Contents

MFI pilot launched

Further improvements needed to bring sector into mainstream

S&P, in collaboration with the Inter-American Development Bank's Multilateral Investment Fund, is launching a pilot ratings programme for 10 microfinance institutions (MFIs). Though the move is seen as a step in the right direction, investors are calling for further improvements to the ratings framework for microfinance securitisations.

Rating methodologies should better reflect the geographical regions and specialised nature of the originators involved in the microfinance industry, says Alessandro Tappi, head of guarantees and securitisation at the European Investment Fund. "For example, we participated in a CLO transaction that securitised loans to MFIs in the Balkans. The rating agencies – which were not involved – would have assumed that correlation for the region was close to 100%, but we disagree. Another aspect to consider is that some MFIs don't even hold banking licenses, yet they are granting loans. The methodology hasn't been tested here either," he notes.

Analysts estimate that private investment in the MFI sector will grow to US$20bn by 2015; however, reaching this figure will require the resources of the mainstream capital markets. The vast majority of microfinance investors are in contact directly with individual MFIs, typically funding the subordinate or senior unsecured loans. So the challenge for the industry is to increase the number of investors actually reaching the MFIs – and an efficient way of achieving this is through CLOs.

"Investors spend weeks doing their own due diligence on a single MFI and obviously the length of time increases if they try to achieve diversification across a portfolio of MFIs. If they invested via a CLO, possibly on a senior tranche level and with a collateral portfolio which by definition is more diversified, it lightens the due diligence burden – and to the extent they can trade the bonds in the secondary market, it will help target a different investor base," Tappi explains.

While the creation of standardised analytical tools (including an improved ratings framework) will help broaden the microfinance investor base, it needs to be accompanied by education about structured finance. "Some investors are knowledgeable about individual MFIs, but they typically don't understand CLOs," confirms Tappi.

He adds: "With the increased number of counterparties and the inclusion of, for example, mezzanine positions, structured finance makes the analytical side more challenging because it requires additional quantitative skills which some funds lack. Equally, the MFI CLOs that have closed have so far been quite small and so they don't typically attract the interest of arrangers, whose job is also to explain to potential investors the deal structure and any special features."

The aim of S&P's 18-month ratings pilot is to evaluate as broad a group of MFIs as possible from across the Latin American and Caribbean region. The key factors that will be considered in choosing the participating MFIs are diversification by size of portfolio, geography and type of institution, and a cross-section of some of the major microfinance networks.

"Beyond developing independent and readily understood opinions about credit risk and the ability to compare the creditworthiness of various instruments, we believe that our efforts will provide both clear standards for disclosure and financial accounting and outcomes that MFIs can use to enhance their ability to attract donor and other non-capital market investment," analysts at S&P note.

The aim is to provide investors with tools to better define risk/reward parameters when considering the sector. S&P believes that a more robust secondary market for MFI instruments may develop as a result, along with a greater acceptance of these loans in structured transactions. Both of these advances should, in turn, lower issuance costs for MFIs.

While analysts report that the volume of microfinance CLOs is unlikely to ever grow astronomically, they expect a core of tier one and tier two MFIs to participate in securitisations in the future. S&P confirms that it has a number of requests for microfinance securitisation ratings in its pipeline.

CS

Increased engagement

Renewed focus on clearing and settlement

The credit derivatives industry appears to be coalescing around the importance of efficient settlement and collateral management, thanks to the rise in volumes during the summer and the increasing number of buy-siders entering the market. Exchange-based initiatives for the CDS sector still seem to be falling short of the mark, however.

"The operational dimension of portfolio reconciliation has increased in importance recently, building on ISDA's push to standardise the items being reconciled. Moreover, for some trades, collateral practitioners are almost performing an audit-like role now," notes Richard Metcalfe, global head of policy and senior regulatory adviser at ISDA.

One dealer at an American bank confirms that the market has seen a significant increase in engagement by the buy-side to resolve CDS settlement issues. "It has been an interesting nine months: there was a huge rise in CDS volumes during the summer and the market constituency is now changing, with the amount of trading on the buy-side growing," he says.

Indeed, investors report that CDS trading will become standard for many funds over the next few years. But this begs the now-familiar question of how well the market infrastructure will cope with increasing volumes, especially given that collective action is a tougher proposition for the buy-side compared to the limited number of dealers involved on the sell-side.

Sources indicate that the Depository Trust & Clearing Corporation (DTCC)'s central settlement service for OTC CDS (see SCI issue 71) is driving standardisation and consolidation in this space. The DTCC is set to incorporate in its settlement platform LCDS in April and tranche products in August (it is still in consultation about the inclusion of ABS CDS). However, it currently only serves the sell-side – although the offering will eventually be extended to the buy-side.

While the DTCC says it aims to balance the flexibility of OTC derivatives trading with the efficiencies of an exchange infrastructure, the exchanges themselves are trying to make inroads into the CDS sector. NYSE Euronext looks set to become the newest entrant, as it reportedly plans to offer an OTC clearing service via its BClear platform.

But ISDA's Metcalfe suggests that there is little demand for central clearing of CDS trades via an exchange because of the bespoke nature of the contracts. "In addition, there is interest in some quarters in maintaining a degree of control over risk by keeping collateral agreements bilateral – there is natural tension between the need for operational efficiency and what may be proprietary risk management standards. After all, as a derivative dealer, it is important to have the appetite to take on a counterparty for a long time," he notes.

Eurex and the Chicago Mercantile Exchange both launched CDS futures contracts last year, which have seen little industry take-up so far (see SCI issue 38). "The difficulty with exchange-traded CDS is developing an appropriate correlation model; plus, the contracts aren't fungible. It is hard to see what an exchange could add that isn't already provided for in the OTC market," the dealer concludes.

CS

Restructurings conclude

HSBC and Eaton Vance plans get underway

The last of the SIV restructurings are drawing to a close. HSBC's Asscher Finance is now awaiting the results of an exchange offer into a new vehicle dubbed Malachite Funding, while the Eaton Vance Variable Leverage Fund (EVVLF) has restructured its enforcement events.

Investors in the outstanding income notes issued by Asscher Finance have until 25 March to decide whether to exchange their holdings for an equivalent investment in Malachite Funding. The presence of certain features, such as a term repurchase facility, is intended to enable the issuer to access senior funding more readily than under Asscher's senior debt programmes.

The portfolio of assets to be held by Malachite will be broadly similar to the portfolio currently held by Asscher. The provisional capital structure of the new vehicle comprises a committed repo facility agreement (accounting for 86.6%), which is senior to triple-A rated deferrable junior senior EMTNs (6%), and Tier 1, 2 and 3 income notes rated single-A (5.5%), triple-B (1%) and unrated (1%) respectively.

After closing, Malachite will use the note proceeds and the repo facility (provided by HSBC) to fund the purchase of the asset portfolio, thought to be worth around US$6.8bn with a 4.38-year WAL. Of the preliminary portfolio, 94.49% of the assets are rated double-A minus or higher and 89.86% are rated triple-A. The repo facility will be at par, with neither margin calls nor haircuts, and will amortise in tandem with the assets – thereby eliminating market risk and liquidation risk from the structure.

Income notes can be partially redeemed ahead of the senior notes. However, this can only occur once the subordination to the senior and deferrable junior senior notes exceeds certain predefined levels. A failure to pay interest and/or principal on the repo facility will lead to enforcement.

Based on the composition of the expected portfolio, S&P's CDO Evaluator calculated a scenario default rate of 7.06%, 3.59% and 2.13% for the AAA/A/BBB rating levels respectively.

Changes in EVVLF's operating terms, meanwhile, include the removal of the price tier operating limit and the capital adequacy test as enforcement events. However, the leverage compliance test remains in effect, which – if breached – could force the vehicle into enforcement mode.

Eaton Vance's revised approach to managing its SIV also calls for an orderly amortisation of the existing outstanding MTNs as prepayments and scheduled principal are received on the loan portfolio, as well as selective asset sales (but only as necessary to avoid an enforcement event). The vehicle was the first to term out its financing, thereby relieving the roll risk associated with the short-term funding that has impaired other SIVs. Nevertheless, it still faces market value risk based on the leverage test and therefore S&P has placed its debt programmes on watch negative.

Elsewhere in the SIV sector, Moody's has confirmed the Aaa and Prime-1 ratings assigned to Tango Finance's MTN and CP programmes, following the sale of all its remaining assets by Rabobank. At the same time, Moody's downgraded the vehicle's income notes from Caa3 to C, reflecting the decline in NAV and the fact that losses will be realised in line with the current NAV.

Tango also holds cash in breakable deposits with highly rated financial institutions that in each case would be replaced on a loss of its Prime-1 rating. The sum of the funds available to Tango will be sufficient to repay senior debt as it falls due. The last MTN to mature will do so on 30 June 2010.

S&P has also placed its ratings on Sigma Finance on watch negative, reflecting its view of the continuing and intensifying pressure that is still present in the credit and fixed income markets. The vehicle has approximately a 175bp spread cushion that translates to about a 7.4% market value price coverage relative to par of its liabilities.

CS

Lehman cuts back research

The latest company and people moves

Lehman cuts back research
Lehman Brothers has shut down its two-man European credit strategy team in London. David Brickman, head of European credit strategy, and structured credit strategist Ben Bennett are understood to be looking at possibilities for redeployment elsewhere in the firm.

Lehman's European credit strategy is now being covered out of the US, although it does still have desk analysts in Europe (albeit they cannot produce written research).

Hamilton joins Alcentra
Hiram Hamilton, former co-head of European CDOs at Morgan Stanley, is believed to be joining Alcentra, the international asset management group focused on the management of sub-investment grade debt.

Halcyon to go public
Halcyon Asset Management will access the public equity markets through an acquisition by Alternative Asset Management Acquisition Corporation (AAMAC). The new entity will be called Halcyon Management.

The transaction values Halcyon at approximately US$974m. Under the terms of the agreement, members of Halcyon entities will receive up to US$505m in cash and notes, and will retain LLC interests in Halcyon exchangeable into shares of AAMAC on a one-for-one basis. Partners of Halcyon entities will further align their interests with fund investors, reinvesting 75% of the after-tax cash proceeds in Halcyon funds, typically for three years, at full fees to the public stockholders.

Halcyon Asset Management is currently privately held and controlled by 11 active partners. All current management members of the Halcyon management team will remain with the company.

The transaction is expected to be completed during the third quarter of 2008, pending AAMAC stockholder approval, Halcyon client consent, regulatory approval and other customary closing conditions. The parties intend to seek listing of Halcyon Management's shares to trade on the New York Stock Exchange following the closing.

CCC winds up
Carlyle Capital Corporation (CCC) has announced that its Class A shareholders have voted unanimously in favour of a compulsory winding up proceeding under the Companies Law in Guernsey. The company will now move forward with the winding up and liquidation application.

During a compulsory winding up, all remaining CCC assets will be liquidated by a court appointed liquidator in a timely and orderly manner. The move follows CCC's announcement last week that it had not been able to reach a mutually beneficial agreement to stabilise its financing (see last issue for more).

Then, as expected, the company received default notices from its remaining two lenders and it believes that its lenders have now taken possession of substantially all of its US government agency triple-A rated RMBS. As a result, CCC believes its liabilities exceed its assets.

Thacher Proffitt forms distressed asset group
Law firm Thacher Proffitt has brought together experienced distressed asset attorneys from its structured finance, bankruptcy, litigation and tax practice groups to create an interdisciplinary team to advise clients seeking to capitalise on what it sees as emerging opportunities in distressed assets.

The group, which is co-chaired by bankruptcy partner Hugh McDonald and structured finance partner Christopher Lewis, focuses on all aspects of distressed assets from acquisition to disposition. This includes: structuring and negotiating rescue and exit financing; foreclosures, asset dispositions and other creditor remedies/debtor defences; formation of hedge funds, private equity vehicles and other investment structures for the acquisition of distressed assets; acquisition and disposition of distressed debt and other claims, including corporate debt and structured finance securities (CDOs, SIVs, RMBS, CMBS and ABS); and negotiating, documenting and advising with respect to distressed loan and claims trading.

Roy heads for Morgan Stanley
Ranodeb Roy is understood to be joining Morgan Stanley to head up the firm's fixed income group in Asia ex-Japan. He joins as head of interest rates, credit and currencies (IRCC), taking on responsibility for both trading and distribution.

Roy – a long-term high-profile player in the Asian credit markets – was previously at Merrill Lynch as co-head of the firm's Asian fixed income unit. He was fired from Merrill last November as part of senior management cuts in the wake of the firm's sub-prime losses.

NumeriX hires Jockle
James Jockle has joined NumeriX as svp of marketing. He joins after nine years' at Fitch Ratings, where he was most recently responsible for global marketing communications and corporate communications.

In his new role, Jockle will oversee NumeriX's marketing department and support all areas of strategy and management, as well as provide leadership and direction for the market research function. He will also drive branding initiatives, corporate and product positioning and associated intellectual property agreements, while managing all aspects of NumeriX's marketing communications.

MP

Frank's bill could spark ABX

A round up of this week's structured credit news

Frank's bill could spark ABX
A proposed new home mortgage bill from US Senator Barney Frank – FHA Housing Stabilisation & Homeownership Retention – appears to offer up to an additional US$300bn in the FHA programmes already announced, which analysts say should help stimulate the markets. Senator Chris Dodd has offered a similar plan with some differences, but it is believed that the two will reconcile these proposals.

According to analysts at RBS, under the Frank proposal, mortgage holders could receive a cash payment for owner-occupied mortgages originated between 1 January 2005 and 1 July 2007 in exchange for possible losses to establish a 5% loss reserve for the FHA, bringing the loan-to-value ratio on the new FHA-loan down to no more than 90% of a property's current appraised value. Holders would therefore need to accept a substantial write-down, receiving no more than 85% of the property's current appraised value as payment in full for the existing loans.

Under the aegis of the proposed bill, the new loan must result in a meaningful reduction in mortgage debt service by the borrower. But no mention was made in the Discussion Draft of whether borrowers could have had past arrears – a hallmark of the earlier programme (one month in the last twelve).

As compensation for the new loan, the borrower will agree to pay from any profits the higher of an ongoing exit fee equal to 3% of the original FHA loan balance or a declining percentage of any profits (for example, from 100% in the first year to 20% in year five and 0% thereafter). After the fifth year of the loan, only the 3% exit fee will apply.

The proposal also includes up to US$10bn in loans and grants to facilitate the purchase and rehabilitation of vacant foreclosed homes, with the goal of occupying them by families subject to income limits. The proposed programme will have a sunset provision of two years that may be extended.

Analysts at JPMorgan believe this type of plan has merit in that it targets negative equity, the root of the problem, and also acknowledges the scale of the challenge and the need for a major government role in the fix. Inevitably, some party will need to absorb the sub-prime mortgages losses and under nearly any bailout the current loan holders will need to accept partial principal write-downs.

If this type of bailout occurs, triple-A ABX tranches are expected to rally and short speculators would likely be forced out of market in covering. This would solve a lot of mark-to-market issues for banks and go a long way to fixing the credit crunch, the analysts say.

Bank write-downs analysed
S&P believes that the bulk of the write-downs of sub-prime securities may be behind the banks and brokers that have already announced their results for full-year 2007. There may be some additional marks to market as market indicators have shown deterioration in the first quarter. However, when the percentage of write-downs taken against various types of exposures are dissected, in S&P's opinion the magnitude of some write-downs is greater than any reasonable estimate of ultimate losses.

The write-downs of ABS CDOs by large banks in North America and Europe to-date total approximately US$110bn. To this amount S&P adds approximately US$40bn in write-downs of insurers (financial guarantors and other insurers) and banks in the Gulf States and Asia to arrive at a rough estimate of US$150bn in global disclosed write-downs to-date.

Most of the write-downs have been on the super-senior tranches of ABS CDOs. To date, banks have written down their unhedged super-senior exposures by more than US$65bn.

On an original exposure of about US$160bn, this represents about a 40% discount. However, that discount percentage varies tremendously from institution to institution.

In S&P's view, some of the variation may be based on differences in the specific securities the institution owns, as the securities vary widely in their ultimate loss characteristics. Some of the variables that affect the valuation are whether the exposure was to CDO-squared securities or to the super-senior tranches of high-grade CDOs or mezzanine CDOs; the proportion of the underlying loans that were of 2005 or earlier vintages; how many of the CDOs' investments were in other CDOs and in sub-prime RMBS; and the levels of subordination in each structure.

Based on available information, the agency believes that the largest players can be seen as having undertaken a rigorous valuation methodology to come up with conservative valuations. Citi and Merrill Lynch, for example, value their high-grade super-senior tranches at 52% and 68% discounts to original exposure respectively.

The broader range of banks values them at only a 30% discount. Similarly, Citi and Merrill value the super-senior tranches of the mezzanine CDOs at 63% and 73% discounts respectively, whereas the broader range of banks values them at a 48% discount.

In S&P's view, much, though not all of the differences in valuations may be attributed to differences in vintages of exposures and other deal-specific characteristics. Banks that have taken relatively lighter write-downs on securities often have much higher proportions of 2005 or older vintages of securities. This is true for SG and Barclays Bank, for example.

Some of the difference, however, may also have to do with the modelling methodology. There appears to be general consistency among banks on certain assumptions, such as projected cumulative losses for the sub-prime loans underlying ABS CDOs. Nonetheless, within a model framework that effectively frontloads the losses versus one that spreads them out over a longer time, those assumptions can produce different results.

Other valuation models rely more on the ABX indices. The decline in those indices could produce more write-downs in the first quarter.

Yet other methodologies combined a mark-to-market methodology with one focused on ultimate recovery, depending on the likelihood of actually having to liquidate the investment. In addition, banks have adjusted their models to reflect cashflow assumptions based on specific characteristics of individual loans.

Further write-downs could occur in the portions of bank portfolios that are hedged by monolines. Banks collectively have taken about US$12bn of losses to-date as reserves against the counterparty risk of the monoline insurers that have provided hedges on, or guaranteed, a further US$125bn (notional amount) of super-senior CDO exposures. More than US$6bn of the US$13bn in reserves against monoline counterparty risk was to entirely write off the value of the ACA Assurance hedges after ACA was downgraded to triple-C.

If the banks' own internal credit departments downgrade the monolines, reserves will be raised. In addition, if the value of the hedges increases (because the value of the CDO declines), the reserves will need to be increased again, even if there is no change in monoline creditworthiness.

The banks' internal ratings falling below investment grade would call into question the hedge's effectiveness. The banks would then likely write down the full value of the hedge.

The potential losses can be estimated as follows. Hedge values are running at about 30% of the notionals (the par amount of CDOs being hedged), or about US$38bn. If all monolines' creditworthiness were to deteriorate to the non-investment grade range, banks would have to write down the value of the hedges by US$38bn, as if the hedges did not exist.

S&P estimates that for every rating category of downgrades for the monolines, reserves would need to be raised by 30% of the hedge values. In that fashion, the reserves would get to 100% of the hedge value in equal increments if the monoline ratings fell to non-investment grade.

Canadian conduit restructuring moves forward
DBRS has downgraded 20 of the conduits represented under the Montréal Accord to D, following the announcement that a filing has been made on behalf of each of them under the Companies' Creditors Arrangement Act (CCAA). The agency says that the move should not be seen as indicative of deterioration in the credit quality of the assets held by the conduits.

The CCAA filing by the Pan-Canadian Investors Committee on behalf of the 20 conduits represents a first step in the restructuring process proposed in the Framework Agreement of the Montréal Accord. The Agreement calls for all investors in the conduits to exchange their holdings for term notes matching the amortisation and maturity of the transactions held within each series or trust, as applicable.

The rating action reflects the fact that the conduits are now subject to a court-supervised process which, if successful, will see their obligations be restructured per the terms of the Framework Agreement. Under the CCAA, the objective is to restructure obligations so that the filing entity remains viable.

Upon the CCAA filing, creditors of the conduits will be stayed from enforcing their claims. This court-ordered stay will effectively replace the standstill agreement which was agreed to as part of the Montréal Accord.

LevX 2 sees €2.8bn on first day
The Markit iTraxx LevX index, which rolled into its second series on 17 March, traded more than €2.8bn on its first day of trading. These estimated volumes are based on a desk-by-desk survey of market-makers conducted by Markit.

LevX Series 2 comprises a larger basket of credits than Series 1, with a senior index of 75 LCDS referencing first-lien leveraged loans, and a subordinated index of 45 LCDS referencing second and third-lien loans. The new series has been restructured in consultation with LCDS market-makers and ISDA to make the index more attractive to dealers and investors. Changes include simplifying the LevX documentation and moving from cancellable to non-cancellable contracts.

In the event of a refinancing, instead of dropping out of the index, constituent loan contracts will now be replaced by their successors. The index annex will remain unchanged unless there is a cancellation or credit event, in which case a new index annex version will be published. This means that trade durations will no longer be affected by refinancing events and the limited number of new index annex versions will improve operational efficiency.

The LevX move to non-cancellable contracts is supported by Markit RED (Reference Entity Database) which provides verified loan reference data to enable counterparties to document and confirm LCDS transactions. The composition of the underlying index portfolio is drawn from Markit RED, and refinancing and cancellation notifications will be made available to subscribers in accordance with the Markit RED Continuity Procedures for European LCDS.

Stephan Flagel, md and head of indices at Markit, says: "The Markit LevX Series 2 is more representative of the broad European leveraged loan markets and we expect this to boost liquidity in both the cash and synthetic markets. The new series also marks a milestone in its move to non-cancellable contracts, which will make the index simpler to trade, and brings it closer to its North American sibling, the Markit LCDX."

Analysts at Barclays Capital agree that the evolution of the LevX index to a near non-cancellable format will allow for more liquidity and provide quicker access to this market for more participants, as well as traditional loan investors and bank loan books. "The index is vital for investor appetite, as it helps macro players and hedge funds take a view on the leveraged loan market by providing them with a liquid nearly bullet benchmark which almost truly reflects the credit risk in the leveraged loan market, especially as the risk of cancellation has been cut," they say.

Loan portfolio managers and bank loan books, however, would have some difficulty in hedging their loan books with the new LevX as the refinancing aspect of loans has been more or less nullified in the new index, the analysts add. As such, any loan portfolio manager trying to accurately hedge their loan portfolio will run a significant mismatched basis risk, given that expected life of the loan portfolio and the LevX will be widely different. For such players, it might make sense to hedge the book using single name LCDS without opting for continuity.

The advent of the index should improve liquidity in the single name LCDS market, which is also nearly non-cancellable. Moreover, in the long term, the index will also support the development of more sophisticated products inthis market, such as synthetic CLOs – market conditions permitting.

The LevX Licensed Market Maker Group includes the following: Bank of America, Barclays Capital; Bear Stearns; BNP Paribas; Calyon; Credit Suisse; Deutsche Bank; Dresdner Kleinwort; Goldman Sachs; JPMorgan; Lehman Brothers; Merrill Lynch; Morgan Stanley; RBS; and UBS.

Ambac affirmed ...
Moody's and S&P affirmed the triple-A insurance financial strength rating of Ambac Assurance (outlook negative). However, at the same time Moody's downgraded the debt ratings of the holding company, Ambac Financial Group, by one notch to Aa3.

These rating actions reflect the rating agencies' assessments of Ambac's ongoing efforts to strengthen its capital position in light of its troubled mortgage and mortgage-related CDO exposures, as well as the significant changes the company is implementing to reduce the volatility associated with its insured portfolio over time. The monoline's recently completed US$1.5bn capital raise was a critical factor leading to the confirmation of its insurance financial strength ratings at the company.

Based on Moody's assessment of the risks in Ambac's portfolio, estimated stress-case losses (consistent with a scenario where 2006 sub-prime first-lien mortgages realise an average of 21% cumulative pool losses, with other vintages and products stressed accordingly) would approximate US$12.1bn. This compares to Moody's estimate of Ambac's claims paying resources of approximately US$15bn, resulting in a total capital ratio of 1.24x, which exceeds the triple-A "minimum" level, but is short of the 1.3x triple-A "target" level by about US$700m.

Moody's further noted that in the most likely or "expected" scenario, Ambac's insured portfolio will incur lifetime losses of approximately US$4.2bn in present value terms, and that its current claims-paying resources cover this expected loss estimate by about 3.5x. The shortfall in capitalisation from the triple-A target was considered in relation to Ambac's plans for closing the gap through a combination of capital strengthening measures, and was determined to be consistent with a triple-A rating.

Ambac is implementing substantive changes to its underwriting and risk management guidelines, including the discontinuation of certain structured finance and asset management activities, as well as the tightening of single risk limits. Moody's views this shift in risk strategy as a very important element in the company's efforts to reduce the volatility in its insured portfolio that has become evident with deterioration in the US residential mortgage market.

The ability of the company to re-establish its strong market position in the financial guaranty sector will take time. In Moody's opinion, however, Ambac's extensive relationships with issuers, as well as its prominent market position, expertise and execution capabilities in several market sectors, provide the company with a good foundation from which to regain market confidence.

The negative outlook on Ambac's ratings reflects remaining uncertainties as the company finalises its capital plan and implements its revised strategy, as well as uncertainty regarding the ultimate performance of its mortgage and mortgage-related CDO exposures. Moody's says that the rating outlook could return to stable within the next six to twelve months, as visibility improves on the firm's likely losses from mortgage-related exposures, and as the details and effectiveness of Ambac's revised business strategy become more apparent.

S&P's negative outlook on the monoline reflects its view that the potential for further mortgage market deterioration remains uncertain and could challenge Ambac's ability to gauge its ongoing capital needs accurately in the near term.

... while CIFG is downgraded
S&P has lowered its financial strength, financial enhancement and issuer credit ratings on CIFG to single-A plus from triple-A. The downgrades reflect its view of CIFG's impaired franchise value, mirrored in its scaled-back underwriting activity, turnover of senior staff and recent other rating downgrades – which, in S&P's opinion, will impinge on the monoline's ability to carry out its business plans and broaden its market acceptance.

CIFG has lagged the industry in terms of par volume in recent years and, in S&P's view, has not developed a strong franchise. Because of this, and given the agency's view that total insured business volume will be off for the industry in 2008, it believes that the monoline is more prone to damage to its franchise than the more well-established financial guarantors.

The outlooks remain negative, reflecting S&P's reservations regarding the CIFG's ability to maintain its position as a viable competitor in the bond insurance industry, given its current staffing levels and its below-average earnings and return on earnings. In addition, although a non-executive chair has recently been appointed, S&P believes that additional time will be required to assess how or whether these changes will affect the company's performance.

More CPDO downgrades
Moody's has downgraded to single-C two CPDOs (Series 116 and 121 Tyger Notes) exposed to a portfolio of financial names, and placed on review for downgrade another (Series 104 Tyger Notes). The affected CPDOs represent 100% of the existing financial CPDOs and 5.5% of all CPDOs rated by the agency.

The two downgrades are a result of the weighted average spread of the underlying portfolios reaching such a level that the net asset value (NAV) of the transactions fell to the cash-out trigger of 10%, thereby causing the deals to unwind. The NAV is the aggregate value of the assets of the SPV.

The transaction placed on review for downgrade continues to be impacted by the continuing widening and the volatility of the spreads associated with financial names underlying the transaction, particularly monolines and investment banks. The weighted average credit spread of the underlying portfolio has widened by approximately 90bp over the last two weeks.

The current rating (Baa2) is mainly driven by the probability that the NAV will reach the cash out trigger (at 15%), leading to a total unwind of the structure and an approximate 85% loss to investors. The NAV for this deal is currently around 42%.

LSS hit again
Moody's has downgraded approximately €293m of leveraged super-senior transactions (LSS) with spread plus loss triggers. The affected deals (from the Eirles Two, Ruby Finance, Motif Capital and Cairn MASS vehicles) represent 100% of the existing LSS with spread plus loss triggers rated by Moody's in Europe.

These transactions have been impacted by the continuing widening and the volatility of the spreads of their underlying corporate and financial names, particularly monolines and investment banks. Spreads on the underlying portfolios have widened significantly in the last month, with the weighted average credit spread of the underlying portfolios now ranging between 160bp and 369bp, while the spread triggers range from 367bp to 775bp.

The Cairn transaction only has 75bp of cushion remaining and, accordingly, has been downgraded further than the other transactions, which have more than 200bp of cushion each – although the average credit quality of their underlying portfolios is better. The current ratings are mainly driven by the probability that the portfolio spreads will reach the spread triggers, leading to an unwind of the structure, and an approximate 100% loss to investors. The average credit rating on the underlying portfolios is in the Ba2 to Baa2 range.

S&P SROC results in
After running its month-end SROC (synthetic rated overcollateralisation) figures, S&P has taken rating actions on synthetic CDOs from across Europe, the US and Asia.

The agency's credit watch actions on 112 European CDO tranches include: 95 tranches being placed on watch with negative implications; three on watch with positive implications; and 14 removed from watch with negative implications and affirmed. Of the tranches placed on watch negative: 23 reference US RMBS and US CDOs that are exposed to US RMBS which have experienced recent negative rating actions; and 72 have experienced corporate downgrades in their portfolios.

Meanwhile, ratings on 129 US CDO tranches were placed on watch negative, while one lowered and another was raised. Additionally, six tranche ratings were affirmed and removed from watch negative.

The watch negative placements reflect negative rating migration in the transactions' respective portfolios and SROC ratios that were below 100%, as of the February 2008 month-end run. The tranches with ratings affirmed and removed from watch negative had SROC ratios that were at 100% at their current rating levels.

The one downgraded tranche had an SROC ratio that was below 100%, as of the February month-end run and at a 90-day forward run. The one upgraded tranche had undergone a rebalance of its portfolio, which brought the SROC ratio above 100% at the next higher rating level (which was the original rating on the tranche at closing).

Finally, S&P has placed its ratings on 25 Asia-Pacific CDOs on watch negative due to their SROC levels falling below 100% at the current rating level in the SROC analysis for February 2008. This was as a result of negative ratings migration in the reference portfolio.

Rating transitions for Asia and EMEA released
Moody's has published its annual studies of Asia-Pacific (ex-Japan) and EMEA structured finance rating transitions. The reports contain a detailed analysis of upgrade and downgrade rates for structured finance ratings in both regions, focusing on 2007 results and long-term historical averages.

The credit performance of structured finance ratings in the Asia-Pacific (ex-Japan) market avoided much of the turmoil that occurred in the global market in 2007. Ratings in this region experienced a stability rate in excess of 97% – much higher than that of global structured finance and of corporate ratings in the same region.

All rating changes in 2007 occurred among ABS and CDOs. The ABS sector experienced three downgrades and five upgrades, while CDOs experienced 11 downgrades and two upgrades.

Changes in corporate ratings and their subsequent effect on the credit quality of CDO portfolios were the major cause of Asia-Pacific rating downgrades. The most common reason for upgrades was the upgrade of a credit support provider due to refinements in Moody's bank rating methodology.

Meanwhile, for the EMEA region, although some sectors were adversely affected by the stressful market conditions of 2007, overall the 12-month upgrade and downgrade rates held close to their historical averages. The majority of the rating changes were concentrated in CDOs and, while most sectors exhibited some increase in downgrade frequencies, upgrades continued to outnumber downgrades for CMBS and RMBS.

Dividend declared
Permacap Carador has declared an interim dividend of 5.2 cents per ordinary share in respect of the financial year ending 31 March 2008. The aggregate dividend payments in the year ending 31 March 2008 will, therefore, amount to 14.1 cents – of which 3.9 cents relates to the period ended 31 March 2007.

Meanwhile, Volta Finance has published its February monthly report. As of 29 February 2008, the company's gross asset value per share was €6.50 – down €0.79 per share from 31 January 2008.

The further significant deterioration of the GAV in February affects mainly two asset classes: UK non-conforming residuals and European leveraged loan TRS. The expected cashflows on these two asset classes had already been revised by the company as of end-January. The company anticipates that this further deterioration in mark-to-market is likely to be reflected in a further reduction in expected cashflows from those assets.

iTraxx indices gear up for roll
The Markit iTraxx Asia indices will all roll into their ninth series on 20 and 21 March, except the Asia ex-Japan Main and the iTraxx Japan 80 indices. The decision for these two indices not to roll was taken based on dealer polls conducted by Markit.

Based on liquidity polls, two constituents have been replaced in both the iTraxx Asia ex-Japan IG and Asia ex-Japan HY indices. Two constituents were replaced in the iTraxx Australia and Japan HiVol indices, while four were replaced in the iTraxx Japan Main index.

The iTraxx Europe indices will also roll into their ninth series on 20 March. Ten constituents have been replaced in the iTraxx Europe Main index, while six were replaced in the iTraxx Europe Crossover index and eleven in the iTraxx Europe HiVol index.

Analysts at BNP Paribas note that trading activity on the iTraxx Europe Main index has taken centre stage in preparation for the roll. "We believe investors focused on unwinding their existing longs in series 8, resulting in large amounts of protection selling, which caused spreads to grind significantly tighter. The move tighter was further exacerbated as the longs took the opportunity to take profits, before they look to buy protection again on the new index," the say.

For investors actively trading the skew, recent movements have had important implications, the analysts add. On the main index, trading the skew has become more profitable, given that decreased volumes have been causing large skew movements.

Going into the roll, the skew on the iTraxx Europe Series 8 moved promptly into negative territory and close to 'normal' levels, mirroring the behaviour of this parameter during previous rolls. "Aside from the size of the skew, the current roll shows a significant resemblance with last September's Series 7 roll, where the measure went from positive to negative a few days previously. If the post-roll behaviour were similar, we could see iTraxx Europe Series 9 trade wider than its underlying constituents in the days after 20 March," the analysts conclude.

CS

Sub-prime write-downs are likely past the halfway mark

The magnitude of sub-prime RMBS write-downs is discussed by Scott Bugie, credit analyst at S&P

The huge losses on write-downs of US sub-prime ABS have already earned 'sub-prime loans' a prominent place in the ranking of global financial stresses over the past three decades. The total market value of write-downs of sub-prime ABS disclosed so far by financial institutions – banks, brokers and insurers – well exceeds US$150bn globally.

This compares with S&P's broad estimate that valuation write-downs of sub-prime ABS – primarily ABS CDOs, but also sub-prime RMBS – could reach US$285bn for the global financial sector. This figure is slightly higher than the US$265bn we published in January because we have, since then, increased our assumption of percentage write-downs of high-grade ABS CDOs with collateral from 2006 and 2007.

The magnitude of the current and likely further near-term losses from write-downs has destabilised the global financial system and provoked a liquidity and credit crunch starting in the summer of 2007. The lack of observable market prices on sub-prime ABS and the complexity and global reach of sub-prime risk exposures have driven down valuations and exacerbated the financial market's woes.

The events of the past half year have called into question certain aspects of the risk management and transfer policies of financial institutions. The sub-prime saga is an example of the heavy losses that are often the consequence of overlending during a credit boom.

The positive news is that, in our opinion, the global financial sector appears to have already disclosed the majority of valuation write-downs of sub-prime ABS. Significant write-downs have dominated the 2007 results of the investment banks that were the leading arrangers and dealers of ABS CDOs.

We believe that the largest players, like Merrill Lynch and Citi, have rigorously and conservatively valued their exposures to sub-prime ABS such that most of the damage should be behind them. Indeed, these institutions may benefit from future recoveries in market prices if the performance of sub-prime borrowers stabilises and risk premiums for uncertainties dissipate.

But, right now, market forces are placing further downward pressure on valuations. The ABX.HE indexes have dropped substantially since the beginning of 2008.

Margin calls and events of default clauses in CDOs are beginning to force liquidations at distressed prices. Disclosure to date appears to be uneven across the financial sector, including among regional and emerging-market financial institutions. Due to all these factors, we expect to see more write-downs related to these pressures in coming weeks and months.

We believe that any near-term positive impact of reducing sub-prime risk in the financial system via increased disclosure and write-downs will be offset by worsening problems in the broader US real estate market and in other segments of the credit markets. A major repricing of credit risk is taking place across the debt markets, with credit spreads having further widened in most segments since the beginning of 2008, after opening up in the second half of 2007.

If the wider spreads hold to the end of the first quarter or half of this year, financial institutions will suffer further market value write-downs of a broad range of exposures, including leveraged loans. This article focuses exclusively on US sub-prime ABS, addressing the basic assumptions that underlie our estimate of the decline in market values of sub-prime securities in the global financial industry.

Deterioration in sub-prime loans
At the heart of the decreasing value of ABS CDOs and sub-prime RMBS is the poor underwriting of sub-prime loans in the US from 2005 to 2007. The delinquency and default rates of the pools of sub-prime loans from those years, particularly from the 2006 and 2007 vintages, have deteriorated continually since early 2007.

The slowing US economy and continuing fall in US house prices have further weakened borrowers' repayment capacity and reduced recoveries on sales of foreclosed properties. As a result, in January 2008 S&P increased its lifetime loss projection for the 2006 vintage of sub-prime loans to 19%, based on a 42% default rate and 45% loss severity.

The loss projections are significantly worse than we or other market participants expected based on historical performance. While successive decreases in the benchmark Federal Funds rate by the US Federal Reserve and US government actions to ease the payment burdens on sub-prime borrowers may help limit the damage, it is clear that the ultimate credit losses on the more than US$1.2trn of sub-prime loans originally granted in the US from 2005 to 2007 will be substantial.

Synthetic references to mezzanine sub-prime RMBS amplify losses
Our global estimate of write-downs of sub-prime ABS represents current losses in market value to be borne by the broad financial industry: banks, broker-dealers, financial guarantors, insurers, hedge funds and other institutional investors. However, ultimate total write-downs could vary considerably, both on the up and down side of this estimate.

Indeed, the wide disparity in assumptions on pool performance and in percentage markdowns of sub-prime ABS already disclosed by financial institutions reflects the wide range of opinions in the market. Clearly, the lack of liquidity in sub-prime RMBS and ABS CDOs has pushed valuations downward.

Nevertheless, despite its limitations, the global estimate helps us to compare the impact of valuation losses from this segment to those in others, such as leveraged loans. The estimate and underlying assumptions also serve as a benchmark for analysing and comparing the sub-prime exposures and write-downs of individual entities, including the impact on earnings and capital.

For the estimate of valuation write-downs, we define sub-prime ABS as US sub-prime RMBS and CDOs that invested in US sub-prime RMBS. The estimate notably excludes many segments of the debt markets that also have experienced wider spreads and erosion in valuations: Alternative-A loans, securities backed by home equity loans, non-securitised sub-prime loans (those that remain on the balance sheets of lenders), leveraged loans, CMBS and RMBS backed by European real estate. The estimate covers the 2005-2007 vintages only, since the performance of the sub-prime RMBS pools of 2004 and prior has been in line with expectations and not led to material downgrades of sub-prime RMBS backed by mortgages from those years.

The year (and quarter) of origination of the sub-prime loan collateral is the primary determining factor in the potential for loss. In our view, holders of sub-prime ABS from the riskier 2006 and 2007 vintages are far more vulnerable to losses than those that hold sub-prime ABS of 2005 and earlier. Clearly, the performance and valuation of individual sub-prime CDOs and RMBS will vary greatly, depending on portfolio composition, degree of subordination, the existence and amount of excess spread built into the structure, and the important factor of vintage.

The absolute amount of market value write-downs (and potential losses) of ABS CDOs greatly exceeds the amount of write-downs on sub-prime RMBS because ABS CDOs purchased the majority of the subordinated tranches of sub-prime RMBS issued in 2006 and 2007. In fact, the supply of mezzanine sub-prime RMBS fell short of demand and, consequently, ABS CDOs created over US$75bn in mezzanine positions by synthetically referencing triple-B and single-A rated sub-prime RMBS from those years. The synthetic exposures to mezzanine sub-prime RMBS taken by CDOs represent the largest single factor that has amplified the impact of the deterioration of the sub-prime collateral pools on the global financial sector.

Potential credit losses of sub-prime pools
Our estimate of market value write-downs of sub-prime ABS starts with a projection of credit losses in the pools of sub-prime mortgage loans backing sub-prime RMBS of 2005, 2006 and 2007 through to September 2007. S&P revised upward its loss expectations for 2005-2007 sub-prime collateral in January 2008 (see Table 1).

We applied these credit loss estimates, which include projections for the default rate and severity of loss of the loans in the pools, to estimated outstanding amounts of sub-prime RMBS by vintage (see Table 2). Note that the absolute amount of sub-prime RMBS outstanding is less than the amount originally issued, due to loan prepayments and, to a lesser extent, defaults and foreclosures of loans in the pools.

We estimate that RMBS from 2005-2007 currently outstanding total approximately US$900bn, compared with over US$1.2trn in total sub-prime RMBS issued and rated by S&P from 2005 through to September 2007. Our estimate of the amount of sub-prime RMBS outstanding excludes securities unrated by S&P and, by definition, excludes sub-prime mortgages that were not pooled into sub-prime RMBS. Adding these could increase the amount outstanding by US$100bn-US$200bn.

Applying the percentage loss assumptions to the outstanding S&P-rated sub-prime RMBS issued in 2005-2007 yields a total credit loss estimate of US$136bn, of which US$109bn is from the 2006 and 2007 vintages due to the projected poorer performance of sub-prime collateral from those years. Approximately 80% of the outstanding amount of sub-prime RMBS was rated triple-A at origin.

In a tiered structured financing, the lowest rated tranches are the first to absorb the losses. Thus, from a global perspective, applying the global loss projections by vintage to the amount outstanding (and not taking into account differences in specific collateral pool performance and degree of subordination), the tranches rated double-B to single-A plus should absorb all the losses projected for the 2005 vintage, while the tranches rated double-B to double-A plus should absorb the losses projected for the 2006 and 2007 vintages.

This means that, from a global perspective, the subordinated tranches in the risky 2006 and 2007 vintages should cover all losses. From this perspective, the triple-A rated tranches would not suffer any losses through to the maturity of the securities.

But all sub-prime RMBS are not identical. As we have said, the performance of specific securities depends on portfolio composition, the tiering of the security, the degree of subordination, and the existence and amount of excess spread. Consequently, some triple-B rated sub-prime RMBS from 2006 may pay through to maturity and some triple-A rated sub-prime RMBS from 2006 may ultimately default, depending on these security-specific factors.

This estimate, by rating of the credit losses on sub-prime loans applied to the tranches of sub-prime RMBS, helps us analyse the potential market value write-downs of sub-prime RMBS and CDOs with exposure to sub-prime risk. Our global US$285bn estimate of valuation write-downs of sub-prime ABS is more than double the US$136bn projected credit losses on the underlying pools of sub-prime loans.

Three factors are at work:

• ABS CDOs created additional mezzanine sub-prime RMBS through synthetic references.
• Market illiquidity has increased uncertainty and driven down valuations.
• Events of default clauses and margin calls are leading to forced liquidations at distressed prices.

Estimate for ABS CDOs based on average write-downs
Our estimation of valuation losses on ABS CDOs is the equivalent of a mark-to-market approach under which the percentage write-downs of ABS CDOs disclosed by market participants serve as a broad proxy for market valuations in the absence of transactions. The average percentages mask significant differences in classification and standards of disclosures on ABS CDOs across the financial sector. Factors that vary across institutions include: the definition of sub-prime ABS; accounting standards for sub-prime ABS; the stating of positions as gross or net due to third-party guarantees; reporting on vintage of collateral; subordination and attachment points; and differences in the starting date of exposure when measuring cumulative loss in value through write-downs.

As stated earlier, ABS CDOs purchased a high amount of sub-prime RMBS and also created, via synthetic references, significant additional exposures to mezzanine sub-prime RMBS – particularly those rated triple-B and single-A from the 2006 and 2007 vintages. The result is that high-grade and mezzanine ABS CDOs issued in 2006 and 2007 have 40% (for high-grade) and 67% (for mezzanine) collateral exposure to sub-prime RMBS.

To calculate the potential global decrease in market value of ABS CDOs, we estimated average percentage write-downs by vintage (2005-2007) and type of ABS CDO: high-grade (CDOs that consist of mainly double-A and single-A securities), mezzanine (CDOs that consist of mainly triple-B and single-A securities) and CDO-squareds (CDOs that invest in other CDOs). The estimated average percentage write-down of ABS CDOs with collateral from 2006 and 2007 is much greater than in 2005 (see Table 3). ABS CDOs with collateral from these two years represent the bulk of the estimated value write-downs of sub-prime securities for the global financial sector.

Applying the average percentage write-downs by CDO type and vintage to the amount of ABS CDOs outstanding yields a global estimated loss in market value of US$231bn (see Table 4). Note that the "other" column in Table 4 reflects mainly CMBS CDOs, which have performed much better than RMBS CDOs. The estimate includes no losses from write-downs of the "other" CDOs, although these securities are not immune to the nervous and illiquid conditions prevailing in the debt markets.

The triple-A rated ABS CDOs with collateral from 2006 and 2007 have suffered a significant loss in market value because of the relative thinness of the subordinated tranches supporting them. This holds for super-senior ABS CDOs, which may represent up to two-thirds of total outstandings. We rated triple-A approximately 85% of the absolute amount of ABS CDOs of 2005, 2006 and 2007 (through to September).

Write-downs of ABS CDOs dominate global estimate
We estimate that the total losses in market value of sub-prime ABS – primarily ABS CDOs, but also sub-prime RMBS – could reach US$285bn for the global financial sector. Most of the estimated write-downs will be on Abs CDOs, with the remainder on sub-prime RMBS.

Here is our logic. We assume that 60% of sub-prime RMBS issued from 2005 through to 2007 and rated double-A plus and lower was purchased by ABS CDOs. Essentially this means that, from a market-wide perspective, the majority of losses from write-downs of sub-prime RMBS are shifted to ABS CDOs.

We adjusted our estimate of losses on sub-prime RMBS by the 60% factor and thus reduced the US$136bn estimate of losses on sub-prime RMBS explained earlier to US$54bn. We use the US$54bn as a proxy for the loss in market value of sub-prime RMBS held directly by investors outside of ABS CDOs. Our analysis of market information on write-downs of investors in sub-prime RMBS supports this approach.

The global estimate of US$285bn is consequently calculated by adding the US$231bn estimate of write-downs of ABS CDOs to the US$54bn projected loss in market value of sub-prime RMBS outside of ABS CDOs (see Table 5). We believe that the difference between the minimum US$150bn in losses from write-downs in market value disclosed to date and our global estimate of US$285bn may be not only additional write-downs at banks and brokers, but also losses from write-downs at hedge funds, monoline insurers, other insurers and other institutional investors.

A final point is that our estimate is for gross write-downs by the broad financial sector. We would expect the net impact on the financial sector to be less, to the extent that a material amount of the positions of ABS CDOs – upwards of US$75bn – are synthetic positions taken via CDS.

The CDS is between a protection buyer (that pays for protection) and protection seller (that receives payment). ABS CDOs typically created synthetic positions by selling protection; in many cases, they hedged their own positions with financial guarantors or otherwise via CDS.

Gross losses from write-downs of sub-prime ABS will be offset at least in part by gains of entities that bought protection on sub-prime risk and shorted sub-prime ABS. The complexity of hedging strategies and secondary market transactions renders a complete assessment of the distribution of gross and net sub-prime ABS risk throughout the financial sector extremely difficult.

We are concerned about gross write-downs on sub-prime ABS because they hit the earnings and capital of rated financial institutions, and because the headline risk they create can damage franchise and reputation, which are key analytical factors. Nonetheless, from a macroeconomic perspective, we believe that net write-downs may better reflect the ultimate burden on the financial system. But it might take some time for the market to make that final reckoning of the damage of sub-prime loans to the global financial system.

© 2008 Standard & Poor's. All rights reserved. This Research Note was first published on 13 March 2008 by Standard & Poor's.

Trading ideas: prospective pricing gains

John Hunt, senior research analyst at Credit Derivatives Research, looks at a negative basis trade on PPG Industries

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

Constructing the negative-basis trade position
We construct this trade to be default-neutral. In the unlikely event that PPG defaults, the position will neither gain nor lose.

We present a simple duration-matched position in a government bond to hedge interest rate risk. This risk could also be hedged with an interest rate swap, but we understand that government bonds are the most useful hedging instrument for most investors. We understand that most investors will prefer to hedge interest-rate risk at the portfolio level in any event.

In this case, because all the instruments involved have almost the same maturity, the trade is almost a pure arbitrage: if held to maturity, the position should win if there is no default and will not lose if there is a default. In the interim, the trade is exposed to mark-to-market fluctuations. For example, a continuing rally in Treasuries would hurt the trade position in the short term.

Our strategy for both the CDS and the Treasury hedge is strongly influenced by a desire for simplicity. Perfect hedging would require adjustment of the CDS and Treasury positions over the life of the trade. We are happy to discuss such strategies with clients, and we also provide a set of sensitivities to help clients implement more sophisticated hedging strategies.

Trade specifics

Bond cheapness
Based on our valuation approach, the five-year PPG new issue, priced to yield 325bp over five-year Treasuries (5.70%), is trading cheap to fair value, as Exhibit 1 indicates.

Exhibit 1

Exhibit 2 compares the bond z-spread with the CDS term structure and fair bond z-spread, and shows that the recommended bond is indeed trading wide of the closest-maturity CDS and its fair z-spread.

Exhibit 2

Exhibit 3 illustrates the projected performance of the trade as a function of bond-CDS convergence over a six-month time horizon. Based on our assumptions about trading costs (five-year CDS bid-ask spread equal to 5bp, bond bid-ask spread equal to 5bp over Treasuries), even slight cash-CDS convergence will be enough for the bond to cover its trading costs. The projection is based on the assumption that bond and CDS spreads remain the same except for convergence – that is, that the company's credit does not improve or deteriorate over the six-month time horizon.

Exhibit 3

Risk
The position is default-neutral. Although the trade should produce a quasi-arbitrage profit if held to maturity, in the shorter term it is slightly long PPG's credit on a DV01 basis, so parallel widening of cash and credit spreads will harm the position in the short run.

Another risk comes from the Treasury hedge. Technical factors affecting the Treasury market may be different from those affecting the corporate bond market, and a short-term mark-to-market loss could result.

Liquidity may be a challenge on the trade exit, as described below.

We provide a suggested simple, duration-matched Treasury position to hedge interest rate risk. Exhibit 4 presents a number of sensitivity calculations for the bond for investors who are interested in more complex hedging strategies.

Exhibit 4

The trade has positive carry, given current levels, and this carry should cushion the investor from short-term mark-to-market losses.

As with any bond-CDS basis trade, investors should ensure that the bond is a deliverable obligation for the CDS.

Liquidity
The recommended CDS is in the five-year maturity, and we expect continued liquidity. It's more difficult to judge longer-term liquidity for the bond, but it is part of a benchmark issue, which gives us some degree of comfort. We recommend this trade, despite the liquidity challenges on exit, because carry is attractive enough to justify holding the position until there is more liquidity in the market generally.

Fundamental and quantitative factors
Our negative basis trades are based on the assumption that the bond is mis-priced relative to the CDS. They are not premised on an expectation of general curve movements. We briefly present our view of the firm's future credit performance.

Our quantitative model suggests that PPG is a strong credit, and that its fair five-year spread is tight of its current level of 140bp (which, in turn, is well under the average for NAIG9 – currently around 190bp). Equity volatility is low and interest coverage is very strong, as is the ratio of free cashflow to debt. Earnings and free cashflow are stable, and modelled default probability is fairly low.

Summary and trade recommendation
Last week was a week of many new issues, despite big price concessions. Based on the guidance we've seen, the PPG Industries concession is the biggest so far. That's no surprise, given that the deal was announced on 12 March, but pricing negotiations apparently continued into 13 March.

With the bond almost US$4 cheap to fair value in the five-year maturity, we can't resist jumping on the opportunity to pick up 79bp with no default risk. Although basis trades have recently shown much higher volatility than in the past and although cash liquidity has been an issue for exits, the discrepancy here is big enough that this trade is worth taking on those risks.

Buy US$10m notional PPG Industries Inc. 5-Year CDS protection at 147.5bp.

Buy US$10m notional (US$10m cost) PPG Industries Inc. March 2013 new issue at US$100 (T+325bp; par coupon 5.63; z-spread 227.8bp) to gain 79.3bp of positive carry.

Sell US$9.4m notional Treasury 2.75s of February 28, 2013 at a price of US$101.62 (US$9.55m proceeds) to hedge bond interest rate exposure.

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

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

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