Contents

Help or hindrance?

Volatile structured credit numbers to continue as accounting standards take effect

FAS 157 and IFRS 7 have played a vital role in helping analysts better understand the market impact on assets and liabilities accounted for at fair value. But another year of relatively volatile numbers is expected until the standards have bedded down.

"There is a belief that it is harder to hide things under the new regime and this will help the market come to terms with what has happened as loss numbers continue to come out. There is no doubt that the information is useful, but how useful is still to be seen," says one structured credit investor.

FAS 157 was only available for adoption from the beginning of 2007, but most US banks adopted it early. As industry practice and interpretation developed, they have disclosed more detailed information in relation to illiquid or price-unobservable inventory (known as Level 3) each quarter. Sources say that the introduction of FAS 157 provided a hook to better understand the fair value measurements disclosed by banks, but that it currently has the potential to mislead because the standard hasn't had time to bed down.

"Auditors now have more guidance than they previously did," confirms Tom Millar, senior manager within Deloitte's treasury and capital markets group in London. "We expect the requirement to explain Level 3 numbers and to show relevant price sensitivities to be useful, but because the rules were only adopted during 2007 we understand that there has been a challenge for banks in ensuring that their reporting is comparable to their peers."

Millar suggests that now FAS 157 is in place, there is less flexibility for companies to arrive at significantly different answers based on different approaches - although he acknowledges that some flexibility still exists. "A significant problem for the banks has been the current low levels of liquidity in certain asset classes, which presents challenges finding observable market transactions against which to compare the fair values they have calculated."

Additionally, the monolines could be accused of only disclosing when it became necessary. The current situation highlights the need for more clarity about when information should be disclosed: it's a difficult balance between disclosing risks that have the potential to cause problems and not wanting to exacerbate volatility even further unnecessarily.

IFRS 7 is less prescriptive than FAS 157 in terms of the exact information surrounding risk management and uncertainties regarding value that require disclosure. As this standard is also new, comparability issues with the level of information that is disclosed and how to define it are expected to emerge through market practice in the coming year.

"IFRS 7 still requires disclosures in relation to price-unobservable inventory, similar to the US equivalent - although it is more principles-based than US equivalents, therefore there is a perception that it is more flexible. Certainly transparency is improving around financial instruments, but there are still issues to iron out," explains the investor.

Fitch analysts agree that comparability may become more difficult. The flexibility the standards offer, as well as the ability to fair-value a company's own liabilities will continue to be a concern, the agency says.

Meanwhile, concerns about exposure to risks relating to off-balance sheet entities (OBEs) continue. The primary question being raised by market players is whether the accounting and footnote disclosures pertaining to OBEs are robust enough to judge the potential exposure to loss.

Transparency in this area has nevertheless been given some impetus recently by the SEC suggesting that companies may want to explain the risks of their off-balance sheet vehicles in the front part of their accounts. Although this aspect of disclosure was on the agenda for long-term convergence plans, the SEC has taken action faster than the accounting standard setters could have.

"The wording from the SEC is likely to be acted upon. Banks are, in general, trying to be forthcoming about their exposures. But the difficulty is presenting the information so that investors can recognise a situation where the probability of a bank being impacted by its off-balance sheet exposures is remote, and therefore understand why they don't have to take everything back on-balance sheet," the investor concludes.

The IASB is also thought to be preparing a consultation paper to reevaluate the accounting and disclosure of OBEs.

CS

Equity returns

Intrinsic value of discounted loans may be understated

Valuing CLO equity on a 'return-to-worst' basis ignores the possibility that performing loans bought at discounts may, in time, return to par. A new study argues that, as a result, the market may be understating the intrinsic value of such assets.

CLO equity valuation more than ever requires considering the call option, according to analysts at JPMorgan, as purchasing loans below par creates a contingent opportunity based on prices at call or termination. In a new study they argue that, if loans recover, new-issue equity can monetise the upside via optional redemption or, absent a call, pull to par. If loans do not recover, however, vintage equity may be a superior alternative to take advantage of the locked-in cheap funding.

The analysts compared hypothetical cashflow and credit profiles of a vintage and a new-issue CLO equity transaction, with the premise that on-the-run equity enjoys discounted assets and the potential upside of price appreciation, but has higher funding costs. To proxy a vintage CLO, the portfolio was ramped and reinvested in an environment with par priced loans, assuming debt funding of 50bp - roughly the level in 1H07.

For a new issue, asset coupons were increased by 50bp over the vintage transaction and asset purchase prices were decreased to US$96 and reinvested at US$98. Funding costs were also set roughly to current levels of 145bp, while a 15% constant prepayment rate (CPR) was assumed for both transactions.

In a 2% constant default rate (CDR) no-call scenario under this analysis, projected IRRs for vintage are roughly the same as for new issue. Greater excess spread early in the vintage transaction is largely offset by greater principal returned late in the life of the new issue transaction.

In a 6% CDR scenario, projected IRRs drop significantly to approximately 6% for vintage and 4% for new issue, assuming no call. At first glance this may seem counterintuitive – a new issue clearly does not have the excess spread of a vintage portfolio. However, equity is sheltered for a longer period of time due to greater subordination; the discounted assets offer higher overcollateralisation, subject to how heavily the liabilities are discounted.

Since the target portfolio price is US$96, there are four more points of asset yield flowing through the capital structure and four more points of subordination to debt, assuming par pricing. From a present value perspective, the value of new issue cashflows exceeds vintage transactions from roughly year three through to year ten, well past the first call date.

Should the loan market recover in 3-5 years' time, the NAV of a portfolio originally acquired at 96 is likely to exceed the PV of the projected cashflows remaining; should the market recover to par, new issue outperforms. Exercising a call at 100 in year five results in a 19% IRR in the 2% CDR environment, while exercising at 97 in the 6% CDR environment projects a 6% IRR.

"CLO equity investors who are bearish on the loan market and prefer to sacrifice excess spread for subordination may therefore find value in new issue equity, as it is able to keep interest flowing longer," explains Chris Flanagan, head of global structured finance research at JPMorgan. "A front-loaded default environment could see new-issue transactions outperforming vintage via greater overcollateralisation. Conversely, a back-loaded default environment will favour vintage transactions, as these are relatively less dependent on back-loaded cashflows."

Discounting CLO liabilities has two primary implications: lower required coupons result in funding costs of roughly 100bp and greater excess spread flowing through the transaction. As such, the CLO is able to sustain a higher level of leverage, say 11x. In the 2% and 6% CDR scenarios, respective projective returns to new issue CLO equity are 18% and 5%.

Essentially, discounted liabilities allow greater excess interest to flow to higher leverage equity. Shifting this excess spread forward in time increases equity IRRs in low default scenarios. However, in higher default scenarios a similar result to the 6% CDR example emerges: while the discounted transaction still has a higher overall IRR (5% versus 4%), the par transaction actually outperforms from a PV cashflow perspective from roughly year three to nine, due to lower leverage and higher subordination to the first O/C trigger.

To show call valuation sensitivity, the analysts tabulated probabilities for loan exit prices, all of which assume purchase at US$96 and a CLO call in year five. The results show that when incorporating the call, new issue projected returns are just about in line with vintage returns, which are not as contingent on the call due to historically cheap funding. When run to no call, vintage equity IRR is roughly two points back of new issue.

"Some market players may feel that these two points are a cheap price to pay for higher quality collateral, given that loans going forward are likely to be less leveraged and have more covenants. However, the cheaper funding and better reinvestment opportunities of vintage equity are more tangible - despite the greater relative value new issues can offer in a high default environment around the first call date," Flanagan concludes.

CS

Bailout blues

Monoline capital raising continues as rescue plan is delayed

Rating action continues in the monoline sector as guarantors scramble to put capital raising alternatives in place. But, while the New York insurance regulator's bailout proposal (see last week's issue) represents the industry's desire to ensure that monoline ratings do not fall too far, the plan has not met with uniform support.

Fitch continued its review of the monoline sector by downgrading SCA to single-A and leaving it on watch negative, cutting by more than it had originally indicated. The agency said this was because even if the guarantor's abandoned capital raising exercise had failed to make up the full US$2bn capital shortfall, it would have gone some way towards addressing it (SCA is pursuing other options instead).

Fitch is expected to downgrade FGIC imminently, as the six-week deadline it was given by the agency to raise more than US$1bn expired on Monday. Moody's and S&P seem to be holding off a while longer in case any progress is made in brokering a monoline bailout.

The New York State Insurance Department has, over the last week, met with banks to persuade them to inject capital into the monolines - reportedly in the region of US$5bn in immediate capital and ultimately to commit up to US$15bn - as concern mounts that further guarantor downgrades could force a fresh round of write-downs. Details remain sketchy, but it appears that contributions to the bailout fund would not necessarily be based on how much exposure each individual bank has to the monolines.

It will nevertheless take time to finalise any plan, so monolines are likely to continue pursuing individual capital raising activities in the short-term, as well as explore reinsurance and other options. Analysts at SG reckon that one solution could involve ring-fencing the structured credit businesses within each entity.

"Rating agencies would define the capital required to maintain triple-A and double-A ratings, and then sufficient capital would be transferred to the businesses, or reinsurance would be used to shore up these spin-offs," they note. "The entity insuring only municipal exposures would then find it easier to raise additional capital, providing confidence that a triple-A really is a triple-A and so allowing the guarantors to underwrite new business. However, segregating lines of credit between the two entities would be challenging."

Banks do have an incentive to support the monolines, given the potential write-downs they would have to take on the value of credit protection bought from the insurers if they were significantly downgraded or failed. While the reported US$5bn injection is close to the aggregate of Fitch's stated capital shortfalls, it won't necessarily be sufficient to ensure that triple-A ratings are maintained.

A longer-term solution involving US$15bn may be sufficient, depending on the eventual losses suffered by the monolines, but other factors are now becoming more important in the agencies' ratings, according to Michael Cox, analyst at RBS in London. "The damage done to the monolines' reputation, the uncertainty on what eventual losses will be and the heightened interest of the market are all very significant barriers to triple-A status being maintained or regained," he says. "Regaining investors' trust is also about far more than triple-A ratings. However, it is stability rather than triple-A ratings that are more important in the short-term in our view."

Analysts at JPMorgan estimate – by marking monoline exposures to market via the ABX – that bond insurers as a group have CDO losses of around US$31bn and RMBS losses of around US$13bn. Ambac has an estimated mark-to-market loss of US$12bn, versus MBIA at US$9bn, SCA at US$4.5bn, CIFG at US$7bn and ACA at around US$8bn.

Losses are likely to be incremental and extremely extended. Direct RMBS exposures, mezz SF CDOs and SF CDO-squareds will take losses earlier (interest shortfalls within 18 months and principal shortfalls either gradually in RMBS or 30-40 years out in CDOs). High grade SF CDO losses will be the most delayed, with interest shortfalls beginning at least 4-5 years out and principal claims 30-40 years out.

Given the scale of the industry's exposure to monolines (totalling around US$2.4trn), a recapitalisation of the scale being mooted looks modest. But, while there is a desire to ensure that monoline ratings do not fall too far, the regulator's plan has not met with uniform support from the large banks - some of which are thought to prefer a federal government-backed rescue and are, in any case, wary of signing up to a potential open-ended line of credit.

Indeed, for the scheme to be implemented, it will likely require collective effort from the US Treasury, Federal Reserve and the banks. Many sources believe the risk that the fund will fail to gain enough support, just as M-LEC did, is material.

CS

Liquidity matters

Sustaining liquid markets in a credit crunch environment is discussed by Mark Beeston, president of T-Zero

The challenges faced by the structured credit market in 2008 are varied, but many come back to basic forms of liquidity. For structured credit, that liquidity matters across three major areas: funding of the structured vehicle; pricing and liquidity of the structure's embedded credit names; and liquidity of trading in the CDS of the underlying credit names.

As has already been well documented, a number of the high profile problems faced by various vehicles late in the summer of 2007 were a function of funding or other issues, rather than those of actual default. To that end, the maintenance and sustainability of scalable trading in the underlying building blocks that the market relies on to innovate with becomes a critical factor in both creating value and managing risk in the structured credit markets.

The challenges of summer 2007 resulted in significant spikes in trading volume and demonstrated areas of strain in the front, middle and back office processes. At T-Zero our focus since inception has been to enable the electronification of these processes. In doing so, we have worked closely with our partners at banks and investment advisors to enable further multiple increases in market volumes and enhance the return on investment, both capital and human, that they bring to bear in the credit arena.

So, how does the use of T-Zero by these banks and investment advisers create such scalability and what are the results? T-Zero is electronically connected to the trade capture systems of most of the dealers.

By connecting at this level, we enable counterparts who trade to see exactly what the dealer has booked at the time of the trade. In volatile markets, where spotting an error minutes after trading can help to avoid a six- or seven-figure P&L impact, this is invaluable.

T-Zero's connectivity allows the counterparts to allocate their trades across multiple funds, which results in the automatic direct booking of these trades back into the dealers' risk systems with no human intervention. That has allowed the market to remove the first middle office scalability issue at source and enabled human resources to focus on issue resolution rather than trade rebooking.

In the same way, T-Zero has set the standard with similar workflows to support trade novation and consent. These allow an investment advisers to initiate a novation, communicate the details of the trade to the remaining and step-in counterparts electronically, and obtain that consent in real-time.

All of these messages can be leveraged directly into other areas of infrastructure, such as risk management, documentation execution (including DTCC and Warehouse-eligible trades), fund administration and other areas. This ensures that all downstream systems and operational and risk functions are utilising 100% accurate trade data, thus delivering 100% return on investment in the systems chosen, as well as delivering maximum efficiency and hence scalability.

When trade booking and processing is built on these electronic foundations, organisations become insensitive to volume increases. This is already allowing these key markets to function effectively and ensures that demand, rather than operationally constrained supply, remains the driver of liquidity and bid-offer spread.

Recognition of these facts have resulted in T-Zero already being live with the vast majority of the FED 14, as well as a number of other dealers. The platform has over 160 live buy-side clients and over 100 more in the process of on-boarding, along with their prime brokers where applicable. The platform succeeds because its users view their utilisation of it as more of a partnership than a pure vendor relationship - and certainly one in which everyone wins, yielding lower operational risk and cost, and better resultant liquidity during volatile times when markets need it the most.

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.

Merrill Lynch to quit structured credit?

The latest company and people moves

Merrill Lynch to quit structured credit?
Merrill Lynch's new chairman and ceo John Thain has reportedly announced at an investor conference today that the firm is to exit the structured credit and CDO business. Reports were light on specifics and could not be verified prior to going to press.

Schüler exits Deutsche
Marcus Schüler, head of integrated credit marketing at Deutsche Bank, has left the firm. His future destination is not yet known.

Gibson leaves Merrill
Lang Gibson, director of CDO research at Merrill Lynch in New York, is understood to have resigned. His future destination is not yet known.

ISDA promotes CDS lawyer
ISDA has promoted Mark New to assistant general counsel. He joined ISDA in 2007 and is based at the organisation's Washington DC office, focusing primarily on credit derivatives documentation.

Before joining ISDA New was a structurer on the European structured credit products desk at Citigroup global markets in London. In that capacity, he worked on new product development and structuring credit transactions, including managed synthetic CDOs and credit CPPI.

Moody's acquires BQuotes
Moody's has acquired BQuotes, a global provider of price discovery tools and end-of-day pricing services for a wide range of fixed income securities. Terms of the transaction will not be disclosed, and the financial impact to Moody's is not expected to be material.

BQuotes' product line will be integrated into Moody's Analytics' new suite of pricing and valuation products, which include model-based fair value estimates, evaluated pricing and observed pricing.

MP

Further ABX losses implied

A round up of this week's structured credit news

Further ABX losses implied
Averages derived from current Markit ABX index prices imply that the market expects total losses for the ABX vintages to be in the region of US$290-US$320bn, according to structured credit strategists at Dresdner Kleinwort – substantially above the hitherto published write-downs. All this leaves at least US$180bn of write-downs for late 2005-2007 collateral still unaccounted for.

To calculate a meaningful estimate of the expected loss for the ABX indices, the strategists suggest taking all available price information into account, relating it to the complete capital structure and deriving the expected loss by taking the weighted average of the expected losses over all the tranches, weighted by their widths.

Technical factors and speculative selling have driven ABX prices below the levels that the strategists' fundamental analysis suggests. These dynamics are unlikely to change significantly; therefore, this gap will remain.

However, the difference between the two is not as large as it might initially appear to be. Dresdner Kleinwort's approach indicates market-implied losses of just over 29%, only marginally higher than the 25% resulting from the strategists' fundamental analysis.

More CPDO downgrades as new product mulled
Moody's has downgraded to Aa3 another three financial CPDOs, worth approximately €110m in total, and withdrawn its ratings on a further three series of notes. Meanwhile, a similar product but with a different acronym is believed to be in the works - MLTS transactions. The idea behind so-called mean reversion leveraged trading strategies is to take advantage of the wide spreads that are available in financial names by taking exposure to strong double-A credits.

The Moody's rating actions reflect the adverse net asset value (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 January 2008 and 22 January 2008 involved monolines: FGIC (from 696bp to 1287bp); XL Capital Assurance (from 698bp to 934bp); and MBIA Insurance (from 293bp to 490bp). The downgraded transactions are the Series 104, Series 116 and Series 121 Financial Basket Tyger Notes issued through the ELM vehicle.

The ELM Series 115, Series 117 and an associated CDS are the notes that have had their ratings withdrawn because they are being restructured (once again). These CPDOs represent 41% of the outstanding CPDOs linked to financial names and 7% of all CPDOs rated by Moody's.

ECMBX postponed
Last Thursday Markit announced that, following extensive discussions, the dealer community had decided to postpone the launch of the ECMBX index. (The data provider had declined to comment for SCI's story on the subject published the previous day.) The decision was made based on a lack of appetite for a synthetic European CMBS index, due to the limited liquidity of both cash and synthetic markets.

Markit did, however, confirm that dealer conversations are continuing about launching a synthetic RMBS index. The new index will reference UK prime RMBS and be known as Markit ERMBX.UK.

The firm is in the process of putting the proposal out to the broader dealer community to assess interest in the index and will update the market with further information in due course.

Quebecor default hits CDOs
Moody's has put nine European CDOs, worth approximately €1.6bn in total, under review for downgrade due to the default of Quebecor World (see last week's issue). The agency rates 45 European managed and static synthetic CDOs of corporate exposures with Quebecor World in the underlying portfolios.

The ratings of the affected CDOs depend, in some part, on the realised losses that will be measured on the instruments referencing Quebecor World debt that are part of the portfolios of these CDOs. Of the nine deals, six are publicly rated: Skylark Series 2003-03, SEA CDO Series 2003-3, Secured Fixed Rate Optimum Notes, Classic Finance Serie 2004-1, MSCS Credit Derivative Transactions (GR_1 to GR_20), Triplas Series II Synthetic CDO and Alexandria Capital 2003-1.

The rating on Quebecor World has been progressively downgraded over the last few years, previously to Caa2 in December 2007, and more recently to Ca last week. Moody's monitors all corporate synthetic CDOs on a continuing basis, and downgrades to Quebecor World have been taken into account when monitoring these synthetic CDOs over that time.

Remittance reports mixed
Monthly remittance reports for the January distribution date show mixed data once again. On a month-on-month basis, aggregate 60+ day delinquencies increased 248bp, 280bp, 207bp and 264bp, compared with the 316bp, 166bp, 226bp and 262bp rise last month for Markit ABX Series 06-1, 06-2, 07-1 and 07-2 respectively.

These increases represented growth rates of 9% (down from 13%), 11% (up from 7%), 9% (down from11%) and 17% (down from 20%) over last month's numbers. Thus, while the absolute level of delinquencies continued to rise, the month-on-month pace of deterioration moderated across three of the four index series, note analysts at Barclays Capital.

Foreclosures rose for all but three trusts, with the rate of increase growing for about two-thirds. REO also went up on 88% of the trusts, though the rate of growth slowed on about 75%. However, the developing foreclosure pipeline looks likely to translate into greater REO in coming months.

Despite modest rises in prepayments this month, all index series continue to suffer from an overall low level of prepays - which is likely to result in a higher degree of tail risk. Aggregate prepayment speeds were reported at 25 CPR at 31 WALA, 34 CPR at 26 WALA, 14 CPR at 19 WALA and 11 CPR at 14 WALA for Series 06-1, 06-2, 07-1 and 07-2 respectively. Despite rising from last month's levels, these prints remain well below historical levels at similar WALA.

Series 06-1and 06-2 are in the middle to tail-end of interest rate resets on 2/28 ARMs and, with such low prepayments, the BarCap analysts expect borrowers that have already reset to exhibit increased delinquencies. The proposed stimulus package announced this week, including raising the conforming GSE loan limit to as high as US$700,000, may have a moderate impact on sub-prime prepayment speeds, as about 18% of sub-prime ARM loans have current balances of US$417,000-US$700,000. Nevertheless, other contraints may serve to restrain a sub-prime prepayment wave, including documentation and down payment/equity requirements.

Sigma ratings withdrawn
Fitch Ratings has withdrawn Sigma Finance's senior note programme ratings of triple-A on its US$31.6bn of MTNs and F1+ on its US$2.3bn CP. Both ratings are withdrawn with their rating watch negative status unresolved.

Fitch is unable to resolve the rating watch negative that was placed on Sigma's senior notes on 18 January before withdrawal because the manager, Gordian Knot, is no longer willing to provide information on Sigma to Fitch. When coupled with the continuing high degree of market uncertainty, the agency lacks sufficient information to give a fully informed opinion and thus resolve the current status of the ratings.

New pricing service launched
Reuters has launched a pricing service that delivers bespoke valuations for derivatives and complex securities. Reuters DataScope Derivatives Pricing Service has been launched in response to customer demand as part of Reuters' strategy to speed up the process of valuing complex securities.

Using the service, customers can request a price for bespoke transactions, with completely transparent Reuters pricing and methodology behind each valuation. The service complements Reuters DataScope Select, which already provides prices for instruments that have a broader market adoption. This means Reuters now provides valuations for over 1.1 million hard-to-value financial instruments.

The need for an independent, trusted source to price derivatives has grown to record levels as the search for above-average investment gains intensifies in particularly volatile market conditions. The importance of complete transparency, both in pricing and methodology, accuracy and speed in valuations has become even more of a priority following recent write-downs related to US sub-prime mortgage debt exposure.

Clients also increasingly need to understand how valuations are calculated and it is this key aspect that Reuters DataScope Derivatives Pricing Service delivers to existing customers, as well as new ones who require pricing for instruments being developed and traded on a day-to-day basis, the firm says.

Tim Rice, global head of Reuters pricing and reference data, comments: "Many of our clients trade financial instruments for which establishing the correct market price can be difficult. This service allows them to tap into the independence and integrity of Reuters to give a custom made guide to the value of securities they hold."

Meanwhile, Reuters DataScope Onsite product and has been integrated with the PALADYNE suite of products. Reuters DataScope Onsite provides comprehensive pricing, factors, terms and conditions, corporate actions, cash flows and analytical data on the universe of ABS. This joint product offering is in response to an increased demand for comprehensive asset-backed data within the alternative investment industry. Reuters and Paladyne Systems are now servicing over forty new clients using the data as part of Paladyne's fully-hosted ASP platform.

Negative rating actions to continue
Fitch Ratings says in a special report summarising its global rating outlooks that the likelihood of a slowdown in economic growth, continuing elevated levels of market risk and a move away from the very low levels of credit defaults seen since 2004 will all likely contribute to a continuing trend of negative rating actions during 2008.

"The pace and scale of negative rating activity will be affected by the role of credit ratings as guides to relative default likelihood, rather than market pricing or economic activity," notes Richard Hunter, regional credit officer for Europe. "The majority of ratings at the portfolio level are still anticipated to remain stable over 2008, but there will be a strong bias toward negative actions over positive actions. Concentration of negative actions within certain sub-segments of structured and corporate finance will likely contribute to the continued fragility of sentiment."

In structured finance, Fitch notes that, although the majority of asset performance outlooks remained either stable or improving as at end-December 2007, this year sees a record number of sub-sectors - more than 30 - where Fitch anticipates declining asset performance. For corporate entities, Fitch anticipates that financial and business risk issues will re-emerge in rating activity in 2008, ahead of the event risk-related actions prevalent in 2007.

For financial institutions, despite the scale of market turmoil, the average ratings of regulated institutions remain at a strong level. Current expectations are that only a limited likelihood exists of widespread or multi-notch downgrades. Fitch acknowledges that risk management appears to have made a meaningful difference in the relative performance of individual institutions, but also notes that several more quarters' reporting are likely to be required before confidence in bank exposure levels can begin to be restored.

The report goes on to note that the broadly positive rating trend which has characterised emerging markets issuers in recent years is also expected to slow significantly in 2008. Fitch also expects, with regard to investor sentiment, that - given the broad variety of sectors facing negative asset or business environments - any improvements in individual sectors are likely to be offset by further deterioration in others.

Nightingale Finance affirmed
Moody's has affirmed the Aaa and Prime-1 ratings assigned to the MTN programmes and the Prime-1 rating assigned to the CP programmes of Nightingale Finance. The rating affirmation follows the successful restructuring of Nightingale by the SIV's sponsor, Banque AIG.

Under the restructuring, CP and MTNs are fully backed by commitments provided by AIG Financial Products. AIG FP agrees to purchase Nightingale's CP and MTNs under a senior note purchase commitment and to provide funding through a repo commitment.

The sum of these commitments will equal the outstanding amounts of CP and MTNs. In Moody's view, any realisation of current or future mark-to-market losses will be avoided, given the support of AIG FP - provided that it remains a going-concern.

DBRS reviews LSS MTM triggers
DBRS has commenced a review of its mark-to-market (MTM) trigger methodologies in relation to levered super-senior (LSS) transactions, with the intention of completing this review before April. This action is in part a result of the unprecedented volatility experienced by global credit markets since August, which has resulted in several LSS transactions facing margin calls.

Losses to LSS transactions are considered a remote credit risk; however, these transactions exhibit funding risk. LSS transactions include leverage in that the collateral held by the swap counterparty will be smaller than the potential maximum exposure under the CDS.

As such, the credit protection seller may be required to post additional collateral if its exposure under the swap increases. There are three main types of margin call regimes: those based on loss only, spread and loss, and MTM.

Four conduits (away from those covered by the Montréal Accord) have been placed under review with developing implications by DBRS. Each of the four conduits has at least one LSS transaction with a MTM margin call.

In conditions where markets were open to issuance and ongoing rollover of obligations, margin call funding would usually be met by issuing additional notes, by negotiating a revised margin call with the swap counterparty or by using other sources of liquidity, such as advances from the conduit sponsor. Any of the affected trusts that would presently experience a margin call would not have access to any of these options; the margin call would therefore likely go unsatisfied.

Upon a margin call not being met, the swap counterparty would have the right to unwind the transaction and liquidate the collateral. The documentation for each LSS transaction entered by the affected trusts has granted the swap counterparty a first priority security interest in any collateral. Noteholders have a second priority interest and would recover any balance of the collateral remaining after the obligations to the swap counterparty were met.

Considering the volatility and uncertainty in current credit markets, it is possible that a swap counterparty would not recover all of the costs associated with liquidating the collateral and unwinding the transaction at market value, thereby leaving noteholders with very large losses on their notes. For some transactions, this may be the case, even though the absolute amount of credit protection available to noteholders may exceed triple-A minimums.

DBRS will continue to monitor the situation closely and will provide rating updates as more information becomes available.

Visage liquidated
S&P has removed from credit watch with negative implications and lowered to single-D from triple-C minus its ratings on the Class A2, B, C and D notes issued by Visage CDO II, following the execution of the enforcement priorities of payment. At the same time, the agency lowered its ratings on the Class E, F and G notes to single-D from double-C.

On 27 December, S&P received a notice of enforcement from the trustee. This stated that the total return swap counterparty, as the controlling class, had directed the trustee to declare Visage CDO II's notes due immediately. In turn, this triggered a termination of the total return swap agreement.

The notice of enforcement followed a previous notice declaring an event of default as of 24 December. The event of default occurred under condition 11(j) of the notes' indenture after the Class A2 par value ratio fell below 100%.

On 28 January the agency received a notice from the trustee stating that all available proceeds have been distributed and that no further payments on the notes are anticipated. The available funds were insufficient to redeem the Class A2, B, C, D, E, F or G notes in this transaction.

CS

Trading ideas: rotten yields

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at an outright short on Ryland Group

No matter how you shake it, twist it or turn it, we are in the midst of the worst housing market since the Great Depression, end of story. So, when the CDS spread of an issuer such as Ryland Group - whose business is homebuilding - rebounds on massive short covering, we see opportunity.

The current bear market rally has squeezed RYL spreads tighter by an amazing 200bp (intra-day levels) over the past week, due to the possible bail out of the bond insurers and Fed rate cuts. Our MFCI model indicates RYL to be a good short and, with what we think will be deteriorating fundamentals, it will be even better in the future. We recommend buying protection on RYL at 305bp.

Implied factors say it all
Part of our MFCI model ranks an issuer relative to its peer group based upon market-implied factors, and Ryland has the worst score out of the entire consumer cyclical sector. One of the market-implied factors is BDP (Barra Default Probability), which takes equity and balance sheet information and backs out a probability of default for the company. RYL's BDP is in the 90th percentile, which means it has a very high probability of default compared with the rest of its sector.

We also look at implied volatility data taken directly from the equity derivatives market to gives us a forward-looking view. RYL ranks in the 90th percentile when looking at three-month at-the-money volatility.

Given that Ryland has a spread of 305bp, there is a mispricing here. Our MFCI model indicates the fair spread of Ryland to be 445bp (Exhibit 1).

Exhibit 1

Market rebound... Thanks for the opportunity
The possibility of a bail out of the bond insurers has helped pretty much every single global market rebound from multi-year lows/wides over the past week. The homebuilders and retailers (both favourite shorts of the market over the past few months) rebounded hard, probably due to massive short covering.

Ryland benefited from the sell-off, tightening by over 150bp (Exhibit 2) and outperformed the IG index in the rally. We believe a move, such as this, creates opportunity to place a short on a credit from the sector that has the worst future potential (the homebuilders) at an extremely rich (tight) level.

Exhibit 2

Fundamentals... Down the drain
Ryland released last year's earnings and managed to squeak by with some positive free cashflow. However, everything else did not look so good.

Revenue was down, number of homes sold way down (-30%), average price of home sold down (-10%), and it posted a loss for the year. We believe this trend will only get worse as we head further into 2008.

Risk analysis
This trade takes an outright short position. It is un-hedged against general market moves, as well as against idiosyncratic curve movements. Additionally, we face about 20-30bp of bid-offer to cross, which is significant given RYL's current levels.

The trade has negative carry, which means we face a double challenge of paying carry and fighting curve roll-down.

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

Liquidity
Liquidity – i.e. the ability to transact effectively across the bid-offer spread in the bond and CDS markets - is a major driver of any longer-dated trade. RYL has decent liquidity in the CDS market at the five-year tenor.

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

Though RYL's fundamentals seem OK for the time being, we believe that the continued housing implosion will only deteriorate further as we head into 2008 and 2009.

Summary and trade recommendation
Temporary tax breaks, the monoline bailout rumours and the Fed cut have all helped drive investors to somewhat euphoric levels on the builders. Yet results show things are deteriorating faster than many expect and we don't see it turning around anytime soon.

The current short covering rally has opened the door for anyone looking for attractive shorts. We've been scouring the homebuilders for the past few months and just found spreads too wide to initiate any outright shorts.

We believe now is an opportune time to short Ryland Group, a company that has deteriorating fundamentals in a sector that has not witnessed such destruction since the 1930s. Our MFCI model indicates RYL to have a fair spread of 445bp and therefore we recommend buying protection on RYL at 305bp.

Buy US$10m notional Ryland Group Inc. five-year CDS protection at 305bp to pay 305bp of carry.

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

Copyright © 2008 Credit Derivatives Research LLC. All Rights Reserved.

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