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Problems for Paulson plan?

Rate freeze could come unstuck by its voluntary nature

US Treasury Secretary Paulson's proposal to freeze interest rates on certain sub-prime mortgages has been broadly welcomed by the market, with the ABX and CMBX indices rallying on the news. But the voluntary nature of the scheme may mean that it is less effective in stemming losses than it could be.

Under the Paulson plan, lenders and regulators have temporarily agreed to freeze interest rates on qualifying sub-prime mortgages for a period of five years. ƒnIn order to be eligible, borrowers must have taken out loans between 1 January 2005 and 31 July 2007 which are due to reset between January 2008 and July 2010. Additionally, they must not be more than 60 days delinquent over the past year, must have less than 3% equity in their homes and must be unable to afford an upward adjustment in their interest rate.

Borrowers with credit scores below 660 would be given priority provided their scores have not risen by more than 10% from origination; borrowers with scores above 660 would be scrutinised more closely. Congress may also be considering legislation that provides "a safe harbour from legal liability" to mortgage servicers.

Analysts at Wachovia Securities note three take-aways from the proposal: it provides some support to the housing market (home prices) by reducing the potential supply of foreclosed properties; for the most part, ABS and CDO noteholders should benefit from reduced expectations of default and the commensurate increase in asset valuations; and that it will likely only partly alleviate the credit crunch.

Other observers point out that, while fewer foreclosures is obviously better, the scheme will only have a positive impact on a minority of investors in a minority of deals. "The Paulson plan won't help older RMBS transactions that are already in trouble, the CDOs that reference those bonds or the borrowers who are already experiencing delinquencies," says one. "It will make losses experienced by AAA/AA noteholders a little less likely, but won't make any difference to A/BBB noteholders." Estimates differ as to how much losses will be reduced by as a result of the proposal, but it is likely to be in the region of 2% out of an overall expected 15-20%.

The main criticism of the plan is that it is entirely voluntary. "There is a concern that any such modification made to a mortgage underlying an RMBS may be contrary to the terms of the securitisation ¡V and so the scheme has been made voluntary in order to minimise the risk of litigation. Borrowers may end up being stymied by documentation," notes one ABS trader.

Some evidence of this difficulty emerged at the beginning of the year, when US mortgage servicers were encouraged to begin a programme of individual loan modifications, but their progress was limited by the terms of some securitisations. Apart from states legislating in favour of the scheme (which would likely turn into a long and messy process), it appears that the only measure which would be meaningful across the board is government-sponsored enterprises broadening their programmes to allow sub-prime borrowers to refinance their mortgages into 30-year fixed rate loans at an affordable rate.

But the regulatory authorities are unlikely to allow this to happen, given previous accounting problems at the mortgage agencies and the fact that they're currently in the process of shoring up their capital base. "A programme of mass refinancing is the only way to affect broad-based improvements in the short-term. It might be possible for the mortgage agencies to revisit this later on in 2008, but by then a whole raft of prime mortgages will begin resetting. We're already seeing delinquencies and subsequent rating downgrades coming through in the US prime and Alt-A space," the trader concludes.

CS

M-LEC overshadowed

Municipal investors could complicate SIV restructurings

M-LEC appears to be becoming increasingly irrelevant, with most European SIV sponsors preferring to pursue their own restructuring arrangements. However, the emergence of a raft of unsophisticated US municipal investors in SIV debt is likely to complicate some restructuring efforts.

BlackRock on Friday confirmed its role as the adviser to M-LEC (see SCI passim), which would see it buying SIV assets and then deciding whether to sell a security at a particular price or hold it until maturity. Each of Bank of America, Citi and JP Morgan are expected to contribute US$5bn to US$10bn into the fund and then raise more money from other financial institutions. Wachovia is the only additional bank to agree to participate in the fund so far.

Slated for launch at end-January, the size of the 'super-SIV' is believed to have been slashed to around US$50bn. Some observers say that the fee required for selling assets into the vehicle – reportedly at around 1% – is expensive, given that sellers must also agree to take a haircut (which can rise or fall with the assets' quality). Others say that the rescue fund represents too little, too late.

"There has been a rapid decline in portfolio valuations since M-LEC was first mooted, with many SIVs experiencing losses too quickly to wait for its launch. The majority of SIVs, if they haven't already been restructured, will have gone into enforcement by end-January and so won't be in a position to negotiate with the vehicle," comments one structured credit investor.

Together with straightforward de-levering of the vehicles via asset sales, SIV restructurings are emerging in the form of asset switches (or 'vertical slices'), changes in the funding mix, the addition of conduit-like features or amending documentation to eliminate various triggers. While most buy-siders believe that SIV managers are trying to preserve value as best they can within the operating guidelines, there is significant concern about whether unsophisticated investors – in particular US state treasurers and municipal funds – who hold SIV CP and capital notes would be able to agree on any such restructuring.

According to one dealer: "In a SIV restructuring investors typically only have two options: accepting a haircut on their holdings; or participating in an asset switch. Neither of those options is available to US municipal funds, which are only allowed to invest in short-dated highly-rated paper. Plus, any restructuring effort is likely to get bogged down in litigation because these investors won't accept less than par for the assets."

Certainly, any SIV restructuring that involves municipal funds is likely to be a long and painful process, potentially turning into a scandal given that these treasurers are elected by the public. The dealer adds that a sensible move would be for them to club together and hire an expert, like the State of Florida has done.

"Florida has hired BlackRock to take over the affected funds," he observes. "Investors have been allowed to withdraw a portion of their funds and BlackRock will work the rest out, including selling some of the more liquid assets down over the next few months. If other municipal funds took on outside advisors, it could facilitate block votes on restructurings."

Standard Chartered recently undertook an asset switch, exchanging US$140m of capital notes with one investor for a pro-rata vertical slice of US$1.68bn in assets from its SIV, Whistlejacket, with more such exchanges expected before year-end. Dresdner Kleinwort is also thought to have taken a similar approach with its K2 vehicle.

The restructuring of the Victoria SIV is one example of a change in the funding mix, meanwhile, whereby a vertical slice of its portfolio (US$120m of capital notes and US$2bn of assets) was transferred into a CDO with term financing called Farmington Finance (presumed to be retained by Citic Bank). Other SIVs, such as Eaton Vance Variable Leverage Fund, have issued longer-dated MTNs to relieve the pressure of maturing short-term funding.

Many SIVs – including those sponsored by Citi and HSBC – have been refinancing liabilities in the repo market since August (Citi reduced its SIV exposure from US$80bn to US$66bn). And in terms of adding conduit-like features, Citi has also provided a liquidity facility with traditional terms, which covers a small portion of outstanding CP.

Other vehicles have been supported by bank sponsors buying back the CP or by providing liquidity facilities. For example, WestLB has established a cash account that benefits Kestrel Funding and Harrier Finance Funding's senior investors.

And HSH Nordbank has set up a combination of repurchase facilities to fund maturing CP and senior MTNs in its Carrera vehicle, while HSBC is restructuring its SIVs – Cullinan and Asscher – into new vehicles that will benefit from a 100% liquidity facility. Rabobank and SG are also set to take the remaining €5.2bn and US$4.3bn assets of their Tango Finance and PACE SIVs respectively onto their balance sheets.

CS

Capital idea

Credit spreads and equities diverge further

Bank capital raising is driving the decoupling of credit spreads and equities even further. While credit spreads in the non-financial sectors are expected to continue underperforming versus equities, credit is thought likely to outperform on financials going into 2008.

"This is because corporates are still re-leveraging [see SCI issue 37] – just look at the volume of M&A activity that has been announced in the last month, for example," explains Hans Peter Lorenzen, credit strategist at Citi.

However, because financial names have been hurt by write-downs and liquidity issues, many banks should enter 2008 with weaker corporate ratios. "In response, we expect some will bolster their ratios by cutting dividends and issuing new capital. Additional subordination should unequivocally benefit credit but it is much less positive for equities, not least given the dilution of existing shareholdings," Lorenzen adds.

Lower Tier 2 financial spreads in particular are attractive, agrees Rajeev Shah, credit strategist at BNP Paribas. But he also considers non-financial valuations to be rich, especially at the triple-B level.

"We think the relationship between financials and non-financials will reverse in 2008. Non-financials do not compensate sufficiently for the expected growth slowdown and the increase in leverage," he adds.

Indeed, this trend was highlighted in a recent BNP Paribas credit survey: respondents expect further widening and so are positioned to be overweight defensive sectors, such as utilities. "The majority of investors are still bearish on the outlook for spreads – significantly more so for high yield. High yield spreads have much further to go, as the default cycle will accelerate next year (as also anticipated by the rating agencies) with the slowdown in growth," notes Shah.

Moody's reports that its global speculative-grade default rate drifted lower in November, ending the month at 1% down from 1.1% in October. The agency's default rate forecasting model predicts that this level will rise sharply to 4.2% a year from now, after finishing this year at 1.2%.

"Our baseline forecast incorporates a slowing US economy in 2008 but no recession," says Moody's director of corporate default research Kenneth Emery. "If a recession were to materialise, default rates could increase to near double-digit levels."

In general, in terms of the credit cycle, the jury is still out as to how 2008 will develop. "The market is divided over whether we are at the end of another economic cycle or whether we are just experiencing an extended period of weakness within an expansion phase," explains Lorenzen. "As credit strategists, we are not expecting a turn in the credit cycle just yet. In other words, we expect more corporate re-leveraging, not de-leveraging. This could change, should the economic slowdown turn out to be much longer and more severe than our economists currently expect."

UBS announced on Monday, 10 December, that it plans to raise capital following its admission of another US$10bn in write-downs on its sub-prime (mostly CDO and super senior) holdings. The bank will issue a total of SFr13bn via a 9% coupon two-year mandatory convertible to Government of Singapore Investment Corp (accounting for SFr11bn) and an anonymous gulf investor (SFr2bn). It will also sell SFr2bn of treasury stock which had been up for cancellation and a SFr4.4bn bonus issue (replacing the cash dividend for 20007 with a stock dividend).

The move comes after Citi announced a US$7.5bn capital injection via an equity sale to the Abu Dhabi Investment Authority at the end of November (see SCI issue 66) and has fuelled rumours about such activity occurring at other broker-dealers too. Lehman Brothers, Bear Stearns, Goldman Sachs and Morgan Stanley are all due to report over the next week or so.

CS

EODs rise

Concern mounts about potential asset overhang

The triggering of events of default (EODs) in ABS CDOs continues apace. As the third liquidation of such a portfolio comes to light, dealers report a dampening in activity on concerns over a potential asset overhang.

"Current buy-side activity really only comprises short position covering. There isn't much fundamental investing going on because of the overhang from SIV and US CDO unwinds," one dealer explains.

Controlling investors in Vanderbilt Capital's US$500m Montrose Harbor CDO I are understood to have voted on Friday, 7 December, to accelerate repayment of the notes after par erosion triggered an EOD. Moody's downgraded the transaction and left the senior notes on rating watch negative.

Prior to this, State Street Global Advisor's Carina CDO (see SCI issue 64) and Credit Suisse Alternative Capital's Adams Square Funding I transactions were liquidated after the Class A overcollateralisation ratio fell below 100%. The collateral from the Adams Square liquidation yielded, on average, the equivalent of a market value of less than 25% of par value.

According to the notice from the trustee, the sale proceeds from the liquidation of the cash assets, along with the proceeds in the collateral principal collection account, super-senior reserve account and CDS reserve account were not adequate to cover the required termination payments to the CDS counterparty. As a result, the CDO had to draw the balance from the super-senior swap counterparty.

The trustee anticipates that proceeds will not be sufficient to cover the funded portion of the super-senior swap in full and that no proceeds will be available for distribution to the other noteholders. Consequently, S&P lowered its ratings to single-D and Moody's to single-C on the senior swap and Class A, B1, B2, C, D and E notes issued by Adams Square, totalling US$487.3m of paper.

A further 12 transactions are thought to have breached par value-based EOD triggers and could be liquidated at the request of the most senior class of investors. While liquidation is not the best course of action for value preservation, the sheer amount of similar deals in the market means that liquidation is likely to be selected often in an attempt to work out the sub-prime assets as quickly as possible, note analysts at RBS.

As of 10 December, S&P had received 39 notices from CDO trustees of a breach of the O/C ratio test EOD for ABS CDOs. These transactions include: 24 mezzanine SF CDOs collateralised primarily by single-A through double-B rated tranches of RMBS; 10 high-grade SF CDOs collateralised primarily by triple-A through single-A rated tranches of RMBS; and five CDO-squareds.

Over the last week the agency has placed several tranches of Octans III CDO, Rockbound CDO I, Cetus ABS CDO 2006-3, Armitage ABS CDO, Brooklyn Structured Finance CDO and Millstone IV CDO on rating watch negative due to EOD triggers being breached. S&P has also downgraded Sagittarius CDO I, which may have to begin liquidating cash assets if it is unable to make required payments under the CDS agreements.

Meanwhile, Moody's has downgraded Markov CDO I due to a breached EOD trigger, and placed six classes of the US$1.7bn G Square Finance 2007-1 on watch negative in response to credit deterioration in the underlying portfolio and a potential EOD. Collateral consists of approximately 240 US structured finance assets, of which 60 are currently on watch for downgrade.

While punitively high year-end funding rates are also contributing to the lull in activity, some positive news has emerged for the European market in the form of demand from specialist ABS funds. According to the dealer: "The funds have recognised a buying opportunity – although there is still a difference in opinion on asset prices between buyers and sellers, this suggests that there will be increased demand for paper next year."

CS

Structured credit hedge funds dip again

Latest index figures show another drop in returns, but 50% stay positive

After a brief respite in September (see SCI issue 62), both gross and net monthly returns for October 2007 in the Palomar Structured Credit Hedge Fund (SC HF) Index returned to the pattern seen since the credit crunch and dropped again on the month. The latest figures for the index were released this week and show a gross return of -0.64% and a net return of -0.76% for October. Nevertheless, 16 out of 32 funds were able to report positive results.

The dispersion of returns was lower than observed in September. In terms of sub-strategies, two - 'long investment grade leveraged' and 'long junior, value oriented' - once again reported negative results in October, while 'short bias' and 'multi-strategy' sub-strategies fared best.

Three funds were removed from the indices at the end of the month for non-compliance with index guidelines. As a result, the total number of funds in the index now stands at 32, from a high of 40 as of 1 July 2007.

Overall, the gross and net indices' cumulative returns since calculations began in January 2005 stood at 101.17% and 95.40% respectively on 31 October 2007. For more Index data click here.

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

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

CS

EM manager launches

The latest company and people moves

EM manager launches
Marketing is underway for a new asset manager that will specialise in emerging market-focussed mutual fund, hedge fund and structured credit strategies. Global Evolution leverages strongly off the extensive EM experience of Sydbank (see SCI issue 22); even the name has echoes of Sydbank's and the world's first EM CDO – Evolution. Notably former mds at the bank, Søren Rump and Morten Bugge are the new firm's ceo and cio respectively – although not all of the firm's 16-strong staff have moved directly from the Danish Bank.

In addition to portfolio management of both pooled/segregated/customised EM mutual funds and EM hedge funds, Global Evolution offers structured credit portfolio management of traditional full capital structure cash deals, single-tranche synthetic CDOs and hybrids. Furthermore, through partnerships with international investment banks and distribution partners, Global Evolution offers tailor-made structured solutions based on customised or existing portfolios – such as capital protected notes (CPPI, DPI etc) and notes giving investors exposure (potentially in a leveraged format) to the outperformance of Global Evolution.

Calyon gains one head but loses another
Pierre Trecourt, Calyon's head of structured credit markets for Asia ex-Japan, will be moving to London to take up a position as global head of credit structuring – a role that was previously occupied by Rayas Richa, who left in October (see SCI issue 60). In his new role Trecourt will report to Benjamin Jacquard, global head of structured credit markets. Based in Hong Kong, Samy Beji is replacing him as head of structured credit markets for Asia ex-Japan.

Meanwhile, Edouard Bremond, previously global head of cash CDO structuring, has left the bank.

Deputy exits
Officials at SG CIB confirm that former deputy head of securitisation for Europe, Richard Hopkin, has left the bank to pursue new opportunities. Rumour has it that he is to join a monoline.

RBS GCM head leaves
Fred Matera, head of CDOs at RBS Greenwich Capital Markets, is understood to have left the bank. It is unclear whether his departure is part of additional staff cuts in the CDO group after those seen in August (see SCI issue 53).

One sales switch...
Renzo Arcoria, formerly head of Southern European structured credit sales at Bank of America, has joined Barclays Capital as head of Italian bank coverage for structured credit.

...and another
Deri Bainge, formerly vp in structured credit sales to Germany and Austria at Bank of America, has joined Nomura in London in a similar role.

Paladyne and Markit team up
Markit Group and Paladyne Systems, a solutions provider for the hedge fund industry, have announced the certified integration of Markit's credit pricing and reference entity data into the Paladyne suite of products.

The two firms say that hedge fund professionals will benefit from a completely integrated credit derivative workflow within Paladyne security master and Paladyne price master products, resulting in increased accuracy, efficiency and standardisation of derivative trading with counterparties. Paladyne has integrated Markit RED, Markit iTraxx and Markit CDX index constituent data, single name credit curves and other Markit content.

AMG buys into BlueMountain
Affiliated Managers Group, a diversified asset management company, and credit alternatives manager BlueMountain Capital Management have announced that AMG has acquired an equity interest in BlueMountain's business. BlueMountain's management team continues to hold a majority of the equity in the company and, consistent with AMG's partnership approach, will retain operating autonomy to manage the business.

Sean Healey, AMG's president and ceo, comments: "BlueMountain is an excellent addition to our top-performing group of affiliates, and the credit alternatives segment further diversifies our participation in alternative investment strategies. With this investment, we continue to build on our track record of successful investments in high quality alternative firms, which are attracted to our proven partnership approach. We believe that secular growth in alternative investments will continue, and that our enhanced exposure offers the potential for meaningful upside to our earnings going forward."

As part of the transaction, BlueMountain's six managing partners have signed long-term employment agreements with the company and AMG. The managing partners will invest a significant portion of the proceeds from the transaction in BlueMountain's products. BlueMountain's management, investment philosophy and process will remain unchanged.

MP

Moody's extends SIV review

A round up of this week's structured credit news

Moody's extends SIV review
Moody's has extended its review period for SIVs due to the receipt of new, material information about possible changes to these issuers' operations. In some cases, SIV managers are contemplating changes to their management strategies with the objective of reducing market value risk for senior debt investors, while in other cases SIV managers are in the process of implementing restructuring proposals that would provide more protection to senior debt holders (see separate news story).

Given the complexity and evolving nature of these wide-ranging remedial measures, Moody's requires additional time to thoroughly evaluate the rating impact of each SIV's unique action plan. In addition, the agency will announce the conclusion of its individual SIV reviews as they occur, rather than upon the completion of a sector-wide review, in order to avoid unnecessary delay in communicating its rating actions to the public. It expects to conclude its review of most of the affected SIVs within two weeks.

S&P takes action on SIVs
S&P has placed its ratings on the CP and MTNs of Orion Finance Corp, PACE and Harrier Finance Funding on credit watch with negative implications. In addition, it has lowered its ratings on all the capital notes issued by the SIVs it rates, affecting a total of 14 ratings.

At the same time, it has assigned a negative outlook to the issuer credit ratings (ICRs) on 18 SIVs. SIVs that already have senior ratings on credit watch negative maintain their ratings.

The rating action on Orion Finance is a result of the vehicle's move into the enforcement mode of operation, while PACE is very close to breaching its capital adequacy test. If a breach occurs, the vehicle would enter into enforcement.

The ratings on Harrier Finance, meanwhile, reflect the fact that the NAV has fallen below 50%, as well as a higher concentration of assets that S&P deems to currently have high price volatility (defined as ABS CDOs and US sub-prime, Alt-A and closed second-lien RMBS) compared with its peers.

S&P's analysis includes a review of the asset, liability and operational condition of each SIV, as well as the leverage of each vehicle on a mark-to-market basis. A credit watch placement has not been applied to the ratings on those SIVs that are maintaining their stability in these areas. Furthermore, the ratings on SIVs that are actively funding in the general marketplace, or have already submitted advanced restructuring plans that have few or no open questions associated with those plans, are also not placed on credit watch negative.

Rating actions on the junior ratings are based on an analysis of key rating factors that include the following: NAV, realised losses from asset sales, and the value of the portfolios' exposure to assets considered to be at risk of liquidating at lower than the current reported prices. Portfolios combining low NAV and high concentrations of risky assets have generally seen more significant downgrades.

S&P confirms that it has reviewed amendments to operating guidelines that establish conditions under which SIVs may operate as if they are in a restricted funding mode without actually having to formally enter that operating state. The agency is also currently evaluating proposed new structural guidelines that would enable SIVs to tap the CP markets, in addition to the MTN and capital markets, for their funding.

Some SIVs have also reviewed their documentation in an attempt to reduce the likelihood of an enforcement, or at least to delay enforcement, as they pursue restructuring options. Examples of amendments include Victoria and Kestrel, which each amended their operating guidelines to update one or more conditions precedent to a resulting enforcement.

An additional path that SIV managers have pursued is to amend the vehicle's operating guidelines, including focusing on the so-called 50% NAV triggers. This feature in a vehicle's documentation can read very differently: in some SIVs, the consequence of the capital note's market value falling below 50% is a defeasance or a restricted funding; in others the documentation proscribes an enforcement as the consequence of breaching the 50% NAV trigger; while others still only reference the realised loss of 50% of the NAV of the capital note.

Analysts at S&P note that, in general, SIV managers are doing what is expected of them by the agency. "Managers are successfully selling assets in the open market, executing asset switches with capital investors, and trying to manage the structures toward potential 'soft landings'. Indeed, our ratings analysis for SIVs assumes that assets would be sold at some point and that the presence of the manager would be potentially superior to a receiver or security trustee, as the manager would strategically and creatively pursue all options to get senior obligations paid in full."

The agency continues to monitor all SIV ratings and is in talks with managers regarding all aspects of the vehicles. The agency says that in its future analytic framework, it will:

- Address contagion risk;
- Consider the use of index information as a source for trading prices because the use of indices can be challenging, given what's being observed in the ABX index;
- Consider whether structured finance assets are viable assets to be funded in market value structures. Values of structured finance assets have in certain circumstances shown a lack of transparency, and it doesn't help that structured finance documentation is far from standardised and that there's no place to see daily marks on traded or held assets;
- Review its market value assumptions for frequently-traded asset sectors;
- And review assumptions regarding funding gap and asset/liability analysis.

Rating agencies comment on loan modification
Both Moody's and S&P this week released reports on loan modification and loss mitigation strategies (see lead news story for more on this topic).

Moody's cites insufficient use of loan modifications, along with underlying loan defaults and home price depreciation, as a contributing factor to recent sub-prime RMBS downgrade actions. The agency believes that judicious use of loan modifications can be beneficial to securitisation trusts as a whole.

Based on its recent servicer survey results, the number of modifications
to date has been relatively small. The proposed framework seems to provide a reasonable approach for identifying borrowers suitable for streamlined modifications and should expedite the number of modifications going forward.

Time will tell how successful servicers are in identifying and modifying the loans most appropriate for modification, Moody's says. The ability of servicers to determine a borrower's eligibility for FHA Secure or other refinancing options may vary, since a servicer's expertise generally lies in servicing and not in underwriting. Larger servicers with both servicing and origination arms may be better equipped to manage this process.

Generally speaking, a higher level of interest rate modifications should decrease delinquencies post-reset, thereby also potentially contributing to ratings stability for securities backed by sub-prime collateral.

Meanwhile, freezing interest rates on US sub-prime adjustable-rate mortgages (ARMs) could have a negative impact on certain US first-lien sub-prime RMBS unless they also lead to offsets in default frequency or loss severity, according to S&P's commentary. The agency supports appropriate loss mitigation strategies to prevent foreclosures and allow sub-prime borrowers to remain in their homes.

By extending the initial interest rate that homeowners paid during the fixed-rate period of their hybrid ARM loan terms, the potential for payment shock may be mitigated, thereby potentially reducing the risk of default. However, as a possible consequence of these actions, there may be a corresponding reduction in excess spread that was initially incorporated into our ratings analysis, S&P says. Although loan modifications that extend the mortgage's fixed-rate period may result in lower defaults, the reduction in excess spread may offset the benefits of lower defaults, resulting in diminished investor protection.

Moody's updates on monolines
Since outlining last month the approach it is taking to assess the impact of deteriorating conditions in the US mortgage market on ratings of monoline insurers, Moody's has received numerous enquiries from investors and other market participants regarding its specific analytic methods, process and timing for concluding this assessment, and the likelihood of ratings reviews or downgrades. As a result, the agency has updated the market about its analytic work and offered additional detail about its methods and process.

To assess the impact of continuing mortgage market deterioration on financial guaranty capital adequacy, Moody's is employing a two-pronged analytical approach. Under the first approach (the base case), it is re-estimating financial guarantor capital adequacy ratios using its traditional financial guaranty portfolio model, a transaction-by-transaction stochastic stress model, by updating the risk estimates associated with RMBS and ABS CDO exposures in light of its recent rating actions in these sectors.

Under the second approach (the stress case), Moody's is refining the stress case simulation model described in its 25 September report on financial guarantors' exposure to mortgage risk within ABS CDOs. Rather than applying the broad sub-prime collateral performance assumptions used in that earlier stress model, the new model draws upon the agency's pool-level performance assumptions for individual RMBS collateral types, thereby incorporating differences in collateral performance by vintage, asset type and lender.

In addition, the new model also considers the impact of projected timing of losses. Moody's intends to apply this updated stress model not only to ABS CDOs, but to other mortgage related exposures as well. These additional refinements are intended to provide greater confidence in the results and enable Moody's to better assess a guarantor's ability to withstand a range of stresses related to the ultimate performance of mortgage risk.

The decision to undertake additional stress case analysis reflects the uncertainty surrounding future mortgage market performance and the potential effect of different outcomes on guarantors' RMBS and ABS CDO exposures. The agency's approach is to assess the impact of different scenarios on a firm's capital adequacy by comparing model results against Moody's established capital benchmarks. As part of this process, it is reviewing specific transactions that result in significant modeled loss contributions in order to confirm its understanding of each one's structure and to identify the specific risk characteristics that lead to such modeled losses.

There are three factors that will largely determine whether Moody's takes rating actions on those financial guaranty insurers most exposed to deterioration in the mortgage markets:

1) Current capital adequacy – whether the guarantor meets Moody's capital adequacy benchmarks for its rating;
2) Prospective capital adequacy – whether the guarantor will meet Moody's capital adequacy benchmarks in the near and medium term;
3) Strength of franchise and business model – whether the guarantor will be able to access, going forward, attractive business opportunities consistent with its rating level.

In prior research, Moody's identified five monoline financial guarantor groups as being most exposed to deteriorating performance of RMBS – CIFG, FGIC, SCA, AMBAC and MBIA. Based on further analysis conducted since early November, it continues to believe that CIFG is most likely to fall below Aaa capital benchmarks, though the monoline has announced a capital enhancement plan which would significantly reduce that risk.

Moody's also continues to see FGIC, SCA and AMBAC as somewhat likely to exhibit a capital shortfall under one of the stress models previously described. And with regard to MBIA, additional analysis of its direct RMBS portfolio leads the agency to believe the guarantor is at greater risk of exhibiting a capital shortfall than previously communicated; it now considers this somewhat likely. (MBIA has since received a US$1bn capital injection from Warburg Pincus.)

The agency expects to affirm ratings where it is satisfied about both the firm's capital adequacy and the robustness of its business franchise. With respect to capital specifically, an affirmation would likely occur only where the company's capital ratios are above Moody's benchmarks for the rating level. If capital fell below these benchmarks, it would assess whether the guarantor's capital remediation plan was reliably expected to result in the company exceeding the relevant benchmarks and over what timeframe.

Moody's would expect to review ratings for possible downgrade where the firm's capital adequacy is less certain over the near term. Specifically, capital would be below Moody's benchmarks for the rating level and any capital remediation plan would be either reliable but take longer to become effective (typically more than one quarter), or shorter term but less reliable.

It would expect to downgrade ratings without initiating a review where it believes the current rating no longer reflects the long-term financial strength of the firm, even considering the potential benefit of any credible capital remediation plan. Specifically, capital would be below Moody's benchmarks for the rating level and any capital remediation plan would be considered unreliable in returning the company to capital adequacy consistent with the current rating level.

There are a number of different vehicles that could well be used as part of an overall capital plan. Some of these – including quota share reinsurance, specific excess-of-loss reinsurance, aggregate excess-of-loss reinsurance and triggering contingent capital facilities – may have little execution risk and could be put in place quickly. Infusion of new capital could also take multiple forms but have more execution risk, varying based on the specific nature of the arrangements. The assessment of execution risk, therefore, will involve judgement that would be difficult to express in a set of criteria – though the agency says it would be conservative in evaluating the execution risk of any capital plan.

ESF releases draft data file format
The European Securitisation Forum has released the exposure draft of its CDOs Data File Format. In order to improve the efficiency, transparency, and usefulness of reporting on CDOs, the ESF, in concert with market participants, is recommending a standardised format for data files related to the performance of CDO transactions that are disseminated on a regular basis by trustees to investors and other interested parties.

The ESF welcomes comments on the files, with the comment period running from 12 December 2007 through to 14 March 2008. At the end of the comment period the association will review all comments and will issue a recommended data file format that will standardise the multiple formats currently used by trustees of CDO transactions in Europe.

The ESF CDO Data File Format currently include 350 fields and definitions of which 67 are required. Simultaneously in 2008, SIFMA will update its CDO Data File Format to match, so that there is a unique standard for CDO transaction reporting in Europe and in the US.

A key benefit is that the standardised, machine readable format for the data file will allow users to process the vast amount of data that are provided in reports on CDO transactions more quickly and efficiently. An end-user should be able to process and manipulate data files from any trustee that produces compliant files with a single import process.

Standardised values for specific fields will enable the users of the files to compare deals on a like-for-like basis, with assurance that the data points will be reported in the same context manner, no matter the origin of the report. The standardised values will help to eliminate confusion that arises when similarly named fields have different meanings depending on which trustee created the report.

One credit event for synthetic CDOs
During the third quarter of 2007, only one new credit event was called on corporate obligors in the synthetic CDOs rated by S&P, according to its latest report for that sector. The obligor, The Wornick Co, was only referenced in one transaction rated by the agency, and the final valuation resulted in a 55% average recovery rate.

During the period, final valuations were also received for credit events previously called on Remy International Inc (an auto parts and equipment manufacturer based in the US) and Insight Health Services Corp (a US-based provider of diagnostic imaging services). For these entities, final valuations resulted in average recovery rates of 94.8% and 15% respectively.

The cumulative global average recovery rate on credit events called through the third quarter of 2007 was approximately 39%.

The tightening global credit environment is not yet showing through in synthetic CDO credit events, nor in corporate default rates generally. The quarterly global corporate default rate fell to 6.7bp during the third quarter of 2007, from 6.9bp during the second quarter of 2007.

More European CDOs on review
Moody's has placed 18 tranches from nine European CDOs on review for downgrade. The rating actions are a response to credit deterioration of the underlying portfolios, which include exposure to downgraded US ABS CDOs of the 2006/07 vintage and to downgraded US sub-prime RMBS securities of the 2006 vintage.

They also incorporate Moody's view on the impact of exposure to other US RMBS and ABS CDO vintages, particularly 2005 and 2007. Further, these rating actions integrate the agency's view on the impact of exposure to US RMBS and ABS CDO tranches which are currently on review for downgrade, and in some cases, on review for further downgrade.

The rating actions impact the Linker Finance, Eirles Two, Coriolanus, Menton II CDO and Menton CDO IV deals. The proportion of ABS CDO assets present in these portfolios ranges from 14% to 43%, while RMBS ranges from 0% to 42%.

The rating action also affects Napa Valley VIII (Series 76 and 77), Napa Valley IX Series 81 and Chrome Funding (Series 15, 16 and 17) transactions. The proportion of downgraded ABS CDO assets present in these portfolios ranges from 0% to 4%, while downgraded RMBS ranges from 3% to 6%.

Of the European CDOs impacted, the most negatively affected are those containing US ABS CDOs assets that were originally rated Baa or below, due to the greater severity of downgrades already experienced by these securities.

Further downgrades for US CDOs
S&P has lowered its ratings on 101 tranches and affirmed another 47 from across 24 US cashflow and hybrid CDOs. The downgraded tranches have a total issuance amount of US$4.5bn, and all are from ABS CDOs collateralised by structured finance securities, including US RMBS.

All but 24 of the lowered ratings were on credit watch with negative implications before the downgrades. Thirty-five tranche ratings either remain on watch negative or were placed on watch negative today, indicating a high likelihood of future downgrades on these tranches.

To date, including actions on both publicly and confidentially rated tranches, S&P has lowered its ratings on 810 tranches from across 291 US cashflow, hybrid and synthetic CDO transactions as a result of exposure to RMBS securities that have seen credit deterioration, while 548 tranche ratings from 147 transactions are currently on watch negative. The downgraded tranches represent an issuance amount of US$30.1bn, and the tranches with ratings on watch negative US$24.8bn.

S&P will continue to monitor the CDO transactions it rates and take rating actions when appropriate. Additionally, the agency will continue to review its current criteria assumptions in light of the recent performance of RMBS assets and CDOs.

Jumbo SME CLO priced
Best SME 2007, the €7.5bn fully-funded synthetic balance sheet CLO for Rabobank, has priced. The retained €7.1bn triple-A rated 1.6-year Class A notes came at 15bp, while the privately-placed subordinated tranches priced at 85bp on the €123.8m double-As, 130bp on the €75m single-As and +230bp on the €120m triple-Bs. There was also an unrated Class E piece worth €48.8m.

The transaction references a portfolio of bank loans, and revolving credit facilities or overdraft facilities granted by Cooperatieve Centrale Raiffeisen-Boerenleenbank (Rabobank Nederland), or any affiliate, to SMEs in the Netherlands. The transaction aims to provide regulatory capital relief to Rabobank under Basel I.

UK NC RMBS exposure rising in CDOs
Fitch says that structured finance CDO exposure to UK non-conforming RMBS with negative outlooks is increasing. On 5 December 2007, Fitch assigned negative outlooks to 43 tranches of UK non-conforming RMBS.

Currently, there are 75 total UK non-conforming tranches with negative outlooks, with a total volume €3.8bn. Out of a universe of 94 European SF CDOs, 23 European CDOs now have a combined exposure of €432.4m to these RMBS tranches.

Negative outlooks alone will not result in downgrades at the CDO level, but future negative performance in the non-conforming sector would likely lead to CDO downgrades. While the majority of exposed CDOs continue to perform within Fitch's expectations, the agency will continue to carefully monitor exposure to the UK conforming sector.

The highest exposure of any Fitch-rated CDO to these RMBS tranches is currently 10.9% of the transaction's portfolio, while the average exposure across the 23 CDOs is 3.4%. The affected UK RMBS tranches referenced in CDOs are all in the triple-B or double-B rating category, and the CDO transactions are managed single-tier structures.

Ten CDOs are synthetic transactions and 13 are cash transactions. The CDO transactions' vintages range from 2001 to 2007. US and Asian CDOs have no exposure to these assets.

Two of the exposed CDO transactions were downgraded in November 2007 due to exposure to US RMBS sub-prime transactions. UK negative outlook exposures in these two portfolios are 2% of each portfolio. Given that rating actions in November 2007 were calibrated to anticipate future negative performance and that these exposures are relatively small, these transactions are expected to avoid negative rating action.

SROC results for Asia Pacific
S&P has placed its ratings on 15 Asia-Pacific synthetic CDOs on credit watch with negative implications, and placed its ratings on one other CDO on credit watch with positive implications. The synthetic rated overcollateralisation (SROC) levels for the ratings placed on credit watch negative fell below 100% during the end-of-month SROC analysis for November 2007, indicating negative rating migration within the reference portfolio. For the transaction placed on credit watch positive, the SROC increased above 100% at a higher rating level.

The November SROC report is due to be published soon. In the week following the publication of the November SROC report, a full review of the affected tranches will be performed and appropriate rating actions, if any, will be taken. The Global SROC Report provides SROC and other performance metrics on more than 3,000 individual CDO tranches.

Japanese synthetic CDOs hit
S&P has placed its ratings on 29 tranches relating to 19 Japanese synthetic CDO transactions on credit watch with negative implications. At the same time, the agency has affirmed its ratings on two tranches of two such CDOs, and removed them from negative watch.

The tranches removed from negative watch had synthetic rated overcollateralisation (SROC) levels that recovered to 100% or above during November's month-end run. The tranches that have been placed on credit watch negative had SROC levels that fell below 100% during November's month-end run.

SLSDs gain in importance
Fitch Ratings has published a special report on single loan sell-downs (SLSDs), a commentary addressing insights into its view on the emergence of SLSDs as a new asset class. It aims to provide national and international participants with an overview of the common structure for this product, the market dynamics and the components of Fitch's credit analysis.

"In the absence of a vibrant credit derivatives market, single loan sell-downs have emerged as an important asset category for risk management, as well as for funding purposes," says Peeyush Pallav, associate director in Fitch's Indian structured finance group. "We expect the market to continue on a robust growth trajectory for the foreseeable future and expand across a variety of issuers."

SLSDs are essentially loans originated by banks or non-banking financial companies (NBFCs) sold down to third-party investors through an SPV assignment. Owing to the ease with which they can be created, as well as the single borrower credit element and the relatively short duration, there is considerable demand for these instruments from both issuers and investors.

Yearly SLSD issuance volumes since their inception in 2002 have grown tremendously at a CAGR of around 35%. In recent years, the SLSD market has also evolved in terms of new structures, such as embedded put/call options and credit enhanced SLSDs, enabling the issuers to lend to a diverse set of obligors and securitise it at flexible tenors. In light of the growing volume of such transactions that have come to market in recent months, Fitch believes that this report will help market participants to understand the SLSD markets, as well as the associated risks and rationale behind the ratings of these instruments.

Fitch downgrades PREPS 06-1
Fitch has downgraded the Class B (to triple-B) and affirmed the Class A notes of PREPS 2006-1. The move follows a review of the transaction's performance after the initiation of insolvency proceedings of a portfolio company on 4 December, a debt restructuring moratorium of another company on 5 December and a default of a company in October 2007 for missing two payments.

The transaction's exposure for the above three companies are €4m (1.2% of the initial collateral pool), €9m (2.8%) and €10m (3.1%) respectively. As a result of the above defaults, the credit support available to the Class B notes has reduced and was deemed insufficient to support its previous rating.
As a result of these three events, the principal deficiency ledger (PDL) was debited with €23m, and the Class A notes will be amortised by the equivalent amount using excess spread from the portfolio. The current PDL balance is expected to be repaid to the Class A noteholders over the next seven payment periods, provided no further defaults occur within this timeframe.

The portfolio credit quality, which was assessed using a mapping approach, has deteriorated slightly since close but remains in the same weighted average rating quality category of BB+/BB.

TYGER Series 121 launches
Moody's has assigned a Aaa long-term rating to the €5m Financial Basket TYGER Notes due 2017 issued by UBS' ELM vehicle under Series 121. The transaction relates to the restructuring of the TYGER Series 103 CPDO notes (see SCI passim).

The rating of the notes is primarily based on: an analysis of the portfolio; the leverage formula; the promise of a coupon of 50bp over Euribor to noteholders; the legal structure of the transaction; and the credit quality of UBS as swap counterparty. Noteholders are exposed to a leveraged portfolio of financial names, comprising 50 equally-weighted10-year CDS exposures.

Quantifi releases waterfall tool
Quantifi has released a new GUI-based application for modelling, risk analysis and reporting of structured finance, corporate and synthetic CDOs based on waterfall payment rules. As the boundary between cash and synthetic structured products blurs, the market has been demanding more sophisticated tools that can analyse both cashflow and synthetic products on a single platform.

Quantifi has responded to this demand by working with several strategic clients to develop a new GUI-based application that allows modelling of cash flow CDOs within its existing platform. This new application, for the first time, allows clients to easily perform advanced Monte Carlo statistical analysis, as well as more traditional scenario-based analysis, for a wide range of instruments including CLOs, CBOs, MBS, ABS and CDOs of ABS. It also has the ability to tie in with popular deal and cashflow libraries.

Rohan Douglas, ceo and founder of Quantifi, says: "Quantifi delivered the first version of our new CDO modelling application in August of this year and we have been steadily refining and developing it since. Our clients' response has been overwhelmingly positive. We see this as a natural extension of our product set based on our clients' growing adoption of this asset class. We are keen to reaffirm our leadership position in structured credit analytics by providing a single platform for pricing both cash and synthetic transactions with an ease of use that our clients have come to expect."

Spread widening for Euro CLOs
Spreads on European primary CLO issuance widened again in Q3, pushing funding up to levels last seen in late 2003 and early 2004, according to S&P's latest periodical for the sector. Despite difficult secondary market conditions and weak investor appetite, 15 new CLOs priced in the third quarter compared with 20 in the previous quarter, and 15 in the comparable period in 2006.

This issuance level has occurred against a backdrop of a shifting of power to potential buyers, who might now be tempted by the wider spreads on new issuance or price discounts on existing inventory. However, although new issuance is possible, CLO arbitrage has come under pressure because of rising funding costs.

Unable to find a ready home for loans on their books, several banks are investigating the possibility of structuring static CLOs to help clear the overhang of unprofitable CDO warehouse portfolios and unattractive inventory (see SCI passim).

CS

Trading ideas: paint the town red

Dave Klein, senior research analyst at Credit Derivatives Research, looks at an outright short on Sherwin Williams

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

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

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

In this trade, we make an event-risk, fundamentals play on Sherwin Williams (SHW) in an outright short position. Given the lack of liquidity away from five-year CDS and the volatile gyrations of credit indices, this is the best trade available and possesses reasonable economics. We would love to find a positive carry position, but we believe the upside of a naked short on SHW (going long protection) outweighs the benefits of hedging with a credit index at this time.

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

Exhibit 1

SHW has rallied considerably over the past two years, although it has sold off a bit since its recent lows. Given the event-risk surrounding this name, discussed below in the Fundamentals section, this looks like an opportune time to short SHW.

Given our negative view for SHW, we want to be short the credit. We can take this position either by shorting bonds or buying CDS protection.

Given the lack of opportunity in SHW's bonds, we choose to express our view by buying CDS protection. With liquidity concentrated in the five-year maturity, we view this as the best opportunity and buy protection there. Although we are facing negative carry and roll-down, we choose not to hedge with a credit index at this time.

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

The trade has negative carry, which means we face a double challenge of paying carry and fighting curve roll-down. We believe that the challenge is worthwhile, given SHW's current levels and our outlook for the credit. Exhibit 2 charts the potential P&L for the trade in six month's time, taking transaction costs and carry into account.

Exhibit 2

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

Liquidity
Liquidity – i.e. the ability to transact effectively across the bid-offer spread in the bond and CDS markets – is a major driver of any longer-dated trade. SHW has good liquidity in the CDS market at the five-year tenor. However, given that the December roll is upon us, we recommend asking for a March 2013 level.

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

Carol Levenson, Gimme Credit's Chemicals expert, maintains a deteriorating fundamental outlook on SHW. While Carol expects paint sales to remain relatively strong for the time-being, she notes that the company should be preserving cash for its potential lead-based legal liabilities.

Carol further notes that, rather than following this more conservative course, SHW has raised its dividend, accelerated share buybacks and continued acquisitions. Her analysis points to "reduced financial flexibility" combined with "worrisome" short-term debt.

Summary and trade recommendation
With the market rally of the past two weeks, we take the opportunity to go short SHW, a name facing potential legal liabilities and the prospect of a slowdown in demand for its products. Although SHW has held up relatively well given the housing downturn, the company has eroded its financial flexibility by funding acquisitions, increased dividends and share buybacks with cash and short-term debt.

Back in May 2007, we put on a positive carry short on SHW, hedged with the CDX, and saw SHW rally modestly while the CDX sold off dramatically. Given this disconnect from the index, we view an outright short position as the best way to express our (continued) negative fundamental outlook for SHW.

Buy US$10m notional Sherwin Williams five-year CDS protection at 43bp to pay 43bp of carry.

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

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

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

Correlation markets: what price default risk?

The dichotomy of flattening credit curves together with rising equity correlation is discussed by Gregorios Venizelos and John Schofield of RBS' structured credit strategy team

The dramatic flattening of credit curves seen since July suggests there exists a substantial bid for default protection. However, the tranche market has seen equity correlation rise to all-time highs, which would appear to suggest that default protection is cheap. We analyse this apparent dichotomy.

Curve pain
Over the past couple of years, an extremely popular trade in single name and index CDS has been the DV01-neutral 5s10s steepener, whereby the investor would sell five-year protection and buy 10-year protection in a ratio that left them unaffected by parallel curve shifts. As credit curves at the 10-year point are typically quite flat, the trade would not only benefit from net positive carry, but also from net positive roll down as five-year protection decays much quicker than 10-year protection.

The then current market conditions also favoured hedged credit exposure as, although spreads were widely acknowledged as being too tight, there was no consensus over when widening would occur. Finally, it was also a popular LBO trade, as this kind of event tends to steepen curves in absolute terms (although 3s5s is much more sensitive). This increasingly crowded trade had driven credit curves steeper (monotonically so in Crossover) since 2004.

The trade off for this positive time value is the risk of default. Because the notional amount of 10-year protection is about half as much as that held in five-year, the position is net exposed to defaults. Additionally, the trade would suffer from extreme credit deterioration (more than would come with a LBO), as this normally sees credit curves flatten, or even invert.

In the benign credit environment of recent times, investors were happy to bear this risk, and were content to receive increasingly poor rewards for doing so.
This changed over the summer, as five-year spreads underperformed 10-year, causing mark-to-market losses on steepeners (see Exhibit 1).

Exhibit 1

Traders viewing the strategy as a carry positive "LBO option" started to exit as LBO risk retreated. Capitulation then forced curves flatter and, now at year-end, we have banks hedging out loan book nominal exposures by buying the cheapest protection – short dated, low spread names.

Default protection in tranches
We've established that a DV01-neutral curve trade is mostly spread-neutral, with an exposure to defaults and gaps wider in spread. This sounds similar to delta hedged equity, which is also exposed to default risk while having a first order indifference to spread levels.

So why are curves getting flatter even as equity tranches get tighter? Correlation is at a historically high level, indicating a drop in default risk (see Exhibit 2).

Exhibit 2

Why has correlation risen so much? We provide some reasons below.

- Index volatility has provided convexity gains for delta hedged equity risk. This long volatility position proved attractive as the index moved by 10bp or 20bp in a single day. Selling pressure on equity protection was the result.

- "Cheap delta" macro shorts on X-100% tranches. From a correlation viewpoint, these are equivalent to selling protection on 0-X% and therefore have resulted in higher correlation.

- Super senior unwinds and monoline hedging. Forced covering of long risk super-senior positions has driven correlation higher at the top of the capital structure.

Comparing reward for jump-to-default (JTD)
Absent from the list of rationale for higher correlation is any mention of default risk, as it simply wasn't at the forefront of strategy formulation. Higher correlation should result in less reward for bearing JTD risk as spread for selling equity protection is reduced.

To test this, we calculated the six-month time value of five-year iTraxx equity protection. This is simply the carry earned in six months, plus the estimated roll down, given static credit curves.

We then compared it to the present value of a default by an index constituent. If JTD risk is poorly compensated, then we should expect to see the time value per unit of JTD fall.

Exhibit 3 may come as a surprise. Despite a slight fall in the price of default protection since the summer, the current level is still substantially higher than it was for most of the prior twelve months.

Exhibit 3

As spreads widened, delta fell – which means that the index hedge's contribution to net JTD also fell. This has the effect of making the trade more exposed to defaults.

But higher spreads also increased the time value of equity, as expected roll down of the upfront price is greater and there is less index to pay for. The two effects largely offset each other, leaving the net effect of the correlation change rather small. Of course, JTD is not the sole consideration for an equity tranche, as a protection seller also expects to make gamma gains from dynamic delta hedging.

Repeating these calculations for the curve trade gives us Exhibit 4. As expected, this chart shows us that the cost of hedging default risk through the 5s10s curve is very high at the moment.

Exhibit 4

We compare in Exhibit 5 the reward versus risk profiles for both delta-hedged equity and the 5s10s curve, combining the two previous charts. The two actually appear to track each other, in the loose sense that they are higher now than they were a year ago. The effect of higher correlation can be seen in the slight decline in the equity's metric since the summer, but the overall magnitude is small.

Exhibit 5

Conclusion
Our calculations show that the cost of default protection in the tranched market is not as low as one would expect based on correlation alone. The pricing of JTD risk has not therefore decoupled from the untranched market.

On the subject of the dramatic flattening seen in credit curves, our strategists assign this to technical effects, such as relatively price-insensitive loan book hedging for year-end and also the capitulation of the crowded steepener trade. They expect steeper curves in investment grade credit to come in the new year.

We re-iterate our belief that correlation is too high in the tranche market. We previously recommended a short position in equity correlation on the back of substantial market chatter surrounding difficulties at ResCap. The market has calmed somewhat since then and correlation has been stable, leaving the trade with a small, negative 25bp mark-to-market.

We now think the fall in correlation will be delayed until January, with little trading taking place for the remainder of this month. To avoid the transaction costs associated with unwinding, then renewing the position, we suggest perseverance with any existing short correlation trades.

© 2007 The Royal Bank of Scotland. All Rights Reserved. This Research Note was first published by The Royal Bank of Scotland on 6 December 2007.