Contents

Succession questioned

Monoline division sparks credit definition concerns

Suggestions that some monolines may split their businesses into separate municipal and structured finance divisions have sparked concern about CDS succession and credit event processes. Indeed, protection buyers are already positioning themselves with respect to potential defaults of the structured finance entities.

"There will be a scramble to find the cheapest obligations to deliver," explains one CDS lawyer. "There is a significant difference in price between wrapped municipal bonds (which typically trade at 90 cents on the dollar) and wrapped CDOs (which are currently trading at around 10 cents on the dollar), for example. So if a protection buyer can deliver a wrapped CDO obligation, they could receive a 90 cent protection payment (assuming physical delivery applies to the swap)."

It seems likely that FGIC and Ambac (and potentially other monolines) will each split their businesses into two divisions – one referencing municipal bonds and the other referencing structured finance (see News round-up). Should such a proposal be enacted, credit strategists at Banc of America Securities believe that monoline CDS contracts could rally significantly, either entirely succeeding to the new municipals division or splitting the notional equally between the municipals and structured finance businesses.

Under ISDA's 2005 monoline supplement to the 2003 credit derivatives definitions, if between 25% and 75% of financial-guaranteed obligations are transferred to a new division, then existing CDS contracts would be split equally between the original and the new entity. If 75% or more of the obligations are transferred to a new division, then the original monoline reference entity would be deleted entirely and replaced with the new division.

However, these thresholds are not clear-cut for existing monoline obligations. Based on the strategists' preliminary estimates (which exclude CDO deliverables), Ambac's CDS deliverables are split 70%/30% between its municipals and structured finance portfolios; for SCA the split is 66%/34%, while for both FGIC and MBIA it is 84%/16%. In this scenario Ambac and SCA CDS would therefore be equally split between the original and the new entity, while FGIC and MBIA CDS would succeed to the new division.

But the problem in the case of the CDS being split equally between the municipals and structured finance divisions is that a protection buyer will be exposed to what are essentially "stable" and "risky" portfolios, paying the same premium for both. Sources say that hedge funds are already buying wrapped CDO obligations in expectation of the "risky" entity defaulting.

It is possible to deliver wrapped bonds or loans under the monoline supplement – the only caveat being when a transaction is issued through a monoline transformer vehicle and the issuer enters into a CDS with another counterparty which is then wrapped by a monoline. Because such a transaction is arguably not a debt obligation, the wrap isn't counted as being deliverable.

Nonetheless a major disruption in the CDS market always seems to raise new questions about the ISDA definitions. In the case of the monolines, the questions circulating the market surround how the reference entity will be split, what happens if more than two entities are formed and what if there is subsequent a credit event?

"There is concern about, if a monoline defaulted and a credit event was called, whether an ISDA auction process could be conducted within the 30-day limit set in ISDA protocols. This concern is due to the variety of deliverables, as well as the fact that dealers may not agree on a realistic price for the deliverable obligations. In this case, counterparties would have to settle unilaterally, based on the cheapest-to-deliver debt (thereby running the risk of pushing the price of the bonds up unrealistically)," one source explains.

The BofA strategists point out that cash settlement is currently only an expectation, not a requirement. If a monoline were to suffer a credit event, they believe it would be very difficult to cash settle due to the mechanics of the auction.

To assemble a list of deliverable obligations for a monoline, the dealer community would have to agree that each proposed deliverable obligation is indeed deliverable into CDS contracts. Each dealer would then have to value each deliverable obligation to determine the cheapest-to-deliver obligation, which would be a time-consuming and difficult process, the strategists say. Moreover, a CDS settlement protocol would have a substantial risk of realising a very low recovery rate.

However, another lawyer away from the situation warned against the market becoming too alarmist. He remains confident that the ISDA credit definitions are robust and that a settlement auction would lead to a fair price in the event of a monoline credit event.

CS

Mixed bag

Some SIV restructurings could come unstuck

Income note investors in HSBC's Cullinan Finance SIV last week formally accepted its exchange offer, while Citi put support facilities in place for six of the vehicles it sponsors. However, not all SIV restructurings are progressing as smoothly as had been hoped.

"Some of the SIV restructurings are going to get messy: a lot of the value has been destroyed by sponsors of the vehicles waiting too long before they act, with capital note investors likely to end up with impaired assets," says one structured credit investor.

A number of capital noteholders who took vertical slices of SIV portfolios as part of a restructuring agreement face losing more in market value deterioration than the size of their original investment. "It is slowly dawning on some investors that rather than having, for example, US$100m (the size of their original investment) at risk, they've now got US$1bn notional at risk. Some of the assets are unlikely to revert to par and it's not looking like a good trade any more – particularly when they have to explain the losses to their management," the investor adds.

The terms of the HSBC exchange offer, however, involves Cullinan investors exchanging their income notes for notes issued by two new vehicles, Mazarin Funding and Barion Funding (see SCI issue 74). Mazarin is an ABCP conduit that will issue CP and MTNs – expected to be rated A-1+/P-1 and AAA/Aaa respectively – backed by a 100% liquidity facility provided by the bank, while Barion is a term-funded vehicle.

Additionally, CP and MTN investors in Cullinan will be offered an opportunity to sell their holdings and purchase Mazarin senior debt. Cullinan will be wound down after its assets are transferred to Mazarin and Barion and its senior debt is switched out or matures.

Under the restructuring, both Mazarin and Barion will have combined senior funding of around US$26bn. The new vehicles also provide for the removal of market-value triggers.

HSBC says that the move provides a long-term solution to address the funding constraints faced by SIVs. According to the bank, its exchange offer was the first comprehensive restructuring plan announced for a major SIV (see SCI issue 66) and is the first to reach this key milestone.

Meetings with income note and mezzanine note holders in HSBC's other SIV, Asscher Finance, began on 18 February. A formal exchange offer for the income and mezzanine notes will follow within a month. The vehicle that will replace Asscher is expected to have senior funding of about US$6bn.

The Cullinan going-concern-based resolution contrasts with Citi's restructuring approach, which is effectively aimed at allowing for a more orderly unwind of the vehicles, note analysts at Deutsche Bank. "Unlike other bank-based SIV proposals, Citigroup does not intend to provide any backstop liquidity facility but instead appears to be relying on asset sales to meet senior debt redemptions, with the recent additional capital sized primarily to maintain the Aaa/P-1 ratings of senior debt."

The support facility for Citi's SIVs takes the form of a commitment to provide additional capital to each of the vehicles should the market value of capital approach zero. If that were to happen, each vehicle is entitled to draw the full amount of the commitment, which varies from programme to programme.

The commitment stands at US$1.038bn for Beta Finance (the equivalent of 8.21% of senior debt outstanding); at US$883m for Centauri Corporation (7.01%); US$495m (7.85%) for Dorada Corporation; US$548m (7.44%) for Five Finance; US$423m (6.85%) for Sedna Finance; and US$68m (4.92%) for Zela Finance. Citi's seventh vehicle, Vetra, did not have its senior debt placed on negative watch and therefore wasn't restructured at this time.

Moody's has confirmed the ratings of Prime-1 for the vehicles' US and Euro CP programmes, and Aaa and Prime-1 for the vehicles' US and Euro MTN programmes as a result. In the agency's opinion, each of these support facilities provides sufficient credit enhancement consistent with Aaa/P-1 senior debt ratings for the affected vehicles.

Bank of Montreal is also thought to be planning to provide up to US$12.2bn in senior ranked support for its two SIVs, Links Finance and Parkland Finance. "As we have remarked in recent weeks, the unfolding resolutions to the bank SIV crisis recently are more often based on orderly portfolio unwinds, whether engineered (as in the case of Citi) or forced via enforcement or receivership (as in the case of Standard Chartered, IKB). We remain of the opinion, therefore, that the technical (overhang) risk to ABS is likely to be prolonged," conclude the Deutsche Bank analysts.

CS

Secondary market stalls

European catch-22 spreads

The catch-22 situation that characterised the European primary securitisation market coming into January now appears to have gripped the secondary market too. Participants agree that, unless the secondary overhang is absorbed, prices are unlikely to stabilise – and without a stable ABS market, new issue CDOs will struggle.

"The conditions that investors are looking for before they put their money to work are pricing stability and the secondary market overhang to be absorbed," confirms Rick Watson, head of the European Securitisation Forum.

Some accounts have cash to spend and the requisite access to data, but the most significant issue – particularly for triple-A investors – is the current mark-to-market environment. "Investors are reasonably comfortable from a credit perspective, but they can't tolerate price volatility. While there is a continuing resolution of SIV issues, secondary overhang still needs to be absorbed, so that primary paper can be sold in a stable environment," Watson adds.

On the supply side, few investors are willing to sell at deep discounts and recognise losses unless forced to do so, as they generally believe fundamentals warrant better pricing. On the demand side, even though some portfolio managers see value in prime triple-A ABS at current spreads, either their investors or senior management are reluctant to add exposure and risk further mark-to-market losses.

"As a result, cash liquidity remains extremely thin," explain ABS analysts at Lehman Brothers. "Some opportunistic investors are monitoring the market to take advantage of the occasional forced sale, but many of those waiting in the wings find credit default swaps more attractive than cash bonds. With negative news dominating headlines – with forecasts of further bank write-downs and monoline downgrades – we think there is likely to be little change in this dynamic any time soon."

ABS analysts at SG add that efforts towards bringing new, safer, structures therefore remain challenged. "A growing part of the business could be ready to re-enter the market, and could do so through high quality assets with very straightforward and crystal-clear structures. At current spread levels, this new paper would offer a great risk/reward profile. Unfortunately, the market remains totally driven by technicals, with more unwinds from leveraged structures still likely. We expect it will be some time before the market returns to fundamentals and spread volatility subsides," they say.

Although home equity ABS pricing is gaining some stability in the US, more negative price movements are expected in the CMBS, leveraged loan and monoline spaces, according to Jenna Collins, portfolio manager at Cairn Capital. "ABS prices in the US had further to fall and they began falling earlier, whereas prices are still falling in Europe," she notes. "Delinquencies and repossessions are indeed rising in the UK, albeit from very low levels, especially in UK non-conforming RMBS. Concerns about property prices and financing are being reflected in technical moves at the triple-A level."

While performance remains generally good in Europe, investors are aware that in the US even prime RMBS began to perform more poorly in a declining house price environment. Because of this, there is continuing uncertainty about the UK market in particular.

However, Collins says that it is an interesting time to be an investor, given the numerous opportunities to do long/short trades. "For example, despite having low LTVs and strong performance, if one has a negative view on the UK housing market, perhaps the most liquid way for investors to express this view is by shorting liquid names, such as Permanent and Holmes. This is why spreads have moved out on these names, despite good credit quality. In another example, given the fact that US ABS prices have fallen to levels that price in a serious recession, one could go long short-duration US high grade home equities and short UK non-conforming RMBS," she explains.

The exception to the rule is the European secondary CLO sector, which this week saw an up-tick in activity with a high dispersion across vintages, WALs and spreads (see separate news story on CLOs). However, again, spreads seem to be on a widening trend.

"A handful of investors are indeed buying but only at distressed levels, with the rest being kept at bay by market instability. Direct bids are more effective than bid lists, which became inefficient in a market where the only trade that seems to work is one from a forced seller desperate to place a trade within a limited timeframe," concludes Gianluca Giurlando, a structured credit analyst at RBS in London.

CS

CLO doldrums

Europe still becalmed, but US shows glimmer of potential

The European CLO primary market remains paralysed, with no pricing activity since December – despite five deals doing the rounds. The second US CLO of the year has priced, however, suggesting that the US market could be on its way to recovery.

"The CLO market still remains the most widely tipped of all the CDO markets to survive and thrive once the peak of the crunch has passed. Pundits point to a second half recovery in the US CLO market; we think that Europe will take longer than this to re-gather any steam," observe structured credit strategists at RBS.

Morgan Stanley priced the second US CLO of the year – the US$731m Camulos Loan Vehicle I deal, managed by Camulos Capital (a hedge fund targeting distressed asset investment opportunities). The transaction comprises US$555m 6.1-year triple-A rated notes, which came at 85bp over Libor, and US$46.7m 7.6-year Aa2/AA notes that priced at 250bp over (albeit steep discounts were rumoured). The capital structure also included US$31.5m A2 notes (which came at 300bp), US$205m Baa2 notes (500bp) and US$24.5m Ba2 notes (800bp).

Morgan Stanley has also begun marketing the US$450m Babson Loan Opportunities CLO for Babson Capital. Guidance for the US$344m triple-A and US$20m Aa2/AA notes is in the 100bp area and 275bp area respectively. The manager is expected to retain the US$18m Baa2/BBB and US$13m Ba2/BB pieces.

The US CLO pipeline is estimated to stand at around US$6.3bn, while for European CLOs it is about €5bn-€6.5bn. Fortress I, Queen St III, Base CLO and Halcyon 08-01 are all still marketing in Europe, alongside the jumbo CELF Partnership Loan Funding 2008-1. The RBS strategists note that the launch of the transaction would bring Q1 European CLO volumes within their January expectations of €2bn-€2.5bn (albeit across three or four deals).

Goldman Sachs is marketing the Carlyle Group's CELF Partnership Loan Funding deal, a €2bn CLO that pools leveraged loans trading at distressed prices in the secondary market. The majority of the collateral is thought to have been ramped at around 92 cents on the euro or lower, with the portfolio expected to comprise 18% North American assets and the remainder European.

Rated by Moody's and S&P, the capital structure consist of €1.47bn triple-A notes (with price whispers at 85bp area over Euribor), €85m Aa2/AA notes (225bp area), €90m A3/A– notes (325bp area), €70m Baa3/BBB– notes (450bp area), €50m Ba3/BB– notes (650bp area) and €80m B3/B– notes (1000bp area). The triple-A notes have a four-year WAL, while the remainder have a five-year WAL.

The equity slice accounts for 8% of the deal size, but it isn't yet clear whether Goldman Sachs will provide a principal guarantee for this portion as part of its EPICS programme (see SCI issue 33). Spread guidance nonetheless looks markedly wider than the CLOs priced in December, indicating that levels in Europe are catching up with US CLO spreads.

CS

The devil in derivatives processing

Full-cycle exposure management is discussed by Frank Reiss, director and head of derivatives product management at Euroclear Bank

The OTC derivatives market continues its meteoric surge. Bank for International Settlements statistics show that notional amounts in all OTC derivatives classes grew a record 135% in the first half of 2007 compared to the second half of 2006, to leave some €354trn outstanding. However, the global OTC derivatives market is sitting on a timebomb caused by extremely low levels of processing automation.

It's amazing that an industry with triple-digit growth rates remains stuck in the dark ages when it comes to confirming deals between trading parties. The average number of outstanding confirmations doubled year-on-year from 2006 to 2007, according to Markit's key operational statistics, among the top 18 OTC dealers.

In addition to confirmation backlogs, the lack of processing automation is hitting operational performance. Tradebooking errors are common in up to 20% of all credit derivative transactions, and higher for some of the more exotic derivative types.

Today, firms wrestle with reams of unprocessed paper for OTC transactions, as well as grappling with reconciliation breaks, unsettled cashflows and problems with collateral and exposure management further downstream. Derivatives managers are desperate for ways out of this processing quagmire.

Controlled exposures
Solutions exist for firms to confirm OTC derivatives transactions and calculate portfolio exposures arising from their trading activity. For example, the Depository Trust & Clearing Corporation (DTCC) offers Deriv/SERV – an OTC derivatives confirmation matching service for credit derivatives, designed to streamline the confirmation of trades.

In the domain of interest rate and equity derivatives, SwapsWire provides an electronic network for trade-data capture. In Europe, organisations like ISDA, together with SWIFT, Euroclear Bank and the Collateral Framework Group, are co-ordinating their findings and furthering standardisation and automation.

Euroclear Bank has subsequently delivered a unique exposure-management solution called DerivManager. Launched at the end of 2007, it enables counterparties to accurately track all of their portfolio exposures arising from OTC derivatives trading.

Based on client-provided valuation data of their bilateral derivatives contracts, Euroclear Bank automatically standardises and compares the two data sets, and detects and reports any discrepancies in the mark-to-market values of these trades across entire portfolios. Subscribers get a precise overview of their aggregated exposures. They can also outsource the management of collateral covering exposures to an established triparty agent like Euroclear Bank to take advantage of a fully automated and secure STP environment.

By outsourcing the administrative tasks associated with bilateral collateral management, firms are effectively veering away from operational risk. AutoSelect, Euroclear Bank's automated collateral selection and substitution module, is designed to follow pre-determined collateral acceptance criteria. Concentration limitations, set bilaterally by both counterparties, are respected while extending collateral flexibility to almost any type of transaction requiring collateral movements.

Accurate pricing data is key to any third-party offering in order to mitigate exposure-reconciliation disputes and provide both trading parties with a realistic view of their risks and exposures to manage. Use of multiple data sources is vital. Equally important are frequently refreshed valuations of the collateral required to cover the exposures.

Full-cycle exposure management
With the cloud of the sub-prime crisis still lingering, firms are opening their eyes to the operational risks they face by operating in sub-optimal conditions. Granted, derivatives transaction processing follows a different set of rules and practices than fixed income and equities, but there is definitely room for better OTC derivatives processing to eliminate the risks intrinsically linked to manual intervention.

Euroclear Bank's DerivManager takes both counterparties to an OTC derivatives deal to a higher ground by matching the trades, reconciling portfolio discrepancies and ultimately collateralising the net underlying exposures with Euroclear Bank acting as a neutral triparty agent. There is a way out of the derivatives processing quagmire.

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/.

Income-driven alpha

Mark Cernicky, enhanced credit portfolio manager at Aviva Capital Management Alternative Strategies, answers SCI's questions

Mark Cernicky

Q: When, how and why did your firm become involved in the structured credit markets?
A: Aviva Capital Management (ACM) began investing in single name, investment grade corporate credit default swaps (CDS) in 2001 and high yield, bespoke portfolios of CDS and CDS indices in 2004 for clients with targeted investment objectives. Our CDS investments are diversified across sectors and the capital structure, with an emphasis on first-loss tranches. ACM specialises in creating high income-driven strategies from these securities for large institutional investors.

Our enhanced credit business is the innovation of our chief investment officer, Greg Boal, and was established by our Alternative Strategies team in 2004 when interest rates were low and our institutional clients were looking for ways to enhance income. We turned to structured credit as a way to help our clients enhance income in their existing portfolios. Our structured credit investment strategy is built around the application of fundamental credit research, portfolio construction and active hedging strategies.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: The creation of a liquid index and tranche market has been the most significant development in the structured credit sector in recent years. The developments of these instruments allowed investment managers to isolate credit risk and improve risk management techniques, which in turn added liquidity to single-tranche CDOs and ultimately attracted more investors to these strategies.

The structured credit market was tested when equity correlations gapped lower during May 2005. Although this was a significantly stressful time for the structured credit sector, new investors entered the market and dealers learned to create better index and correlation hedging strategies.

As a result, an expansion of new products followed. This expansion ultimately resulted in the creation of the Markit ABX, CMBX and LCDX indices.

A more recent test has been the fundamental re-pricing of credit risk precipitated by the sub-prime mortgage-backed securities crisis. The structured credit sector has been severely tested, with substantial widening in all credit spread levels.

Most investors have been surprised at the speed at which the market has recently re-priced. Although it has been painful for many investors, we think the market will benefit from the re-pricing in the long term.

As in previous market cycles, the current market stress should give rise to a more mature investor base, as well as to market stability. Structured credit is going through a cleansing phase. We believe at the end of this phase, we should end up with better-crafted products.

Furthermore, the recent market stress has accentuated the liquidity and transparency of the corporate CDS market. This being in contrast to the relative lack of liquidity and transparency in the ABS structured product market.

Throughout the recent market turmoil, the corporate CDS market never stopped trading and the transparency of the inputs into synthetic CDOs allowed us to validate our counterparties' marks. This is the true test of a market and is one of the most significant developments in the credit markets.

Q: How has this affected your business?
As a result of the increase in CDS spreads, we have an increased appetite for structured credit, taking advantage of dislocations in the credit markets. On the risk management front, we may revise our portfolio optimisation, reducing hedging error and enhance our fundamental credit models to try and better anticipate downgrades. Anticipating potential downgrades is fundamental to our structured credit and enhanced structured credit investment strategies, and one of our key strengths.

Q: What are your key areas of focus today?
A: Most of our primary, enhanced credit investment strategies invest in what we call Equity Duration Annuities (EDAs). An EDA is a fully-funded investment in a credit derivative.

The investor makes a non-recourse, upfront payment in exchange for quarterly cashflows linked to the timing of defaults (or lack of defaults) in a portfolio selected by ACM. There is no financial leverage in these investments.

As discussed above, we can actively hedge market value risk of the EDA utilising liquid credit indices and tranches. The performance of this strategy is based on the formula P = I + V – H, where "P" stands for profit, "I" for income of the EDA, "V" for volatility of the EDA and "H" for hedges (customised to client risk tolerance). If our hedges and credit selection can minimise the volatility of the EDA, such that V=H, then performance should be driven by income, which is really income-driven alpha from our idiosyncratic exposure.

We believe our EDA strategy differentiates us from other managers. ACM is one of the few investment managers that attempts to generate alpha primarily from income.

Although some credit portfolio managers have similar approaches, they reduce the volatility of the market value risk of their first-loss investments by delta-hedging. We prefer to hedge the systematic (or market) risk of our first-loss investments with liquid indices and tranches.

We do not take a black box approach to credit, nor do we explicitly trade correlation. Our research begins, and ends, with our ACM analysts and our proprietary fundamental, technical and valuation (FTV) process.

Q: What is your strategy going forward?
A: We expect to be busier in 2008 – not only because volatility creates opportunity, but also because the recent market stress has proven that active management of credit can really add value. Adding value both in terms of spotting pricing discrepancies and because market volatility has placed more focus on research and hedging strategies.

We observed during the summer of 2007 that both research and hedging are the real drivers of performance, thereby creating the opportunity to differentiate ourselves. Consequently, the key for us at the moment is applying what we've learned in times of market stress, and enhancing the process around research and risk management. One example of knowledge application could entail the recalibration of our hedging process to include micro, as well as macro, hedges and some form of portfolio stratification.

Q: What major developments do you need/expect from the market in the future?
A: Our belief is that investment managers will develop strategies or products to take advantage of the current dislocations, much like the advent of leveraged super-senior trades did in 2005. One possibility is single-tranche CLOs, which may serve to stabilise the loan market and, in turn, stabilise the high yield/bond market (see SCI issue 67).

Another possibility is negative basis trades, whereby real money investors (who typically have not played in the super-senior space before) take the place of monoline insurers. Of course, the ultimate back-stop will continue to be hedge funds.

Investors will nonetheless be looking for high-quality asset managers and the right subordination/recovery rates, together with the opportunity to earn an attractive spread on assets that have been overdone. The emphasis will be on taking advantage of the current dislocation by putting money to work in an intelligent risk management framework.

About Aviva Capital Management
Headquartered in Des Moines, Iowa, Aviva Capital Management is an SEC-registered, GIPS compliant investment adviser. The firm specialises in institutional, income-driven asset management, which allows it to offer targeted investment advisory services. Adhering to strict risk management policies, it seeks to position clients for long-term success.

ACM is the US asset manager for Aviva plc, the fifth largest global insurer, which manages over US$713bn in assets under management worldwide.

As of 31 December 2007, ACM has over US$32bn in AUM. The 125-member organisation, including 54 investment professionals, seeks to deliver superior results to institutional clients worldwide, using disciplined processes and customised solutions while providing exceptional client service.

This interview represents the current opinions of ACM as of the date of the publication and is not intended to be a forecast of future events, a guarantee of future results, or investment advice. Such opinions are subject to change without notice. The information in this interview is for educational purposes and is not intended to provide specific advice or to be construed as an offering of securities or a recommendation of any particular security, strategy or investment product.

CS revelation and suspensions rekindle fears

The latest company and people moves

CS revelation and suspensions rekindle fears
On Tuesday Credit Suisse revealed a 58% increase in write-downs, only a week after announcing its full 2007 results. The bank says it has undertaken an internal review which has resulted in the re-pricing of certain asset-backed positions in its structured credit trading business within investment banking.

An ongoing investigation into the pricing errors on Credit Suisse's CDO and RMBS positions "by a small number of traders" has resulted in the suspension of those thought to be involved, understood to include Kareem Serageldin, global head of synthetic CDOs. Credit Suisse declined to comment.

The revelation can only serve to further add to market jitters. As credit research analysts at BNP Paribas observe: "Beyond Credit Suisse, this news may rekindle market fears that investment banks are not marking their books properly, and that more nasty surprises are upcoming."

In a statement Credit Suisse says the current total fair value reductions of these positions, which reflect significant adverse Q108 market developments, are estimated at approximately US$2.85bn (having an estimated net income impact of approximately US$1bn).

In the first quarter to date, the bank estimates that it remains profitable after giving effect to these reductions. The final determination of these reductions will depend on further results of its review and continuing market developments, Credit Suisse says. It will also assess whether any portion of these reductions could affect 2007 results.

BNP Paribas' credit analysts comment: "We find that we still lack clarity on this issue. CSG said that the bulk of the write-downs relate to mark-to-market in Q1, but still refused to give an idea of how significant the mispricing and pricing errors were. Moreover, it is worrying to us that write-downs could have increased so much in the space of just six weeks, and this on CDOs and RMBS (it does not include mark-to-market of leveraged loans and CMBS, for example)."

Ambac reorganises risk management
Ambac Financial Group has appointed David Wallis as chief risk officer. In this newly created role, Wallis will be responsible for three principal areas: capital and risk analysis, portfolio risk management and credit risk management.

Wallis previously had responsibility for portfolio risk management. Ambac says the addition of credit risk management and a greater focus on capital will greatly enhance its ability to strengthen its underwriting process while retaining its focus on risk-return driven capital management.

Bob Selvaggio will head capital and risk analysis, while Cathy Matanle will head portfolio risk management, both reporting to Wallis. The credit risk management group will retain distinct public and structured finance reporting lines such that each will maintain their distinct credit-driven focus.

US public finance credit risk management will be lead by Peter Cain; Bob Bose and Rick Persaud will co-head structured and international finance. All three individuals will report directly to Wallis. William McKinnon, who previously headed credit risk management, has retired from the firm.

BlackRock denies rumours
BlackRock took the unusual step on Tuesday, 19 February, of issuing a statement to deny market speculation that it was sitting on a large CDO and sub-prime related loss. The fund manager's hand was forced as its share price declined rapidly on the back of such market talk.

BlackRock stated: "There is simply no truth to today's reported rumours. As the company has previously disclosed in its SEC reports and earnings releases and calls, BlackRock has no material exposure or losses related to either sub-prime assets or CDO investments, whether held in the US or in off-shore vehicles. In its fourth quarter earnings release, the company disclosed US$12m of impairment charges related to CDO seed investments, which represented a substantial portion of the remaining balance sheet exposure to CDOs. In addition, BlackRock is not aware of any Department of Justice investigation relating to BlackRock."

Merrill CDO head exits
Craig Lipsay, formerly co-head of Merrill Lynch's strategic solutions group, is understood to have left the firm. The move is thought to be connected to the ongoing reductions in fixed income staff at the bank.

Those reductions are believed to have seen the exit – some voluntary, some not – of around 20 senior executives since the reorganisation that saw John Thain become the firm's new chairman and ceo.

F&C appoints head of credit research
F&C has appointed Peter Stage to the new position of head of credit research. Stage joins F&C from Gordian Knot, where he was head of credit. At F&C he will report to Patrick Hendrikx, head of credit.

Stage was responsible for an eleven-strong team at Gordian Knot, providing the credit analysis of circa US$60bn of predominantly investment grade exposure in two SIVs, Sigma Finance Corp and Theta Corp, spanning ABS, banks and other corporates. At F&C he will be tasked with directing and enhancing the credit research process, managing and mentoring both the investment grade and high yield credit analysts, and strengthening idea sharing.

Brown returns to MBIA and opens communication with Dinallo
Joseph (Jay) Brown has returned to MBIA, resuming his positions as chairman and ceo and becoming president of MBIA. He replaces Gary Dunton, who has resigned from the monoline.

Brown comments: "I look forward to working with the MBIA team to frame a new model for the financial guarantee business. In addition, it is critical that we expedite our communications with the New York State Insurance Department. I have already spoken with Superintendent Eric Dinallo. I believe we can look forward to improved dialogue with the Department. Eric and I had a constructive discussion regarding MBIA's plans and he provided us with helpful guidance. We expect to rebuild confidence in the company and in the industry."

Until May 2004, Brown had served as chairman and ceo of MBIA and retired as executive chairman in May 2007. He joined the company as chairman and ceo in January 1999, having been a director since 1986.

MP

Quebecor fixes

A round up of this week's structured credit news

Quebecor fixes
Markit and Creditex, in partnership with 13 major credit derivative dealers, yesterday, 19 February, conducted a credit event auction to generate a cash settlement price for contracts referencing Quebecor World Inc. The final price was fixed in the afternoon at 41.25%, following an initial bidding price arrived at in the morning of 42.125%.

However, the next auction the market sees could well have a key difference, according to one structured credit investor. "You have to ask what the chances are of an auction using a recovery rate of 40 happening again in the foreseeable future – as more defaults come, you will see lower and lower recovery rates because people don't want the assets anymore," he says.

The potential subject of the next auction is also cause for concern, the investor adds. If not a flurry of defaults, a key single name – such as Idearc, which appears in the top-ten of nearly all dealer loan lists – could cause widespread damage to the market.

Quebecor, a Canadian commercial printer, missed a 15 January interest payment on its senior notes and filed for protection from creditors on 21 January, triggering a credit event on CDS contracts referencing the company (see SCI issue 72). The credit event auction enabled institutions to cash settle single-name, index and tranche CDS at the final auction price.

The auction was run in accordance with the ISDA 2008 Quebecor CDS Protocol published on 31 January. During the auction, dealers submitted orders electronically on the Creditex platform. The auction submissions were electronically delivered to Markit, which calculated and verified the results, and published them on the credit fixings website.

The credit event auction process was launched in 2005 by Markit and Creditex in collaboration with ISDA and major credit derivative dealers to facilitate the settlement of credit derivative contracts in the event of a corporate default. Previous auctions were held for Movie Gallery, Collins & Aikman, Delta Air Lines, Northwest Airlines, Delphi Corporation, Calpine Corporation, Dana Corporation and Dura.

FGIC downgraded...
Moody's has downgraded from Aaa to A3 the insurance financial strength ratings of the operating subsidiaries of FGIC Corp, including Financial Guaranty Insurance Company and FGIC UK. The agency has also downgraded the senior debt rating of the holding company, FGIC Corp, from Aa2 to Ba1 and the contingent capital securities ratings of Grand Central Capital Trusts I-VI from Aa2 to Baa3.

These rating actions reflect Moody's assessment of FGIC's meaningfully weakened capitalisation and business profile, resulting in part from its exposures to the US residential mortgage market. These ratings remain on review for possible downgrade, reflecting continuing uncertainty about the firm's strategic and capital plans. An unfavourable outcome in those areas could lead to a lower financial strength rating, most likely to the Baa level.

The Moody's-rated securities that are guaranteed by FGIC have also been downgraded to A3, and remain on review for further downgrade, except those with higher published underlying ratings.

Based on the risks in FGIC's portfolio as assessed by Moody's, estimated capitalisation required to cover stress-case losses at the Aaa target level would be in the range of US$9bn. This compares to Moody's estimate of FGIC's claims paying resources of approximately US$5bn, which the agency considers to be more consistent with capitalisation at the single-A rating level. Moody's estimates that the monoline's insured portfolio will incur lifetime losses on a most likely basis of approximately US$2bn in present value terms.

FGIC is currently pursuing several capital management and restructuring initiatives that, according to Moody's, could reduce but would not likely eliminate the company's capital shortfall at the Aaa rating level if successfully executed.

In Moody's opinion, FGIC's significant exposure to mortgage-related risk has had consequences for its business and financial profile beyond the associated impact on capitalisation, which affects its opinion about FGIC's other key rating factors. The agency believes that FGIC's historically strong franchise, particularly in the municipal segment, has weakened significantly relative to the other large financial guarantors, as has its prospects for future profitability and financial flexibility.

With respect to underwriting and risk management, Moody's believes that FGIC's relatively significant exposure to the mortgage sector is indicative of a risk posture somewhat greater than the peer group overall and reflects the company's aggressive portfolio growth and capital management since its ownership change in December 2003. The monoline's participation in higher risk segments of direct RMBS and ABS CDO segments in 2006 and 2007, in particular, contributed to this view. Going forward, Moody's believes that FGIC's strategic direction may change meaningfully, introducing further uncertainty into its credit profile.

FGIC's profitability is likely to remain depressed in the near to intermediate term as losses on mortgage related exposures are incurred. While Moody's expects the company to continue earning premiums on its in-force book for many years, as well as investment income on its investment portfolio, the agency believes premium volume on new business production will diminish significantly and operating expenses will become a greater burden on earnings over time.

Moody's ratings of MBIA and Ambac remain under review for possible downgrade, with those reviews expected to conclude within the next few weeks. Although further analysis remains to be completed before those reviews can be brought to conclusion, Moody's believes that, in contrast to XL Capital Assurance and FGIC, MBIA and Ambac are better positioned from a capitalisation and business franchise perspective.

Meanwhile, ACA Capital Holdings has entered into a third forbearance agreement with its structured credit counterparties. This agreement, which is longer-term than the two preceding agreements, will remain effective through to 23 April.

Under the agreement, the counterparties will continue to waive all collateral posting requirements, termination rights and policy claims relating to the rating of ACA Financial Guaranty Corp under their respective transaction documents. The firm says that the extension will allow discussions to continue around developing a lasting solution for its capital and liquidity issues.

... while muni/SF split mulled ...
Speculation intensified this week as to whether Ambac and FGIC (and potentially other guarantors, including MBIA – see Job swaps) will split their businesses into municipal and structured finance divisions under the ongoing bailout efforts for the sector.

According to ABS analysts at SG, the resulting isolation of non-core business into a closed book run-off structure would arguably provide increased clarity which the rating agencies could use to asses repayment risk. "Although these businesses would not be likely to warrant triple-A ratings, it is equally unlikely that ratings in a closed book structure would fall dramatically, while claim-paying reserves cover likely default scenarios," they note.

Structured finance analysts at RBS, meanwhile, pointed out that the key issues regarding such a split are: what form the separation would take; how well capitalised and how well rated each division would be; which exposures are likely to be in which division; and what happens to the CDS contracts on the insurance and holding companies (see separate news story for more on this).

They suggest that one way of splitting the businesses would be to set up a new entity, "Newco", to provide look-through reinsurance for the "good" book. The existing insurance company ("Oldco") could pay Newco to take on the risk, effecting a split of claims-paying resources between the two entities.

Consequently, Newco would find new capital easier to source as it would be untainted by the problems in the structured finance portfolio. Meanwhile, Oldco would be left with the "bad" book, and reduced claims-paying resources.

In terms of ratings, there seems to be a weight of new capital ready to pour into insuring municipal bonds. The RBS analysts therefore expect that Newco could be capitalised to triple-A standards, provided it was structured to be sufficiently profitable.

For Oldco, part of the issue is how much capital would be paid to Newco for the reinsurance to make it sufficiently attractive for new investors. The dream outcome would be that the allocation of claims-paying resources to Newco would be less than that required to be held against this book by the rating agencies, with new capital being used to address any shortfall. That would free up capital to support the book retained by Oldco.

Ambac is reportedly planning to raise US$2bn through a discounted rights issue to stabilise its capital position ahead of a split into two businesses.

Eliot Spitzer, the New York Governor, said in last week's Congressional hearing on the monoline sector that his strong preference was to find ways to strengthen the bond insurers to maintain triple-A ratings. While stressing that the regulator's aim is to protect all policyholders, it was made clear that municipal investors could not be allowed to suffer from problems caused by another sector of the market. Monolines were asked to come up with plans to protect the municipal side of their businesses and the triple-A rating of municipal bonds.

... and monoline exposure is explored
Moody's says that the deterioration in the credit risk profiles of financial guarantors may have significant implications for a relatively small number of banks and securities firms. In its new report, the agency has updated its ongoing analysis on guarantor exposures at global banks and securities firms.

"It is becoming quite apparent that the rating agencies are flagging all the issues which would come into play once the monolines are split and downgraded – a fact being acknowledged by the credit markets, but falling on deaf ears within equities," note credit strategists at BNP Paribas.

The report reviews the key information sets that Moody's analysts are seeking from banks and securities firms regarding their financial guarantor exposures, and how the rating agency is analysing that information for each type of exposure. David Fanger, Moody's chief credit officer for financial institutions, emphasises that banks' public disclosure about their financial guarantor exposures is limited and Moody's analysis is still underway.

"Moody's has not yet reached any definitive conclusions about whether or not specific rating actions may be required on banks or securities firms as a result of their guarantor exposures," he states.

Moody's report divides the guarantor exposure at global banks and securities firms into four broad categories: CDS and derivatives; wrapped and direct exposures; liquidity facilities; and reputational exposure. The agency then points out that an important factor in its analysis is the quality of the underlying assets on which financial guarantors have provided a guarantee. Nearly all of the underlying assets were of investment-grade quality when they were guaranteed.

In addition, the rating agency states that, even if a Moody's-rated financial guarantor is no longer rated Aaa, it expects that the firm would be able to perform on its guarantee and CDS obligations – albeit with a lower level of confidence than that implied by an Aaa rating. Fanger adds: "The analysis of the risks for banks and securities firms involves an assessment not only of the risk of loss due to declines in the value of the guaranteed assets (or increases in the replacement cost of CDS), but also of the likelihood that a financial guarantor might still be able to perform on its obligations – even though it may no longer be rated Aaa."

Moody's believes that the largest potential losses which banks and securities firms may face in the event of further deterioration or downgrades of financial guarantors involve their holdings of CDS on ABS CDOs purchased from financial guarantors as hedges. "Our initial assessment has identified CDS hedges with financial guarantors on ABS CDOs totalling approximately US$120bn," Fanger notes. "These exposures are spread across approximately 20 different banks and securities firms."

Downgrades of financial guarantors could lead these firms to increase counterparty reserves on such exposures, perhaps by US$7bn-US$10bn in aggregate. But, should both the market value of the hedged securities and banks' internal risk ratings for guarantors fall significantly lower than they are today, this could rise to as much as US$20bn-US$30bn.

Moody's is currently evaluating the individual exposures at each institution in order to assess how these firms can absorb the additional counterparty reserves that might be required. According to the agency, those banks holding securities backed by sub-prime, Alt-A and second-lien mortgage or home equity loans wrapped by financial guarantors may also face impairment.

But it does not believe the impairment on those instruments will be as severe. "Nevertheless, since the size of these holdings at individual banks is less clear, the extent of these charges remains more uncertain," Fanger concludes.

EC transparency deadline met
The European financial services industry last week presented to the European Commission its proposals for improving market transparency (see SCI issue 69).

The industry, represented by eight trade associations including the European Securitisation Forum (ESF) and the Securities Industry and Financial Markets Association (SIFMA), outlined three key areas for their initiatives. These relate to transparency around Pillar 3 of the Capital Requirements Directive (CRD), industry market data and investor information.

The first initiative aims to address concerns about transparency with regard to the exposure of investment firms and credit institutions to securitisation under Pillar 3 of the CRD. The aim is to develop EU CRD good practice guidelines on securitisation disclosures, to be published for consultation at end-June 2008.

The second and third initiatives aim to aggregate information on the public securitisation markets and identify secondary market information. Part of this process involves the ESF taking a root-and-branch look at term securitisation in order to make it more available/easily accessible by investors.

"The industry is committed to transparency – that term investors in public ABS should have access to both prospectuses and remittance reports. But for a variety of legal issues, they're not always easily accessible. For example, since securitisations are typically targeted at institutional investors, there can be restrictions to prevent marketing to retail investors," notes Rick Watson, head of the ESF.

He says that in most cases data is available through commercial vendors, many of whom digitise and standardise data output to a consistent format. However, since these data providers don't necessarily all use the same standard of formatting and some investors don't use commercial vendors, the result is that investors don't have a single standard of formatting.

"There are other legal and commercial obstacles, such as banking secrecy, confidentiality provisions and contractual issues, that can restrict issuers' ability to provide certain information," adds Watson. "Also, given that transactions are sold globally, we're trying to come up with global definitions that will be used consistently. For example, how does the definition of 'sub-prime' differ from country to country?"

The exchange community has reportedly offered to share its transparency model with the securitisation industry, but until the market in general agrees to provide two-way quotes, it is unlikely to be adopted. Nonetheless, part of the industry's remit is to ensure the investor community acknowledges that securitisations – especially the mezzanine tranches, which are usually small in size – are typically illiquid.

Indeed, being exchange-traded wouldn't automatically mean that securitisations trade more frequently – they were illiquid before the current turmoil began because it takes time to update loan-level information and analyse the cashflows. Strengthening the valuation process is therefore more important: the necessary infrastructure needs to be developed to enable senior management to understand how to value and trade transactions.

Rand-denominated CPDO launched...
Barclays Capital has launched its latest Alhambra CPDO notes out of the Arlo X vehicle. Unusually, the Series 2008 B-1Z transaction is denominated in South African rand – albeit at a small size.

Moody's has assigned an Aa2 rating to the ZAR300m (US$39.2m) notes, which have a legal final maturity in 2018 and will be managed by Deutsche Asset Management. The reference portfolio is comprised of long CDS exposures referencing single name corporates.

The manager can change the composition of the portfolio through time, investing into long and short single name CDS exposures. It also has some ability to manage the leverage, which is otherwise determined by a leverage formula and strategic maximum starting at 6x and increasing up to 20x at maturity.

The notes include a cash-in mechanism such that exposure to the reference portfolio stops whenever the transaction's net asset value is higher than the present value of all future liabilities of the issuer. A coupon of 190bp over Jibar is expected to be paid to noteholders at maturity.

Rand-denominated CDS prices are determined by applying a predefined adjustment to market euro prices. Moody's analysts note that the transaction is not directly exposed to movements in ZAR foreign exchange rates or CDS prices.

...while 16 others are downgraded
Moody's has downgraded and left on review 16 corporate CPDOs worth approximately €1.1bn of securities, representing 42% of the total volume of CPDOs rated by the agency.

The rating actions are a response to the widening of the iTraxx Europe and CDX.NA.IG indices' weighted average spreads to very high levels. The combined weighted average index spread has increased from approximately 35bp when many of these transactions closed to approximately 120bp. In addition to widening, the spread remains highly volatile: the combined weighted average index has increased by 35bp in the last month alone.

Over the next few weeks, Moody's will be updating its analytical approach to take into account the current high spread volatility environment. As a result, the ratings have been left on review.

The leverage in these CPDOs range between six and 15 times, making each transaction's net asset value (NAV) very sensitive to the recent spread widening. As a result, the NAVs of these transactions have fallen to between 40% and 75%. At a NAV of 10%, most of these transactions would unwind, resulting in an approximate 90% loss to investors.

The CPDOs affected by the actions are: SURF Series 5, 6, 7, 8, 9, 10 and 12 issued through the Castle Finance I vehicle; SURF Series 2 issued through Castle Finance II; Thebes Capital Series 2006-1; Artemis Series 2007-1 and 2007-2; RECIPES Series DE issued by Aquarius + Investments; REDI Series 55 issued by Clear; Ruby Finance Series 2006-2 and Series 2007-2; and RIDERS Series 2006-3 issued by Magnolia Finance IV.

European LBO trends analysed
The European leveraged finance market has entered a phase where defaults are rising and economic growth is slowing, making it increasingly important for investors to pay close attention to the performance of LBO transactions. Yet information on the performance of leveraged loans is hard to obtain, as the majority of such loans in Europe are not publicly rated, with just 15% publicly rated in 2007.

In an effort to shed some light on prevailing trends in the European leveraged finance market, S&P recently carried out research using a sample from its private credit estimate portfolio of European leveraged loans, composed primarily of loans backing private equity buyouts. "Our research shows that 53% of companies in the sample are behind on their original EBITDA forecasts, while 47% are outperforming original forecasts," says S&P research analyst Taron Wade.

Moreover, the agency also examined how close companies in the sample were to their original forecast plans to deleverage. Here, the sample group was split evenly: 50% were on track or performing ahead of deleveraging plans, while the other 50% had more debt on their balance sheets than they had originally forecast.

"The exuberance of the leveraged finance markets in Europe over the past few years has meant that most transactions attracted an abundance of investors," adds Wade. "But that does not mean that all deals will perform well."

Hence, monitoring the performance of private equity transactions becomes paramount as credit conditions tighten and growth slows, because there is a heightened potential for defaults. In addition, the excess demand from investors for transactions in a frothy market has meant that investor protection through financial covenants has become weaker, so the early warning signs that a company might be getting into trouble are no longer immediately apparent.

"It is necessary to look at the variance of data to portray a clear picture of performance," explains Wade. "When the total sample is viewed, overall performance can look quite rosy." For example, the median EBITDA performance is only 5% below expectations, which is very close to target.

"But dig deeper and the variation in the sample is much more telling," continues Wade. "EBITDA underperformance or overperformance has a standard deviation of 22% and for leverage statistics, the variation is even greater." Median statistics showed that companies were slightly ahead of target for their deleveraging forecasts (minus 0.5% less debt), but the standard deviation was 46% – indicating that, although some companies are well ahead of their targets, others are lagging, which puts them at greater risk of covenant breach or default.

The agency looked at 36 names in its private credit estimates portfolio, which were split among four sectors: chemicals, industrial equipment, publishing and retail. It randomly selected credits in each sector, but ensured that the sample was representative by country, size and vintage to help reflect the distribution of credits in the European leveraged loan market.

Almost three-quarters of the transactions were virtually evenly split among France, Germany and the UK. The remaining deals were made up of transactions from Denmark, Hungary, Italy, the Netherlands and Spain.

Moody's rating transitions analysed
Moody's has released its sixth annual global structured finance rating transitions study. The agency reviews the 2007 and historical transition rates, both on an aggregate basis and within key asset classes, and provides comparisons to the corporate rating transition experience.

The key findings of the study include:

• The 12-month downgrade rate for the global structured finance market climbed to a historical high of 7.4% in 2007 from 1.2% in 2006, while the upgrade rate decreased from 3.6% to 2.2%. Overall, 8725 ratings from 2116 deals were downgraded and 1954 ratings from 732 deals were upgraded.

• The average number of notches lowered over the year per downgraded security also increased dramatically from 2.9 notches in 2006 to 5.8 notches in 2007. Meanwhile, the average magnitude of upgrades fell from 2.6 notches to 2.3 notches.

• Frequencies of transitions to Caa and below increased from the previous year and were higher than their historical averages for almost all rating categories.

• The large numbers of downgrades in 2007 were primarily driven by the poor performance of recent vintage US mortgage-backed securities backed by sub-prime and Alt-A loans and structured finance CDOs with exposures to these securities. The 12-month downgrade rate for US HEL (including sub-prime securities), US RMBS (including Alt-A securities) and US CDOs in 2007 rose to 18.1%, 4.7% and 8.4% respectively.

The number of structured finance upgrades in 2007 also greatly exceeded the number of downgrades for the Asia-Pacific region and Latin America. However, while the EMEA structured finance market avoided the large numbers of negative rating actions that occurred in the US, European CDOs and SIVs were also negatively impacted by the US housing market recession and general market volatility. As a result the EMEA downgrade rate also increased from 1.2% in 2006 to 2.7% in 2007.

The extreme rating volatility of the sub-prime and Alt-A RMBS sectors in 2007 had a direct and negative impact on US CDOs, particularly for SF CDOs. Following the large numbers of downgrades in the US HEL and RMBS sectors, downgrades among US CDOs totalled 1453 among 491 deals for 2007. US CDO upgrade activity was limited to 109 tranches from 48 deals, producing a downgrade-to-upgrade ratio of 13 to1.

Indeed, 95% of the US CDO downgrades in 2007 occurred among SF CDOs, mostly due to their exposure to poorly performing RMBS securities in the underlying collateral pools. Market value CDOs, which were hurt by stressful market conditions, were a distant second in downgrade activity.

SF CDOs were also the leaders in upgrade activity (39%), followed by high-yield CBOs (HY CBOs at 21%), high-yield CLOs (HY CLOs at 17%) and SME CLOs (at 12%). Most of the upgrades cited the ongoing delevering of the transaction as a primary factor behind the rating action and roughly two-thirds of the upgrades occurred among deals securitised between 1999 and 2001.

Over 90% of the CDO downgrades, both by count and volume, occurred among deals issued in 2006 and 2007, as they had the most significant exposure to the poorly performing 2006 and 2007 sub-prime and Alt-A vintages. Like US HEL and RMBS, Baa and single-A rated CDO securities were the most downgraded rating categories by count.

However, in contrast to the mortgage-backed sectors, CDO downgrade activity was more evenly distributed among ratings with significant downgrades occurring among securities originally rated Aaa and Aa. Because the size of a tranche in a deal generally increases with the seniority and rating of the tranche, downgrade volume by original rating followed this same pattern, with Aaa securities accounting for 57% of the 2007 downgrades by volume, declining to 16% for Aa, 13% for single-A and 11% for Baa.

EODs near 100
As of 13 February, S&P had received 98 notifications of EODs on US ABS CDOs since August 2007, estimated at around US$112bn outstanding.

The full list of affected deals includes 58 mezzanine ABS CDOs, 26 high grade ABS CDOs and 14 CDO-squared transactions. So far, three of these transactions have liquidated their collateral (Adams Square I, Carina CDO and TABS 2006-5), accounting for 3% of total volume or US$3bn.

Out of the 98 CDOs, 33 have sent S&P an acceleration notice and 17 have already sent a liquidation notice – a total of around US$56bn outstanding.

US credit markets surveyed
The Fitch Ratings/Fixed Income Forum Survey is designed to provide insight into the opinions of professional money managers on the state of the US credit markets. In carrying out this survey, the fourth in the series, a wide range of senior fixed income investment professionals (88 in total) were asked to comment on the outlook for the US economy, for specific industry and asset categories, and for corporate and investment strategies going forward.

Importantly, in this recent edition, completed at the beginning of 2008, Fitch introduced several new questions related to the ongoing dislocation in the credit markets. These focused primarily on the likely duration of the housing market downturn and related credit crisis.

Investor sentiment, not surprisingly, shows a dramatic reversal from June 2007. Concerns regarding shareholder-enhancing activities have greatly diminished, while worries over the state of the broader economy and credit quality have leapt to the forefront. Perhaps most significantly, the survey reveals that many senior investors expect the credit markets to be volatile through to the third quarter of 2008 or later.

Highlights of the survey include:

• Respondents were decidedly pessimistic on the state of the housing market, with a significant majority not expecting the market to stabilise until 2009 at the earliest. However, investors were somewhat more constructive on the credit markets in general, with the majority expecting some stabilisation later this year.

• Considered most critical to bringing stability back to the capital markets was "confidence in financial disclosure of mark-to-market (MTM) losses." "Home price stabilisation", "successful implementation of market-driven remedies", and "further Fed easing" were also considered to be at least "important" by a majority of respondents. Interestingly, the majority of investors surveyed believe that "government-driven remedies" could either be harmful or are not important.

• Not surprisingly, "weak overall economic activity" leapt to the top of the list of investor concerns with regard to various macro factors, with virtually all respondents (99%) believing the risk of recession in the US to be either "moderate" or "high".

• "Housing market disruptions", along with "failure of a major financial institution", "hedge fund collapse", and "geopolitical risk" were all significant concerns for the US credit markets, while anxiety over "shareholder-oriented activities", previously the most worrisome risk factor, fell dramatically.

• Fundamental credit conditions are expected to worsen across all asset classes; this is particularly the case for high yield and most structured finance asset classes. The number of respondents expecting the corporate high yield default rate to increase significantly rose significantly.

• In a sharp reversal from prior surveys, when it had consistently been ranked the least significant risk factor, investors stressed a decline in banks and other investors' willingness to lend as the greatest risk currently posed to the leveraged loan market.

• In keeping with expectations of a softening macroeconomic backdrop, fundamental credit conditions for cyclical sectors are expected to deteriorate significantly more than others, while investors also expect US firms to assume a much more defensive posture with regard to their use of cash.

• The percentage of respondents whose firms make at least "moderate" use of derivatives grew somewhat, with nearly 50% reporting either moderate or extensive use and a majority of respondents still expecting to increase their usage somewhat.

S&P affirms Primus Financial Products
S&P has affirmed its triple-A issuer credit rating on Primus Financial Products (PFP). The rating affirmation follows PFP's disclosure of the changes in the unrealised market value of its credit protection portfolio, which resulted from widening credit spreads (see SCI issue 74).

The reported fluctuations in the market value of PFP's credit swap portfolio didn't have a direct effect on the agency's view of PFP's issuer credit rating due to the "continuation" structure that allows the firm to hold these positions through maturity, rather than forcing it to liquidate them over a short time period. In addition, PFP does not post collateral in favour of any counterparties with regard to any swap positions that have a negative mark-to-market.

PFP's portfolio includes US$80m in (RMBS), or 0.33% of its overall portfolio. On 30 January S&P's rating downgrades on six RMBS bonds totalling US$45m triggered an option held by PFP's counterparties to physically settle the relevant credit default swaps by delivering the referenced bonds, at par, to PFP any time they are outstanding. As of 7 February, no counterparties have exercised this option and, therefore, no realised losses have occurred. PFP, however, reported a US$41m capital provision that reflects the current market valuations of those six RMBS bonds.

Other than its 0.33% exposure to RMBS, PFP does not have exposure to structured finance or ABS. Its single-name corporate credit exposure is approximately 80% of the total overall portfolio, 2.15% of which represents single-name monoline insurer credit exposure. PFP also has 1.29% monoline insurer exposure across its tranche credit default swap portfolio, which makes up 20% of the overall portfolio.

Based on the most recent reports S&P received from PFP, its portfolio is passing all the rating-related tests, including the capital adequacy test. Its portfolio also shows passing results in additional stress scenarios, including those where PFP's capital is reduced by the full notional amount of its US$80m RMBS exposure. This stress run showed, in our view, that PFP's portfolio could withstand the zero recovery on its RMBS portfolio with comfortable cushion in the capital.

S&P is correcting its internal data entry for PFP's issuer credit rating so that it will appear as an organisational level rating, rather than a rating on specific instruments. The agency will continue to monitor PFP's portfolio and provide updates as appropriate.

Volta Finance reports
Volta Finance has published its January monthly report, revealing that as of 31 January the company's gross asset value per share was €7.29, down €0.90 per share from 31 December 2007.

The report goes on to say that the company's expectations for cashflows of its leveraged loan total return swap (TRS) and five of its ABS residuals have changed in view of deteriorating market circumstances. As a result of these changes, Volta Finance expects to recognise losses in expected cashflows in an amount close to €49m in its semi-annual report for the period from 1 August 2007 to 31 January 2008.

These expected write-offs will reduce the distribution income shown for that period in its income statement to the end of January 2008. As of end-July 2007, the company had €263m total assets, as previously stated in the latest annual report.

The definitive impact will be determined following consultation with Volta Finance's advisors, and more detail will be provided in its semi-annual report and accounts to be published at the end of March. However, at this time, the company has announced that, in view of the difficult market circumstances and the expected write-offs, it does not expect to pay any dividend for the period from 1 August 2007 to 31 January 2008.

European/US SROC results in
After running its month-end SROC (synthetic rated overcollateralisation) figures, S&P has taken credit watch actions on 71 European synthetic CDO tranches. At the same time, the agency placed its ratings on 79 US synthetic CDO tranches on credit watch with negative implications and lowered its ratings on three.

Of the European deals, ratings on 39 tranches were placed on credit watch with negative implications, 11 tranches were placed on credit watch with positive implications and 21 tranches were removed from credit watch with negative implications and affirmed. Of the 39 tranches placed on credit watch negative, 11 reference US RMBS and US CDOs that are exposed to US RMBS which have experienced recent negative rating actions, while 28 have experienced corporate downgrades in their portfolios.

S&P also affirmed 34 US tranche ratings and removed them from watch negative.

The negative credit watch placements reflect negative rating migration in the respective portfolios and SROC ratios that had fallen below 100%. The downgrades reflect recent implied write-downs in the transactions' respective reference portfolios, which caused the rated subordinated notes to take a loss. The classes with affirmed ratings had SROCs at 100% at their current rating level.

Associations comment on incremental default risk
ISDA, the Institute of International Finance (IIF), the London Investment Banking Association (LIBA), and the International Banking Federation (Ibfed) have commented on the Basel Committee on Banking Supervision's consultative document entitled "Guidelines for Computing Capital for Incremental Default Risk- in the Trading Book". The joint association working group represents many of the firms invited and intending to participate, and others who are not participating in, the Basel trading book impact study.

The associations view this consultation as a final chance to improve guidelines that may shape the industry's trading book regulatory capital models for many years to come. They recognise and support the goals and objectives set out in "The Application of Basel II to Trading Activities and the Treatment of Double Default Effects" as to align regulatory capital requirements more closely to the underlying risks, and to promote a more forward looking approach to capital supervision.

Particularly relevant to these proposals is the intention to provide a more flexible framework that can better evolve with advances in markets and risk management practices. The associations feel it is crucial that the guidelines do not prioritise short-term regulatory objectives over and above promoting sound risk management practices.

The associations' key concern with the proposals is that they will likely result in a rigid framework that could constrain the development of industry practices precisely in an area characterised by rapid and constant evolution. It is important to bear in mind that there is presently no industry consensus on the correct way of modelling default risk in the trading book, even in principle.

As internal practices evolve and modelling techniques develop, the detail provided in these proposals will become less relevant and therefore more likely to diverge from industry practice over time. The major consequence of having this much detail in the proposed guidelines is an Incremental Default Risk Charge (IDRC) which will be unable to adapt to better understanding of the risks in the trading book over time. Without adequate consideration of the economic risks in firms' trading book portfolios, the resulting increase in capital cannot be entirely justified.

Related to this is the need to ensure robust dialogue between the industry and the regulatory community on the results of the impact study, in the same manner that the QIS exercises were conducted and analysed during the Basel II process. In the associations' view, the policy-making process currently underway needs to be informed by the results of the impact study and the active discussion of its implications between firms and supervisors.

CS

An application of CDS-implied ratings to synthetic CDOs

How Moody's CDS-implied ratings for corporate reference names, together with an analytic CDO ratings model (CDOROM), can be used to derive CDS-implied tranche ratings for CDOs is examined by David Hamilton and Eugenia Fingerman of Moody's credit strategy group

CDS have revolutionised credit investing and risk management. According to the Bank for International Settlements, over US$42trn in total notional single-name and multi-name CDS contracts were outstanding as of June 2007, an eightfold increase since 2004.

The enormous growth of the CDS market has been fuelled by manifold economic benefits. First and foremost, it is usually more efficient to trade corporate credit risk in the form of CDS compared to bonds.

This is particularly true for establishing short positions. CDS now allow investors to hedge existing exposures to default risk, as well as to speculate on expected changes in credit risk without taking an active position in the underlying cash bond or loan.

Trades in the CDS market also provide a new source of information about credit risk. CDS prices are the purest measure of the cost of default protection.

A large body of literature, produced by both Moody's and academics, has shown that CDS price changes are accurate predictors of future ratings changes and defaults. For example, previous Moody's credit strategy research shows that over a one-year time horizon, firms whose CDS-implied ratings were two notches lower than their Moody's ratings are more than 10 times as likely to be downgraded as upgraded. Equally, CDS-implied ratings have been shown to be more efficient at predicting defaults over a one-year time horizon than Moody's corporate ratings.

Moody's has used these insights to develop CDS-implied ratings as part of its Market Implied Ratings platform. Figure 1 shows the monthly time series of Moody's senior unsecured ratings and the CDS-implied ratings for GMAC and Delphi Corp.

Figure 1

In the case of GMAC, its CDS traded in line with Ba2-rated names in October 2002, while Moody's rated the company A2. Almost three years later Moody's cut GMAC's rating to Ba2.

On the right side of Figure 1, we see that the CDS market anticipated Delphi's bankruptcy by inferring lower ratings in advance of the event. By the time Moody's began to cut Delphi's ratings in January 2005, the CDS market was pricing Delphi six rating notches below its Moody's rating.

Also contributing to the strong growth of the CDS market has been the fact that credit default swaps are used to create more complex structured credit products, such as synthetic CDOs.

Credit ratings on corporate entities are a fundamental part of the CDO market. Rating agencies rely on such ratings to measure the default risks of assets in a CDO, while investors use the resulting tranche ratings to make investment decisions.

Moody's structured credit ratings are statements of ultimate (at-maturity) expected credit losses and do not address other risks that investors may care about, such as market risk, rating transition risk and liquidity. Unlike in the
single-name market, structured credit investors have heretofore had no alternatives to traditional credit ratings to measure the risks of CDO liabilities.

Indeed, structured credit investors would likely benefit even more than single-name credit investors if market price-based credit metrics were available. As we illustrated in Figure 1 using CDS-implied ratings, market price-based ratings possess an advantage over traditional credit ratings: over short time horizons they are better at detecting ratings changes and defaults.

Structured credit ratings tend to change less often than similarly-rated corporates, but when they do, changes tend to occur in larger notch increments and have more momentum. The consequences of ratings changes are also arguably greater for structured products. As they are less liquid, a tranche rating downgrade likely has a relatively larger impact on its investment performance.

Furthermore, a restructuring or wind-up might be triggered in response to a downgrade or default. Hence, the value of spotting trouble (or opportunity) before it manifests itself in actual ratings changes is arguably greater for structured credit investors.

In this article we demonstrate how Moody's CDS-implied ratings for corporate reference names, together with an analytic CDO ratings model (CDOROM), can be used to derive CDS-implied tranche level ratings for CDOs. This report takes the form of a case study.

We analyse a hypothetical static synthetic CDO based on the reference names included in the CDX.NA.IG.HVOL series 3 index. We calculate tranche ratings at monthly intervals between September 2004 and September 2007 using Moody's ratings and CDS-implied ratings for the reference names.

This allows us to analyse the differences between Moody's ratings-based tranche ratings and CDS-implied tranche ratings, and how they evolve over time. We find that many of the beneficial features of CDS-implied ratings (e.g. detecting transition risk and defaults) carry over to CDO tranche ratings in our case study. We also find that for our case study the benefits of early detection do not come at the cost of greater ratings volatility; in fact, CDS-implied tranche ratings for our case study are less volatile than the Moody's-based ratings more than half the time.

Methodology and data
We calculate tranche ratings for a static synthetic CDO of corporate assets using CDOROM, an Excel-based Monte Carlo simulation model used by Moody's analysts to rate synthetic CDOs. We chose to analyse a static synthetic CDO because such structures are generally much more transparent and simple than cash CDOs, and the data required to rate them is also readily available.

However, we would like to emphasise that the approach we describe here is more general and can be used for other structured deals based on corporate assets using the appropriate ratings model (e.g. implied ratings for cash CDOs of corporate assets could be estimated using CDOEdge). Specifically, we consider a hypothetical five-year static synthetic CDO whose assets consist of the reference names in the CDX.NA.IG.HVOL series 3 index.

We selected the CDX.NA.IG.HVOL series 3 for several reasons. First, because the index consists of reference names that are considered to be relatively more volatile than the broader CDX index, we expect that their CDS-implied ratings will be relatively more volatile than their Moody's ratings; how this affects the tranche rating is of great interest.

Second, the CDX indices are standardised and actively traded. We intend our research to be directly relevant to our clients, and we believe that this case study shows that CDS-implied ratings are a powerful new tool for CDO investors and participants trading in the CDX market in particular.

And third, we chose CDX.NA.IG.HVOL series 3 because it contained several significant credit events, including some notable fallen angel rating downgrades (GMAC and Ford Motor Credit), as well as a default (Delphi Corporation). We fully realise that in low-volatility credit environments and over a larger data sample that the results we find for our case study may be somewhat weaker. It is, nevertheless, a very good and probably representative test case for a stressed scenario, in which CDO investors are most likely to be exposed to the risk of credit losses due to downgrades and defaults.

For the CDOROM simulations we make the following assumptions:

� Total notional value of US$10m;
� Tranche detachment points: 3%, 7%, 10%, 15%, 30%;
� Five-year maturity;
� 3.79% discount rate (the Libor rate prevailing at the time the index was formed);
� 40% recovery rate in the event of default.

Given the above assumptions, the critical data we need for the CDROM model is the ratings on the reference names. The ratings data we use in this study is derived from Moody's Market Implied Ratings (MIR) platform.

Moody's MIR platform consists of five datasets: bond-implied ratings, CDS-implied ratings, loan CDS-implied ratings, equity-implied ratings and Moody's Default Predictor (MDP)-implied ratings. The data also includes Moody's senior unsecured ratings (or their equivalents). We compare CDOROM rating results using three sets of ratings for the CDO assets: the CDS-implied ratings; Moody's senior unsecured ratings; and Moody's ratings adjusted for watchlist status.

When rating a CDO, Moody's will typically adjust collateral ratings if they are on its watchlist for upgrade or downgrade. Ratings on review for upgrade are notched up one rating notch, while ratings on review for downgrade are notched down one rating notch. This is done in an effort to mitigate the impact of moral hazard on the part of CDO collateral managers.

CDO collateral managers often choose assets that trade cheaply for their ratings (in other words, have negative ratings gaps) in order to boost the investment performance of the deal. Of course, names trade cheaply because they possess higher credit risk and are subject to higher likelihood of downgrade and default.

In our analysis we focus on Moody's Metric (MM) rather than on ratings per se. MM is a mapping from Moody's discrete, ordinal ratings scale to a continuous numerical measure ranging from 1 (corresponding to Aaa) to 21 (corresponding to C).

Because CDO ratings are based on expected losses for a given maturity horizon, it is difficult to directly compare ratings across CDO tranches with different expected maturity dates, or even analyse the risk of the same CDO at two different points in time. MM is essentially a credit score that allows one to compare the risk of CDO tranches that have different expected maturity dates.

It should be clearly understood that the tranche MMs (or ratings) we analyse in this study are not actual Moody's MMs (or ratings). Moody's does not rate any CDX index tranches at the moment.

Moody's also does not change CDO ratings at regular time intervals, but only when it believes that a CDO note is likely to experience a (discounted ultimate) loss. However, this does not invalidate our results.

The MMs we discuss are the product of simulations using Moody's analytic model and actual Moody's unsecured ratings on the reference entities. Hence, they could be considered a type of 'shadow rating' in the sense that they were derived using Moody's methodologies but have not benefited from the full ratings committee process.

Similarly, we also slightly redefine what we mean by a ratings gap. A ratings gap is generally defined as the Moody's rating minus the market-implied rating. In this study, the ratings gap is defined as the Moody's rating-based tranche MM minus the CDS-implied based tranche MM.

Reference entity portfolio characteristics
Figure 2 shows the distribution of Moody's ratings and CDS-implied ratings for names in the reference pool over time. The average rating in each month is represented by the coloured squares, and the highest and lowest ratings are shown by the white bars and the pluses and minuses respectively.

Figure 2

The graphs show that average ratings for each of the two sets of data are actually quite close and stable over time. Based on the Moody's ratings, the reference name portfolio has an average rating of Baa2/Baa3.

Using CDS-implied ratings, average ratings for the reference name portfolio hover around Baa3/Ba1. The range and volatility of the two sets of ratings are quite different, however.

Not surprisingly, Moody's ratings are more tightly distributed around the average, and the range of ratings does not fluctuate much over time. The distributions of CDS-implied ratings for the reference pool, on the other hand, exhibit fatter tails at every point in time.

Rating actions (upgrades and downgrades) also differ significantly between the two data sets, as shown in Figure 3. For the Moody's ratings, downgrades are much more common than ratings upgrades. For the CDS-implied ratings, downgrades and upgrades are more or less equally balanced over the study time period.

Figure 3

Neither of these findings will come as revelations to those familiar with market price-based credit measures; Moody's ratings are through-the-cycle opinions, while CDS-implied ratings are point-in-time estimates of credit risk. The important take-away from this section is that, although the portfolio of reference names has about the same average ratings whether one uses Moody's or CDS-implied ratings, the dynamics of the ratings are different – and these differences will help drive divergences between the Moody's ratings-based tranche ratings and the CDS-implied ratings-based tranche ratings.

Figure 4 displays some of the industry sector characteristics of the reference entity portfolio. The left panel shows the broad industry sector distribution of the 30 reference names.

Figure 4

The majority of names in the portfolio are in just two sectors: the consumer products and retail category (37%); and telecom, media and technology sector (TMT, 30%). While the automotive sector represents just 10% of the firms in the portfolio, its credit trends have a meaningful impact on the derived tranche ratings, as we will see later.

To gauge the impact initially, we calculate the average ratings gaps for the firms in each industry sector and display them in the right-hand side panel of Figure 4. The automotive sector stands out as having relatively large (as large as -8 at one point) and persistently negative average ratings gaps.

Simulation results
The results of our simulations show that:

� CDS-implied ratings-based tranche ratings for the CDX.NA.IG.HVOL.3 portfolio are always lower than Moody's ratings-based tranche ratings during the time period of our study. Moreover, while CDS-implied tranche ratings fluctuate in response to the perceived changes in credit quality of the reference portfolio, they remain more or less anchored near their initial levels.
� Initial ratings gaps are large, ranging from about -2 to -5 rating notches depending on the level of subordination. Figure 5 summarises the time series of ratings gaps for each tranche. Over time, ratings gaps are closed by the Moody's tranche rating converging toward the CDS-implied tranche rating. By the middle of the study period, the Moody's and CDS-implied tranche ratings are generally within 1.5 notches of each other, and remain close through September 2007.
� The relatively large negative initial ratings gaps for each tranche suggest that CDS-implied ratings appear to have anticipated the impact on the loss distribution of the significant credit events in the portfolio. This is particularly true for the mezzanine tranches. In our case study, the Moody's ratings actions on the reference names that experienced negative credit events lagged the CDS market's reaction, which fed through to the tranche ratings.

Figure 5

In our case study there was only one default (Delphi Corp); given our assumed severity of loss (60%), only the equity tranche would have experienced a credit loss. The differences in the ratings of the equity tranches are not likely to be very economically significant.

The tranche was initially rated Caa2/Caa3 by Moody's and Ca by the CDS market. These ratings levels are all consistent with a near-default situation.

Although losses due to default would have been small in our case study, the tranche ratings downgrades would likely have imposed market losses on investors in all parts of the CDO capital structure. These downgrades would have been the result of the large number of downgrades of the collateral.

The difference is particularly important for the 7-10% tranche, which would have been rated investment grade using Moody's ratings but speculative grade using CDS-implied ratings. The difference is also significant for the senior tranche. Although the initial ratings gap would have only been about two ratings notches, the difference between a Aaa rating and a Aa2 is meaningful.

In Figure 6 we calculate relative tranche MM volatilities, defined as the ratio of standard deviation of the CDS-implied tranche MM to the standard deviation of the Moody's-based tranche MM. A ratio greater than one indicates that CDS-implied MM volatility is greater than Moody's-based tranche MM volatility.

Figure 6

At the single-name level Moody's has shown that there is a trade-off between accuracy (in terms of default prediction) and stability: in order to achieve higher accuracy, ratings must change frequently. Somewhat surprisingly, Figure 6 shows that CDS-implied tranche MM volatility is generally lower than the Moody's-based tranche MM volatility.

Despite the fact that the underlying Moody's corporate ratings generally exhibit much more stability than CDS-implied ratings, the CDS-implied tranche ratings in our case study are relatively more stable than those based on Moody's ratings. Apparently the CDS-implied ratings had already adjusted to a level reflecting the market's relatively dimmer view on the credit quality of some of the reference names (e.g. Delphi, Ford Motor Credit, GMAC) at the time the portfolio was created. The Moody's ratings on these reference names subsequently had to play catch-up through aggressive ratings downgrades, and therefore higher portfolio volatility.

Conclusion
Recent volatility in structured credit markets has drawn attention to the need for market-based measures of risk for structured credit products. Implied ratings for CDOs may be derived in at least three ways: directly through trading prices; based on mark-to-model valuations; and using market-implied ratings on the assets in conjunction with an analytic ratings model. Trading prices on even the most liquid structured securities would be the first best approach, but it is also the most challenging to achieve.

The available data is often specific to certain market segments, have short histories and are too thin to directly derive market-implied ratings. Implied ratings based on mark-to-model valuations are also somewhat unsatisfactory as they may not necessarily accurately represent the market's view, or may be self-referential to the extent that ratings are often inputs into the valuation models.

We believe the third approach, which we have outlined in this article, provides the best method currently available for deriving implied ratings for CDOs of corporate assets, for the following reasons:

� The analytical framework is easy and fast to implement. One just needs information on a CDO's capital structure (which the user provides) and Moody's and market-implied ratings data (CDS-implied data is already available as a feed directly into CDOROM).
� In addition to using CDS-implied ratings, one may also choose to use bond-implied, LCDS-implied or equity-implied ratings for the collateral, depending on which ratings suit the analysis of the deal best.
� Many of Moody's structured finance ratings models (such as CDOROM) and methodologies are public, transparent and industry standard.
� The approach we described in this paper to derive implied tranche ratings can be used for standardised as well as bespoke structures, static as well as managed deals.
� Market-implied tranche ratings can be compared like-for-like with Moody's-based tranche ratings.

Our case study suggests that CDS-implied tranche ratings may provide the benefits of early default and rating downgrade detection, but not necessarily at the cost of greater tranche ratings volatility. We are, however, careful to point out that these results are indicative and we will need to verify whether they hold up in a large sample. Nevertheless, we believe the findings presented in this study show that CDS-implied tranche ratings can provide a valuable additional analytical input for structured credit investors.

© 2008 Moody's Analytics. All rights reserved. This Research Note was first published by Moody's Analytics on 1 February 2008.

Trading ideas: investment allows recovery

John Hunt, senior research analyst at Credit Derivatives Research, looks at a default-neutral basis trade on Idearc Inc.

Idearc's bonds are trading cheap to CDS-implied value, and we seek to take advantage of that through a default-neutral basis trade. Because the market is pricing in a relatively high probability that Idearc will default, our conclusion that the bond is cheap depends on the recovery rate assumption, which we examine in greater detail than usual.

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

Trade specifics

Bond cheapness
As Exhibit 1 shows, whether the Idearc bond is trading cheap to CDS-implied value depends on the recovery rate assumption. Using the conventional 40% recovery rate assumption, the bond is trading over US$5 cheap.

Exhibit 1

As recovery rate goes down, the bond's fair price and cheapness go down. At a recovery rate of 0-10%, the bond is at fair value.

The market's implied recovery rate is far less than the 40% we normally assume for senior unsecured debt, and Idearc's capital structure suggests that a lower-than-average recovery rate is probably justified. The company has over US$9bn in debt, including US$6.5bn in bank debt, and only US$1.7bn in assets.

But liquidation value probably isn't the right way to look at it: Idearc's fundamental business, though both cyclical and declining, is quite well-established (it's the former directory arm of phone giant Verizon) and it's been generating a solid and reasonably stable earnings stream (EBITDA has ranged from US$1.3bn to US$1.6bn over the past four years). Reorganisation rather than liquidation seems the most likely scenario in default. And in reorganisation, it seems to us that 15% recovery – which is less than half of average recovery on senior debt for any year on records – is low.

For comparison, take a look at Movie Gallery – another overleveraged player in a declining, cyclical industry – which declared bankruptcy in October of last year. Even though 75% of the company's debt was in the form of bank loans, as opposed to 70% for Idearc, and even though the bank loans had clear priority over the bonds, Movie Gallery bonds traded around 30 immediately after bankruptcy – more than double the implied level here. Even assuming that recovery rates will be lower for the next few years than they have been, the fact that the implied recovery rate for Idearc is one-third that for Movie Gallery implies that we have a pretty good margin of safety.

Exhibit 2 shows the z-spread for the bond, the premium for the on-the-run five-year CDS and the difference between the two over the past year. The difference has widened out recently, suggesting that this is a good time to enter a negative basis trade.

Exhibit 2

Exhibit 3 illustrates the projected performance of the trade as a function of bond-CDS convergence over a six-month time horizon under different credit scenarios.

Exhibit 3

Risk
Please refer to the 'Risk' section of the trade summary for a discussion of trade risks.

Exhibit 4 presents a table of the bond's sensitivities to interest rates and credit spreads both for parallel shifts and for various tenors along the curve, along with a calculation of the bond's theta.

Liquidity
Please refer to the 'Liquidity' section of the trade summary for a discussion of bond and CDS liquidity.

Fundamentals
This trade is not motivated by a directional view on Idearc's credit. The consensus of reports we've reviewed seems to be that Idearc has a strong franchise in a declining industry.

With advertising as its base, the company is likely to suffer in a recession. The company is highly leveraged and persists in significant dividends, despite a bond rating that is deep in high-yield.

To the extent we have a view, it appears that Idearc's credit is declining. If it further declines in the short term, we'd expect its CDS to start trading up front, which should help the position.

Summary and trade recommendation
Idearc's single large bond issue appears to be trading cheap to CDS-implied fair value in the wake of S&P's downward revision of its rating outlook earlier this week. Given the high probability of default priced into the market, fair value is rather sensitive to default recovery assumptions, so we take a closer look at likely recovery in default.

The market is pricing in a recovery rate of 0-10% on Idearc's bond. Although some number lower than the 40% we'd usually use seems justified given Idearc's highly leveraged and loan-heavy capital structure, anything south of 20% or so seems too low.

Recovery rates are lower in default-heavy times, but 23% is the lowest average annual recovery in the past 20 years. Even more telling, the 0-10% that the market is pricing in is way, way under the 30% at which Movie Gallery bonds traded at immediately after the company filed its prepackaged bankruptcy in October.

Movie Gallery – like Idearc an overleveraged player in a declining, cyclical industry – had 75% of its debt in the form of bank loans, as opposed to 70% for Idearc – and those loans had clear priority over the bonds. Although there are certainly differences between the situations, we feel comfortable that the sub-10% recovery rate the market is pricing in for Idearc is too low.

This position is not motivated by a bearish or bullish view on Idearc's credit, but in its default-neutral weighting it is somewhat long Idearc credit over a six-month time horizon on a simple spread basis. However, if Idearc's credit does deteriorate, we'd expect to see CDS cross over into upfront trading, which could allow a quick, profitable exit.

Buy US$7.3m notional Idearc Inc. five-year CDS protection at 965bp.

Buy US$10m face value (US$7.35m cost) Idearc Inc. 8s of 15 November 2016 at 73.50 (priced to yield 13.19%, or five-year T+1045bp; z-spread of 903bp) to gain 195bp of carry.

Sell US$8.2m notional Treasury 2.875s of 31 January 2013 at 100.46 (2.77% yield, US$8.24m proceeds) to hedge bond interest rate exposure.

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

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

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