Contents

CDPCs change tack

Systemic exposure a concern

Market circumstances have forced CDPCs to take a more opportunistic approach to debt funding. At the same time, concern over the vehicles' potential systemic exposure has prompted some counterparties to demand uncertainty premia.

The fact that credit spreads are at all-time highs means that CDPCs don't have to run at a high leverage to give comfort to counterparties. "The industry has accepted that debt raising will be a challenge in the current environment, but the market has responded dynamically by convincing sponsors that it's OK to run with equity only. This signifies a new trend for the CDPC sector: financing through the equity initially and then looking to fund opportunistically in the debt market," explains Paula Horn, president of DeSari Capital, a newly-established asset manager (see Job swaps).

She says that the key for CDPCs in the current market is to ensure that they continue working with counterparties to make them comfortable with the business model. "It will be an axe-driven market in the near term, so it is important that CDPCs build relationships with many different counterparties. We have the flexibility to structure protection to the individual needs of a counterparty and the rating agencies are forcing our hand to create uncorrelated books of business. But this has been our business model from day one: we know how to manage idiosyncratic risk."

Transparency is another issue for CDPCs: managers face heightened scrutiny in terms of core competencies, expertise and track record. However, the flip-side is investors should understand that, although GAAP numbers can sometimes be large and negative, there is no market-value impact – CDPCs don't need to post collateral and aren't subject to margin calls.

Primus Guaranty last week posted an incremental US$400m in mark-to-market write-downs on its US$23bn CDS portfolio (see last week's issue), causing S&P to revise its outlook on the firm – which is rated triple-B plus – to negative from stable. The agency notes, however, that the mark-to-market losses are unrealised and have no immediate cash effect on the holding company, which continues to maintain sufficient cash to meet its expectation for liquidity at the parent company.

"At this time, the negative outlook is not a reflection of imminent fundamental deterioration in the credit portfolio, but offers a cautious view of future economic performance at the primary subsidiary and its potential subsequent impact on the holding company," S&P analysts note. But they add that, of the corporate names included in Primus' portfolio, they are monitoring exposures in single name monoline insurance and homebuilder entities.

Continuing declines in net revenues, evidence of tightening liquidity and/or capital constraint could prompt a downgrade from the current rating level. Conversely, should Primus stabilise its economic results while maintaining satisfactory liquidity and capital levels, S&P's outlook could revert to stable.

Horn reckons that the market can sustain significant growth in the CDPC sector. She says: "The average position size in a CDPC portfolio is in the US$20m-US$40m range, so positions per obligor are relatively small. The sector has been through a number of cycles and, given that they are so stringent in their criteria, the risk of rating agencies changing their game isn't there. This gives comfort to counterparties."

However, the CDPC business model is unproven through recession and counterparties should consequently expect an uncertainty premium, according to one structured credit investor. "Permacap funding is obviously more reliable than CP funding, but there is a risk of systemic exposure with CDPCs. Only time will tell whether they are a good business model," he concludes.

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Performance problems

Loan sell-off augurs down-turn

Leveraged loans sold off dramatically this week on negative economic news and a number of market-value CLO downgrades and liquidations. With concern rising over increasing loan defaults, the sector is bracing itself for a down-turn in performance.

"A fear is that credit rationing and closed leveraged loan markets makes it hard for issuers to maintain liquidity, increasing defaults," explain structured credit strategists at JPMorgan. The rolling 12-month issuer default rate is now 1.52%, according to S&P.

Over the last two months there have been defaults or missed payments on at least 11 loans, several each in the automotive and construction sectors. Markit LCDX.9 is now trading near US$92, while cash loans are bid even lower – in the mid-80s for both US and European flow names.

If policy actions to limit the downside of the cycle are successful, defaults may rise above trend in 2010; if not, the JPM strategists expect a sharp increase in defaults beginning in late 2009. "We may see more loan work-outs than sales, given distressed market prices and low liquidity, which would put a premium on CLO managerial experience," they note.

The turn in the cycle is also likely to differ from the previous one in 2001, where defaults were concentrated in a few sectors (telecoms and utilities). If it develops into a broad consumer recession led by declining household wealth and over-leverage, a broader array of companies are likely to be stressed, focusing on the consumer cyclical arena.

Fitch analysts agree that dislocation in the credit markets has spread to leveraged loans and CLOs, and will continue to affect performance during 2008. "The ongoing credit crunch is reshaping the leveraged loan market," says William May, senior director at the agency. "Aggressive loan structures, in particular, will be put to a significant test over the coming year."

In a new report, Fitch notes that risk in the leveraged loan market has been building for some time, due to declining structural protections and other aggressive features of new deals brought to market in recent years. The abundance of loans originated to fund shareholder-oriented activities, such as LBOs, as well as cov-lite and second-lien loans, was a part of this trend.

As weaker macroeconomic conditions, softer credit fundamentals and constrained liquidity push up corporate default rates, these risks will continue to weigh on market sentiment and performance, the agency says. Recovery rates are also expected to suffer, as a result of loan-heavy capital structures and weak structural protections. Fitch believes that high-yield default rates will rise towards their historic average of 5% by the end of 2008.

Meanwhile, the fourth wave in a series of negative rating actions has seen the agency downgrade 28 tranches of total rate of return (TRR) CLOs. All classes remain on watch negative. Approximately US$125m of securities affected by these actions are from transactions which have breached their total return swap (TRS) termination/liquidation triggers, and for which Fitch has received confirmation that the TRS counterparty has elected to terminate the swap and liquidate the collateral.

In addition, approximately US$79m of securities affected by these actions are from transactions which have breached their TRS triggers, and for which Fitch has received notification that the TRS counterparty is currently reviewing its options – which may include liquidation of collateral at some point in the future. And approximately US$1.4bn and €75m of securities affected by these actions are from transactions which have undergone a further deterioration in their collateral values, resulting in additional erosion of cushion with regard to their TRS triggers.

The agency has also been informed that three transactions which had previously triggered their TRS triggers, and for which the TRS counterparty sent a notice of termination, will not be imminently liquidated but will be subject to a review of options by the TRS counterparty. No action is being taken on those three transactions: Beecher Loan Fund, Bushnell Loan Fund, and Stedman Loan Fund – all of which were downgraded on 6 February.

The transactions impacted by the downgrades are Castle Harbor II CLO, CENT Income Opportunity Fund I, Coltrane CLO, Fall Creek CLO, Hartford Leveraged Loan Fund, Hudson Canyon Funding, PPM Riviera Loan Fund, Silver Crest Loan Fund, SERVES 2004-1 and SERVES 2006-1. Rivendell Loan Fund has also breached its TRS trigger, but the collateral manager (Nationwide Mutual Insurance Company) has infused additional funds into the deal in order to bring the current net collateral value (NCV) in-line with the original NCV and thereby continue the transaction.

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Changing of the guard

Pressure to strengthen rating operations steps up a gear

S&P and DBRS followed hot on the heels of Moody's last week when they announced proposals for strengthening their rating operations. The move comes as regulators and other industry bodies appear to be ratcheting up the pressure for change at rating agencies.

Charlie McCreevy, European commissioner for internal market and services, last week told the Society of Business Economists in London that if rating agency proposals which "are meaningful and robust are not forthcoming in coming months, I will not hesitate to move forward quickly to have the issue addressed by regulatory action".

He said: "Strong, independent, professional oversight of the credit professionals within the rating agencies – including their performance, pay and promotion – and of the operation and processes of the rating functions themselves is absolutely essential if market and regulator confidence is to be restored in respect of the effective management of the conflicts of interest inherent in the rating agencies' business models."

The question is whether a triple-A rating in structured credit is really the equivalent of that for corporate bonds, according to Miguel Ramos, managing partner at Washington Square Investment Management. "The difference in levels of risk between the two is clear and investors should demand a spread consistent with those risks. It's easy to say in hindsight, but ultimately getting paid 20bp over Libor for triple-A rated CLO paper was unsustainable," he notes.

SEC chairman Christopher Cox reportedly told delegates at a securities law conference on Friday that rules may be proposed to enhance investor understanding of the differences between ratings for municipal/corporate bonds and for structured finance instruments. And IOSCO's technical committee announced that it is reviewing possible advancements in its code of conduct for rating agencies, including the disclosure of the assumptions underlying the individual ratings for structured finance transactions; the prohibition of advice on the design of structured products which an agency also rates; and reasonable steps being taken to use information of sufficient quality to support a credible rating. The organisation expects to produce a consultation paper on these proposed changes by early March.

S&P's proposals include enhancements in the areas of governance, analytics, information and education (for more on its 27-step plan, see News round-up). The agency is implementing new measures that build on existing governance policies to further strengthen the integrity of the ratings process; taking steps to ensure that its ratings models, processes and analytical talent continue to be of the highest quality; and providing market participants with greater transparency about the ratings process and the risks that could cause a change in ratings assumptions.

"This initial set of actions is the product of a comprehensive, formal assessment of our policies and practices conducted in collaboration with an independent third-party expert, as well as active dialogue with market participants, regulators and legislators," explains Deven Sharma, president of S&P. "These actions are consistent with our commitment to continuous improvement. Our goal is not only to enhance specific processes, but also to minimise even the potential for perceived conflicts of interest and provide the public a greater understanding of how our ratings are determined, what they mean and how market trends and events affect them."

DBRS, meanwhile, is prepping new disclosure procedures designed to help investors better understand the risks involved in structured finance securities. The agency aims to provide more details on the proposal next month.

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Structured credit hedge funds fall further

Latest index figures show continued decline

Both gross and net monthly returns for December 2007 in the Palomar Structured Credit Hedge Fund (SC HF) Index show a negative return for the third month in a row, with 15 of 30 funds reporting positive results. The latest figures for the index were released this week and show a gross return of -1.58% for December, while the net return was -1.70% for the month.

Three sub-strategies, 'long investment grade leveraged', 'long junior, value oriented' and 'relative value, intra-credit', reported negative results in December. The dispersion and range of returns increased slightly compared to the data observed in November.

In 2007 the full-year returns of the indices were -16.44% gross and -17.96% net, compared to +10.88% and +8.30% in 2006. For more Index data click here.

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

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

CS

Confidence boost

Data transparency and standardisation is discussed by Marco Angheben, director at the European Securitisation Forum

Clearly the securitisation market is set to change. The European Securitisation Forum's (ESF) 2008 issuance forecast projected total issuance at €272bn, a 41% reduction in issuance volume from 2007. A major impact has been the global market turmoil.

The global crisis has highlighted a very important fact that banks operate globally. Contagion rooted in US lending practices spread beyond its borders by the inherent structure of the industry. There is no single palliative, but containment and effective treatment require measured steps taken simultaneously by the affected.

There have been immediate responses, with the central banks' 'liquidity injections' and larger financial institutions bolstering their balance sheet with added capital from various investors. Governments and regulators, though currently eschewing a heavy-handed approach à la Sarbanes Oxley, are looking to develop some regulatory response to monitor the industry together with consideration of various options for an effective fix.

This is an opportunity for the industry to bring meaningful and practical solutions to the table by working together with regulators and other market participants to develop standards that transcend the need for a super regulator or Sox-like regulations – the benefits of which are doubtful. Ultimately, the industry's working mandate is to restore confidence and market liquidity.

Transparency is one aspect of speeding resolution to the credit crisis. The ESF has laid out a number of initiatives to improve the frequency, standardisation and digitalisation of securitisation data, which will allow investors to have a greater ability to perform credit and risk assessments. At the same time, market participants, authorities and policy makers will have additional tools to monitor trends in the market.

Over the next few months the industry will be working intensively on a number of industry projects, such as:

• setting out industry best practice guidelines on various asset classes, including RMBS and CDO, for post-issuance reporting;
• gauging investors' views on RMBS and CDO current disclosure practices.

Work on setting standardised guidelines relating to the CDO and RMBS products has already begun, with the issuance of exposure drafts for CDO Data File for cash and synthetic securitisation transactions and the launch of a Standardised Loan-by-Loan Data File for UK non-conforming RMBS in December 2007 (see SCI issue 69). The CDO Data File comment period runs until 14 March 2008. At the end of the comment period, following a revision of the comments received there will be a recommended data file format aimed at standardising the multiple formats in relation to CDO transactions in Europe and the US.

Guidelines are voluntary, but in 2008 take-up in Europe of the recommended guidelines for CDO transaction reporting will be synchronised with the US, so that there is a unique and single standard. To ensure broad participation, the files will be created in both Extensible Markup Language (XML) format and in Pipe Separated Values (PSV) format that are machine readable. These advantages will allow investors and other market participants to further develop modeling cash flows and valuation techniques.

Guidelines for standardised loan-by-loan data files for UK non-conforming RMBS are meant to encourage issuers to publish data in a consistent manner for use by investors, rating agencies and other market participants. These guidelines are focused on the UK non-conforming market, which is one of the most advanced in terms of reporting but at the same time one of the more challenging, given the wide variety of mortgage products available and the amount of information on the borrowers.

This is undoubtedly a pivotal year for the industry, but there is widespread recognition that changes are necessary to continue improving business practices.

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 visit www.structuredcreditinvestor.com/core08/.

New CDPC in the works

The latest company and people moves

New CDPC in the works
Deerfield Capital Management has spun off the CDPC it had been working on since 2005. DeSari Capital, a newly-established asset manager headed up by ex-Deerfield president Scott Roberts and md Paula Horn, has taken the project on. Deerfield Financial Products was one of the first CDPCs to receive preliminary triple-A ratings from Moody's for the single name corporate space (see SCI issue 26).

"The ownership structure at Deerfield made CDPC capital raising difficult, so it was decided that it was in everyone's best interests to spin it out. We have a track record in investment grade corporate names, having managed five deals including two investment grade synthetic CDOs," comments Horn.

DeSari has chosen Calypso, in conjunction with Sky Road, to structure the new CDPC. "The Calypso and Sky Road partnership offered a powerful combination: their time to market was incredibly competitive and they have a significant track record with other CDPCs. A key issue for us is to have open architecture to allow us to integrate with other systems further down the line," adds Horn.

ACA announces intent to sell
ACA Financial Guaranty has entered into a letter of intent with FSI Capital to sell its US ABS and corporate credit CDO asset management business. The company has also entered into a letter of intent with Resource Financial Fund Management, a wholly-owned subsidiary of Resource America, and the parent company of Apidos Capital Management, to sell its US CLO asset management business.

FSI Capital, through its affiliates and subsidiaries, currently manages 17 CDOs totalling approximately US$7.5bn. Apidos Capital Management has closed eight CLOs, with approximately US$2.8bn of assets under management.

Each of the transactions is subject to final due diligence, the negotiation and execution of a definitive agreement and other standard conditions.

Hedge fund adds distressed team
GSO Capital Partners is understood to have hired Najib Canaan, former head of ABS at Brevan Howard, along with a number of his colleagues. The new team will focus on distressed mortgage-based asset opportunities.

Babson takes over Osprey
Babson Capital Management has assumed the management of Osprey CDO 2006-1. The deal was previously managed by Brightwater Capital Management, a division of WestLB Asset Management.

Osprey's portfolio includes both high-yield bank loans and mezzanine tranches issued by other CLO funds. Russell Morrison, co-head of Babson's US bank loan team, comments: "Babson Capital's unique skill-set combining the talents of our structured credit team with the extensive resources and CLO management experience of our US bank loan team was key to being selected as the replacement manager by Osprey CDO investors."

Bank reorganises DCM
CIBC World Markets is believed to have implemented a reorganisation that sees its debt capital markets group split into two divisions, one focused on fixed income and currencies, and a second built around structured credit.

Ron Lalonde, senior evp administration, technology and operations at the parent bank will head the structured credit team, which will initially focus on restructuring CIBC's exisiting portfolio.

Hilscher named senior research fellow at Kamakura
Professor Jens Hilscher has been appointed senior research fellow at Kamakura Corporation. He will continue to serve as assistant professor of finance at Brandeis International Business School, while working with Kamakura.

"Professor Hilscher's work in corporate default modelling is extremely impressive, and we are very pleased to have Jens involved in taking Kamakura's KRIS default probability technology to an even higher level," says Warren Sherman, Kamakura president and coo.

Lehman promotes structured credit head
Lehman Brothers has announced that Georges Assi and Kieran Higgins have assumed the roles of co-heads of fixed income for Europe and the Middle East. In addition to his new responsibilities, Assi will continue to serve as global head of the bank's CDO and structured credit businesses, and head of credit products for Europe and the Middle East.

Higgins will continue to serve as head of interest rate products for Europe and the Middle East, a role he has held since January 2007, in addition to his new role.

Manager promotes and hires
Prudential Fixed Income Management, an asset management business of Prudential Financial, has promoted Michael Lillard to chief investment officer, responsible for overseeing all portfolio management and trading across the firm. Prudential has also named Citi fixed-income veteran Arvind Rajan as its new head of quantitative research and risk management.

Most recently, Lillard was senior investment officer for insurance portfolios, liability-driven investment and hedge strategies, and also headed the quantitative research and risk management departments. Rajan joins Prudential after serving as co-head of US fixed-income strategy and global head of structured credit research for Citi's fixed-income business. Most recently, he founded a shop that traded emerging market and credit instruments.

They will both be based in Newark, New Jersey and report to James Sullivan, head of fixed income at Prudential Fixed Income Management.

Among other appointments at the firm, Peter Cordrey has been named head of alternative products in a new position responsible for Prudential's hedge fund platform and CDOs.

MP

SCA downgraded

A round up of this week's structured credit news

SCA downgraded
Moody's has downgraded to A3 the insurance financial strength ratings of the operating subsidiaries of Security Capital Assurance, including XL Capital Assurance and XL Financial Assurance. The agency has also downgraded the debt ratings of the holding company, Security Capital Assurance Ltd, and a related financing trust.

These rating actions reflect Moody's assessment of SCA's weakened capitalisation and business profile resulting, in part, from its exposures to the US residential mortgage market. The rating outlook is negative.

As a result of this downgrade, the Moody's-rated securities that are guaranteed or by XLCA and XLFA are also downgraded to A3, except those securities with higher public underlying ratings.

Based on the risks in SCA's portfolio, as assessed by Moody's, capitalisation required to cover losses at the triple-A target level would exceed US$6bn. This compares to Moody's estimate of SCA's claims paying resources of US$3.6bn, which the agency considers to be more consistent with capitalisation at the single-A rating level. It further notes that it estimates SCA's insured portfolio will incur lifetime expected losses of approximately US$1.2bn in present value terms.

SCA is currently pursuing several capital management initiatives that, according to Moody's, if successfully executed could reduce but would not likely eliminate the company's capital shortfall at the triple-A rating level. Moody's further comments that capitalisation, and the prospect for improvements in capitalisation, were considered in the context of the rating agency's opinion about the guarantor's ongoing business and financial profile.

In Moody's opinion, SCA's significant exposure to mortgage-related risk has had consequences for its business and financial profile beyond the associated impact on capitalisation, and affects its opinion about SCA's other key rating factors. The agency believes that SCA is more weakly positioned than many of its peers with respect to business franchise, prospective profitability and financial flexibility.

With respect to underwriting and risk management, Moody's believes that SCA's relatively significant exposure to the mortgage sector is indicative of a risk posture somewhat greater than the peer group overall. The company's participation in super-senior mezzanine tranches of ABS CDOs, in particular, contributed to this view. Going forward, Moody's believes SCA's strategic direction could change meaningfully, with implications for the business profile that are currently uncertain.

MBIA raises US$1bn equity
MBIA last week raised US$1bn in equity, an increase from the US$750m originally planned. The shares were sold at a 14% discount, according to structured finance analysts at RBS, with Warburg Pincus taking US$300m of the capital raising.

"MBIA has certainly differentiated itself from its peers in its ability and willingness to raise fresh capital to protect its triple-A ratings. In our view, this may not be enough to maintain its triple-A ratings, but it is certainly a step in the right direction," the analysts say.

Most of the proceeds are likely to be contributed to the insurance company. At the same time, MBIA revised its unallocated loss reserve by US$100m after receiving December 2007 servicer reports for some transactions after the results were originally released. The addition relates to its second-lien RMBS transactions.

Meanwhile, another rumour circulated about the potential monoline bail-out, suggesting that banks may be willing to accept an unwind of the credit protection they have purchased in return for equity warrants.

S&P launches 27-step ratings plan
S&P is implementing new measures to strengthen the integrity of its ratings process (see separate news story for more). Below are brief descriptions of some of the major new actions that the agency is undertaking.

In order to enhance governance, S&P will:

• Establish an Office of the Ombudsman that will address concerns related to potential conflicts of interest and to analytical and governance processes across S&P's businesses that issuers, investors, employees and other market participants may raise. The Ombudsman will oversee the handling of all issues, with authority to escalate any unresolved matters, as necessary, to the ceo of the McGraw-Hill Companies and the Audit Committee of the Board of Directors.
• Engage an external firm to periodically conduct an independent review of S&P's compliance and governance processes. This firm will issue a public opinion that addresses whether the agency is effectively managing potential conflicts of interest and maintaining the independence of its ratings.
• Institute periodic rotations for lead analysts.
• Implement "look back" reviews whenever an analyst leaves to work for an issuer to ensure the integrity of prior ratings.

In order to strengthen analytics, S&P will:

• Complement traditional credit ratings analysis by highlighting non-default risk factors, such as liquidity, volatility, correlation and recovery, that can influence the valuation and performance of rated securities and portfolios of these securities.
• Add new surveillance capabilities, including tools, models and data sets, which will enable S&P to better monitor the performance of collateral pools over time.
• Establish a model oversight committee within the quantitative analytics group, which will be separate from and independent of the business unit, to assess and validate the quality of models and tools.
• Increase annual analyst training requirements, enhance training programmes and establish an analyst certification programme.

In order to increase transparency of information, S&P will:

• Develop an identifier that will highlight to the market that the rating is on a securitisation or on a new type of instrument.
• Include "what if" scenario analysis in rating reports to explain key rating assumptions and the potential impact on the rating of unexpected events. The goal is to help investors better assess an issue's risk profile.
• Work with issuers and investors to improve disclosure of information on collateral supporting structured securities.
• Request greater minimum portfolio disclosure criteria of issuers of certain structured securities.
• Collect more information about the procedures issuers and originators use to assess the accuracy and integrity of their data and to detect fraud.

In order to educate the public, S&P will:

• Create a credit ratings user manual and investor guidelines to promote better understanding of its ratings process and the role of ratings in the financial markets.
• Establish an advisory council with membership that includes risk managers, academics and former government officials to provide guidance on addressing complex issues and to establish topics for market education.
• Broaden distribution of analysis and opinions via the web and other media.

ERMBX no-show halts short plans
News that the proposed launch of Markit ERMBX will likely be delayed beyond March has disappointed those hoping to put on new index-based short strategies. Markit confirmed that, following extensive feedback from all market participants and in light of current volatile market conditions, it has been agreed that any decision regarding the launch of the new index will be made at a later date.

"We had expected Markit's triple-A and triple-B UK RMBS index to push spreads wider, allowing those seeking to short the market with an outlet for their view. However, many market professionals realised this and have taken measures to stop its launch, given the current market predicament. The general consensus is that an index would allow spreads to be pushed much wider than those able to invest at present would be comfortable with," explain structured finance analysts at SG.

For most investors, price stability and transparency are the biggest factors impacting confidence. Clarifying an exact market price is very hard at present, the analysts add, with typical spreads for UK prime triple-A RMBS in the 80-100bp range. While the index would promote price transparency, it would do so at a wide level where few cash sellers would participate.

If launched, the index will offer exposure at the triple-A and triple-B points of the capital structure, based on the seven UK RMBS master trust issuers excluding Granite. There would be one eligible bond per issuer, denominated in euros with an average life of 3-6 years. The bonds must be publicly-placed tranches, with the triple-B tranche being the corresponding subordinated tranche of that included in the triple-A index.

Ben Logan, md of structured finance at Markit, says: "It is Markit's desire to create an index that will attract market support and be actively traded. We will continue to work towards completing the documentation for the index, and will update the market on any decisions that are taken about the launch in due course."

NEO liquidated
S&P has lowered its ratings on all eight tranches from NEO CDO 2007-1 after receiving notification from the trustee of the controlling noteholders' intent to liquidate the collateral and terminate the transaction. The ratings on five of the downgraded classes remain on credit watch with negative implications.

The agency received a notice on 4 February for NEO CDO 2007-1 stating that a majority of the controlling noteholders is directing the trustee to proceed with the liquidation of the collateral supporting the notes. This notice follows a previous notice declaring an event of default as of 18 December, under section 5.1(i) of the indenture dated 5 April 2007.

The rating action reflects S&P's opinion regarding the impact on the transaction of a potential liquidation of the collateral at the current depressed market prices. The controlling class' election to liquidate the collateral at this time may result in losses for all classes of notes. Therefore, the rating actions are more severe than would be justified based solely on the credit deterioration of the underlying collateral.

NEO CDO 2007-1 is managed by Harding Advisory.

Lessons learned from Cheyne Finance ruling
A recent Clifford Chance client briefing highlights the judgment on 17 October given in respect of the meaning and interpretation of "unable to pay its debts as they fall due" in section 123(1)(e) of the Insolvency Act 1986 (IA 1986) concerning Cheyne Finance. This decision is significant because it is the first time a court has directly considered the extent to which future indebtedness not yet due should be taken into account when considering the cashflow or commercial test for insolvency, the law firm says.

"From a credit crunch perspective, where this test may feature in an increasing number of solvency analyses, it is useful to have some guidance and an appreciation of the range of consequences and the different interpretations this test could have. In addition, it is interesting to consider the particular impact it had on Cheyne Finance Plc as a structured investment vehicle (SIV) and its various senior creditors," the authors of the briefing write.

The briefing notes that the court has taken a very commercial approach to this fundamental concept of English insolvency law, in particular considering the reality, in this case, that it was necessary to have regard to future liabilities. They favoured this approach over a literal interpretation of the section which does not in terms refer to prospective or future debts partly because it was a more "flexible" and "fact sensitive" interpretation of the phrase "as they fall due", and did not produce what they considered to be a wholly artificial result of conferring payment priority on the senior creditors who just happened to have shorter priority than other senior creditors of the same class.

For many financings, both the cashflow test in section 123(1) IA 1986 and the balance sheet test in section 123(2) IA 1986 will normally be included as an insolvency or enforcement trigger. This avoids the need to consider in detail some of the issues that arose in the Cheyne case.

For the purposes of wrongful trading, the decision should not affect the directors' analysis of a company's financial position. Directors should continue to take into account both the company's cash flow (which necessitates looking at future debts falling due within the relevant period) and its balance sheet when considering whether it is appropriate to continue trading without the risk of incurring personal liability.

In this case, Cheyne could pay its early maturing senior debt on a 'pay as you go basis', but this would have meant a forced sale of the asset portfolio – which inevitably would have been at a huge discount and, as such, the receivers could not manage or realise the portfolio so as to enable all the senior debt to be paid in full. It was essential, from a practical perspective, and to enable the receivers to fulfil their obligations, to retain flexibility in the disposal strategy so as to try and realise the asset portfolio for the benefit of all those holding the senior debt, to establish an Insolvency Event had occurred within the meaning of the Security Trust Deed. As a result of including future debts in the cashflow test (the balance sheet test having been omitted from the contract), they could achieve this and so implement a more orderly realisation for the benefit of all senior creditors.

Whistlejacket downgraded on NAV breach
Moody's and S&P have downgraded Whistlejacket Capital's MTN and CP ratings, following an enforcement event. Approximately US$6.4bn of securities have been affected.

On 30 November 2007 Moody's placed the ratings of the above programmes on review for possible downgrade. Standard Chartered, Whistlejacket's manager and sponsor, announced on 31 January 2008 that it would provide liquidity support to the vehicle for the repayment of its senior debt.

After that announcement, Moody's received proposals from Standard Chartered addressing the implementation of the necessary facility. The agency had expected the facility to be in place by the end of March 2008.

Due to the deterioration in market value of Whistlejacket's asset portfolio, the vehicle breached its capital value trigger on 11 February 2008, causing an enforcement event. The capital value declined from 55% to 41% between 6 February and 11 February, corresponding to a decline from 95.13% to 93.96% in the average portfolio market value.

Following the occurrence of the enforcement event, control of the vehicle has moved to the security trustee, the Bank of New York Trust Company, which is believed to have appointed Deloitte & Touche as receiver. Deloitte's mandate is to advise the trustee on the course of action that is in the best interest of secured parties.

The trustee has a number of options, including acceleration of senior debt, continuation of the repayment of senior debt as it falls due and completion of the plan initiated by Standard Chartered to provide liquidity support. The long-term rating assigned to the MTN programmes reflects the uncertainty surrounding the course of action that it will pursue. Moody's review will therefore focus on both the intentions of the trustee and the evolution of the market value of Whistlejacket's asset portfolio.

Structured finance analysts at Barclays Capital suggest that the remaining Whistlejacket investors were not quick enough in accepting the sponsor's proposal. "In our opinion, this turn of events highlights the execution risk with complex SIV restructurings and might call into question recent announcements from other bank sponsors, including Citigroup and HSBC regarding the support of their SIV's. More detailed disclosure from each of the SIV sponsors regarding the exact nature of their SIV support should address these concerns," they note.

Permacaps release interim reports
Carador and Queens Walk Investment (QWIL) have released interim management statements relating to the period from 1 October to 31 December2007.

According to Carador's performance summary, the company's share price has increased by 4.5% during the period, but NAV per share has decreased by 7.6%. The NAV includes an estimated €2.2m of net cashflow interest received in the three months ended 31 December 2007 (to be allocated between capital and income), which equates to €0.044 per share.

Carador's fall in NAV was mainly due to the general mark-down in CLO valuations, following the sentiment of the market, the company says. In December, the fall in NAV of 1.9% was mainly due to the mark down of a CLO transaction (where the manager has improved portfolio quality but as a result reduced target returns) and the write-off of a seasoned (largely 2004/05) sub-prime ABS CDO.

In January, the company identified two underlying corporate defaults in one CLO held by Carador, EV8. These represent, in aggregate, less than 0.5% of the CLO portfolio. One of these senior loans traded after the event at a price of 75% versus 12% for the unsecured debt.

Meanwhile, the credit crisis has not had a material impact on the cashflow performance of the QWIL's assets as at 31 December 2007. Cashflows from the company's investment portfolio exceeded €20m per quarter for the three quarters ending 31 December 2007.

As at 30 September 2007, the company's NAV was €6.90 per share, down from a NAV of €7.24 per share as at 31 March 2007. This reduction in NAV has predominantly been a result of write-downs to the company's US-related investments. As at 30 September 2007, the direct and indirect exposure to the US sub-prime mortgage sector was 2.3% of the company's gross asset value.

On 16 July 2007, QWIL replaced its short-term financing with a four-year €135m term financing facility (see SCI issue 54). The financing facility has provided the company with a stable financing solution as it eliminates the liquidity risk of short-term borrowings. The net leverage ratio as at 30 September 2007 was 8.6% (after taking into account cash balances allocated to settle the tender offer and the company's dividend).

Since 18 July 2007, QWIL has returned in excess of €40m of capital to shareholders using a combination of share buyback and tender offers. In October, the company purchased €28m notional of two-year put options struck against 90% of the September 2007 value of the Halifax UK house price index.

The hedge is currently in-the-money as UK house prices have fallen in the last four months. This hedge is intended to minimise portfolio losses in the event that house prices give up the gains that have occurred since early 2006.

LSS deals hit
S&P has lowered its ratings on three leveraged super senior (LSS) CLNs issued by ELM, Midgard CDO and Sceptre Capital. The rating action follows a significant increase in spreads for the underlying assets over the past five to six weeks.

During this period, spread volatility has seen a difference as large as 74bp between the highest and lowest weighted-average portfolio spreads. This trend of increased portfolio spreads has led to the probability of default calculated for each transaction to increase so that it is no longer commensurate with the initial ratings assigned to these transactions.

LSS transactions contain both credit and market value risks associated with the underlying portfolio. The affected transactions have a market value trigger based on the weighted-average portfolio spread and portfolio losses at a given point in time. If breached, this would lead to an unwind event.

CRE CDO delinquencies up
US commercial real estate loan (CREL) CDO delinquencies are up slightly from last month, according to the latest US CREL CDO loan delinquency index from Fitch Ratings. Four new loans contributed to a delinquency rate for January 2008 of 0.70%, compared to last month's delinquency rate of 0.64%.

The loan delinquency index includes loans that are 60 days or greater delinquent, performing matured balloons and repurchased loans. Although the overall delinquency rate for CREL CDOs remains low, it is more than double the rate of the US CMBS loan delinquency rate of 0.28% for December 2007.

The CREL CDO delinquency rate is anticipated to be more volatile than the CMBS delinquency index, given the smaller universe of loans; while the Fitch CREL CDO delinquency index tracks approximately 1,100 loans, its CMBS delinquency index covers over 48,000 loans.

The January 2008 index encompasses ten loans, which includes four loans that are 60 days or more delinquent, four performing matured balloons and two repurchased loans.

Three of the new additions are performing matured balloons. An increase in these types of delinquencies is not surprising, given the difficulty associated with refinancing in today's market. These performing matured balloons include one loan, which was subsequently paid off in full, while the other two such loans are reported to be negotiating loan extensions.

Additionally, asset managers reported that two assets (0.19%) were repurchased from two separate CDOs in January 2008. One of the loans was included in the December 2007 index as a performing matured balloon, while the other loan was reportedly less than 30 days delinquent in December, and thus not included in the index. Given the lower available liquidity in the market, Fitch expects fewer repurchases of troubled loans and more workouts within the trust.

The agency also reviewed loans that were 30 days or less delinquent. Although not included in the loan delinquency index, this category can be an early warning signal that a loan could ultimately be classified as delinquent.

Two loans, representing 0.07% of the CREL CDO collateral, were 30 days or less delinquent in January 2008. This statistic is down from last month's total of 0.15%, which included a chronic late payer that is now current.

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

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

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

Lifeline for sub-prime?
Bank of America, Citi, Countrywide Financial, JPMorgan, Washington Mutual and Wells Fargo have announced their participation in Project Lifeline, a new plan to help troubled mortgage borrowers of all stripes, not just sub-prime. The banks pledged to try to contact borrowers that are at least 90 days past due and, in some cases, offer a 30-day freeze on foreclosure proceedings while loan modifications are considered. The plan will not apply to loans that are in bankruptcy, have a foreclosure sale date within 30 days, or are investor or vacant properties.

There is no mention of forbearance plans in the proposal, nor does it guarantee a loan modification. The programme is not a foreclosure moratorium, but a case-by-case foreclosure pause where appropriate, note analysts at Barclays Capital.

The analysts say they have reservations as to whether 30 days is long enough to determine if loan modifications will help borrowers currently 90+ days delinquent. Ultimately, most borrowers in this cohort likely cannot afford their loans at the current terms, so a proposal to pause foreclosures and potentially offer loan modifications is likely to have only incremental effect.

To the degree that foreclosure pauses do not result in modifications, the net effect may simply be a slight worsening of loss severities. The analysts estimate a loss severity increase of roughly 1% if all sub-prime loans were paused, but since only a small fraction of loans is likely to be paused, the overall effect on losses should be negligible.

Solid CDO issuance for Japan
The Japanese CDO market in 2007 saw comparably solid issuance of balance-sheet CDOs and SME CDOs while the market was affected by US sub-prime turmoil, says Moody's in its review and outlook for the sector.

In 2007, Moody's Tokyo office rated 43 deals totalling approximately ¥1.1trn. These included 14 balance-sheet CDOs, including SME CDOs, totalling ¥680m, and 27 deals totalling ¥420m of arbitrage CDOs and other related deals.

Japanese CDO market transaction amounts in 2007 were not robust as a whole, mainly because Japanese investors became cautious, especially in the second half of the year, due to US sub-prime turmoil. However, the actual number of balance-sheet CDOs and SME CDO transactions rose, while the number of arbitrage synthetic CDOs and repackaged deals declined.

Stable European SME CLO performance
Fitch says that the performance of European SME CLOs in 2007 was largely stable, with a few downgrades across transaction type. This information is available in the agency's latest issue of its Pan-European SME CDO performance tracker (SME Tracker) report.

This issue of the quarterly report presents issuance volume and rating actions for the year ended 31 December 2007, while the performance trends across jurisdictions and transaction type are as of the end of September 2007 for comparison purposes.

The report concludes that Spanish SME CLOs have generally performed in line with expectations through Q407. Of the 200 tranches reviewed, only one tranche has been downgraded and another assigned a distressed rating. Nevertheless, rising delinquencies and anticipated slowdown in the real estate sector remain sources of concern.

The report also highlights that German capital market mezzanine CLOs have suffered several downgrades in the Preps transactions. This was due to a clustering of actual defaults, as well as increased risk of future defaults. Further, balance-sheet SME CLOs continued to exhibit largely stable performance, with 86 tranches affirmed from 16 transactions.

Moody's reports on Spanish SMEs
In Q107 Spain was the second-largest European SME market after Germany, but by the end of 2007 the Spanish market had become the largest issuer of true sale SME transactions in Europe, notes Moody's in it new Spanish SME Q407 Index report .

"Some €30.2bn worth of SME notes were issued in Spain in 2007, up from €17.6bn in 2006, with two-thirds of last year's transactions securitised in Q4 2007," says Ludovic Thebault, a Moody's senior associate and co-author of the report.

Delinquency performance – measured as more than 90 days overdue up to the point of artificial write-off – was stable in Q407. Older vintages perform better than newer vintages, as delinquencies for the 2005 vintage trended as high as 0.95% whereas the 2003 vintage showed levels of 0.30% to 0.40% 24 months after issuance. So far, cumulative defaults have remained low in Spanish SME transactions, with often only a few basis points of defaults two years after closing.

Three transactions drew down on their reserve funds last year: IM Grupo Banco Popular Empresas 1, FTPYME Bancaja 4 and PYME Bancaja 5. In IM Grupo Banco Popular Empresas 1, the reserve fund was not fully funded at closing and was meant to increase overtime towards its target level of €45m.

In Q3, however, a large unpaid loan led to a decrease of the reserve fund. The situation returned to normal in Q4, and the reserve fund is now coming close to its target level.

While draws by FTPYME Bancaja 4 and PYME Bancaja 5 were primarily performance-related (high delinquencies in the case of FTPYME Bancaja 4 and one large default in the case of PYME Bancaja 5), an imperfect interest rate swap also limited the amount of excess spread available, according to the Moody's report.

"Spain has enjoyed a sustained period of robust economic growth, contributing to the good performance of SME transactions," says Nitesh Shah, a Moody's economist and report co-author. "However, a sharp real-estate recession could seriously affect the SMEs involved in the sector, as well as the collateral involved (mortgage values)."

Although the percentage of mortgage collateral included in the securitised portfolios has reduced over time (in 2003: 76%; 2007: 47%), Moody's highlights in the current report the linkage of the Spanish SME securitisation to the Spanish real estate market.

More S&P downgrades
S&P has lowered its ratings on 94 tranches from 17 US cashflow and hybrid CDO transactions worth a total issuance amount of US$8.9bn. The downgrades reflect a number of factors, including credit deterioration and recent negative rating actions on sub-prime RMBS securities, as well as the changes S&P has made to the recovery rate and correlation assumptions it uses to assess US RMBS held within CDO collateral pools.

All of the affected transactions are mezzanine ABS CDOs collateralised in large part by mezzanine tranches of RMBS and other SF securities. The transactions are among the CDOs most affected by the agency's recent RMBS rating actions. Thus, the results for these deals may not necessarily be indicative of the outcomes S&P expects for all of the remaining mezzanine ABS CDOs with ratings currently on watch negative.

To date, the agency has lowered its ratings on 1,449 tranches from 426 US cashflow, hybrid and synthetic CDO transactions as a result of stress in the US residential mortgage market and credit deterioration of US RMBS. In addition, 2,573 ratings from 628 transactions are currently on watch negative for the same reasons. In all, the affected CDO tranches represent an issuance amount of US$342.2bn.

Duke Funding assigned DR rating
Fitch Ratings has assigned distressed recovery (DR) 6 ratings to Duke Funding High Grade II-S/EGAM I Series 1 and 2 notes. The action is due to notices being provided by the issuer that events of default have occurred.

Although there is a forbearance agreement in place with the repo counterparties, Fitch does not expect any recovery on the notes. The issuer is a market value structure that closed in March 2006 and is managed by Ellington Global Asset Management.

The proceeds of the notes were used to acquire a diversified portfolio of triple-A rated, primarily floating-rate private-label prime, mid-prime and sub-prime RMBS. The portfolio is levered using reverse repurchase agreements.

Asia Pacific SROC results
S&P has placed its ratings on six Asia-Pacific synthetic CDOs on credit watch with positive implications. Additionally, the ratings on seven other CDOs have been placed on credit watch with negative implications.

The synthetic rated overcollateralisation (SROC) levels for the ratings placed on watch positive rose above 100% at a higher rating level during the end-of-month SROC analysis for January 2008, indicating positive rating migration within the reference portfolio. For those transactions that have been placed on watch with negative implications, the SROC decreased below 100% at the current rating level.

CS

Hedging your returns - part 2

In the second of this two-part series on FX risk in CLOs, hedging with portfolio/macro swaps and multi-currency revolvers is examined by Domenico Picone and Priya Shah of Dresdner Kleinwort's structured credit strategy team

Single portfolio cross-currency swap
Instead of hedging each single loan with an asset-specific swap (as discussed in part 1 published last week), the CLO manager can also define a hedge at portfolio level. In a standard portfolio cross-currency swap, the portfolio weighted average spread of the non-euro denominated collateral is used to define the swap interest payments, with the non-euro collateral weighted average life used to set the maturity of the portfolio swap.

To avoid any FX risk leak associated with prepayments, defaults and recoveries, the portfolio currency swap can also be purchased together with the same cancellation and acceleration options available for the asset-specific swap for an amount equal to the portfolio swap notional. The option price would also be paid upfront.

However, in practise, CLO managers very rarely buy these options in their complete format, as this results in an extremely high price. More often, they prefer to introduce a 'level of optionality', where the cancellation and acceleration options are linked to a percentage of the currency swap notional.

Other times, the manager may purchase the acceleration option without the cancellation option or vice-versa. The result is a trade-off between cost and efficiency, where the protection bought at a cheap price at the outset might become insufficient and entail additional cost to unwind a portion of the cross-currency swap depending on its mark-to-market.

There is another element that needs to be considered when one loan defaults. The manager has to decide whether to exercise the cancellation option on the default date or at a later date when the recovery proceeds are received.

In the first case, on the default date the CLO manager must inform the swap counterparty of the expected recovery amount as the swap needs to be accelerated. The risk is that more than expected is recovered.

Alternatively, they can wait and exercise the two options when the recovery proceeds are paid. In this case they will have to continue servicing the swap and make interest payments to its swap counterparty until such a day.

Macro cross-currency swaps
A more practical option to the portfolio currency swap is to buy FX protection through a set of macro cross-currency swaps. In this instance, similar loans are aggregated and hedged as a group.

The individual loans in the group will share the risk exposure for which they are designated as being hedged. Further, the change in fair value attributable to the hedged risk for each individual loan in the group will be expected to be approximately proportional to the overall change in fair value attributable to the hedged risk of the group.

The 'level of optionality' must also be decided. For example, the CLO manager may want to pull together loans with the same expected recovery rate, so that they can exercise the acceleration option when a loan defaults without delay. Effectively, the CLO manager would buy an acceleration option for a notional equal to the portfolio's expected recovery rate.

As already seen above, there is the risk that when the manager has to unwind a portion of the macro swap he might have to realise a loss when the cross-currency swap mark-to-market has moved against him in the meantime. For this reason, he may want to add an extra cushion to the notional of the acceleration option, which may be used if the recovery proceeds are higher than originally expected.

FX hedge residual risks
As clearly seen above, the macro cross-currency swap is cheaper and easier to execute. However, it is also less accurate than an asset-specific cross-currency swap and, therefore, some residual FX risk still remains. The risk may be substantial when very little cancellation and acceleration protection has been purchased, or when the acceleration option has been bought without the cancellation, or vice-versa.

Principal mismatch – acceleration without cancellation option
When one or more sterling loans default, the cross-currency swap is immediately accelerated. A currency principal mismatch will occur between the performing sterling loans and the currency swap sterling notional.

As these notionals are now different, the non-sterling paying loans are effectively supporting the principal shortfall and causing some FX risk. In actual fact, the CLO manager must pay the original cross-currency swap notional, denominated in sterling, to the swap counterparty.

However they can only partially fund a portion of this through the recovery proceeds in sterling. The remainder will have to be funded at the prevailing FX spot rate with the euro-denominated loans.

If the manager has some assets temporarily invested in a cash account, the principal mismatch could be funded without delay. Alternatively, they will have to draw the liquidity facility. However, converting a portion of the cash account or the liquidity facility into sterling (from euro) could be expensive, particularly if the euro has depreciated against the sterling and the cost increases the further away the prevailing FX spot rate is from the swap strike rate set at the outset.

Principal mismatch – cancellation without acceleration option
When one or more sterling loans default, the cross-currency macro swap is immediately cancelled, hence no principal must be exchanged. However, the recovery proceeds denominated in sterling have to be converted into euro and hence there is an FX risk.

Interest mismatch
There is also an element of interest rate risk when sterling-denominated loans default in absence of cancellation and acceleration options. This is because some Libor proceeds are lost at the top of the interest waterfall. The interest mismatch increases when the Libor rate has risen and the euro has depreciated from the time the loans defaulted.

Interest rate caps and deep out-of-the-money FX options
In most instances, the CLO manager would buy interest rate caps and deep out-of-the-money FX options such that the high costs associated with principal and interest mismatch and swap amortisation due to defaults can in part be offset by out-of-the-money caps and FX options that will monetise in extreme economic scenarios.

Multi-currency revolvers
An alternative approach to using cross-currency swaps for hedging the FX risk is the issuance of a multi-currency liability structure where non-euro denominated tranches are issued to fund the purchase of non-euro denominated loans. This strategy creates a natural hedge that significantly reduces the hedging costs and increases the flexibility for the CLO manager to move between currencies.

Multi-currency revolvers and pari-passu triple-A tranches
For example, a dual-currency tranche is issued as a revolving triple-A tranche 'revolver', together with a pari-passu triple-A term tranche denominated in euro. The dual-currency revolver can be drawn either in sterling or in euro. If the structure performs well until the end of the reinvestment period, the portion of the revolver denominated in sterling will be redeemed with the proceeds from the sterling-denominated loans, whereas the remaining part of the revolver and the triple-A term tranche will be redeemed with the euro proceeds.

This type of solution presents a series of advantages compared with the macro and asset-specific cross-currency swaps. First, it is cheaper and easier to execute since no synthetic hedge must be established and maintained throughout the life of the contract and it does not incur any unwind or termination costs. Second, it provides the CLO manager with greater flexibility to invest and move between loans denominated in different currencies.

Third, it produces a quantifiable liability since the upfront purchase of FX options, if any, translates into no ongoing costs to transactions. And finally, the sterling loans, in the absence of defaults, will continue to yield more than the funding cost of a sterling triple-A revolver. However, multi-currency revolvers do not fully eliminate FX risk, which may arise as a result of rising defaults, with the effect of reducing potentially the arbitrage in the structure (FX volatility can also work in favour of the deal).

Defaults and recoveries

Principal mismatch
If the sterling-denominated collateral suffers some defaults, the resulting principal shortfall between the multi-currency revolver and the performing sterling-denominated collateral might cause some FX loss. This is because at maturity the full repayment of the currency revolver can only be ensured via a portion of the euro-denominated collateral, which will have to be converted into sterling at the prevailing FX spot rate. To address this issue, structures allow the possibility of re-denominating a fraction of the multi-currency revolver in euro, and hence the FX risk is avoided or partly reduced.

Interest mismatch
With significant defaults in the sterling-denominated loan collateral, there is also an element of FX risk associated with the possibility of incurring an income shortfall as the performing sterling-denominated collateral may not generate enough income to pay the interest accruing on the revolver. In this instance, being at the top of the interest waterfall, the interest due to the revolver will be paid before the interest due to more junior notes and in part subsidised with the interest accrued from euro-denominated loans, hence leaving the structure exposed to FX risk.

Excess margin
There is also a natural FX risk in the excess margin income generated by the sterling loans after paying the funding cost of the revolver. The sterling excess margin income will in fact be distributed to the equity investors at the end of the interest waterfall, once it has been converted into euro. Therefore, any volatility in the FX rate will have an impact on equity investor IRR.

Breaching an OC trigger in the reinvestment period
In addition, if as a result of much higher defaults an OC trigger is breached and cannot be cured, the triple-A term tranche and the triple-A revolver will be accelerated and redeemed on a strictly pro-rata basis. This means that some of the cash proceeds denominated in sterling will have to be converted into euro and paid to the triple-A term tranche (and vice versa when proceeds are received in euro).

In this scenario, the structure will face a principal mismatch between the sterling loans and the sterling tranche, as they are likely to amortise at a different pace. To mitigate some of this risk, some CLO structures have a matched waterfall which allows for different amortisation schedules, matching like-for-like currency cashflows.

Sterling default impact on deal leverage
Significant loan defaults will lead to changes in CLO leverage. Non-euro denominated losses can amplify any leverage change if the FX rate has moved since inception.

Amortisation period
During the amortisation period (the final stage of a CLO), the proceeds from non-euro denominated loans are used to amortise the multi-currency revolver as long as no coverage test is breached. Otherwise, the triple-A tranche and the multi-currency revolver become strictly pro rata, and consequently a currency mismatch can occur depending on the amortisation of non-euro denominated loans. To some extent this is addressed by having shorter maturity sterling loans, allowing euro-denominated loans to generally mature later.

Multi-currency revolvers in pro-rata CLOs
Pro-rata CLOs have also made their debut in Europe, primarily as a result of the fierce competition for institutional tranches experienced over the last few years. They enable managers to invest in the bank tranches (TLA and RC facilities) of leveraged loans, in addition to the regular collateral mix of institutional tranches. Therefore, they offer their investors extra flexibility in asset sourcing and improved access to the loan market when compared with the 'traditional' CLOs which are only allowed to invest in institutional tranches.

Even though bank tranches would typically pay a lower spread, an arbitrage can still be created as a result of upfront syndication fees. The credit turmoil has, however, affected the syndication fees of institutional loans, which in the past had fallen to nearly zero by pushing fees up to over 250bp - making the preservation of arbitrage in pro-rata CLOs more challenging.

The management of pro-rata CLOs is not easy. In fact, because bank tranches are not bullet, their repayment profile creates asset/liability management issues and can be more efficiently managed using revolvers on the liability side. In addition, as revolving credit facilities may be drawn in different currencies, the FX risk involved is also complex and cannot only be managed with cross-currency swaps because they are too expensive.

When multi-currency revolvers are used in pro-rata CLOs, in addition to the typical FX risks which we covered earlier for ordinary CLOs, they also potentially trigger a currency mismatch between the multi-currency revolving facilities and amortising loans, and the multi-currency revolver during the amortisation period. This risk is particularly relevant when the RC and TLA sterling loans amortise slower than the euro term loans at the end of the reinvestment period. In this instance, the euro proceeds will have to be converted into sterling to pay, pro rata, the triple-A euro tranches and the multi-currency revolver.

We found some pro-rata CLOs mitigating this risk in two ways: including a covenant which allows non-euro revolving facilities to be only reinvested for a shorter period than that allowed for term loans; and adding into the priority of payments a specific item which traps FX proceeds and uses them to repay the corresponding currency liability on a like-for-like basis.

Conclusion
CLO investors must be aware of the FX hedge strategy being used, as - too often - when it is prepared, savings in terms of currency hedging costs drive the choice at the expense of hedge efficiency. For equity investors, the impact of a poor FX hedge on the CLO IRR could be sizable.

Debt investors should also review the FX hedging tools. FX volatility in the absence of adequate hedging tools in the CLO may lead to additional costs for the structure, in the form of a reduction of the credit enhancement of their tranche.

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

Trading ideas: stainless steel

Dave Klein, senior research analyst at Credit Derivatives Research, looks at a capital structure arbitrage trade on AK Steel Corporation

Credit and equity risk are unambiguously linked, as the risk of debt holders not receiving their claims is akin to the risk of equity prices falling to zero. In today's trade, we analyse hedging CDS directly with equity.

The trade exploits an empirical relationship between AK Steel Corporation (AKS) CDS and equity. With a straddle-like liability that works against us in the case of big market moves, we are going short volatility and receiving positive carry.

Delving into the data
When considering market pricing across the capital structure, we compare equity prices (market caps) and equity-implied volatilities to credit market spreads. There are a number of ways to accomplish this, including the use of structural models that imply credit spreads (through an option-theoretic relationship) from equity prices and the analysis of empirical (historical) relationships between the two markets. We refer the reader to a CDR Trading Technique article – Capital Structure Arbitrage – for more detail.

The first step when screening names for potential trades is to look at where equity and credit spreads stand in comparison to their historical levels. Exhibit 1 shows the past year's levels for AKS' equity (inverted) and CDS spreads.

Exhibit 1

Recently, AKS' CDS has disconnected a bit from equity, and the motivation for this trade is a bet on a return to fair value. We do note that AKS at-the-money implied equity volatility has a slightly stronger relationship to its CDS, but we find the economics of shorting stock as a hedge to be more beneficial. Interested clients should contact us for hedge ratios if they wish to put on the CDS-option (put) trade.

Comparing market levels over time gives a rough feeling for how each security moves in relation to the other. In order to judge actual richness or cheapness, we rely on a fair value model.

Given that our trade is a combination of CDS and equity, we consider the empirical relationship between CDS and share price. Exhibit 2 plots five-year CDS premia versus an equity-implied fair value over time.

Exhibit 2

If the current levels fall below the fair value level, then we view CDS as too rich and/or equity as too cheap. Above the trend line, the opposite relationship holds.

At current levels, AKS CDS is cheap (wide) to fair value. This bolsters our view of selling protection on AKS.

We caution that this statistical analysis lags the market and in times of dislocation, such as now, it takes time to 'catch up'. Therefore, we do not solely rely on this simple fair value model to make our assessment.

Taking equity price in distress into account, we build a hybrid fair value model that again estimates CDS levels based on equity share prices. Exhibit 3 charts market and fair CDS levels (y-axis) versus equity prices (x-axis). With CDS too wide when compared to equity, we expect a combination of shares falling and CDS tightening.

Exhibit 3

Hedging CDS with equity
Our analysis so far has pointed to a potential misalignment between the equity markets and credit spreads of AKS. It would appear that we should sell protection (buy credit) against a short equity position. Again, we note that we also like the sell CDS protection, buy equity puts trade but cannot recommend it due to trade economics.

As default approaches, we see CDS rates increase (to points upfront) and equity prices fall close to zero. In this situation, our equity position will drop in value (good for us), but this loss should be offset by our loss due to the CDS sell-off. If equity rallies, we expect CDS to rally as well.

Exhibit 4 charts the P&L for the trade after two months for various CDS-equity price pairs. The green square shows the expected P&L for a return to fair value; the grey squares indicate (roughly) other fair value pairs for CDS and equity.

Exhibit 4

The longer we hold the trade, the easier it will be to make money given the positive carry/positive rolldown we face. However, given the volatility AKS is currently exhibiting, we must be careful not to hold the trade for too long lest CDS sells off too much in the case of credit deterioration or equity rallies too much. The main trade risks are that AKS volatility rises and we are unable to unwind the trade profitably or that AKS begins trading under a different regime and the current equity-CDS relationship no longer holds.

Risk analysis
This position does carry a number of very specific risks.

Recovery and 'default' stock price assumption: In the default scenario, our equity exposure will not compensate us for an expected CDS protection obligation.

CDS present value (PV): The CDS PV is an expected value, but not necessarily a realised outcome. In practice, the CDS may trade on an up-front and/or running basis.

Corporate actions: Spin-offs and private equity buyouts, for instance, could radically change the equity-CDS relationship, leaving investors with a mis-hedged position. It is our expectation that an LBO (however unlikely) would be a highly negative event for this trade, as we would expect CDS to sell-off and equity to rally.

Mark-to-market: In our view, credit and equity markets operate largely independently and this can lead to trade opportunities. At the same time, however, any relative mis-pricing may persist and even increase further, which could lead to substantial return fluctuations. Additionally, the trade faces a fairly substantial bid-offer to cross in CDS.

Straddle-like liabilities: As constructed, if the equity-CDS relationship holds and there is a major market move, we will lose money on the trade (especially in the case of a CDS sell-off). The trade is a bet on improving credit coupled with a return to fair value.

Change in equity-CDS relationship: The hedge ratio is estimated using historical data. If equity and CDS begin trading under a new regime, the ratio will be off. If we have shorted too many shares (in hindsight), we might lose money on the trade, even if CDS rallies.

Overall, frequent re-hedging of this position is not critical, but the investor must be aware of the risks above and balance them with the straddle-like liability. If dynamic hedging is desired, this is best achieved by adjusting the equity position, given transaction costs.

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. Our data on liquidity, created from the volume of bids, offers and trades we see each day, provide us with significant comfort in both the ability to enter a trade in AKS and the bid-offer spread costs.

AKS is a reasonably liquid name and bid-offer spreads are around 20-25bp. AKS is also liquid in the equities market.

Fundamentals
This trade is based on the relative value of AKS CDS versus equity. Although the trade does not rely on company fundamentals, we believe they are worth considering given our long credit position.

Carl Blake, Gimme Credit's high yield basic materials expert, maintains an improving fundamental outlook for AKS. He notes that AKS has restored profitability and is now focused on rewarding shareholders.

Carl further notes that AKS faces the risk of a global economic slowdown. He believes market perception of this risk has driven bond spreads wider.

CDR's multi-factor credit indicator model (MFCI) rates AKS as a long, with an expected spread well below current market levels. The MFCI model uses both market data and fundamental data to rank credits, and then calculate expected CDS spreads based on similarly-ranked peers.

Summary and trade recommendation
We turn to one of the cheapest credits indicated by our market-wide capital structure arbitrage screen, as well as our high yield MFCI model. Although we like AKS as an outright long due to our improving fundamental outlook and MFCI expected spread, we choose to hedge by going short equity to lessen our exposure to a credit sell off. We believe the healthy carry earned, positive rolldown and the potential profit from a return to fair value more than compensate us for the risk of a major market move.

Sell US$10m notional AK Steel Corporation five-year CDS at 430bp.

Sell 40,000 AK Steel Holding Corporation shares at a price of US$46.76/share to earn 430bp of carry.

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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).