Contents

Margin maelstrom?

Lender tightening exacerbates vicious circle for funds

Another high-profile leveraged ABS fund, Carlyle Capital Corp, last week failed to meet margin calls – prompting fears of mass hedge fund unwinds. The ensuing flurry of panic and spread widening was seen by some as a legitimate reaction, while others saw it as an overreaction. Either way, the wider impact of lender tightening seems unlikely to diminish any time soon.

The market is concerned that hedge fund unwinds could become a downward spiral that spins out of control, according to Rob Ford, portfolio manager at Synapse Investment Management. "Each new collapse pushes spreads wider, which then puts mark-to-market pressure on the next fund, which is forced to sell more assets and spreads are pushed even wider. What is particularly scary in the case of Carlyle Capital is the assets that have been impacted: the fund is invested in Fannie Mae and Freddie Mac RMBS that is essentially guaranteed by the US government," he notes.

Carlyle Capital's lenders issued margin calls in excess of US$400m and are believed to have liquidated collateral securing approximately US$5bn of indebtedness in the open market. The company says it is in ongoing negotiations with the remaining lenders, who hold approximately US$16bn in securities, and has requested a standstill agreement whereby its lenders refrain from foreclosing and liquidating their collateral.

The potential extent of a broader hedge fund unwind is difficult to judge because it depends on how each hedge fund is positioned. Many funds tend to be run as a long/short business – before its troubles Peloton Partners, for example, made money by going short sub-prime as spreads began widening.

"Some hedge funds could be long triple-As and short triple-Bs, and the question here is whether triple-As have further to go," says one structured credit investor. "This could be what's causing the damage now. Some funds could have made profits from tumbling prices in triple-Bs – now these assets are trading at very low levels so there isn't that much further to go, while triple-A prices have fallen sharply but still have room to keep falling."

Sources suggest that some hedge funds could be looking to restructure their mark-to-market triggers on an individual basis with their financiers. However, the success of any such arrangement will ultimately depend on whether it aids the lender's capital preservation efforts.

The investor observes: "There has undoubtedly been something of an overreaction in the current market and so, looking ahead, lenders will likely lend on an overly conservative basis – if they lend at all. It will take time for banks to rebuild the confidence necessary to return to the kind of lending practices that the market had become used to."

This hardening of prime broker criteria and consequent increase in margin calls not only potentially precipitates more hedge fund liquidations, but also underlines a broader issue for the securitisation market. "Current market conditions are not so much stressing the underlying credit risk, which remains very subdued in Europe, but more the actual ABS issuers. This has caused many lenders to scale back or close down operations. The next stress will likely test the de-linkage to such companies, with many clean-up calls already appearing unlikely to be exercised," conclude ABS analysts at SG.

CS

Parallel parked

Europe sees first MV CLO restructuring

Deutsche Bank has priced what is thought to be the first restructuring of a European market value CLO, following in the wake of a number of such deals in the US (see SCI issue 77). The new vehicle, dubbed Eurocredit Opportunities Parallel Funding I CLO, takes advantage of the original deal's cheap financing.

The €450m transaction is the result of a restructuring of Intermediate Capital Group (ICG)'s Eurocredit Opportunities CLO, which involved selling half of the original assets into a parallel vehicle structured as a cashflow CLO. The new vehicle is believed to have been structured as a sub-set within the old deal, thereby allowing the manager to take advantage of the original transaction's cheap term funding.

"The market value triggers relating to the revolver in the original Eurocredit Opportunities fund were obviously not set up to cope with the amount of mark-to-market volatility we're seeing at the moment," a source familiar with the deal explains. "ICG didn't want to have to sell the assets and crystallise a loss in this environment. It also looked at restructuring the market value triggers, but that course of action appeared to be inappropriate for rated debt."

While the original financing remains in place for Eurocredit Opportunities, the new structure provides it with a buffer against mark-to-market volatility by increasing its NAV. Technically ICG didn't need to seek approval for the plan from investors in the initial CLO, but nonetheless structured the new vehicle in consultation with them. Indeed, the original investors still own the equity of the assets in the new vehicle.

The triple-A piece of the restructured deal went to a new investor, however. Parallel is understood to have been executed relatively quickly and placed with a small group of accounts. Investors appear to have viewed the CLO as an opportunity to get exposure to quality assets that are trading at cheap levels.

Below the €312.5m triple-A rated Class A notes (which priced at 145bp over Euribor), there are €10m Aa2/AA Class Bs (250bp), €8m A2/A Class Cs (350bp) and €40m Baa3/BBB- Class Ds (800bp). The unrated equity slice is sized at €80m. Rated by Moody's and S&P, legal final is in February 2019.

Widely acclaimed as the first true European market value CLO, Deutsche Bank closed the original €400m Eurocredit Opportunities CLO in November 2005. The transaction was subsequently tapped twice in May and November 2006, with its size currently standing at €900m.

Analysts suggest that the European market is likely to see other similar restructurings take place in the coming months, as has happened in the US. Most recently, Babson Capital's US$680m Vinacasa CLO I last week priced triple-A to triple-B paper with spreads of 140bp, 350bp, 500bp and 700bp over Libor.

At the same time, the US$378m Bushnell Loan Fund II priced its triple-As wide to indicatives at 200bp, but also offered double-A and single-A paper at 350bp and 500bp. Both restructurings are lightly managed transactions where prepayments and sale proceeds are used to amortise notes sequentially.

So far the only other European market value CLO to be hit by a decline in asset values – Deerfield Capital Management's €498m Coltrane CLO – entered into an event of default, as a result of a threshold value event that remained uncured for five business days. KPMG has been appointed as receiver on the transaction to discuss the various options for its assets with creditors, with a view to maximising the value of the portfolio.

CS

Auto index mulled

Implications for issuers and investors emerge

The creation of a CDS index referencing US auto loan ABS is under discussion by Markit and the dealer community. While some believe such an index will provide investors with an effective way of shorting the consumer more broadly, others say that the resultant speculative trading could lead to a drop in auto ABS valuations – with serious implications for both issuers and investors.

"An index can be created for any underlying, if it is liquid enough. With all the talk about CPDO and hedge fund unwinds at the moment, the concern is that neither the cash nor the CDS market is liquid. So bringing another index will simply add to the illiquidity – it will be wide open to speculative trading at onerous levels, given the current lack of pricing stability," notes one ABS trader.

Based on the market's experience of the Markit ABX and CMBX indices so far, it is clear that few credit investors use the indices to go long. Most investors prefer to choose their own portfolio, either through cash bonds or single name CDS.

This situation leaves a one-sided market, where short sellers dominate, according to ABS analysts at Wachovia Capital Markets. "With no rules concerning the posting of margin, low-cost unconstrained short selling has exacerbated an already serious credit condition in the mortgage market. The momentum of falling prices in the indices has created a 'downward speculative bubble', where speculators have pushed prices below fundamental valuations in many cases," they say.

Under these market conditions, a new auto CDS index might change the financing environment for auto companies – the potential for a drop in auto ABS valuations, resulting from shorting activity, could be a real concern. The Wachovia analysts point to two critical implications for auto ABS issuers: loans originated through their financing subsidiaries could depreciate faster than the cars driving off their lots; and, as the cost of financing in the capital markets via ABS rises, it will become harder to provide financing and/or financing incentives.

"The impact of financing constraints could have an adverse effect on the company. As sales fall and revenue is reduced, equity values fall and the market response may be exacerbated by additional shorting in the corporate CDS markets," they add. And from an investor's perspective, the introduction of an auto CDS index will likely result in wider spreads – leading to reduced demand for both primary and secondary trades, due to increased volatility.

However, as another trader notes, volatility is here to stay. He argues: "While the introduction of any CDS index will lead to speculative trading, the important point to consider is how much speculative trading a potential auto ABS index will sustain? For example, the concern about the recently-debated ERMBX was that, given where the market is currently, everyone trading it would have been a seller – which would have created an element of front-running. But there is no harm in getting the documentation ready and building a structure that everyone is comfortable with in the meantime."

CS

Structured credit hedge funds edge down

Latest index figures show another drop, albeit with some deceleration

Both gross and net monthly returns for January 2008 in the Palomar Structured Credit Hedge Fund (SC HF) Index show a negative return for the third month in a row. The decline is, however, the smallest seen since the start of the credit crunch.

The latest figures for the index were released this week and show a gross return of -0.22% and a net return of -0.34% for January. The SC HF Index's December return was revised upwards from -1.58% to -1.04% gross, as one of the member underlying funds reported a substantially better return than previously estimated.

The Index was rebalanced in January, leading to a net decrease of six of the funds included in the index, as nine were excluded and three new funds added. Due to the new funds representing a comparatively high level of assets under management, the total AUM of all funds in the index decreased to a lesser extent than the number of funds.

Overall, the gross and net indices' cumulative returns since calculations began in January 2005 stood at 98.11% and 92.15% respectively on 31 January 2008. For more Index data click here.

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

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

CS

Stressed emphasis

Bruno de Pampelonne, ceo of Tikehau Investment Management, answers SCI's questions

Bruno de Pampelonne

Q: When, how and why did your firm become involved in the structured credit markets?
A: Tikehau Capital, our parent, was established three years ago by Antoine Flamarion, an ex-Merrill Lynch/Goldman Sachs professional, as an opportunistic investment company based in Paris. The 14-member Tikehau Investment Management (TIM) team has significant experience of the fixed income markets (25 years in my case).

After all these years' experience, we decided to do something different – specifically, we realised that there was room for a specialist fixed income house in Paris. Only between 30-40% of our investors are French, however. French institutional investors are typically more conservative and more regulated, so it is difficult for them to invest in new asset classes and opportunities.

Nonetheless, we believe that the fixed income universe offers tremendous opportunities; and it is clear that the period of market correction we're going through will also create some interesting opportunities.

TIM has three sets of expertise: credit analysis, credit management and structuring. We manage three funds across the fixed income asset class: a long/short credit fund; a mezzanine fund; and an opportunity fund.

The opportunity fund, which was launched four months ago, invests in all stressed/distressed assets – from structured credit to corporate risk – but is barely invested so far (around 10%). The fund has a two-year investment period before cash is returned to investors

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: Over the last few years the market has seen the development of many new instruments, from the iTraxx indices to CPDOs and others. The indices allowed a different approach to credit asset management: through the hedging and management of long exposures in a more efficient manner, credit management has become more flexible. Additionally, it has become easier to manage portfolio volatility, even though the current crisis has shown the limit of the exercise.

But the excess leverage that some of these new instruments are tied to, essentially triggered the crisis. The fact is that dislocation has occurred in the market to a level never seen before: there are no buyers, significant sellers and the banking system is in total shambles.

This is clearly by far the most significant, albeit violent, development the market has seen – the crisis will remain in the industry's memory for a long time. However, some good will come of it in the medium term: there was too much leverage in the system and so the correction should bring the market back to sensible levels.

It's currently a bit like a pendulum – there could be further to go on the other side though, with banks facing severe balance sheet constraints. It will take some time for the market to find some equilibrium.

Q: How has this affected your business?
A: The crisis clearly makes our jobs more difficult on a day-to-day basis because the portfolio is more volatile; on the other hand it offers incredible opportunities. However, we need to be disciplined, thorough and patient in our approach.

Q: What are your key areas of focus today?
A: The current emphasis is on the opportunity fund because there will only be a potentially small window of opportunity for these assets (less than a year we believe). The fund comprises three buckets. First, a corporate risk bucket for bonds and loans: some of these assets are trading at discounted levels (10/15% yield), despite strong fundamentals.

Second, there is a structured product bucket, which invests in CLOs, CDOs and ABS. So far, we've only invested in a small number of triple-B CLO tranches, which are paying a spread of over 1000bp and should therefore be able to sustain a significant default.

And third, a real estate bucket which invests in CMBS and RMBS. The opportunities haven't arrived yet for this bucket, but they will come.

We hedge our portfolio through long/short positions. Correlation isn't necessary – there are enough opportunities without the need to do over-complicated trades.

Q: What is your strategy going forward?
A: Our strategy is to continue raising assets across the different funds. We've raised €115m so far for the opportunity fund and are looking to close it in June, depending on the availability of assets and the investor cohort – we're hoping to attract €200-€300m.

While investors are convinced about the opportunity represented by the opportunity fund, it is harder to explain that it doesn't offer liquidity. We are investing in illiquid assets, so they need to be kept for a while. We've always believed that the asset class needs a medium to long-term horizon for investment.

Once we've closed the opportunity fund, we'll continue to focus on our core strategies – credit and fixed income – and develop the performance of all three funds. We'll also look for new opportunities: we want to become the reference for the credit market in Paris.

Q: What major developments do you need/expect from the market in the future?
A: The major development we'd like to see is on the investor side. We'd like to see European investors (French in particular) dedicate more investment to the credit markets. There are a variety of regulations ¬– for example, local insurance and tax rules – that complicate the process.

The regulations sometimes seem inconsistent because, while debt will always be senior to equity, it is often easier to invest in equity. There isn't much impetus to improve the situation – particularly now, in light of the credit crisis – which is a pity because the asset class represents a strong risk/reward story.

About Tikehau Investment Management
Tikehau Investment Management (TIM) is an asset management company created in December 2006, which specialises in the fixed income area and more specifically in credit markets. TIM is regulated by the Autorité des Marchés Financiers and has over €200m in assets under management.

TIM is a private company, owned by the Tikehau Group and its management team. Tikehau Group is a joint venture between its management and CNP (Companie Nationale à Portefeuille, a company listed on Euronext Bruxelles and controlled by the Frère family).

Structured fund team joins CAI

The latest company and people moves

Structured fund team joins CAI
Rajesh Kumar and his portfolio management team from HSPI have joined Citi Alternative Investments (CAI). Kumar was founder and cio of Halcyon Securitized Products Investors (now known as HSPI), which he bought from former affiliate Halcyon Asset Management.

HSPI specialised in constructing and managing multiple structured product investments. It also managed an internally seeded credit hedge fund focused on ABS and CDO investments. The former HSPI team is believed to be planning the launch of a new fund designed to take advantage of opportunities in the US residential ABS and CDO markets.

The team joining from HSPI also includes Rajesh Agarwal, who has been named an md and will report to Kumar, also now a CAI md. Agarwal was a portfolio manager at HSPI responsible for selecting RMBS credits and managing ABS CDOs.

Guggenheim expands CDOs
Guggenheim Capital Markets, a broker/dealer subsidiary of Guggenheim Partners, has announced the expansion of its CDO effort through the hiring of Alexander Rekeda and Paolo Torti, who will lead a team based in New York. Named managing directors, Rekeda and Torti will work under Ron Iervolino, head of Guggenheim Capital Markets trading desk.

Prior to joining Guggenheim, Rekeda managed the structured credit products platform at Mizuho Securities, having joined there from Calyon (see SCI issues 20, 31 and 69). Torti also joins from Mizuho Securities, where he worked as the head of structured credit trading.

BlueMountain makes two senior-level hires
Credit and equity asset manager BlueMountain Capital Management has hired Derek Smith as a senior portfolio manager focusing on fundamental trading strategies and Scott Lessing as head of corporate research.

Smith joins BlueMountain from Deutsche Bank, where he was an md of global credit trading. In that role, he managed the investment grade and high-yield credit cash and derivatives desks across the US and Europe. Prior to joining Deutsche in 2005, Smith spent 15 years at Goldman Sachs working in various aspects of the fixed income, derivatives and credit markets.

Lessing was previously at Citi, most recently as coo for Citi Global Wealth Management Investments – the alternative investments, investment advisory products, mutual funds, annuities and insurance unit of Citi's wealth management division. Previously, he was coo for Citi's equity and corporate bond research division.

Lewtan promotes Karanian
Lewtan Technologies has promoted Thomas Karanian and combined two key departments. Karanian has been appointed to the new post of svp technology and data operations while retaining his role of chief technology officer.

Concurrent with the promotion, Lewtan has combined its data-services, development and operations organisations. By integrating them into a single unit, Lewtan says it is enhancing its ability to bring relevant, high-quality products and services to its customers in a timely fashion.

MBIA and Fitch start war of words
MBIA's chairman and ceo Jay Brown has heavily criticised Fitch Ratings in a letter requesting that the agency withdraws MBIA's insurer financial strength (IFS) ratings while continuing to rate MBIA's debt. The rating agency has swiftly responded in kind.

Brown's letter explains that MBIA had undertaken an evaluation of the impact each rating has in the various global marketplaces in which the monoline operates, the rating methodologies used by each rating agency, and the costs associated with maintaining the ratings. That evaluation came to four main conclusions.

First, Fitch's coverage of the underlying credit quality of MBIA's insured portfolio is extremely limited. Second, and related to the first issue, Fitch's capital model assumptions for public finance risks are inconsistent with MBIA's view, the markets in which these securities trade, and the views of the other major rating agencies.

Third, Fitch's capital model for financial guarantee insurance companies presents severe operational challenges for capital planning and pricing of MBIA's product. Finally, and in consideration of the above reasons, the monoline says it can no longer justify the high cost of the Fitch IFS rating.

In his response Stephen Joynt, president and ceo of Fitch Ratings, unsurprisingly refutes all of MBIA's assertions. Then, perhaps more surprisingly, turns to a more abrasive tack.

After describing his belief that MBIA is saying one thing in public and another in private, Joynt continues: "Your conflicting views lead me to question whether it is the Fitch capital model, rating process or fees that you object to or rather is it that you are aware we are continuing our analytical review and may conclude that, in our view, MBIA's insurer financial strength is no longer 'AAA'.... It seems an unusual first step in attempting to rebuild MBIA's reduced credibility with investors to limit information, decrease transparency and restrict "informed opinions" (which I believe Fitch has) just because we may not conclude that MBIA is a 'AAA' company."

Joynt concludes: "I believe that the best way forward for MBIA to re-establish the value of its products in the market is to make more information available to more rating agencies rather than just aligning MBIA with Standard & Poor's and Moody's.... We are considering your request that we withdraw the IFS ratings and return the portfolio information you previously provided us and will be consulting with regulators, issuers, investors and our own advisors and expect to announce publicly our views in the next several days."

Watch this space...

MP

CIFG downgraded ...

A round up of this week's structured credit news

CIFG downgraded ...
Fitch and Moody's have downgraded the insurer financial strength rating of CIFG from AAA/Aaa to AA-/A1. While Fitch has the ratings on rating watch negative, Moody's has them on outlook stable.

Fitch comments that its action on CIFG is based on the view that the monoline's shareholders may be less willing to provide further capital support to it in the future than in the past. Unquestioned capital support from large, strong shareholders has been a key qualitative aspect of CIFG's triple-A IFS rating historically, and played a tangible role in Fitch's maintenance of the rating following deterioration in CIFG's insured portfolio due to sub-prime exposures. The strong parental support provided through its shareholders Caisse Nationale des Caisses d'Epargne et Prevoyance (CNCE) and Banque Federale des Banques Populaires (BFBP) was demonstrated in late-2007, when the ownership group provided a capital infusion of US$1.5bn into CIFG to meet its prior modelled capital shortfall.

Though its analysis is ongoing, Fitch believes CIFG will likely need considerably more capital resources to support a triple-A IFS rating when the agency completes its updated review of the monoline's capital position. The agency believes it is highly probable that CIFG's ratings will be downgraded further, in the near-term, after further analyses are completed.

Fitch's updated review of CIFG and several of its financial guaranty competitors, which is still on-going, centres on its exposure to SF CDOs. Based on updated loss assumptions and the speed with which adverse information on underlying mortgage performance is becoming available, Fitch believes both simulated capital model losses and expected losses will increase materially for CIFG because of the company's significant SF CDO exposure within its insured portfolio, which was US$9.2bn as of 30 September 2007. Higher cumulative loss levels on sub-prime mortgage bonds will potentially have a greater impact on CIFG, given this guarantor's greater concentration of mezzanine SF CDOs, which were originally backed by underlying collateral rated triple-B.

The review will also consider a number of qualitative considerations such as CIFG's future business and competitive position, which Fitch views as challenged, as well as recent and future changes in management, governance and ownership.

Meanwhile, Moody's rating actions reflect its assessment of CIFG's weakened capitalisation, impaired business opportunities and uncertain strategic direction, as a result – in part – of its exposures to the US residential mortgage market. In the agency's opinion, CIFG's significant exposure to mortgage-related risk has material adverse consequences for its business and financial profile beyond the associated impact on capitalisation, and affects its opinion about CIFG's other key rating factors.

Moody's believes that CIFG's significant exposure to the mortgage sector, especially ABS CDOs, is indicative of a risk posture far greater than would be consistent with a Aaa rating going forward. The company's participation in several mezzanine ABS CDOs, in particular, contributed to this view. The rating agency notes that CIFG is implementing significant changes to its governance and risk management to address some of the shortcomings of its prior strategy.

Moody's adds that CIFG, as the smallest and most recent entrant to the financial guaranty sector, has not yet established a market position on par with its larger competitors and that the ongoing credit stress at the firm significantly weakened its franchise – raising questions about the degree to which it will be able to regain market traction within a reasonable timeframe. CIFG's profitability is likely to remain weak over the near to intermediate term, particularly given the losses that are likely to be generated by its insurance portfolio, the expected reduced issuance volume and the limited in-force book of business, Moody's says.

... while FSA is affirmed ...
Moody's has affirmed the Aaa insurance financial strength ratings of Financial Security Assurance and its affiliated insurance operating companies (outlook stable). The agency has also affirmed the Aa2 senior unsecured ratings of parent company, Financial Security Assurance Holdings. These rating affirmations reflect Moody's assessment of FSA's strong capital position, despite some deterioration in its HELOC book, as well as the firm's strengthened market position.

Based on the risks in FSA's portfolio, Moody's estimated stress-case losses would be in the range of US$4.5bn, including approximately US$1.1bn from its mortgage exposures, with home equity lines of credit (HELOC) being the main contributor. This compares to Moody's estimate of FSA's claims paying resources of approximately US$6.5bn, resulting in a total capital ratio of over 1.4x, which exceeds the 1.3x Aaa target level. Moody's further noted that in the expected scenario, FSA's insured portfolio will incur lifetime losses of approximately US$1.2bn in present value terms, and that FSA's current claims-paying resources cover this expected loss estimate by over 5x.

In February 2008, FSA received a US$500m capital injection from its parent, the Dexia Group, to shore up the guarantor's financial resources, helping the firm maintain capital resources above Moody's target total capital ratio at a time of high underwriting growth for the firm and greater credit uncertainty.

In Moody's opinion, the current level of stress in the market has benefited FSA's business prospects relative to many of its peers, who have experienced a decline in market share in light of credit concerns over large ABS CDO and mortgage exposures. FSA has been able to take advantage of the current environment by generating high quality business at historically strong premium rates. FSA's broad and deep relationships with issuers, as well as its prominent market position and execution capabilities in several market sectors, provide the company with a solid foundation from which to capitalize on today's market conditions.

The rating agency says that FSA's large underwriting volume is also an important indicator of the perceived value of financial guaranty insurance by the capital markets more generally. Moody's believes, however, that FSA's current competitive strength is likely to weaken somewhat as financial market conditions normalise and as certain other guarantors gain or regain market traction. With respect to underwriting and risk management, Moody's believes that FSA's conservative underwriting strategy has resulted in a generally high-quality and well-diversified insurance portfolio, but that single risk and sectoral concentrations – such as those evidenced by the company's second lien mortgage portfolio – will need to be monitored closely going forward.

Moody's also believes that the company's non-core asset management activities, including GICs, place incremental negative pressure on its ratings. The rating agency noted that FSA had to correct a material weakness in internal controls over financial reporting of hedging transactions in 2005, and that it recently received a Wells Notice from the SEC. The SEC staff is considering recommending a civil injunctive action and/or administrative proceedings against FSA, alleging violations of some anti-fraud provisions of the Securities Exchange Act of 1934 and Securities Act of 1933.

This action by the SEC follows a lengthy investigation of practices in the municipal GIC market. FSA, along with other financial institutions, received a subpoena from the SEC in November 2006. The US Attorney's Office for the Southern District of New York has also been pursuing a criminal investigation into these matters. Moody's will continue to follow the situation for material developments.

... and Ambac completes share offering
Ambac has priced a public offering for US$1.1bn of shares of its common stock (par value US$0.01 per share). The monoline concurrently priced a public offering of equity units, with a stated amount of US$50 per unit for a total stated amount of US$500m. The underwriters of these public offerings – Credit Suisse Securities, Citigroup Global Markets, UBS Securities and Banc of America Securities – have been granted a 30-day option to purchase additional shares of common stock or equity units to cover over-allotments, if any.

Michael Callen, chairman and ceo, comments: "This capital raise, along with our recent strategic actions, our increased emphasis on risk-adjusted returns over the course of an economic cycle and a six-month suspension of the structured finance business, will strengthen our capital base. We expect to be better positioned to take advantage of the current favourable market environment for credit enhancement."

Moody's commented that the move represents an important component of Ambac's overall plan to strengthen the credit profile of its financial guaranty insurance subsidiary, Ambac Assurance Corporation. The rating agency said that it will evaluate Ambac's ability to raise capital at reasonable terms in today's difficult market environment as an indication of the company's financial flexibility and overall level of support from investors.

Moody's and Fitch begin Alt-A review
Moody's and Fitch have begun reviews of Alt-A transactions originated between 2005 and 2007.

Conditions in the US housing market have deteriorated rapidly in the last several months, according to Fitch, whose review encompasses 417 Alt-A RMBS transactions with an outstanding balance of approximately US$160bn. The RMBS under review have been placed on rating watch negative: Fitch will release updated ratings for each deal as reviews are completed through the course of March and April.

Fitch's review will first focus on the US$10bn of subordinate Alt-A RMBS which face substantial pressure from rising mortgage defaults; it will subsequently analyse the triple-A rated securities that are better protected against default and loss in the mortgage pools. The agency anticipates that its rating review of these securities will be substantively completed by 30 April 2008.

"Accelerating home price declines partly due to the recent dramatic contraction in the non-agency mortgage origination and securitisation markets has been the primary catalyst of the Alt-A performance downturn," says md and RMBS co-head Glenn Costello. "This development has effectively eliminated the option to sell or refinance a home for many borrowers."

Serious delinquency levels for these Alt-A vintages have been rising rapidly in recent months. For the 2006 vintage, fixed-rate mortgage (FRM) transactions averaging 60+ day delinquencies have reached 6.4% for Fitch-rated deals and 8.6% for the market as a whole.

For the 2006 vintage adjustable-rate mortgages (ARMs), Fitch-rated 60+ day delinquencies are 9.6%. The market's delinquencies are 13.6%. While it should be noted that these delinquencies are much lower than those for sub-prime mortgages (2006 60+ day of 27%), they are substantially higher than historical Alt-A levels – which, for Fitch-rated transactions, averaged around 1%-2%.

Fitch's RMBS analysis is based on a forecasted real (inflation-adjusted) home price decline of approximately 25% from peak home prices in 2006. As in the sub-prime market, although to a lesser degree, the willingness of Alt-A borrowers with high LTV mortgages to 'walk away' from mortgage debt has contributed to high levels of early default.

As Fitch has described in recent sub-prime RMBS commentary, this behaviour appears to be largely attributable to the use of high risk mortgage products such as 'piggy-back' second liens and stated-income documentation programmes, which in many instances were poorly underwritten and susceptible to borrower/broker fraud. While Alt-A mortgage pools represent a broad range of borrower and loan characteristics, these risk factors are present in many Alt-A transactions.

Fitch's review encompasses 138 ARM and 279 FRM deals. Of the ARM deals, 21 are backed by pools of pay-option ARMS; the remainder are backed by hybrid ARMs. The distribution of transactions by vintage is 92 from 2005, 164 from 2006 and 161 from 2007.

Positive factors that could influence Alt-A default and loss rates include declining interest rates and the recently enacted stimulus package. The combination of these factors should lead to greater liquidity in the mortgage market and help to limit additional home price declines.

Preliminary revised estimates of the lifetime expected loss for Fitch-rated Alt-A FRM, as a percentage of original balance, are 1% for the 2005 vintage, 2.9% for the 2006 vintage and 3.4% for the 2007 vintage pools. These estimates reflect the very high delinquency rates currently being experienced, combined with expectations of continued stress due to declining home prices.

Initial single-B rating average loss expectations for fixed-rate transactions ranged from 0.3% in 2005 to 0.45% in 2007. For hybrid ARM pools, the loss estimates are 1.5% for 2005, 3.1% for 2006 and 4.1% for 2007.

Initial single-B rating average loss expectations for Fitch-rated hybrid ARMS ranged from 0.4% in 2005 to 0.65% in 2007. These expectations were based on the historical performance of Alt-A quality mortgages.

Meanwhile, Moody's began releasing rating actions from its Alt-A review on 10 March, starting with rating actions on the Bear Stearns Alt-A shelf. According to Amy Tobey, vp of Moody's RMBS Surveillance Group: "The actions are part of a wider review of all RMBS transactions, in light of the deteriorating housing market and rising delinquencies and foreclosures. Moody's will continue to announce results of reviews on an on-going basis over the coming two to three months."

New LCDS documentation released
ISDA has launched a documentation template for credit default swaps referencing the Markit iTraxx LevX index of European leveraged loans. The ISDA iTraxx LevX Standard Terms Supplement for Use with Credit Derivative Transactions on Leveraged Loans is designed to document credit default swap transactions where the reference obligation and the deliverable obligation are a European syndicated secured loan listed in the index.

The form is primarily intended for use in the European market. This index version is based on the documentation template for single-name credit default swaps referencing European syndicated secured loans that ISDA published in July 2007. As with the single-name contract, the index version of the contract is structured so that it will continue after the refinancing of the reference obligation, referencing instead the new loan (or loans) that refinanced the original reference obligation.

ISDA also announced today that it has published a revised version of the (single-name) Standard Terms Supplement for Use with Credit Derivative Transactions on Leveraged Loans. This template has been updated to conform with the index version, providing consistency for those entering into single-name loan CDS trades on reference obligations that are listed in the index.

"Volumes continue to grow in loan CDS, based on standardised documentation produced by ISDA for single name trading. We believe that the publication of this standard document for index trading will provide the necessary stimulus for further growth in Europe, as publication of the index templates did in the US," says David Geen, general counsel, ISDA. LevX Series 2 is scheduled to start trading on 17 March.

K2 debt programmes on review
Moody's has placed the ratings of K2 Corp's CP and MTN programmes on review for downgrade due to funding difficulties and declines in the SIV's portfolio market value. Since mid-August 2007, K2 has had limited access to the commercial paper and medium-term note markets.

In addition, the market value of its asset portfolio has declined from 100.1% on 27 July 2007 to 96.1% on 6 March, causing the company's Capital Value to decline to 68%. A further price drop of approximately 2% in portfolio market value, assuming no further change in the market value of liabilities, would cause a breach of the Capital Loss Limit test.

Enforcement, an operating state in which control of the SIV passes to the security trustee and a receiver, could be caused by a loss of A3 or Prime-1, or by a breach of the Capital Loss Limit test. This test requires that K2's Capital Value, computed as the difference between the market value of the asset portfolio and the market value of liabilities (expressed as a percentage of paid-in capital) be greater than 50%.

Dresdner Bank announced on 21 February its intention to offer K2 a liquidity support facility to ensure the repayment of all senior debt. Based on Moody's preliminary review of initial drafts of the support facility, the company's senior debt ratings could be confirmed if the support facility is put in place.

US CDPCs stable
The rating outlook for US credit derivative product companies (CDPCs) for 2008 is stable, according to Moody's in its just-published annual review and outlook report for the sector. The outlook could change, however, if the rate of corporate defaults in 2008 exceeds current expectations.

During the coming year, CDPC performance may benefit from the arbitrage opportunities created by widened spreads on the credit default swaps that are their business, says Moody's. However, at the moment, limited trading in the CDS sector is constraining CDPC activity, as conditions make it difficult for CDPCs to find new counterparties.

During 2007, no Moody's-rated CDPC debt was downgraded, despite the deterioration in the credit markets. CDPC counterparty ratings have also been stable, with Moody's taking no downgrades since first issuing them in 2002.

Some CDPCs with auction rate notes have been unable to roll these notes, leading the notes to reset at higher interest rates. These higher rates are already incorporated into the capital model, as Moody's ratings assume that liabilities are bearing their maximum possible spreads.

In 2007, Moody's assigned final ratings on ten tranches of debt of three new CDPCs and provisional ratings on four tranches of debt of two new CDPCs. There are currently between 10 and 15 new CDPCs in the pipeline at various stages of Moody's analytical process. The agency says five CDPCs could be assigned definitive ratings during 2008.

Japanese rating transitions analysed
In a new report, Moody's says both upgrade and downgrade rates in the Japanese structured finance market were higher than their historical averages in 2007. The CMBS and RMBS sectors maintained their strong performance, while downgrades for ABS and CDOs were higher than the historical rates. Nevertheless, Japanese structured finance ratings on average experienced lower downgrade rates and higher upgrade rates than global structured finance sector ratings.

These conclusions are contained in Moody's just-released fifth annual study of changes in Japanese structured finance ratings, on an aggregate basis and in key sectors – namely, ABS, CDO, CMBS, and RMBS. Over the course of 2007, nine ratings were downgraded and 104 were upgraded, the report says – adding that the upgrades occurred in all four sectors and the most commonly cited reason for the rating action was increased credit enhancement.

Both ABS and CDO sectors experienced downgrades, according to the report.
Seven ABS downgrades were related to consumer finance loan ABS, most of which were the result of revisiting the risk of overpaid interest claims. Two CDO downgrades were related to two CDO transactions backed by SME loans, and each downgrade was made to a tranche initially rated single-B or below.

The report notes that, of Moody's-rated Japanese structured finance transactions, none are backed by or refer to US sub-prime mortgage loans, structured finance transactions backed by US sub-prime mortgages or US residential mortgage lenders. Accordingly, no Japanese structured finance transaction was directly affected by the US sub-prime turmoil.

Starting with this report, the criteria used to create the data set have been changed – the most notable modifications being that pari-passu tranches are no longer collapsed and that interest-only (IO) tranches are included. In addition, the rating immediately prior to withdrawal is now used to count downgrades and upgrades.

The report says that at the beginning of 2007, there were 1,637 Japanese structured finance ratings outstanding, compared to just two ratings at the beginning of 1995. Of the 2007 ratings outstanding, 94.6% were investment-grade, and 54.5%, Aaa. By asset type, ABS (43.1%) and CMBS (31.4%) remained the two largest sectors, followed by RMBS (16.2%), CDOs (7.7%) and WBS (1.5%).

S&P launches Hedge Fund Evaluator V.2
S&P has launched Hedge Fund Evaluator (HFE) V.2, an analytical tool which combines stochastic simulation of hedge fund performance with detailed cashflow models to provide analytic results for a variety of applications including securitisation, gap risk pricing and capital charges associated with Basel II risk analysis. HFE is a premium product based on the internal analytics used at S&P to rate collateralised fund obligations (CFOs).

"Hedge Fund Evaluator helps users to create models, simulate portfolio performance and apply 'what-if' scenarios to hedge fund portfolios," says Ram Ranganath, vp, global CDO product management. "HFE employs Monte Carlo methods to simulate the performance of a hedge fund portfolio across multiple evaluative dimensions. It identifies the weighted set of sub-strategies of a hedge fund index that correlate with a hedge fund portfolio, projects their performance over time and runs cashflow and risk analysis on the results."

Banks and other specialised institutions that arrange CFOs can use HFE to help model CFOs and replicate the quantitative aspects of S&P's rating analysis for a structure. This new version of HFE provides a full liability waterfall, with user-defined formulas, credit tests and an end-to-end evaluation of tranche cashflow and credit, as well as a mapping tool that for the first time allows full end-to-end analysis of these structures.

Lenders to hedge funds and fund-of-funds can use HFE to help identify default probabilities and allocate capital for Basel II purposes. Institutional investors such as insurance companies and pension funds with fund-of-fund or diversified hedge fund holdings can use HFE to help run their holdings for capital charge purposes or to perform liability-matching analytics.

"HFE analysis can also be used to help analyse future asset value distributions, default probabilities for any liability, custom analysis of hedge fund portfolios and gap risk transactions," adds Ranganath.

S&P continues CDO downgrades
S&P has lowered its ratings on 59 tranches from 12 US cashflow and hybrid CDO transactions. The agency removed 51 of the lowered ratings from credit watch with negative implications.

The downgraded tranches have a total issuance amount of US$4.2bn. Eleven of the 12 transactions are mezzanine ABS CDOs collateralised in large part by mezzanine tranches of RMBS and other SF securities. The other transaction is a CDO-squared transaction collateralised at origination primarily by notes from other CDOs, as well as by tranches from RMBS and other SF transactions.

At the same time, S&P has lowered its ratings on four tranches from four US synthetic CDO transactions. It removed two of the lowered ratings from credit watch with negative implications.

The US synthetic tranche ratings have a direct link to the rating on their respective reference obligations, which have been lowered as part of recent ABS CDO rating actions. The downgraded tranches have a total issuance amount of US$198.1m.

The downgrades reflect a number of factors, including credit deterioration and recent negative rating actions on US sub-prime RMBS securities. To date, S&P has lowered its ratings on 2,230 tranches from 547 US cashflow, hybrid and synthetic CDO transactions as a result of stress in the US residential mortgage market and credit deterioration of US RMBS. In addition, 1,236 ratings from 301 transactions are currently on credit watch negative for the same reasons.

LSS notes downgraded
S&P has lowered by between five and 10 notches and placed on credit watch with negative implications its ratings on 24 spread-based leveraged super-senior (LSS) secured credit-linked notes issued by the Chess II, Eirles Two, ELM, Midgard, Saphir Finance, Omega Capital and Sceptre Capital vehicles. At the same time, it has lowered and kept on credit watch negative its ratings on six LSS credit-linked notes.

The rating actions follow a significant increase in spreads for the underlying assets in these transactions over the past four weeks. During this period, spread volatility has seen an increase in weighted-average portfolio spreads of approximately 70bp in some cases. This trend of increased portfolio spreads has led to the probability of default calculated for each transaction to increase so that it is no longer commensurate with the initial ratings assigned to these transactions.

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

Caliber preliminary results in
Preliminary annual results for the Caliber permacap vehicle indicate a company-only NAV of US$0.91 per share as at 31 December 2007 (compared to $1.29 as at 30 September 2007). Consolidated NAV for the vehicle was US$3.15 per share at year-end (compared to US$0.10 as at 30 September 2007).

The EGM resolution of 30 August 2007 resulted in unrealised accumulated losses being taken to the income statement: the net loss for the first quarter to 31 December totalled US$80m, after an impairment charge of US$84m resulting in a loss per share of US$3.25 for the quarter The estimated company-only NAV per share at 31 January 2008 is US$0.83 and for the consolidated NAV it is US$3.26 per share.

At current market levels the first distribution may be delayed beyond March 2009. Shareholders will be informed if the target date for realisation of assets is extended beyond 30 August 2008.

The company-only NAV excludes those non-recourse SPVs which contributed negative net assets to the consolidated NAV. The continued decline in company-only and consolidated NAVs is largely due to unrealised losses, and reflects the depressed market prices for assets in the company's portfolio. In light of the continuing disruption in the financial markets and the illiquidity of the company's portfolio, neither NAV should be taken as a guide to the likely disposal price of such assets in the current environment or in the future.

Further Moody's and S&P CPDO/CPPI downgrades ...
Moody's and S&P continued their re-rating of the CPDO sector this week, with actions affecting the majority of the transactions rated publicly. Moody's even turned its attention to the CPPI sector for the first time.

Moody's has downgraded €155m CPDOs exposed to portfolios of financial names. The affected CPDOs, issued through the ELM vehicle, represent 100% of the existing financial CPDOs and 5.5% of all CPDOs rated by Moody's.

These downgrades reflect the negative NAV impact of the continuing widening and the increased volatility of the spreads associated with financial names underlying these CPDOs, particularly monolines and investment banks. The weighted average credit spread of the underlying portfolios widened by approximately 90bp over the last 10 days.

The current ratings are mainly driven by the probability that the NAV will reach the cash-out triggers (around 10%), leading to a total unwind of the structure, and an approximate 90% loss to investors. The NAVs for all of these deals are currently in the 15% to 43% range.

The agency also downgraded, and left on review for further possible downgrade, eight other CPDOs – which account for 23% of the total volume of CPDOs rated by Moody's. These managed CPDO transactions are exposed to spread movements of bespoke portfolios, with one also including long-short strategies. The transactions affected by this action are the Alhambra, Cairn, M.A.V.E.N. and Coriolanus vehicles.

The rating actions are a response to the widening of the indices' weighted average spreads to very high levels. In addition to widening, spreads remain highly volatile.

Over the next few weeks, the agency 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 the CPDOs ranges between 1x and 12x, making each transaction's NAV very sensitive to the recent spread widening. As a result, the NAVs of these transactions have fallen to between 27% and 66%.

These actions followed the previous downgrade of 21 CPDOs (issued through the Castle Finance I and II, Thebes Capital, RECIPES, Ruby Finance, Magnolia Finance and SEA vehicles) and six CPPI transactions (Greenwood, Credit Pill and Alpaca notes). The Greenwood and Credit Pill transactions, issued by Magnolia Finance VI, are currently not invested in any credit strategy; the amount available above the value of the zero-coupon bond is now small relative to its initial value.

The Alpaca transactions still have proceeds invested, but currently the value of this investment is a small fraction of its initial value. Moody's believes there is significant probability that all six transactions will not pay all their coupons to the investors.

Meanwhile, S&P has lowered its ratings on 22 CPDO transactions (issued through the Castle Finance I, Chess II, Rembrandt New Zealand and Australia Trusts, Saphir Finance, Antara Capital, Coriolanus and Motif Finance vehicles). All deals have been placed or remain on credit watch with negative implications. The credit watch negative placements reflect the volatility of credit spreads in recent weeks and the possibility of further market disruption.

... while another CPDO is hit by its SIV investment
Moody's has downgraded to C from Aa3 one CPDO transaction issued by Clear (the REDI Notes Series 55). As well as being exposed to spread movements of the iTraxx Europe and CDX.NA.IG indices, the deal is exposed to the market value risk of the collateral which was purchased with the proceeds from the sale of the notes. This last feature is not present in other Moody's-rated CPDOs and is unique to this transaction.

The rating action is a response to the widening of these indices' weighted average spreads to very high levels, pushing the NAV of the swap to approximately 45%. The combined weighted average index spread has increased from approximately 30bp when this transaction closed to approximately 145bp.

The market value of the collateral has fallen to approximately 65%. The collateral is a Yen-denominated Sigma Finance Corporation 2022 bond.

The combination of the fall in NAV of the swap and the collateral pushed the overall NAV to under 10%, triggering a cash-out credit event. The transaction will now unwind, with a loss to investors likely to exceed 90%.

TRUPS CDO outlook stable
The outlook for US bank and insurance Trust Preferred Securities (TRUPS) is stable to negative in 2008, while it is stable for bank and insurance TRUPS CDOs, says Moody's in its annual sector review.

"US bank and insurance TRUPS have been a stable asset class since bank TRUPS were introduced in 2000 and insurance TRUPS in 2003," says the report's lead author James Brennan, a Moody's vp - senior analyst. "Although most of the bank and insurance issuers in TRUPS CDOs have minimal exposure to sub-prime residential mortgages, slowing economic conditions in the US and the threat of a possible recession may cause an increase in the number of bank and insurance deferrals, but due to structural features in TRUPS CDOs, ratings in 2008 should be stable."

The outlook for REIT TRUPS and REIT TRUPS CDOs is negative. Moody's says that problems among REIT TRUPS CDOs have been largely limited to the mortgage REIT and homebuilder areas. The liquidity and other credit issues that emerged after mid-year are likely to continue through 2008.

Some TRUPS CDO portfolios holding REIT obligations have been directly affected by the sub-prime crisis. Moody's is finalising rating actions on 11 REIT TRUPS CDOs that are on review for possible downgrade.

Through June 2007, REIT collateral made up an increasing share of the collateral in TRUP CDOS. This trend has stopped. In all, Moody's expects the pace of TRUPS CDO issuance in 2008 to lag that of recent years.

Not only have overall market conditions declined, the agency says, but a sharp widening in credit spreads has dampened the incentive to refinance older TRUPS. Few banks are currently looking to finance acquisitions, which have historically been in part financed with TRUPS.

CS

The SIV asset overhang in context

The continued threat of SIV asset sales is discussed by Conor O'Toole and Ganesh Rajendra, research analysts in Deutsche Bank's European securitisation research team

Despite significant headway being made on SIV restructurings, we see a continued threat of SIV asset sales based on orderly unwinds rather than any forced liquidations. Different incentives for asset sales exist, depending on whether the vehicle has been restructured by a sponsor bank or has entered enforcement.

The prevailing vehicle leverage (based on the size of equity cushion) should provide some guide to hypothetical floor prices for SIV assets, as both receivers and bank sponsors are unlikely to sell at prices that result in losses to senior debt holders. Taken in isolation, we find that the quantum of SIV ABS assets that needs to be sold in the near-term (that is, the overhang) is a lesser threat to the various outstanding structured finance sectors than initially thought, mainly on account of the extent of asset downsizing that has already taken place.

A brief re-cap
To date SIVs are currently in one of three operating states – enforcement, status quo, or have been bailed out by a bank sponsor (see Exhibit 1). To date six SIVs have entered enforcement, while Gordion Knot's Sigma is the only remaining vehicle not to have engaged in a restructuring (also Vetra from Citi, but we assume Citi would likewise step in with a restructuring solution).

Exhibit 1

The remainder have all been bailed out, with restructuring proposals announced by their sponsor bank (Dresdner's K2 and Bank of Montreal's (BMO's) Links and Parkland were the final three bank sponsored vehicles to benefit from such proposed solutions). Yet SIVs have made good progress in downsizing their portfolios, with sector assets-under-management having fallen from US$380bn in July 2007 to around US$200bn today (see Exhibit 2), as the combined effect of capital note investors engaging in asset capital/vertical slice trades, SIV managers selling down assets to meet senior debt redemptions and asset maturities continued apace.

Exhibit 2

Despite banks effectively bailing out the senior debt of their vehicles, in most cases in their statements announcing their proposed restructuring solutions they have alluded to, if not directly stated, the fact that they will continue to use asset sales to meet maturing debt as it falls due. Also, although receivers have announced that fire-sales are not being considered, this does not entirely discount the prospect of sales where prices are deemed attractive. We examine our thoughts on these two operating states below.

Discussion on vehicle states and incentives to sell

a) Enforcement
Any asset sales from vehicles that have entered enforcement will be effectively conducted by the receiver acting in the interest of senior debt holders. Given that any vehicle that has entered enforcement is likely to have a significantly reduced NAV, much (if any) of the cushion remaining for the benefit of senior debt will likely be fully eroded in a fire-sale liquidation scenario, ultimately leading to principal loss to senior debt investors. Faced with the choice of crystallising a loss on their investment today or extension but ultimate repayment of principal upon asset maturity, we believe senior debt holders will choose the latter and therefore receivers are unlikely to conduct liquidations at fire sale prices.

However, asset impairments or, at the very least, risk of the same will also be a consideration and could even lead to senior debt investors deeming it more prudent to take a certain loss today. But, while the senior debt of vehicles that have entered enforcement have typically had portfolios comprised of riskier assets to include US sub-prime and CDOs backed by US sub-prime, we still believe that on balance senior debt holders will opt to extend rather than book a loss in today's illiquid markets.

b) Bank sponsored bail-out
All bank sponsors bar Standard Chartered have stepped in to rescue their vehicles, yet the nature of the bail-outs differ greatly. For the most part, it appears that the vehicles that have benefited from bank sponsor-led restructuring will also engage in asset sales. The one notable exception at this stage is HSBC's Cullinan (and perhaps also its proposal for Asscher).

Banks have generally adopted to put in place liquidity facilities, which in most cases take the form of 100% backstop facilities to the senior debt. In the case of the Citigroup restructuring, there is no 100% backstop but rather a mezzanine facility sitting above capital notes but below senior debt and sized to provide sufficient cushion to the former. What the proposals involving liquidity facilities have in common is that they continue to rely upon asset sales to redeem senior debt, at least to the extent possible.

While the statements from banks do not explicitly state at what stage the facilities would be drawn down, one can assume again that an important consideration (again similar to vehicles that have entered enforcement) would be the loss of principal to senior debt. However, the difference between a vehicle that has entered enforcement and a vehicle that has been bailed out by a bank sponsor is that if an individual asset is sold below the senior debt cushion, the sponsor bank – to the extent it has 100% backstopped the liquidity facility – will ultimately have crystallised the loss on that asset. Therefore it can be argued that liquidity facilities will effectively be drawn only in cases where the price falls below the level at which senior debt gets out whole.

The hypothetical floor price for SIV assets
Both SIV states described above effectively speak to a minimum weighted average price floor for asset sales. Minimum because once the equity cushion is eroded this represents a loss to senior debt, either existing debt investors in the case of enforcement or debt investors and bank sponsors (the latter to the extent facilities are drawn) in the case of restructured vehicles. And weighted average because there may be scope to sell individual assets below this floor, as long as the loss can be offset by other asset sales above this level.

If we consider a SIV with leverage of 12.5x, the equity cushion will equal 8% (100/12.5 = 8), meaning that senior debt will get out whole if portfolio assets are sold at a weighted average minimum price of 92% (see Exhibit 3). In the case of enforcement (ignoring the time value of money) this is clear; however, in a bank restructured vehicle there is the further consideration of the cost and amount of funding.

Exhibit 3

Effectively it becomes a trade off between the negative carry the bank bears for providing funding potentially over the life of the assets and the loss on sale of those same assets today. Indeed, the bank sponsor may elect to sell assets below the equity cushion if the cost of carry in this respect is estimated to be greater than the loss upon sale.

Two important points should be underlined on the minimum hypothetical price floor. First, the price floor only pertains to SIV assets. Second, as already mentioned, it relates to a weighted average and appropriate caveats should therefore be duly noted.

Sizing the SIV asset overhang
So what is the size of the SIV asset overhang currently and what is the asset composition? As mentioned earlier, based on our estimates, SIV AUM currently stands at just north of US$200bn.

While senior debt funding is weighted towards US$ currency (80%), the assets underlying the bonds are roughly split 50/50 into US/Europe and Australia. According to Moody's, roughly more than 50% (US%100bn) of SIV senior debt liabilities (net of scheduled asset maturities) need to be re-financed by the end of 2008 (see Exhibit 4); therefore, if we assume a sector leverage of 12.5x (8% equity cushion), we estimate that US$92bn of assets will have to be either sold or re-financed in 2008.

Exhibit 4

Roughly 56% of SIV AUM is comprised of ABS currently, on our estimates, with the balance comprising financials at 42% (to include monolines of 8%) and other bonds of 1.5%. To date asset sales have been weighted towards ABS assets (65%), presumably given the smaller natural buyer base for lower tier 2 debt and the more ready bid (relatively at least) for shorter dated, higher-rated ABS triple-A paper. So, if we assume that SIV AUM continue to be sold down along the same proportion, we would see some US$60bn of ABS assets offered over the course of the coming year, of which we estimate that US$30bn would be backed by European collateral.

Exhibit 5

Although nominally a sizable amount, when compared to the ABS market outstanding, this US$60bn looks relatively less threatening. Indeed, comparing the SIV asset overhang in each sector (see Exhibit 5) with global issuance outstanding in that respective sector suggests that the technical impact on structured finance markets from the ongoing SIV unwind, if taken in isolation, is likely to recede going forward.

© 2008 Deutsche Bank. All rights reserved. This Research Note is an excerpt from Deutsche Bank's European Securitisation Monthly, which was first published on 6 March 2008.

This article is written by Conor O'Toole and Ganesh Rajendra, Global Markets Research at Deutsche Bank ('DB'). The opinions or recommendations expressed in this article are those of the author and are not representative of Deutsche Bank as a whole. DB does not accept liability for any direct, consequential or other loss arising from reliance on this article.

Trading ideas: flat out

Tim Backshall, chief credit derivatives strategist at Credit Derivatives Research, looks at a steepener trade on CDX.NA.IG Series 9

The last few days have seen enormous volatility in the major credit indices as index arbitrageurs and macro momentum players have vied for position. An underlying tone of negativity remains, as day after day we see more evidence of the creeping contagion of the sub-prime to structured finance to leveraged credits to unwinds trail.

While we remain negative in our view on US credit, we cannot help but look for value – and most frequently that value is found at the single-name outright or capital structure level. Our negative view, though, does not stop us from taking opportunistic longs or positive views when the time is right (and breakevens look attractive) and we feel, with the recent spike in spreads, that our theme trade of buying a steepener in IG9 is extremely attractive.

The index has been trading inverted in 5s10s and dipped to its most inverted as spreads peaked on Thursday, 6 March. We are not calling the top (or bottom) here, but with carry running over 130bp and breakevens (from both curve and default shifts) appearing attractive, the benefits outweigh the draw-downs and we feel the steepener is a conservative way to play both longer-term recovery in financials as well as short-term technicals due to the roll.

Looking back to look forward
The steepener is clearly a more positive trade – in that we would expect the curve to shift from inverted to more upward-sloping only in the event of a significant improvement in spread levels – but we find that historically even Series 8 (with RESCAP et al.) is less inverted as time goes by. Exhibit 1 shows the 5s10s curves for the last three CDX.NA.IG series in the US and the on-the-run Main series in Europe.

Exhibit 1

The current IG9 curve is the flattest and most inverted of all of these curves. At first glance, this is not incredible but when we remember that Series 8 IG has RESCAP and the same builders and MBIA, and the European index has a greater weighting in financials versus non-financials than the current IG9, it is notable that perhaps the current curve is too inverted (based on its constituents) – thanks as much to a lack of structured credit flow at the long-end – or that as time rolls on, the curve will gently steepen (as with Series 8 and Series 7 versus Series 9).

So our first reason for taking on the steepener (a more bullish position than our negative credit view would otherwise warrant) is the relative flatness or inversion versus other indices of similar composition. The CDX series has only been running for five or so years and not really through a cycle of severe recession or defaults and so judging curves based on this is marginally satisfying.

In an effort to better understand curve and level dynamics through a recessionary and default-prone environment, we look at default rates over the past 30-40 years and derive a series of both expected levels and curves based on those default rates. We find that the average default-based level for a diversified investment grade portfolio is around 140bp (in CDS terms). For those who read our comments, this is nothing new – we discussed this level as a target when spreads were at 80bp and anything above 140bp for five-year risk is implying a severe default environment – as our current Series 9 is at the moment.

More importantly (especially if our wish is to construct this trade as DV01-neutral) is how the curve shapes change through time. Exhibit 2 illustrates the changes in the 5s10s curve shape implied by real defaults through the last three major recessions.

Exhibit 2

The finding is that the curve tends to reach a trough around 40bp (with 70s showing far less and 2000s showing a little more). Hence, we see our downside from the current level as being around 40bp of inversion – with notably the trough to flat tending to last less than four years at most.

Our current curve is inverted around 5-7bp, leaving it far more inverted than any other IG index since inception, most inverted since IG9 contract inception, and having 30-35bp of downside from recessionary default-laden expectations. On the upside, we note that curves have been as steep as 30-40bp (both in Exhibit 1 and 2).

Carry and roll me home
So arguably we are relatively cheap (flat) in terms of curve based on historical realised defaults and traded curves, but more importantly we note two additional factors that make this trade very appealing at this time. The first is a bit more fleeting – the current curve is cheap in the five-year and almost rich in the 10-year – in other words, last week's action has pushed the curve slightly more inverted to intrinsics than it has been recently (assuming our long-dated single-name levels are relatively liquid).

The second additional factor is the attractive breakevens of the current spread differentials. Constructing the trade DV01-neutral (with a weighting of approximately 1.75-to-1) generates around 145bp of carry (184 bid on five-year and -7 offer on 5s10s switch). This very positive carry covers over 26bp of inversion or around three defaults per year. That is a default rate of 2.4% per year, compared to an average IG default rate far lower than 1%, and the inversion is extreme for one year.

Breakevens therefore are very attractive, despite the index implying around 16 defaults over its remaining life. We do not expect investors to hold this trade to maturity of the five-year leg, although the curve would likely steepen as it rolls (based on historical precedent).

The roll down the curve or theta is less interesting to us than the pending index/CDS roll in two weeks. We usually see a rally into the roll as shorts cover in the old index to reset into a lower spread new portfolio – this rally has been seen in most of the last few rolls.

The CPDO activity does throw a slight spoke in the works, as they tend to buy back the five-year protection post-roll to sell protection in the new roll – causing the post-roll legacy index to sell-off – we would expect the same behaviour this time. However, the pre-roll rally may be enough for us to grab a quick profit and the post-roll sell-off may be small (given a number of CPDOs are at maximum leverage already, have already unwound, or are closing in on unwind triggers). Either way, these effects tend to be less long-lived than the underlying fundamentals, but we do note that the technicals are dominating activity in the indices currently.

Risk analysis
The curve steepener is inherently exposed to default risk, given its DV01-neutral nature (more sold protection in five-year than bought protection in 10-year), but we feel the carry cushions much of that impact. While short-term neutral to parallel spread moves, DV01s are not static and will shift if we get an extreme jump in spreads.

We will address this in our comments, but in the meantime the balance should provide stability. The further curve inversion from continued stress in builders and financials can be covered by the carry cushion and roll-down.

Liquidity
The CDX.NA.IG Series 9 index is a very liquid market with 1bp bid-offers at most in general. Current market environments make bid-offers tough to judge, but our choice of five- and 10-year reflect the best liquidity, despite 10-year being more quoted as a 5s10s switch than outright.

Fundamentals
This trade is not impacted by any idiosyncratic fundamentals; it is more of a conservative and positive carry bet against a systemic bias towards weakening fundamentals across the board. While we expect (at a macro level) spreads to remain wide, we also expect the current financial crisis to be worked through (likely with some defaults) and the switch from risk premia in financials to non-financials as the pinch of the recession and tough funding are felt more widespread than currently implied.

Summary and trade recommendation
The rapid decompression of spreads in investment grade credit over the last few weeks has shifted many single-name curves to significant levels of inversion, with 46% of the liquid CDS universe now having 10-year levels below five-year (including HY) and 42% of the IG9 credits. As the CDO market shutdown, so the cut-off in flows at the long-end of the CDS curve forced dealers to withdraw liquidity and – with expectations of rising default rates and a severe recession priced into spread curves – marginal default risk has become over-weighted in the short-term forcing IG9 inverted.

The very recent spike wider pushed that inversion to contract lows and far ahead of any previous IG index (even Series 8 with RESCAP). Breakevens on the DV01-neutral steepener offer very attractive terms compared to historical real default experience, covering three defaults per year or over 35bp of inversion.

The last three previous recessions have seen peak curve inversions of 10, 40 and 50bp, and so downside is limited as carry, roll-down and the prospects of curve normalisation remain attractive trade-offs. The short-term technicals pre-roll 9 shorts covering) and post-roll (CPDO rolls) remain a concern, but should be relatively modest compared to the underlying fundamentals required to move the curve. Although grabbing a quick profit on a short-covering rally is not out of the question, we see the carry and roll-down as providing a great deal of comfort for waiting out a recovery to IG9 financials or at least for funding shorts.

Markets are moving very fast in the current environment. This trade remains attractive at wider/more inverted levels of the curve – offering more carry and better breakevens – helping to manage the sizable MTM swings in the short-term.

Sell US$17.5m notional CDX.NA.IG Series 9 5 Year CDS protection at 184bp.

Buy US$10m notional CDX.NA.IG Series 9 10 Year CDS protection at 177bp (-7bp 5s10s switch) to gain US$145,000 or ~83bp of carry (on 5Y notional).

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