Contents

Growing pains

Progress made on LCDS issues

The New Year has brought renewed impetus to resolve outstanding issues in the LCDS market on both sides of the Atlantic. While dealers in New York are making progress on the cancellability option, those in London are quietly confident that the LevX index will roll by end-March.

There are still some administrative issues to work through in terms of fitting the nuances of single-name LCDS documentation to the LevX index format, according to Shane O'Gorman, director and LCDS trader at Credit Suisse in London. "The process has been made even more complicated by the number of new dealers getting involved in the market: when the ISDA documentation was agreed in the summer there were five or six dealers involved; now there are around 15 involved. So it's proved difficult to appease each new player. But there seems to be renewed vigour in the New Year to resolve these issues," he says.

The credit crisis has hampered activity in the LCDS market, but the new LevX series is expected to act as a catalyst for activity in Europe to pick up again. As such, the senior LevX index is likely to be expanded to 75 names and the subordinate index to 50.

"The aim is to create greater diversification, but also to reflect the huge number of new names based on massive loan supply at end-2006/early-2007. It is necessary to increase the number of names in the index so that a better hedge for the loan market can be achieved," explains O'Gorman.

Dealers in New York, on the other hand, are involved in ongoing discussions about establishing a methodology to deal with unwinds prior to an LCDS maturing. The trading community has been divided between protection buyers – who want fully cancellable LCDS – and protection sellers, who prefer bullet structures.

"The lack of transparency surrounding unwinds has made it difficult to trade LCDS with any confidence," reports one dealer. "When you unwind a trade in the secondary market, the soft prepayment feature makes it difficult to value. Both buyers and sellers of protection are losing out, which means the market isn't reaching its potential in terms of liquidity and growth."

One solution that has been discussed is trading on a dollar basis; another is trading on a running spread and then providing a dollar price. But both of these options involve making certain assumptions about duration.

"We're basically working with clients and other dealers to find a solution," the dealer confirms. "But it's slow-going – it will take a while for the market to reach full maturation."

Meanwhile, tranched LCDX appear to be on a widening trend after equities plummeted and further bad financial news emerged last week. The 15-100% tranche moved from 110bp to 140bp on the week.

Analysts at JP Morgan note that triple-A CLO paper, at 95bp, looks expensive versus a 30-100% LCDX trade (estimated to be around 80-90bp). "Senior tranches require thin margin, perhaps 3-5%, and cash funding costs are in the 40-50bp area. Though LCDX is a more volatile series than cash CLOs, to date it has been an effective indicator for cash spreads," they say.

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Mixed asset, multi-jurisdiction

Innovative project finance CLO closed

Joint-arrangers ABN AMRO and Espirito Santo Investment have closed Lusitano Project Finance 1 - Europe's first-ever multi-asset, multi-jurisdictional project finance CLO. The €1.1bn cash transaction was retained by originator Banco Espirito Santo (BES), with the aim of placing it publicly when market conditions improve.

Lusitano's portfolio comprises 20 infrastructure assets from across four jurisdictions and eight industries, split into 14% energy assets, 14% airport assets, 10% railways, 18% ferries, 4% stadia, 15% ports, 1% prisons, 17% roads and 7% other types of assets. "This is the first time such a wide range of industries has been represented in a project finance CLO," says Steve Curry, md and European head of FIG capital markets at ABN AMRO.

He adds: "The portfolio composition partially mirrors BES' underlying geographical exposure to project finance loans in that Portuguese, UK, Spanish and Hungarian loans are represented. BES also has project finance capabilities in North America, Brazil and Africa, but it decided to only focus on European assets in this case. UK PFI has typically been the area of focus for such deals issued in the recent past."

BES began working on Lusitano in January 2007 with the usual true sale objectives in mind - capital relief, funding and risk transfer. But the credit crisis put paid to its plans to place the transaction publicly at closing (and thereby realise capital relief).

"The intention is to eventually place the paper publicly – we're conscious that there is a universe of investors who would like to get exposure to such a portfolio," Curry confirms. "We're already receiving some reverse enquiries, but when we decide that market conditions are suitable to publicly distribute the deal, it is BES's intention to formally market it. However, there needs to be more price stability before we do so." In the meantime, BES can use the triple-A notes as collateral against repo funding agreements.

A true sale structure was chosen in preference to synthetic because, in the current circumstances, BES felt that it offered a more comprehensive means of risk transfer. The cash format was also seen as a way to allow the firm to grow its project finance business and turn illiquid assets into liquid securities.

But there were challenges in terms of transferring the assets: because they are project finance loans, there is a lack of homogeneity. Extensive borrower and other lender approvals are required; and there were complications in terms of tax issues due to the multi-jurisdictional nature of the portfolio.

The capital structure is split into 82.5% triple-A rated notes, 3.3% double-As, 3.7% single-As, 2.2% triple-Bs, 1.1% double-Bs and the remainder equity. S&P assigned ratings to the transaction at closing, following an in-depth due diligence process which included an analysis of each of the individual project finance loans. Fitch also performed this level of analysis, thereby giving BES the option of seeking Fitch ratings for the deal without changing its terms or amending documents.

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Centrally settled

New platform to reduce operational risks

In what is being hailed as a groundbreaking move for the industry, the Depository Trust & Clearing Corporation (DTCC) and CLS Bank International have launched a central settlement service for OTC credit derivative transactions. The new platform is expected to reduce operating risks for users by replacing manually processed bilateral payments with automated, netted payments.

"Central settlement provides the credit derivatives market with infrastructure that assures certainty of payment and processing scalability to address the explosion of credit derivatives transaction volume and the inherent operational risk of the previous highly manual processes," explains Randolph Cowen, co-chief administrative officer at Goldman Sachs.

He adds: "The central settlement process, which leverages DTCC's Trade Information Warehouse, has produced full straight-through processing - allowing us to go all the way from confirmation to payment calculation to settlement with virtually no manual intervention."

In the first quarterly central settlement cycle for the new service on 20 December the amount of trading obligations requiring financial settlement was reduced by 98%, from US$14.3bn gross in aggregate US dollar terms to US$288m net. Gross settlements by the 14 participating OTC derivatives dealers were consolidated from 340,000 to 123 net settlements. Payments were made in five currencies: US dollars, euros, Japanese yen, British pounds and Swiss francs.

Dealers agree that the move is a necessary step in helping the CDS market grow and deal with increasing volatility - although one wanted to see whether the technology could cope with the anticipated extra volume before forming an opinion. Another London-based player felt that the platform is too US-centric.

The new service ensures that bilateral netting and settlement is completed and reports generated for counterparties early in the morning on settlement day. The function has been designed to enable payments associated with transactions confirmed through Deriv/SERV and residing in the Warehouse's global contract repository to be netted by value date, currency and counterparty. Payments eligible for settlement include initial payments and one-time fees, coupon payments and payments associated with post-trade events.

The Warehouse generates bilaterally netted payment instructions and sends them to CLS for settlement. CLS automatically notifies its settlement members, who effect settlement through CLS on a multilateral, netted basis. Over time, the number of currencies in which payments can be made will be expanded from the initial five.

"The settlement service breaks new ground in OTC derivatives operations," comments Michael Bodson, DTCC executive md, business management, strategy and marketing for all DTCC businesses. "Counterparties used to manage payment reconciliations and funds transfers for thousands of payments on a bilateral basis using manual processes. Now, once trades are fed into the Trade Information Warehouse, these steps are handled automatically and, for the first time, counterparties obtain a full audit trail. The results in terms of cost savings, risk mitigation and efficiency gains are tremendous."

During the initial launch, which followed an extensive testing period, the participating dealers settled with each other in defined clusters. During 2008 additional dealers will go live on the service, and participants will begin settling among each other outside of their defined clusters. In addition, the Warehouse's settlement capabilities will be expanded in preparation for bringing buy-side firms on board.

See this week's Talking Point for more on STP for OTC derivatives.

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Taking control

The need for flexible standards within derivatives processing to deliver greater STP is discussed by Mark Taylor, business consultant at SmartStream

Everywhere you look at the moment in the financial sections of papers there is an unofficial league table of which institution has written off the most money. This isn't a prize organisations are fighting to win.

However, fund managers are concerned about their current rankings and how far some of them are slipping behind hedge funds, due to a perceived lack of competitive advantage. The efficient processing of OTC derivatives is key to maintaining a competitive advantage. However, as volumes continue to grow – average daily turnover is up by 20% year-on-year, according to the latest BIS survey – performing this task manually, as some still do, is simply not viable.

Manual processing is unreliable and error prone; it can become extremely complex and introduces unnecessary risk. Crucially, it is also much more expensive, which impacts directly on profitability.

Automation and the drive towards that once most hated of acronyms, STP, for confirmation and settlement of certain derivative instruments is becoming mandatory. Further, derivative trades that are currently low in volume and that are considered exotic or alternative now will eventually be commoditised and efficiently processed in the future.

The issue is, as the front office is chomping at the bit to trade these new instruments, organisations are not able to process them because the middle and back office are not geared to cope, thereby creating processing bottlenecks. The length of time taken to deploy traditional technology with "dumb gateways" is expensive and error prone.

Central to overcoming these issues and enabling greater automation is capturing and exchanging data in agreed formats. FpML's product definition is supporting the drive for automation. The key derivatives service providers - SwapsWire, DTCC Deriv/Serv and T-Zero - all use FpML as the underlying standard to communicate trade information.

However, FpML is just one form of standardisation. Another is following best practice guidelines.

The flow of these types of trades requires them to be repeatable and efficient, effectively being choreographed from start to finish. Having definable processes that are executed by flexible workflow rules also provides greater risk mitigation.

Therefore processing trades of this nature is not enough because greater control is required. As recent events have shown, it is not just a case of having a better understanding of your position, but ensuring you have one in the first place. Comparing this to indicators of performance and risk is key.

Reacting to and dealing with exceptions as they occur is a good thing. However, to truly benefit from automation and deliver even greater risk reduction and levels of control is to move to proactive management. This requires alerting people to an issue that may occur and escalating it for resolution before it becomes an exception.

The knock-on effect of this proactive approach delivers further benefits. By having well-defined processes and a clear understanding of your data, a firm can extrapolate that information over all outstanding deals to create a cashflow ladder.

Having this ability to view forward and drill down to the underlying trades can assist in negating some common industry issues. This includes the constant headaches of quarterly rollovers in the CDS world that can take days to resolve.

As a result, vendors and their associated technology are being pressed to deliver solutions with at least the following four key elements:

• Standardisation: so that trades are repeatable, scalable and efficient.
• Flexibility: delivering faster time to benefit as new alternative instruments appear, enabling organisations to employ new derivatives faster.
• Control: to provide greater risk mitigation via reconciliation with counterparties and re-valuation of trades by regular marking to market.
• Value added servicing: as part of the process to give greater visibility of KPIs and KRIs.

Solution vendors that provide these capabilities are able to add value to investment managers and help to deliver a competitive advantage. The institution gains more transparency through better, tighter, standardised best operational practices with controls, while also providing a greater degree of flexibility as the future unfolds.

Attend CORE '08 to hear from senior representatives of leading buy-side and sell-side institutions as they discuss operational challenges, procedures and solutions in the credit derivatives market. For further details about the conference and the full agenda, please click here.

Acquisitions emerge

The latest company and people moves

Acquisitions emerge
In what is expected to become a broader trend, two larger CLO managers have revealed details of their acquisitions of smaller rivals. Katonah Debt Advisors (KDA) has bought Scott's Cove Capital Management and The Blackstone Group is purchasing GSO Capital Partners.

Analysts at RBS suggest that the moves are indicative of what might be one of the major trends in 2008 – a significant contraction in the number of active CLO managers (see also SCI issue 64). RBS warns that there may be only 15-20 managers able to print out of 60 currently active, and smaller managers, with one or two deals under management, deciding to sell their portfolios to expanding rivals trying to build up their assets.

To this end Kohlberg Capital Corporation announced last week that its wholly owned affiliate and asset manager KDA – which had US$2.1bn of assets under management as of 30 September 2007 – has completed the purchase of substantially all of the assets of Scott's Cove. The assets were acquired by Katonah Scott's Cove Management, a wholly owned subsidiary of an affiliate of KDA.

Scott's Cove focuses on an event-driven credit long/short investment strategy. "This acquisition will give KDA greater expertise in high yield bonds, distressed debt and equities which will strongly complement our leveraged loan capabilities," says E.A. Kratzman III, president of KDA.

Phillip Schaeffer will continue as portfolio manager of Katonah Scott's Cove, which currently has approximately US$60m of assets under management, reporting to Kratzman.

Meanwhile, US$98.2bn Blackstone and GSO have agreed in principle on terms under which Blackstone will acquire GSO. GSO is an alternative asset manager specialising in the leveraged finance marketplace, with approximately US$10bn under management. It manages a multi-strategy credit hedge fund, a mezzanine fund, a senior debt fund and various CLO vehicles.

Blackstone says its acquisition of GSO will augment its global alternative investment platform in the credit area, adding several new lines of business and creating significant synergies and opportunities for the firm. Stephen Schwarzman, chairman and ceo of Blackstone, comments: "Given the current dislocation in the credit markets, this is an ideal time to create a more powerful, diversified platform from which to grow Blackstone's business."

BoA cuts back CDOs
Bank of America has announced that it will focus its investment banking and global markets coverage on areas of traditional strength to ensure continued growth. The bank says this will lead to: reduced activities in certain structured products, including CDOs; resizing BoA's international platform to emphasise core strengths in debt, cash management and trading; and a reduction of 650 positions in its global investment banking and global markets division.

The bank says the announcement reflects the results of a strategic assessment announced in October 2007 and reflects changing market conditions. BoA adds that the realignment will result in shifts in investment away from activities that do not directly contribute to the success of the company's integrated model and to avoid risks that are not commensurate with the rewards available.

Additional guidance on the realignment will be provided on 22 January, when BoA's fourth quarter and full-year 2007 financial results are released.

Kirkland joins Point Clear
Walter Kirkland has joined boutique structured credit asset management firm Point Clear Capital Management as chief investment strategist. His responsibilities will include developing new trading strategies and raising capital for the firm. Kirkland will also sit on the firm's investment committee.

Kirkland has had a distinguished capital markets career, which includes 11 years with Citibank, during which he was head of US agency trading and head of European fixed income sales and trading. After his tenure with Citibank, Kirkland transitioned to investment management, where past positions include stints with Ellington Management Group, Eastbridge, Carl Marks & Company and Lazard Asset Management.

Established in 2005, Point Clear Capital Management provides both asset management and advisory services to its clients. The firm currently has approximately US$80m in assets under management and approximately 60 investors and clients.

Manager adds strategist
Raja Visweswaran, formerly head of international credit strategy research at Bank of America in London, is understood to be joining Asteri Capital this month. Once there, he is expected to focus on emerging markets credit.

CRE CDOs cut
Merrill lynch has cut back its US CRE CDO team. Malay Bansal, director and head CRE CDOs at the firm, and two colleagues have left with immediate effect.

Akeroyd exits RBC
Shane Akeroyd, global head of fixed income and financial product sales at RBC in London, left the firm last Friday.

GFI appoints new London head of credit
GFI Group has promoted Richard Giles to head of credit, Europe. He remains in London and reports to Julian Swain, GFI's head of London brokerage. Giles joined GFI in 1993 and has worked for the firm in currency options, energy and credit in both Hong Kong and London.

Hopkin arrives at monoline
Richard Hopkin, who left his role as deputy head of securitisation, Société Générale, London last year (see SCI issue 68), has - as expected - joined FSA as md, securitisation, Europe and Australia. He reports to Philippe Tromp, md, Europe and Australia. Hopkin will be based in FSA's London office, along with other FSA teams focused on infrastructure finance, CDOs and credit solutions.

Stroock names new partners and special counsel
Law firm Stroock & Stroock & Lavan has appointed two new partners and one special counsel who will be involved in structured credit. Overall, the firm named six new partners and seven new special counsel, effective 1 January.

Eugene Balshem – made partner in real estate, Miami – concentrates in real estate transactions and related matters. He represents investment firms, pension funds, banks and other financial institutions in connection with the origination, purchase, sale, syndication and securitisation of commercial real estate loans. Balshem has also been involved with loan restructuring and workout/foreclosure alternatives for distressed loans.

Craig Mills - made partner in structured finance in New York - has worked on transactions involving a variety of asset types, with a primary focus on CDOs. He has extensive recent experience with synthetic CDO transactions (including representing counterparties) and has also been active in emerging insurance-linked securities, including the first capital markets securities supporting XXX and AXXX reserves and disability reserves.

Naji Massouh - named as special counsel, structured finance, New York - concentrates in structured finance and insurance-linked securities. He has represented underwriters, issuers, lenders and insurers in US public offerings, private placements and offshore offerings involving a variety of asset types. Massouh has been active in the field of insurance-linked securities and has been involved in structuring and documenting CDOs, credit derivatives, repurchase agreements, ABCP programmes, letters of credit and royalty income stream obligations.

Blance joins OTC Valuations
OTC Valuations has announced that Ian Blance is joining the company as vp of strategic sales. He will be responsible for driving business development for OTC Val globally.

Blance recently left Interactive Data after 12 years in a variety of senior positions in its fixed income evaluations business in London and New York, and has over 20 years' experience in the financial markets.

Markit opens Sydney office
Markit has opened an office in Sydney, which is its first in Australia and its third office in the Asia Pacific region.

David Crammond, ceo of Markit Asia, comments: "The Asia Pacific region is key to our expansion plans, and we are seeing a surge in demand for our pricing and valuation services in the area."

Euan Johns, director, will lead Markit's Australian operations. Johns previously worked on the Totem service in London for five years and will now focus on the Totem Interest Rate Swap service for the Asia Pacific region.

Codefarm opens new London HQ
Codefarm has opened new headquarters in the City of London to help meet the increasing demand for its technology and services. Codefarm's staff numbers and revenues have more than doubled annually for the past four years.

The new London HQ will accommodate the growing UK sales, marketing and customer support divisions. A new development team in Slovakia has more than doubled the resources of the development division based in Brighton. Codefarm's offices in New York will continue to service the North American markets.

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CDO EODs reach 60

A round up of this week's structured credit news

CDO EODs reach 60
As of 14 January, S&P had received notification from CDO trustees of 60 non-monetary events of default (EODs) on mezzanine ABS CDOs, high-grade ABS CDOs and CDO-squared transactions that were originated during 2006 and 2007. The EODs were triggered by breaches of the EOD overcollateralisation (OC) ratio tests. All of the transactions are backed in part by recent-vintage RMBS and either directly hold notes from the RMBS transactions or hold notes from other CDO transactions collateralised by RMBS.

The 60 transactions for which the agency has received EOD notifications to date represent an aggregate issuance amount of US$69.9bn. These transactions include: 35 mezzanine ABS CDOs, collateralised at origination primarily by single-A through double-B rated tranches of RMBS; 18 high-grade ABS CDOs, which were collateralised at origination primarily by triple-A through single-A rated tranches of RMBS; and seven CDO-squared transactions, collateralised primarily by notes from other CDOs, as well as tranches from RMBS.

S&P has also received notices from the trustees of four CDOs stating that a majority of the controlling classes of the transactions were directing the trustee to proceed with the liquidation of the collateral supporting the rated notes. Three of the transactions (BFC Silverton CDO, ACA ABS 2007-2 and Hartshorne CDO I) are hybrid ABS CDOs collateralised in large part by mezzanine tranches of RMBS; the fourth transaction – Lancer Funding II - is a cashflow CDO collateralised predominantly by tranches of ABS CDOs. All four transactions had previously experienced EODs after failing to maintain coverage ratios above the minimum threshold levels specified in section 5.1 of their indentures.

The amount of EODs is still relatively minor: affected par represents between 12-17% of volume issued in 2006 and 2007. Analysts at JP Morgan expect the list of names to continue to grow over the next two quarters, perhaps plateauing at 100-150 names.

"The chief factor, in the near-term, is whether ratings-based haircuts are in EOD OC clauses; eventually (in 18-24 months) transactions will begin to experience EODs based on actual cashflow shortages rather than the ratings actions which are driving current EODs," they say.

In the transactions that have commenced liquidation, only a small proportion of the assets was taken down by the market while the majority was taken back by the controlling class. The motivating factor is generally to place risk when bids are reasonably attractive, but keep the rest by topping the highest bid and taking it back onto balance sheet, note the analysts. This strategy saves fees and interest (where acceleration language is weak) by converting the CDO structure into a single name portfolio owned entirely by the super-senior.

Based on current ABX prices, JP Morgan estimates an average super-senior recovery value of 32% for mezz SF, 65% for HG and14% for CDO-squareds. HG SF shows a fair amount of disparity; estimates range from 52% to 100% recovery. The one transaction completely liquidated so far (Adams Square I) recovered less than 25% on its assets and only the super-senior received any funds.

Moody's reports on SIVs
Moody's has published two special reports on SIVs, with the aim of providing further detail regarding its position towards them in light of its ongoing review of SIVs' senior debt and also enhancing the market's understanding of these instruments by providing detailed statistics about SIV holdings.

Moody's believes that transparency and improved disclosure is essential for alleviating the pricing and liquidity pressures affecting structured finance – and this is particularly the case for the SIV sector. "Indeed, all SIVs are affected by the recent price decline of fixed income assets and all SIV managers have been actively adapting the structure of their vehicles to this stressed environment," says Paul Mazataud, group md of Moody's international derivatives team and co-author of the reports.

"The sector has reported a decline in assets under management from almost US$400bn in July 2007 to around US$300bn by mid-November and around US$200bn by mid-December 2007," adds Henry Tabe, md for SIV ratings and co-author of the reports. Moreover, Moody's reports that managers and sponsors of SIVs now acknowledge that the senior debt investor base is unlikely to return to the sector in the absence of fundamental changes to the business model.

Moody's first special report is entitled 'FAQs Regarding the Current State of the Structured Investment Vehicle Market'. The FAQ provides answers to the many questions that the rating agency has received from market participants since Moody's announcement on 5 December that it was extending its review period for the senior debt of SIVs due to the receipt of new, material information about possible changes to the operations of SIVs.

Many of these SIVs had been affected by the rating actions implemented by Moody's on 30 November because of the continued decline in the market value of asset portfolios. In light of the complexity and evolving nature of these wide-ranging remedial measures, the agency decided that additional time was required to thoroughly evaluate the rating impact of each SIV's unique action plan.

The second special report, entitled 'Moody's Update on Structured Investment Vehicles', provides details of SIV holdings and other performance parameters, presenting several statistics on variations of these parameters across the sector. As such, the report acts as a supplement to the monthly performance overviews for SIVs that the agency has been publishing since January 2004.

The report explains various restructuring and other alternative funding initiatives that have been, or are currently being, implemented by SIVs. The report also presents statistics on capital net asset values; the maturity profile of senior liabilities; the portfolio sector, rating and country compositions; available backstop liquidity and cash deposits; the average life of asset portfolios; aggregate mark-to-market prices and realised values; and the amount of leverage applied by vehicles in the sector.

US CLO market reviewed
S&P's recent review of the US CLO market - since its inception in 1997 - found that performance has remained strong through a number of economic cycles which affected corporate credit, according to a report published today.

Since 1997, S&P has rated 657 cashflow CLOs through 30 November 2007, 77 of which have been called in full. During this period - which included a spike in corporate defaults due to the internet and telecommunications bubble - CLOs had minimal negative ratings activity, with less than 0.45% of all US rated CLO tranches being downgraded.

The strong overall CLO rating performance primarily reflects the senior secured nature of the underlying assets, which had recovery rates of 70%-80% of par. In comparison, many of the high-yield collateralised bond obligations during that time recovered only 30%-40% of par on corporate bond defaults.

S&P contacted more than 25 CLO managers that had redeemed one or more CLOs and asked them to provide information on the equity internal rates of return (IRRs). The agency obtained the IRRs of 53 CLOs, including 44 cashflow CLOs, four hybrid synthetic CLOs and five market value CLOs. The CLOs were originated between 1998 and 2004.

"We focused on these vintages because not all the CLOs were issued during the same economic cycle and, therefore, we were able to see how CLOs issued across diverse credit conditions have ultimately performed from an equity IRR point of view," says S&P credit analyst Milbert Bentham.

The report also discusses the methodology behind the study, the factors that affect equity IRRs and the timing of optional redemptions.

S&P revises surveillance assumptions
S&P has revised the assumptions it uses for the surveillance of US RMBS and is in the process of revising the correlation and recovery assumptions used to rate and monitor CDO transactions backed by US RMBS.

The agency has made three fundamental changes to its surveillance assumptions for US RMBS:

1.) Stresses of the expected loss amount have been extended over the lifetime of the transaction (compared with the 36-month period currently used) to evaluate the adequacy of credit enhancement.
2.) Expected losses for the 2006 vintage sub-prime collateral have been revised to 19% from 14%, as delinquencies continue to rise, and lifetime loss expectations will be recalculated for all vintages of US RMBS.
3.) Assumptions on availability of excess spread have been revised, as the increased number of loan modifications will likely reduce future excess spread available to cover credit losses.

These revisions reflect the growing economic consensus that US home price declines will be larger than previously forecasted and that the slump in the US housing market is expected to last far longer than previously anticipated. These factors, combined with the persistence of significant growth in seriously delinquent borrowers, are leading to upward revisions in loss expectations and greater likelihood that these expectations will be realised. Loan modifications appear to be gaining traction in the industry, increasing the likelihood that excess interest in the affected securitisations will decline and reduce credit enhancement to cover losses.

At the CDO level, the agency is reviewing the correlation and recovery assumptions used for US RMBS securities held within CDO collateral pools. Existing ABS CDO transactions with exposure to US RMBS securities could be affected by these changes in CDO assumptions.

S&P believes US RMBS transactions backed by sub-prime loan collateral of all vintages could be adversely affected by its pending assumption changes, especially those transactions issued in 2005, 2006 and 2007, as they are collateralised by mortgage loans that are less seasoned and are more sensitive to current market conditions. Once the agency finalises its revised base surveillance assumptions, it will conduct a review of all outstanding RMBS to determine the impact of these assumptions on its outstanding ratings.

Moody's updates CDOROM
Moody's has released an updated version of its synthetic CDO modelling tool. CDOROM v2.4 includes: Moody's latest methodologies for analysing CRE CDOs, CPDOs and CPPI transactions; recent changes in Moody's correlation assumptions for CDO-squareds and ABS CDOs; refinements to Moody's approach for modelling muni CDOs; updated emerging market assumptions; and additional reporting and flexibility features.

As described in a 2007 report, the CRE CDO approach is based on a CDO-squared style look-through analysis into each underlying loan in the collateral pool, whether held directly or through a CMBS tranche. Correlation and rating assumptions for the loans are supplied by Moody's CMBS team and CDOROM automatically determines the amount of credit enhancement required, so that the CMBS exposures can be modelled as synthetic CDO tranches that have expected losses consistent with their ratings.

CDOROM v2.4 also incorporates the framework used to model CPPI and CPDO structures. This is a Monte Carlo simulation-based approach where the user supplies a bespoke analytical component implementing the specific economics of the transaction being modelled. CDOROM generates scenarios of future ratings and credit spreads for each of the names in the portfolio, while the bespoke component calculates the performance of the structure given these inputs.

With regard to increased correlation assumptions for ABS CDOs and CDO-squared transactions, many of the factors behind the changes in assumptions were noted in an April report and will be discussed further in an upcoming publication. Because of the extensive exposure to similar RMBS in ABS CDOs, Moody's will triple the assumed correlation between ABS CDO tranches in its analysis of CDO-squareds and other transactions.

In light of recent sub-prime RMBS performance, it will also apply higher 'key agent' (e.g. RMBS originator) and vintage stresses to its correlation assumptions. As announced in September, the RMBS 'sub-prime' and 'mid-prime' categories have been combined. Finally, CDOROM v2.4 will apply up to 100% correlation to tranches of ABS CDOs and market-value CDOs that are included in CDO-squared transactions.

The muni CDO-related changes include the addition of five new sectors, updated recovery rate assumptions that are consistent with Moody's March publication and updated correlation assumptions. The new release can also accommodate mixed portfolios that include municipal, corporate and structured instruments. Also, specific guarantors can be identified to accurately model wrapped municipal bonds.

In accordance with the publication of Moody's revised emerging market methodology, CDOROM v2.4 includes the updated correlation weights and EM recovery rate assumptions to be used when modelling CDOs with exposure to EM corporates.

Fitch to maintain Sigma ratings
Fitch will maintain the ratings of Sigma Finance Corporation's MTNs and CP as long as sufficient information is available to the agency. The agency says that Gordian Knot, the investment manager of Sigma, formally requested on 8 January that Fitch immediately withdraw all its ratings on Sigma, but also notes that it is ultimately the decision of the agency whether it maintains or withdraws a rating.

Based on the high level of investor interest in both the limited purpose finance company and structured investment vehicles, Fitch does not currently plan to withdraw the ratings. However, in accordance with Fitch's Code of Conduct, if it believes it no longer has access to adequate public and non-public information to maintain the ratings, it will withdraw the ratings.

MBIA surplus notes rated
S&P has assigned a double-A rating to US$1bn of surplus notes issued by MBIA Insurance. At the same time, the agency lowered its ratings on MBIA Inc.'s corporate credit rating and senior unsecured debt and the North Castle Custodial Trust's committed preferred stock to double-A minus from double-A to reflect the issuance of the surplus notes, which creates US$1bn of obligations that rank senior to those obligations.

The double-A rating reflects the fact that the notes are subordinate to all existing and future indebtedness, policy claims and other creditor claims of MBIA. The surplus note rating is tiered off of MBIA's tripe-A financial strength rating - reflecting S&P's standard application of surplus note rating criteria, which calls for notes to be rated two notches below the financial strength rating of their issuers.

S&P affirmed its triple-A financial strength rating on MBIA in December, following the results of a capital adequacy test that incorporated updated loss assumptions regarding RMBS and related CDO exposures. This surplus note issuance is a component of a capital plan that MBIA is developing to address the capital deficiency identified by the capital adequacy test.

The downgrade on the committed preferred stock reflects the rating that we would apply to MBIA's preferred stock. The existence of the surplus notes further subordinates the relative standing of the preferred stock, as well as holding company debt. Thus, when analysing the holding company, S&P views the surplus notes as debt.

This new debt brings the holding company's total debt to 22.9% of its capitalisation as of 30 September; the new offering and the US$1bn of new equity that MBIA has committed to raise are pro forma and exclude any of the announced reserves that the company will use in the fourth quarter of fiscal 2007. Debt ratios higher than 20% are not consistent with a double-A rating on holding company senior debt. The negative outlook on the debt rating reflects the negative outlook on MBIA's financial strength rating.

Ratings for currency swaps
Fitch Ratings has introduced public ratings with respect to the currency swap obligations of SPVs in global structured finance transactions.

Stuart Jennings, head of European structured finance research at Fitch, says: "We have seen increased interest in obtaining specific ratings for SPV obligations with respect to structured finance currency swaps. This interest is likely to increase following the recent implementation of Basel II, since the capital requirements for a currency swap position where there is no rating will be higher than those which are specifically-rated."

In a criteria report, Fitch outlines the circumstances and limitations under which a rating can be accorded to an SPV's currency swap obligations. Ratings are limited to those currency swaps that are linked to a specific rated note tranche. Given that the obligations for such currency swaps are usually either pari passu or senior to payments with respect to the related note tranche in transaction priority of payments, the currency swap obligations will usually be awarded the same rating as the note tranche itself.

According to the Basel II framework, all derivative transactions – such as currency swaps, interest rate swaps and credit default swaps linked to securitisation structures – are deemed under the new regulations to be securitisation positions. Banks using the internal ratings-based (IRB) approach must generate a capital charge for such positions based on various attributes of the structure and the riskiness of the underlying assets. In order to do this, they require either an external rating or, in the absence of an external rating, need to apply the supervisory formula (SF) specified in the Basel and Capital Requirements Directive regulations - or use an inferred rating approach to arrive at an equivalent rating.

As the SF method requires a number of inputs and is quite complex, it cannot be used to determine the credit risk in derivative transactions. Therefore, by default, IRB banks will have to apply the inferred rating approach to determine the credit risk and associated capital charges in derivative transactions in the absence of a specific rating.

The use of inferred ratings will result in derivative transactions receiving a rating that is inferred from any public rating from the most senior subordinated position below the derivative in the priority of payments. For currency swaps, this could result in fairly punitive capital charges for banks, where the swap hedges a note with a specific rating and with which it ranks pari passu; a lower rating has to be inferred from a position further down the capital structure.

S&P downgrades continue
S&P has lowered its ratings on 149 tranches from 31 US cashflow and hybrid CDO transactions, and placed its ratings on four other tranches on credit watch with negative implications. The downgraded tranches have a total issuance amount of US$8.74bn. At the same time, the agency affirmed its ratings on another 46 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 54 of the downgraded tranches remain on credit watch with negative implications, indicating a significant likelihood of further downgrades.

To date, S&P has lowered its ratings on 1,290 tranches from 402 US CDO transactions as a result of stress in the US residential mortgage market and credit deterioration of US RMBS. In addition, 726 ratings from 181 transactions are currently on credit watch negative for the same reasons. In all, the affected tranches represent an issuance amount of US$83.5bn.

CDS basis reviewed
Fitch Ratings has published a report entitled 'A Brief Review of the Basis', which describes, in general terms, the nature and behaviour of the relationship between CDS, LCDS and bonds over the turbulent market cycle of the last six months. More specifically, the basis was examined for several more volatile corporate names.

"With regard to single-name CDS, not unexpectedly, derivatives generally tracked the underlying cash instruments closely, although CDS may have been susceptible to more abrupt movements at times," says James Batterman, md, Fitch Ratings. The agency notes that there is a distinct possibility that the CDS market may have led the cash market wider in the few instances examined.

Fitch's analysis also examines the CDS/LCDS relationship, which allows researchers and investors to make inferences with regard to the market's perception of relative recovery rates for the underlying cash instruments, as well as the relationship between certain credit derivative and cash market indices.

The credit derivative indices would ordinarily be expected to react rapidly and abundantly to a significant change in investor sentiment, and this certainly appears to have been the case over this turbulent period. However, care should be taken in comparing cash market indices to those of derivatives given compositional and pricing differences.

Japanese SROC results in
S&P has placed its ratings on two tranches relating to two Japanese synthetic CDO transactions on credit watch with negative implications. At the same time, the agency affirmed its ratings on 10 tranches relating to eight Japanese synthetic CDO transactions, and removed them from credit watch with negative implications.

The tranches removed from credit watch with negative implications had Synthetic Rated Overcollateralisation (SROC) levels that recovered to 100% or above during December's month-end run. The tranches that have been placed on credit watch with negative implications had SROC levels that fell below 100% during December's month-end run.

SROC is the key measurement used to determine whether a rating action is required. It captures the major influences on portfolio performance: events of default, asset migration, amortisation of assets and time decay.

Rating transitions updated
S&P has begun providing weekly updates on its rating transitions for structured finance securities. The first section of the report focuses on the US housing market-related sectors and vintages that have experienced high rating activity in recent months. The second section provides a perspective on the rating behaviour of structured finance securities on a global scale.

The US housing market-related securities discussed in this report include RMBS, ABS CDOs and SIV-lites. RMBS includes sub-prime, closed-end second lien, net-interest-margin (NIMS), Alternative-A (Alt-A), prime and other sub-sectors. ABS CDOs include cash, synthetic and hybrid.

The report covers the long-term issue ratings of securities with vintages of first-quarter 2005 through third-quarter 2007, but does not include issuer credit ratings and short-term ratings. Downgrades, number of notches and other statistics are calculated on a cumulative basis (since issuance). Dollar-weighted statistics are based on the original issuance amount.

Overall, S&P observed the following key trends about the rating behaviour of US housing market-related securities:

• The agency has downgraded about US$144bn (4.5%) out of about US$3.2trn in original issuance, and an additional US$80bn (2.5%) is still on credit watch negative for these vintages and sectors.
• Among the downgraded securities, about US$4bn in original issuance has defaulted.
• The securities that were downgraded from investment-grade to speculative-grade account for about 49% of the downgrades (by original issuance).

For US RMBS:

• So far, out of US$2.75trn in original issuance for these vintages and sub-sectors, S&P has downgraded about US$98bn and an additional US$33bn is on credit watch negative.
• A total of 343 securities remain on credit watch negative across the US RMBS sub-sectors.
• S&P has lowered approximately 25% of the ratings on these vintages and sub-sectors since their issuance (about 5.2 cumulative downgrade notches).
• It has lowered approximately 2.5% of the original triple-A ratings on these vintages and sub-sectors (about 8.2 cumulative downgrade notches).
• About 86% of closed-end second lien, 31% of NIMS, 29% of sub-prime and 23% of Alt-A securities experienced downgrades.
• A greater percentage of 2007 vintage sub-prime securities has been downgraded when compared with the 2005 and 2006 sub-prime vintages.
• 2007 vintage sub-prime ratings have been lowered by an average of two to three notches and 2005 and 2006 vintage sub-prime ratings by an average of four to six notches.

For US ABS CDOs and SIV-lites:

• So far, out of about US$480bn in original issuance for these vintages and sub-sectors, S&P has downgraded about US$46bn, and an additional US$47bn is on credit watch negative.
• A total of 701 securities remain on credit watch negative across the US ABS CDO sub-sectors and SIV-lites.
• Approximately 29% of the ratings on these vintages and sub-sectors have been lowered since their issuance (about 5.0 cumulative downgrade notches).
• At least one original triple-A rating in every five transactions for these vintages and sub-sectors has been lowered (about 3.7 cumulative downgrade notches).
• On a cumulative basis, about 43% of hybrid ABS CDOs, 32% of synthetic ABS CDOs and 21% of cashflow ABS CDO securities experienced downgrades.

Moody's downgrades Duke Funding debt
Moody's has downgraded to single-C two classes of Duke Funding High Grade II-S/EGAM's mezzanine term notes, with approximately US$255m of debt securities affected.

On 30 November the agency downgraded the ratings of the Class A2 and Class B1 notes following the inability of Duke Funding to meet margin calls in its repurchase agreements. The latest rating action is prompted by the decline of Duke Funding's capital net asset value from 21% on 23 November to below zero on 11 January.

This followed the declaration of an event of default by Duke Funding on 6 December 6. As a consequence of both the NAV decline and the occurrence of an EOD, one of the counterparties to the repurchase agreements, holding 8% of the portfolio, has exercised its right to liquidate assets. The remaining four counterparties, holding 92% of the portfolio, have agreed to forebear such liquidation rights on a temporary basis.

In Moody's view, holding the assets to maturity, which is one option for the counterparties, is unlikely. Rather, counterparties may exercise their right to liquidate assets; this would result in expected losses commensurate with a rating of single-C for both classes of notes. Duke Funding is a SIV-lite managed by Ellington Global Asset Management.

ICMA to review ABCP
ICMA, working with the European Securitisation Forum, will soon publish a review of the European ABCP market, structures, reporting practices and investor considerations. The report will serve as a discussion paper with ABCP investors as to ways in which current business practices could potentially be enhanced so as to maximise investor participation. The report will be submitted to the European Commission to aid in discussions on the wider credit crunch (see SCI issue 69).

In addition, the ABCP market in Europe is planning to adopt a Code of Conduct on Disclosure as a standard of best practice. Such a Code of Conduct would be designed to ensure that investors in ABCP have access to information through different sources: the information memorandum; the monthly investor report; investor meetings; and rating agency reports.

This information should be reviewed by investors, both before buying and on an ongoing basis. Purchases should not be based on rating alone. Specifically, investors should know, monitor and be comfortable with: the type of assets financed; the sponsor of the programme; the sponsor's ability to administer the programme; the liquidity support and credit enhancement provided; and the mechanism for repaying the commercial paper should market conditions not permit rollover.

In keeping with the Commission's preference for market-led initiatives as opposed to additional regulation, the Code of Conduct would be voluntary. Participants in the ABCP market would be invited to comply with the code, the final version of which would be promoted by ICMA through its Euro Commercial Paper Committee, and possibly also by other trade associations.

Performance monitoring tool for US ABS
Markit has launched a performance monitoring tool for US ABS. Launched in response to market conditions, the new US ABS Performance Data will bring greater transparency to the sub-prime mortgage market.

The platform combines complete historical data at the bond, collateral pool and loan level to provide ABS market participants with a vital and timely source of information for deal monitoring and securitisation analysis. Additional RMBS and ABS asset classes will be added in due course.

Ben Logan, md of structured finance at Markit, says: "Increasingly, ABS investors require a more timely and comprehensive understanding of the collateral underlying each ABS deal. Markit's new product aims to bring much needed transparency to the US ABS markets by providing clients with an up-to-date collateral monitoring tool, alongside the other unique and valuable content we offer. It will enable market participants to remain at the forefront of the markets and evaluate both the historical performance and the current risk profile of their ABS positions with ease and accuracy."

Features of the tool include:

• Concise monthly snapshot reports with key deal statistics.
• Comprehensive collateral performance information at pool and deal level including: delinquency, loss and prepayment levels and speeds.
• Waterfall-related triggers: step-down, delinquency, cumulative loss.
• Complete bond payment and collateral performance history.
• Loan-level statistics with data feed functionality.
• All deals updated within two days of monthly distribution date.
• Data validated to ensure integrity.
• Ability to track customised portfolios.

Victoria defaults
S&P lowered its issuer credit ratings on Victoria Finance, as well as its ratings on the vehicle's CP, MTNs and junior subordinate notes. Moody's downgraded the vehicle's MTNs. The downgrades reflect a technical default incurred by Victoria for failing to pay CP that had matured on 10 January.

As stipulated by the security agreement, an enforcement manager must be appointed and Ceres Capital Partners will be replaced as Victoria's manager. Deutsche Bank Trust, as the collateral agent, must appoint the new enforcement manager within 10 days of Victoria entering enforcement mode.

Before Victoria entered enforcement mode, Ceres Capital Partners facilitated and worked with Victoria's senior creditors to amend the security agreement to prevent immediate asset liquidations and potentially a fire sale of assets. The security agreement had originally contemplated that, if the market value of the portfolio - based on actionable bids - was deemed insufficient to pay senior creditors in full, all collateral would be liquidated and the proceeds of the sale would be distributed pro rata to the senior creditors.

Now, however, the amendment gives senior creditors the option to decide not to have their pro rata share of the portfolio liquidated immediately. The amendment stipulates that by 17 January, senior creditors must decide whether they want their pro rata share of the Victoria portfolio liquidated.

Any senior creditor who does not respond or chooses to liquidate will have their share of the portfolio liquidated immediately. The senior creditors who elect not to liquidate must allow the enforcement manager to review the portfolio over a yet-to-be-determined time period.

After this time period, the enforcement manager will determine if the proceeds from a sale of the remainder of the portfolio would be sufficient to pay off all senior creditors. If all senior creditors would be paid in full, the enforcement manager will liquidate the portfolio and use the proceeds to pay the senior creditors their remaining liability amounts.

However, if the enforcement manager determines that the proceeds from a sale would not be sufficient, senior creditors would need to vote again if they would like their share of the portfolio liquidated or if they would like to remain a senior creditor in the Victoria vehicle. The senior creditors would then have to work with the enforcement manager to determine which restructuring proposal they will pursue.

The outstanding amount of Victoria's senior debt is approximately US$6bn (including an approximately US$225m committed liquidity facility that must be repaid) and the outstanding amount of its subordinated junior notes is approximately US$777m.

SROC results for US CDOs
S&P has lowered its ratings on 13 US synthetic CDO tranches and placed its ratings on 22 tranches on credit watch with negative implications. At the same time, it placed one tranche rating on credit watch with positive implications, and affirmed eight tranche ratings and removed them from watch negative. In addition, the agency withdrew one tranche rating after the notes were terminated.

The negative credit watch placements and downgrades reflect negative rating migration in the respective portfolios, as well as synthetic rated overcollateralisation (SROC) ratios that fell below 100% as of the December month-end run. The classes with affirmed ratings had SROCs at 100% at their current rating levels. The one rating that was placed on watch positive had an SROC that was at or above 100% at the next higher rating level.

CS

Trading ideas: pear-shaped risk

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at a CDX IG Series 9 tranche trade

With the CDX IG five-year index trading above 100bp and after a significant amount of risk has shifted to the middle of the capital structure, we believe bespoke synthetic investors will eventually re-enter the market. We recommend selling protection on the CDX 10-year 7-10% tranche hedged with the index, as investors will no longer be forced to reach for yield.

Even though bespoke investors will most likely sell protection on shorter term maturities, we believe this pressure will also push the 10-year 7-10% tranche tighter. Our Tranche Index Multiple (TIM) model indicates this segment of the capital structure to be the cheapest.

TIM model
A simple, yet effective way to gauge an index tranche's richness/cheapness is by looking at its relationship with the index itself. For our TIM model, we regress the tranche spread on the index level and the index level-squared, allowing for a non-linear fit. This model relies on a historical relationship to continue into the future and runs the risk of regime shift.

In order to have a long enough time series, we combined both the CDX Series 8 and Series 9 in the regression, enabling us to estimate our model back to March 2007. Exhibit 1 shows the time series of the difference between the model-implied spreads and actual tranche spreads. The tranche has widened considerably relative to the index over the past few weeks.

Exhibit 1

We also run separate regressions using only Series 9 data and Series 8 data independently. This gives multiple fair value spreads for the same tranche and, as shown in Exhibit 2, the 7-10% tranche is undervalued by all three models.

Exhibit 2

'Carry-ed' away
Another simple measure is the carry of the trade and how it compares with historical carry positions, had we entered the trade at previous dates. Exhibit 3 is a graph of the historical carry for the trade using a delta of 3.3x. Over the past month, the negative carry on the trade has dramatically decreased, which is another way of saying that the spread of the tranche has widened out more than the index.

Exhibit 3

Risk analysis
A long 10-year 7-10% tranche hedged with the index is slightly long correlation; however, the main risk to the trade is the correlation skew. For a 1% increase in the skew, the trade will have a positive P&L of around 125k (see Exhibit 4).

Exhibit 4

Liquidity
The liquidity of the index and 10-year tranches is very good, even during 'illiquid' times, with both having bid-offer spreads of 0.5bp and 3-4bp respectively.

Fundamentals
This trade is not based on fundamentals, but if we see a drop in credit volatility and mild recession, we believe this trade will outperform.

Summary and trade recommendation
Once credit volatility starts to drop and investors return to the table to take long positions in bespoke synthetic CDOs, we believe they will sell protection on tranches with greater subordination than seen over the recent past. The CDX 10-year 7-10% tranche currently offers more than 2.5x the spread seen last spring.

This is a compelling yield for real money investors that are willing to dip their toes back in the water on the longer end of the curve. We recognise that investors will most likely take positions in shorter maturities (five-year and seven-year); however, this should still provide pressure on the 10-year tranche.

As we enter the default cycle, our view is that credit curves will continue to invert and the safest way to play this is out on the longer end. We recommend selling protection on the CDX 10-year 7-10% tranche hedged with the index, as our TIM model also shows fair value to be around 40bp tighter.

Sell US$10m notional CDX IG Series 9 10Y 7-10% tranche protection at 309bp.

Buy US$35m notional CDX IG Series 9 10Y index at 108 to pay 69bp in 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).

New Year, same challenges

Risk aversion on the iTraxx index is discussed by Andrea Cicione and Rajeev Shah, credit strategists at BNP Paribas

Credit spreads ended 2007 at multi-year wides. Volatility on risk assets increased significantly during the year, as the iTraxx five-year Master and Crossover indices widened by 27bp and 120bp respectively. Cash spreads weathered larger losses, with average iBoxx corporate spreads widening by 64bp (largely led by financials, in particular the higher beta sectors such as bank T1).

2008 has opened up pretty much where 2007 left off. However, there has been a distinct difference in performance between cash and CDS, particularly within the investment grade space.

Exhibit 1

Cash spreads that had widened significantly prior to year-end have widened modestly in the New Year, while CDS has been playing catch-up. The iTraxx S8 Master index has gapped out by 19bp since the beginning of the year, while an equivalent basket of cash iBoxx spreads has widened by 5bp (see Exhibit 1).

Within high yield, the widening has been broader, with Crossover wider by 66bp, while cash high yield spreads have moved out by around 50bp. With expectations of default rates increasing sharply over the year, we believe high-yield spreads have a lot more room for further widening relative to investment grade spreads.

The widening in spreads has taken place within the context of a general aversion to riskier assets. With the VIX increasing to above 25% again, equity markets have weakened significantly, leading to the movement in credit spreads. It is these external market influences that have helped the movements in credit spreads.

It seems that technicals in credit are not strong enough on their own to override changes in general market risk appetite. We believe the changing macro environment, with its impact on bottom-up earnings estimates, will continue to be the principal determinant for equities and credit in the medium term.

Exhibit 2

Crossover offers little value
As iTraxx indices' spreads move into uncharted territories, it is fair to ask - in light of reviewed economic growth forecasts and the possibility of a US recession - whether the current levels adequately compensate investors for risk - or should we rather expect further widening? We therefore provide breakeven default rates analysis for the iTraxx Europe and Crossover indices (summarised in Exhibits 2-3 and Table 1).

Exhibit 3

The Europe investment grade index has always had a sizeable risk premium built into the spread, even when this was at its tightest in May last year. Back then, iTraxx Europe's spread compensated investors for a 1.7% default rate over the five-year duration of the contract, or a bit more than two defaults in the 125-name strong index.

Table 1

Historically, the default rate among issuers with a comparable triple-B average rating has been 0.95% in Europe, according to S&P. And even during the worst five consecutive years of the past half-century, Moody's says that only 2% of Baa-rated names have defaulted.

Today the breakeven default rate for iTraxx Europe, with the index flirting with the 70bp mark, stands at 4.8%. This is more than five times the historical average for triple-B rated issuers and, in our view, provides a very attractive entry point for investors who can navigate the likely short-term P&L volatility.

The picture for the Crossover index is not as attractive. When the index was trading below 200bp early last year, the five-year breakeven default rate was, at 15%, below the single-B rated entities' historical average default rate of 18%. Today, even though the breakeven rate of roughly 30% is well above the historical average, it is still less than half the 68% rate of default experienced by single-B rated companies during the 1988-1992 period – the worst five years on record.

Defaults still at record low, but set to rise
While the rating agencies continue to report historically low levels of default – Moody's published a 26-year low of 0.9% for global high-yield issuers in December – they expect rates to increase more than five-fold and come close to 5% in 2008 (see Exhibit 4). Our own model - based on forecasts for S&P 500's EPS, return and price-to-EBITDA, as well as US GDP growth - yields similar results, with the sub-investment grade default rate predicted to rise to up to 4% by the end of the year.

Exhibit 4

Actual default rates, even when they rise sharply, can take a few years (typically between four and six) before they hit their highest point. If defaults started to rise this year and headed for levels comparable with past peaks, they would probably average 5-6% over the next five years. In this case the current iTraxx Crossover spread would still compensate investors for the consequent expected losses – but only just.

Exhibit 5

The Russell 2000 index has also been a good leading indicator of rising defaults, particularly for the smaller capitalised high-yield issuers. Exhibit 5 shows that negative year-on-year declines of the Russell 2000 index of more than 10% have historically led to a sharp rise in defaults.

The index has already dropped close to 20% from the recent peak set in July 2007 and, on a year-on-year basis, it has fallen by 9.5%. From a technical perspective, this ties in well with our and the rating agencies' expectations of much higher default rates by the end of the year.

Sell iTraxx Europe protection, buy Crossover
Our analysis shows that there seems to be more value in iTraxx Europe than in the Crossover index at current levels. As Exhibit 6 illustrates, the underperformance of iTraxx Europe relative to Crossover has been marked and the basis between the latter and eight times the former - at about -150bp - is extremely tight.

Exhibit 6

We believe there is scope for this measure to revert to the average, particularly when one considers that, from a fundamental point of view, the speculative grade sector is likely to underperform investment grade in a slowing economic environment (Exhibit 7). To take advantage of this, investors could buy protection on the iTraxx Crossover and sell protection on the main index. With a hedge ratio of between 7 and 8, the trade would be carry-positive and broadly delta-hedged.

Exhibit 7

An alternative way to express a similar view is to buy protection on iTraxx Crossover and sell protection on the iTraxx Financials Sub index, with a ratio of 5-to-1. This trade is consistent with our view that Crossover offers little value and our overweight recommendation for Bank LT2.

© 2008 BNP Paribas. All rights reserved. This Research Note was first published by BNP Paribas on 11 January 2008.