Contents

Monoline momentum

Relief in the short term, but concerns remain

The market breathed a collective sigh of relief after S&P affirmed MBIA and Ambac's ratings, and Moody's affirmed MBIA's, signalling the prospect of some much-needed stability. However, sources were quick to warn that continued deterioration in the housing sector may force the rating agencies to revisit their actions.

"Although it appears that MBIA and Ambac have dodged the bullet – and it is certainly a positive step for the market in the short term – the broader monoline sector remains on negative watch with the rating agencies. Continued deterioration in house prices or CDO performance, for example, could lead to these decisions being reviewed along with further monoline downgrades," explains one trader.

S&P took rating action on five monolines, crucially affirming MBIA and Ambac's triple-A ratings, but downgrading those of XLCA and FGIC. The agency also affirmed CIFG's triple-A ratings. All ratings remain on negative watch, apart from MBIA and CIFG's, which have been assigned a negative outlook.

The removal from credit watch and assignment of negative outlooks on MBIA reflects the monoline's success in accessing US$2.6bn of additional claims-paying resources, which is a strong statement of management's ability to address the concerns relating to the capital adequacy of the company, S&P says. The affirmation of Ambac's triple-A rating, meanwhile, reflects the agency's assessment of the scope of Ambac's capital-raising plans and the monoline's ability to implement them. The rating remains on watch negative to reflect uncertainty surrounding the risk profile and capitalisation plans for the new corporate structure being contemplated by the holding company.

The affirmation of CIFG's rating reflects the contribution of US$1.5bn in capital resources by Banque Federale des Banques Populaires (BFBP) and Caisse Nationale des Caisses d'Epargne (CNCE) to support the monoline's claims-paying resources. CIFG's outlook was changed to negative from stable in June 2007 due to concerns about the effectiveness and processes of the company's board, appropriate succession planning and the degree of long-term support to be provided by its parent Natixis. (CIFG remains on review for possible downgrade by Moody's.)

The downgrade of XLCA from triple-A to single-A minus reflects S&P's assessment that the company's evolving capital plan has meaningful execution and timing risk, while the lowering of FGIC's rating from double-A to single-A reflects its assessment of potential losses which is higher than previous estimates, the agency says.

Moody's also confirmed MBIA's triple-A rating, reflecting the guarantor's ongoing efforts to strengthen its capital position and the changes being implemented to reduce the volatility associated with its insured portfolio. The rating outlook is negative due to remaining uncertainties as the company finalises its capital plan and implements its strategy (the guarantor has stated it expects a Q1 mark-to-market loss).

Based on the risks in MBIA's portfolio estimated stress-case losses would be in the range of US$13.7bn, compared to Moody's estimate of MBIA's claims paying resources of approximately US$16.1bn – resulting in a total capital ratio significantly in excess of the minimum triple-A level, but short of the triple-A target level by about US$1.7bn. The monoline is considering a number of initiatives that should enable it to meet the triple-A target threshold over the next six to twelve months, including dividend elimination and a six-month suspension of new structured finance underwriting.

Moody's current ratings for MBIA do not reflect the impact of its intention to pursue the public sector and structured finance businesses through distinct legal entities. The agency believes that the structured finance guarantor would be more challenged than its public finance affiliate to maintain a triple-A rating, due to the relatively greater complexity of risks and higher risk concentrations evident in that sector of the market.

The market is now waiting for Fitch's decision on MBIA, and for all agencies to conclude reviews of Ambac – which is unlikely until its capital plan is announced and implemented. It is expected to comprise a backstopped US$2.5bn equity issue and a US$500m surplus note issued by the municipal side of the business. Sources indicate that the banking consortium involved now includes private equity and banks not exposed to the insurer, implying that a reasonable investment case can be made by those without a vested interest in propping it up.

However, structured finance analysts at RBS caution that S&P appears to have been the least negative agency, so it may be harder for the monolines to convince Moody's and Fitch of their triple-A status. "To the extent the [Ambac] plan is seen as credible and deliverable by the agencies, we would expect them to hold fire on downgrades. An upgrade from Fitch may be too much to ask for in the short-term, however. The agency has made comments along the lines of triple-A status not being appropriate for a monoline insurer incurring significant claims, no matter what its capital position," they conclude.

CS

CFoFO for Natixis

Hedge fund pool-backed deal begins marketing

Natixis is marketing a small but unusual collateralised fund obligation. The €46.7m Syracuse Funding EUR transaction is backed by shares in a diversified pool of funds of hedge funds.

Provisionally rated by Moody's, capital structure consists of €19.1m Aaa rated Class A notes, €3m Aa2 rated Class Bs, €2.1m A1 rated Class Cs, €3.4m Baa1 rated Class Ds and €8.5m unrated Class P notes. Above the rated notes – all with a scheduled maturity in February 2018 – is a €10.6m Aaa rated credit facility provided by Natixis.

The transaction will be managed by Hypercube Portfolio Management. Its role is to adjust the leverage of the deal – in order to maximise the investment return to the issuer – by determining the number of Syracuse cell units (participating shares) to be held by the issuer, as well as the amount drawn on the credit facility, in accordance with the management guidelines (including a series of market-value tests).

The notes will be collateralised by Syracuse cell units such that the amount of units purchased will be approximately equal to the amount of notes issued after deduction of any costs payable on the issue date. Other Syracuse cell units may be purchased after the closing date with the proceeds of further issuances.

The Syracuse cell fund is exposed to a global pool of hedge funds of different strategies and managers through investment in nine funds of hedge funds – Arden Alternative Advisors (accounting for 10% of the portfolio), Blue Elite Fund (5%), GEMS Recovery Fund (10%), KGH Fund (10%), Liongate Multi-strategy (15%), Nemrod Diversified Holdings (10%), Permal FX, Financials & Futures (15%), SAIL Pacific Explorer (5%) and one anonymous fund (15%). The most concentrated strategy allocations are in long/short hedged (accounting for 15.7% of the portfolio), macro (15.2%), fund of funds (12%) and equity market neutral (11.1%).

Moody's quantitative rating analysis was supplemented by an assessment of the qualitative nature of the underlying funds of funds managers, including the staff and processes in place at Natixis and the collateral manager, due diligence material for each of Syracuse's proposed fund of hedge funds investments and on-site reviews of two funds of funds. The CFO will be required to adhere to investment guidelines ensuring that the final portfolio is well diversified across fund managers, strategies and liquidity profiles.

Such constraints are not enforceable at the level of the underlying hedge funds of funds but at the level of the issuer. An uncured breach of these guidelines could trigger the liquidation of the portfolio and the redemption of the notes.

Interest and principal payments on the notes will be made through the redemption of Syracuse cell units and, in certain circumstances, drawings under the credit facility agreement. If the market-value of the cell units drops below a certain level and can't be cured within a given timeframe, the overcollateralisation tests may be hit.

These LTV ratios, calculated as the ratio between the current principal amount of notes and the current market value of cell units, are intended to anticipate the sale of units in a context where the performance appears to be negative. Consequently, an amount of shares calculated to be sufficient to cover the shortfall would be redeemed and, after the receipt of these proceeds, the notes will be redeemed in sequential order.

However, Moody's analysts note that investors are exposed to the effective redemption price of the Syracuse cell units. The cell fund is subject to certain liquidity constraints which may lead to a relatively long waiting period between the date of sale and the date on which the liquidation proceeds are effectively received.

CS

Correlation quandary

Extracting value in a range-bound environment

Weakening fundamentals are expected to maintain default correlation at its current highs until the risk of recession/defaults decreases. A new study suggests, perhaps counter intuitively, that some long gamma trades can provide value in such a range-bound environment.

Although the index tranche market has been driven ever-upward by fundamental concerns of late, it – as always – remains highly susceptible to technical drivers. On the back of high default expectations investors are currently attempting to hedge jump-to-default risk of long equity positions via flattening curve trades. But should actual investment grade defaults materialise, investors would be driven a step further and the market could see large scale unwinding of these long equity gamma trades – which would invariably push correlation lower.

Nevertheless, there is a limit to how much correlation can drop as a result of materialising defaults, according to Dresdner Kleinwort structured credit strategists Domenico Picone and Priya Shah in a study published last week. "Without a doubt, unwinding of long gamma trades will have an impact, but we don't expect investors to start implementing new short equity positions in a rising default scenario. Not only will short risk positions be expensive, but the continued volatility associated in a recession/default scenario will offset the short correlation gains, with continuous hedging required to mitigate the negative gamma effect," they say.

Additionally, defaults and resulting downgrades will result in many CSOs being unwound and short super-senior positions being increased in order to maintain hedges. While this scenario is already priced in to an extent, actual defaults will still have a significant effect, leading to upward pressure on correlation.

Overall, the Dresdner Kleinwort strategists therefore do not expect correlation to decrease significantly in the short term but to remain range-bound and close to current levels. Correlation will only start to decrease significantly once fundamentals also move in the same direction; in other words, spreads begin to tighten and default risk decreases.

To create value in a range-bound correlation environment in the short term, therefore, the study recommends a long gamma trade based on a 3-6%/3-7% tranche at seven-year or even five-year maturities. Like the 10-year junior mezzanine tranche, the widening in spreads over the last few months and resulting higher expected losses now mean that the seven-year 3-6%/3-7% and increasingly the five-year are now more equity-like (i.e. long in correlation).

In the current high spread environment any strategy based on a long/short position on a junior mezzanine tranche should take into consideration the dual behaviour of the tranche. As expected losses increase, there is a gradual shift from being long correlation to being short correlation.

The transition between the two regimes does not depend on a single cut-off level of expected losses. One method of identifying this shift is to look at the expected losses at index level relative to the detachment point of the tranche.

Index losses greater than the detachment point automatically indicate that the tranche is long correlation. However, when expected losses are within the tranche width but close to detachment levels, it is necessary to consider how the tranche delta changes over time compared to the delta of the equity tranche.

Although the equity tranche is initially the most sensitive to changes in spreads, as expected losses increase, its sensitivity to further losses begins to decrease (losses after a certain point are already priced in because of the detachment cap). Conversely, for the senior tranches delta increases with spread widening as there is now an increased probability of losses exceeding their attachment points.

For the mezzanine tranches the behaviour of the delta is more complex. Due to larger losses at the longer maturity, the CDX 10-year junior mezzanine tranche has always been more sensitive to spreads then the equity tranche. This same effect is now occurring on the CDX seven-year and iTraxx 10-year, and increasingly more on the five-year 3-6%/3-7% tranches, indicating the shift to long correlation.

As correlation is expected to remain range-bound but volatility elevated, the study suggests a long correlation trade with a long junior mezzanine tranche to generate a decent positive carry while providing a positive convexity effect. If defaults materialise there could be a negative mark-to-market impact, but this can be hedged more cheaply with first-to-default baskets or lower leveraged index curve trades.

CS

Reframing the issue

Whether the market can rethink its approach to the complexity of credit derivatives is discussed by Brad Bailey, director in business development at Knight Capital Group

Since the sub-prime summer of 2007, the credit market has posed a number of challenges. The impact has been powerful and the ramifications are very much being felt. The street is littered with the heads of the fallen, from junior analysts to bulge-bracket ceos.

It is often said that, while success has many parents, failure is an orphan – which is not the case when it comes to dissecting the causes of the credit crisis. There are myriad explanations: all the readers of SCI will have their own theories.

The pain has been real for investors. But, from the pain, can some good come of it?

Despite the valiant efforts of many market participants, despite regulatory pressure in the past to clean up operational challenges in various OTC markets, there still has not been enough action to change certain practices in the industry. An entire industry has been born on top of products that have grown beyond their ability to function with the level of demands on them.

As creative as they are, many solutions offered to the OTC derivative world are solving just part of the problem. Perhaps the fundamental issue has to be restated.

The success, on-going growth and adoption of credit derivatives result from the fact that they solve a very big problem. Just as their predecessors offered a means of mitigating such risks as interest rate or exchange rate risk, they have offered an effective means of mitigating credit risk.

They have grown bigger and faster than most could imagine. It makes perfect sense, as mitigating credit risk is hugely important.

It is, hence, logical that the credit derivative is considered to be one of the most important financial innovations of recent times. But what if the solution becomes the problem?

The credit derivative market has evolved in a piecemeal fashion. Challenges arise and solutions are offered reactively, reflecting the best possibility for a given time. Dedicated professionals have come together time and again, despite high levels of competition with one another, to solve each new problem: definitions, events, settlements, lock-ins and so on.

After 15 years of this iterative process, we have wonderful parts but a whole that does not add up. An optimist thinks we live in the best of all possible worlds, a pessimist knows it. The credit derivative as a tool for mitigation of risk and for creating innovative products has been a huge success; the credit derivative as a product gets a less than glowing review.

In other words, perhaps we have not been framing the problem correctly to date. We need what a credit derivative can do, but the vessel to affect that is so imperfect that it has created numerous problems.

Ultimately, the mid-to-long term impact of the credit market dislocation is not clear. What is clear, however, is that the ability to offer credit risk mitigation is a huge benefit to many.

There is nothing like a market meltdown to help people rethink their approach to the complexity of this market. From a transparency, valuation, accounting, trading, settlement and operational perspective, there is a lot of work to be done.

Attend CORE '08 to hear from senior representatives of leading buy-side and sell-side institutions as they discuss operational challenges, procedures and solutions in the credit derivatives market. For further details about the conference and the full agenda, please click here.

Manager hires CDO head

The latest company and people moves

Manager hires CDO head
Michael Herzig, formerly head of CDO distribution in the US for Deutsche Bank, is understood to be joining McDonnell Investment Management as a partner in its marketing and client services group. Officials at Herzig's expected and previous employer declined to comment.

While at Deutsche, Herzig reported to Fritz Thomas, global head of CDO distribution, and it is believed that Deutsche's US distribution team will now do so directly. Michael Lamont and John Pipilis continue to be global co-heads of CDO structuring, based in New York and London respectively.

Deutsche appoints new heads...
Deutsche Bank has appointed five new members to its global markets executive committee. Colin Fan and Boaz Weinstein take on roles as co-heads of global credit trading, reporting to Rajeev Misra, global head of credit and commodities.

Deutsche says the appointments will allow the bank to manage its credit business in more volatile markets while continuing to explore opportunities in structured credit. Weinstein was previously head of global credit trading in North America and Europe, while Fan was most recently head of equities in Asia. He previously served as Deutsche's global head of convertibles trading and co-head of structured credit trading, and from 2001-2004 was head of emerging markets credit derivatives globally.

Meanwhile, Bill Broeksmit joins the bank in the newly-created position of head of portfolio risk optimisation, a role in which he will take responsibility for monitoring and managing global markets' risk exposure across business lines and asset classes. Broeksmit joins Deutsche having been an independent consultant on risk management for financial services firms since 2001.

In addition, Rich Herman, most recently European head of debt sales, has been appointed global head of the institutional client group with responsibility for coverage of the bank's investing clients across asset classes. Head of institutional client group in the Americas Fred Brettschneider is now also head of global markets in the Americas.

In addition to these new appointments, Deutsche Bank says it will be integrating its leading emerging markets debt business into its respective global markets product lines – global credit, global finance & foreign exchange and global rates.

...and promotes in Japan
Deutsche Securities Inc (DSI) has made Aaron MacDougall head of global credit trading. He joined Deutsche Bank Group in June 2000 as a senior trader in the global credit trading business and, prior to this appointment, was the head trader across DSI's flow, structured and exotic corporate credit trading and convertible bond trading businesses.

MacDougall replaces David Shrenzel, who becomes head of global banking, Japan. He assumes the post from David Hatt, president & ceo of DSI, who has held the post on an interim basis. Shrenzel also remains a co-head of the global capital markets division at DSI with Yuji Nomoto.

Coo leaves
Hillmark Capital Management's coo Jack Chen has left the firm. His future destination is not yet known.

HSH Nordbank sues UBS
HSH Nordbank says it has decided to start legal proceedings against UBS to recover losses incurred on the US$500m North Street 2002-4 CDO. UBS arranged the deal and manages the portfolio of assets held by North Street 2002-4 on a discretionary basis. The investments were sold by UBS in 2002 to Landesbank Schleswig-Holstein, which subsequently merged with Hamburgische Landesbank to become HSH Nordbank.

HSH Nordbank says it expects to file its claim against UBS in the State of New York by the end of February. It will argue that UBS's management of the portfolio has been in breach of its contractual obligations and fiduciary duties, and that substitutions were made solely for the benefit of UBS.

Bernhard Blohm of HSH Nordbank comments: "Our investment in the North Street programme was to be conservatively managed by UBS according to prudent investment objectives. Our claims against UBS will show that the manner in which the investments were sold to HSH Nordbank and UBS's subsequent management of the assets were clearly contrary to our interests."

He continues: "We came to the realisation that the world's largest asset manager, UBS, appears to have condoned actions which benefited only itself, at the expense of its clients. After repeated attempts to discuss our concerns with senior management at UBS, we find that, with regret, we have no alternative but to commence legal proceedings against UBS. HSH Nordbank is committed to the prudent management of its capital and to the recovery of its losses which we regard as the responsibility of UBS."

Monoline class action brought
Coughlin Stoia Geller Rudman & Robbins has announced that a class action has been commenced on behalf of an institutional investor in the US District Court for the Southern District of New York regarding the purchase of MBIA common stock during the period between 26 October 2006 and 9 January 2008 (the class period).

The complaint alleges that during the class period, defendants issued materially false and misleading statements regarding the company's business and financial results related to its insurance coverage on CDO contracts. As a result of defendants' false statements, MBIA stock traded at artificially inflated prices during the class period.

MP

Action taken on 23 SIVs ...

A round up of this week's structured credit news

Action taken on 23 SIVs ...
S&P has assigned one new senior SIV rating, lowered four senior and 10 subordinated SIV ratings, placed one on and removed another senior rating from watch negative, and affirmed 15 senior ratings. The rating actions reflect its ongoing review of the restructuring plans offered by those SIVs that have not entered enforcement mode.

Many banks have stated that they will support the SIVs that they sponsor; however, the method of support varies according to sponsor. S&P says it is now providing its view of the status of each SIV's restructuring to address the uncertainty resulting from Whistlejacket Capital becoming the first bank-sponsored SIV to default on its outstanding senior obligations.

The ratings on Whistlejacket, which is sponsored by Standard Chartered
Bank, were lowered to single-D on 22 February to reflect the fact that the latest payment date – after all grace periods were exhausted – passed with the receiver failing to authorise payment. Standard Chartered's efforts to restructure its SIV were derailed as a result of the vehicle failing the net asset value (NAV) test and entering enforcement mode on 11 February.

As a result, the investment manager declared an insolvency event and all payments were suspended. Standard Chartered had initially stated that it would still support Whistlejacket, even if the vehicle entered enforcement mode, and that it was working with the receiver to do so. On 20 February, however, the bank issued a statement saying that it would no longer support the vehicle.

Meanwhile, the issuer credit rating (ICR) and the ratings on the senior MTNs of Links Finance and Parkland Finance, which are sponsored by Bank of Montreal, were lowered to double-A minus to reflect the bank's rating given the proposed addition of formal liquidity support that the bank will provide. For Bank of Montreal's sponsored SIVs, the bank has pledged 100% liquidity support upon execution of legal documentation.

The SIV's ratings, which remain higher than the bank's long-term ratings, reflect S&P's view of the strength of Links' and Parkland's asset portfolios. Each of these portfolios is among those that hold low percentages of assets that have experienced the greatest magnitude of price volatility in recent months, including CDOs and non-prime US RMBS.

Links holds approximately 13.01% of its portfolio in CDOs, excluding CLOs, and non-prime US RMBS. Parkland holds approximately 3.91% of its portfolio in those categories. In comparison, in other SIVs, the lowest exposure to those categories is approximately 3.48% and the highest concentration is approximately 76.63%.

It is important to note that, while the facility moves through the stages of legal execution, the vehicle itself does not have the market-value based triggers that would force the vehicle into enforcement before completion of the agreement, such as the 50% erosion on the NAV of capital.

S&P's ratings on Beta Finance, Centauri, Dorada, Five Finance, Sedna Finance, Vetra Finance and Zela Finance – all of which are sponsored by Citibank International – were affirmed to reflect its view of the addition of a mezzanine capital facility and the written confirmation of commitments to provide the vehicles with additional liquidity support (see last week's issue). The new mezzanine capital facility approximately doubles the capital supporting each of the SIVs' senior outstanding debt.

The sizing of the mezzanine capital facility reflects the updates to assumptions regarding the market price volatility of the assets held by the vehicles, and focuses on the vintage of the ABS assets and remaining maturities of the assets in the portfolios. The price volatility assumptions, which included stress scenarios in which the volatility observed in the past nine months repeated itself, as well as scenarios where the price drops of assets in sectors most acutely affected in recent months – CDOs and US non-prime RMBS – were stressed significantly beyond the volatility observed in the past nine months.

The ratings on the capital notes of Five and Zela and the mezzanine notes of Sedna were lowered to triple-C minus as a result of the addition of this mezzanine capital facility, which effectively subordinates the existing capital noteholders, and the continued price erosion in the asset portfolio. The new mezzanine capital facility does not apply to Vetra. The ratings on Vetra were affirmed in light of what we consider to be the vehicle's low leverage.

The ratings on Cullinan Finance (Cullinan), which is sponsored by HSBC Holdings, were affirmed to reflect the agency's view of the bank's restructuring effort. Two newly established vehicles, Barion Funding and Mazarin Funding, launched on 18 February (see last week's issue) – each benefiting from liquidity support through either 100% liquidity facilities or supporting repurchase agreements with the bank. The subordinated ratings on Cullinan were lowered to reflect S&P's view of the decreased likelihood that investors will be repaid in full, given the continued erosion in the asset prices.

The ratings on Asscher Finance, also sponsored by HSBC, were lowered to reflect the possibility that the vehicle – which is still in the process of a restructuring that has not yet been completed – may face challenges in that effort. The ratings were also lowered due to the fact that S&P believes the vehicle has a low NAV relative to the other SIVs that have not entered enforcement.

Asscher does not have the same NAV triggers as other SIVs and, therefore, has not entered enforcement mode. The subordinated ratings remain on watch negative, where they were placed on 28 January.

Regarding WestLB's SIVs, the senior ratings on Harrier Finance Funding and Kestrel Funding remain on watch negative, where they were placed on 7 December and 10 September respectively. The senior ratings reflect the potential downgrade associated with the maturity of the last non-affiliate-held senior issuance expected in June 2008.

The senior ratings for each vehicle reflect in-place support agreements from WestLB, in addition to cash collateralisation of some but not all of each SIV's senior obligations. The cash collateralisation has been established in accounts specifically for the benefit of current senior obligors who are not affiliated with WestLB.

However, the cash collateralisation does not cover all the senior obligors who are pari passu from a senior class perspective. Both SIVs' non-affiliate-held senior obligations are expected to mature this year and are expected to be repaid from the cash collateral accounts.

After those maturities in June 2008, the remaining outstanding senior creditors will not have the backing of the cash collateral but rather the assets in the respective SIV portfolios. The ratings on the capital notes of Kestrel reflect S&P's view that full repayment on the capital notes is highly unlikely.

At the end of January 2008, the NAV of each vehicle's capital notes were approximately 0% for Kestrel and 9.47% for Harrier. Both Harrier and Kestrel made amendments to their underlying programme documents (Kestrel in October 2007 and Harrier in November 2007) that effectively removed any enforcement consequences associated with falling NAVs. Therefore, the agency believes neither vehicle is at risk of enforcement due to declining NAV tests.

The ratings on K2 (sponsored by Dresdner Kleinwort), on the other hand, have been placed on watch negative to reflect the fact that its liquidity agreements have not yet been signed. The ratings reflect S&P's analysis of both the strength of the underlying asset portfolio and the announcement that the bank intends to provide 100% liquidity support to the SIV.

This reflects a change in the bank's stance because it had not previously indicated that it would provide formal support. The agency believes K2 is currently not at material risk of failing its NAV test because the vehicle's NAV remains high relative to the remaining SIVs that have not entered enforcement mode.

Finally, the senior ratings on Nightingale Finance (sponsored by Banque AIG), Premier Asset Collateralized Entity (Société Générale), Abacas Investments (NSM Capital Management and Emirates Bank), Cortland Capital (Ontario Teacher's Pension Plan), Carrera Capital Finance (HSH Nordbank), Tango Finance (Rabobank International) and Eaton Vance Variable Leveraged Fund (Eaton Vance) were affirmed. Nightingale, PACE and Carrera each have 100% liquidity support facilities in place, as well as provisions to address any potential downgrades of the liquidity providers. As a result of the signed liquidity facility, S&P removed the senior ratings on PACE from watch negative.

Cortland's senior obligations benefit from a low leverage structure and are largely defeased by cash and cash equivalents (short-term instruments). Cortland's outlook was revised to negative from stable to bring the vehicle in line with all the other SIVs.

Eaton Vance was the first SIV to completely refinance, and it has termed out its financing. As a result, S&P assigned a triple-A rating to Eaton Vance's senior MTNs to reflect the terming out of its senior obligations. In addition, Eaton Vance managed to anticipate the current pressure on process in the corporate loan market and removed the market value tests that remained post-term out of the funding.

The ratings on Tango were affirmed in light of Rabobank International's commitment that senior investors will be supported by liquidity support from the bank. In addition, the senior liabilities are currently fully cash supported to meet current maturities in 2008 and early 2009.

The ratings on Abacas were affirmed based on the US Treasury-type investments currently held in the vehicle's portfolio and the written statements S&P received from the manager, which states that the manager does not propose to be active in the ABS or corporate debt markets until a written proposal to restructure the vehicle to term funding has been finalised.

... while Moody's downgrades two
Moody's has lowered the ratings assigned to the debt programmes of Whistlejacket Capital, following an insolvency acceleration event, and to Eaton Vance Variable Leverage Fund (EVVLF).

Whistlejacket's Euro and US MTN programmes have been lowered to B2/Not Prime, while the capital note programme of White Pine was lowered to single-C. On 12 February Moody's downgraded the rating of the senior debt programmes to Ba2 on review with direction uncertain, following the occurrence of an enforcement event. But Standard Chartered declared an insolvency acceleration event on 15 February (followed by the temporary suspension of payments to senior debt investors), and the withdrawal on 20 February of its proposals to provide liquidity support to Whistlejacket.

The B2 rating assigned to the MTNs reflects the likelihood of a high or full recovery upon the probable liquidation of the collateral portfolio by the security trustee as directed by the receiver. The overcollateralisation ratio of senior debt is 110% by book value and 105% by market value.

The single-C rating assigned to the capital notes reflects Moody's view that the recovery amount for the notes is unlikely to exceed 25% of paid-in capital.

Meanwhile, the agency has placed EVVLF's MTN programme on review for downgrade and lowered its capital notes from Baa2 to Ba3 on review for downgrade. The Prime-1 ratings currently assigned to the vehicle's CP programme are unaffected by the rating action. No short-term debt (with maturities less than a year) is currently outstanding.

The SIV invests primarily in the leveraged bank loan market where the obligors are typically corporations with non-investment grade ratings. The rating actions reflect ongoing deterioration in the market value of its asset portfolio, which has caused the operating leverage ratio to be close to the leverage enforcement limit.

As a result, Moody's believes that the expected loss of the capital notes is no longer consistent with a Baa2 rating. Furthermore, Moody's will review whether the expected loss of the MTN programme and the capital notes is consistent with the expected loss implied by Aaa and Ba3 ratings respectively.

As part of its ratings review, the agency will evaluate restructuring proposals presented by EVVLF's management, which may involve substantial deleveraging of the transaction or conversion to a more traditional CLO structure.

Further CPDOs downgraded ...
Moody's has downgraded and left on review for further downgrade two CPDOs (Coriolanus Series 92 and Riders Series 2006-18), while placing three others (Alhambra Series A1E and A2E, and MAVEN Series 4828) under review for downgrade. At the same time, S&P lowered its ratings on 28 CPDOs.

The transactions affected by Moody's rating actions make up 12% of the total volume of CPDOs it rates. Four of the deals are market value synthetic CDOs which are exposed to spread movements of bespoke portfolios, with one of those also including long-short strategies. The other is a market value synthetic CDO which is exposed to spread movements of the iTraxx Europe and CDX.NA.IG indices.

The rating actions are a response to the recent substantial widening and increased volatility of the weighted average credit spreads on the corporate names underlying these transactions. For example, the combined weighted average index (Globoxx) spread has increased by approximately 50bp over the last month.

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, these ratings have been downgraded and left on review, or placed under review.

The leverage in these CPDOs range between three and 16 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 70%.

Of the transactions affected by S&P's rating actions, meanwhile, 26 were removed from watch negative – where they were placed on 20 December – and two were kept on watch negative. The rating on a 29th transaction was affirmed and remains on watch negative.

The affected CPDOs include: Castle Finance I (Series 5-12), Chess II (Series 24-39), Coriolanus Series 43, Eirles Two, Motif Finance 2007 (Series 3-6), Rembrandt New Zealand, Rembrandt Australia 2006 (Series 2-3) and Saphir Finance.

... while S&P revises its approach
The continued placement on watch negative of CPDO transactions that are rated triple-A and double-A reflects S&P's ongoing review of the sector, with the latest rating actions reflecting its revised modelling approach. This incorporates asset transition elements and revised assumptions using recent data on credit spreads, volatilities and the current lower net asset values.

For most CPDO transactions, there is an increased risk that asset values may not be able to build value sufficiently for the structures to cash in. The main feature of the agency's revised modelling approach is the introduction of a multi-period rating transition framework, which models the ratings on the assets in the underlying portfolio.

It also models the spread levels for each asset using the spread parameters for the relevant rating level of the asset. The revision of the spread parameters takes into account the levels seen in recent market volatility.

Downgrades depend on the specific structural features of the different transactions – primarily in the leverage functions, the maximum leverage positions, the coupon structures and the coupon levels. Transactions that provide for variable leverage functions and lower coupons are the least-affected.

The NAV of structures with lower maximum leverage or variable leverage functions are currently greater than those with higher maximum leverages. The reason for this is that CPDOs tend to assume maximum leverage at the beginning of a transaction, and there has been significant spread-widening since July 2007. This will lead to a larger decline in NAV for higher-leveraged structures.

Also, transactions that either pay a lower margin or structures that pay a variable coupon depending on the current spread level will distribute less from their returns as interest. Consequently, their NAVs will be relatively higher than structures with higher coupons.

Fitch reports on bank exposure to monolines ...
Fitch has delved into the exposure of major US banks and broker/dealers to financial guarantors to evaluate the impact of guarantor rating downgrades. In a new report, the agency summarises its findings and presents financial institutions' publicly available information of exposure to financial guarantors.

The analysis encompassed exposures to the financial guarantors by type of risk and by specific financial guarantor. Fitch believes credit exposure to the financial guarantors is considered manageable for the major US banks and broker/dealers.

Exposure levels vary substantially, however, and could lead to additional ratings pressure for Citigroup, Merrill Lynch and UBS, which remain on negative outlook. While these institutions have recently raised sizeable capital, additional write-downs may put incremental pressure on their ratings when combined with other financial challenges.

The proposed initiatives to restructure certain financial guarantors could have additional negative effects on exposures.

Exposures to the financial guarantors arise from the following:

• CDS counterparty exposure associated with protection purchased on securities ranging from CDOs, CMBS, RMBS, other ABS and corporate bonds.
• Loans and lending commitments to financial guarantors.
• Trading inventories of equity or debt of the financial guarantors.
• Municipal bonds, RMBS and other securities wrapped by guarantors held in trading or investment portfolios.
• Municipal bonds wrapped by guarantors associated with Tender Option Bond (TOB) and Variable Rate Demand Obligation (VRDO) programmes.
• Loss protection written by guarantors for various conduits associated with financial institutions.
• Potential support of money funds containing securities enhanced by guarantors.

... while Moody's is to publish insured underlying ratings ...
Moody's says it will attempt to contact the largest and most active issuers or sponsors of insured securities when the associated insurer has been downgraded, to determine whether they desire the publication of the underlying rating. The agency believes that broader disclosure of underlying ratings may benefit market transparency. It will publish requested underlying ratings and any updated ratings on wrapped securities as soon as possible, subject to the volume of issuer requests.

An insured security benefits from both the credit strength of its financial guarantor and its intrinsic, underlying credit quality in the absence of any guaranty. Moody's practice in rating insured securities is to assign the higher of the two ratings – the guarantor's rating or the rating that would be assigned to the security in the absence of the guaranty – provided that the underlying rating is already public.

In the absence of a published underlying rating, Moody's rating on an insured security reflects only the credit quality of the financial guarantor. Since most financial guarantors were until recently rated Aaa with stable outlooks, many issuers historically had not elected to obtain an underlying rating.

However, in light of recent downgrades in the financial guarantor sector, some insured securities may now carry ratings that are lower than those that would be assigned based on the strength of the underlying issuer or structure. Moody's is therefore seeking to ensure that issuers understand they may request an underlying rating, and will facilitate the publication of such ratings when requested.

... and ISDA publishes monoline deliverables
ISDA has published on its website the first list of obligations for which a monoline insurer is the reference entity. The purpose of the list is to provide information as to the range of obligations that market participants believe may be delivered in the occurrence of a credit event.

The Association states that publication of the list does not indicate that it believes that such a credit event with respect to any particular entity or class of entities is imminent or likely.

TRR CLO downgrades continue ...
Fitch has downgraded and left on watch negative a further 24 tranches of total rate of return (TRR) CLOs. At the same time, the agency has placed one additional transaction on watch negative.

The actions are a result of the continued decline in loan prices in the secondary market, as evidenced by a drop in the average loan price as reported by the Loan Syndications and Trading Association (LSTA) to 86.27 as of 15 February from 88.20 as of 8 February. Since the last rating action on 12 February (see SCI issue 75) Fitch has confirmed that four additional transactions have breached their TRS termination triggers and an additional four transactions are estimated to be within 3.5 points of their respective triggers. Overall, a total of 10 transactions have breached their TRS Termination triggers since 18 January.

Of note, this unprecedented decline in loan values has occurred amidst a strong performance in the credit of the underlying loan collateral class. The US leveraged loan market has continued to experience historically low default rates, which are currently well below 1%.

As a result of this and other considerations, many transactions which have breached their total return swap (TRS) termination/liquidation triggers have not been subject to a liquidation of their underlying collateral, but have been recapitalised or restructured. To date, only two transactions have formally liquidated (Aladdin Managed LETTRS Fund and Hartford Leveraged Loan Fund).

With respect to the eight other transactions that have breached their triggers, the TRS counterparties have either delivered a TRS notice of termination (which would normally cause a near-term liquidation of collateral) or a notice that they now have the option to terminate, but have elected not to liquidate the underlying collateral while they review possible options. In all cases, the TRS counterparties have retained their right to terminate and/or liquidate at any point in time.

The liquidation of the Aladdin Managed LETTRS Fund portfolio occurred on 5 February and the termination payments were distributed on 12 February. Neither Class A nor Class B noteholders received any proceeds on the final payment date. Fitch estimates the liquidation weighted average price of the loan portfolio was approximately 84% of par (as compared to approximately 89% of par, according to the trustee, on the date the termination notice was received).

The portfolio of Hartford Leveraged Loan Fund was successfully auctioned on 8 February. The termination payments have not yet been distributed.

The transactions affected by the rating actions are: Canal Point I, Canal Point II, Castle Harbor II CLO, CELTS 2007-1, Hudson Canyon Funding, Invesco Navigator Fund, LCM VII, PPM Riviera Loan Fund, SERVES Series 1998-1 and SERVES Series 2006-1.

... and three other deals are restructured
Three total rate of return (TRR) CLOs previously affected by Fitch downgrades have been restructured and are currently marketing as cashflow CLOs: Babson Capital's US$644m Vinacasa CLO, the US$382m HIMCO Bushnell Loan Fund and the US$562m HIMCO Stedman Loan Fund (all arranged by Citi). The transactions are static, with principal or sale proceeds to be used to amortise notes sequentially.

Guidance for the deals is identical, with price talk for the double-A and single-A tranches at 275bp and 425bp respectively. Vinacasa also offers a triple-B tranche at 600bp.

Anecdotal evidence suggests that the original mezzanine and/or equity investors in these market value transactions invested additional funds in order to terminate the return swap with the senior counterparty and fund wider coupon payments to new debt investors. These resolutions are positive for the CLO and loan market, note analysts at JPMorgan, in that they allow the CLOs to wind down gradually rather than crystallising loan losses immediately.

A number of such transactions are reviewing alternative options, including the issuance of additional notes or amendments to documents to change structural features of the transaction such as the timing and amounts of interest due to noteholders, in order to avoid breaching their market value triggers. Three others, including the Rivendell Loan Fund, have received direct equity infusions from their manager or other sponsor.

In the case of a TRR CLO converting to a cashflow CLO, underlying loan collateral assets could either be transferred into the new CLO SPV at par (with all existing capital holders retaining their respective stakes and positions) or the underlying collateral could be transferred at market rates, with the TRS counterparty or senior bank revolver provider being repaid, while the junior noteholders would realise a loss. Fitch says it considers the latter case to be a liquidation of collateral.

In other cases, timely interest rated classes may become PIKable, noteholders could become subject to a reduction in their rated coupon or the transaction could face other changes in structural terms that adversely affect the rated notes when compared to the original transaction. Fitch considers such cases to be a distressed debt exchange.

Second Troika CDO closed
Troika Dialog and Deutsche Bank have successfully closed the second full capital structure rouble-denominated CDO backed by Russian local currency corporate bonds. The three-year RUB5bn (US$203m) managed synthetic CDO follows the RUB8.98bn deal the two firms brought to the market in August 2007 (see SCI issue 54).

"The interest shown by investors around the world is a testament to the growth in appetite for corporate bonds both in Russia and abroad," says Pavel Teplukhin, ceo of Troika Dialog Asset Management.

The capital structure of the CDO includes three tranches: equity, mezzanine and senior. Troika Dialog Asset Management may make substitutions within the portfolio based on certain agreed criteria so as to maintain the diversity and credit quality of the underlying portfolio.

Global valuations platform to launch
Markit is set to launch what it claims is the first global, multi-bank cross-asset client valuations platform. Dubbed Markit Valuations Manager, the firm says it will bring considerable operational efficiency and transparency to the valuation process by offering electronic delivery of dealer OTC derivative and consensus cash valuations, alongside Markit's own independent valuations, on a single platform.

The initiative comes as recent regulatory and accounting changes have increased the importance of reliable, independent valuation sources for funds. Markit Valuations Manager will provide the buy-side with an accurate, efficient tool to handle the increased regulatory and accounting burden, and will enhance the integrity of position information, counterparty marks and third-party valuations.

Jeff Gooch, evp and head of valuations and trade processing at Markit, comments: "Regulators around the world are increasingly focused on the importance of greater transparency, establishing best practice for client valuations, and a trusted, independent process is key. Markit Valuations Manager is a tremendously exciting initiative which will allow financial institutions to better understand and manage their risks at this challenging time."

Six global investment banks have agreed to work with Markit to support the launch of the platform: Citi, Credit Suisse, Goldman Sachs, JPMorgan, Merrill Lynch and UBS. They will provide Markit with end-of-day and end-of-month client valuations for OTC derivative instruments and cash securities. Markit will aggregate this information and offer clients access to a composite of dealer marks for cash securities and counterparty present values for OTC derivative positions.

Clients will be able to compare the dealer marks with Markit's independent valuations. Additionally, the platform will offer seamless integration with Markit's trade processing solutions to allow full life-cycle support for OTC derivative transactions.

David Lefferts, md at Markit, will lead the initiative. It aims to launch the platform in the second half of 2008 with core coverage of bonds and derivatives. The platform will subsequently be expanded in phases to include more banks and all major cash and derivative asset classes, including structured instruments such as asset-backed and mortgage-backed securities.

European synthetic CDOs hit
S&P has taken rating actions on 98 European synthetic CDO tranches. At the same time, Moody's downgraded or watch-listed US$550m of European CDOs.

Specifically, S&P has downgraded 14 tranches previously on watch negative; affirmed three tranches that were previously on watch negative; downgraded 72 tranches which remain on watch negative; and upgraded nine tranches that were on watch positive.

Of the 86 tranches lowered, 68 reference US RMBS and US CDOs that are exposed to US RMBS which have experienced recent negative rating actions, while 18 have experienced corporate downgrades in their portfolios. The affected tranches represent 3.1% of the total number of European synthetic CDOs S&P rates.

The move is a result of S&P's revised CDO correlation and recovery assumptions which it announced at the beginning of the month.

Meanwhile, Moody's rating actions are a response to credit deterioration of the underlying portfolios, which include significant exposure to CDOs of US ABS and to downgraded US sub-prime RMBS securities. A total of 20 tranches from five CDOs are affected, with defaults suffered ranging from 1.25% to 9% in the individual portfolios. The average exposures of the affected CDOs to US RMBS securities and CDOs of ABS from the second half of 2005 to 2007 are 14.5% and 21% respectively.

The agency also downgraded and left on review for further downgrade 11 classes of notes issued by Securitized Product of Restructured Collateral, Lunar Funding V and Linker Finance – all transactions reference US RMBS and/or US ABS CDOs of the 2005 and 2006 vintages.

Basel Committee reports on liquidity risk
The Basel Committee on Banking Supervision has released a paper on the management and supervisory challenges of liquidity risk. The Committee's Working Group on Liquidity began work on this topic in late 2006 to review liquidity risk supervision practices in member countries. In response to the financial market turmoil that began in mid-2007, the Working Group's mandate was expanded to evaluate how these developments had affected liquidity risk at financial institutions.

In view of the relevance of the Working Group's review, the Basel Committee has published the key findings. The paper highlights financial market developments that affect liquidity risk management, discusses national supervisory regimes and their components, and outlines initial observations from the current period of stress.

"The extreme liquidity conditions of last summer and resulting difficulties that persist today are vivid illustrations of the critical importance of market liquidity to the banking sector," explains Nout Wellink, chairman of the Basel Committee and president of the Netherlands Bank. "These events emphasised the links between market and funding liquidity, the interrelationship between funding liquidity risk and credit risk, and the fact that liquidity is a key determinant of banking sector soundness."

The Working Group is currently conducting a fundamental review of the Basel Committee's sound practices for managing liquidity risk in banking organisations published in 2000. Drawing from recent and ongoing work on liquidity risk by the public and private sectors, the Committee aims to enhance these sound practices to strengthen banks' liquidity risk management and improve global supervisory practices. It plans to issue the revised sound practices for public comment this summer.

Mixed remittance results
The ABX remittance report for the February distribution date shows that, while monthly aggregate 60+ day delinquencies increased by 229bp, 261bp, 198bp and 261bp (compared with the 248bp, 280bp, 207bp and 264bp rise last month) for Series 06-1, 06-2, 07-1 and 07-2 respectively, the rate of growth slowed across the board. Many deals posted declines in 60- and 90-day delinquency buckets.

Serious delinquencies increased by 7% (down from 9%), 9% (down from 11%), 8% (down from 9%) and 14% (down from 17%) over last month's numbers. However, despite the declining growth rate of total 60+ delinquencies, analysts at Barclays Capital warn against reading too much optimism in the remittance numbers, as there is a fair degree of seasonality that will be at work during the next couple of months.

Over the past several years, there has been a noticeable trend in declining 30-, 60- and 90-day delinquencies during the February and March collection periods (March and April remittance reporting dates). However, beginning with the May remittance date (April collection period), delinquencies tend to start rising, the analysts note.

CS

Counterparty risk in credit derivatives - part 1

In the first of a two-part series on credit derivative counterparty risk, mitigation techniques are discussed by Barclays Capital's quantitative credit strategy team

Counterparty risk is the risk taken on by each party in an OTC contract that the other will not fulfil the obligations of that contract. As an illustration, Figure 1 shows the maximum potential loss to either party of a CDS contract.

Figure 1

While the maximum potential loss to the seller of protection is the contract spread for the rest of the contract duration, the buyer of protection could arguably lose the full notional of the contract (in case of simultaneous defaults by counterparty and the reference credit, and zero recovery). Thus, counterparty risk is evidently more of a concern for buyers of protection.

At a basic level and assuming no collateral has been exchanged, in the event of a failure of a counterparty the protection buyer may face one of the following scenarios:

• The original contract is out-of-the-money, in which case the survivor closes out the position with the defaulter by paying off its obligations and then re-hedges its position with a new counterparty. There is no profit or loss incurred in this case by the survivor due to the counterparty defaulting;
• The original contract is in-the-money, in which case the survivor closes out the position with the defaulter but does not receive its dues. The survivor in this case incurs a loss equal to the market value of the old CDS contract.

Figure 2 illustrates a possible timeline around a typical counterparty default scenario, highlighting the actual risks faced by the surviving counterparty. An extra risk arises because of the unhedged position of the survivor between time 't1' (when it received the last margin payment) and 't4' (when it re-hedges its position). The survivor remains exposed to the risk of spread on the reference gapping fast in this period, and for a buyer of protection this gap-risk can be as high as a jump-to-default.

Figure 2

Managing counterparty risk
Banks and other financial institutions that have large derivative exposures use several techniques to limit, forecast and manage their counterparty risk. These techniques are usually implemented at the firm level, across asset classes. The standard practises implemented by banks can be roughly divided into the following three categories:

• Contractual credit risk mitigation;
• Risk forecasting; and
• Risk management.

Contractual credit risk mitigation
It is standard practice for financial institutions to enter derivative contracts documented on Master Agreements as recommended by ISDA. All ISDA contract holders are ranked pari passu to senior debt, in terms of claims on a defaulting counterparty. This makes CDS contract holders' positions sensitive to standard recovery rate assumptions.

The Credit Support Annexes (CSA) to the Master Agreement help parties establish bilateral mark-to-market security arrangements. Margining and collateral posting, as well as netting are typically adopted to help mitigate credit risk.

Margin agreements require banks to post different levels of collateral on their outstanding contracts depending on the current mark-to-market of the contract. Typical acceptable collateral is either cash or highly-rated (double-A or higher) securities. Margin thresholds are usually the previous day's mark-to-market for all outstanding contracts, but exceptions might be made for highly-rated corporates.

Given their higher risk profile, margining for hedge funds tends to be somewhat more stringent. They typically post collateral at 100% of their current exposure, and furthermore might also be asked to post collateral to cover close-out risk on their contracts for a certain number of days going forward. The estimation of forward exposure is done through forecasting future scenarios, as explained in further detail in the next section.

Margining is perhaps the most effective way of reducing counterparty risk. It minimises gap risk to just within the period between margin calls.

While margining mitigates to a large extent the mark-to-market risk of liquid instruments, it must be mentioned here that it is only as effective as its operational implementation. Various factors play a role, such as:

• The frequency of margin calls;
• The time it takes for collateral posted to reach the bank (typically T+2 or T+3, but could be longer);
• The quality of collateral (whether cash or securities of doubtful quality);
• The difficulty in pricing complex illiquid instruments on a daily basis; and
• Perhaps most significantly, the ability of small entities to impose two-way margin agreements with bigger counterparties.

Another advantage of trading within the ISDA framework is the provision of netting. Netting agreements come into action in the case of actual counterparty default. Without such agreements, a surviving counterparty would legally have to fully meet its obligations to the defaulting counterparty, while only being left with a claim on its dues from the same.

However, the provision for netting allows a bank to calculate its dues to a defaulter by netting out-of-the-money and in-the-money contracts and to arrive at a single figure for dues. In fact netting agreements are typically applicable across all derivatives that are traded on ISDA contracts, effectively building in a natural hedge to counterparty default risk on a firm-wide level.

Risk forecasting
A drawback of margining is that it is almost always backward-looking, and thus leaves the bank exposed to sudden changes going forward. To help mitigate this, there needs to be some way of estimating future exposures to specific counterparties.

The actual estimation of Potential Future Exposure (PFE) that a bank has to its counterparties is a very complex task. Most banks have sophisticated risk management systems which model and attempt to quantify these exposures. This is usually done by simulating future market scenarios on a Monte Carlo engine, using evolution models of all relevant risk factors.

In each scenario, at each point in time, pricing models value all outstanding derivative contracts – thus estimating the bank's net counterparty risk exposure. Repeated simulations on the Monte Carlo engine help provide a distribution of the risk at different points of time in the future.

Active risk management
This forecasting of counterparty exposure allows banks to manage their risk going forward by:

• Placing limits on exposure to any given counterparty. The first step in managing future exposure for a bank would be to limit exposure to the specific name. Limits are typically monitored at both a firm-wide level and across asset classes;
• Actively managing counterparty exposure. Having arrived at some estimate for counterparty risk, a bank will often actively try to hedge that risk by netting exposures across asset classes and then buying CDS protection on the specific counterparty to cover the risk. While this might sound circular and liable to add more counterparty risk instead of reducing it, it works in practice because of the margining of such trades.

It is worth keeping in mind that buying CDS protection to manage risk is not possible for hedge funds or smaller institutions. This is part of the reason such entities have to pay close-out margin, covering potential future exposures.

How much should I pay for a higher-rated counterparty?
Estimating a bank's net counterparty exposure is a very complex task, but much simpler models can be used to estimate counterparty risk approximately. These models typically use as inputs the risk priced into single-name CDS contracts by the credit derivatives market.

All else being equal, a buyer of protection would prefer to trade with a higher-rated counterparty, as this would imply a lower risk of counterparty default. Though the current CDS market does not currently discriminate between protection sellers with different ratings, it is at least theoretically possible to price the risk inherent in buying credit protection from a riskier counterparty. Further, if default rates were to see a significant up-tick in the future, these prices could be expected to begin to be factored into actual market quotes.

As explained in the first section, in a CDS contract the buyer of credit protection has the biggest value at risk (VaR), viz. notional x (1 - recovery) in the case of simultaneous defaults of the counterparty and the reference credit. Estimating the market-implied price of this VaR gives a very conservative estimate of counterparty risk.

Assuming survival of the buyer of protection over any period of time, four 'default scenarios' for the reference and the seller of protection are possible (see Figure 3).

Figure 3

This section models the likelihood of the fourth default scenario. In our analysis, we ignore the effects of the protection buyer re-hedging his position immediately after the counterparty defaults.

This implies an assumption that all double defaults within any given time horizon happen concurrently. While this might not be very realistic, it provides a more conservative estimate of counterparty risk.

The CDS curve for any entity implies a default probability function for that entity. To determine the counterparty risk we join these CDS-implied marginal default probabilities of the counterparty and the reference into a bivariate distribution, using a Gaussian copula model.

This allows an estimation of the joint default probability of the counterparty and the reference. This joint default probability is converted back into a spread using expected loss measures.

Running this model on different dates allows us to gauge the evolution of counterparty risk as priced in by the credit market. We prefer to use market-implied probabilities of default as opposed to historically realised default rates, since the former provide a more dynamic and forward-looking estimation of risk (see Figures 4a and 4b).

Figure 4a

Figure 4b

We make several simplifying assumptions in the implementation of this model, some of which cause an overestimation of the actual risk due to counterparty default. These are:

• Ignoring the impact of margining and netting in reducing risk. This impact can be quite significant; for instance, in the case of a gradual deterioration of the reference credit, mark-to-market gains ought to be gradually collateralised, reducing the size of the jump-to-default loss;
• No re-hedging if the counterparty defaults before the reference, in effect assuming instantaneous default whenever defaults are correlated.

Other significant assumptions we make are as follows:

• The ordering of default is assumed to follow a symmetrical distribution; i.e., the likelihood of the reference credit defaulting before the counterparty is taken to be the same as that of the counterparty defaulting before the reference credit;
• A recovery rate of 40% is assumed for the counterparty and 10% for the reference;
• The correlation of asset returns between financial entities and corporates is assumed to be 80%.

The rationale behind using asset correlation of financials and corporates as an input into the model is that, when such correlation is high, it will indicate an increased probability of joint default. In our model the worst-case scenario is a 100% correlation of returns, when double defaults will be most likely. Intuitively, this means a buyer of protection would always prefer to trade with a counterparty with least business risk tied in with the reference credit.

Using the above described model with banks as counterparty and corporates as reference credits, we get the following spread numbers on a rating by rating basis (see Figure 5). These numbers can be interpreted as being the annual spread that a buyer of protection should price in due to counterparty default. For example, the number in the first cell shows that CDS protection bought from a double-A rated counterparty referencing a triple-A rated corporate carries a counterparty risk (over five years) equivalent on average to the default risk of an entity with 9bp (5-year maturity) CDS spread.

It is also interesting to note the differential in spreads across rows, viz. across banks of different ratings. To take another example, Figure 5 indicates that the price of counterparty risk in a 5-year CDS contract on a triple-A reference bought from a double-A bank is on average 9bp.

Figure 5

However, the same protection bought from a single-A minus bank has a counterparty risk of 15bp. Thus, the single-A minus rated bank should have a 6bp lower ask as compared to the double-A rated bank, given its greater risk of defaulting.

Figure 6

Figure 6 shows the same calculations, but based on spread-implied default rates at the beginning of 2007. Not surprisingly, we find the levels are much lower than they are today – in the extreme cases by a massive factor. For example, the estimated compensation for counterparty risk with a single-A minus counterparty and a single-B plus reference has increased 17 times over the last year.

© 2008 Barclays Capital. This Research Note was first published by Barclays Capital's quantitative credit strategy team on 20 February.

Trading ideas: something's gotta give

Dave Klein, senior research analyst at Credit Derivatives Research, looks at a pairs trade on CDX IG 9 versus VIX

There has been much talk about the credit-equity disconnect recently. Commentators wonder how the credit markets can act as if the end of the world was yesterday, while the equity markets (after a brief scare at the beginning of the year) are acting optimistically. One of the more insightful analyses that we've seen posits that credit anticipates recessions while equity confirms them.

In this trade we look at the historical relationship between the VIX and the CDX index and recommend selling protection on the CDX and buying VIX futures. If a recession is confirmed by the equity markets, we expect volatility to rise.

If a recession is avoided, we expect a rally in the credit markets. In either case, we look for a convergence between the CDX and VIX towards their empirical relationship.

Delving into the data
As volatility rose in the beginning of 2007, the VIX and CDX indices began to trade in-line with each other as seen in Exhibit 1.

Exhibit 1

Clearly, at the end of 2007, this relationship broke down. With the CDX trading near 160bp and the VIX at 25 points, the markets are well away from their expected values, as seen in Exhibit 2.

Exhibit 2

While we are not brave enough to call a top to the CDX market, we would certainly expect a rise in the VIX if the CDX held steady or sold off more. Basing trading ideas on past historical relationships should be done with caution. The old saw "it's different this time" sometimes is true.

We do not expect the CDX to rally down to 80bp any time soon, but we do expect the CDX and VIX to converge closer to fair value. Keeping that in mind, we base our hedge ratio on the long-term historical relationship.

Exhibit 3 provides the expected three-month trade P&L, including transaction costs and carry across a variety of CDX/VIX scenarios. Given our expectation of a combination of rising VIX and rallying CDX, we expect the trade to end up somewhere in the lower left-hand quadrant of scenarios. The hefty carry of the CDX provides a cushion against losses on the trade.

Exhibit 3

Risk analysis
This position does carry a number of risks.

Time to Convergence: While the VIX and CDX have a strong empirical relationship, converging back to fair value can take a substantial amount of time. From the middle of 2006 through the spring of 2007, the CDX traded too tight when compared to the VIX. We do not expect convergence overnight and expect to roll into new futures contracts (and possibly into new CDX series) over the life of the trade.

CDX present value (PV): The CDX PV is an expected value, but not necessarily a realised outcome.

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

Overall, frequent re-hedging of this position is not critical, but the investor must be aware of the risks above and balance that with the positive carry.

Liquidity
Liquidity – i.e. the ability to transact effectively across the bid-offer spread in the bond and CDS markets – is a major driver of any longer-dated trade. Our data on liquidity, created from the volume of bids, offers and trades we see each day, provide us with significant comfort in both the ability to enter a trade in the CDX and VIX.

Fundamentals
This trade is based on the expected reversion to an empirical relationship and is not based on fundamentals.

Summary and trade recommendation
Credit-equity disconnect. Credit-equity disconnect. Credit-equity disconnect. Financials commentators and analysts are beginning to sound like a broken record when discussing the state of the market.

Has credit gone crazy? Are equities ignoring reality? In today's trade, we focus on the historical relationship between the CDX and the VIX.

This year, that relationship has broken down dramatically, leading us to believe that either the CDX or the VIX are incredibly cheap (or both). Given how disconnected these two indices have become, we believe that this is an opportune time to jump in and sell protection on the CDX and buy futures contracts on the VIX.

Sell US$10m notional CDX IG Series 9 5Y at 159bp.

Buy 14 CBOE VIX May 08 futures contracts at 25.50 index points (1000 multiplier per contract) to earn 159bp of carry.

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

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

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