Contents

European index buzz

ECMBX on its way, new product in the works

Renewed efforts are underway to launch a suite of European structured finance CDS indices. Dealers expect the Markit ECMBX index to be operational by the end of the first quarter, but they are also working on a potential new RMBS product - dubbed ERMBX.

Markit confirmed that a dealer working group has been established to look into the structure of a new ERMBX index, but could provide no further details. Rob Ford, portfolio manager at Synapse Investment Management, suggests that the launch of a European RMBS index has been mooted because the lack of liquidity since last autumn has forced the market to go back to basics, with players picking on a couple of benchmarks as an indicator for market direction.

"These benchmarks are the bigger, most frequent issuance names in the UK mortgage space, such as HBOS and Abbey through their respective Permanent and Holmes programmes, as well as the major European issuers (Storm and Hermes from Holland, for example)," he explains. "The ECMBX index isn't the clearest benchmark because the constituents are typically large, less granular loans and, unlike RMBS, have greater corporate linkage. So I think some traders felt that, given market volatility, it might be a good idea to develop an RMBS index alongside ECMBX."

There are around 10-14 programmes in Europe that could be considered as possible ERMBX constituents because they don't utilise the master trust structure and issue around €1bn-equivalent at a time. These deals all have approximately two- to four-year WALs.

Market participants have had time to digest the events of last summer which forced the delay in the launch of the ECMBX index, meanwhile, and it is now likely to appeal to a much wider audience. The index was initially expected to be mainly used as a proxy investment by those investors who had been disappointed by allocations in the primary market or were unable to find suitable investments in the secondary market, as well as by CMBS issuers to hedge their pipeline.

"But now investors will look to use it as an additional market hedge - certainly the more traditional UK funds, which have considerable exposure to UK commercial property, may see the index as an alternative hedging tool. In addition, regular investors in CMBS may also use ECMBX to more efficiently manage their long exposure, as well as speculative players (such as hedge funds from outside the European ABS market) using it to take directional views," says Ford.

The ECMBX index will consist of four sub-indices: triple-A and triple-B indices in both euro and sterling. The indices will each consist of 20 single name pay-as-you-go CDS referencing eligible European CMBS bonds and are expected to roll on a semi-annual basis. Constituents will be selected according to a defined set of rules.

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Hedge risk

CDS contracts under increasing stress as hedging tools

CDS contracts are expected to come under increasing stress this year as the risk of defaults rises – the first credit event is already imminent (see separate news story on Quebecor). In the current environment complex documentation and counterparty risk could provide the instrument with its first real test.

The CDS market, in its present configuration, is substantially untested, according to Satyajit Das, risk consultant and author of 'Traders, Guns & Money: Knowns and Unknowns in the Unknown World of Derivatives'. "In 2007 actual defaults in corporate credit were low - it was a case of a credit crisis with no defaults, a 'phoney war' if you like. As the credit crisis deepens and spreads, especially into the real economy, the risk of actual defaults becomes real. That is where the CDS market will be tested: it may not function as participants and regulators are hoping when actual defaults start to occur," he notes.

CDS contracts have inherent 'documentary asymmetry', whereby the hedge may not function as intended. CDS documentation does not exactly match the documentation of the underlying credit exposure being hedged due to the lack of a direct contractual relationship between the two parties.

In addition, says Das, the ISDA standard CDS contract is a trading instrument. "Traders want - and have got - standardisation and simplicity, but the features that promote liquidity make it difficult for a hedger to exactly match their risk. You don't really know how well the hedge via the CDS will work until you test it where there is a real default."

A buyer of protection is not protected against "all" defaults; they are protected against defaults on a specified set of obligations in certain currencies. There could be situations where a loan has defaulted but there are technical difficulties in triggering the CDS hedging that loan.

Triggering a CDS contract relies on the concept of publicly available information. "Most of the credit events so far experienced by the market were Chapter 11 filings, which are fairly straightforward," Das explains. "But if the credit event is failure to pay or restructuring, then there may be problems in establishing that the credit event took place."

This has a systemic dimension - to trigger the contract, a CDS protection buyer may have to put the reference entity into bankruptcy in order to settle the contract. Losses may consequently be exacerbated.

CDS outstandings on many reference entities are in excess of the available deliverable obligations: on the most actively traded names CDS volumes are around 6-10 times outstanding debt. The protocols established to deal with the operational risk and practical restrictions on simultaneously settling a large volume of CDS contracts bring their own documentation risk.

In the case of the Delphi default from 2005 the protocol resulted in a settlement price of 63.38%, but Fitch assigned an R6 recovery rating to the company's senior unsecured obligation - equating to a 0-10% recovery band. Far below the price established through the protocol, this resulted in the protection buyer potentially receiving a payment on their hedge well below their actual losses.

Indeed, Das argues that CDS contracts do not eliminate credit risk - the risk of the protection seller is substituted for the risk of the loan or bond being hedged. "This means a protection buyer is exposed to two risks - the credit quality of the protection seller and the default correlation between the reference entity being hedged and the protection seller. Protection sellers include monolines, hedge funds and regional banks. In the case of monolines, the decline in credit-standing is well documented [see separate article]; hedge funds are highly leveraged entities and regional banks vary in terms of credit quality."

What effect will defaults have on insurers, hedge funds and banks? If the economic climate worsens and defaults rise, then does the overall ability to rely on these hedges decline? The diversification of risk may diminish exactly when the market needs it.

The ability to trade credit, create different types of credit risk and take highly leveraged credit bets has become increasingly important. If defaults rise, the high leverage, inherent complexity and potential loss of liquidity of CDS contracts and structures based on them may cause significant dislocation in the structured credit market.

As Das, who warned of some of these problems as far back as 2006, concludes: "Banks may well take losses on transactions where they assumed that the risk had been sold off. And settlement problems may result in markets becoming grid-locked, which could result in additional issues in inter-bank/inter-dealer counterparty risk."

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First to default?

New credit event imminent

The market is bracing itself for a credit event to be called on Quebecor World, a constituent of the Markit CDX HY index. The firm, North America's second-largest publicly traded printer, has sought protection from creditors in the US and Canada after it failed to secure refinancing as talks over a rescue deal unravelled.

Quebecor applied for creditor protection under the Companies' Creditors Arrangement Act in Canada and Chapter 11 of the US Bankruptcy Code and has asked for a 30-day extension to the standard 15-day period in which to gather all the necessary financial information. The firm does not have sufficient liquidity to pay its obligations, according to a filing in the US Bankruptcy Court, Southern District of New York.

S&P and Moody's cut the company's ratings to D, following the non-payment of interest on its US$400m 9.75% senior unsecured notes, which was due on 15 January 2008. The firm was rated triple-B minus as late as May 2005.

The last credit event to hit the CDS market - which was called on Movie Gallery in September - was the first to test the settlement mechanism of the LCDX index (see SCI issue 57). But the last credit event to involve the CDX HY index was Dura Automotive Systems in October 2006 (see SCI issue 5).

The resulting Dura protocol broke new ground by incorporating settlement of single name and tranche default swaps, as well as the index trades affected by the credit event. ISDA said at the time that it will test the new protocol on a couple of credit events before determining whether the format will be adopted on a prospective basis and folded into its credit derivatives definitions. CDS index protocols have been utilised since 2005 and had previously been introduced on a case-by-case basis.

No information was available at press time about a potential settlement protocol for Quebecor. But the market will be watching any developments keenly, given the anticipated rise in defaults this year and the additional stress this may put CDS documentation under (see separate news article for more on this).

One possible addition to any new protocol is an arbitration panel to resolve deliverability disputes. However, this is still believed to be in the early planning stages and unlikely to be in place in time for the next few credit events the market looks set to face.

Analysts at JP Morgan estimate that 30-40 CLOs hold the Quebecor World name, with average position size at around 0.66%. There is broader exposure to Quebecor Media (at over 120 CLOs), a subsidiary of the common parent - although this company is unaffected by the bankruptcy filing.

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Gaining momentum

Proactive portfolio reconciliations are discussed by Henrik Nilsson, head of business development at TriOptima

OTC derivatives trading volumes continue their extraordinary growth across asset classes. The escalating volumes, complexity of structures and increasing number of counterparties have presented new and urgent challenges to operations as well as counterparty risk management.

During the past year, portfolio reconciliation has gained much attention. The sub-prime credit crisis has heightened awareness about the importance of reconciling trade populations and valuations regularly with counterparties in advance of market turbulence.

Increased volatility and sudden illiquidity, coupled with an increased velocity in trading, resulted in significant valuation and trade population differences between counterparty portfolios. This in turn increased the number of collateral calls and valuation disputes. Counterparties who had begun to proactively reconcile their portfolios were in a much better position to make the daily collateral calls required by their legal agreements, manage the increased work-load in their collateral departments and understand their counterparty credit risk exposures.

It is essential that OTC derivatives dealers are able to mitigate counterparty exposures through timely exchange of collateral, since any unsecured exposures require capital reserves on the balance sheet. As unsecured exposures grow and capital becomes a scarcer resource, collateral management is increasingly becoming an issue for senior management. Regular portfolio reconciliation has also become a focus of regulatory interest (see BIS CPSS 2007 study on 'New Developments in Clearing and Settlement Arrangements for OTC Derivatives'), and an industry initiative by the Collateral Framework Group has been addressing the practical aspects of portfolio reconciliations.

Reconciled trade populations lead to several operational benefits beyond collateral management. By identifying and correcting legal entity mis-bookings and resolving any other discrepancies earlier rather than later, many settlement breaks can be avoided.

For buy-side institutions, generating monthly fund net asset values is significantly easier since trade data is reconciled continuously throughout the month. It enables buy-side institutions to produce accurate NAVs quickly.

An online community for reconciliation
Until recently each market participant would perform portfolio reconciliations when collateral disputes arose either by exchanging spreadsheets with each other or using software packages with broader functionality. These solutions work for smaller volumes of data and counterparties but do not meet the challenges of large portfolios, daily collateral calls and increasing numbers of counterparties. Their limitations make it impossible to identify and analyse quickly the causes of portfolio discrepancies.

Recognising a growing need, the market has seen the introduction of alternative solutions by software vendors and service providers that address these limitations in varying ways. TriOptima has created its own solution, triResolve, which solves these problems with an easily accessible, networked workspace where counterparties research and resolve their differences online.

The triResolve web-based portfolio reconciliation service forms a virtual community where counterparties see a common view of the issues and can communicate with each other directly online, placing comments, uploading confirmations and assigning breaks. Currently, the majority of large OTC derivatives dealers use the triResolve service. Each week, portfolios of more than three million trades are reconciled, including data from the participating dealers and hundreds of their clients.

Now that the majority of dealers are actively using reconciliation software or services such as triResolve, there are emerging opportunities for buy-side institutions to reconcile a large portion of their trades with subscribing counterparties, providing benefits for both sides. As the role of portfolio reconciliation expands across and within market participants, vendors also expand and improve their reconciliation software and services. From collateral dispute resolution to regular position reconciliation and valuation statement distributions, portfolio reconciliation is proving to be a flexible solution to many of the most challenging problems in post-trade derivative operations.

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.

Observing the cycles

Jamie Stuttard, head of structured credit at Schroders, answers SCI's questions

Jamie Stuttard

Q: When, how and why did your firm become involved in the structured credit markets?
A: The current overall team has managed credit at Schroders since 1998. Our CIO joined in 1998, our head of global credit research in 2000 and our head of credit strategy in 2000; I'm in my fifth year at the firm.

We have significant institutional resources, including 25 dedicated credit analysts spanning four continents, nine dedicated credit portfolio managers, a strong quantitative team and a credit structuring team (hired from BGI, Babson and Solent). Schroders has a strong track-record in the following sectors: global investment grade since 2002; levered absolute return product since 2003; dedicated high-yield product since 2004; and credit long/short CPPI since 2006. We've experienced no defaults for seven years and just four distressed sales over that time, so we believe we have a superior track-record to many of our competitors.

The reason why we became involved in structured credit is because we recognised that our credit process can be applied to various different tailored vehicles appropriate to specific investor needs. In particular, our active long/short approach serves CPPI and certain CSO tranches well.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: The increase in innovation in credit over the last six to seven years and the increase in leverage have been the two significant developments across credit markets. For example, credit derivative indices have enabled risk to be transferred quickly and in size; CDS allows positions to be marked to market more frequently and transparently. The greatest benefit is the ability to go short single names and markets – without this you're exposed to tail risk.

However, the indices have brought more volatility to the market. Correlation desks are now marginal drivers of new trade positions, spurring huge intra-day swings.

Q: How has this affected your business?
A: Increasing innovation has enabled us to build out our short strategies in single names and indices, as well as apply our extensive credit research and portfolio management skills to different products tailored to specific client types.

The increase in leverage has allowed us to maximise returns from our credit process and, because it enabled IRRs to compete with equity product, it has helped us to participate in structured credit as an institutional player. But we have been careful to avoid the multiple areas of misuse in leverage that this cycle has witnessed, such as structured finance CDOs, SIVs and CP-funded structures.

Q: What are your key areas of focus today?
A: Schroders has been through over 30 recessions globally; we're conservative and our brand means a lot, so we won't launch product that doesn't offer long-term value to investors. It is important to us to launch products which are appropriate to whichever stage the economic, credit and liquidity cycles are at.

A manager that is in it for the long term has to be aware of what may come next: the maturities of deals mean that current and future trends have to be considered, and we believe long/short portfolios are more cyclically appropriate. If you manage a five- or seven-year deal, there will be a recession during that time frame, making short buckets essential. The fact that our products have held up OK - through employing short CDS strategies - shows how versatile structured credit can be.

So our immediate focus today is on long/short CSOs. Because of the skew and asymmetric risk characteristics of credit, we can always find short opportunities throughout the cycle. Shorts work well in our credit investment process and can help dampen NAVs for mark-to-market investors.

Nevertheless, we believe that credit spreads are approaching cyclically cheap levels – well into the cheapest quintile of historic cyclical credit spread ranges. While we believe there will be significant volatility in H108 as a number of economies enter recession, such wide spread levels offer tremendous long-term value over, say, a five-year horizon. Launching corporate credit CSOs this year will present excellent opportunities for long-term investors: they have the chance to start at par, yet generate outsized returns as spreads ultimately recover over the next few years.

Q: What is your strategy going forward?
A: Our investment outlook for structured credit is divided into two periods. We believe many single name CDS spreads will cheapen over the next couple of quarters as reduced earnings, weaker macro data and potentially weaker stock markets all impact spreads. Potential systemic problems remain a risk, given the deterioration in liquidity and capital positions of major financial institutions.

But, ultimately, we don't expect a prolonged period of stagnation. Proactive moves from policy makers will engineer economic recovery and bring each economy's respective recession to an end.

Ultimately, while the default rate is highly likely to increase, after a period of time, M&A activity will help the recovery of single name CDS for some of the credits that have strong franchises but happen to have stressed financials. And, as negative ratings migration and defaulted credits drop out of the IG universe, the new IG indices in 2009 and beyond will see optically lower spreads. Most importantly, however, the IG universe will benefit from the anticipation of recovering macro-economic conditions in a few quarters' time - once recessions are over - leading to an ultimate cyclical peak and consequent spread recovery.

Our strategy is driven by these two fundamental timelines. As such, we continue to use short buckets extensively in our current deals (focusing on retailers, homebuilders and financials) and to favour defensive sectors (utilities, telecom, tobacco) over cyclical credits. In the long term we expect to cut our shorts somewhat and find credits that fundamentally have attractive business models, while continuing to avoid the weakest/stressed credits.

Q: What major developments do you need/expect from the market in the future?
A: We expect significant changes to occur in the structured credit market this year; namely an increase in transparency and simplicity – a return to the traditional credit lending route, without unnecessarily complex structural features. There will also be an ascendancy of synthetics over cash: CDS are transparent and commoditised, whereas the liquidity and mark-to-market transparency of cash product continues to get worse.

In terms of asset classes, corporate credit (via CSOs and CLOs) will be the main focus for the structured market in our view. Corporate credit structures are more mature, having experienced 11-12% defaults in the last recession; and corporate structures have benefited from a gradual development in rating agency methodology. For this reason, there has been no major "crisis" in the agency approaches to CSOs and CLOs over the last 12 months, unlike in ABS CDOs, SIVs and CPDOs.

Finally, there will hopefully be more alignment of interests between arranging banks, managers and clients. We expect more performance fees, as well as a higher proportion of fees to be delayed until the end of transactions so that managers are properly aligned.

Once a consensus has been reached that multiple economies are entering a period of recession, spread levels will be pushed into interesting areas. At that point, some investors will realise that there are opportunities out there.

We believe brand new investors, who like the look of increased spread compensation for default risk, will enter the market. We also expect that, for default-based products, previous investors who got out in the bull-run could come back. As the year unfolds and spread levels reach cyclically highly attractive levels, we agree with that opportunistic strategy and share the same cyclical philosophy.

About Schroders
Schroders is a global asset management company with £137.7bn under management as at 30 September 2007. Its clients include corporations, insurance companies, local and public authorities, charities, pension funds, high net-worth individuals and retail investors.

Schroders' aim is to apply its specialist asset management skills in serving the needs of clients worldwide and in delivering value to shareholders. With one of the largest networks of offices of any dedicated asset management company and over 300 portfolio managers and analysts covering the world's investment markets, the firm offers clients a comprehensive range of products and services.

CS

Morgan Stanley reorganises

The latest company and people moves

Morgan Stanley reorganises
Morgan Stanley has reorganised its global fixed income trading business and combined its interest rates, credit and currencies units into one group, which will be led by London-based Roberto Hoornweg, former head of the interest rates and currencies division. At the same time, the bank has integrated its structured products business into its credit business.

As a result, Matthew Zola, global head of structured credit in London, will also take responsibility for the origination, structuring and trading of cash as well as synthetic CDOs. Meanwhile, Armins Rusis, head of corporate credit in Europe, has also been made head of credit trading for the US and head of global MBS trading.

Officials at the bank confirmed the above moves. However, they declined to comment on speculation that Robert Palache, md and global head of capital markets – securitisation origination, has left Morgan Stanley.

UBS adds workouts
UBS has embarked on a reorganisation after cuts in its structured credit and proprietary businesses that began last October. As part of the reorganisation, a newly-created real estate workout group will take on the bank's illiquid MBS, ABS and CDO portfolios and look to develop exit strategies.

Within its credit division, UBS aims to make a series of changes to simplify its operating model. These include the creating of an integrated flow credit sales and trading team – bringing together the bank's investment grade, loans sales and trading, crossover and high-yield businesses – and exiting principal finance in the US.

Ambac replaces ceo
Ambac's board of directors has named Michael Callen as chairman and interim ceo. He succeeds Robert Genader, who retired from the company effective from the day the announcement was made.

Callen has been presiding director and a member of the audit and risk assessment, compensation and governance committees of Ambac's board of directors. He has stated that he views the current perceptions of Ambac's business by both the market and rating agencies as underestimating the insurer's strengths and future potential (see separate news story). As of 31 December, it had claims-paying ability of US$14.5bn, supported by a high quality investment portfolio.

Callen believes that Ambac can realise new business opportunities in its core markets and through reinsurance while the firm strengthens its capital position further to maintain triple-A ratings under S&P and Moody's, as well as seek to regain them under Fitch. The insurer is also evaluating strategic alternatives with a number of potential parties in order to grow shareholder value.

Fitch names new SF management
Fitch Ratings has made three key managerial appointments in its global structured finance team. Ian Linnell, formerly head of EMEA banking, has been appointed head of EMEA structured finance; John Olert is the agency's new head of global structured credit; and Philip McDuell becomes head of structured credit for EMEA and Asia-Pacific. Olert and Linnell report to Paul Taylor, group md and head of global structured finance, while McDuell reports to Olert.

Linnell replaces Huxley Somerville, who is returning to the agency's New York office in a new role focused on strategic and operational initiatives. Stuart Jennings, md, leads the newly formed EMEA structured finance special projects and research group. Jennings was previously head of EMEA RMBS.

Calyon hires Neilinger
Calyon has hired Neal Neilinger as head of trading, sales and syndicate of its debt and credit markets business. He will be based in London and report to global head of debt and credit markets, Jim Siracusa.

Neilinger was previously at investment firm NSM Capital Management, which he co-founded following stints at Dresdner Kleinwort and BNP Paribas in senior credit roles.

MP

Bond insurance stress test updated

A round up of this week's structured credit news

Bond insurance stress test updated
S&P has updated the results of its bond insurance stress test, originally published on 19 December, to incorporate the revised assumptions announced on 15 January by its RMBS surveillance group. The agency was criticised for reviewing the sector again less than a month after concluding its previous review.

As analysts at SG explain: "This newsflow will prove a significant negative for ABS markets as the confidence that structured product ratings are accurate will be somewhat dented by the fact that within a four week period S&P revised its loss expectations, while Moody's changed its view on little new information."

The new results show total projected losses for the industry to be 20% higher than those in the previous review. Individual company increases ranged from a low of 2% to a high of 36%. S&P has not taken rating action on any company at this time.

The increased projected losses did not materially impair the adjusted capital cushions of the companies that had stable outlooks. For the other companies, the fact that their ratings either had a negative outlook or were on credit watch reflected uncertainty surrounding the potential for further mortgage market deterioration and the companies' ability to accurately gauge their ongoing additional capital needs. This latest round of revised assumptions is an example of the deterioration that was contemplated.

The agency does not view the extent of the deterioration as significant in the context of each company's capital position and the comprehensiveness and degree of completion of projected capitalisation strengthening efforts that are underway.

The revised assumptions announced by the agency's RMBS surveillance group reflect the growing economic consensus that US home price declines will be larger than previously forecasted and that the US housing market slump may last far longer than previously expected (see last week's News round-up for more).

The problem with the rating agency stress tests is that they appear to reflect a rosy scenario, rather than a stressed situation, according to analysts at RBC Capital Markets. S&P and Moody's both use a 19% loss assumption on 2006 vintage sub-prime RMBS as a benchmark in their analysis. This is based on the expectation that US housing price will decline by 8% to 10% from peak to trough.

Although this is an improvement over the initial RMBS assumptions of almost continuous housing price gains, many analysts expect a peak to trough decline in the range of 15%. The impact of increasing expected defaults within commercial real estate and auto securitisations appear to be missing from the analysis. Taken together, higher expected losses can be inferred within the monoline portfolios, say the RBC analysts.

Quantitative credit strategy indices launched
Barclays Capital has launched a set of new products based on the Barclays Capital Credit Strategy Index Family (BCSIF). The BCSIF tracks the performance of quantitative credit strategies in the European and North American credit derivative markets.

"This is a new direction in the evolution of credit index products," says Waqas Samad, head of index products at Barclays Capital. "Our clients now have unprecedented access to the kind of investment strategies in the credit markets that were previously difficult to tap into. We believe that this is an innovative step that opens the doors to a new range of investment opportunities in a transparent and efficient manner."

The bank believes it is the first to market with this approach and aims to increase the range of products within the family rapidly over the coming months. The strategies were developed jointly with the Barclays Capital quantitative credit strategy team, leveraging their market-leading position in innovative credit derivative strategies.

Steepener, flattener and long-short strategies will now be available for institutions, asset managers and certain private banking clients in index form, making it easier than ever before to get exposure to the performance of these investment techniques and the Barclays Capital products linked to them. Using the indices, clients can take more sophisticated views on the underlying credit markets in Europe and North America. The BCSIF will enable them to implement those views efficiently through a range of investment vehicles that are now available through Barclays Capital.

"These instruments will be a vital tool for investors seeking to navigate the present enormous dislocations in valuations across the credit spectrum," comments Robert McAdie, head of credit strategy at Barclays Capital. "It is an important extension to current credit products available in the market, allowing investors to express a variety of market views efficiently and assist them in better managing their risks."

CDO equity correlation clarified
Kamakura Corporation has released a paper seeking to clarify and contest the common market belief that synthetic CDO equity is long correlation risk (i.e. as correlation increases, equity spreads decline). In fact, the authors argue, the impact of correlation on CDO equity spreads is indeterminate a priori and model-specific.

The paper holds that for realistic models CDO equity will be short correlation risk, contrary to common belief. The belief that the higher the default correlation, the more valuable the CDO equity tranche is important because it relates to the sign of the equity tranche's hedge.

If the sign is wrong, then hedging becomes doubling up instead. Unlike the simpler vanilla interest rate derivatives or CDS, valuing and risk-managing (hedging) CDOs requires a sophisticated model.

This is true for many reasons. First, both the collateral pool underlying the CDO and the CDO's waterfall structure are very complex, sometimes involving various triggers. This complexity makes risk management - hedging the risks of a CDO - too difficult to understand without a model.

In some sense, this is also true for the simpler CDS, but there is a difference. Although one needs a CDS model to determine the exact hedge ratio, intuition can at least get the sign of the hedge ratio correct. With CDOs, in contrast, this may not be true with respect to the equity tranche.

Second, in illiquid markets (such as those experienced since the summer of 2007), valuation can only be done by marking-to-model. In a liquidity crisis, without a good model, financial institutions cannot even determine the asset value of their portfolios.

Third, a CDO model enables a financial institution to determine fair value - a useful statistic that is the basis for the construction of profitable quantitative trading strategies.

To study this issue, the authors first provide two robust examples that provide the relevant intuition. For both examples, depending upon the model's parameters and the equity's detachment point, equity can be either long or short correlation risk. Since both examples are plausible, this presentation demonstrates that the impact of correlation on CDO equity values is indeterminate and model-specific.

After illustrating the intuition in the context of these examples, the authors next demonstrate the same comparative statics using a realistic but hypothetical synthetic CDO. Two models are studied: the standard static copula-based approach; and a multi-period and dynamic reduced form model.

This shows that the standard copula-based model implies that equity is long correlation risk, while the reduced form model implies the reverse. Given the well-known shortcomings of the copula-based model, the paper adds another property to the list.

CPDO downgrades continue
CPDO downgrade activity continued over the last week, with Moody's taking repeated action on four vehicles and one related CDS referencing financial names. The affected notes total €340m, representing 63% of the financial CPDOs and 11% of all CPDOs rated by the agency.

The CPDOs impacted by the action are the Series 115 and 117 ELM Tyger notes and a related CDS, together with the Castle Finance II and Chess III notes issued by the SURF vehicle. While the Series 117 notes were downgraded to Caa1, the remaining deals were left on watch, having been downgraded the previous week.

The negative rating actions reflect the adverse NAV impact of the continuing recent widening and the increased volatility of the spreads associated with financial names underlying these CPDOs, particularly monolines and investment banks. Three of the largest spread movements seen between 11 and 17 January involved monolines: XL Capital Assurance (from 698bp to 1358bp); FGIC (from 696bp to 1295bp); and MBIA Insurance (from 293bp to 545bp).

The ELM Series 115 and the associated CDS, both of which have monoline exposure, are undergoing restructuring. The pending restructurings are expected to reduce these exposures.

The current rating actions are mainly driven by the probability that the NAV will reach the cash out triggers (around 10%), leading to a total unwind of the structure and an approximate 90% loss to investors.

European SROC figures out
After running its month-end SROC (synthetic rated overcollateralisation) figures, S&P has taken credit watch actions on 72 European synthetic CDO tranches. Specifically, 47 tranches were placed on credit watch with negative implications, eight tranches were placed on watch positive, and 17 tranches were removed from credit watch with negative implications and affirmed.

Of the 47 tranches placed on watch negative, 22 reference US RMBS and US CDOs that are exposed to US RMBS which have experienced recent negative rating actions; 25 have experienced corporate downgrades in their portfolios.

December surveillance report released
Moody's downgrades of US SF CDO securities in December totalled US$23.3bn across 243 tranches of 75 deals, according to the agency's latest monthly CDO rating surveillance report. For the entire year of 2007, 1,390 tranches from 462 SF CDO deals totalling US$75.9bn have been downgraded, representing 30.6% by tranche count, 47.3% by deal count and 14.1% by tranche original balance.

As of end-December, 2,120 tranches from 580 SF CDO deals totalling US$185.3bn remained on review for downgrade. These outstanding negative reviews account for 46.6% of the total number of US SF CDO securities, 59.4% by deal count and 34.5% by tranche original balance.

Negative rating activity in 2007 has affected US SF CDOs issued in 2006 and 2007 significantly more than those issued prior to 2006. For example, less than 5% of US SF CDO securities issued in 2004 and 2005 were downgraded, compared to 39.1% from the 2006 vintage and 53.1% from the 2007 vintage. Additionally, 9.5% of the securities from the 2004 vintage and 16.9% of the securities from the 2005 vintage were on review for downgrade as of year-end 2007, compared to 62.4% for the 2006 vintage and 70.1% for the 2007 vintage.

By the end of 2007, Moody's completed its preliminary rating review of all SF CDOs and is now in the phase of resolving the ratings of more than 2,000 SF CDOs tranches still on review.

Watch negative for Sigma debt
Fitch Ratings has placed Sigma Finance's senior note programme on rating watch negative, affecting US$31.6bn of MTNs rated triple-A and US$2.3bn F1+ rated commercial paper.

The rating action reflects the ongoing illiquidity of global capital markets, the declining market value even of the high quality assets that vehicles such as Sigma are exposed to and the challenges they face - in particular, vehicles that are not fully term-funded and do not have 100% liquidity support from a highly rated party. These factors continue to place significant stress on many entities, including Sigma.

Despite having pursued a greater mix of intermediate-term funding leading up to the liquidity crisis last year, Sigma has been forced to rely on access to secured repurchase agreements and, to a lesser extent, asset sales to meet maturing liabilities. While this has provided some short-term funding flexibility, Fitch has concerns over the long-term viability of Sigma's funding strategy and its implications for senior investors in the current market environment, including reliance on secured funding from repo counterparties.

The agency will continue in the near term to consider the viability of maintaining the rating on Sigma. However, in the absence of new information from Gordian Knot it is likely that Fitch will have to withdraw the rating shortly.

S&P downgrades continue
S&P has lowered its ratings on a further 95 tranches from 23 US cashflow and hybrid CDO transactions, and placed its ratings on 14 other tranches on watch with negative implications. The downgraded tranches have a total issuance amount of US$4.75bn.

All of the downgraded tranches come from mezzanine ABS CDOs, high-grade ABS CDOs or CDO-squareds collateralised either directly or indirectly by US RMBS. The ratings on 37 of the downgraded tranches remain on watch with negative implications, indicating a significant likelihood of further downgrades.

As at 17 January, the agency had lowered its ratings on 1,383 tranches from 422 such transactions as a result of stress in the US residential mortgage market and credit deterioration of US RMBS. In addition, 841 ratings from 196 transactions are currently on watch negative for the same reasons. In all, the affected tranches represent an issuance amount of US$98.26bn.

Orion defaults
S&P has lowered its issuer credit ratings on Orion Finance, as well as its CP and MTNs. The downgrades reflect a technical default incurred by the SIV for failing to pay CP that had matured on 14 January.

On 7 December S&P commented that the vehicle had entered into enforcement mode, and that it was up to the senior creditors and the security trustee to determine whether payments would continue on current interest and maturing principal of debt issued by Orion. At that time, the agency placed the senior ratings on credit watch negative, but maintained the rating at AAA/A-1+ because restructuring discussions were under way and the net asset value (NAV) was just below 60.

On 14 January the Bank of New York Mellon, as the security trustee, notified S&P that Henderson Global Investors, acting in its capacity as the security trustee's financial adviser, had advised it that the deposited funds available as of that date were not sufficient to pay the senior obligations coming due. As a result of that determination, Orion's documentation required that the security trustee determine whether the portfolio could be liquidated to repay all senior obligations in full.

S&P has been informed that Orion's security trustee concluded that, given the current market conditions, it was likely that a collateral liquidation would not result in the full repayment of senior obligations. Therefore, it is the agency's understanding that the security trustee determined not to liquidate the assets.

The security trustee has declared an insolvency event, which, under the transaction documents, triggered a mandatory acceleration and resulted in the notes becoming due and payable. The senior creditors must now agree on how they wish to proceed, which - as we have seen with other SIVs and SIV-lites - could lead to protracted restructuring discussions. At this time, it is uncertain whether Eiger Capital Management will be replaced as Orion's manager.

Spanish SME CDO performance analysed
Fitch Ratings says in a special report that the majority of the agency-rated Spanish SME CDO transactions continued to perform within expectations through Q407. This follows the performance analysis of 200 tranches issued from 43 Spanish SME CDOs, taking into account the underlying loan performance as well as a variety of structural elements common to the Spanish SME market.

Of the 200 tranches reviewed, 198 tranches were affirmed, one was downgraded and one was assigned a distressed recovery rating. Higher delinquency levels and the potential slowdown in the Spanish economy are sources of concern for the sector.

While increasing credit enhancement levels driven by de-leveraging had led to upgrades of Spanish SME CDOs in previous years, in 2007 many transactions suffered higher delinquency and default levels, which offset the positive impact of increased credit enhancement driven by continued de-leveraging.

In order to provide additional transparency, Fitch has published a data file accompanying the report, which incorporates the relevant performance data on all the Spanish SME CDO transactions reviewed by the agency in 2007.

SIV-lite ratings suspended
S&P has suspended its ratings on all classes of notes issued by Golden Key and Mainsail II, due to a prolonged period of insufficient information received from the security trustee regarding both SIV-lite vehicles. The agency says that once it obtains the necessary information, it is possible that the rating may be reinstated.

CS

Trading ideas: food, fertilizer and funds

John Hunt, senior research analyst at Credit Derivatives Research, looks at a negative basis trade referencing Cargill Inc.

Cargill's new five-year issue is still trading cheap to CDS-implied value, and we recommend a negative basis trade to take advantage of the situation.

Trade basics
Please refer to previous negative basis trade ideas for an explanation of the premises of this type of trade (see SCI issue 62). CDR's August 2006 Market Strategy article describes the CDS-implied bond price model that we use as a starting point for identifying basis trades, and the Bond Valuation topic under CDR's Trading Techniques gives more mathematical detail.

Constructing the negative-basis trade position
We construct this trade to be default-neutral. Because the bond is trading near par, there is little exposure to recovery rate risk.

The trade is slightly long Cargill credit in the short term, but convergence between cash and credit spreads, and not the absolute change in credit spreads, is the main driver of the trade's performance (see Exhibit 3). We present a simple duration-matched position in a government bond to hedge interest rate risk.

This risk could also be hedged with an interest rate swap, but we understand that government bonds are the most useful hedging instrument for most investors. We understand that most investors will prefer to hedge interest rate risk at the portfolio level in any event.

Because of the maturity mismatch, the trade is not a pure arbitrage. However, the bond matures before the CDS, so the investor will not be faced with buying CDS protection at uncertain future levels – a floor can be put on the hold-to-maturity performance of the trade today.

Our strategy for both the CDS and the Treasury hedge is strongly influenced by a desire for simplicity. Perfect hedging would require adjustment of the CDS and Treasury positions over the life of the trade. We are happy to discuss such strategies with clients, and we also provide a set of sensitivities to help clients implement more sophisticated hedging strategies.

Trade specifics

Bond cheapness
Based on our valuation approach, the recommended Cargill bond is trading around US$2.75 cheap to fair value, as Exhibit 1 indicates.

Exhibit 1

Exhibit 2 compares the bond z-spread with the CDS term structure and fair bond z-spread, and shows that the recommended bond is indeed trading wide of the closest-maturity CDS and its fair z-spread.

Exhibit 2

Exhibit 3 illustrates the projected performance of the trade as a function of bond-CDS convergence over a six-month time horizon. Based on our assumptions about trading costs (five-year CDS bid-ask spread equal to 10bp, bond bid-ask spread equal to US$0.50 over Treasuries), the raw basis needs to converge by about one-fifth of its current value over the six-month period to cover trading costs.

Exhibit 3

The projection is based on the assumption that bond and CDS spreads remain the same except for convergence – that is, that the company's credit does not improve or deteriorate over the six-month time horizon. As noted, we chose the position weighting so that the position should not be affected much by parallel moves in cash and synthetic credit spreads.

Risk
Liquidity is the major risk we see for this trade, as described below. As already explained, the trade is default-neutral.

Another short-term risk comes from the Treasury hedge. Technical factors affecting the Treasury market may be different from those affecting the corporate bond market, and a short-term mark-to-market loss or gain could result. Exhibit 4 presents a number of sensitivity calculations for the bond for investors who are interested in more complex hedging strategies.

Exhibit 4

The trade has positive carry given current levels, and this carry should cushion the investor from short-term mark-to-market losses.

As with any bond-CDS basis trade, investors should ensure that the bond is a deliverable obligation for the CDS.

Liquidity
Liquidity is the major issue for this trade.

The recommended CDS is in the liquid five-year maturity, and we see solid quote flow in that tenor.

The bond is a large issue. Although Cargill's bonds may be less actively traded than average, the new issue seems to be liquid currently. That said, trade exit could be a challenge.

Fundamentals
Our negative basis trades are based on the assumption that the bond credit spreads are too wide relative to CDS spreads. They are not premised on an expectation of general curve movements, but if the firm's credit deteriorates or improves, that tends to affect the basis. Accordingly, we briefly review the firm's fundamentals.

Despite cost pressures from high energy prices, we would expect its food processing and distribution operations to continue performing well in a recession, and would expect demand to remain strong for the company's global fertilizer operations. Cargill's extensive financial operations have not been performing as well as the food and fertilizer business units. As a private company, Cargill may be subject to less pressure to take measures to help shareholders at creditors' expense than public companies.

Summary and trade recommendation
The new issue on 16 January from Cargill went out around US$3.00 cheap to CDS-implied fair value, and we recommended a negative basis trade at the time. Although the negative basis has tightened a bit since – making us suspect that at least some people were putting the trade on – the negative basis trade still looks good at current levels.

We're not sure we'd have recommended outright purchase of the bond: given that Cargill is primarily a food company, it is exposed to our overall concerns about overbuying in defensive sectors as more and more investors come to expect recession in the near future. The oversubscription to the new issue drives that point home.

The basis trade, however, takes advantage of the mis-pricing between bond and CDS markets without exposing the buyer to Cargill's default risk. With Treasury yields around multi-year lows, it seems to us that the opportunity to bring in 60+ bp over Libor without default risk ought to be attractive.

Buy US$10.1m notional Cargill Inc. 5-Year CDS protection at 85bp.

Buy US$10m face value (US$10.00m cost) Cargill Inc. 5.2s of 22 January 2013 at 100.47 (priced to yield 5-year T+217bp; z-spread 149.5bp) to gain 63.9bp of positive carry.

Sell US$10.2m notional Treasury 3.625s of 31 December 2012 at 103.20 (2.93% yield, US$10.53m proceeds) to hedge bond interest rate exposure.

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).

The 'unrealised factor' and CDS pricing

CDS cumulative loss rates are discussed by Glenn Schultz and John McElravey, senior analysts at Wachovia Capital Markets

We have argued that prices in the ABX and CDS markets often imply cumulative loss rates that are significantly higher than will most likely be realised on certain mortgage pools. Our argument is centered on the idea that, based on pool factors, it is nearly impossible to achieve the implied losses. Too many loans have already exited the pool.

This concept seems more intuitive when pool factors are 40% or less of the original balance. However, when pool factors are greater than 40% the concept may be less evident. In order to explore this idea further, we introduce the concept of "unrealised pool factor".

As long as a loan is in a pool, regardless of its performance status (current, delinquent, foreclosure or REO), it is included as part of the current collateral balance outstanding. That is to say, the current collateral balance is not the balance outstanding that is current, but the outstanding balance of all loans in the current month.

The unrealised pool factor takes the percentage of loans that are 60+ days past due, in foreclosure and REO (real estate owned), and assumes that 100% of these loans will default. Although these loans are counted as part of the outstanding balance, it can be assumed that they will exit the pool when liquidated.

Mortgage pools with very high delinquency, foreclosure and REO buckets would have relatively low unrealised pool factors compared to the reported pool factor. The unrealised pool factor provides an indication of the loans available for default in the future to contribute to projected cumulative losses.

Consider for example the CARR 2006-NC1 deal issued in February 2007. The pool factor as of December 2007 was 62.57% and the percentage of loans 60+ days delinquent, in foreclosure and REO was 3.52%, 9.02% and 5.63% respectively. Using this data, we can calculate an unrealised pool factor, which would be implied by writing down those buckets.

The unrealised pool factor is equal to:

Unrealised Pool Factor = current pool factor (.6257) (1 – [60+ dpd (0.352) + foreclosure (.0902) + REO *(.0563)]) = .5120

Once we have the unrealised pool factor, we can then estimate the required default rate of the current and delinquent loans required to achieve the loss given default by the CDS price. The composite CDS price of the CARR 2006-NC1 M5 tranche as of 14 January was US$43.06.

The implied loss given default is US$100 – US$43.06 = US$56.90. The current percentage of the capital structure is 2.7% for M5, and the credit enhancement below the Class M5 is 17.3%.

Thus, the implied cumulative loss is (0.5690*.027) + 17.3% = 18.8%. From this figure, we can look at pipeline cumulative losses (60+ delinquent, foreclosure and REO) and assign a loss severity.

This provides the percentage of the loans that must default above and beyond the existing pipeline. The analysis is provided below for the CARR 2006-NC1 M2, M5 and M8 tranches (see Exhibit 1).

The percentage of performing loans outstanding that must default in order to tie out to the CDS prices of the M2, M5 and M8 tranches are 61.0%, 29.8% and 5.8% respectively. An anomaly from our analysis is that the three CDS tranches are backed by the same collateral pool, but trade at prices that imply different cumulative loss expectations. The contracts reference one pool of collateral, but have three different views on losses.

Because the fixed income markets can be quite segmented, there are different sets of participants at each level of the capital structure. The cumulative loss differences are largely driven by technical pressure on CDS prices.

This implies that an arbitrage opportunity exists, and market inefficiency may be exploited. Single name CDS may be trading closer to the ABX prices even if credit performance does not warrant it.

Source: Wachovia Capital Markets, LLC, Intex

The unrealised pool factor and the percentage of current loans required to hit the CDS implied cumulative losses provides a methodology to handicap the CDS market's assessment of future defaults and losses. In addition, the framework provides a means to compare pricing across the capital structure and examine the internal consistency of market opinion with respect to collateral cumulative losses.

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