Contents

Transition revamp

Rating agency proposals catch market by surprise

All three rating agencies this week came out with proposals to change aspects of their methodologies as they continue realigning sub-prime-related ratings with default risk. But perhaps the one that surprised the market the most was Fitch's draft proposal for corporate CDOs.

"The rating agencies are falling over themselves in their efforts to re-rate the sub-prime space, but their hotchpotch approach is really confusing investors and making it nigh-on impossible to assess expected losses with any confidence. The market, in general, believes that they are only scratching the surface of AAA/AA ratings and that a huge number of downgrades are still to come. The headline risk will continue as long as the market is distracted by this," one dealer observes.

Principal changes to Fitch's corporate CDO criteria include: updated historical default rates, with protection for highly-rated tranches calibrated above historical peak default rates for the relevant portfolio; increased credit enhancement for concentrated portfolios; mechanisms to identify and provide additional protection against adversely selected names and portfolios; lower recovery rates; and portfolio composition and rating considerations that place greater emphasis on qualitative factors to supplement quantitatively established inputs and results. The agency is seeking market feedback regarding these changes and anticipates that the final criteria will be issued by end-March, at which point Fitch will recommence issuing ratings for corporate CDOs.

"With the structured credit markets under unprecedented stress, Fitch wanted to proactively challenge existing CDO rating assumptions, learning from areas where underperformance has already materialised," explains the agency's head of global structured credit John Olert.

He adds: "Fitch's proposed revisions to its corporate CDO methodology are designed to provide an updated, more forward-looking view of corporate default and loss experience. The intention is to produce CDO ratings that perform similarly in terms of default risk and ratings migration with the market's expectation for other asset classes. This is particularly true for triple-A and other highly-rated CDO tranches."

Static synthetic CDOs are expected to be most affected by the revised criteria, with an average downgrade of five notches likely to impact numerous tranches currently carrying a triple-A rating. The magnitude of downgrades for cashflow CDOs holding high-yield assets is expected to be less severe, with the majority of senior classes expected to be affirmed. Junior tranches are more susceptible to downgrades, and these are expected to range from one to three notches.

By increasing the level of the attachment point to safeguard investors in investment-grade tranches, credit strategists at BNP Paribas reckon that Fitch is moving in the right direction, given that corporate defaults are expected to increase over the coming years. However, they estimate that around 600 transactions worth US$220bn, including US$50bn currently rated triple-A, will be negatively impacted as a result.

The proposed criteria will apply to corporate CDOs with portfolios of 50-500 obligors, and with exposure to emerging market corporates between 0-5%. Criteria updates for other asset classes will follow over the next few months.

RBS structured credit strategists warn that substantial downgrades of triple-A rated CSOs could prompt forced unwinds by constrained investors, thereby moving the correlation markets and causing an exacerbation of the sell-off in senior mezz that the market has seen in recent weeks. "A strong bid for single name protection would also occur, causing indices to trade very rich and ultimately dragging credit wider in general. The danger then is of a snowball effect, where people exiting CSOs cause additional MTM pain for those who decided to stay put – then causing further unwinds."

Meanwhile, Moody's issued a request for comment, discussing possible alternatives for differentiating structured finance ratings from non-structured finance ratings, highlighting potential features and limitations of these options, and seeking market opinion on the appropriate next step. The agency plans to provide feedback within the next two to three months.

Moody's proposals include: using numerical ratings instead of letters, which would map to the existing corporate ratings; adding a modifier to the rating to label it as structured finance; using suffix to provide additional rating information, such as rating volatility or model risk (this could appear in a separate field); and no change to the rating scale, but providing extra information in written research.

The RBS strategists welcome the move. "We feel it would add discipline if Moody's were to be more forthright in their estimation of rating stability, model risk, etc... For instance a CPDO could still be rated triple-A, but would receive a very poor stability measure," they say.

The agency concedes that some performance characteristics of structured securities – including characteristics not measured by current ratings – have demonstrated behaviours in certain asset classes that are different from those of corporate and government-related securities. Modelling uncertainties, together with structural features and asset pooling characteristics of structured products could continue to cause greater rating transitions – resulting in both larger and more frequent upgrades and downgrades – in certain structured finance asset classes relative to corporate securities. Distinguishing between ratings could therefore help raise investor awareness of potential differences in meaning and behavioural attributes.

And finally, S&P revised the correlation and recovery assumptions it uses to rate certain new CDOs and to perform surveillance on CDOs backed by RMBS, while Moody's revised its expected loss assumptions for 2006-vintage SF CDO surveillance. The changes follow the revision of certain surveillance assumptions for RMBS, given the observed difference between actual and originally-expected behaviour of certain collateral (see SCI issue 71).

The CDO transactions affected by S&P's announcement include: those backed by prime, Alt-A, sub-prime, HEL and tax-lien RMBS issued in the US during or after Q405; CDOs backed by RMBS issued before Q405; and any CDO-squareds. The agency's previous methodology was based on historical rating transitions; its revised methodology is based on calculating the joint probability of default of the RMBS tranche and the CDO tranche, after taking into account the correlation of the underlying RMBS assets and the credit support available to each tranche.

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LatAm launch

Synthetic balance sheet deal debuts

ABN AMRO has closed an unusual US$850m synthetic balance sheet CLO dubbed Iguaçu. The deal could be the precursor for a number of emerging market transactions this year.

Given the paucity of traditional CDO collateral supply expected in 2008, emerging market assets may increasingly find favour among structured credit investors. "From a macro perspective, I think there will certainly be a lot of good opportunities in EM loans," agrees one. "But not many shops have the necessary expertise in the segment to bring an EM CLO."

In the case of Iguaçu, ABN AMRO leveraged its local presence. Referencing a portfolio of exclusively Brazilian corporate loans originated by the bank's subsidiary Banco Real, the transaction is thought to be unique in terms of its underlying and scale.

ABN AMRO worked closely with Dutch pension fund PGGM to execute the deal, with the two institutions sharing the first and second-loss pieces and PGGM buying the mezzanine risk (the remainder of the capital structure, tranche sizes and other investors are undisclosed). Iguaçu is structured along similar lines to a transaction the two parties worked on that closed in December 2006, which referenced a global portfolio worth €15.5bn.

"Similar to the previous transactions, including those with ABN AMRO and other partners, it was important for us that Banco Real was prepared to really share the risk – instead of an outright transfer – so the interests are well aligned," explains Raymond van Wersch, senior portfolio manager, structured credit at PGGM. "Furthermore, Banco Real applies high environmental and social standards throughout all its business processes, which is in line with our responsible investment policy."

The deal is tailored to PGGM's specifications in terms of size and exposure to ensure diversity in its overall portfolio of investments. "The larger pension funds generally have two objectives: diversifying risk and enhancing yield. In those respects, Iguaçu is a compelling trade for PGGM. In addition, the firm was already familiar with our underwriting and due diligence procedures," notes Adam Rose, head of financial markets distribution Netherlands at ABN AMRO.

Mascha Canio, head of infrastructure, private equity and structured credit at PGGM, confirms: "With this transaction we have further diversified the continuously growing structured credit portfolio, as well as the overall portfolio. For PGGM this is an effective way of investing in assets that are difficult to find in the public market."

ABN AMRO's objective, meanwhile, is to achieve an optimal capital deployment strategy. The transaction is structured to ensure its efficiency under Basel I and Basel II, with Banco Real employing capital management techniques previously not used in the Brazilian banking sector.

The portfolio comprises a few hundred loans made to Brazilian corporates (again, the exact number and industry concentration of these loans were unavailable). Although the single-jurisdiction nature of the deal meant that it was easier to identify appropriate underlyings, Rose says it was still a challenging process because of the transaction's size and the emerging market collateral.

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Rates cut

Sub-prime payment shock significantly reduced

The significance to the structured credit market of the Federal Reserve's second rate cut in a row and its impact on dollar Libor was lost last week amid continuing negative headlines (see News round-up). However, the move will likely reduce sub-prime payment shock more effectively than the Paulson plan proposed last December – thereby benefiting investors at the top of the capital structure.

"The 200bp drop in Libor in the past six weeks dramatically reduces the rate reset stress for sub-prime borrowers. We estimate over 60% of borrowers will have a payment shock of 0-5%, versus 60% with a payment shock of 20-30% had Libor remained at 5%," explain structured credit analysts at JPMorgan.

With most hybrid ARM loans indexed to six-month Libor, a lower index should result in less pressure on borrowers – thereby reducing delinquency rates and commensurate default risk at the ARM rate reset. The rate cut also diminishes the need to modify borrowers' loans as had been proposed in the Paulson plan, which has been criticised by some as violating contract law (see SCI issue 68).

Analysts at Wachovia Capital Markets have also estimated the impact of the rate cuts, indicating a reduction of payment shock to 8% (or the equivalent of US$182) over the next three years from the 33% increase forecast in August. They used Bloomberg's historical regression analysis to examine the relationship between the target Fed funds rate and six-month Libor. The R-square came out at 0.767 and the Beta at 0.88 – with the resulting slope coefficient suggesting that, for every 100bp change in the target Fed funds rate, six-month Libor changes by 88bp.

The average margin for outstanding sub-prime loans subject to resets between January 2008 and December 2010 is 5.76%, with the majority of loans structured such that the first rate reset is capped at the margin. Forward six-month Libor and loan terms were then used to calculate both the rate at reset and an estimate of the rate shock expected to be realised.

"The forward six-month Libor rate is projected to decline to around 2.7% in July 2008 and remain at or near there through to July 2009. The rate shock declines from 127bp in February 2008 to 17bp in May 2009, with the average rate shock for loans resetting between February 2008 to January 2011 estimated to be 106bp," notes Glenn Schultz, senior analyst at Wachovia Capital Markets.

He estimates that the Fed would need to lower rates by an additional 75bp to effectively freeze sub-prime borrowers' rates at the initial fixed rate. The current average rate for all loans is 7.87%; the estimated rate at reset is 8.92%, with the average balance of loans subject to reset at around US$315,500.

House prices remain under pressure, however, and it is unlikely that housing data points will provide any positive news over the next 12 months. Indeed, with equity tranches trading more on the timing of defaults than the potential for defaults, risk has shifted up the capital structure.

Five-year equity correlation last week reached new highs, increasing by 2.5%, as first-loss, mezzanine and super-senior CDX tranches all outperformed on a delta-adjusted basis. Base correlation curves were flatter on the week as risk moved into the senior tranches.

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Far more than just a spreadsheet

Enterprise analytic and trade-capture systems are discussed by Kevin McPartland, senior analyst at TABB Group

Question: Don't you think it is time financial market professionals stop treating Excel like a tactical solution and embrace it as an enterprise analytic and trade- capture system?

Frankly, there is quite a bit more to it than simply installing Excel from the Microsoft Office 2007 CD on every desktop. Speed of development, speed of processing and compliance-related auditing must be addressed to move Excel to the enterprise level. Although the solutions are not trivial, they do now exist and Microsoft is not the only software company that stands to gain.

For years, Wall Street firms have tried to move critical functions away from Excel, as it proved difficult to monitor and maintain. Unfortunately for Excel naysayers, the market has yet to create a trade capture system for bespoke derivatives that provides Excel's flexibility and time-to-market. Although it is a noble goal to displace one of the most successful computer programmes in history with a task-specific application, why fight city hall?

Our modern-day world often demands instant gratification, but for those who deal in structured OTC derivatives, the concept of instant is as foreign as exchange-traded. When web pages can be created with a few clicks and a phone call can be made in one, it seems unreasonable that automation has failed to penetrate a business where daily dollar volumes are measured in trillions.

Risk management pressure now drives brokers and software providers to tackle the difficult task of capturing structured OTC derivative trades. As an industry, improvements to downstream processing are beginning to be made through standards such as XML and FpML, coupled with increasingly intelligent confirmation management systems. Trade capture, however, is still largely dominated by Excel.

Traders remain partial to Excel in large part because it allows them to quickly create new structured products without the need of an IT team. A number of firms are bolstering this process with Excel add-ins that offer everything from real-time market data to the ability to publish structured product prices to interested clients.

Many of these tasks previously required the data in Excel to be keyed into other systems. Today, they can be created and managed in one place.

Another problem with Excel that has been tackled is the inability to utilise the plethora of CPUs in the data centre available to other applications. Pricing of newly created instruments has until recently been restricted by the speed of the user's PC.

Despite massive performance improvement to trader workstations, servers have seen equal improvement and still provide considerably more horsepower than their desktop counterparts. Microsoft, in an effort to encourage Excel's use at the enterprise level, has provided support for server-side Excel in its latest release. Complex formulas can now be run on low-latency servers and leave the trader's PC available for day-to-day tasks.

Last, the biggest bottleneck preventing the full embrace of Excel is the view that traders are free from auditing. It has long been the case that changes to spreadsheets and the financial models within them can be made easily and on the fly, leaving open the window for fraud and manipulation.

No longer is that the case, as several software providers solved this problem by creating software that can monitor updates to spreadsheets in real time. Who made the change, when it was made and exactly what adjustments were made can be overseen by a compliance or risk-management team. Additionally, changes to the most mission-critical formulas and data points can be flagged, so that errors – whether intentional or not – can be caught quickly and rectified.

Excel has driven the business of many companies for 20 years. Trying to replace it is an act in futility because no software company can recreate in months what Microsoft took 20 years to build. Paired with the appropriate and specific financial add-ins and utilisation of Excel's latest and greatest features, spreadsheets could provide automation that has until this point proved elusive to structured product businesses worldwide.

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.

Bank forms new credit group

The latest company and people moves

Bank forms new credit group
The asset management business of Credit Suisse is understood to be setting up a new credit products group within its alternative investments division. Former co-head of US leveraged finance in Credit Suisse's investment bank, Don Pollard, will be leading the new group, reporting to Nicole Arnaboldi and Steve Kantor, co-heads of illiquid alternative investments.

This newly-formed group will be comprised of the existing credit businesses within the alternative investments unit – including both the leveraged investments group, headed by John Popp, and Candlewood Capital Partners, managed by Mike Lau. In addition to his role as head of this new group, Pollard will become co-manager of Candlewood Capital Partners.

Merrill clarifies structured credit position...
Merrill Lynch has issued a statement clarifying its intentions in the structured credit business. The move follows remarks reportedly made last Wednesday by the firm's chairman and ceo John Thain that indicated it was pulling out of structured credit.

"The origination opportunities in many areas of structured finance and ABS CDOs will be minimal for the foreseeable future and our activities will be reduced accordingly. Structured credit, including CLOs and synthetic credit securitisation opportunities, have been and will continue to be an important part of our business," the statement says.

...settles one dispute...
Last Friday, 1 February, mayor of Springfield Massachusetts, Domenic Sarno, Springfield finance control board chairman Chris Gabrieli and attorney general Martha Coakley announced that Merrill Lynch has credited the City of Springfield with approximately US$13.9m in cash – the full original purchase price of CDO investments that have been under dispute. In addition, Merrill Lynch has agreed to pay the legal fees incurred by the finance control board in retaining outside counsel.

The City had previously alleged that the investments in April and June 2007 into three CDOs – Centre Square CDO, South Coast Funding V CDO and Tabs CDO – were made without its full consent and understanding.

...but faces more
As the above announcement came, Massachusetts' secretary of state William Galvin charged Merrill Lynch in connection with the same CDOs. The complaint was filed "in order to commence an adjudicatory proceeding" against Merrill Lynch, Carl Kipper and Manuel Choy for violating the Massachusetts Uniform Securities Act.

"This complaint is focused on Merrill Lynch's sale, through agents Kipper and Choy, of ...(CDOs) to the City of Springfield, Massachusetts, which were unsuitable for the City and which, within months after the sale, became illiquid and lost almost all of their market value," it says.

Among the measures the complaint seeks are: an administrative fine; all profits from the alleged wrongdoing; censure for Merrill Lynch; and the appointment of an independent consultant to review the "systematic supervisory breakdowns and incentives within Merrill that allowed the alleged wrongdoing to occur".

Meanwhile, law firm Klayman & Toskes (K&T) says it is investigating the damages sustained by institutional and retail customers in Norma CDO I. "Norma, brought into existence by Merrill Lynch, bet heavily on the success of the sub-prime market. Just nine months after it sold about US$1.5bn in securities to its investors, the value of Norma has been decimated in the collapse of the housing market and is reported to be worth only a fraction of its original value," K&T explains.

Presently, K&T says it is investigating how Merrill Lynch and others marketed Norma, and whether the brokerage firm properly disclosed the risks of Norma to its customers. The firm is also looking into whether Norma was suitable for the institutional and retail customers that invested in the product.

Director switches post-restructuring
Kate Birchall, formerly a director in Lloyds TSB's structured credit team, has joined the bank's asset management team as a director in asset distribution, reporting to John Winter, head of capital management. Her move follows a restructuring at the firm that has seen its structured credit business folded into the structured products group headed by Mark Grant.

The restructuring leaves three other structured credit figures without current roles – Richard Goldthorpe, formerly head of structured credit; Alan Packman, previously head of structured finance proprietary trading; and former director in structured credit Yousef Shokrai. All three continue to be employed by Lloyds TSB and are looking for other opportunities within the organisation.

Law firm establishes structured resolution group
US-based international law firm Brown Rudnick has brought together members of its practices in structured finance, bankruptcy & corporate restructuring and distressed debt to form a structured resolution group. This interdisciplinary team will analyse the issues surrounding the sub-prime market collapse in an effort to help clients identify and execute on arbitrage and repackaging strategies.

The new group will make its services available to underwriters and structuring agents, proprietary trading desks, hedge funds and private investment funds that are positioned on either the buy or sell-side of the sub-prime/SIV/CDO crisis. Bringing to bear experience in structuring complex securitisations and extracting value for distressed debt holders at the subordinate levels of the capital structure, the structured resolution group aims to provide assistance in dissecting deal structures, identifying levers for various tranche holders, and designing and executing repacks. The group will also apply the firm's expertise in sophisticated insolvency and financial litigation.

Amblard made FI and structured credit chief
BNP Paribas has promoted Guillaume Amblard, previously global head of interest rate & foreign exchange trading, to global head of fixed income trading and quantitative research. In addition to his current role, Amblard will take on additional responsibility for the structured credit, credit arbitrage and flow credit trading teams, as well as BNP Paribas' quantitative research group.

The bank says the appointment is part of a strategic plan to strengthen the business' global trading platform and to continue to expand its client franchise across all markets. Amblard, who has been at BNP Paribas since 1990, is based in London and reports to Frederic Janbon, global head of fixed income.

RBS credit wins out
RBS staffers have retained control of the credit business following a management re-jig after the bank's acquisition of ABN AMRO.

The new global head of credit markets is Symon Drake-Brockman – an expanded remit from his old position as head of debt markets. He will be based in the firm's Greenwich Connecticut office, where he also becomes head of GBM Americas – a role he shares with Jay Levine, until the latter's retirement at the end of March.

Matteo Mazzocchi's head of structured debt derivatives role has been renamed global head of structured credit derivatives & alternatives. Meanwhile, Stewart Booth keeps his position as global head of credit trading.

The only senior ABN figure to get a role in the reshuffle is Mike Nawas, who becomes global head of corporate & structured DCM. Tim Pettit, previously head of structured capital markets, has become global head of the financial structuring group.

FSA gets opportunity funding
Dexia has announced it will contribute US$500m additional capital to its subsidiary Financial Security Assurance Holdings, the holding company for monoline bond insurer FSA. "These resources will add capacity for FSA to take advantage of increasing opportunities that have recently arisen in the US municipal and public infrastructure finance markets," Dexia says.

This injection increases FSA's qualified statutory capital by 18.5% to US$3.2bn and brings total claims-paying resources to US$7.2bn.

Primus reports Q4 loss
Primus Guaranty announced a fourth quarter 2007 GAAP net loss of US$403.9m, which it says was primarily a reflection of changes in the fair value of its credit protection portfolio resulting from widening credit spreads. Primus also reported its Q4 economic results were a net loss of US$28m after a credit event provision on its CDS of ABS portfolio and a restructuring cost relating to the discontinuance of its Harrier Credit Strategies Master Fund.

During the fourth quarter, the company included a provision of US$40.9m to account for credit events that occurred subsequent to the year end on six RMBS referenced by CDS written by Primus Financial that were downgraded to CCC or below by S&P. The US$40.9m provision reflects the net difference between the US$45m notional principal on the credit swap contracts affected by these actions and the estimated current market value of the securities.

Primus decided to discontinue Harrier in November (see SCI issue 63) due in part to Harrier's trading losses and difficulty in raising third-party capital, given the current market environment. In the fourth quarter, restructuring costs of US$3m were charged in connection with Harrier's discontinuation. Harrier also incurred a net trading loss of US$1.1m in Q4.

The company's results also revealed more positive news. Q4 saw record new credit swap transaction volume of US$3.2bn, Primus' highest quarterly transaction volume ever, bringing the total portfolio at year end to US$23.0bn. Further, unearned future premiums on credit swaps sold at year end 2007 were US$378m, with Q4 transactions accounting for US$68m of that figure. Overall, credit protection premium income increased 29.5% from the year earlier quarter.

MP

Downgrade shock

A round up of this week's structured credit news

Downgrade shock
S&P has placed on credit watch with negative implications or downgraded its ratings on 6,389 classes from US RMBS transactions backed by US first-lien sub-prime mortgage collateral rated between January 2006 and June 2007. At the same time, it placed on credit watch negative 1,953 ratings from 572 global ABS CDO and CDO-squared transactions.

In many cases, the magnitude of the sub-prime rating cuts is fairly dramatic, according to structured finance analysts at RBS – who described S&P's actions as "breathtaking".

The affected RMBS classes represent an issuance amount of approximately US$270.1bn, or approximately 46.6% of the par amount of such sub-prime mortgage loans rated by S&P during the period. The CDO classes on watch negative represent an issuance amount of approximately US$263.9bn, which is about 35.2% of S&P's rated ABS CDO and CDO-squared issuance worldwide.

The agency has completed its global review of all its rated ABCP conduits with exposure to these classes and confirms that none of its ratings on any outstanding ABCP notes will be adversely affected solely as a result of the rating actions. S&P has also completed its review of all the SIV and SIV-lite structures it rates, with regard to exposure to these US RMBS classes.

The review shows that there are nine SIVs with exposure to 133 of the affected tranches. The vast majority of the exposure is to tranches with ratings placed on credit watch. These exposures are primarily in SIVs that have restructured, defaulted already or are receiving liquidity support and, therefore, the SIVs are not adversely affected by these rating actions.

Of the five SIV-lites originally rated, only one is currently still operating and has been restructured. The review of this SIV-lite shows that there is exposure to two of the affected US RMBS classes, and the ratings are not adversely affected by these rating actions.

FGIC downgraded, more monolines on watch...
Fitch and S&P have downgraded FGIC's insurer financial strength rating from triple-A to double-A and its long-term issuer rating from double-A to single-A, with the ratings remaining on credit watch. The move is due to FGIC's not yet raising new capital or having executed other risk mitigation measures in order to meet capital guidelines.

The company has a modelled capital shortfall of more than US$1bn at the triple-A rating threshold. The existing capital deficiency, which is now believed to be approximately US$1.3bn, resulted from rapid credit deterioration in FGIC's insured portfolio, in particular: transactions backed by structured finance CDOs and direct exposure to RMBS, namely prime second-lien mortgages.

The continuation of the rating watch reflects the significant uncertainty with respect to the company's franchise, business model and strategic direction; uncertain capital markets; the company's future capital strategy; ultimate loss levels in its insured portfolio; and the challenges in the financial guaranty market overall. Fitch expects to resolve the rating watch after the agency evaluates these various qualitative factors, as well as the progress FGIC makes as far as its future capital enhancement plans. This analysis will include a review of the effectiveness of recent efforts of insurance regulators to support any industry solution.

S&P also placed various ratings on MBIA Insurance Corp, XL Capital Assurance Inc, XL Financial Assurance and their related entities on credit watch with negative implications. The ratings on various related contingent capital facilities were also affected. And Fitch has placed MBIA and CIFG back on rating watch negative, despite having affirmed them with stable outlook after they raised the capital the agency had previously required.

Meanwhile, a consortium of banks (Barclays, BNP Paribas, Citi, Dresdner, RBS, SG, UBS and Wachovia) is believed to be working on a solution to the problems faced by Ambac. Sources indicate that other consortia are working to resolve the situation at MBIA and FGIC, while there has been some speculation that one of the banks involved in discussions about Ambac is proposing a bail-out of only municipal bonds.

Elsewhere, the hope of a co-ordinated bail-out was maintained as the New York Governor Eliot Spitzer reportedly said that the plan by the state's insurance regulator was "making good progress". However, the inability to assess accurately and with confidence the likely losses the monolines will incur is a major stumbling block to finding new investors and to getting agreement on a co-ordinated bail-out by banks (see last week's issue for more).

Moody's is expected to update the market on the current status of its review of the monolines by mid- to late-February. It says its intention is to evaluate each company individually and reach conclusions when the information was available.

...as Fitch revises monoline approach...
Fitch Ratings has, in light of consensus movement towards a view of increased loss projections for US sub-prime RMBS that is now held by various market participants, updated certain modelling assumptions in its ongoing analysis of the financial guaranty industry. The agency believes it is possible that modelled losses for SF CDOs could increase materially as a result of these updated projections. The need to update loss assumptions at this time reflects the highly dynamic nature of the real estate markets in the US, and the speed with which adverse information on underlying mortgage performance is becoming available.

Fitch believes that a sharp increase in expected losses would be especially problematic for the ratings of financial guarantors – even more problematic than its previously discussed increases in triple-A capital guidelines, which has been the primary focus of recent analysis of the industry. Expected losses reflect an estimate of future claims that the agency believes would ultimately need to be paid by a guarantor. A material increase in claim payments would be inconsistent with triple-A rating standards for financial guarantors, and could potentially call into question the appropriateness of these ratings for those affected companies, regardless of their ultimate capital levels.

Fitch expects in addition to increases in expected losses, that its capital guidelines are likely to increase materially as well. An increase in both expected losses and capital guidelines would place further downward pressure on the ratings of those five financial guarantors – Ambac, CIFG, FGIC, MBIA and SCA – that Fitch has previously identified as having material sub-prime exposure within their insured portfolios (see separate monoline story). Ratings on three of these guarantors – Ambac, FGIC and SCA – were recently downgraded by Fitch, and their ratings remain on rating watch negative.

Fitch continues to hold stable rating outlooks for the triple-A insurer financial strength ratings of the operating subsidiaries of Assured and FSA, the two financial guaranty companies that avoided direct exposures to SF CDOs to a material degree. The agency, however, will continue to monitor the impact of deteriorating RMBS performance on SF CDO-related CLNs tied to FSA's guaranteed investment contract (GIC) business. While deterioration in the performance of the CLNs in FSA's GIC portfolio would not cause a direct credit loss for FSA, they could result in early withdrawal of certain GIC liabilities, which could create added liquidity requirements for FSA.

...and monoline impact on banks is analysed
Downgrades of bond insurers have prompted questions about the effect on both commercial and investment banks, according to a new S&P report. Of course, successful capital-raising efforts would eliminate the need to focus on the potential effect of downgrades on financial institutions. In the absence of additional capital, however, it is useful to think about the possible ramifications of downgrades, which could affect the US$2.5trn of obligations guaranteed by the bond insurers, the agency says.

The ripple effects of the still-unfolding sub-prime lending situation have affected various directly-related markets, as such markets trade in or reference sub-prime loans or other securities that hold such loans. The holders of these instruments, the banks and money market investors, as well as certain hedge funds to date are estimated to have suffered more than US$130bn of losses. Now the bond insurers, which have insured some of these instruments, are also being affected and the issues are becoming relevant to a broader cross-section of the market.

Bond insurers are suffering as a result of their roles as guarantors of mortgage-related securities and downgrading them could affect all markets in which they are active, including the municipal bond, CMBS and other structured finance areas. In turn, dislocation in those markets could affect banks.

S&P believes that the specific, identifiable effect on banks may be significant and, in a few cases, could lead to downgrades. Large global institutions have direct exposure to the bond insurers in a number of ways.

The area that represents the potential for the highest losses is the hedges that the bond insurers provide for super-senior CDO tranches. To date, losses that banks have reported on their CDO exposures have predominantly been on unhedged exposures.

However, US$125bn of sub-prime-related CDOs hedged by bond insurers remains concentrated in the hands of a relatively small number of banks. Few banks have disclosed how much that exposure is.

Citi reported that it had bought protection on US$10bn of super-senior tranches of high-grade CDOs (not necessarily all from bond insurers), Merrill Lynch reported US$19.9bn of hedges with bond insurers and CIBC US$9.9bn. The value of those hedges has increased as the values of the underlying CDOs have fallen and now can be presumed to be 40%-60% of the notional amounts.

In some cases, banks have taken reserves against the increased counterparty risk represented by their own assessment of the credit deterioration in bond insurers. Citi added US$900m to reserves, Merrill Lynch added US$3.1bn and CIBC announced US$2bn – with the majority of that related to ACA's severe downgrade to triple-C. More reserving may be necessary to reflect the increase in counterparty risk, if the ratings on guarantors are lowered.

Some of the CDOs hedged by bond insurers are part of a negative basis trade strategy. The spread earned on the CDOs compared to the firm's cost of funds, deducting the cost of the monoline insurance, can be present valued and reported as current income because the position is deemed to be hedged. If the hedge is deemed to be "ineffective", however, that income may need to be reversed.

Meanwhile, the bond insurers cover US$1.5trn of municipal bonds, a much greater amount than CDOs, but the effect is not likely to be as great for banks. Although the bond insurers' downgrades will mean downgrades of the municipal bonds they insure, the stand-alone strength of the municipalities is generally investment grade or high investment grade.

Assuming the ratings remain in the double-A area, the price effect is not likely to be very significant – although the fact that some investors cannot hold securities rated below triple-A may exacerbate price declines if there is widespread forced selling. However, the effect of municipal bond downgrades will not be concentrated, potentially affecting a wide variety of smaller, mainly US banks, as well as the larger ones that commonly hold such securities on their balance sheets.

A somewhat bigger issue than simple holdings of municipal bonds is that some large banks have provided liquidity lines to three different types of SPEs that fund municipal bond investments wrapped by monolines: tender option bonds (TOBs); variable-rate deposit obligations (VRDOs); and auction rate programmes. With the downgrades and price depreciation, investors in TOBs have been exercising their right to tender the municipal bonds back to the banks at par. The banks that hold the subordinated notes in these programmes must not only fund the bonds on their own balance sheets, but must absorb any mark-to-market losses on these bonds.

Downgrades have also been pulling funding away from VRDOs, so banks must, at least temporarily, take these bonds back on balance sheet until the municipalities can restructure their bonds. The auction rate programmes require no obligation on the part of the banks other than to remarket the bonds when the auction fails.

In addition, these banks might provide the SPEs with default protection on the municipal bonds (Merrill Lynch disclosed US$7.9bn of such protection in September). While the mark-to-market losses from downgrades to the double-A level are not likely to be very significant, the bigger issue is liquidity management, as large amounts of securities need to be funded on balance sheet. Although banks can manage the liquidity needs related to municipal bonds, dedicating additional funds to this area may curtail the amount of liquidity available for other needs.

The larger concern is that the bond insurance downgrades may affect not just the key markets in which the bond insurers are directly active, but general markets spread beyond the limited sectors affected to date. This could lead to a further prolonged period of generalised market disruption and a loss of confidence that would not be favourable for any financial institution, S&P says.

At present, it would be difficult to opine on the likely effects on the financial sector of a generalised market disruption. At a minimum, the agency believes that trading results could be affected, as could fixed income business volumes.

Bright future for ILS
JPMorgan's global structured finance research team in New York (JPM) and risk & reinsurance specialist Guy Carpenter (GC) have published reports on insurance-linked securities (ILS). Both are bullish about the products' future.

"We anticipate there is still significant scope for further growth, and expect that securitisation and financial markets can increase underwriting capacity for reinsurers. We project annual issuance of cat bonds to exceed US$10bn in 2008; 2002-2007 growth experience was 47% compounded annual growth," says the JPM report 'Catastrophe bonds and sidecars – a primer'.

The JPM analysts also expect further growth in P&C risk transfer via sidecar transactions. "High insurer capital requirements for peak catastrophe risks will drive cat bond and sidecar growth," they say.

The JPM report goes on to note that cat bonds offer investors a risk whose performance is uncorrelated with other financial instruments. Further, cat bonds also offer an attractive spread pick-up relative to comparably-rated corporate credit and these spreads almost always exceed the modelled expected loss.

Moreover, the GC report – 'ILS comes of age: structured products on the horizon' – says the next stage in the maturation of the market is to structure ILS products using cat bonds, industry loss warranties (ILWs) and derivatives written on both. It says: "Going forward, (re)insurers eager to transfer risk and investors seeking potentially outsized returns are likely to turn to structured products... By customising securities via the CDO structure, decisions can be made on the alpha and beta of a single contract, allowing investors to assess the impact of an inherently diversified portfolio."

GC concludes: "Customised CDOs can be selected for specific characteristics, alleviating the pressure on institutional and individual investors to find individual cat bonds, ILWs or non-ILS that may not meet a portfolio manager's particular needs. The utilisation of structured products is just beginning, but hopes are high."

SIV restructuring continues
Further SIV restructuring activity emerged over the last week. Standard Chartered plans to purchase CP issued by its Whistlejacket vehicle to enable it to meet its senior obligations, provided noteholders agree to drop enforcement conditions that would be triggered by a decrease in NAV below 50%. And HSBC has established two new vehicles – Mazarin Funding and Barion Funding – with which Cullinan income note investors can exchange their holdings.

A proportion of Cullinan's assets will also be transferred to the new vehicles, which will have no market value triggers. Mazarin is structured as an ABCP conduit that is backed by a 100% liquidity facility from HSBC, while Barion is a term funded vehicle. HSBC is reportedly considering restructuring options for its other SIV Asscher.

Meanwhile, Citi has repurchased US$25m second priority senior MTN notes due May 2011 issued by its Sedna Finance vehicle.

European asset performance set to decline
S&P says that the performance of assets backing many European structured finance transactions is set to decline over the next 12 months, constraining new issuance volumes, but expected losses in collateral pools should generally remain lower than the agency's rating stresses. Unprecedented disruption in the global capital markets, caused in large part by problems in the US mortgage sector, means that certain structures and particular asset types may disappear from the European market altogether and others may be under some ratings pressure for the foreseeable future.

On the whole, collateral performance issues over 2008 are most likely to affect speculative-grade or low investment-grade ratings, with most high investment-grade ratings expected to remain generally stable. At a sector level, credit risk is expected to rise in certain CDOs and RMBS.

Looking ahead, the agency will be watching the small number of ABS CDO transactions backed by US RMBS collateral, where structural triggers related to asset ratings could cause early liquidation of the portfolio into a depressed market. While these and other pockets of weakness are emerging, the fundamental credit risk across the European asset-backed markets generally remains good. S&P believes that the divergence between bond spreads and ratings, at least as far as higher grade tranches are concerned, represents an overdue re-pricing of credit risk rather than a significant increase in credit risk itself.

The agency's 2007 European structured finance transition study highlights that rating changes among European structured finance securities were again stable, but that certain credit risks are worsening. "Our study shows that more than 97.5% of ratings remained the same or were raised over the course of the year, an improvement on 96.5% in 2006," comments Simon Collingridge, S&P md and head of European surveillance. "Despite the comparative stability these statistics demonstrate, the default risk of the underlying assets did increase in some sectors. This has generally not been sufficient to cause negative rating actions so far and the default rate in 2007 was only 0.32%. But collateral performance in a number of European structured finance asset classes will likely worsen in 2008."

Collingridge notes that structural features – notably rising credit enhancement over a transaction's life – in many cases more than compensate for deterioration in the underlying asset pool.

The outlook for new issuance in Europe's securitisation markets is proving particularly difficult to read, meanwhile. "Whatever happens, public issuance in the first half of 2008 will be very subdued compared with 2007," says Ian Bell, head of European structured finance at S&P. "Thereafter, the trend will depend on whether the fundamental re-pricing that we are seeing across the whole credit spectrum settles at a point where securitisation transactions once more become attractive for both investors and originators."

He adds that global re-pricing is expected to settle down around the middle of 2008. "If this comes to pass we could see a strong pick-up in issuance in the second half of the year, but should this not occur then it is likely that issuance volumes will lag those of 2007."

At a sector level, European CDOs face a difficult year ahead, but the market is expected to return – albeit with more plain vanilla, tailor-made structures and a continued focus on higher quality assets. "Breaking the sector down further, we see that all products face challenges, but those structures least exposed to US structured finance assets and those without a market value element show greater resilience," Bell continues.

Further Quebecor-related rating actions...
Fitch Ratings has placed 36 tranches from 20 public CDOs and six tranches from five private CDOs on rating watch negative (RWN) following Quebecor World Inc's filing for credit protection under the Companies' Creditors Arrangement Act on 21 January 2008. The agency has identified 23 Asian (all synthetic), 39 European (38 synthetic, one cash) and 11 US (nine synthetic, two cash) transactions, with a total portfolio notional exposure to Quebecor of €3.9bn-equivalent.

The majority of deals that were placed on RWN were European. No Asian deals were placed on watch, while only two US deals – both privately rated – were placed on RWN.

Transactions with exposure to Quebecor which have not been placed on RWN are expected to have sufficient credit enhancement or excess spread to support the current ratings upon Quebecor's default. In performing the analysis, Fitch applied a 50% recovery rate assumption derived from market value estimates, except for deals where fixed recovery rates were applicable.

Fitch will resolve the RWN status on the CDOs when final valuations for Quebecor in each transaction are made available and when Fitch's new CDO criteria is finalised.

...as protocol is launched
ISDA has announced the launch of a protocol created to facilitate settlement of credit derivative trades involving Quebecor World Inc, a Canadian printing company that filed for creditor protection under the Canadian Companies' Creditors Arrangement Act on 21 January 2008 (see SCI issue 72).

The 2008 Quebecor CDS Protocol permits cash settlement of single name, index, tranche and other credit derivative transactions referencing Quebecor. It enables parties to agree to settle their trades on a multilateral basis, based on a final price established at auction. This approach to settlement brings considerable operational efficiencies, while also preserving a participant's right to receive or deliver obligations if desired, ISDA says.

Markit and Creditex will administer the auction, scheduled for 19 February 2008, which will determine the final price for Quebecor bonds.

"At a time when credit concerns are permeating the global financial markets, the ISDA mechanism reassures derivatives industry participants of a smooth and reliable settlement process," comments Robert Pickel, ISDA's ceo and executive director. "ISDA is committed to supporting the integrity of credit risk management practices and operational efficiency across privately negotiated derivatives."

While earlier ad hoc protocols enabled cash settlement only of index trades, the move marks the second time this settlement methodology has been applied to a broad range of credit derivative transactions. The mechanism was successfully implemented in the 2006 Dura CDS Protocol.

The Protocol is open to ISDA members and non-members alike. The adherence period for the Protocol runs until 8 February.

Japanese CRE CDO trends analysed
Moody's has released a report which explores trends in Japanese CRE CDO transactions and the expected collateral of such deals. The report also explains its approach to analysing CRE CDOs and notes some of the issues regarding management and monitoring of the transactions.

The report is based on Moody's previous report detailing its approach to rating EMEA CRE CDOs, making adjustments to information on elements that are specific to Japanese commercial real estate transactions, such as the evaluation method of underlying commercial real estate related assets.

QWIL enters repurchase agreement
Queen's Walk Investment Ltd (QWIL) has entered into an irrevocable, non-discretionary arrangement with Citi and JPMorgan Cazenove to repurchase on its behalf ordinary shares in the company for cancellation during the close period commencing on 4 February and ending on or around 5 March 2008, being the proposed date for the publication of its 31 December 2007 interim results.

The maximum price to be paid shall be not more than 105% of the average of the middle market quotations for the company's shares for the five business days before the day on which purchase is made. JPM Caz and Citi will have the authority to consider, on each trading day, repurchasing more than 50% of the average daily trading volume of the company's shares traded over the 20 trading days preceding that date. The sole purpose of the share buy back is to reduce the capital of the company.

CB MezzCAP downgraded
S&P has removed from credit watch with negative implications and lowered its ratings on the Class B, C, D and E notes issued by CB MezzCAP Limited Partnership, a German SME CLO transaction. At the same time, the triple-A rated Class A notes were placed on watch negative.

The rating actions take into account the latest insolvency in the portfolio, ODS Optical Disk Services GmbH, and its effect on the structure. ODS is one of the SMEs in the underlying portfolio to which the issuer made cash advances. The portfolio analysis relies on updated probabilities of default for each company in the portfolio, which were quantitatively derived by using CreditRiskTracker and running 2006 year-end financials.

"Based on the most recent information made available to us, the portfolio credit quality has significantly decreased. Furthermore, we have to assume that ODS's insolvency will have a severe effect on the level of losses incurred by the issuer under its participation right," says credit analyst Viktor Milev.

ODS had issued a €6m profit participation right to CB MezzCAP and filed for insolvency on 5 October 2007. The default of the company triggered a principal deficiency event in the transaction, and consequently the €6m exposure was credited to the principal deficiency ledger (PDL).

Milev adds: "Whether or not a recovery will be achieved, and what the potential level of that recovery could be, depends on further insolvency proceedings. At the moment, we can only assume a minimal recovery rate due to the deeply subordinated nature of the participation right. We will continue to monitor the insolvency proceedings and remain in close contact with the financial adviser and transaction monitor to obtain the latest available information on the recovery process."

As of the 25 January 2008 payment date, the PDL in the transaction was €15.8m. The actual clearance of the PDL will depend on the availability of future excess spread and on potential recoveries received.

"In our analysis, which included credit and cashflow modelling of the transaction, we assumed a minimal recovery on the last two defaulted entities, Erich Rohde KG and ODS. Our CDO Evaluator was applied to derive updated scenario default rates at the various rating levels. This modelling relied on the updated probabilities of default and took into account the remaining term until maturity of the underlying participation rights," concludes Milev.

EMEA CDO outlook
The EMEA CDO market continued to see sustained growth in issuance levels in 1H07, but the impact of the US sub-prime crisis and general credit turmoil 2H07 resulted in only a modest overall rise in issuance for the year, says Moody's in its "2007 Review & 2008 Outlook" report on this market. Uncertainties over the timing of a market recovery make issuance predictions challenging, but the agency believes a year-on-year decline of between 30% and 50% is not unlikely in 2008.

Total CDO issuance in EMEA rose 11% in 2007 to €112.8bn compared to 2006, though the number of deals increased at a somewhat higher rate of 20% to 304 from 251. "The slowdown in activity in the second half was an unprecedented phenomenon in the history of CDOs in the EMEA region: the lower volumes that we had seen in 2003 and 2004 reflected the development of the single-tranche market, which was associated with smaller transaction sizes, rather than a downturn in activity," says Florence Tadjeddine, Moody's vp - senior credit officer and author of the report.

She adds: "The most significant factor was certainly the impact of the US sub-prime crisis. Those EMEA SF CDOs that were exposed to deteriorated US assets experienced significant downgrade activity by year-end. SF CDOs that have been affected by either a rating downgrade or a rating review for possible downgrade account for 18% of EMEA SF CDOs and 5% of total EMEA CDOs. More generally, the crisis heightened investors' caution towards structured finance products, thereby creating a severe and generalised drop in market value across virtually all structured asset classes."

In the European leveraged loan market, activity set new records in the first half of the year but issuance then essentially ceased for a number of months on the impact of the credit crisis. This was concurrently reflected in a significant increase in the CLO risk premium and a relative slowdown in issuance after two years of vigorous activity, Moody's report says.

CPDOs continued to attract significant interest but represented only a very small proportion of total CDO issuance. As banks and insurance companies – and particularly monolines – have also been hit by the crisis, spread-widening has affected those CPDOs solely exposed to financial institutions; further widening later triggered performance concerns for other CPDOs, although to a much lesser extent.

Moody's report provides the rating agency's views on the macroeconomic and corporate framework that underpins sector outlooks for leveraged loan CLOs and synthetic arbitrage CDOs of corporates. "Although difficulties are undoubtedly starting to loom in the leveraged loan market, refinancing risk is expected to be moderate and the trend in recent years towards weaker covenants is likely to provide companies with greater flexibility to respond to a weaker operating environment. Rating implications should be limited for leveraged loans CLOs thanks to their structural enhancements," Tadjeddine notes.

However, Moody's believes that, as the deterioration in corporate credit quality is likely to continue, the performance of synthetic arbitrage corporate CDO portfolios is expected to weaken. "This weakening should nevertheless continue to be partially offset by the reduction of risk linked to CDO maturity shortening. However, it is important to note that, if we were to see a few more defaults in the vein of Quebecor World Inc occurring, that would certainly start having rating implications for a number of transactions," the analyst cautions.

In terms of new issuance, balance sheet and SME transactions should remain predominant due to a continuous focus on risk management. Moody's expects CLO issuance to be active, although this is conditional on the primary leveraged loan market and the pricing arbitrage efficiency of the structure.

Sachsen Funding defaults, Duke Funding converted
S&P has lowered to single-C and retained on credit watch with negative implications its ratings on the CP issued by Sachsen Funding I. It is also removing from credit watch negative and lowering to single-D its ratings on the mezz Tier 1, mezz Tier 2 notes and the capital notes.

The ratings actions are based on updated current portfolio values and the notification from SachsenLB Europe, which manages the portfolio, that there were not enough proceeds to pay the obligations on the mezzanine and junior notes. The vehicle remains at risk from further market valuation declines and therefore the CP rating remains on watch negative.

Meanwhile, Moody's has withdrawn its rating on the CP issued by Duke Funding High Grade I due to the exercise of a put option that resulted in the notes being converted to Class A-1 LT-b1 notes.

CDO investor survey results
After polling over 200 investors, JPMorgan has revealed the results of its CDO client survey. A summary of the findings include:

• 68% of respondents believe that one or two monolines will be able to wrap transactions
• Over half believe that spread and headline instability are the main obstacles to participation
• Half believe that the CLO market will re-start in 2008, a third in 2009
• 80% plan to maintain or add CLO exposure in the next 12 months
• Most project global 2008 CLO volume to range between US$30bn-US$50bn (US$136bn in 2007)
• 34% see default rates at 4-5% in 2008; 55% see this outcome in 2009.

Credit conditions reach four-year low
Kamakura Corporation says that its monthly index of troubled public companies increased sharply in January, rising by 1.9% to 12.1% of the global public company universe. Current credit conditions are barely better than the 13.4% average for the index in the 18-year period since January 1990.

Current credit conditions are better than only 51.5% of the monthly periods since the index began. The percent of public companies classified as troubled was as low as 8% in September 2007; credit conditions are now at their worst level since December 2003.

Kamakura defines a troubled company as a company whose default probability is in excess of 1%. The index covers more than 20,000 public companies in 29 countries using the fourth-generation version of Kamakura's advanced credit models.

"If one defines a recession as a period when credit conditions are below average, we are teetering on the brink of a recession right now," explains Warren Sherman, Kamakura president and coo. "The credit crisis that began in late spring is now pervasive. The auto companies, for example, which were in crisis in May 2005, now have default probabilities as high as they had in that crisis period."

Tough month for CLOs
The market took a deep breath as January ended – a month the like of which the CLO sector has not seen before. In Europe, despite three traditional CLOs doing the rounds (Fortress I, Queen St III and Halcyon 08-01), no transactions priced versus a monthly average in 2006/2007 of €2.6bn or six deals, according to structured credit strategists at RBS. One US CLO priced: Silvermine Capital's ECP CLO I is a low-levered deal (6x), with AAA/AA/A spreads at 85/300/400bp (versus December's average spreads of 75/300/375bp).

A new €320m European transaction – dubbed Base CLO – has begun marketing and the strategists estimate that a further €2.5bn of CLOs is in the wings for H1, albeit they are still warehouse-clearing exercises. Whereas the traditional CLO was pretty much the only way to buy leveraged loan portfolios over the past few years, going forward they expect more variety in leveraged loan portfolio structures – such as TRS, low levered, funds and synthetic – as banks continue to explore ways to clear out the leveraged loan overhang.

Whether February will fare any better for the CLO sector depends on the fortunes of the triple-A benchmark prime RMBS and the monoline issue. The catalyst to reopen the primary CLO market lies, the strategists believe, in establishing a clearing level in prime mortgages. This would help restore the disturbed natural pricing order of the securitisation markets (balance sheet CLO tranches have recently traded wide to their arbitrage CLO homologues).

With around 60% of triple-A CLO paper being monoline wrapped, the outcome in this sector is very relevant to triple-A CLO spreads dynamics – with risk that, as downgrades occur, selling activity will occur. Additionally, over the long term triple-A funding costs are likely to remain elevated.

S&P reports on rating transitions
As 2007 came to a close, the global CDO market reflected on a year marked by increased rating volatility, widening credit spreads, a liquidity squeeze, severe markdowns and a sharp drop in issuance (particularly during the fourth quarter). S&P downgraded approximately US$103.3bn (5.59%) out of the US$1.85trn in original issuance for outstanding global CDOs during the year.

The overall credit quality of global CDOs, when accounting for both the frequency and magnitude of rating transitions for the entire year, declined approximately 25% of a notch in 2007, compared with an increase of about 1% of a notch in 2006. On the market value side, SIVs and SIV-lites also experienced an unprecedented level of rating volatility during the second half of 2007.

'Transition' refers to how much an S&P rating has changed, either up or down, over a certain timeframe. These transition rates can be useful to investors and credit professionals in various ways because they show the degree to which the agency's ratings are stable or volatile.

The unusual number of downgrades that S&P took on RMBS collateralised by US mortgage loans contributed significantly to the rating volatility of synthetic, cashflow and hybrid ABS CDOs. Overall, the agency downgraded approximately US$107.7bn (2.55%) out of about US$4.2trn in original issuance for outstanding US RMBS in 2007. This rating volatility in RMBS and CDOs collateralised by these securities also led to downgrades in CDO-squared transactions.

Among the cashflow corporate segments, however, credit performance for CBOs and CLOs improved in 2007. ABS CDO issuance declined sharply late in the year because these transactions saw high rating volatility. This was primarily due to the poor performance of the 2005, 2006 and 2007 vintage RMBS securities, which make up a significant proportion of the collateral for many 2006 and 2007 vintage ABS CDOs.

For the third consecutive year, synthetic corporate investment-grade CDOs with exposure to issuers downgraded to speculative grade from investment grade dominated the downgrades.

In 2007 overall, conditions for corporate credit remained relatively benign and the US high-yield annual corporate default rate was at a 25-year low of 0.97%. However, S&P downgraded some frequently referenced investment-grade corporate obligors to speculative-grade levels during the year.

A number of these rating actions were related to private equity firms' leveraged buyouts of companies, such as Alliance Boots, ALLTEL Corp, TXU Corp and First Data Corp. These events affected the credit quality of CDOs, particularly synthetic transactions.

S&P expects the US high-yield corporate default rate to increase through 2008 and head even higher if the US suffers a recession. Any further rise in defaults could potentially hurt the credit quality of CDOs, especially those backed by corporate securities.

As the market enters 2008, CDO ratings will depend on the state of the global economy and the risk of recession; labour markets; interest rates; and, most important, housing market fundamentals, as well as the performance of corporates and RMBS. S&P expects the downgrades and defaults of CDOs backed by RMBS will continue through 2008 as a result of the large number of RMBS downgrades since July 2007. In addition, the agency expects that the US housing market-related concerns and the possibility of a recession may continue to create rating volatility for ABS CDOs collateralised by RMBS tranches through 2008.

It's important to note that so far rating volatility has primarily affected mortgage-related securities and borrowing and, to a lesser extent, financial institution ratings. If the current credit problem spreads into the corporate world in 2008, however, downgrades and rating volatility for CDOs backed by corporate credits could result.

CS

Hedging your returns - part 1

In the first of this two-part series on FX risk in CLOs, the benefits of acceleration and cancellation options in asset-specific swaps are examined by Domenico Picone and Priya Shah of Dresdner Kleinwort's structured credit strategy team

A common practice in the European CLO market has been to partially collateralise the issued notes with non-euro denominated loans, typically sterling. As the structure remains exposed to an FX risk, whose management is not the primary expertise of the CLO manager, it is necessary to include hedging strategies so that an adequate level of protection against losses due to FX fluctuations is preserved.

If we look at the historical performance of the EUR/GBP exchange rate, sterling suffered a progressive depreciation from 2001 to May 2003, when the currency reached its historical low at 0.72. Thereafter and until the beginning of the credit crunch in August 2007, the exchange rate stabilised at around 0.67, with a limited and temporary dip down to 0.66 between April and August 2004 and in January 2007.

A new depreciation phase has begun with the credit crisis, where sterling has lost 11% of its value, with the exchange rate reaching a new historical low of 0.76 in January 2008. The overall depreciation in the period 2001-2007 reached a remarkable 14%.

At the same time, implied vols - which measure future volatility expectations - have more recently also risen, together with the forward rates that are pricing in a further depreciation against the euro. Any European CLO with a relevant content of sterling loans would have suffered without the support of adequate FX hedges.

Hedging is consequently necessary. Some hedging strategies are more flexible than others; however, they are also more expensive. Therefore, unsurprisingly, a lot of innovation and creativity in the field of currency hedging in leveraged loan CLOs has been seen to reduce the hedging cost burden.

Some managers have used asset-specific cross-currency swaps, which are perfect hedging instruments when combined with acceleration and cancellation options. However, they are again expensive and subject to wide variations in pricing, which depends on the swap counterparty.

Other managers have preferred single portfolio and macro cross-currency swaps with embedded cancellation and acceleration options, which - although appearing cheaper and easier to execute - may result in some residual losses. This is because the level of optionality defined at portfolio or macro level can result in protection which is in excess or lower than what it is required, due to loan defaults, recoveries or prepayments.

More recently, CLOs have been structured with multi-currency liabilities, where a multi-currency revolver is issued to fund the purchase of non-euro denominated loans. The latest innovation in the CLO space has been the issuance of multi-currency revolvers in pro-rata CLOs, where non-euro denominated tranches are issued to fund the purchase of non-euro denominated bank (pro-rata) loans. Even though the use of multi-currency revolvers creates a natural hedge that significantly reduces hedging costs and increases the flexibility for the CLO manager to move between currencies, the structure is not immune to FX risk.

In the next sections, we look more in-depth at the different FX hedging techniques used in CLOs, where any non-euro denominated loans are assumed to be in sterling. We, however, start by first providing a quick introduction to leveraged loan CLOs, particularly regarding collateral diversification.

A credit arbitrage vehicle
When we talk about leveraged loan CLOs, we are generally referring to dynamically managed credit arbitrage vehicles which invest in senior secured loans to sub-investment grade companies (BB/B+), primarily issued for leveraged buyout purposes (LBOs). While the senior secured leveraged loan market comprises either revolving credit facilities (RC) or term loans (TLA, TLB or TLC), CLOs will typically invest in institutional term loans B and C.

TLB and TLC are bullet loans which usually have a seven or eight-year tenor and are callable at any time, generally without penalty. CLOs also allow a 20-25% bucket of non-senior secured loans, predominantly mezzanine loans and second lien loans, and sometimes high yield bonds.

There are, however, some CLO managers that have launched vehicles with a much smaller, occasionally nil, content to these high yielding assets. As an alternative, small CLO buckets can also be included.

Matched funding and prepayments
The CLO is also a term matched investment vehicle. This is because the WAL of the CLO tranches are very close to the average bullet term of the TLB/C collateral.

In addition, the CLO is not exposed to Libor changes because the tranches are offered at a spread over the Libor rate, while the collateral (TLB and TLC loans) returns a relatively higher spread over the same Libor rate. Therefore, assets and liabilities have a similar duration, effectively creating a leveraged credit fund with minimal exposure to interest rate changes.

This modus operandi is, however, continuously challenged by high levels of prepayments in the leveraged loan market. High prepayments tend to increase the CLO position in cash balances and, as a consequence, reduce the initial CLO arbitrage and the CLO equity IRR. The manager therefore has to keep all of his existing CLO fully invested in performing collateral and, when prepayments arise, source new leveraged loans without delay.

Prepayments will typically be as a consequence of a sponsor recapitalising the deal (recap). In order to take some profit from an LBO transaction, the sponsor will often re-lever the deal after a period of good performance, borrowing money to pay itself dividends. In order to re-lever or recap, the sponsor must first prepay all existing loans.

A key indicator of the level of prepayments is the average time between LBO and recaps. Data from Fitch suggests that the average time between an LBO and a dividend recap was just 20 months from 2005 until the first quarter of 2007. Following the liquidity constraints resulting from nervousness following the US sub-prime market downturn, we are however likely to see this period increase going forward.

Quarterly repayments are also used to estimate the speed at which the collateral is exposed to prepayment. The European repayment rate of senior leveraged loans dropped somewhat over the third quarter of 2007, but this is after the rate reached 11.4% in Q2 (see Exhibit 1).

Exhibit 1

Diversification – loan purpose and industry
Diversification - in terms of industry, loan purpose and region - is an important aspect of the investment decision and indirectly provides CLO investors with a greater choice when selecting a suitable CLO. CLO tranche investors should be looking for a manager with a history of keeping CLO portfolios well diversified, without too much concentration in a few industries.

While CLO equity investors may consider less diversity (i.e. more correlation) a theoretical benefit, in reality they may prefer more predictability and stability in returns, and thus may also prefer to see diversified portfolios. Concentration limits and diversity tests are an integral part of the rating agencies' methodology, and limits will be in place restricting the ability of the manager to run portfolios with too much concentration risk.

In total nearly €152bn of senior leveraged loan issuance was as a result of institutional (TLB/C) and pro-rata (TLA/RC) syndication in 2007. Although most European leveraged loans are either LBO or M&A-related, the industry classification is broad, with no single sector accounting for more than 12% of the total issuance in 2007 (Exhibit 2).

Exhibit 2

Geographic diversification
Since the institutional loan market was established, we have seen the majority of issuance coming from three countries - namely the UK, Germany and France. In 2007 these countries remained the largest issuers, accounting for 60% of the European issues (see Exhibit 3).

Exhibit 3

In every year since 2000 the UK has had the highest number of deals and also the highest volumes of leveraged loan issuance. Germany and France have made up for the next highest number and volume of deals in every year since 2002. We would thus expect portfolios to be heavily concentrated in these three countries.

We should also note that UK issuance is typically in sterling and some managers may be restricted from investing in non-euro denominated currencies. However, not investing in sterling loans restricts the ability of the manager to run a portfolio which is as diversified as it could be, and also means that the manager limits the pool of potential investments available from which to select the best.

Transactions outside these three main countries, grouped as 'Other', have also remained stable at 40% over the last three years, providing investors and managers with a much broader market for sourcing loans. 'Other' includes US$ denominated loans; however, we should be careful about US exposure in European leveraged loan CLOs.

Sometimes this will refer to US loans which have been syndicated in the US loan market and priced at US spread levels, as well as being issued in dollars, with the subsequent hedging cost requirement. More often, however, it will refer to euro-denominated loans to US companies, syndicated in the European market and used to fund European operations, or euro carve-outs of US loans.

In terms of future geographical composition of the leveraged loan collateral, a lot will depend on what is available in the primary leveraged loan market when the manager needs to purchase loans. However, as leveraged loan CLOs are dynamic vehicles, the future trends in leveraged loan issuance are important elements to take into account when estimating how the collateral will look in the near future, because inevitably they will influence the CLO managers' investment decisions.

Hedging the FX risk
On acquiring non-euro denominated leveraged loans funded with the proceeds of euro-denominated tranches, the CLO manager has to be able to hedge the risk of fluctuations in euro exchange rates. An appropriate FX management strategy needs to consider both the type of non-euro denominated assets, as well as the structural features of the CLO transactions, in particular waterfall amortisation schedules.

FX hedges used in CLOs are primarily based on standard cross-currency swap agreements under which all the non-euro cash proceeds, principal and interest received from the non-euro denominated loans are converted into euro by the swap counterparty at the swap FX rate set at the outset. One key element is that the manager must decide on the level of flexibility they want from the cross-currency swap agreement and how much they are prepared to pay.

In fact, a perfect hedge - providing protection against normal performance, defaults and prepayments - can only be guaranteed with asset-specific cross-currency swaps with embedded options, which are expensive hedging tools. An alternative hedge - however less precise but cheaper - is provided by the cross-currency swap macro hedge.

As with any swap arrangement, there is additional counterparty risk associated with the swap. To mitigate this impact, the swap counterparty must typically meet minimum rating requirements imposed by rating agencies.

If these requirements are breached during the term of the swap, the swap counterparty must be replaced with another entity that meets the minimum ratings sought by the rating agency. Additionally, initial and ongoing collateral margins can also be adjusted, with more stringent requirements imposed on lower-rated counterparties.

Asset-specific swaps – benefiting from acceleration and cancellation options
With asset-specific swaps, each leveraged loan is specifically hedged with its own cross-currency swap. The perfect swap is structured with options to cancel and/or accelerate the contract notional at no cost if the loan prepays or defaults before the swap maturity, set equal to the legal term of the loan.

The acceleration and cancellation options together are particularly effective when a loan defaults. The acceleration option can be exercised to ensure recovery value payment at the contractual swap rate, and the cancellation option is exercised for the amount equal to the loss, terminating all outstanding future liabilities at zero cost. Rating agency methodologies also encourage the use of asset-specific swaps and for this reason they tend to be preferred by CLO managers.

To fully appreciate the value of the acceleration and cancellation options, we compare the swap payments below on a defaulting loan with and without these two options. Additionally, to highlight the benefits of the dual option, as opposed to only one stand-alone option, we also detail the mechanics as if the cross-currency swap was purchased with only the acceleration option or the cancellation option (see Exhibit 4).

Exhibit 4

Detailed example
Assume a sterling-denominated loan is purchased with a notional of £100, paying an annual coupon of 100bp over £-Libor and has a remaining legal maturity of five years. At the same time, the CLO manager also enters into a €-£ cross-currency swap at a contractual swap €-£ rate of 0.70. Suppose, additionally, that in two years' time this loan defaults, recovering only 65%.

Cross-currency swap without acceleration and cancellation options
After default, without any options, the investor is still liable to exchange, in the remaining 3-year swap term, the originally expected £-coupon and final principal payment of £100 into euro at the contractual swap rate. They will therefore have to terminate this swap, with a cost (or gain) depending on how the FX and interest rates have moved during the time of swap initiation to default.

Additionally, the 65% recovery amount received will be in sterling and will need to be converted into euro at the prevailing spot rate when recovery proceeds are received. If euro has appreciated relative to the sterling, then recovery proceeds in euro will be lower than 65%.

The CLO manager is therefore exposed to the risk of unknown future FX and interest rates movements, and a default may result in a larger loss than implied by the recovery amount. By adding on these options, the manager can mitigate the downside risk associated with FX and interest rate changes, and focus purely on managing the default risk aspects of an investment.

Currency swap with acceleration and cancellation options
If the two options are additionally purchased, after default there are no more obligations to make interest payments to the swap counterparty, and no interest mismatch exists as the loan has defaulted. Effectively, the swap is frozen.

Once the CLO manager receives the recovery proceeds, the swap notional equivalent to the recovery value can be accelerated and converted into euro at the original FX swap rate. The acceleration option is exercised if the euro has appreciated relative to the swap rate, thereby ensuring a minimum recovery in euro of at least 65%. On the upside, if the euro depreciates the recovery value in euro would be greater than 65%, and the option would not be exercised.

The cancellation option then ensures that the remaining obligations are terminated at no cost. Consequently, the currency swap is cancelled and no additional principal is exchanged between the counterparties (see Exhibit 5).

Exhibit 5

Currency swaps with only an acceleration option
With only an acceleration option, upon recovery following a default the full swap notional is accelerated. (In contrast, when a cancellation option is also available, only the recovery amount of the final notional payment is accelerated). On this day the CLO manager receives from the swap counterparty the euro equivalent of the sterling par balance of the defaulted loan, converted at the original FX swap rate, thereby receiving 65% recovery.

However, without any cancellation option the CLO manager must pay the currency swap counterparty the remaining sterling notional amount of 45%, representing the loss on the defaulted loan. These sterling funds will need to be raised in the open market and, depending on the prevailing FX rate, a loss can incur.

Currency swaps with a cancellation option
Upon default the swap is cancelled and, as a result, no further interest or principal swap payments are exchanged between the counterparties. However, when the recovery sterling proceeds are received, the manager will incur either a loss or a profit depending on the prevailing FX rate.

The cost of the acceleration and cancellation options results in an upfront payment and depends on various factors, such as FX rate volatility, forward Libor curves, the interest rate volatility and correlation between rates, FX and interest rates. In a perfect asset swap scenario the unwind risk is borne by the swap counterparty, who also guarantees the recovery rate in the CLO manager's base currency. Generally, these two risks are offsetting and the cost of having both options together is therefore cheaper then the sum of the individual options.

Loan sale
A cancellation option terminates the swap at nil cost prior to legal maturity. However, it can only be exercised if the loan prepays or defaults.

The manager may as well decide to sell a loan denominated in sterling (discretionary trading). In this instance, the asset-specific cross-currency swap would need to be terminated at a cost or profit, depending on the change in the FX swap rate since the swap inception.

If a new sterling-denominated loan is then purchased, the manager will have to re-negotiate the corresponding new cross-currency swap. These costs need to be taken into account by the CLO manager when considering buy/sell decisions.

All cash proceeds received from prepayment and recoveries from the defaulted loans can also be used to purchase new sterling loans. However, this is allowed only as long as no CLO reinvestment or investment constraint is breached.

FX swaps, when used with cancellation and acceleration options, are flexible and versatile. However, they are also expensive and in practise also subjected to wide variations in pricing, depending on the swap counterparty.

Part two of this Research Note, published next week, will look at hedging with one portfolio swap or macro swaps, as well as multi-currency revolvers.

© 2008 Dresdner Kleinwort. All rights reserved. This Research Note was first published by Dresdner Kleinwort on 15 January 2008.

Trading ideas: temple of doom

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at an outright short on Temple-Inland Inc.

After a spectacular rally and ultimately reaching a high of almost US$39, Temple-Inland's stock plunged over 50% by the beginning of 2008 (Exhibit 1). Temple-Inland has an extremely shareholder-friendly minority owner, Carl Icahn, and its fundamentals are starting to look shaky at best.

Exhibit 1

Our MFCI model has picked up on these negative attributes and highlights TIN as our best short from the basic materials sector. Temple-Inland's recently reduced debt load has by far outweighed their rising equity volatility and falling stock price. We recommend buying protection on TIN at 140bp.

Equity-implied junk
Part of our MFCI model ranks an issuer relative to its peer group based upon market-implied factors and Temple-Inland has the worst score out of the entire basic materials sector. BDP (Barra Default Probability), one of the market-implied factors, takes equity and balance sheet information and backs out a probability of default for the company. This model is also known as a hybrid structural model.

TIN's BDP is in the worst decile, which means that from a structural model perspective TIN has very high probability of default relative to the rest of its sector. Exhibit 2 shows how its BDP has skyrocketed over the past couple of months and yet TIN's CDS spread has lagged behind.

Exhibit 2

Another way of viewing the relationship between CDS and BDP is though a cross-section scatter plot of the entire sector. Exhibit 3 clearly shows how out of line Temple-Inland is with regard to the rest of its sector. Its BDP is implying a serious upward shift in its credit spread.

Exhibit 3

Fundamentals... barely hangin on
Though Temple-Inland has decent interest coverage and earnings, its free-cash flow and earnings stability leave something to be desired for. One of the MFCI's fundamental factors is the average free-cash flow of the company over the past five quarters.

Temple's FCF factor is one of the worst for the basic materials sector. This, coupled with Carl Icahn's share-friendly bias, makes us very concerned for the future of TIN's credit profile.

Our MFCI model gives TIN an expected spread of 391bp, which is miles away from its current offered spread of 140bp.

When placing an outright bet on an issuer such as TIN, we also like to see what the fundamental experts have to say. Carol Levenson, Gimme Credit's basic materials expert, cites the firm's increased exposure to the economic cycle as a risk in her latest report on Temple-Inland.

In her own words, "the remaining company will be about as cyclical and commodity price-sensitive as any we can think of, while its smaller scale, lack of readily saleable assets and reduced financial flexibility will leave it much more vulnerable to the economic cycle." Carol holds a deteriorating view on Temple-Inland, which is corroborated by our MFCI model.

Risk analysis
This trade takes an outright short position. It is un-hedged against general market moves, as well as against idiosyncratic curve movements. 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 TIN has good liquidity in the CDS market at the five-year tenor.

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

Summary and trade recommendation
Sometimes the equity market is much quicker to the punch than the credit market and Temple-Inland currently represents such a case. After celebrating a monster multi-year rally, TIN's stock has been sent to the graveyard over the past seven months. However, its CDS has managed to outperform its peers during a nasty credit sell-off.

After checking its fundamentals, our MFCI model and Gimme Credit's expert fundamental opinion, we are taking sides with the equity market on this one. We recommend going short TIN by buying CDS protection at 140bp.

Buy US$10m notional Temple-Inland Inc. five-year CDS protection at 140bp to pay 140bp 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).