Contents

Sign of the times

Dynamic CDO valuation model mooted

The standard copula-based CDO valuation model has been shown, over the last six months, to have significant deficiencies. A new study supports an alternative, dynamic model and highlights the need for far greater sample sizes to be used in Monte Carlo simulations.

Current industry best practices are based on a single-period CDO valuation model, which implies that default probabilities and correlations are constants over the life of a transaction. In addition, it is assumed that all pairs of credits have identical correlations. Such deficiencies generate CDO valuations that are too optimistic relative to more complex models, according to a new study released by Kamakura Corporation.

Focusing on the corporate synthetic sector, the study involves a numerical comparison of computed tranche values for a hypothetical five-year CDO. To calibrate the CDO model to market prices, the term structure of default probabilities was based on a hazard rate estimation procedure derived from a historical database with 1.5 million monthly observations from January 1990. A 40% recovery rate in the event of default was chosen, with the CDO referencing 500 triple-B rated credits worth US$1m notional each.

To provide a richer environment in which to study the impact of various inputs on the copula CDO valuation, the transaction was allowed to experience defaults every month over the CDO's life (instead of using a static setting the model), thereby generating a more realistic cashflow pattern. The analysis investigated the sensitivity of CDO values to default probability inputs, as well as the sensitivity of CDO values to input correlations. Each simulation consisted of 10,000 samples.

Under the base case using one-month probability of defaults (PDs) and no default correlations across credits, the first loss occurs in month three and the second in month 12. By the end of the five years there have been five defaults and a total loss of US$3m, with the equity tranche valued at US$3,509.

To measure the impact of the term structure of PDs on the results, the simulation was repeated using the annualised five-year default probabilities. The loss experience in this case is US$3.6m, with the first loss occurring in month two and losses of US$600,000 incurred in month 38. The value of the equity tranche is now -US$248,710, representing a loss of almost 5% of notional principal.

To study the sensitivity of the standard copula CDO value to different correlation inputs, meanwhile, values for correlations from 0 to 0.99 in 0.05 increments were simulated using the one-month PD. The scenario count was also increased to 500,000 scenarios to reduce the sampling error.

The results show that, in general, the sensitivity of the tranche's value to default correlations increases moving from the super-senior tranche to the equity tranche, with the largest sensitivity reflected in the equity tranche. The equity tranche rises in value as the correlation coefficient rises; in contrast, values for the other tranches decline as the correlation increases.

The authors of the study suggest that a reasonable alternative to the standard static copula model is a dynamic – multi-period – model that allows both default probabilities and correlations to vary with the business cycle. To create such a model, they estimated the business cycle-dependent annualised one-month default probabilities for each reference name using a logistic regression that links each company's default probability to 27 potential macro-economic variables, thereby allowing for the inclusion of default contagion. It was assumed that the realisation of these macro-economic variables follow either a geometric (lognormal distribution) or standard (normal distribution) Brownian motion process.

However, when simulating business cycle-dependent default probabilities, idiosyncratic risk needs to be explicitly modelled as well. To model the idiosyncratic component, the authors identified a 'true' time series for each company's default probabilities, which were then used as the dependent variable in a second logistic regression and included in the simulation via independent draws from a standard normal distribution.

The median cumulative losses after 60 months under the dynamic model are approximately US$15m or 3% of the original notional principal. The worst-case quantile's cumulative losses were in excess of US$50m (with the equity tranche wiped out after month six); even in the best case scenario, loses after five years total about US$5m (with the equity tranche wiped out after month 56). All of the 10,000 scenarios show losses, and the equity tranche's CDO value is -US$4.7m.

Most market participants hold PDs constant and use one correlation number in the standard copula approach. The authors believe that their results also apply to the case where default probabilities are allowed to move over time along a term structure and where more than one correlation input is used.

The Kamakura study goes on to analyse the simulation sample size necessary to obtain CDO values that lie within the bid-offer spread with a high confidence level, using the same hypothetical CDO but with the coupons assumed to be higher based on the dynamic CDO valuation model. Focusing on the 3-4% tranche, the simulation was performed using 100 different simulations of its value using 10,000 scenarios each time, with the resulting values ranging from US$600,000 to a loss of almost -US$300,000.

It is clear from the results that 10,000 samples are not enough to arrive at usable values and so the simulation sample size was increased from 10,000 to 10 million observations. The results show that 6-11 million scenarios are necessary in order to have a high confidence that valuations fall within the bid-offer spread.

CS

Moscow pulse

Russian SME CLO debuts

UniCredit Aton has closed an unusual two-tiered transaction dubbed TransAlp 2 Securities - Moscow Region Pulse. The Rbs3.9bn deal is thought to be the first rated cash CLO of loans to Russian SMEs.

Rated by Moody's, the transaction comprises Rbs2.3bn Baa1 Class A bullet notes that priced with a coupon of 10%, together with Rbs1.6bn of unrated Class Bs which came at 16.89%. The notes were issued under the TransAlp Structured Note Programme, sponsored by HVB, and have a legal final maturity in October 2009.

The motivation behind the deal is to refinance the lending book of the originator, Moscow Mortgage Bank (MMB), which has collected a portfolio of 23 standard-form loans extended to 21 SMEs under the Moscow Region's Programme for Public Utilities and Municipal Building Maintenance. This programme provides local municipalities in the region with financial support to fund their annual maintenance of public utilities and the modernisation of their infrastructure.

The proceeds from the note issuance have funded a senior loan and a subordinated loan granted by the issuer – an Irish SPV – to Belior, a bankruptcy-remote SPV incorporated under the laws of Cyprus. Belior's obligations under these loans are secured by the portfolio of SME loans, with the legality of the assignment by MMB confirmed by a true sale opinion provided by the Russian Legal Counsel.

The work carried out within each municipality is covered by individual municipal budgets on an annual basis and by funding from the government of the Moscow Region. The programme provides budgeted allocations to the municipalities, which contract construction and maintenance services companies (all of which are SMEs) to perform works under the annual utility maintenance plan.

To finance the works, MMB has extended short-term rouble-denominated loans to the SME contractors selected by the municipalities to perform services and works under the regional programme. Upon electing to tender for a contract, each SME contractor – the majority of whom are unrated – has undergone credit checks and has been approved by the underwriting team of the originator.

The loan agreements between the originator and the obligors are guaranteed by 346 guarantees from 70 participating municipalities. Each guarantee corresponds to the amount of the loan spent on the projects that have been pre-approved by the guaranteeing municipality. The maximum portfolio concentration of guaranteed loans per municipality is 6.1%, with an average concentration of 1.4%.

At closing, the initial US dollar proceeds of the note issuance were converted by the calculation agent (the Bank of New York) into roubles at a spot rate, allowing the issuer to extend converted Rbs3.9bn as senior and subordinated loans to Belior. The note notional is therefore calculated in roubles, but the initial proceeds from the notes and the repayments to the noteholders will be made in US dollar amounts determined by the calculation agent at the spot FX rate two business days before each corresponding payment. The rating promise on the notes is based on the rouble obligations of the issuer only.

CS

CRE concerns bite

CMBX relative value remains

CMBX spreads appear to have settled on a widening bias, having traded in an extremely wide and volatile range over the past month. Nevertheless, the index's many vintages and potential for technical trading should continue to offer compelling relative value opportunities.

Conflicting near-term data releases combined with significant short covering provided much of the impetus for CMBX's whipsaw-like movements in December. Spreads have since begun widening in the mezzanine parts of the capital structure across all four series, with CMBX.2 and CMBX.3 bearing the brunt of the move.

"Our takeaway is that, despite tighter spreads that were the manifestation of month/quarter/year-end issues and a potentially more on-point Fed, we suspect prices have room to fall further over the coming months," note analysts at JP Morgan. They point to the slowing economy, financial market de-leveraging, commercial real estate loan delinquencies ticking upward, macro hedge funds buying protection and investors that had previously used the ABX to hedge macro-related risks turning to the CMBX instead as drivers behind this widening.

Analysts at Fitch agree that such pricing does not solely reflect the anticipated worsening credit of the underlying loans and bonds; rather it demonstrates the overall distress in the credit markets. Sources indicate that the implied default rate on CMBX is now almost three times historic default rates, leading the agency to comment that recent pricing on the index is extreme.

Actual historic CMBS 10-year cumulative loan default rates are 8% - meaning the implied default rates on CMBX are as high as 24% on average. "Fitch expects loan defaults to rise given the current capital market environment, but not three-fold," comments Susan Merrick, md and head of Fitch's CMBS group.

The increased risk of loan defaults merits some change in subordination levels, especially for the mezzanine bonds of the capital structure, the agency says. For example, a rise in enhancement levels of 10-20% for triple-B credit and of 5-10% for triple-A credit should address the increased risk. Even if actual losses rise by 50%, these increases in subordination should keep the typical margins of safety in excess of seven times expected loss for triple-A rated bonds and approximately 2.5 times expected loss for triple-Bs.

While losses to the loans collateralising the CMBX will be significantly more back-end loaded than those collateralising the ABX, CMBX tranches will likely continue trading towards dollar prices that mirror their ultimate expected loss-adjusted implied ratings - which the JP Morgan analysts believe to be two to three notches below their current, original ratings. As such, the analysts remain short-risk tranches rated triple-B and lower for CMBX.1, single-A and lower for CMBX.2 and 3, and single-A and triple-B minus for CMBX.4.

With the market establishing wide spread differentials across CMBX vintages and most of the trading being technical in recent months, factors such as fixed carry, margin, bid-offer requirements and mark-to-market changes will largely determine CMBX trade P&Ls in the short term. But analysts at Citi point out that, with such differences across vintages and tranches, investors will have many opportunities to take advantage of spread dislocations.

"In the longer term, we actually expect that, as investors understand the CMBX better, demonstrated fundamentals will start to play a much bigger role in the relative value of the vintages. So there could be, for example, a trade in which investors who appreciate the relative strength of the CMBX.4 (compared to what its market spreads imply) could end up with very profitable positions," they say. Additionally, significant differences between the residential and commercial markets, and the ABX and the CMBX indices are expected to have a stronger impact on trading throughout 2008.

Meanwhile, an AJ tranche was added to the off-the-run CMBX indices on 4 January. The new tranche will provide enhanced trading opportunities to institutional investors seeking exposure to an additional credit class, Markit says.

CS

Structured credit hedge funds fall again

Latest index figures show further decline

Both gross and net monthly returns for November 2007 in the Palomar Structured Credit Hedge Fund (SC HF) Index show a negative return for the second month in a row, despite 14 of 30 funds reporting positive results. The latest figures for the index were released this week and show a gross return of -2.204% for November, while the net return was -2.32% for the month.

Two funds were removed from the indices due to liquidation. As a result, the total number of funds in the index now stands at 30, from a high of 40 as of 1 July 2007.

Notably, three sub-strategies - 'long investment grade leveraged', 'long junior, value oriented' and 'relative value, intra-credit' - reported negative results in November, while the 'short bias' and 'correlation' sub-strategies fared best. The dispersion of returns decreased substantially and the range narrowed slightly compared to the data observed in October.

As a result of the overall pattern of negative returns since June and the summer's credit crunch, the gross and net indices cumulative returns since Index calculations began in January 2005 have suffered - now showing at 99.08% and 93.31% respectively. For more Index data click here.

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

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

CS

Conference launch

Details of SCI's CORE 08 conference revealed

Structured Credit Investor, in collaboration with Financial Technologies Forum, has announced initial details of its groundbreaking one-day, two-centre conference - CORE 08. The Credit Derivatives Operations & Risk Efficiency conference will take place on 5 March in New York and on 13 March in London.

Focusing on CDS risk management in the back office, conference sessions range from connectivity and documentation to settlement and warehousing. Buy-side experts speaking include representatives from Cairn Capital, ECM and New Bond Street Asset Management. Discussion panels also feature: Bank of Scotland; Brown Brothers Harriman; Commerzbank; DTCC; ESF; GFI; ISDA; JP Morgan; LCH.Clearnet; Morgan Stanley and Swapswire.

A full line up will be announced in due course, but for regular updates and reservations visit here. Conference sponsors include SmartStream, TriOptima and T-Zero.

Meanwhile, in response to demand in part due to the volatile credit environment and uncertainty over valuations, SCI is offering a two-day master class on credit derivatives pricing, hedging and risk. Led by Geoff Chaplin of Reoch Credit Partners, the training course will take place on 28-29 February in London and on 4-5 March in New York.

This course provides an in-depth review of the pricing and risk analysis methodologies in current use for bespoke CDOs, together with practical examples and an investigation of how structures respond to changes in the credit environment. For more information, please click here.

Credit 101

The fundamentals of risk assessment are discussed by Jane Klemmer, risk management consultant and former head of structured finance underwriting at MBIA Insurance Corporation

Much has been written over the past few months about the unravelling of the sub-prime mortgage market and the credit crisis which followed on its heels. With lots of finger pointing, anyone and everyone associated with the home finance industry or the credit markets that created this mess has been assigned some portion of the blame:

1) mortgage lenders for their aggressive and loose underwriting standards;
2) borrowers for over leveraging their homes and personal balance sheets;
3) regulators for failing to reign in harmful consumer credit practices while continually lowering interest rates which further fuelled the rise in housing prices;
4) investment banks for providing the warehouse lines and securitisations to fund the growth in sub-prime lending and then re-packaging these mortgage securities as structurally opaque CDOs, for which there is no discernable value;
5) financial guarantee insurers for taking on concentrations of CDO risk; and
6) rating agencies for their liberal triple-A ratings on securities for which the underlying collateral turned out to be far less creditworthy than industry players had anticipated.

When put in these terms, the current credit crisis seems like a perfect storm that was just waiting to happen. Nevertheless, the magnitude of the crisis caught everyone off-guard, pointing out just how unaware market participants were of the credit evolution in recent years that allowed this to occur.

So, what really went wrong here? The growth of securitisation and the ease at which risks can be transferred has completely altered the ways in which we evaluate credits today.

The complexity of financial structures has shifted our emphasis from credit fundamentals to computer programme-driven results, exposing all investors to an extraordinarily high degree of model risk that had not existed before. Assessment of potential losses is no longer based upon common sense credit judgment. Various loss assumptions are plugged into complex computer models which have allowed financial engineers to 'tranche' these securities into different layers of risk.

The models predict the adequacy of credit protection which the lower rated and riskier layers in the capital structure provide to the higher rated tranches. And, since these higher rated securities were typically 'triple-A' or 'super triple-A', investors felt comfortable relying solely on the rating agencies as the arbiter of the credit soundness for the securities they held. After all, credit quality would have to plummet to unprecedented levels for these assets to lose value and suffer losses.

To truly comprehend how we evolved to a credit culture where deal sponsors and investors no longer assume responsibility for sound risk assessment, it is instructive to reflect on simpler times when financial institutions made loans and were held accountable for their credit decisions. Prior to the globalisation of the capital markets, the job of extending credit to consumers and many corporations was largely the domain of consumer and commercial banks.

These buy-and-hold lenders understood that the assets they underwrote would remain on their balance sheets for the full tenor of the loans. If their risk assessment turned out to be wrong, banks would be forced to enter into potentially time-consuming and costly workouts, and face possible losses.

So banks underwrote loans by adhering to a well-defined and rigorous set of credit standards and guidelines. Universally, the single most important principle of lending was to "know your customer".

Today these same loans are extended by thinly capitalised finance companies which have been able to leverage their balance sheets thanks to securitisation. These companies were able to pool and sell their loan collateral in order to create asset-backed or mortgage-backed securities.

In the early years of securitisation, the loan originator held the layer of the pool that would assume the losses, also referred to as the first-loss protection. Over time investors became more comfortable with the risks, which – when combined with ample market liquidity searching for yield – allowed issuers to off-load most if not all of the exposure.

It is now widely known that the securities these originators issued were further bundled into complex and often opaque financial products, such as CDOs, nearly all of which were reviewed and rated by at least one of the three nationally recognised rating agencies.

Given the structural complexity of the securities, the reliance on sophisticated models, the generally high investment grade ratings and, with the exception of financial guarantee insurance companies, the absence of buy-and-hold investors who might be concerned about the lack of ability to transfer the risk, is it any wonder that the principles of basic credit analysis for most investors have been lost? Investors who believed they could sell down their position at any time had no clue which underlying loan originators were in their CDO securities, and we can safely assume that they certainly did not "know their borrowers" in the traditional credit sense.

Let me underscore a point that should not get lost as we sort through this credit crisis morass: securitisation and CDOs as a means of financing are not inherently evil, nor is financial modeling a poor tool for sizing potential losses. Asset securitisation can be a viable and economically favourable financing alternative for both investment grade and non-investment grade borrowers.

Nevertheless, investors in ABS have the responsibility to perform proper due diligence on the asset originator or CDO manager, the collateral and loan underwriting standards, and the legal structure of the securitisation in order to understand the true quality and risks of the investment. Computer models can also play an important role in risk assessment. However, the results of computer modeling are just another tool to be used judiciously in evaluating potential loss exposure, but should never fully replace common sense credit judgment.

It is reasonable to expect that sophisticated and well compensated Wall Street bankers should be more diligent in their risk evaluation, whether their institutions will ultimately hold the securities or sell them to client investors. Due to a single-minded fixation on profits, which in many cases blinded them to the magnitude of the risk they were assuming, banks have been forced to recognise massive losses that will have ramifications both internally and with respect to their client base for months, if not years to come.

The message should be very clear: the only way to restore faith and discipline in the credit markets is to return to some core credit fundamentals. Investors learned the hard way that not all triple-A rated securities carry the same risk, a fact that would have surfaced with more in-depth due diligence.

The bottom-line lesson here is that anyone holding the risk needs to be responsible for making that evaluation, or must hold the banker or deal sponsor accountable for doing so. If securitisation as a corporate finance tool is to regain respectability, certain credit principles must be re-introduced into the framework of risk analysis.

Know your borrower/loan originator: not all are created equal
Specialty finance companies proliferated with securitsation in the last ten to fifteen years. Certain FASB accounting rules, such as those which permitted finance companies to accelerate the recognition of income each time they securitised assets, turned these companies into addicts looking for their next fix in the form of a securitisation. This factor – combined with the lack of adequate regulatory oversight similar to that which is required for banks – fed into this sector expansion, making it possible for many companies to start and grow their businesses with very little capital.

The only way to distinguish among the myriad of industry players seeking warehouse lines and access to securitisation for their assets is to do some proper due diligence: meet with management, understand the business model and underwriting criteria, know the competition and become familiar with the variables that drive the industry. Imagine financing billions in loans without having this basic knowledge.

For insights into a company and its management team, there is no substitute for a face-to-face meeting with management and other employees in their offices. Never underestimate the importance of management integrity – which, by the way, you cannot ascertain by reading an annual report. It may mean the difference between your loans or securities performing or not.

And with so little regulatory oversight and capital required to start up a consumer finance company, wouldn't it be logical for potential creditors to invest the time to understand what it is that they are financing? This type of due diligence is critical for evaluating CDO managers as well, given that quality, style and investment strategies can vary widely.

Moreover, it is not practical to expect that investors will have access to the various originators in a CDO pool to do adequate due diligence. Therefore, it is incumbent upon the investor to make sure that the CDO manager has done its homework.

Think like a buy-and-hold investor, especially with esoteric assets. You may be stuck with the risk
What else needs to be said on this point? Banks took huge write-offs on assets for which the limited secondary market dried up overnight. Furthermore, the extent to which puts were sold with the assets is another indication that the bankers were clueless with respect to the magnitude of the potential risk that would come back to bite them.

Follow the money and know who is making it
If loan originators or CDO managers are making hefty profits but holding little or none of the risk, or the cashflow structure allows them to exit well before your investment pays off, they probably don't have sufficient skin in the game to look out for your interests too. Remember the risk/reward trade-off they teach in business school? If you end up holding most of the risk and someone else is reaping all the rewards, think again about whether it is a worthwhile investment.

If you don't understand it, don't invest in it
Here is where the single-minded focus on profits got in the way of good judgement. If you can't follow the structure, then for sure you will not be able to calculate the economics. Both are critical for assessing the degree of credit risk the investor will hold.

It may not be in the banker's interest to explain to you exactly how the deal works; too much information may reveal the inequity of the profit taking. A good credit analyst is not afraid to ask the tough questions. If reasonable answers are not forthcoming, take a pass.

Understand the difference between credit risk, liquidity risk and market risk
Each has different ramifications for the investor. Will the borrower be able to pay back the loan; might there be a hiccup in access to funding for a portfolio of investments; or will the value of the securities decline even if neither of the former two occurs? Liquidity can dry up really fast at the hint of a credit blip.

This became painfully apparent for SIVs when they could no longer roll short-term CP to finance their long-term assets. Perhaps there is some validity to a concept learned early in any financial analyst's career: an asset/liability mismatch means the investor is exposed to funding or liquidity risk, especially when the music stops.

Even prior to the liquidity crisis but at the hint of potential credit problems, investors began taking write-downs on assets in accordance with FAS 133 mark-to-market accounting. The sharp decline in market values is a reaction to credit issues, being forced to sell into a market with few willing buyers and, in many cases, questionable initial valuations.

Nevertheless, keep in mind that not all of these assets will ultimately default. Without minimising the credit concerns impacting many of these CDOs, the fear factor is often a primary driver of market risk, as is evident here.

Though it may take months to fully sort through the quagmire of risks associated with sub-prime mortgages and related CDOs, now is the appropriate time to dust off our dog-eared Credit Principles 101 and return to some basic fundamentals of risk assessment. In order to restore confidence in the system, the alternative is not an option.

Credit head hired

The latest company and people moves

Credit head hired
Joachim Erhardt, formerly head of credit structuring for West LB in London, has joined LBBW as head of structured credit. He reports to Mark Northway, LBBW's head of credit capital markets.

Citi cuts
In mid-December Citi cut 30 members of staff from its structured credit group and undertook an extensive internal reorganisation. As a result, Carey Lathrop, head of global credit trading, and Jeff Perlowitz and Mark Tsesarsky, heads of securitisation and special situations securitisation respectively, have assumed overall responsibility for Citi's structured credit products activities.

Meanwhile, rumours circulated last week that Citi would be making bank-wide cuts of up to 10% of head count – roughly equivalent to 30,000 staff – on the back of expectations of further significant credit crunch losses being revealed in the firms Q4 earnings announcement next week.

Analysts at RBS note: "Citi has previously flagged the need to take an additional US$8-11bn hit on super-senior risk but the new ceo Pandit may choose to take the opportunity to make as clean a sweep as possible, particularly with continuing charge-offs from mortgages and consumer credit. Here credit costs are increasing but the ability to take a kitchen sink P&L charge is limited by accounting rules. Pandit must also beware the need to preserve capitalisation, which will also be under pressure from balance sheet growth, including the decision to take its SIVs in house as well as any reported loss."

Upcoming reporting dates at present are as follows: Citi 15 January; JP Morgan 16 January; Wells Fargo 16 January; CIT 17 January; WaMu 17 January; Merrill 17 January; BofA 22 January; and Wachovia 22 January.

DBRS closes European offices
Rating agency DBRS has closed its offices in London, Paris and Frankfurt, letting go 43 staff. The move is believed to be largely a result of depressed revenue expectations from all of its offices.

The firm also cut support staff positions in Chicago, New York and Toronto, reducing overall staffing levels from 270 to about 200.

DFGIA ownership transfer
DundeeWealth has completed an agreement transferring 90% of its New York-based subsidiary DFG Investment Advisors (DFGIA) to Kym Anthony, chair of DFGIA, and a small group of DFGIA employees.

DFGIA was established early last year as a structured credit asset management company focussed initially on assisting the new Dundee Bank of Canada with the development of an investment portfolio largely weighted in investment grade CLOs. The Bank was sold to The Bank of Nova Scotia on 28 September.

Structured credit products were among several investment initiatives pursued as a result of DundeeWealth's acquisition of K L Nova in 2005 and the hiring of its controlling shareholder and founder, Kym Anthony. Anthony resigned from DundeeWealth late last year.

In addition, 480,000 common shares of DundeeWealth and 360,000 unvested options to purchase common shares of DundeeWealth, issued as part of the K L Nova acquisition but held in escrow to satisfy certain vesting conditions, are cancelled.

Going forward, DFGIA will manage structured credit assets ranging across the spectrum, including approximately US$90.7m in high quality CLOs managed for DundeeWealth. DundeeWealth is a Canadian owned, diversified wealth management company.

CCorp restructures and adds CDS
The Clearing Corporation (CCorp) has completed a corporate restructuring that results in ownership of CCorp by 17 stockholders, including 12 major global dealers, three leading inter-dealer brokers, Europe's largest derivatives exchange and the foremost OTC service provider. In addition to continuing to provide traditional clearing services to multiple exchanges and marketplaces, the reconstituted CCorp will expand its product line to include a centralised clearing facility for a number of OTC derivatives products.

Beginning in early 2008, CCorp's first new OTC-related clearing product will be in the credit default swaps market. CCorp says it plans to work closely with The Depository Trust & Clearing Corporation (DTCC) by acting as central counterparty for CCorp's eligible clearing participants with respect to certain CDS transactions registered within DTCC's Deriv/SERV trade information warehouse.

Under its restructuring, all shares in CCorp, which remains a Delaware Corporation, are now held by: Bank of America, Bear Stearns, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan, Lehman Brothers, Merrill Lynch, MF Global, Morgan Stanley, UBS, Eurex, GFI Group, ICAP, Creditex and Markit.

Hintze appointed AIS coo
Atlantic Information Services (AIS), a provider of structured finance software, has appointed Jeremy Hintze coo. He will be based in Danbury and report to Scott Turley, AIS president and ceo.

Hintze joined AIS in June of 2004 and has led its analytics, consulting and business development efforts.

Moody's increases Midroog stake
Moody's Investors Service has increased its equity stake in Midroog Limited, an Israeli rating agency, from 40% to 51% to capitalise on the continued strong growth in the country's domestic debt markets. Terms of the transaction were not disclosed. The closing of the transaction completes a process that Moody's initiated in September when it exercised an existing call option.

MP

ABX roll postponed

A round up of this week's structured credit news

ABX roll postponed
As predicted in SCI issue 61, the ABX.HE index roll has been postponed for three months following the dearth of US RMBS deals issued in the second half of 2007 eligible for inclusion. The new series - ABX.HE 08-1 - was scheduled to launch on 19 January.

The decision to postpone its launch was taken following extensive consultation with the dealer community, according to Markit. The ABX.HE 07-2 remains the on-the-run series until further notice.

Under current index rules, only five deals qualified for inclusion in ABX.HE 08-1. Markit and the dealer community considered amending the index rules to include deals which failed to qualify initially, but have decided against this approach at this time. However, they remain fully committed to the index and will update the market as and when appropriate.

S&P moves on monolines
S&P added its weight to the re-rating of the monoline sector at the end of December by announcing various rating actions, including a downgrade, on six financial guaranty insurance companies. The move was prompted by worsening expectations for the performance of insured non-prime RMBS and ABS CDOs.

Based upon current stress test analysis, the details of which were published simultaneously with the announcement, the affected companies may experience claims and/or capital consumptive negative rating transitions such that their capital resources may no longer be sufficient at their respective rating levels. Another consideration in the analysis, if there is a capital shortfall, is the magnitude of the shortfall and the extent to which the company has raised or is planning to raise new capital, and the viability of that capital plan.

The actions involved downgrading ACA Financial Guaranty Corp. from single-A to triple-C, as well as changing rating outlooks for or watch-listing Ambac Assurance Corp., FGIC, MBIA Insurance Corp. and XL Capital Assurance. S&P also affirmed the ratings of Assured Guaranty Corp., CIFG, Financial Security Assurance, Radian Asset Assurance and PMI Guaranty.

Meanwhile, following the release by MBIA of additional information related to its CDO exposures, Moody's has clarified that in its recent stress testing of MBIA's mortgage-related risk the rating agency included the CDOs totalling US$30.6bn in net par. For those CDOs whose underlying collateral included ABS CDOs, Moody's analysis included stressing the performance of the 'inner ABS CDO' collateral based on its specific composition.

Agreement on Canadian ABCP
The Pan-Canadian Investors Committee for Third-Party Structured Asset Backed Commercial Paper has reached an agreement in principle regarding a comprehensive restructuring of the ABCP issued by 20 of the trusts covered by the Montreal Accord ahead of the new 31 January 2008 deadline.

The restructuring will extend the maturity of the ABCP to provide for a maturity similar to that of the underlying assets; pool certain series of ABCP which are supported in whole or in part by underlying synthetic assets; mitigate the margin call obligations of the existing conduits with margin call risk and create a structure to address margin calls if they occur; and support the liquidity needs of those ABCP holders requiring it. Leveraged super-senior triggers are also set to be restructured in order to become more remote and transparent spread loss triggers.

The restructuring has also been approved in principle by certain dealer bank asset providers, as well as by the sponsors of each of the trusts. Certain other lenders, including several large Canadian banks, have indicated an interest in providing credit facilities to support the restructuring.

"I am confident that this plan will provide most holders of outstanding commercial paper with the opportunity to receive the full repayment of principal by holding restructured notes to maturity," comments Purdy Crawford, chairman of the Investors Committee. "Importantly, based on the advice of JP Morgan, the Committee's financial advisor, most of these notes are expected to be triple-A rated. Since the beginning of the Committee's process, we have had as our objective the creation and preservation of maximum value for all investors."

22 trusts, with approximately C$35bn of outstanding ABCP, are covered by the Accord; the restructuring plan addresses 20 of these conduits. Skeena Capital Trust successfully completed its restructuring on 20 December, while the Investors Committee continues to consider separate restructuring alternatives for Devonshire Trust and remains in discussions with the sole dealer bank asset provider to that conduit.

While there may be some diminution from the original ABCP par value in some cases, for the vast majority of the ABCP the restructuring gives investors a reasonable expectation of receiving the full par value over time and substantially reduces the risk that external events affecting credit markets in general will have an adverse impact on the restructured notes.

Corporate credit quality strained
The deteriorating economic environment and continuing dislocation in financial markets will strain the credit quality of European corporates and financial institutions in 2008, according to a report published today by S&P. The research reveals that credit rating downgrades are expected to outnumber upgrades for the first time in three years by two to one. Default rates are also forecast to climb from the current record low level, while remaining below the European speculative-grade historical average of 3.5%.

S&P's report covers predictions for credit quality in the European banking, corporate, infrastructure and insurance sectors. Key expectations for 2008 include:

• A marked slowdown in economic growth in Europe, to 1.9% in 2008 from 2.7% in 2007.
• A gradual return to calmer conditions in financial markets late in the first half of 2008, which will improve access to liquidity. Nevertheless, the agency doesn't see any reversal of the broad re-pricing of credit that has taken place since the summer.
• Downward pressure on corporate profit margins, particularly in export- and consumer-related sectors (including banking). Companies will be squeezed by inflationary pressures, weakening property markets, very strong European currencies relative to the US dollar and a global economic slowdown.
• Selective cutbacks in capital spending amid tighter lending conditions by banks, as firms adjust to a less supportive economic environment.

"While we expect the majority of European firms to remain relatively resilient, as demonstrated by the majority of stable outlooks, their fortitude depends on the scale and duration of the current market dislocation," notes Blaise Ganguin, European chief credit officer at S&P. "If market conditions deteriorate further, or if economic prospects weaken materially, ratings could be exposed to broader downward pressures."

In this event, two areas in particular would witness declining credit quality: banks exposed to declining construction and real estate sectors; and highly leveraged buy-outs (LBOs) that could be pushed over the edge by a more-severe-than-anticipated downturn. In the banking sector, the agency expects credit risk to rise in 2008 as the current market disruption and tighter credit conditions start to affect broader economic activity.

It will in particular monitor banks' exposures to: LBOs; the commercial real estate and construction sectors in countries such as Spain, the UK and Ireland; and the most vulnerable segments of the household sector. Funding constraints are expected to remain prominent in 2008 and may over time result in rating pressure.

In the LBO market, S&P's concern centres on the fact that the average debt to EBITDA for LBOs is running at a record level of more than 6x, and that close to 80% of LBOs that make up the S&P's European Leveraged Loan Index (ELLI) are rated or assigned credit estimates in the single-B category, compared with only 49% in 2003. Should tight credit market conditions persist through 2008, refinancing and liquidity problems could affect the ratings on higher-rated entities and increase defaults in the speculative-grade sector.

At this stage, companies most at risk from a liquidity perspective include those with key operations in emerging markets, LBOs with very high leverage or tight covenant headroom and companies with weak operating performances - sometimes as a result of poor trading conditions - in combination with financing requirements.

"We strive to rate through the cycle, so cyclical weakening does not automatically lead to lower ratings," says Ganguin. "This is indicated by the high proportion of companies currently with a stable outlook, particularly at investment grade. However, the headroom available to accommodate adverse conditions and credit-dilutive initiatives, such as acquisitions and share buybacks, shrinks as economic growth softens."

VECTOR review extended
Fitch Ratings has extended the review period of its core VECTOR modelling assumptions and methodology that could impact ratings of all CDOs, including those with corporate bond or corporate loan collateral. Given the complexity of the analysis, the agency requires additional time to thoroughly evaluate all key elements and inputs of its ratings process.

Fitch expects the review to be completed in mid-January. The current analytical framework that it is pursuing includes a number of key changes, which will lead to a greater level of protection for CDO noteholders in the form of increased credit enhancement.

The underlying default assumptions and confidence intervals have been updated to reflect the most up-to-date corporate default and transition data for the market. Recovery rates are being revised to reflect all available data and reduced recovery prospects going forward, consistent with the views espoused by Fitch's corporate and leveraged finance teams and its research in these areas. Tiered recovery rates will continue to be a mainstay of the methodology, although the tiering has been further adjusted to ensure a greater level of differentiation at various ratings levels and the likelihood of lower recoveries during periods of increased defaults (pro-cyclicality).

Finally, measures are being taken to address the risks of adverse selection and obligor, industry and geographic concentrations - all issues that have been associated with instances of CDO ratings underperformance. Upon completion of the review, Fitch will publish the new criteria as an exposure draft for market comment.

EDS deals downgraded
Moody's has downgraded a total of €973m equity default swap notes issued by the CEDO I, II, III, 4 Ahorro and 4 CSAM vehicles, as well as the Series 07-1 and 07-2 notes issued through the Edelweiss Capital vehicle. The move is a result of credit migration and equity share price movements in the underlying portfolio, particularly in the financial and real estate sectors, which have observed relatively weaker performance than the global equity market.

While the affected transactions are composed of an equal number of equity default swaps in the risk portfolio (long EDS exposures) and in the insurance portfolio (short EDS exposures), the presence of a higher proportion of financial and real-estate exposures in the risk portfolio has significantly contributed to the downgrades. Countrywide Financial, KB Home, Mitsubishi UFJ Nicos Company, Centex, Pulte Holmes, Compass Group, Macy's, Dr Horton, Banca Italease and Boston Scientific are the reference entities that have seen their share price fall below their EDS trigger level.

Distressed equity events observation periods will begin at various times throughout the year for each transaction and will last for three years, such that no equity event related losses have occured at this stage and all tranches still benefit from their initial subordination levels.

New European CDPC
Moody's and S&P have assigned a provisional triple-A counterparty rating to Lutece, a new CDPC. Aaa and Aa3 ratings have also been assigned to its Class A and B notes respectively, worth €300m in total.

Lutece is established for the purpose of buying and selling CDS protection on diversified portfolios of static tranches of investment-grade corporate credits. The company will be capitalised through the issuance of the debt securities, as well as participation notes.

The ratings rely on Lutece being managed with a capital model that restricts its ability to trade and is designed to maintain a counterparty expected loss given default of less than 55%. In addition to the required resources suggested by the capital model, a €25m buffer will be retained to reflect non-quantifiable sources of risk, such as operational failures.

Natixis Asset Management is portfolio manager to the company.

ABCP IRG launched
Fitch Ratings has issued its new ABCP Issuer Report Grade (ABCP IRG) report. The ABCP IRGs evaluate the financial performance information provided to Fitch by the sponsors of Fitch-rated ABCP conduits in EMEA. These IRGs are intended to assign a comparable value to all conduits, measuring the degree of disclosure provided to Fitch in relation to published criteria.

The aim of the IRGs is to maintain a good reporting practice, while encouraging the sponsors of the conduits to improve their reporting standards. The report gives clear guidance for these sponsors on how they can make their reports more useful to Fitch and, by implication, to investors.

Victoria debt downgraded
Moody's and S&P have downgraded approximately US$6.1bn of the senior debt of Victoria Finance. The SIV's CP and MTN programmes are now rated Not Prime and single-B by the respective agencies.

The downgrade actions reflect the steep decline in the market value of the vehicle's asset portfolio from 98% on 5 September 2007 to 95.5% on 7 December 2007. As a result, the market value of the portfolio is now equal to 104.9% of the nominal amount of the vehicle's senior debt, compared to 107.8% last July. In the current market environment the cushion available to senior noteholders is now consistent with Baa3.

The rating actions take into account the partial success of Victoria Finance's alternative financing plan, which involved the exchange of capital notes, together with a proportionate amount of senior debt, for a vertical slice of the vehicle's asset portfolio. The maturity profile of senior debt exchanged and cancelled was somewhat front-loaded, thereby reducing Victoria's need to sell assets; the capital notes retained upside potential in the assets purchased. The plan attracted the support of a major third-party (Citic Bank) that provided funding to capital note investors who needed external financing for their vertical slice transaction.

The outstanding amount of the securities held by Victoria Finance has decreased from US$14.3bn in July to US$6.4bn. The plan has, however, achieved only partial success as not all capital note investors have responded positively to the vertical slice initiative.

Another SIV restructuring to be completed recently involves SIV Portfolio, formerly Cheyne Finance. Deloitte & Touche have reached agreement the sale of the entire investment portfolio held by the company to Goldman Sachs International and/or alternative bidders. The terms envisage that certain reinvestment opportunities will be offered to a number of existing creditors of the company.

Meanwhile, as predicted in SCI issue 68, the consortium of banks behind M-LEC have announced that the rescue vehicle is "not needed at this time". Improving conditions in the short-term credit markets and the emergence of a variety of SIV restructuring plans were cited as the reasons for the move. SIV assets are thought to have been reduced to less than US$265bn in senior debt outstanding in early December, from US$340bn before the credit crunch set in.

Further S&P downgrades
S&P has lowered its ratings on 89 tranches from 22 US cashflow and hybrid CDO transactions and placed its ratings on seven other tranches on credit watch with negative implications. The downgraded tranches have a total issuance amount of US$3.68bn. At the same time, the agency affirmed its ratings on another 53 tranches from these transactions.

All of the downgraded tranches come from mezzanine ABS CDOs, high-grade ABS CDOs or CDO-squared transactions collateralised either directly or indirectly by US RMBS. The ratings on 34 of the downgraded tranches remain on credit watch with negative implications, indicating a significant likelihood of further downgrades.

To date, the agency has lowered its ratings on 1,180 tranches from across 378 US cashflow, hybrid and synthetic CDO transactions as a result of stress in the US residential mortgage market and credit deterioration of US RMBS. In addition, 666 ratings from 155 transactions are currently on credit watch negative for the same reasons. In all, the affected tranches represent an issuance amount of US$70.9bn.

Credit crisis roots revealed
The roots of the current credit crisis are extremely deep and quite strongly entrenched, says Moody's in a new report. In addition, given that the global financial system has become exponentially more complex in recent years, it is unlikely that simple solutions can be found to address these fundamental issues without materially reducing financial development and growth and the overall profitability of the financial sector.

"Since the onset of the current credit turmoil, there has been considerable soul-searching to understand exactly what triggered it, including an assessment of whether our current financial system is less resilient because of increased disintermediation," explains Pierre Cailleteau, Moody's chief international economist and author of the report. In particular, there is a question as to whether banks' new business models, whereby they originate and redistribute loans, has resulted in unchecked risk-taking, liquidity risk and untenably large off-balance sheet liabilities.

The latest in a series of 'Global Financial Risk Perspectives' papers, Moody's report identifies what the rating agency views as the key roots of the crisis and addresses some of the practical implications, including the challenges these have posed for rating agencies in general. First, in Moody's view, incentive structures in the financial industry appear to be flawed in some respects, resulting in a lack of "biodiversity" in the financial ecosystem as well as excessive risk-taking, with no reasonable likelihood that such flaws will be eliminated going forward.

Second, the reason why financial crises still occur, despite enlightened policymakers having some idea of their causes, is because any system of financial regulation that promotes growth necessarily accepts a risk of financial meltdown. "Although there might be ways to almost eradicate the risk of crises, policymakers have implicitly preferred the option of accepting the frequent failure and occasional crises that come with financial innovation because that course is, ultimately, growth-maximising. This can be viewed as a 'Faustian pact' that policymakers have made with the financial industry," says Cailleteau.

Another problem is the difficulty of measuring risk over time: the complex interaction between credit risk and the economic cycle has proved challenging for risk managers and rating agencies alike. "As financial innovation has progressed, the traceability of risk has declined - perhaps forever. This raises two issues. First, greater capital buffers will be needed or required by counterparties and regulators. Second, not just more, but more intelligible information is needed," Cailleteau adds.

Other roots of the crisis explored by Moody's report include intellectual confusion over fundamental concepts, such as liquidity, the absence of a satisfactory valuation paradigm and the paradoxical contrast between the sheer complexity of the global financial system and the precision of financial reporting. A key question is whether, beyond the current episode, these root causes of financial disorder can be addressed in a way that either eliminates or at least minimises the risk of recurrent turmoil.

Moody's believes that, as the global financial system has become exponentially more complex in recent years, it has spawned problems that defy simple solutions for maintaining financial development and growth and the overall profitability of the financial sector. "Although another model is conceptually possible, such as one based on contra-cyclical devices and enhanced shock absorbers, great care must be taken to avoid the lethal risk that an increase in regulation poses to the financial ecosystem, namely reducing 'biodiversity'," Cailleteau concludes.

CRE CDO delinquencies on the rise
US commercial real estate loan (CREL) CDO delinquencies are up again from last month, with increased loan extensions and modifications expected, according to the latest US CREL CDO loan delinquency index from Derivative Fitch.

Though true trends are not conclusive due to the relatively small universe of loans, three new delinquent loans contributed to a 0.47% US CREL CDO loan delinquency rate for December 2007, compared to last month's delinquency rate of 0.15%, excluding repurchased loans. Loan delinquencies consist of loans that are 60 days or greater delinquent, including performing matured balloons.

When accounting for last month's repurchased loans, the December 2007 US CREL CDO loan delinquency rate is 0.64%. Although the overall delinquency rate for CRE CDOs remains low, it is double the rate of the US CMBS loan delinquency rate of 0.31% for November 2007. Seven loans were delinquent as of the December 2007 index; two of these loans, which are contributed to two different CDOs, are secured by the same property.

The three new delinquent loans are further classified as performing matured balloons. An increase in these types of delinquencies is not surprising, given the difficulty associated with refinancing in today's market.

The performing matured balloons include two B-notes secured by the former Drake Hotel site, which is located in Midtown Manhattan. This land/pre-development loan comprises over 45% of the total delinquencies for the month.

It should be noted that on 2 January, subsequent to the cut-off date for this Index, this asset was repurchased from one of the CDOs. Without this loan interest, the delinquency rate, excluding repurchased loans, would drop to 0.29% from 0.47%.

Fitch also reviewed loans that were 30 days or less delinquent. Although not included in the loan delinquency index, this category can be an early warning signal that a loan could ultimately be classified as delinquent. Three loans, representing 0.15% of the CREL CDO collateral, were 30 days or less delinquent in December 2007. One loan, representing over 50% of the total 30-day or less delinquencies, is a chronic late payer that is not currently anticipated to result in a loss to the CDO.

Fitch considers credit-impaired assets that have been removed from the pool to be part of the delinquency rate. Excluding these repurchased loans would overstate the performance of a pool.

To date, most CREL CDO asset managers have opted to buy out credit-impaired assets at par rather than workout the loan within the CDO. This month, an asset manager reported that three assets (0.17%) were repurchased, all from the same CDO. Given the lower available liquidity in the market, Fitch expects less repurchases of troubled loans and more workouts within the trust.

One advantage of a CDO is that it generally allows issuers the flexibility to modify loans even before they become delinquent. Modifications could include term extension, rate reduction, or posting of additional collateral.

In its ongoing surveillance process, Fitch will increase the probability of default to 100% for delinquent loans that are unlikely to return to current. This adjustment could increase the loan's expected loss in the cases where the probability of default was not already 100%.

The weighted average expected loss on all loans (pool-wide expected loss or PEL) is the credit metric used to monitor the performance of a CREL CDO. Issuers covenant not to exceed a certain PEL and Fitch determines the ratings of the CDO liabilities based on this covenant.

Fitch analysts monitor the as-is PEL over the life of the CDO. The difference between the PEL covenant and the as-is PEL represents the transaction's cushion for reinvestment and negative credit migration.

Moody's reports on EODs
In a new special report, Moody's describes its rating approach after an event of default (EOD) occurs in a CDO backed by ABS. The agency does not assume that the party controlling the CDO will necessary move to accelerate the CDO's outstanding obligations.

According to Moody's, among the CDOs that have experienced EODs in the past few months, investors have so far chosen acceleration only about half the time. "The post-EOD rating process is necessarily complex," says author of the report and Moody's vp Stephen Lioce. "Our rating actions following a notice of EOD take into account the specific circumstances of each deal, including performance of the collateral pool, legal structure, potential changes to the priority of payments and the interests of any affected parties."

The agency's first action upon receiving a notice of EOD is to contact the trustee and, if possible, the controlling party to determine the likely remedy. If there is no clear indication of what the controlling party will do but to Moody's best knowledge the controlling party does not have any conflicting interests that would cause it not to choose acceleration, Moody's ratings on all tranches will reflect the acceleration waterfall. However, if Moody's believes there is more uncertainty over the choice that will ultimately be made, its ratings will continue to be based on the pre-EOD payment waterfall.

Over the past two months, 57 ABS CDOs worth a total of US$65.8bn have experienced an event of default as a result of the credit deterioration in the non-prime RMBS market. In each EOD, the CDO has tripped a trigger tied to a failure to maintain a minimum level of overcollateralisation - the ratio of the par value of assets to the face amount of the CDO's senior obligations. Moody's notes that none of the EODs to date have been caused by a CDO's failure to make timely payments to noteholders.

Visage CDO II and Ansley Park ABS CDO are among the latest transactions to be accelerated as a result of experiencing an EOD.

CS

Trading idea: bull's-eye

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at an outright short on Target Corporation

In today's trade, we take advantage of our enhanced Multi Factor Credit Model (MFCI), which shows Target Corporation (TGT) as one of the richest credits within the consumer cyclical sector. Given the lack of liquidity away from five-year CDS and the volatile gyrations of credit indices, we are recommending an outright short on TGT as 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 TGT (buying protection) outweighs the benefits of hedging with a credit index at this time.

Gimme Credit's retail expert downgraded Target Corporation to a deteriorating credit, citing activist shareholder concerns "at the same time as sales and earnings visibility has become increasingly murky".

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

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.

Enhanced MFCI
The MFCI model ranks credits using both market implied and fundamental factors to derive an initial score, which is then adjusted using Gimme Credit's forward-looking view on the issuer. This score is then cross-sectionally regressed against the log of CDS spreads.

The MFCI score now represents a credit spread's distance from fair value in percentage terms of current spread. For example, if an MFCI score is -50%, this means that the fair value spread for the credit is 50% wider than its current spread.

After calculating each credit's expected spread, we are then able to rank all the credits within the sector. This method will allow us to have both spread target goals for our trades and to compare two inter-sector credits on an apples-to-apples basis.

Consumer cyclical sector
Target comes up as one of the richest credits relative to its current CDS spread from the consumer cyclical sector. Our model shows TGT to be 120% too tight (see Exhibit). At a spread of 92bp, we are setting a spread target of ~190bp.

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 5bp of bid-offer to cross, which is significant given TGT'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 TGT's current levels and our outlook for the credit.

Entering and exiting any trade carries execution risk, but TGT 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.

TGT, a member of the CDX IG 9, has good liquidity in the CDS market at the five-year tenor.

Fundamentals
This trade is based on our negative outlook for TGT 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 retailers expert, recently downgraded TGT to a deteriorating fundamental outlook and says the following regarding management's recent response to activist shareholders: "But these actions have neither satisfied activist investors nor boosted the stock price, leading us to believe that the odds of credit-harming actions by management have increased at the same time as sales and earnings visibility has become increasingly murky."

Summary and trade recommendation
Ahead of tomorrow's (10 January) December numbers, we are recommending an outright short on Target Corporation. Even if December sales beat expectations, we believe this issuer has much more room to the downside. Our enhanced MFCI model shows this issuer to be one of the richest credits relative to its CDS spread and this view is corroborated by our deteriorating fundamental outlook.

Buy US$10m notional Target Corporation five-year CDS protection at 92bp to pay 92bp of carry.

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

Copyright © 2008 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).