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Transparency deadline nears

Trade association hurries to meet European demands

The European Securitisation Forum is under the cosh to meet a mid-January deadline for providing the European Commission (EC) with detailed proposals on improving market transparency. The launch of RMBS and draft CDO data files (see last week's News Round-up) is part of a programme of initiatives that are due to be revealed next month in an attempt to avoid regulatory heavy-handedness.

"We're looking at improving transparency for both short-term and term securitisation instruments," confirms Marco Angheben, director at the ESF (a SIFMA affiliate). "A host of different measures are under consideration because the message is clear – unless the industry takes concrete steps to increase transparency, the regulators will act themselves."

The ESF is aiming to deliver details of its initiatives to the EC ahead of the EC's target of reporting to G8 finance ministers and European central bankers on what the industry intends to do to improve the market situation post-credit crunch in early 2008. It appears that the EC's concerns are driven by the lack of data on the extent of losses in the securitisation sector, as well as the lack of clarity on how illiquid assets can be evaluated.

Overall, the process is fraught with difficulty, according to securitisation market participants. They argue that the ESF's task is not made any easier by the fact that the EC appears to be unsure about what it wants.

"The Commission has to report to the member states who know that something bad and complicated has happened but don't quite understand what or how. The trouble is the EC is not really well-placed to explain it either and all everyone knows is they want it to stop – and that's too broad a brief," says one.

All of the ESF's initiatives – which have been put together in conjunction with industry representatives, regulators and other associations – have not yet been made public. But it is believed that they will be grouped into three areas: issuer best practices, investor best practices and a data portal.

Under the proposals, issuers will be required to provide free access to fundamental portfolio information on all public deals – although how this will be enforced isn't clear. The proposals also recognise that investors have historically relied too heavily on ratings and that better credit assessment processes should be put in place.

In addition, it is understood that a data portal could be established to link to trustee websites in order to make available basic disclosure and ongoing portfolio information, ultimately in a standard format that is machine readable. To help the process, rating agencies may accept monthly information in a standard format rather than each insisting on their own format.

Meanwhile, rumours are circulating that the public disclosure of securitisation exposures under Pillar 3 of the capital requirements directive may also form part of the ESF's proposals. Annex 12 of the BIS framework includes a requirement for banks to report the aggregate amount of securitisation exposures they hold, broken down by exposure type, as well as the capital requirements arising from these exposures (see SCI issue 63).

The American Securitization Forum released a series of recommendations for increased disclosure of mortgage details, payment history and timeliness at the beginning of December. The guidance establishes a common, minimum recommended framework for securitisation monthly reports, and includes provisions for defining modified loans and recommended loan modification data fields.

Investment banks will also be called upon to refrain from underwriting securities from any issuer that does not sign on to follow the best practices protocol. In addition, they will be required to reveal the methodology used to arrive at their valuations.

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Monoline model mulled

Opportunities and pitfalls for financial guarantors discussed

The re-rating of the financial guaranty sector is drawing to an end, with Moody's announcing its findings wholesale and Fitch drip-feeding its rating actions to the market. But the episode begs the now-familiar question as to whether the monoline business model will survive intact.

"In some ways, the current period of dislocation in credit markets presents business opportunity for financial guarantors, as investors develop heightened sensitivity to credit risk and the risk premium for credit increases," note analysts at Moody's.

However, they add: "At the same time, the exposures of some guarantors to the same type of credit stresses seen in the market more generally have led investors to view financial guaranty insurance – and some financial guarantors – more cautiously. It is not yet clear if, and how, recent disruption in credit markets might alter the demand function for financial guaranty insurance in the future."

The ratings of two monolines have been placed on watch negative, two have been affirmed with negative outlooks and four affirmed with stable outlooks as a result of Moody's evaluation of the sector (see News Round-up for more). So far, Fitch has affirmed the ratings of one monoline and placed two on watch negative, with further rating action expected over the next few days.

There appears to be some interest in how Fitch will approach Ambac and MBIA, given their respective recapitalisation exercises. According to one buy-sider: "Fitch indicated that it feels the most likely method of recapitalisation is to use reinsurance, but when we're talking billions of dollars of exposure, reinsurance is unlikely to provide enough capital. Moody's has implied that it would've affirmed Ambac without the reinsurance, so perhaps the monoline received certain indications from Fitch and wanted to demonstrate its flexibility."

FGIC and Security Capital Assurance are the two guarantors that have had their ratings placed on negative watch by both rating agencies. The action reflects capital shortfalls, concerns about portfolio quality and uncertainty regarding the monolines' recapitalisation plans. Fitch has given the firms a period of four to six weeks to raise fresh capital, while Moody's is allowing two months.

Michael Cox, analyst at RBS in London, reckons that Fitch's timeframe is tight, particularly as it includes the Christmas period. "Moody's timeframe is a bit more realistic," he says. "It will be much harder for FGIC to find a private investor than the more established monolines, particularly as it will have to convince them that it's a worthwhile investment – a difficult proposition when you have significant exposure to problem areas of credit and don't have as strong a franchise."

Moody's says that uncertainty exists regarding the ultimate performance of financial guarantors' insured mortgage-related portfolios in the current environment, which could result in further capital needs. There is also some uncertainty about how these companies' strategies – and even the business of financial guaranty insurance more generally – could change in the future, given the dramatic dislocation seen in credit markets in recent months.

Certainly better new business opportunities, together with greater pricing power, will be available for the monolines which have had their ratings affirmed with a stable outlook as a result of Moody's and Fitch's reviews. And the loss of a triple-A rating will obviously limit a guarantor's capacity to wrap bonds, but even with affirmed triple-A ratings and a negative outlook they may struggle to attract new business.

Nonetheless, RBS' Cox is surprised at the calm with which the wrapped market has received the re-rating of the monoline sector. "Maybe we've already seen the correction – after all, the magnitude of any downgrades are likely to only be one or two notches, unless forced selling comes into play," he says.

However, other observers point out that the US municipal bond market may yet be negatively impacted by the re-rating of the sector – and the extent to which banks will have to recognise counterparty credit risk if a monoline is downgraded is still unclear.

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Monetising CDO CDS

Exit opportunities for distressed junior positions

A wide range of potential value exists in CDO CDS contracts, depending on transaction specifics and CDS strike prices. A new study shows that investors looking to exit distressed junior positions may be able to exit at higher than intrinsic value if a 'motivated' buyer can be found.

Many subordinated SF CDO tranches may never receive another cashflow due to severe collateral downgrades causing them to PIK or even accelerate. Analysts at JP Morgan have, in a new study, consequently sought to clarify the value of pay-as-you-go (PAUG) versus physical settlement for CDO CDS in a stressed performance environment.

It was assumed in the analysis that principal default always occurs 40 years out, that complete interest shortfalls begin immediately and that implied write-downs are 100%, either one quarter from now, five quarters from now or nine quarters from now. To illustrate how the cost of protection interacts with interest shortfall caps (and Libor), four spread situations were considered: CDS premium = bond coupon; CDS premium = bond coupon + Libor/2; CDS premium = bond coupon + Libor; and CDS premium = bond coupon + Libor*2.

In addition, two discount rates were used - 5% and 10% to represent a higher rate of return on alternative investments. Only one reference obligation (RO) rating level was used - a triple-B cash bond with a 1 January spread level of 365bp - with the relevant variable being the gap between the CDS premium and the RO coupon.

The interest and principal shortfall that the protection seller is obligated to cover was combined for each period. The implied write-down protection contract was shown to generally have a much higher intrinsic value, both in the short and long term - the more so the earlier write-down occurs.

Physical settlement is one alternative to gradual monetisation of shorts through PAUG payments: the protection buyer can do this immediately given an implied write-down or distressed downgrade, or after 12 months of interest shortfalls. Many tranches face OC shortages; many also qualify for physical settlement on the basis of ratings downgrades alone.

To deliver, a bondholder must own or source the cash bond. The analysts assumed for simplicity that the protection buyer is reimbursed full par first quarter out if they deliver immediately, or five quarters out if they deliver a year from now.

The bondholder's payout for doing so is the notional value of the bond (discounted back either one or five quarters), minus its cost. The results were adjusted for any interest shortfalls or write-down payments received during the 12-month period. The NPV of the physical delivery can be contrasted to the NPV of PAUG settlement, and theoretically represents the maximum price the bondholder would pay to acquire the cash bond.

These scenarios imply a wide range of theoretical prices for cash bonds, with the high end resulting from the variable cap contracts, say the analysts. "The somewhat ironic result is that bonds which may never see another cashflow still may have substantial scarcity value, indicating that CDS shorters face a 'short squeeze'."

The more that future cashflows are discounted, the more the bondholder is incentivised to settle today. The CDS premia is insignificant, while the timing of write-downs is key (the more accelerated, the better).

For fixed cap implied write-down contracts, physical settlement is less attractive. Variable-cap protection buyers can gain more from physical delivery, but the gap between the CDS spread and the RO coupon is paramount.

Another alternative to PAUG settlement is to close out the position, or enter into an offsetting trade. To reverse a short, a bondholder would go long and likely receive a large upfront payment along with a capped running spread.

"The key is the upfront payment, which should incorporate the likely timing of obligations and the value of contract features. Given market illiquidity, however, reversing a trade is unlikely to be significantly more valuable than the intrinsic value of the contract," the analysts conclude.

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Auction action

Central bank move a success, but concerns remain

The first round of coordinated central bank auctions has been a success, ensuring that no bank will fail to meet its obligations over the 31 December reporting deadline. However, the market remains divided over whether such support is really a positive move.

"While the extra liquidity injection should benefit the overall stretched market, most participants believe that the amount pledged is too little, given the magnitude of the crisis, and the efforts a bit late in coming," explain Domenico Picone and Priya Shah of Dresdner Kleinwort's structured credit strategy team. But others say that the move underlines the level of distress that financial institutions are really in, and that it could be inflationary.

The ECB yesterday, 18 December, injected €349bn of year-end liquidity at a preset rate of 4.21% with the promise that all bids would be filled (390 banks bid). The £10bn Bank of England auction took place at an open market rate and was covered only 1.1x times (average clearing rate was 5.95%).

The auctions were coordinated with the US Federal Reserve's initiatives to address current liquidity pressures in the interbank lending market: it has introduced a temporary term auction facility (TAF); and foreign exchange swap lines with the ECB and the Swiss National Bank. In addition, the Bank of England has expanded the amount of reserves offered in its existing three-month facility and widened the acceptable range of collateral; Bank of Canada is holding two term repos over year-end and expanding acceptable collateral; SNB will offer a US dollar repo transaction spanning year-end; and the ECB will conduct two US dollar liquidity-providing operations in connection with the TAF.

"As well as being effective in their own right, the measures are highly significant in being a coordinated response by the major western central banks," says Stephen Gallagher, SG's US chief economist.

Under the TAF, the Fed will auction funds to a broader range of participants (any depository institution that has access to the discount window) against a wider range of collateral than in typical open market operations. Four auctions have been scheduled so far – two in December and two in January – and more could be added in subsequent months.

The advantage of the TAF over the discount window is that the rate will likely be lower, having the Fed funds rate as a floor and the discount window rate as a cap. Analysts at BNP Paribas note that the facility should significantly contribute to bringing Libor rates down. But the risk is that, if demand for TAF funds exceeds supply (standing at US$20bn for each of the first two auctions in December), the auction rate will turn out to be significantly higher than the Fed funds rate and close to the discount window rate – thereby undermining the effectiveness of the facility.

Meanwhile, the Fed's US$20bn and US$4bn swap lines with the ECB and SNB respectively are aimed at providing the banks with greater flexibility in addressing their own liquidity issues stemming from the sub-prime crisis. Shortages of dollar term liquidity have been particularly acute in the European banking system, with the ECB and SNB having been unable to address these pressures due to their inability to create dollar reserves.

The Fed recognises that failing to address liquidity shortages and prohibitively high funding costs now would force it to cut rates more aggressively later on, according to Gallagher. "The latest actions are consistent with the Fed's earlier efforts to separate liquidity needs from economic needs. Though the Fed is more reluctant to reflate the economy by aggressively cutting the fed funds target, it is showing deep awareness of the risks stemming from tight liquidity and is working vigilantly to address these problems," he concludes.

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Mizuho reduces US CDO business

The latest company and people moves

Mizuho reduces US CDO business
Mizuho Securities Group has cut the headcount of its New York-based structured credit team. Notably Alexander Rekeda, head of structured credit Americas, is believed to have left, having joined the Japanese house along with members of his team from Calyon (see SCI issue 20) – a move which caused the French bank to subsequently file a law suit (see SCI issue 31). Several other members of the structured credit team are understood to have also left, but sources suggest that not all the names being bandied around the market are correct.

For its part, Mizuho's only comment was: "Due to unprecedented turmoil in the global structured credit markets, Mizuho Securities plans to continue its CDO business on a reduced scale while assessing the market conditions. The Mizuho Securities Group intends to continue to provide a broad range of innovative, high-quality products and services to meet our customers' financial needs."

Cioffi quits
Amid continuing investigations by US regulators into the collapse of two of Bear Stearns Asset Management (BSAM) structured credit hedge funds in the summer, the manager of those funds – Ralph Cioffi – has left the firm. Cioffi had been relieved of his fund management duties in June, but had remained at BSAM in a consultancy role.

Senior correlation trader leaves
Alexis Grzanka, a senior correlation trader at Dresdner Kleinwort in London, is understood to have left the bank last week. Grzanka is a relatively long-standing member of the correlation trading team, which forms part of the bank's credit exotics team that saw new head Ed Selby and director Michael Coats join recently (see SCI issues 50 and 60).

McCabe moves to SG Sydney
Stephen McCabe, former md of quantitative research at S&P in London, has joined Société Générale in Sydney as a director in structured credit and securitisation.

Opportunity fund launches...
The Blackstone Group has launched Blackstone Credit Liquidity Partners (BCLP) with capital commitments in excess of US$1.3bn. "The fund was created to capitalise on the recent dislocations in the credit markets by investing in a broad range of debt and debt-related securities and instruments, including bank debt, publicly traded debt securities, bridge financings, securities issued by CDOs and other debt instruments, all on a global basis," Blackstone says.

In addition to this new Credit Liquidity fund, Blackstone's corporate debt group manages 11 CDOs and two private investment partnerships. These various vehicles, including BCLP, have aggregate capital commitments of over US$11bn. They include seven US CDOs (US$4.7bn), four European CDOs (US$2.9bn) and two private mezzanine funds ($2.1 billion). Blackstone was assisted in the fundraising by Park Hill Group.

...as another is planned
BlackRock's co-founder and chief investment officer of fixed income, Keith Anderson, is understood to be leaving the firm to start his own credit opportunity fund. Anderson will remain with BlackRock as an advisor until March 2008, helping to ensure an effective transition.

Scott Amero was named vice chairman and global chief investment officer for fixed income for BlackRock. Amero, who joined the firm in 1990, will also continue as co-head of its fixed income portfolio management group.

Additionally, Peter Fisher was named co-head of BlackRock's fixed income portfolio management group. Fisher joined BlackRock in 2004, following service as Under Secretary of the US Treasury for Domestic Finance.

Sachsen takeover finalised
Landesbank Baden-Württemberg (LBBW) has finalised a takeover plan for Sachsen LB, which is to be implemented on 1 January. The cornerstone of the agreement, which was approved on 13 December by LBBW's shareholders, is a comprehensive risk shield for LBBW.

Out of €28bn in Sachsen LB's structured portfolios, a total of €17.5bn (Ormond Quay, Sachsen Funding and Synapse ABS) is to be transferred to an off-balance sheet SPV that will not be consolidated by LBBW. To cushion any payment defaults in these portfolios, the Free State of Saxony provides a guarantee of €2.75bn. The special purpose company is to be run by a management company appointed by the Free State of Saxony in consultation with LBBW.

Other well-rated structured portfolios totalling about €11bn are to remain with Sachsen. The Free State of Saxony will provide €500m to cover any revaluation losses resulting from market fluctuations.

Agreement was also reached on the purchase price for Sachsen. This was set at €328m, a figure that corresponds to the equity of Sachsen after deducting the above-mentioned €500m.

As analysts at RBS note: "This has become a relatively low risk trade for LBBW, with some mild scope for writedowns only. Integration and headline risk remains though, as will the ongoing saga about whether or not it will try to merge with WestLB."

ESF elects chairman
The board of directors of the European Securitisation Forum (ESF), an affiliate of the Securities Industry and Financial Markets Association, elected Robert Palache as the association's chairman for 2008. Palache is md and the head of European securitisation and asset monetisation group for Morgan Stanley in London.

Palache succeeds Philippe Tromp, md Europe, for Financial Security Assurance. Tromp was the ESF's chair for two years.

ASF adds officers
The American Securitisation Forum (ASF) has announced the election of its new executive officers. Sanjeev Handa, head of global public markets at TIAA-CREF, was elected chair. Jason Kravitt, senior partner in the securitisation practice at Mayer Brown was elected deputy chair, and Diane Citron, general counsel at Carrington Capital Management, was elected secretary.

The ASF has also elected Whitfield McDowell, md at Bank of America, as a new evp. The new executive officers will serve terms beginning on 1January 2008 and ending on 30 June 2010. In addition, outgoing chair Greg Medcraft was named chair emeritus.

MP

Manager replacements begin

A round up of this week's structured credit news

Manager replacements begin
The first termination of a manager following a CDO event of default has come to light. LaCrosse Financial Products, an MBIA affiliate representing a majority of the controlling class of investors in Sagittarius CDO I, directed the issuer to remove Structured Asset Investors as collateral manager.

Pursuant to the right under section 13(j) of the transaction's collateral management agreement, SAI is to be removed for cause effective on the later of 30 days from the date of such direction (10 December 2007) and the date as of which a successor collateral manager has agreed to assume all of the manager's duties and obligations under the collateral management agreement.

Meanwhile, analysts at JP Morgan have surveyed 16 CLO, mezz and HG SF CDOs, looking at key parameters for manager termination. The results show that for-cause removal is fairly restrictive; probably the most relevant clause is manager bankruptcy.

In about half of the deals surveyed, the approval of either the controlling class or the preferred shareholders is neccessary; another quarter of the time, both must approve. A two-thirds voting majority is commonly the hurdle.

As well, in about a third of the deals, managers could be removed without cause (each class of debt and equity must approve) or for overcollateralisation violations (by the affected class i.e. the super-senior). A replacement manager was always required, even in transactions where the reinvestment period is over.

In today's market, the analysts say, a primary motive would be to lower fees when experiencing EODs, in cases where the controlling class is not able to liquidate the transaction or does not desire to. Across the sample, JP Morgan found senior fees from 5-20bp in HG SF CDOs, from 10-30bp in mezz SF CDOs and 20-30bp in CLOs.

Another CDO – Vertical ABS CDO 2007-1 – was liquidated over the last week, while Moody's downgraded a further nine transactions and S&P put seven on watch negative, following EODs being declared.

Unusual LSS transactions from HSBC
HSBC has launched six triple-A rated fixed rate leveraged super senior transactions through its Starts vehicle. Each series of notes references a static portfolio of 100-125 reference entities rated Baa2/Baa3 domiciled in Europe and the US.

Attachment points of the reference swap range from 15-20%, while detachment points range from 25%-100%. Note sizes are between US$150m to US$550m.

Moody's ratings address the promise of the repayment of principal and of the payment of fixed coupon (equal to the CDS premium) until the maturity of the CDS. The noteholders are entitled to additional interest payment from the notes' collateral.

The transactions feature time-dependant thresholds (the loss triggers). Upon the breach of a loss trigger each investor will have the option to purchase additional notes and de-lever the transaction (in which case additional principal will be issued and additional collateral posted); otherwise the transaction (or a pro-rata portion thereof) will be unwound.

Starts' obligations will be collateralised by Aaa-rated floating rate notes, which can be substituted subject to pre-defined eligibility criteria. Noteholders have the option to sell the notes three business days after the maturity of the CDS, in which case they will receive the collateral if still outstanding or proceeds of those if matured.

Monoline winners and potential losers
Moody's has released the findings from its review of the monoline sector, while the results from Fitch's are still coming in. Three gradings for financial guarantors have emerged as a result, with FGIC and SCA needing to work the hardest to retain their triple-A ratings (see separate news story for more).

"Our rating actions stem from our assessment that several of the guarantors still have appropriate levels of capitalisation to support the current rating and those that may not are taking active steps to strengthen their position," says Moody's md Jack Dorer.

He adds: "In the cases in which we moved to a negative outlook or have initiated a review for possible downgrade, capitalisation currently falls below Aaa levels or could fall under that level in one of our stress cases. We will be focusing on both the effectiveness of the companies' capital remediation plans and their risk management strategies going forward."

The triple-A ratings of Ambac, Assured Guaranty and FSA, as well as the Aa3 rating of Radian Asset Assurance have been affirmed by Moody's with a stable outlook. The agency notes that Ambac's capital position is adequate to deal with the uncertainty regarding the ultimate performance of its insured mortgage-related portfolio in the current environment. Meanwhile, Moody's review revealed that Assured has minimal exposure to ABS CDOs and higher risk RMBS transactions.

The two monolines last week entered into a commitment whereby Ambac will cede US$29bn in par exposure to Assured. Assured also announced a US$300m common equity offering, the proceeds of which will be downstreamed to its sister reinsurance company – Assured Guaranty Re – to strengthen its capital position as it pursues opportunities to provide primary financial guarantors with reinsurance capacity.

The affirmation of FSA's rating reflects its strong risk-adjusted capital profile and its high-quality, well-diversified insurance portfolio. The company appears to have largely side-stepped the problems arising from mortgage-related exposures, not having underwritten ABS CDOs in recent years.

The affirmation of Radian also reflects its limited exposure to both RMBS and ABS CDOs. Moody's notes that, while the company's new business volumes have fallen with the widening of its credit spreads, these negative conditions are offset by growing market demand for financial guaranty reinsurance as primary financial guarantors seek to enhance their capital adequacy. (As one of the largest financial guaranty reinsurers, Radian is likely to see enhanced growth opportunities in this area.)

CIFG and MBIA have had their triple-A ratings affirmed, but with a negative outlook. The move reflects both the material stress faced by the firms on their mortgage-related exposures and the measures taken by shareholders to strengthen their capital positions, according to Moody's.

The agency's analysis suggests that, prior to any capital infusion, the current capitalisation of CIFG and MBIA is below the target level for a triple-A rated financial guarantor. Caisse Nationale des Caisses d'Epargne and Banque Federale des Banques Populaires are set to infuse approximately US$1.5bn in, and gain control of, the CIFG Group from Natixis (see SCI issue 66).

Moody's believes that the expected continued support of the parents provides comfort about prospective coverage of the estimated capital shortfalls at CIFG. However, the negative outlook incorporates uncertainty about the ultimate performance of the guarantor's portfolio and its strategic direction – CIFG's significant exposure to mezzanine senior tranches of ABS CDOs exposes it to higher risk of material losses than its peers.

And Warburg Pincus is to invest approximately US$1bn of capital into MBIA (see last week's News Round-up). At the same time, the company expects to establish loss reserves on its mortgage exposures estimated at between US$500m and US$800m, as well as experience a mark-to-market loss during 4Q07 significantly greater than that of the third quarter.

While Moody's believes that the Warburg Pincus investment will address the estimated hard capital shortfall at MBIA, the negative outlook incorporates uncertainty about the performance of the guarantor's portfolio and the ultimate resolution of the firm's total capital plan.

To the extent MBIA fully executes an overall recapitalisation plan that re-establishes a robust capital position, Moody's would expect to revise the outlook to stable. However, MBIA's ratings could be reviewed for possible downgrade if this expectation is unmet.

Meanwhile, the triple-A ratings of FGIC and Security Capital Assurance have been placed on review for possible downgrade upon concerns about their capitalisation. Moody's review of FGIC will focus on assessing its capital remediation plans and their ultimate effectiveness in restoring capital adequacy to levels consistent with a triple-A rating. The agency will also evaluate any plans the company has to modify its risk management infrastructure and risk appetite in response to recent experiences with RMBS and ABS CDOs.

Moody's believes that SCA's ABS CDO portfolio is highly sensitive to increases in cumulative losses on 2006 and 2007 vintage RMBS collateral. Its review will focus on the execution of the company's capital remediation plans, which could include a variety of risk reduction and capital augmentation measures, such as the use of reinsurance, restructuring certain insured obligations with counterparties and raising debt and equity capital.

For both FGIC and SCA, the agency believes that their recapitalisation plans lack the degree of certainty that would have led to a rating affirmation. To the extent they are able to adequately address their capital adequacy shortfalls, Moody's will likely confirm the companies' ratings at their current levels.

However, if FGIC and SCA are unable to resolve the current stress on their capitalisation over the period of the review – which Moody's expects to conclude within the next few months – the companies' ratings are likely to be downgraded. The magnitude of any potential downgrade depends on a number of variables, including capital remediation measures enacted, as well as prospective strategic plans and business profiles.

As a result of these reviews, the Moody's-rated securities that are guaranteed by FGIC and XL Capital Assurance are also placed under review for possible downgrade.

In addition, Fitch Ratings has affirmed Assured Guaranty's triple-A ratings (outlook stable) and placed both FGIC and SCA's on watch negative. The agency says that Assured has a disciplined underwriting strategy exemplified by minimal exposure to higher-risk SF CDOs, improving financial results and sufficient excess capital for its given rating. However, it has concerns regarding expected strong portfolio growth going forward that may pressure the firm's excess capital level – particularly in light of the potential for future negative credit migration, mainly in fairly capital intensive sectors, such as RMBS.

Compared to many of its competitors, Assured remains in a solid operating position and appears to be improving its market penetration both on a direct and reinsurance basis. Operating ROE increased to 11.4% for the first nine months of 2007 from 9.4% for the same period in 2006 via emphasising growth in lower-risk and relatively capital efficient transactions.

Fitch's review indicates that SCA and FGIC's capital adequacy levels, on the other hand, currently fall below guidelines for a triple-A rating by more than US$2bn and US$1bn respectively, due to sharp downgrades in a number of their insured SF CDO exposures. If within the next four to six weeks, the monolines are able to obtain firm capital commitments and/or put in place reinsurance or other risk mitigation measures in order to meet capital guidelines, the agency expects to affirm the companies' ratings with a stable outlook. If they are unable to meet capital guidelines in the noted timeframe, Fitch would expect to downgrade their ratings by one or two notches, assuming little change to the company's current capital position.

Citi to support its SIVs
Citi has committed to provide a support facility that will resolve uncertainties regarding senior debt repayment currently facing its SIVs. The bank says that the action is a response to the ratings review for possible downgrade by Moody's and S&P of the outstanding senior debt of the SIVs, and the continued reduction of liquidity in the SIV-related ABCP and MTN markets.

The facility is designed to support the current ratings of the SIVs' senior debt and to allow the vehicles to continue pursuing their current orderly asset reduction plan. As a result of this commitment, Citi will consolidate the SIVs' assets and liabilities onto its balance sheet under applicable accounting rules.

According to Citi, the SIVs continue to successfully pursue alternative funding strategies, primarily asset reductions, to meet maturing debt obligations. The SIV assets (net of cash and cash equivalents) have been reduced from US$87bn in August 2007 to US$49bn currently, while maintaining the overall high credit quality of the portfolio.

The bank expects that orderly asset reductions will be sufficient to meet liquidity requirements through the end of 2008, which currently total US$35bn. Consequently, Citi expects little or no funding requirement from the facility. As assets continue to be sold, its risk exposure – and the capital ratio impact from consolidation – will be reduced accordingly.

Given the high credit quality of the SIV assets, Citi's credit exposure under its commitment is substantially limited. Approximately 54% of the assets are rated triple-A and 43% double-A by Moody's, with no direct exposure to sub-prime assets and immaterial indirect sub-prime exposure of US$51m. In addition, the junior notes, which have a current market value of US$2.5bn, are in the first loss position.

As a result, Moody's has extended its review period for the six SIVs affected by Citi's announcement. The agency placed the senior debt ratings of Beta Finance, Centauri Corporation, Dorada Corporation, Five Finance, Sedna Finance and Zela Finance on review for possible downgrade on 30 November 2007. Vetra Finance, whose senior debt ratings are not currently under review, is unaffected by this action.

In Moody's view, an adequately sized support facility will have a positive impact on the senior debt ratings of the affected vehicles. The agency will conclude its review of these vehicles no later than the date when the support facility is put in place.

New CDPC launches
S&P and Moody's have assigned a triple-A counterparty rating to 47 Quay, a new CDPC, and preliminary credit ratings to the various classes of debt to be issued by 47 Quay Capital. The issuer will invest the proceeds of the periodic issue of notes in permitted, highly-rated short-term debt instruments or in cash accounts at highly-rated credit institutions. The CDPC itself will not issue any debt securities or borrow under any bank lines.

47 Quay is the entity that actually enters into CDS with counterparties, and is a wholly owned subsidiary of 47 Quay Capital. Its ability to pay settlement amounts under the CDS is dependent on it receiving funding from 47 Quay Capital at the time it receives a claim under a CDS following a failure to pay by, or bankruptcy or restructuring of an underlying reference obligation. 47 Quay Capital will fund its payment obligations using the note issuance proceeds and the investment income earned from the investment of these proceeds.

The structure envisages that the issuer will enter into mirror swap agreements with the CDPC, so that a claim by a counterparty against the CDPC under a CDS will automatically result in a claim by the CDPC against the issuer under the mirror swap, in the same amount as the amount claimed by the counterparty. In addition, it is possible that the issuer will make a payment under a guarantee in favour of the CDS counterparties, regarding the CDPC's payment obligations to the counterparties.

The company's strategy is to provide credit protection against the risk of loss on highly rated tranches (double-A minus or higher) in portfolios of corporate, supranational and sovereign tranches through CDS. Portfolio management will be provided by Natixis through a portfolio management agreement.

Initial note issuance comprises US$250m triple-A rated Class A1 notes, US$100m double-A Class B1s, US$50m single-A C1s and US$100m unrated capital notes.

The vehicle's capital requirements are derived through the use of a proprietary capital model which uses a Monte Carlo simulation of reference entity and counterparty risk, the net asset value risk associated with invested capital and the operating guidelines. This capital model considers the credit rating, tenor, correlation factors and potential termination costs if any of the counterparties were to default. The CDPC must deliver both daily and monthly reports demonstrating compliance with the capital model and operating guidelines.

ECB releases financial stability review
The European Central Bank has published its latest financial stability review, the primary objective of which is to identify and evaluate the main sources of risk and vulnerability to financial stability, as well as to provide a comprehensive assessment of the capacity of the euro area financial system to absorb adverse disturbances. The December 2007 edition of the review places special emphasis on the financial market turmoil.

Although it is too early to draw definite conclusions, a number of weaknesses that have been revealed by the turmoil could be generally considered as a consequence of inadequate risk management by some institutions and insufficient market discipline. There are four broad areas of weakness in risk management which partly relate to the originate-and-distribute banking model and concern (i) the monitoring, assessment and management of credit risk; (ii) the management and pricing of funding liquidity risk; (iii) the assessment of counterparty risk; and (iv) the role of conduits and SIVs in such a model and in the transmission of tensions from the credit and structured finance product markets to the money markets.

Many of these weaknesses had been previously identified, but they combined in such a way that few had anticipated the potential severity of their joint impact on the core money markets. Several issues related to these risks and weaknesses require further examination, which is currently being undertaken by various fora – namely the Financial Stability Forum and the Basel Committee for Banking Supervision.

One important issue concerns the valuation of complex structured finance products, according to the ECB. Investors who had assumed that the model-based ratings for structured credit products had similar statistical properties to those for corporate bonds discovered that these products were very different.

Another problem – closely related to the valuation issue – is the role the rating agencies have played in the development of structure finance products and the propagation of the turmoil, as well as the excessive reliance of investors on ratings in their credit risk assessments. Questions have also been raised about the potential conflicts of interest in the activities of rating agencies.

Finally, with regard to funding liquidity risk, an important ingredient in the turmoil which contributed to the propagation of tensions from the credit markets to the money market was the maturity mismatch on the balance sheets of ABCP conduits. The risks associated with these funding mismatches were further aggravated when market liquidity evaporated from the markets for complex structured credit products. In addition, it became clear that banks often did not have adequate contingency plans in place to deal with unexpected funding liquidity needs arising from the contingent liquidity facilities they had provided to conduits or to deal with the risk that they would face difficulty in syndicating the bridge loans they had extended to finance leveraged buyouts.

Looking forward, the outlook for the subsequent evolution of the sub-prime originated turmoil is highly uncertain, continues the ECB. In order to obtain some indication on the possible propagation of market tensions, the bank has focused on the interactions between credit and market de-leveraging cycles.

It concludes that in an environment in which bank loans are widely used as collateral for ABS, a sudden increase in borrower default rates could have implications on the financial performance of banks not only via credit risks, but also through market and income risks. From this perspective, an important issue for the euro area and global financial stability outlook is the way in which the ongoing re-pricing of credit risk feeds into the evolution of the credit cycle.

A crucial channel that will determine the impact of money market tensions and the re-pricing of credit risk on the credit cycle and the real economy is the extent to which they will affect banks' lending behaviour and, consequently, the financing conditions of households and the corporate sector. Indications of a considerable tightening of lending standards have already emerged on both sides of the Atlantic.

In addition, there are signs that corporate default rates – which reached historically low levels in recent years – are forecast to increase both in the US and in the euro area. In the event that continued or increased market tensions and volatility would constrain banks' ability to extend credit to the non-financial sectors, the turn in the broader credit cycle could be accelerated and the downside risks to economic activity could increase.

SROC results for Europe
After running its month-end SROC (synthetic rated overcollateralisation) figures, S&P has taken credit watch actions on 84 European synthetic CDO tranches.

Specifically, ratings on 73 tranches were placed on credit watch with negative implications; five tranches were placed on credit watch with positive implications; four tranches were removed from credit watch with negative implications and affirmed; one tranche was removed from credit watch with positive implications and affirmed; and one tranche was removed from credit watch with positive implications and placed on watch negative.

Of the 74 tranches placed on credit watch negative, nine reference US RMBS and US CDOs that are exposed to US RMBS, which have experienced recent negative rating actions. 65 have experienced corporate downgrades in their portfolios.

Further Moody's action for US CDOs
Moody's has placed 23 tranches from five CDOs (Palmer Square 2, Sheffield CDO, Stanton Vintage CDO, Cheyne ABS Investments I and Napa Valley X) 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 downgraded US sub-prime RMBS securities of the 2006 vintage. They also reflect the agency's view on the likely rating impact of exposure to US RMBS and ABS CDO tranches which are currently on review for downgrade, as well as to other US RMBS and ABS CDO vintages, particularly 2005 and 2007.

The most negatively impacted of the affected transactions 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. The proportion of ABS CDO assets present in individual portfolios ranges from 0% to 26%, while RMBS ranges from 0% to 44%.

Moody's will continue to monitor all deals with exposure to US sub-prime RMBS and ABS CDOs, and will take further actions in respect of all CDOs placed on review for downgrade once the extent of actual downgrades to 2005 and 2007 US RMBS and 2005 ABS CDO vintages becomes known.

RiskMetrics launches correlation tool
RiskMetrics Group has launched a new structured credit solution embedded in its flagship product RiskManager. Investors can use the turnkey solution to measure the risk of advanced structured credit trading strategies, such as correlation trades and basis trades. The solution is designed for hedge funds and banks trading credit strategies, prime brokers calculating risk-based margin on structured credit trades and asset managers investing in synthetic credit products.

Many investors have built significant positions in structured credit instruments, but risk management of these trading strategies is very challenging, the firm says. Lessons learned through the correlation breakdown of spring 2005 and credit crisis of 2007 demonstrate that proper risk management of structured credit must incorporate measures of systemic credit risk, concentration risk, idiosyncratic risk and correlation risk.

RiskMetrics Group's structured credit solution allows investors to estimate sensitivities, design stress scenarios and calculate statistical measures of downside risk through historical and Monte Carlo simulation. "Given the recent volatility of the credit markets, increasing numbers of investors are demanding proven risk management solutions to properly measure the various sources of risk in structured credit trades," comments Jorge Mina, co-head of RiskMetrics Group's risk management business. "RiskMetrics Group's structured credit solution covers a wide range of structured credit instruments, making it easier for investors to understand the risk exposures across their entire portfolio."

The solution accurately measures basis risk of portfolios containing CDS indices that are also hedged with single name CDS by providing on-the-run basis time series to accurately capture the subtle differences in those markets. To facilitate loading client portfolios, index constituents are automatically mapped for CDS indices and standard tranches. Investors trading bespoke tranches can define their own baskets and attachment and detachment points to accurately measure sensitivities and risk due to spread changes, defaults and correlations.

Further SIV rating actions
Moody's and S&P have withdrawn their ratings on the senior debt programmes of Hudson-Thames Capital. While S&P's ratings on the junior debt remain at triple-C minus, Moody's downgraded it to single-C from Ca. All outstanding senior debt of the vehicle was repaid in full on 11 December.

Meanwhile, Moody's has placed US$209m capital notes from Eaton Vance Variable Leverage Fund on review for downgrade, reflecting ongoing deterioration in the market value of the vehicle's asset portfolio. The agency has also downgraded from Not Prime the Euro and US MTN programmes of Axon Financial Funding to B2 and Ba3 respectively.

The action is prompted by the occurrence of an automatic liquidation event on 26 November, coupled with uncertainty on the course of action that will be pursued by the security trustee. It is understood that senior noteholders have instructed the trustee to suspend all asset sales, thereby preventing liquidation of assets in a depressed market.

French banks launch liquidity fund
BNP Paribas, SG, Natixis, Calyon and HSBC France intend to establish a joint liquidity fund along the lines of an ABCP conduit, raising funds through the CP market. The five banks will provide a full liquidity line to the fund, which is expected to invest in triple-A ABS assets and to initially include €1bn of the their own investments.

According to market sources, the fund's aim is to bail out small to medium-sized asset managers that are suffering from a shortage of liquidity in order to prevent a fire-sale of assets. However, only high quality assets are being targeted.

S&P reports on ABS CDO spreads
During the third quarter, spreads on ABS CDO tranches have widened in most cases across all structure types compared with the same period in 2006, according to the latest quarterly report on the European cash CDO market published by S&P.

Along with this general widening of spreads, there was a slight decrease since 2Q07 in the number of ABS CDO transactions rated by the agency (seven in Q2, five in Q3). For most of the transactions S&P rated, the weighted average portfolio rating was triple-B.

The agency expects the fourth quarter of 2007 to be relatively quiet as investors continue to observe developments in the credit markets. Going forward, S&P expects investors to look for more transparency in the collateral pool (i.e. transactions that are fully ramped or close to being fully ramped at closing), higher-quality assets and diversity in collateral seasoning.

Fitch reports on SIVs
Fitch believes that the actions announced by bank sponsors to support their affiliated SIVs are, in several cases, positive for investors in senior SIV liabilities. A new report summarises recent actions announced by SIV sponsors and their impact on the risk profile of the Fitch-rated vehicles.

The report reveals the most relevant asset and liability parameters for the Fitch-rated SIVs. The average portfolio market value of these vehicles has slightly decreased since October 2007, primarily due to asset price declines in sectors such as HELOC, monolines and other financial institutions. As a consequence, the net asset value of capital has continued to deteriorate.

However, the vehicles have continued to de-leverage, which has increased market value overcollateralisation (MV OC) and has been beneficial to senior investors. The report provides greater insight into the concept of MV OC.

Additionally, the report says that the credit quality and composition of SIV portfolios has remained largely unchanged since the previous report was published on 15 November 2007. Commercial paper issuance continues to be severely limited and SIVs have been de-leveraging their portfolios and relying on alternative sources of funding, such as 'vertical slicing' and repo transactions (see last week's issue).

In November, Fitch downgraded all of Axon Financial's notes to Default. It has also downgraded Sedna Finance's second priority senior notes to triple-C on rating watch negative. Sedna Finance entered a restricted investment operating state and Axon Financial declared an automatic liquidation event over the same period.

Caliber reports
Caliber Global Investment Limited has released its preliminary results for the year ended 30 September 2007, which indicate a net loss of US$228m. This compares with a US$22m net profit for the same period ending in 2006.

A loss per share of US$9.29 for the year was recorded, compared with earnings per share of US$1.18 for 2006. No dividend can be paid for the quarter ending 30 September 2007; aggregate dividends for the year are US$0.25.

Although financing facilities have been restructured to stabilise the portfolio, if severe market disruption continues during the first half of 2008, it may not be possible to realise the potential value of the portfolio in the time-frame envisaged originally, as the company believes that liquidation of the assets in the current environment would not be in the best interests of shareholders.

Caliber has faced considerable challenges throughout 2007 with the turmoil of the US sub-prime markets during the first half of the year and the subsequent disruption in liquidity markets globally. As the US RMBS market began to destabilise, the investment manager challenged the basic investment thesis of the company and the investment restrictions (including asset class, funding and regulatory) under which it operated and considered how best to maximise value for shareholders.

This culminated in a broad ranging strategic review, which included a period of consultation with major shareholders. Following the review, the company decided to pursue an orderly return of capital to investors to maximise value for shareholders. In proposing this new strategy, the board recognised that there was insufficient demand for investment companies exposed to the asset class in which the company invests.

Implementation of this new strategy to date has been severely hampered by the continued deterioration in market conditions. The first priority, therefore, has been to preserve the company's ability to realise capital for shareholders from the portfolio, if and when improved liquidity returns to the market. This has been achieved by restructuring the funding facilities and conserving cash.

The Caliber portfolio has fallen from investment in 274 individual securities with a market value of just over US$1bn to 187 securities with a market value of US$393m. There was a net reduction of 87 securities during the year as a result of asset sales and the termination of the company's interest in the Amber funding facility.

Fitch re-examines market value structures
Ongoing dislocations in the credit markets are placing unprecedented stresses on liquidity and market prices, even for assets that are not credit impaired. This, in turn, is impacting ratings for many market value structures (MVS), such as SIVs, CPDOs, leveraged super senior and market value CDOs. As a result, Fitch Ratings is re-examining its rating methodology for all market value structures.

The agency says that MVS can be divided into two groups – 'traditional' or 'knockout' structures. Traditional MVS feature de-leveraging/protection-based triggers, such as MV CDOs, SIV and SIV-lite senior obligations (CP and MTNs), and closed end funds.

Knockout MVS are those structures in which the market value trigger is initially set at a level significantly away from current market levels. In the event a trigger is breached, there typically will be an unwind of the structure and crystallisation of losses to noteholders. Examples of knockout MVS include CPDOs, SIV and SIV-lite capital notes, many total return swap (TRS) CDOs and leveraged super senior with market value/spread-based triggers.

As published today in an exposure draft for market comment, Fitch is proposing revised liquidity stresses for most market value structures, which in turn would lead to higher credit enhancement levels, as well as ratings 'caps' for certain less liquid assets and for most knockout structures. Additionally, Fitch is advocating greater transparency for investors in the structured finance markets through enhanced disclosure and the addition of various deterministic stresses that capture and highlight the risks of extreme, 'fat tail' events.

"Structural changes in the credit markets and the dispersion of risk through leveraged structured vehicles has made it more difficult for investors to gauge volatility in times of stress and, therefore, Fitch is calling for greater transparency and revisiting its criteria in light of recent events," explains Derivative Fitch chief credit officer, Roger Merritt. "We believe this proposal is an important step toward meeting the needs of investors and bringing enhanced stability to the ratings on these securities."

Under the new proposed framework, ratings would be capped at single-A for less liquid, more complex assets or those for which future liquidity and price volatility is uncertain. For more liquid assets, Fitch expects to continue assigning ratings as high as triple-A to traditional MVS.

However, credit enhancement will likely increase, perhaps significantly, to take into account the most recent market stresses and incorporate the ratings impact of more extreme periods of volatility and illiquidity. Of critical importance, particularly at the highest rating levels, is the ability to comfortably assess asset liquidity and overcollateralisation levels, taking into consideration how markets may perform under future stresses.

For most knockout MVS, Fitch expects that ratings above triple-B will be difficult to achieve. This reflects the lack of structural protections, such as de-leveraging mechanisms, the challenges of modeling future market value declines and the potential for low recoveries in the event a trigger is breached.

"In practical terms, many current 'knockout' MVS will be unlikely to achieve a rating at the investment grade level," Merritt adds. "For illustrative purposes, while we only rated a few SIV capital notes and no SIV-lites, it is unlikely these instruments would achieve investment grade ratings under the proposed criteria."

Upon conclusion of the exposure draft period, in which market participants are welcome to comment on the proposed methodology changes, Fitch will introduce formal ratings criteria. The comment period is until the end of January.

QWIL tender offer results
Queen's Walk Investment Limited latest tender offer closed on 17 December and the strike price for ordinary shares tendered has been set at €5.40, with tenders for 2,777,771 shares conditionally accepted by the company. The total consideration conditionally payable under the tender offer is €14,999,963.40.

The company confirms that 1,404,394 ordinary shares of the company that were tendered at the strike price, being approximately 69.81% of the ordinary shares that were tendered at such price, have been accepted. The tender offer is conditional on the approval of shareholders at the extraordinary general meeting of the company to be held on 18 January 2008.

S&P US CDO downgrades
S&P has lowered its ratings on 156 tranches from 36 US cashflow and hybrid CDO transactions. At the same time, it has affirmed its ratings on another 82 tranches from these transactions.

The downgraded tranches have a total issuance amount of US$6.84bn, and all are from ABS CDOs collateralised by structured finance securities, including US RMBS. The ratings on 57 of the downgraded tranches remain on credit watch negative, indicating a significant likelihood of further downgrades.

In addition, the agency placed its ratings on 63 tranches from 13 other cashflow and hybrid CDO transactions on credit watch with negative implications. The issuance amount of these affected CDO tranches is US$3.59bn.

In 2007 to date, including actions on both publicly and confidentially rated tranches, S&P has lowered its ratings on 991 tranches from 333 US cashflow, hybrid and synthetic CDO transactions as a result of stress in the residential mortgage market and credit deterioration of US RMBS. In addition, 551 ratings from 142 transactions are currently on credit watch negative for the same reasons. In all, the affected tranches represent an issuance amount of US$57.53bn.

Belgian SME CLO debuts
All three rating agencies have assigned preliminary credit ratings to the €5.2bn Park Mountain SME 2007-I, thought to be the first public securitisation of SME exposures. The transaction is a partially funded synthetic balance-sheet CLO, referencing a portfolio of bank loans, revolving credit facilities and overdraft facilities granted by Fortis Bank.

The deal aims to provide regulatory and economic capital relief to Fortis. Below €2.3bn and €151.3m super senior and junior super senior pieces, the CLO comprises €363.3m triple-A Class A notes, €30.3m double-A Class Bs, €30.3m single-A Class Cs, €30.3 triple-B Class Ds and €21.2m double-B Class Es.

The Class A notes have a 1.7-year WAL and the remaining rated classes all have a 2.1-year WAL. There are also two classes of unrated notes – €30.3m Class Fs and €16.7m Class Gs.

Moody's reports on November downgrades
Moody's downgrades of US SF CDO securities in November totaled US$50.9bn across 952 tranches of 267 deals, according to the agency's latest monthly CDO rating surveillance report. The November downgrades represent roughly 9.4% of the original principal balance of Moody's-rated US SF CDOs outstanding on 30 November.

During November, Moody's completed its preliminary rating review of 2006 and 2007 vintage SF CDOs affected by Moody's October 11 rating actions on RMBS. The agency expects to take more negative rating actions on SF CDOs in future months as it reassesses credit risk across all CDO vintages.

Moody's has broadened its rating reviews to pre-2006 vintage SF CDOs due to continuing deterioration in the US housing market, combined with worsening residential mortgage loan performance and the prolonged stresses of the credit markets. As of 30 November, a total of 1,986 tranches from 513 SF CDO deals or approximately US$174.1bn (32.2% of Moody's rated SF CDOs by dollar volume) remained on review for downgrade. The November actions bring SF CDO downgrades for calendar year 2007 to approximately US$62.6bn in 1,249 tranches from 416 deals.

BIS triennial central bank survey results
Positions in credit derivatives stood at US$51trn at end-June 2007, according to the final results of Bank for International Settlements' latest triennial central bank survey, which follow on from the initial results reported in November. This figure compares to US$4.5trn recorded in the 2004 survey.

The very high rate of growth recorded in this period reflects the relative newness of these instruments. The survey results show that the share of transactions with reporting dealers was higher in credit derivatives than in other OTC segments. In part, this may be the result of novations, which involve the transfer of trades to a third party.

Novations are routinely used by hedge funds, which are not reporting dealers in the framework of the survey, to exit positions in OTC derivatives, in particular in credit instruments. Some dealers estimate that roughly 25% of their credit derivatives transactions involve novation. As a consequence, trades initiated by hedge funds might end up as transactions between two dealers.

CDS were by far the dominant instrument in the credit derivatives category, accounting for 88% of positions. Within the CDS category, single-name instruments accounted for approximately three-fifths of open positions, and multi-name contracts for the remainder.

CS

Trading ideas: winging it

Tim Backshall, chief credit derivatives strategist at Credit Derivatives Research, looks at a butterfly trade on the CDX.NA.HY Series 9 index

With our underlying view that the US economy is heading towards a recession with a harder landing than consensus expectations, combined with a rising default risk forecast (implied by our hybrid structural model) and ratings-implied models indicating high yield richness, we remain bearish towards HY spreads on a strategic level.

Although we have discussed the tactical potential of a high yield-investment grade compression trade (based on the view that slowing growth will impact IG credit spreads quicker than defaults will hit HY), we feel a more strategic play is to capitalise on weakness in HY9 (with its builders, autos and ResCap) without being exposed to the huge carry costs associated with an outright strategy. Further, we feel that there is an approach which can provide solid upside in a sell-off, yet protects some of the downside in case of a re-emergence of the credit bulls.

From bad to worse
Our approach is to use the 3s5s7s Butterfly. This position is weighted DV01-neutral, slightly negative carry, but net benefits from defaults if they occur.

In order to judge the efficacy of the position, we have generated a number of scenarios and coincident curves that represent those views (this actually excludes defaults, as they are straightforward and linear in their exposure to the position). Exhibit 1 shows the twelve scenarios.

Exhibit 1

The scenarios represent a forecast of potential curve shapes and levels, given historical curve behaviour, ratings-implied expectations and cyclical default experience. The most important point to note is the inversion of the curves as spread levels push wider, with marginal default risks rising in the short term and dropping in the long term.

This is the single name-type behaviour we have witnessed again and again in builders and financials over the last few months. The index (being a portfolio) will be somewhat insulated from the extremes of this thanks to its diversification, but we expect the index (thanks to its diversification) to follow cyclical default experiences in the speculative grade markets.

The view that things get worse before they get better is not too far-fetched and, as we believe that cycles cycle (despite the Fed's best efforts), we expect a period of rising defaults following the dramatically low default rates we have seen on the last few years. Our equity-implied models (based on a hybrid structural model) of default risk shows rising leverage, rising volatility and falling equity prices combining to push default risk up, with more stress in the next one to three years than three to five years. This is exaggerated by the current funding difficulties many of the cashflow-negative companies in HY9 may have.

The inversion we expect to see in HY9 could be played in many ways – outright short short-dated protection or short-end flattener – but these are very linear in their exposure and leave no room for error in either timing or direction (especially the outrights). We prefer a position that is a little less aggressively positioned but offers a more option-like (non-linear) exposure to stress in the HY markets – and the short 3s5s7s Butterfly provides just that.

Weighting in the wings
Based on these scenarios, we generate P&Ls for the butterfly (and for the 3s5s flattener). We have chosen to build the butterfly DV01-neutral with DV01s of ~$2,600 for three-year, ~$3,800 for five-year and ~$4,600 for seven-year.

This provides a 1.45 to 2 to 0.82 weighting for the 3s5s7s legs. We are choosing to round the three-year leg to 1.5x, given our slight bias towards a bearish inversion in the curve, and this is helped by rounding down the seven-year leg to 0.8x – thereby leaving the position slightly net short credit (very slightly at around US$37 for every 1bp parallel shift up in the curve).

Exhibit 2 indicates the payoffs and scenarios based on these weightings. Column 2 shows the theme for that scenario; columns 3-5 show the curve levels matching Exhibit 1; columns 6-7 show the raw and adjusted P&L (raw reflects a single name-like payoff; adjusted reflects the fixed 375bp 'coupon' of the HY index); and column 7 shows the 3s5s flattener outright P&L.

Exhibit 2

There are a few things to note:

1) The payoff has a somewhat option-like payoff structure – upside strong, downside limited thanks to the general lack of major steepening in the curve that has historically been present.
2) The butterfly has a considerably more attractive payoff profile than the outright 3s5s flattener (betting on continued stress and inversion of the curve).
3) Carry costs on a package based around a US$20m five-year leg are around US$85,000 per annum (not bad compared to payoffs).
4) Bid-offers are reasonable.
5) Roll-down (if possible to really judge) is positive, given the sold protection leg in five-year rolling down the steepest part of the curve.

Exhibit 3 provides the prices and spreads we see for the various legs (note we chose the seven-year on the basis of advice from experienced clients suggesting ten-year liquidity is minimal presently). Carry is a little more than we'd like, but a lot less than the outright or 3s5s flattener, and the butterfly provides us with a cushion against timing and MTM volatility. The butterfly, despite its multiple legs and bid-offers, provides an attractive payoff profile for investors seeking short exposure with minimal downside risk.

Exhibit 3

Risk analysis
The butterfly, consisting of two DV01-neutral curve trades, is prone to liquidity risk but we see no major issue here in HY9. There is a clear danger that the scenarios we chose do not represent reality, but we feel that this is mitigated by the basis for their development (actual default history and actual curve movements).

DV01s are not static and will shift if we get an extreme jump in spreads, but we will address this in our comments. In the meantime, the balance should provide stability.

Liquidity
The CDX.NA.HY Series 9 index is a very liquid market with 5bp bid-offers at most in general. Current market environments make bid-offers tough to judge, but our choice of seven-year rather than ten-year reflects long-term liquidity concerns.

Fundamentals
This trade is not impacted by any idiosyncratic fundamentals. It has more of a systemic bias towards weakening fundamentals across the board, as we see leverage rising and consumer spending growth dropping – leading to a harder landing than many expect.

Summary and trade recommendation
With our models forecasting rising default risk as we see the housing slump combine with the credit crunch to provide a pro-cyclical squeeze on the consumer, we expect spreads to continue to weaken (despite some solid looking bear rallies). Taking short exposure to this market is becoming expensive as many of the gimmies are already wide.

The 3s5s7s Butterfly is a creative approach to gaining short exposure at lower costs than an outright bet, and with a much more option-like payoff structure than a 3s5s flattener. Our scenario generation process provides a framework for judging the expectations of curve inversion in the HY9 curve – and based on this we expect the butterfly to perform well in any continued sell-off, very well in a stressed environment and, notably, remain buoyant if we see any sustained rally. The weighting of the position, combined with roll-down and lower carry, offer a better balance between risk and reward than an outright or flattener, and provides a cushion against timing and direction of move in the short-term.

Buy US$15m notional CDX.NA.HY Series 9 three-year CDS protection at 414bp (US$99).

Sell US$20m notional CDX.NA.HY Series 9 five-year CDS protection at 477bp (US$96.125).

Buy US$8m notional CDX.NA.HY Series 9 seven-year CDS protection at 503bp (US$94) at a cost of US$69,400 or ~35bp of carry (on five-year notional).

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).