for some newer issuance to include mandatory fixed calls or investor puts.

CS

Ups and downs

End of year impact on CDS more pronounced

CDS spreads whipsawed again over the past week before settling somewhat in the past two days. Volatility peaked on thin trading due to Thanksgiving week and, while volumes are still down on the record levels seen in October and early November, there are still reasonably substantial flows as technical pressures on spreads remain.

The CDS market saw record wides last Wednesday, notably on senior and subordinated financial names. A short covering rally occurred on Friday and Monday, with the indices trading in a tight range through Tuesday and Europe's early morning today, 28 November.

"Bad news last week surrounding ResCap and Countrywide drove jump-to-default risk covering. We saw real panic in the market, which is still trying to find some equilibrium. We could see even further spread widening in the future as liquidity/volatility premia overshoot before relative value is found," reports one investment manager.

However, the US Federal Reserve's move on Monday to inject liquidity into the money markets until 10 January brought some relief for dealers. The central bank announced an US$8bn repo – notably larger than the norm – with a specific aim to provide sufficient reserves to resist upward pressure on the Fed funds rate above the 4.5% target around year-end.

Index spreads were held within a range on subsequent days – at around 375bp in the case of iTraxx Crossover – thanks to some positive news for financials. Citi announced a US$7.5bn capital injection via an equity sale to the Abu Dhabi Investment Authority, while Barclays stated that its profits will not be affected by its recent £1.3bn write-down.

Overall, though, the past week's volatility has come off the back of a flow of negative headlines. Much of this has already been priced in, according to Marcus Schüler, md integrated credit marketing at Deutsche Bank. "The credit market generally does well running up to and into December, which has caused shorts to become quite cautious," he adds.

Caution has also impacted CDS flows as dealers and clients begin closing their 2007 books. The usual reduction in risk appetite going into year-end is in evidence, but to a greater extent currently than in recent years.

"As always at this time of the year, there has been significant hedging activity – although it has been more pronounced this year because more assets remain on banks' books and therefore the volume of loan hedging is greater. Clients are also positioning their portfolios for next year by buying the index as a hedge," observes Schüler.

The situation is likely to change once 2008 business begins, with a certain amount of risk appetite expected to return in January bringing with it increased CDS flows. "I guess you can expect a smaller structured credit pipeline than in previous years, although this may make flow trading more interesting. The large pipelines of previous years kept spreads artificially tight, but a smaller pipeline may allow more active trading on single names based on market views and credit fundamentals," Schüler concludes.

CS

Private placement

Jumbo SME CLO launched

Lloyds TSB has closed Goodwood Gold, its third synthetic balance sheet CLO. The £3bn-equivalent transaction is extremely granular, referencing a portfolio of almost 28,000 loans granted to UK SMEs.

In order to place such a large transaction in the current turbulent environment, it was issued privately on a club-deal basis with three large institutional investors who had bought into the quality of the book. "Thanks to the relationships we have built up, we were able to reach out to sophisticated partners who took a view on the market beyond year-end. With credit spreads widening over the last month, it is testament to our counterparties that they stuck with us," notes an official at Lloyds TSB.

The deal involves four mezzanine CDS contracted directly with Lloyds, as well as ten CDS that are contracted between Lloyds and the issuer and which relate to five sterling-denominated CLNs and five euro-denominated CLNs. Below a £2.6bn super-senior tranche, the CDS are grouped into £96m triple-A rated Class A notes, £91.5m Aa2 Class Bs, £88.5m A2 Class Cs, £39m Baa2 Class Ds and £54m Ba1 Class Es.

Within each class of notes, investors could choose euro- or sterling-denominated paper, or enter into a mezzanine CDS with Lloyds (except for the Class As, which only offered CLN exposure). While one account had previously participated in the bank's Ascot Black CLOs, the others were new investors – although familiar with the Lloyds name. The notes and swaps were customised to the individual investors' tastes, with all three elements of choice taken up (albeit one account didn't participate in every form).

Lloyds retained the £45m-equivalent first-loss piece. Sole rating agency on the deal is Moody's.

The attachment and detachment points of each class of CDS define the subordination in the capital structure, with the first loss piece detaching at 1.5% and the super-senior attaching at 13.8%. The mezzanine CDS attach higher within each class than the CLNs.

Classes A to E benefit from synthetic excess spread, with losses that aren't covered by the Class E threshold amount allocated on the annual CDS payment date. Available excess spread to replenish the Class E threshold amount after the loss allocation or replenished Class E threshold amounts can't be used at a later date to compensate for losses that have already been allocated. Loss allocation is done in reverse sequential order starting with the threshold amount.

The £2.9bn reference portfolio consists of 27,937 loans granted to 24,983 entities. The largest reference entity accounts for 0.07% of the total portfolio amount, with the 10 largest reference entities accounting for 0.62%.

The reference entities are diversified across the UK, with the largest geographical exposure in South West England (13.3%). The weighted average remaining maturity of the loans is 13.2 years and the maximum maturity is 30 years.

The reference portfolio can be replenished for three years on a quarterly basis, subject to certain portfolio criteria and stop replenishment triggers not being breached. After the replenishment period the notional amount reduction on the CDS occurs pro rata, providing the stop pro-rata triggers are not breached – thereafter the notional amount reduction under the CDS is done in full sequential order.

A credit event is defined as bankruptcy, failure to pay or restructuring (as in the 2003 ISDA definitions). The transaction will be terminated at the latest at the CDS payment date falling in 2023. However, Lloyds has the option to call the transaction in whole but not in part if a regulatory change occurs; on any CDS payment date falling on or after January 2011; or if the reference portfolio outstanding amount is lower than 10% of the initial balance.

CS

Asia credit head hired

The latest company and people moves

Asia credit head hired
Francois de Supervielle has taken up the role of director, head of structured credit for Asia at Société Générale Corporate & Investment Banking. He joins from Natixis in Hong Kong, where he was head of credit structuring.

Credit veteran's fund launches
John Deacon has launched his new hedge fund – Giltspur – which will invest primarily in ABS. Deacon left Dillon Read Capital Management (formerly UBS Principal Finance) earlier this year to seek fresh opportunities, after seven years with the firm (see SCI issue 33). His decision came prior to the firm being re-absorbed into UBS (see SCI issue 38).

Brunton to join AMP
AMP Capital Investors has announced that Jeff Brunton, former QIC (Queensland Investment Corporation) head of global credit, has decided to join as head of credit markets. He will relocate to Sydney and commence in his role at AMP Capital in early 2008.

Brunton is also a long-standing member of the Australian Financial Markets Association's credit derivatives committee.

CIFG pulled out of Natixis
Following poor results for the quarter at Natixis, the firm's joint owners Groupe Banque Populaire and Groupe Caisse d'Epargne, have decided to acquire monoline CIFG from Natixis. CIFG is currently a subsidiary wholly-owned by Natixis.

The move by Groupe Banque Populaire and Groupe Caisse d'Epargne aims to provide the required financial resources to maintain CIFG's triple-A rating with the three rating agencies. It is estimated that the two firms will have to stump up around US$1.5bn in capital or quasi-capital. Once regulatory approval is obtained for the takeover, which is expected to take about a month, Natixis shareholdings in CIFG will be passed to its parent companies so that they hold 100% of CIFG's capital at par at the end of the operation.

CIFG total par insured amounted to US$90.9bn as of 30 September 2007. Its sub-prime exposure is composed of US$1.9bn of direct exposure on CIFG's RMBS portfolio (98% rated tripe-A, 2% single-A) and US$11.1bn in direct exposure on CDOs collateralised in part by sub-prime, spread across around 40 CDO tranches.

Absolute Capital appoints administrator
The board of Absolute Capital Group Limited has appointed a voluntary administrator. The appointment of administrators Tony McGrath and Joseph Hayes of McGrathNicol relates only to the Absolute Capital Group corporate entities and not to its core products such as the Yield Strategies Fund.

Absolute Capital Group is an Australian-based specialist structured credit investment manager, which has suffered from the prolonged illiquidity in global and local credit markets (see SCI issue 49). The reduction in fees paid to the corporate entity from a number of its investment products impacted the long-term viability of the business, the firm says. As a result, the board took the decision to enter voluntary administration

It is expected that a meeting of creditors will be held next Monday, 3 December. At that meeting creditors will be provided with an update as to the financial position of the group.

MP

Further CPDO rating actions

A round up of this week's structured credit news

Further CPDO rating actions
Moody's has downgraded a further €11.5m of CPDO notes and has placed €340m of CPDOs under review for possible downgrade, following its previous review of the sector (see last week's issue). The affected transactions are exposed to portfolios of financial names.

The Series 103 Financial Basket Tyger notes due 2017 issued by
UBS' Elm vehicle have been downgraded from Ba2 to single-C. The downgrade is a result of the weighted average spread of the underlying portfolio reaching such a level (170bp) that the NAV of the transaction was reduced and hit the cash-out trigger of 10%, thereby causing the deal to unwind. This results in an approximate loss of 90% for the investors.

€41m of the notes were bought back and cancelled by the issuer before the cash out occurred on 21 November.

Moody's has also placed under review for possible downgrade the €100m Series 115, €20m Series 117 and a €100m related CDS of the Tyger notes, together with ABN AMRO's €20m Series 4 and €100m Series 2007-1 SURF notes issued by the Castle II and CHESS III vehicles.

The review for possible downgrade is in response to the continuing spread widening and volatility of the financial names underlying these CPDOs, negatively impacting their net asset values. It is worth noting that sensitivity to spread widening varies per transaction, depending on each transaction's leverage mechanism and exposure to poorly performing assets.

Rating actions for CDO managers
In light of adverse credit developments in the RMBS sector and their consequences for structured finance SF CDOs, Fitch has completed a focused CDO performance review of all SF CDO asset managers to which it has assigned a CDO Asset Manager (CAM) rating. The objective of Fitch's global SF CDO asset manager review, announced at the beginning of October, has been to ensure a consistent framework for evaluating managers' performance at this point in the credit cycle. The agency's normal CDO surveillance practices, which include regular dialogue with each manager concerning portfolio performance, will continue to apply for both rated and non-rated CDO asset managers.

Fitch's rating actions follow full annual reviews of four SF managers and focused CDO performance reviews of 18 SF CDO managers. The performance category score has deteriorated to varying degrees for all managers due to the extensive negative rating actions that have affected the SF sector and its related CDOs this year.

In summary, Fitch has affirmed BlackRock, Cairn Financial Products, PIMCO, Prudential M&G, Redwood Trust, UNIQA Alternative Investments and Western Asset. It has downgraded Declaration Management and Research, Duke Funding Management, GE Asset Management, Rabobank, TCW and Vertical Capital, as well as placing First Republic Investment Management (Trainer Wortham) and Solent Capital on rating watch negative. Additionally, three managers (Bear Stearns Asset Management, C-BASS Investment Management and E-Trade Global Asset Management) remain on rating watch negative.

It should be noted that Fitch's CAM performance category is one of seven categories contributing to a manager's overall rating.

ABX remittance news
ABX indices saw a deceleration in the change of 60+ delinquencies on Series 06-2 and 07-1, according to the latest remittance figures. As a percentage of original balance, 60+ delinquencies increased by 98bp, 79bp, 136bp and 224bp respectively for ABX.06-1 through ABX.07-2 in November. By comparison, 25 October data showed an increase of 91bp, 99bp, 168bp and 223bp for ABX.06-1 through 07-2.

The ABX.07-2 60+ delinquency curve remains the steepest, hitting 13.25% of current balance at loan age 10, compared to 8.69% for ABX.07-1 at the same point, note analysts at JP Morgan. ABX.06-1 delinquencies increased steadily across the buckets over the past few months, a reflection of the rate reset stress for these borrowers.

With all deals now having reached at least loan age 24 (average 28), the range of ABX.06-1 one-month CPRs was approximately 19% to 56%. The average ABX.06-1 pool factor declined to 0.47.

Later vintages of ABX will have significantly less refinancing optionality due to lower and negative house price appreciation, and the analysts expect the 2/28 prepay spike to be 10-15% lower than that of ABX.06-1. One-month CPRs for ABX.07-1 at loan age 16 (18 deals reporting) were 14.85%, compared to 33.05% in ABX.06-1 at the same loan age.

The combined percentage of foreclosure and REO buckets continued to rise as the REO liquidations remain very slow. In ABX.07-1, the combination of foreclosure and REO reached 13.03%, an increase of 1.59 percentage points versus the previous month. The biggest increase of foreclosure and REO in ABX.07-1 were FHLT 06-3 (+409bp to 20.66%) and SASC 06-BC4 (+413bp to 13.5%).

Cumulative losses for each index rose 14bp, 18bp, 13bp and 7bp, reaching 1.17%, 1.22%, 0.55% and 0.17%, on 06-1, 06-2, 07-1 and 07-2 respectively.

S&P revisits position on monolines
S&P is revising its approach to bond insurers' sub-prime exposure. The agency will update the assumptions underlying its stress scenario to reflect current market conditions and recent rating revisions in the RMBS and CDO of ABS sectors. In addition, the new stress scenario will broaden the vintage period covered to incorporate the entire period of 2005 through the third quarter of 2007, as well as incorporate additional asset classes, including Alt-A loans, closed-end second mortgages, net interest margin securities (NIMS), and home equity lines of credit (HELOCs).

As part of this ongoing review of bond insurers' exposure in the RMBS and CDO of ABS sectors, S&P is reviewing insured CDO transactions with overcollateralisation-linked events of default (EOD) to clarify potential courses of action that an insurer might follow in the event of an EOD trigger. The agency is reviewing all bond insurers' exposures to such triggers and monitoring whether any of the triggers are exercised and, if so, if they materially alter its views regarding the potential for losses in any transactions.

Bond insurers' exposure in the CDO sector is written almost solely on a pay-as-you-go model. The bond insurers' payout terms on these transactions closely resemble a traditional financial guarantee policy. This means that bond insurers will only pay principal and interest if there is a default by the reference credit, which mitigates liquidity demand and the potential for an abrupt short-term drain on capital.

Axon Financial Funding defaults
Fitch and S&P have downgraded Axon Financial Funding's US and Euro CP, US and Euro MTNs and mezzanine notes to single-D. The rating actions follow the security trustee's declaration of an automatic liquidation event in light of the rapid decline in the portfolio market value.

As a result of such decline, the manager has determined that the market value of the remaining assets within the portfolio may be insufficient to meet the amount of outstanding senior liabilities in full. The single-D rating reflects the fact that all senior liabilities became due and payable upon such declaration and that such payment has not been made.

Further Fitch SF CDO downgrades
Derivative Fitch has downgraded US$29.8bn and affirmed US$3.8bn of SF CDOs across 74 transactions. These rating actions, in combination with those announced on 12 November, reflect the review of all cash and synthetic SF CDOs with exposure to US RMBS placed on rating watch negative by the agency on 29 October. This review resulted in aggregate downgrades of US$67bn and aggregate affirmations of US$10.7bn across 158 transactions.

Fitch's rating actions are based on the continued credit deterioration of the underlying collateral, as well as changes to the default forecasting assumptions underlying Fitch's Default VECTOR Model (see last week's round up). The updated assumptions reflect increased probabilities of default, reduced recovery assumptions and increased correlation with respect to recent vintage sub-prime RMBS and SF CDOs.

Manager incentives analysed
In a new rating methodology report, Moody's analyses the structural features of adjustable credit enhancement mechanisms in synthetic CDOs in tandem with the manager fee structures of such transactions, noting that these features are important to performance. According to the rating agency, it is essential to study in detail both these mechanisms and the managers' incentive structures in order to assess how closely the managers' interests are aligned with those of the noteholders, thus helping to ensure long-term credit rating performance.

The report also serves as a primer on the workings of CDS trading in such CDOs, as more managers now apply an active management approach versus the purely defensive strategies of the earliest transactions. "Collateral managers can use trading flexibility in order to both defend their reference pools from losses and allow for value generation through active trading. However, unless the managers' interests are aligned with those of noteholders, they may be incentivised to pursue short-term trading gains over long-term credit performance," says Khalid Howladar, a Moody's vp - senior credit officer and author of the report.

In this context, Moody's assesses the incentive structures in managed synthetic CDOs and their impact on the transaction. In addition, such incentives must be considered in tandem with 'adjustable' and 'monetisable' subordination – which are now common features in this market.

The former utilises the profit and losses generated through trading to adjust to the subordination below the rated tranche, rather than make direct credits/debits into some reserve or trading account. The latter allows excess subordination or rating 'cushion' to be monetised and distributed rather than 'trapped' in the deal.

Misaligned application of these technologies can be detrimental to rating stability if not moderated. "The adjustable subordination feature is a clean and efficient means of transferring value between the swap counterparty and the investors in managed synthetic CDOs. However, the linking of manager fees to subordination levels requires close attention to be paid to such mechanisms and an awareness that increases in subordination are not always a result of 'alpha' or value creation," Howladar explains.

Moody's believes that generally interests of CDO collateral managers are well aligned with those of noteholders and ongoing distributions of value from such deals can be an efficient way of enhancing investor returns. However, the effect of such mechanisms needs to be carefully analysed and potentially moderated to encourage long-term rating performance.

S&P rating actions for European CDOs...
S&P has taken credit rating actions on 68 European synthetic CDO tranches.
Specifically, ratings on 32 tranches were lowered and removed from credit watch negative; 16 tranches were lowered and remain on watch negative; 15 tranches were raised and removed from credit watch positive; and five tranches were removed from watch negative and affirmed.

Of the 48 tranches lowered, eight reference US RMBS and US CDOs that are exposed to US RMBS which have experienced recent negative rating actions.
40 have experienced corporate downgrades in their portfolios. In particular, the rating actions on Alliance Boots and Countrywide Home Loans contributed to the credit deterioration of their portfolios.

The agency has also placed 17 tranches issued by six European cash and hybrid CDO transactions on watch negative implications. The affected tranches represent less than 1% of all S&P-rated cash and hybrid CDO tranches in Europe.

...and US CDOs
S&P has lowered its ratings on 136 tranches from 28 US cashflow and hybrid CDO transactions. At the same time, it has affirmed its ratings on another 53 tranches from the same transactions.

The downgraded tranches have a total issuance amount of US$5bn and all are from CDOs of ABS. All but 16 of the lowered ratings were on credit watch negative before the downgrades.

To date, S&P has lowered its ratings on 367 tranches from 72 US cashflow and hybrid CDO of ABS transactions as a result of exposure to US RMBS securities that have seen negative credit migration. Additionally, 574 tranche ratings from 157 US cashflow and hybrid CDO transactions are currently on watch negative.

The agency has also lowered 46 ratings on nine US trust preferred REIT CDO transactions because of stress in the residential mortgage markets, and another 11 ratings from five of these transactions are on watch negative. In all, the 413 downgraded cashflow and hybrid CDO tranches represent an issuance amount of US$17bn; the 585 cashflow and hybrid CDO tranches with ratings on watch negative represent an issuance amount of US$24bn.

In addition, it has lowered 226 ratings on US non-excess spread synthetic CDO transactions as a result of negative credit migration in US RMBS securities referenced by the transactions, and one rating from one non-excess spread synthetic CDO transaction is currently on credit watch negative. In all, the affected public and confidentially rated synthetic CDO tranches represent an issuance amount of US$5.8bn.

BIS reports on CDS
The Bank for International Settlements has released its latest statistics on positions in the global OTC derivatives market. These figures comprise the results of the second part of the Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity, as well as the regular sem-iannual OTC derivatives statistics.

Positions in the OTC derivatives market grew at a rapid pace over the period since the last Triennial Survey in 2004. Notional amounts outstanding increased by 135% to US$516trn at the end of June 2007, which corresponds to an annualised compounded rate of growth of 33%. This is higher than the roughly 20% average annual rate of increase since positions in OTC derivatives were first surveyed by the BIS in 1995.

Particularly rapid growth was reported in the credit segment, where positions in credit derivatives increased more than tenfold to US$51trn. CDS are by far the dominant instrument in this category, accounting for 88% of positions in credit derivatives.

Gross market values, which correspond to the cost of replacing all contracts at current market prices, increased at a lower rate (74%) than notional amounts, to US$11trn at the end of June 2007. Activity in the OTC derivatives market accelerated in the first half of 2007, with notional amounts of all types of OTC contracts increasing by 25%, following a 12% increase in the second half of 2006.

Alpaca CPPI for Pru M&G
Moody's has assigned an A1 long-term rating to the €70m Class A Alpaca Deferrable Interest CPPI notes due 2018 issued by Magnolia Finance VI under Series 2007-24. The transaction was arranged by Credit Suisse and will be managed Prudential M&G.

The structure ensures that there is always sufficient cash to purchase a zero-coupon at any time, using the cash available after sale of the reference portoflio or if need be a payment from Credit Suisse. Such a zero-coupon will enable the payment of the principal at maturity (together with a deferrable coupon of 50bp over Euribor).

The reference portfolio is comprised of long and short CDS exposures referencing mainly corporates. M&G will change the composition of the portfolio through time, providing it passes a model test based on the CDOROM model.

LSS notes downgraded
Fitch has downgraded three leveraged super senior notes issued by the Magnolia Finance V vehicle and arranged by Credit Suisse. The US$28m Series 2006-3 has been downgraded from double-A plus to single-C, the US$14.9m Series 2006-4 from triple-A to triple-B plus and the US$1m Series 2007-6 from double-A plus to single-C.

The downgrades are a result of a breach of the current weighted average rating factor (WARF) trigger. Current WARF for 06-3 is 12.94, with Fitch having downgraded 29.86% of the portfolio between two and eleven notches since end-October.

Current WARF for 06-4, with Fitch having downgraded 7.55% of the portfolio between four and nine notches, while the corresponding figures for 07-6 are 12.75 and 22.53% of the portfolio between two and ten notches. Should the weighted average credit rating of the reference obligations breach pre-specified trigger levels within a specified period, investors have the option to unwind the trade or de-lever their position by posting further note principal.

Negative rating action for PREPS
Moody's has placed under review for possible downgrade the Class B notes issued by the PREPS 2006-1 and 2005-2 transactions, following defaults in their portfolios.

PREPS 06-1 has suffered its first default since inception, totalling €10m of losses, or 3.1% of the portfolio. PREPS 05-2 has suffered its second default since inception, totalling €17m of losses, or 4.7% of the portfolio.

SIV-lites downgraded
S&P has lowered and retained on negative watch its ratings on the Mezz Tier 1, Mezz Tier 2 and capital notes issued by Sachsen Funding I. It has also lowered and placed on watch negative its ratings on all classes of notes issued by Duke
Funding High Grade II, as well as lowering to single-D its ratings on the notes issued by Golden Key and Mainsail II.

The rating actions on Sachsen Funding and Duke Funding High Grade are based on the current portfolio values and a lack of confirmed restructuring proposals. These vehicles are not in an enforcement mode of operation.

However, were they to liquidate all their assets at the current market valuations reported to us by the manager, it is unlikely that all tranches would be repaid in full. In addition, previous restructuring discussions have not led to any firm proposals.

The rating actions taken on Golden Key and Mainsail II reflect their modes of operation and the fact that since going into enforcement, investors have not been paid amounts due on liabilities. The vehicles remain at risk from further market valuation declines and are therefore placed on credit watch negative.

Permacaps report
Cambridge Place Investment Management's Caliber and Cheyne Capital's Queen's Walk Investment (QWIL) permanent capital vehicles have released their results for Q3.

As at the close of business on 30 September, Caliber's unaudited adjusted NAV per share was in the range of US$1.20 to US$1.30, against an unaudited adjusted NAV of US$1.64 at 31 August. The movement in the unaudited adjusted NAV reflects further deterioration in pricing during September.

The unaudited adjusted NAV excludes those non-recourse SPVs which contributed negative net assets to the unaudited consolidated NAV. This figure was in the range of US$0.05 to US$0.15 at 30 September.

Meanwhile, QWIL reported an operating income for the quarter of €9.7m, equating to operating income per share of €0.24 compared to €12.3m or €0.30 per share in the previous quarter. Earnings in the quarter of -€0.6m or -€0.01 per share compared to -€3.2m or -€0.08 per share in the previous quarter.

Distributable income in the quarter was €7.6m or €0.19 per share compared to €8.8m or €0.22 per share as at 30 June 2007. NAV was €6.90 per share as at 30 September 2007 versus €7.01 per share as at 30 June 2007.

Following the completion of the tender offer, approved on 8 October 2007, the NAV per share was €7.07. The board of directors has declared an interim dividend of €0.15 per share for the quarter.

Fair value write-downs of the company's investment portfolio in the quarter totalled €8m or approximately 2.2% of the 30 June 2007 gross asset value. These write-downs resulted principally from continued deterioration in the US sub-prime market and wider market discount rates applied to the company's three CDO residual positions.

CS

CDS market signals cheap IG bonds

John Hunt, senior research analyst at Credit Derivatives Research, looks at hedging opportunities for investment grade bonds

Bonds continue to trade cheap to their CDS-implied fair values, so hedging corporate bond risk with CDS remains an attractive proposition. We combine our CDS-implied bond values and MFCI score with Gimme Credit's fundamental scores and to recommend specific bonds to buy and avoid.

The low-trading-volume days around Thanksgiving haven't changed what the CDS market is saying about corporate bond prices, and our bottom line is: investment-grade bonds are trading cheap to their CDS-implied fair values – about US$1 cheap per US$100 of face value. See Exhibit 1.

In other words, investors are being paid more to take credit risk in the cash market than they pay in the CDS market to lay the risk off. Credit spreads for corporate cash instruments are too high relative to the credit spreads we see in the CDS market.

Our results don't necessarily mean that now is the time to increase exposure to US investment-grade credits. Indeed, our overall outlook is just the opposite – we believe credit spreads are likely to widen. However, they do mean that using CDS to hedge the credit risk of bond investments is relatively cheap at the moment.

Exhibit 1

Twenty cheapest, twenty richest to fair value
Our model also supports the specific buy-sell recommendations in Exhibits 2 and 3. These exhibits present the 20 richest bonds to CDS-implied fair value and the 20 cheapest, along with the issuer's Gimme Credit fundamental credit score and our own fundamental-based MFCI score. We recommend buying the cheap bonds with improving fundamentals (the Reynolds 7 5/8s of June 2016 and Norfolk Southern 7.7s of May 2017) and selling the rich bonds with deteriorating fundamentals (the Macy's 5.9s of December 2016, Pfizer 4 1/2s of February 2014, Weyerhauser 6 3/4s of March 2012, Temple-Inland 6 3/8s of January 2016, and du Pont 5 1/4s of December 2016).

Our cheap bonds average about US$3.50 cheap and our rich bonds average about US$1.80 rich. As Exhibit 1 illustrates, the intermediate five-to-eight year maturity range is the most attractive for buyers. We also note that the regression fit has edged slight higher (bonds have got slight richer) overall.

Financials rich, energy cheap
Financials are our richest sector (averaging US$0.50 rich) as CDS spreads have continued to soar on credit-crunch exposure. Technology bonds are the only other rich sector, at US$0.20 average richness.

The energy and industrial sectors are trading cheapest (by US$1.90, and US$1.80, respectively). Rating differences explain some of this: the financial and technology issuers in our universe are higher-rated than the energy and industrial names and lower-rated investment-grade bonds tend to trade cheaper to CDS-implied prices. Bond investors are more exposed than CDS protection sellers to the risk of forced sale on downgrade to junk and we'd expect them to demand price concessions.

Our lists identify potential pairs trades in a number of sub-industries (rich bond issuer(s) before the "v.", cheap bond's issuer after): consumer finance (Capital One v. SLM), movies and entertainment (Disney v. Time Warner), aerospace and defence (Boeing v. Raytheon), and paper and packaging (Temple-Inland v. PCA).

We also see a potential curve play on mortgage REIT iStar Financial. Its bonds are trading rich in the five-year maturity and cheap in the ten-year. We suspect that investors have overdone it a bit in shortening duration of their cash exposure to this hard-hit credit.

Exhibit 2 - rich bonds

Exhibit 3 - cheap bonds

Methodology
For investors who trade both bonds and CDS, the rich and cheap bonds are candidates for positive and negative basis trades, respectively. (Some rich bonds show a small negative basis, primarily due to differences in maturity between the bond and the closest-maturity CDS.)

For bond-only investors, we highlight buy and sell recommendations in green and red, respectively. We combine fundamental analysis with signals from the CDS markets to arrive at these recommendations.

We recommend buying bonds on our lists that meet these criteria: (1) Name has "Improving" Gimme Credit fundamental score; (2) Name scores in the top quartile according to our MFCI index, which measures whether CDS are selling rich or cheap relative to fundamentals-based measures of default probability; (3) Bond sells cheap to CDS-implied price. We recommend selling bonds that have the opposite characteristics ("Deteriorating" Gimme Credit score, bottom-quartile MFCI score, bond rich to CDS-implied price.

We determine the CDS-implied price as follows: CDS spreads, taken together with an assumed recovery rate, imply a probability that a firm will default in any given time period. These implied default probabilities can be used to price bonds by discounting each promised payment under the bond to account for the probability that the bondholder will not receive the payment (and will receive the recovery value of the bond instead). This is a better way of dealing with credit risk than increasing yield spreads, because it expressly takes into account the probability that each promised payment will not be received.

Our tables reflect the market prices that in our judgment are the best available to us at the time of writing – 26 November 2007.

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).