Contents

Rally all round

Indices gain support from Fed's actions

The US Federal Reserve's recent actions have added further impetus to what traders see as the biggest growth story in 2008 so far – the CMBX index. Fed-related moves in the CDS market have also driven renewed interest in basis trading on both sides of the Atlantic.

Triple-A CMBX spreads tightened from 250bp-270bp to 110bp-160bp and triple-Bs from around 1500bp to 1100bp-1200bp on the back of the Fed's actions, but are still experiencing considerable volatility. Short-covering activity occurred across all of the sub-indices – in sharp contrast to the ABX index, where trading is predominantly focused on the AAA/AA indices.

"The CMBX index is now a bigger market than the ABX – it has been the growth story of the year so far, as players search for the next product to exhibit volatility," explains one synthetic ABS trader.

He adds: "Trading is active at all levels due to a significant divergence in opinions: some players believe that spreads are overblown because losses are low, while others fear that the US commercial real estate sector will see a slow-down as the economic cycle turns and corporates begin defaulting. The new issue market remains open for US CMBS, so there is activity from both real money investors and hedge funds/prop desks."

Adding short-risk exposure in the mezzanine part of the capital structure is one way to benefit from the spread tightening, particularly on CMBX.2, as these tranches look over-valued and prices could still decline by 10-15 points. Indeed, while analysts at JPMorgan note that the probability of moving away from the lows in AAA/AA CMBX prices has increased substantially following the Fed easing and the explicit assistance of financial institutions, they point out that spreads may widen once again going into Q208 if an additional round of write-downs ensues.

The credit curve will likely stay relatively range-bound over the near term, but underlying fundamental credit problems remain unresolved. "The pace of delinquencies has increased with each subsequent CMBX series, with losses now hitting the CMBX.1 and roughly US$175m of loans in the CMBX.2 already in foreclosure. As delinquencies increase and underwriting standards tighten further over the coming months, we view it as inevitable that whole loan spreads will remain wide and that cap rates will continue to increase as property prices decline – which will limit the ability for borrowers with marginally performing properties to refinance," the analysts argue.

The CMBX index and the underlying CMBS market nonetheless have been shown to have a relationship, whereas the ABX and cash ABS remain disconnected. Bond spreads continue to fall because real money accounts don't want to be seen buying RMBS and distressed funds are waiting for prices to decline even further before they enter the market.

Meanwhile, over the last two weeks significant moves in the basis have been driven by various sectors reacting to the Fed action at different speeds. Both the basis between the CDX IG index and CDS, and the basis between CDS and bonds reached historic levels in March (-15bp and -55bp respectively).

The JPMorgan analysts suggest that these moves may signal a shift in investor positioning from concerns about liquidity crises to more fundamental concerns about the health of the economy. "Negative basis packages of -100bp and more are currently available in the market. We believe this represents an attractive investment opportunity. Dislocations between CDS and bonds can persist. However, at such negative levels, we believe the likelihood of significant tightening to be greater than of significant widening," they observe.

The recent iTraxx index rally, on the other hand, has caused CDS to outperform cash – bringing the basis back to more normal levels. The basis is expected to continue to be volatile, however, with structured credit unwinds pushing CDS wider and new issuance pushing cash wider.

"The strength of the rally in corporate credit indices after the Easter holiday – thanks to small pieces of good news from the US – surprised many, but the market is waiting to see if it can be sustained," concludes the trader.

CS

Junked shops

Monoline rating polarisation emerges

The first-ever junking of a "triple-A" financial guarantor last week – swiftly followed by another – underscored the fact that the monoline saga is far from over. Indeed, a stark rating polarisation across the sector is now emerging.

The financial strength ratings of the monolines can broadly be divided into three categories – 'strong', 'stable for now' and 'weak' – according to analysts at BNP Paribas. The first category includes FSA and Assured Guaranty, which are rated triple-A by the three agencies, largely due to minimal exposure to structured finance CDOs and disciplined underwriting strategy.

The second category includes MBIA and Ambac, whose triple-A ratings were affirmed by S&P and Moody's after months of speculation as to whether their insurance subsidiaries would be downgraded. However, the ratings remain on negative outlook with both agencies – and Fitch is yet to take action on MBIA (albeit indicating that it wouldn't be downgraded below double-A). The agency has already downgraded Ambac to double-A.

Finally, CIFG, FGIC and XLCA make up the 'weak' category, where the monolines typically have weaker capital, impaired business franchises and significant exposure to problem areas of credit. These three guarantors have all been subject to rating agency actions over the past week and, despite repeated downgrades, their ratings remain on negative outlook.

The first monoline to have its financial strength rating cut to junk status was XLCA, when Fitch downgraded it to double-B. S&P followed by cutting FGIC to double-B, with Moody's and Fitch lowering their ratings for the guarantor to Baa3 and triple-B. Finally, Fitch downgraded CIFG to single-A minus.

The magnitude of the downgrades surprised the market. Fitch says its action on XLCA is due to its updated assessment of the company's capital position and current capital enhancement plans, as well as its current views on US sub-prime related risks. The downgrade also reflects what Fitch views as the material erosion in the monoline's franchise value and competitive business position, following downgrades to well below triple-A by each of the three major rating agencies.

With the loss of its top credit ratings and its decision to defer raising additional capital at the present time, XLCA has chosen to forego underwriting new financial guaranty business for the foreseeable future to preserve capital. The suspension of new underwriting is expected to help the monoline's capital position as it will benefit from the amortisation of existing insured obligations, some of which exhaust a material amount of targeted capital. Going forward, Fitch believes that it will be very difficult to stabilise the ratings of XLCA until the company can both raise external capital and more effectively limit the downside risk from its SF CDOs through reinsurance or other risk mitigation initiatives.

Meanwhile, S&P says it downgraded FGIC because the monoline has been slow to identify the unfavourable insured portfolio trends that have emerged and has failed to implement a strategic plan to re-establish itself as a viable operating entity capable of writing new business. The guarantor has suspended underwriting new business in order to generate internal capital, but has been unsuccessful so far in raising new external capital. And the violation of certain New York State Insurance Department risk limits may further hamper these efforts.

FGIC has reportedly advised the Insurance Department of its desire to split into a mostly municipal operation, with a second company insuring mostly structured finance transactions, but S&P notes that progress has been slow. In addition, the announcement by the PMI Group, FGIC's principal owner, that it would not be contributing additional capital was a setback.

Furthermore, the holding company's ability to service its debt may be constrained by FGIC's statutory earned surplus deficit, resulting in the monoline being unable to upstream dividends without insurance department approval. As time passes, the possibility of a run-off situation for the monoline becomes greater and the likelihood of it continuing as an operating entity capable of writing new business is waning, according to S&P.

Overall Fitch stands out as taking the most aggressive stance towards the sector, however (see also this week's Job Swaps). "It appears that Fitch has taken some aggressive action by clearly segregating the ratings of the various companies and we expect S&P and Moody's to follow suit, especially if the underlying macro picture deteriorates in line with our macro view," confirm the BNP Paribas analysts. "Clearly, the monoline story is far from over, and will return to face negative headlines over the next quarter. Not only are the fundamentals deteriorating, but also the competitive environment – especially with other market participants looking to enter the market (BRK, Wilbur Ross and FHLB)."

CS

Total recall?

Positive reception to Fitch's about-face

In an apparent volte-face, Fitch has announced that the long-awaited modifications to its CDO methodology should result in more moderate downgrades than had initially been feared. Investors reacted positively to the news – despite little clarification about the treatment of existing transactions and a one-month delay in its conclusion.

"Previously there had been widespread fear that Fitch's actions would result in severe forced unwinds in the corporate correlation space," explains one structured credit investor (see SCI issue 74). "But now, because of Fitch's announcement, investors are hopeful that they will be able to continue holding their investments. We can probably withstand two- or three-notch downgrades, which are what the new methodology is expected to bring about, but five-notch downgrades would have been beyond the pale."

Fitch has received substantial feedback – both analytical- and implementation-based – from the market on the implications of its proposals. The agency says that there is general support for an approach which uses unadjusted empirical inputs wherever possible, captures the systemic risk posed by industry concentrations, the idiosyncratic risk posed by obligor concentrations, and the risk of early CDO downgrade due to unexpected early migration in the underlying corporate portfolio. There was also broad support for the reduction in assumed recovery rates, reflecting the market's forward view of corporate credit risk.

However, specific points concerning base calibration, industry and obligor concentrations, early downgrades and short remaining lives were raised that Fitch believes warrant further analytical consideration. To calibrate CDO ratings against historical default cycles, hypothetical CDO portfolios were created that could be expected to exhibit performance characteristics consistent with broad-based publicly available default statistics.

"Concerns, however, have been raised as to whether the baseline default data includes some level of industry concentration that was inconsistent with a well-diversified CDO portfolio. Fitch is re-examining default data to determine the level of any industry concentrations implicit in the historical figures, and whether this results in an unnecessarily high default threshold for diverse portfolios," analysts at the agency point out. The final methodology is expected to include an updated calibration, as well as an updated correlation framework to better capture the systemic risk posed by industry concentrations.

And, while the notion of capturing the idiosyncratic risks posed by individual obligor exposures was widely supported, the specific proposal was challenged as being overly punitive to high-yield portfolios. Consequently, the final methodology will ensure that CDO liabilities can still withstand a minimum number of obligor defaults, but the proposal for capturing this risk will be modified to balance the idiosyncratic risk measurement with the systemic risk measurement inherent in the base proposal.

Similarly, Fitch's proposed use of CDS-implied ratings as a way to 'filter' portfolio credits with more immediate downside risk was met with some dissent. The agency now recognises that other mechanisms may be equally effective and less problematic for managed transactions, and so it is considering other ways to identify and measure the risk of adversely selected names. "Fitch is seeking to balance the identification and mitigation of the risk posed by 'excessive arbitrage', with the ability of a manager to usefully apply their expertise to add value to CDO noteholders," the analysts confirm.

In addition, the agency has recognised that the current proposal results in loss coverage well above targeted levels for portfolios with short remaining lives, as well as the fact that exposure to individual asset default events may identify CDO risk more effectively than statistical analysis. Consequently, Fitch proposes supplementing the model output with an event-risk matrix whose loss coverage equates to a minimum number of obligors, depending on portfolio size and credit quality. This application is expected to reduce, and in some cases, avoid negative impact on investment grade corporate CDOs with remaining terms of less than three years.

In terms of implementation, the feedback opposed any significant rating downgrades caused solely by model and methodological changes at a time when underlying corporate performance has largely been sound. Additionally, some market participants felt it would be difficult effecting portfolio changes to align with model and methodological revisions in the proposed 90-day implementation timeline.

Fitch says it will consider the market's feedback, develop and test consequent model changes where appropriate, and prepare a detailed implementation plan before the revised 30 April release date. "Some of the modifications under consideration are expected to result in more moderate downgrades than detailed in the initial exposure draft. However, it is too early to express definitively the magnitude of relief the points under consideration will yield," the analysts conclude.

CS

Monolines file suits

The latest company and people moves

Monolines file suits
XL Capital Assurance has filed its answer and counterclaims in the US District Court for the Southern District of New York in response to Merrill Lynch International's March 19, 2008 lawsuit against XLCA (see last week's issue). Meanwhile, details of another set of law suits involving FGIC have also emerged.

In its filing, XLCA disputes the legal claims filed by Merrill Lynch and defends the terminations of the seven CDS entered into between XLCA and Merrill. The counterclaim notes: "In attempting to offload sub-prime mortgage and other liabilities related to troubled CDOs, Merrill Lynch agreed to provide third parties with control rights over seven of its CDOs, even though those same control rights had already been exclusively committed to XLCA."

XLCA says it required sole control rights under the seven CDOs at issue as a "fundamental condition" to entering into the CDS. However, "during its 2007 third quarter in which it would write down approximately US$7.9bn in its CDO and sub-prime mortgage businesses, Merrill Lynch undertook a rushed campaign to find parties willing to hedge or provide protection on its remaining CDO positions... Determined to get these CDO risks off its books at all costs before the third quarter of 2007 closed, Merrill Lynch made the decision to blatantly ignore its prior commitments to XLCA."

XLCA's counterclaims ask the court to declare that XLCA's terminations are effective and that it has no additional obligations under the CDS. In addition, XLCA seeks damages estimated to be at least US$28m for amounts that Merrill Lynch International is obligated to pay XLCA under the terms of the CDS as a result of the terminations.

The company states: "Despite whatever claims Merrill Lynch may make regarding our decision to enforce these contract terminations, we believe Merrill Lynch gave away our control rights on seven CDOs in direct violation of our agreements. On behalf of our policy holders and shareholders, we intend to defend the terminations vigorously and look forward to presenting our case to the court soon."

Meanwhile it has emerged that FGIC is suing IKB Deutsche Industriebank (IKB), Havenrock II, IKB Credit Asset Management (IKB CAM) and Calyon Credit Agricole CIB (Calyon). FGIC and FGIC UK Ltd allege in their complaint, filed in the Supreme Court of the State of New York, that IKB and IKB CAM – through a series of fraudulent misrepresentations and omissions regarding IKB's financial condition and stability – induced FGIC UK Ltd to enter into what it refers to as 'the Commitment Agreement'.

FGIC UK Ltd entered into that Commitment Agreement with Havenrock II Limited, a special purpose vehicle created by IKB, to issue a financial guaranty policy in respect of up to US$1.875bn of high-grade and mezzanine ABS CDOs contained in a US$2.5bn reference portfolio. In addition, FGIC management believes that, subsequent to year-end 2007, a party failed to perform certain responsibilities under the operative documents, and consequently management believes that substantially all of the assets that could potentially have qualified for coverage by FGIC UK Ltd can no longer qualify and that FGIC UK Ltd therefore has no further obligation to insure those assets.

FGIC's operating review for Q407, states: "As noted in the consolidated financial statements of FGIC Corporation in Note 11, approximately 75% of the company's loss reserves at December 31, 2007 related to the Commitment Agreement; those reserves did not reflect the developments described above. Management is assessing whether the loss reserve related to the Commitment Agreement needs to be adjusted in the future to reflect the impact of these developments; any such adjustment could be material."

At the same time, Calyon has issued proceedings in the High Court of England and Wales (Queen's Bench Division, Commercial Court) against FGIC UK Ltd and Havenrock II seeking a declaration that the Commitment Agreement is valid and enforceable against FGIC UK Ltd. FGIC says it intends to vigorously pursue litigation to prove that the commitment to issue insurance under the Commitment Agreement is unenforceable.

Ore Hill and Pemba cross-acquired
Man Group has entered into an agreement to acquire a 50% interest in Ore Hill, the US-based credit specialist fund manager. Simultaneously Ore Hill has entered into an agreement to acquire a 50% interest in Pemba Credit Advisers, the European credit manager subsidiary of Man Group. The net consideration will comprise US$195m in cash funded from the Group's existing resources together with US$40m in new ordinary Man Group shares.

Ore Hill, established in 2002, is headquartered in New York and has approximately US$3bn funds under management. Pemba, with operations in London and Switzerland has approximately US$3.7bn funds under management.

Man says the moves are part of its strategic plans to expand the range of its investment products. Ore Hill will be the platform to develop a leading multi-strategy credit business globally.

Ore Hill's principals will invest the majority of the net proceeds received by them in a combination of Ore Hill funds and Man Group shares, in each case committed for five years. Ben Nickoll and Fritz Wahl, Ore Hill's co-founders and managing partners, will be the managing partners of the enlarged global business, while Pemba's Mark Mink will lead the European operations.

Structured credit earnings hold up?
According to a new survey from executive search firm Napier Scott, bankers' salary and bonus packages have fallen dramatically year on year – 40% on average in London and 60% in the US – but the story in structured credit appears less dramatic. However, not all headhunters are in agreement about the survey findings.

Shaun Springer, ceo of Napier Scott, comments: "The biggest falls in the UK occurred in the debt and credit markets. However, despite these significant reductions there were still packages paid in the UK that were in excess of £1m, particularly in the area of Tier 1 equity derivative sales and still in exotic credit trading, despite the losses."

Springer adds that Asia now commands the highest average packages in the world with a Tier 1 md operating in exotic credit trading receiving £1.48m and his counterpart in credit structuring receiving £1.41m. "This was due to intense competition for talent and the Asia region being relatively less battered by the credit crisis," he says.

According to Napier Scott, Tier 1 exotic trading mds in the UK and the US are now, on average, receiving packages of £1.02m and £680,000 respectively. Packages for structurers at the same level average out at £795,000 in the UK and £555,000 in the US.

However, other headhunters suggest that the survey numbers are awry, with averages contradicting a far harsher reality at some houses. "I know business heads that got between zero, a job and some deferred stock this year. In fact at one bank, anyone who got over £1m in structured credit in 2007 got zero in 2008," says one London-based recruiter.

The Napier Scott survey – now in its seventh year – was conducted among more than 3,000 front office traders covering international markets. FX, commodities, and equities and funds derivatives continue last year's trend of being the products to generate the most profits.

Citi AI adds to structured credit
Citi Alternative Investments (CAI) has added further structured credit expertise (see also SCI Issue 79). Jerome Anglade is to join the Citi credit strategies group as an md from 15 May and will serve as the senior portfolio manager responsible for the creation of a new, stand-alone structured credit opportunities fund. At the same time, Jenny Peng will join Anglade's team as an associate.

Anglade joins CAI from Morgan Stanley in London where he was head of European credit structuring, structured credit group, within the fixed income division. Peng arrives at CAI after working for over two years at Lehman Brothers as a quantitative risk associate.

Two more monolines take issue with Fitch
SCA and CIFG have become the latest monolines to publicly take issue with Fitch Ratings (SCI passim). SCA expressed disappointment with Fitch's announcement of further downgrades of the Insurer Financial Strength (IFS) ratings of XLCA and XLFA to below investment grade. And CIFG has formally requested that Fitch Ratings withdraw the IFS ratings for the following affiliated companies: CIFG Guaranty, CIFG Assurance North America and CIFG Europe.

SCA says that, while Fitch has not shared detailed information on its modelling with it, SCA believes that Fitch employed significantly different assumptions to its own when valuing SCA's ABS CDO portfolio. Based on its analysis, Fitch's estimate of expected losses on SCA's ABS CDO portfolio is stated to range between US$3bn and US$4bn.

However, SCA adds: "The company's comprehensive bottom-up analysis of the collateral supporting the CDO of ABS portfolio resulted in the establishment of case loss provisions totalling US$838.6m before reinsurance and US$651.5m after reinsurance in the fourth quarter of last year."

CIFG says it believes that Fitch is not in a good position to accurately determine the appropriate capital requirements for its insured portfolio. In particular, Fitch does not formally rate many of the RMBS and ABS CDO transactions that it identifies as the source of CIFG's greatest concern.

"The decision to call on Fitch to withdraw CIFG ratings is not directly related to the downgrade to A- (Outlook Negative) announced by Fitch. This was a decision we have been considering for some time," explains John Pizzarelli, ceo of CIFG. "While the company continues to work with Moody's and S&P to address their concerns to upgrade its ratings as soon as possible, CIFG believes achieving higher ratings with Fitch would be impeded by the limitations of that agency's approach to rating financial guaranty companies."

FGIC chief retires
Howard Pfeffer has retired from FGIC. He joined the firm in December 2003 as president and chief underwriting officer. He later assumed responsibility for credit risk management, investment management and enterprise risk management.

ESF elects chairman
The board of directors of the European Securitisation Forum (ESF), an affiliate of the Securities Industry and Financial Markets Association, has elected Steve White as its chairman for 2008. White is co-head of European securitisation for Morgan Stanley in London.

Rick Watson, md of the ESF, comments: "We are very pleased that Steve will lead the association at such a crucial time in the structured credit market. The association's work plan and focus is on restoring normal liquid market conditions. Steve's demonstrated experience in the European capital markets, as well as his extensive network of investor relationships will be key to spearheading the initiatives that the industry is currently undertaking to improve transparency and restore investor confidence."

TSI hires Buble
Trade Settlement Inc (TSI), a provider of electronic settlement services to the global primary and secondary syndicated loan markets, has hired William Buble in the newly created position of coo.

Buble joins TSI with 21 years of financial industry experience. Most recently, he served as the business manager in the credit trading division focused primarily on high yield loan trading at JPMorgan Securities. During his career at that firm, he also supported credit derivatives.

MP

Managers debut in Europe

A round up of this week's structured credit news

Managers debut in Europe
The European CLO market last week saw two managers debut – European Capital and Guggenheim Partners Europe. Deutsche Bank priced European Capital's €476.4m ECAS 2007-1, while Wachovia Securities closed Guggenheim's €296.2m Iron Hill CLO.

European Capital is understood to have ramped its transaction over 18 months, with the close representing the culmination of its successfully termed out bridge financing. The deal is 1.5x levered in order to withstand potential leveraged loan defaults.

Meanwhile, Iron Hill features a €163.6m Class A-T Loan which is a term loan, and a €85.2m-equivalent Class A-R Loan which is a revolver loan. Capital structure also includes Class B and C notes. The transaction is backed by a Euro portfolio of mostly European senior and mezzanine loans, but investments may also include other CLO tranches.

CDS processing goals set ...
The Operations Management Group (OMG) has submitted to US Federal Reserve president Timothy Geithner its latest set of goals for strengthening operational efficiency across privately negotiated credit and equity derivatives products. Consistent with its primary purpose – to encourage the prudent and efficient development of the privately negotiated derivatives business via the continued standardisation of documentation, promotion of sound risk management practices and education of the marketplace – ISDA endorses the commitments and expectations outlined by the industry in its latest letter.

In support of these minimum operating standards, the association will work with market participants to achieve a more fully automated and scalable marketplace. Further, ISDA and its membership have been discussing the incorporation of ISDA's off-the-shelf credit derivative settlement auction mechanism into ISDA documentation and the association has activated a process towards achieving that incorporation where appropriate (a process which has been commonly referred to as 'hardwiring' into the ISDA documentation). ISDA has committed to review with supervisors in May 2008 the industry's status on this matter and a timetable for next steps in the effort.

"ISDA is pleased to be a part of the industry effort to improve operational efficiency," says Robert Pickel, ISDA's executive director and ceo. "In particular we look forward to working with our members and the broader industry as we proceed with the hardwiring of the auction mechanism into the ISDA documentation."

The association has organised nine protocols and auctions for the settlement of credit derivative contracts. The most recent auction – the results of which were used to settle single name, index and bespoke portfolio trades – had the highest number of adherents of any auction to date.

The signatories to the letter support ISDA's efforts to strengthen credit event management across the industry and agree that they will actively participate in the process outlined above.

... while T-Zero launches novations platform
T-Zero has released its next-generation processing technology dubbed Novations+. The new platform is fully integrated with the DTCC Trade Warehouse and directly addresses the new industry commitments announced by the Operations Management Group (OMG).

The launch of Novations+ also comes amid renewed calls from US Treasury Secretary Henry Paulson and from regulators, including the Federal Reserve Bank of New York, for additional scale, automation and standardisation in credit derivative processing. Novations+ functionality enables buy-side and sell-side market participants to achieve 2008 novation targets set by the OMG to submit novation requests via an electronic platform rather than via email.

Additionally, the new technology allows the credit derivatives industry to scale novation processing by providing system-to-system connectivity, interoperability and automation for even the most complex novation operations involving prime brokers and fund allocations. Such operations are not currently automated by any other industry platform, T-Zero says.

"Novations+ represents the next big technology shift in the automation of credit derivative processing," says Mark Beeston, president of T-Zero. "The new platform is uniquely positioned to address scalability issues highlighted by the OMG and Secretary Paulson."

Key elements of Novations+ functionality include: electronic novation request directly from Warehouse records using T-Zero GoldSync+ industry standard novation workflow to allow novation consent on T+0 automation that promotes industry standards; block novation of trades originally allocated across multiple funds; and partial novations, where only a percentage of the original notional is transferred.

"We have been a T-Zero user for well over a year now and it has clearly improved operational efficiency and reduced risk," adds Paul Winter, head of derivatives operations at Fortis Investment Management. "We have evaluated many platforms and some are still developing what has been on T-Zero all along. Novations+ is a significant leap beyond anything else that is out there."

US SME CLO outlook stable
The outlook for US SME CLOs is stable/negative, as it is for CLOs in general, says Moody's in its annual review and outlook report. The stable/negative outlook has limited rating implications.

The outlook encompasses Moody's expectations that the default rate for the US speculative-grade loans that back SME CLOs will increase in 2008. "While we expect an increase in the default rate of loan collateral, we do not expect widespread downgrades of SME CLO liabilities," says David Burger, a Moody's vp and senior analyst who is lead author of the report. "It is worth noting that during the weak credit environment of 2001-2002, CLO ratings were relatively stable."

Moody's ratings on existing CLO tranches performed well throughout 2007. During the year, the credit performance of the underlying loan collateral was stable.

The agency says SME CLO issuance declined in the second half of 2007, although some transactions did close. "As we look ahead to 2008, we expect SME CLOs to remain a viable asset class," says Burger.

IOSCO consults on rating agencies
The International Organisation of Securities Commissions (IOSCO) has published for consultation its report on the role of rating agencies in structured finance markets, which includes proposed changes to the Code of Conduct Fundamentals for Credit Rating Agencies (Code of Conduct). The report, prepared by IOSCO's Technical Committee, discusses the role of credit rating agencies (CRAs) in the recent credit crisis and proposes ways to strengthen processes and procedures at the organisations.

In particular, the report proposes expanding upon the Code of Conduct provisions relating to the quality and integrity of the rating process; CRA independence and avoidance of conflicts of interest; CRA responsibilities to the investing public and issuers; and disclosure of the CRA's code of conduct and communication with market participants.

Michel Prada, chairman of IOSCO's Technical Committee, says: "IOSCO, having completed its review of its Code of Conduct Fundamentals for Credit Rating Agencies, is proposing significant changes to the current code. These changes are required in order to ensure that investors and the financial markets can have confidence that CRAs are producing clear, well-researched ratings, free from bias which can be easily understood by their users. The role played by credit rating agencies in the development of the market for structured finance products has raised serious issues for regulators globally, and I believe that these changes to IOSCO's Code of Conduct will contribute to addressing some of the issues that the current crisis has exposed in relation to the ratings system."

The consultation report proposes making the following revisions under three main areas of the Code of Conduct. First, the quality and integrity of the rating process.

Key proposed changes in this area require that CRAs should:

• ensure that the decision-making process for reviewing and potentially downgrading a rating of a structured finance product is conducted in an objective manner;
• establish an independent function responsible for periodic reviews of the firm's rating methodologies and models;
• take reasonable steps to ensure that the information they use is of sufficient quality to support a credible rating. Ratings involving products with limited historical data should have these limitations made clear;
• refrain from rating a product if the complexity or structure of a new type of rating creates doubts about the feasibility of a rating action;
• prohibit analysts from making proposals or recommendations regarding the design of structured finance products that the CRA rates.

The second area in which changes have been proposed is CRA independence and avoidance of conflicts of interest. Key proposed changes in this area require that CRAs should:

• establish policies and procedures for reviewing the work of analysts who leave to join an issuer the CRA rates, or a financial firm with which the CRA has significant dealings;
• conduct formal and periodic reviews of remuneration policies and practices for its employees to ensure that these policies do not compromise the CRA's rating process;
• disclose whether any one client and its affiliates make up more than 10% of the CRA's annual revenue;
• define what it considers and does not consider to be an ancillary business and why.

Finally, changes have been proposed in terms of CRA responsibilities to the investing public and issuers. Key changes in this area will require that CRAs should:

• assist investors in understanding what a credit rating is, the attributes and limitations of each credit opinion, and the limits to which it verifies information provided to it by the issuer of a rated security;
• disclose on a periodic basis all cases where an issuer of a structured finance product has asked the CRA for a preliminary rating of the proposed structure, but does not subsequently contract that CRA for a final rating, or contracts for a final rating and does not publish it but does publish the ratings of another CRA for that same product.
• when rating a structured finance product, provide investors/subscribers with the information to understand the basis for the CRA's rating;
• disclose whether it uses a separate set of rating symbols for rating structured finance products and why;
• disclose the methodology or methodology version in use in determining a rating.

S&P action on European CDOs
S&P has taken credit rating actions on 81 European synthetic CDO tranches and 40 European ABS CDO tranches.

In terms of the synthetic transactions, the ratings on: 58 tranches were removed from credit watch with negative implications and lowered; 21 tranches were lowered and remain on credit watch negative; and two tranches were removed from credit watch positive and raised. Of the 79 tranches lowered: 20 reference US RMBS and US CDOs that are exposed to US RMBS, which have experienced recent negative rating actions; and 59 have experienced corporate downgrades in their portfolios. The 81 tranches represent 3.1% of the total number of European synthetic CDOs the agency rates.

Meanwhile, the ABS CDO rating actions resolve the watch negative placements made by S&P in January. Specifically, S&P has lowered the ratings on 33 tranches, affirmed two and left another on credit watch with negative implications.

S&P's revised correlation assumptions have resulted in significantly increased levels of expected defaults for transactions backed by US RMBS and ABS CDO assets issued during and after Q405. The ratings in the impacted transactions have also been affected by the credit migration of the underlying assets.

Income note investors accept Asscher exchange
All of Asscher Finance's income note investors have accepted the voluntary exchange offer announced by HSBC on 5 March 2008 (see SCI issue 80). The move follows the unanimous acceptance by income note investors in Cullinan Finance and the acceptance by 24 out of 25 Asscher mezzanine note investors.

Under the terms of the exchange offer, Asscher income note investors exchange their notes for notes issued by a new vehicle, Malachite Funding. Malachite is a term-funded vehicle with senior funding of about US$6bn provided by HSBC. Malachite also provides for the removal of all market-value triggers.

K2 affirmed
Moody's has confirmed the Aaa and Prime-1 ratings assigned to the MTN programmes and the Prime-1 rating assigned to the CP programmes of K2 Corporation. The move follows the establishment of a backstop purchase facility by the vehicle's sponsor, Dresdner Bank, whereby the SIV has the right to sell assets to Dresdner for a price sufficient to repay outstanding CP and Medium MTNs in full. In addition, Dresdner has provided commitments under a US$1.5bn mezzanine facility that can be used by K2 at any time and which may be drawn for periods out to the repayment date of the vehicle's last maturing senior debt.

Pursuant to K2's Security Trust Deed, payment of amounts due under the mezzanine facility is subordinated to the payment of amounts due in respect of K2's senior debt. As both facilities expire on 31 December 2008, K2 will utilise one or both facilities before expiration to repay or provide for the repayment of all outstanding debt when it falls due, unless Moody's has confirmed that K2's senior debt programmes would be rated Aaa/P-1 in the absence of such action.

In Moody's view, any realisation by senior debt investors of current or future mark-to-market losses will be avoided, given the support of Dresdner Bank. Although K2 will be obligated to sell assets to repay senior debt, it will be able to sell to Dresdner Bank to avoid any shortfall or timing mismatch.

In addition, neither the backstop purchase facility nor the mezzanine facility is subject to any market value tests. Moody's notes that the Aaa ratings of K2's MTN programmes depend jointly on the market value and credit quality of K2's portfolio and on the ratings of Dresdner Bank. Significant changes to either or both of these factors could result in a downgrade of the MTNs.

FSF analyses financial system risks
The Financial Stability Forum (FSF) met in Rome on 28-29 March. Members discussed the current challenges in financial markets, the steps that are being taken to address them and policy options going forward.

The financial system faces a number of significant near-term challenges. With many securitisation markets effectively closed, assets are accumulating on bank balance sheets.

Together with valuation losses on mortgages and other assets, this is straining capital positions and contributing to tightening credit conditions. Hoarding of liquidity and counterparty concerns are leading to a shortening of the maturity of banks' funding profiles and causing severe strains in interbank and other lending markets.

While the necessary deleveraging has been ongoing since last summer, the process is being complicated by the lack of transparency and valuation difficulties for some credit instruments. Financial institutions should continue enhancing their disclosures of risk exposures and refining valuation judgments concerning structured credit activities and poorly performing assets on and off the balance sheet.

Banks, securities firms and financial guarantors have made progress in replenishing capital levels and should continue to do so where necessary. The raising of capital and the repairing of credit markets will facilitate balance sheet management by financial institutions and help to counteract the potential cycle of financial market and economic weakness.

National authorities have taken a variety of exceptional steps to facilitate adjustment and to dampen the impact on the real economy. Authorities in the main financial centres are in continuous contact and closely monitoring developments.

Supervisors are working with firms so that risks in current market circumstances are effectively identified and appropriately managed. Central banks have provided liquidity to address market pressures, both individually and in concert, and will continue to do so as long as needed. Authorities will also act cooperatively and swiftly to investigate and penalise market abuse or manipulation.

The FSF discussed the report to be delivered this month to G7 Finance Ministers and Central Bank governors that identifies the key weaknesses underlying the turmoil and recommends actions to enhance market and institutional resilience going forward. The report has been prepared by a working group comprising senior officials from major financial centres and from the international financial institutions and the chairs of international supervisory and regulatory bodies.

It sets out specific policy recommendations in the following areas: prudential oversight of capital, liquidity and risk management; transparency, disclosure and valuation practices; the role and uses of credit ratings; and the authorities' responsiveness to risks and their arrangements to deal with stress in the financial system. These recommendations are concrete and operational, and – if approved – the FSF will report on their prompt implementation.

Fitch launches ABCDS pricing
In order to meet the growing demand for an independent source of pricing data that covers the global ABS product spectrum, Fitch Solutions has launched Fitch ABCDS Pricing to compliment its existing single name CDS and loan CDS services. The service combines consensus pricing for ABCDS with a benchmark service to provide a derived price for illiquid assets.

"Fitch ABCDS Pricing enables financial professionals to measure and monitor credit quality in order to help them make more informed investment decisions," says Thomas Aubrey, md at Fitch Solutions. "Fitch ABCDS Pricing offers a single reputable source of data that removes the requirement to consolidate and clean data from multiple sources. This provides greater transparency for shareholders and regulators."

Key features of Fitch ABCDS Pricing include: global coverage of over 7,500 ABCDS, combining consensus pricing for liquid issues with benchmarking for illiquid issues; asset types include credit card and auto ABS, RMBS and CMBS; and managed data cleaning processes to produce premium quality and reliable spreads.

US Treasury to streamline regulators
The US Treasury has unveiled a plan to streamline the current financial regulatory system in an effort to make it more effective in dealing with crises. The proposal has been in the works since March last year, according to analysts at BNP Paribas.

Over time, the proposal will consolidate the current five banking regulators, two market regulators and 50 state insurance regulators into three powerful authorities: a market stability regulator (most likely the Federal Reserve); a prudential financial regulator overseeing banks; and a business conduct regulator, taking care of consumer protection and business practices. The plan would also create a new federal Mortgage Origination Commission to ensure that lax mortgage lending standards, which have led to the housing crisis and the sub-prime fiasco, will be avoided in the future.

Meanwhile, market sources suggest that the student loan sector will become the next area in search of a Fed bail-out. Problems in the auction rate market and the decline of securitisation to finance new student loans could potentially prevent thousands of students in the US from going to university in September.

Triple-A FELP paper (which is 96%-98% guaranteed by the government) is reportedly trading between 100bp-140bp, having traded at around 10bp-20bp a year ago. And private loan transactions are now trading at 200bp.

Asset-specific interest rate hedges analysed
In a new report, Moody's says asset-specific interest rate hedges for CDO transactions may provide a more dynamic control of interest rate risk than having a single macro interest rate swap for the entire CDO pool. However, asset-specific hedges also carry unique risks that need to be considered.

"Traditionally, to protect themselves against interest rate mismatches between assets and liabilities in CDO transactions, collateral managers have entered into macro interest rate swaps that are generally in place when the transaction closes and seldom modified, even if portfolios change over time," explain Moody's analysts David Burger and Yasmine Mahdavi. "Managers may prefer interest rate asset-specific hedges, as their granular nature may provide a more efficient approach to maintaining interest rate risk neutrality."

Since Moody's does not know in advance how interest rate asset-specific hedges will be used throughout the life of the transaction, there need to be established guidelines around their use. The agency says there are several specific criteria that can mitigate their risks. These include having each hedge associated with only one asset, the initial notional amount of the asset-specific hedge equal to the principal amount of the hedged asset, and the maturity date of the hedge matching that of the hedged asset.

Joint Forum reports on credit risk transfer
The Joint Forum has released for consultation a paper entitled 'Credit Risk Transfer – Developments from 2005 to 2007'. The paper was developed in response to a request from the Financial Stability Forum (FSF) in March 2007 to consider the extent to which the Joint Forum's March 2005 paper 'Credit Risk Transfer' required updating as a result of the continued growth and rapid innovation in the CRT markets.

While development of the paper was underway well ahead of the market disruption that began in the summer of 2007, it has formed the centrepiece of the Joint Forum's submission to the FSF in support of its work on the market turmoil. In fact, the paper was prepared on an accelerated schedule so that it could be presented at the March 2008 meeting of the FSF.

John Dugan, the chairman of the Joint Forum and Comptroller of the Currency in the US, says: "This paper is focused on the performance in the last two years of two particular financial instruments that have been used widely to transfer credit risk: credit default swaps and collateralised debt obligations. The part of the paper that explains and analyses CDOs backed by tranches of sub-prime mortgage-backed securities is especially relevant, given the very substantial losses that major financial institutions have recently sustained with respect to these instruments".

Dugan adds: "I believe the paper is a fundamentally important and accessible contribution to our understanding of certain causes of the recent credit market disruptions. In addition, it provides a number of new recommendations that build on the still relevant recommendations of the 2005 paper."

The Joint Forum, in cooperation with the parent bodies, also wishes to indicate that it will undertake a review of the recommendations in this paper, together with those in the 2005 paper to assess the degree to which they have been effectively implemented. The intention is for this review to take place in one year so that firms and supervisors have time to include necessary changes in their respective processes.

CMSA calls for increased CMBX transparency
The Commercial Mortgage Securities Association (CMSA) has requested that trading data on the CMBX index, including total volume and number of daily trades, be made publicly available in order to increase market transparency. The association made the request in a letter to Markit.

"Public disclosure of derivatives trading data in the CMBX index would provide an invaluable service to investors in the commercial real estate capital market finance arena," says Leonard Cotton, vice chairman of Centerline Capital Group and president of CMSA. "We believe the volatility in the CMBX index caused by momentum traders, rather than fundamental traders, distorts the true picture of the value of CMBS bonds, which are backed by the cashflows from loans on income-producing commercial real estate."

"Given the role the index has come to play in determining the mark-to-market value of securities held by financial institutions in the current market environment, greater transparency on CMBX trading volumes and the number of daily trades would aid investors in assessing the merit of values as indicated by the Index," Cotton added.

Quantifi launches correlation tool
Quantifi has launched a set of enhancements which solve the common CDO correlation calibration problems experienced by market participants. Quantifi is first-to-market in offering these new methods to participants in the global credit markets.

The recent volatility in the credit markets has made CDO base correlation calibration difficult for some parts of the capital structure. For example, the 15%-30% tranche on the CDX IG index has occasionally traded at levels which will not calibrate using common CDO pricing techniques.

"Our clients have been keen to see a reasonable solution for base correlation calibration for this market environment," says Rohan Douglas, ceo and founder of Quantifi. "We have been working closely with select clients to implement a number of techniques which guarantee robust and fast calibration in a way that is consistent with current market best practice and do not rely on arbitrarily adjusting model assumptions such as recovery rates."

Enabling standard CDO Copula models to calibrate across a wide range of market environments, the new models include: top-down or inverted calibration techniques; extended factors which greatly expand the range of market quotes that can be calibrated; and numerical techniques that greatly speed up and stabilise calibration at high correlations. Quantifi's enhanced base correlation calibration is available in the latest release of Quantifi XL.

CS

Trading ideas: count down to extremity

John Hunt, senior research analyst at Credit Derivatives Research, looks at an outright short on CDX.NA.IG Series 10

Taking an outright position on a credit index is either brave or foolhardy, depending on your perspective. We use several different approaches to estimate index fair value and decide whether a position is warranted.

Intrinsic level: The 'intrinsic value' of a CDS index is typically defined as the DV01-weighted average of the index members' CDS spreads. A credit index can trade away from its intrinsic value because of the high trading cost of putting on an arbitrage trade between all the individual names and the index, but indices do tend to revert towards intrinsic value when that happens. If the intrinsic level is higher than the index level, that is a signal to buy index protection.

MFCI-implied fair level: CDR's MFCI model derives the fair credit spread for a firm based on a combination of fundamental and market factors. The DV01-weighted average of the fair spreads for the index names gives the MFCI-implied index fair level. This tells us where the index should be trading based on the current characteristics of its members.

Fair level implied by CDR capital structure arbitrage model: CDR's capital structure arbitrage model permits us to judge fair CDS levels based on equity for names for which a strong empirical relationship exists. (It can also be used to judge the fair equity level for a name based on the fair CDS level).

Fair level implied by historical default rates: Given an assumed default rate and recovery rate, we can compute the value of the index that causes protection premiums to cover payouts over the life of the index. We use a time series of US investment-grade and crossover firms to construct rolling five-year windows of historical default rates, which we combine with a recovery assumption to determine what the fair value for a five-year credit index would have been for each year since 1965. By knowing what the fair value of the index would have been across several business cycles, we can judge what the fair value is now if we assume that we are at a particular point in the business cycle.

Fair level implied by historical ratings transitions: Extensive data on the migration of credits from one rating to another, and eventually into default, allow us to use the credit ratings of the current index constituents to forecast default rates. The default rate forecast can be combined with a recovery assumption to estimate the fair index level. Although credit ratings are far from perfect, the rating-based approach does give us a perspective on the fair value for the index that is independent of market prices and that reflects one measure of the credit quality of the individual names in the index.

Trade specifics
Most of our index analytics point towards an increase in CDX 10 spreads:

• The intrinsic level is still over around 8bp wide to the index level, although the skew has converged slightly over the past few days (see Exhibit 1).
• The MFCI-implied fair level for CDX 10 is currently approximately 200bp, so the index is over 60bp tight to the fair credit spreads of the individual components.
• The CDR capital structure arbitrage model indicates that five-year CDS in general is trading 30bp or so tight to equity levels, suggesting the possibility that the CDS market generally will widen out.

Exhibit 1

The historical-default-implied fair level for CDX 10 depends on an assumption about recovery rates and an assumption about where we are in the business cycle. Assuming that we are in the early stages of a recession, we would expect the number of realised defaults over the next five years to be near a cyclical peak.

Exhibit 2 presents the historical-default-implied fair levels for a forward-looking five-year IG/crossover credit index for every year starting in 1965. Looking at the two big cyclical peaks, we see that an index level of 150bp-200bp would have been justified by a recovery rate of 20%-40% at the mid-1980s peak and by a recovery rate of 30%-50% at the 2000 peak. Given that these ranges cover all reasonable estimates of recovery rates for senior debt of which we're aware, the historical default rate analysis suggests that a fair level for the index is 150bp-200bp.

Exhibit 2

The ratings-implied fair level for the index is around 75bp. We view this as an extremely conservative level for the index, given that the index contains 25 financial names which as a group are probably significantly 'over-rated' relative to their CDS levels. For example, an A3/A-/A rating on CIT seems a bit optimistic, given that the company is drawing down backup credit lines, rumoured to be looking for an acquirer and trading at around 1000bp in five-year CDS.

In addition to these fair value measures, the market's recent behaviour and current overall conditions support the trade. We've seen a pattern emerge since last summer:

1. A credit event that is poorly understood by many participants hits the markets and spreads widen;
2. The Fed takes action to try to calm the situation and spreads tighten;
3. More problems and rumours emerge, causing spreads to bleed wider;
4. Repeat at higher volume, starting with (1).

We think we're now at (2). While it's certainly possible that Bear Stearns' near-bankruptcy and the Fed-brokered buyout is the last panic-precipitating event that will happen before markets return to a fundamental-driven trading range, that just doesn't seem likely to us. The complexity and lack of transparency of the 'shadow banking system' means that market jitters will persist for a long time to come – and that means that the index will be very susceptible to big swings when bad credit-related events occur.

Risk
The main risk is fairly simple: our reasoning could be wrong and index spreads could fall. Secondary issues like hedge performance should not come into play, and we do not see liquidity as a material risk for the trade.

Exhibit 3 presents the trade performance over 30 days as a function of the CDX 10 level at that time.

Exhibit 3

To control risk, we establish target and stop levels up front. Our target level is half the difference between the index's current level and the MFCI-implied fair level, or 170bp.

That's comparable to the average cheapness of CDS relative to equity. Our stop level is the ratings-implied current level of 75bp.

Liquidity
Liquidity should not be a problem for this CDX index trade.

Summary and trade recommendation
For several reasons, we believe that the CDX 10 index will be significantly wider than it is now at some point in the next 30-90 days. We start with the fact that the index is 8bp or so tight to its own intrinsic value (the DV01-weighted average of CDS levels). It's very tight (almost 70bp) to the fair level implied by our MFCI model.

Moreover, CDS with investment-grade spreads in general are trading about 30bp tight to equity-implied fair value. Longer-run time series also support our view that the index spread has a way to go out. Depending on recovery assumptions and your views about just how bad a recession we're in, the index is at or tight to the level that would be actuarially fair based on historical default rates.

Most fundamentally, though, there are plenty of twists and turns left in the saga of Ben Bernanke's efforts to single-handedly tame the world credit crisis. With the index trading in 70bp over the past week or so, we just don't believe that it's all tightening from here on out.

Buy US$10m CDX NA IG Series 10 protection at 139.2bp to pay 139.2bp of carry.

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

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

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