Contents

Emerging asset class

Local currency CDOs to benefit from credit crunch outperformance

Currency appreciation has, in general, outweighed the effects of spread widening on emerging markets (EM) transactions. Indeed, investors report that local currency EM CDOs have outperformed other CDOs during the credit crunch – and, as such, are expected to benefit from renewed interest once the market stabilises.

"The credit crunch has highlighted the fact that transactions, such as Sydbank's Evolution EM CDO I and II [see SCI issue 22], have experienced limited write-downs and that their marks remain higher than in CDOs backed by other assets. This performance will stand EM CDOs in good stead when the market stabilises – the current environment has proved that these structures are robust," says one structured credit investor.

Structured credit analysts at Citi agree that to date local currency emerging markets structured credit has performed well. "It has proved to be an effective way to diversify from products with European or US collateral," they say.

EM has outperformed most other asset classes and jurisdictions thanks to strong technicals and fundamentals, notes Søren Rump, ceo of newly-established asset management firm Global Evolution (see SCI issue 68). "There is significant interest in local currency in particular, with – for example – the World Bank recently investing US$5bn and many sovereign wealth funds looking to become involved."

He adds: "Local pension funds are also growing, so the investor base for the asset class is broadening. Although there hasn't been a complete decoupling between emerging markets and developed markets, strong current account surpluses and commodities have meant that EM fundamentals have outperformed."

In the case of EM CDOs, the added value that managers bring is through creating portfolio diversity. While an individual investor could perhaps manage a pool of 5-10 currencies, the optimal number for diversification purposes is 30-35.

However, broad access to different liquidity providers is required to achieve this figure. In addition, says Rump: "It would be hard for an individual to gain an in-depth understanding of all the markets and look for new opportunities, as well as monitor the portfolio to avoid large jumps in FX rates. Emerging markets are constantly developing and so looking for opportunities is resource-intensive."

Those sceptical of the decoupling argument point to the global nature of economies and reject the theory that an EM group, even one that trades heavily among other EM countries, can be entirely immune to a global recession. Citi economic strategists forecast that growth will slow in emerging markets over coming quarters, although policy offsets are likely to limit the impact of the US-led slowdown.

"Currency forecasts point to a decrease in dollar volatility and a slowing rate of depreciation. In other words, emerging market structured credit is likely to continue to benefit from currency fluctuation, but to much less of an extent than has been the case during the last few years," conclude the Citi analysts.

CS

Sticking with it

Viability of mezzanine SME CLO programmes questioned

Performance concerns have surrounded German mezzanine SME CLOs since before the credit crunch, but even now analysts are divided over future expectations for the lending model. Some say that such programmes are now better placed than ever, while others question their long term viability.

Mezzanine SME CLO programmes make more sense in the current environment – where the soft German bank market has disappeared – than they did when many of the deals were launched, according to Lars Schmidt-Ott, md at Capital Efficiency Group (which manages the PREPS programme). "Demand has increased for these loans but the supply is diminishing, which has increased the spread. At 600bp over, investors are receiving a healthy return for an uncorrelated portfolio. Mid-market loans are good collateral: for most German SMEs, 2007 was their best year," he explains.

However, to date nine deals across six of the seven existing programmes have experienced defaults. Further, sustained downgrades to rated bonds have occurred on three of the 16 transactions outstanding and another three have had bonds placed on negative watch by at least one rating agency (SCI passim).

"While the absolute number of obligor defaults (11) is not overly high, when taken in the context of the small overall number of obligors in each of the pools – ranging anywhere from 35 to 67 – two large obligor defaults are sufficient to have a significant bearing on the ratings stability of junior bonds, and more than two or two allied with negative credit migration in the remaining pool is likely to impinge on the rating stability of senior bonds. This lack of granularity and heavy name overlap are the key reasons why the sector has underperformed," observes Conor O'Toole, research analyst at Deutsche Bank.

The unusually high number of defaults so early on across these transactions has largely been driven by fraudulent borrowers. Four of the five insolvencies experienced across the PREPS programme, for example, were due to fraudulent numbers being presented at the underwriting stage.

While conceding that some investors could be put off by performance issues in the sector, he asserts that the mezz SME CLO business model is still valid – albeit in need of some readjustments. "With larger pools (80-100 names), better pricing and amendments to the structure – such as giving investors more rights – it's a good trade. The fact that the normal checks and balances aren't there should be priced in – although we've developed a fraud check in cooperation with the big five accountancy firms, which means there is a high risk of a fraudulent issuer being discovered."

Looking ahead, refinancing risk could become a performance issue for some programmes – especially those sponsored by banks that have different priorities in the current environment. Typical mezzanine SME CLOs consist of seven-year fixed rate bullet loans, so at the end of the scheduled term the entire pool must be refinanced at a time when the CLO capital structure remains fully levered. If the securitisation market remains shut for this type of lending, investors are then reliant upon German banks stepping into refinance the loans at maturity.

Most borrowers will seek alternative options to defaulting on their loans, given the desire to protect their brand. Nonetheless, it has long been argued that there are too many mezz SME CLO platforms for such a small market. The fact that some bank sponsors may walk away from their programmes paves the way for consolidation around a more appropriate number of 2-3 platforms (in contrast to seven), thereby providing the requisite economies of scale and diversification.

In the meantime – as with the broader CDO sector – while plenty of equity investors are interested in mezz SME CLOs, it is difficult to find both senior investors and the leverage. To get such a deal away in this environment, says Schmidt-Ott, it is necessary to collaborate with a pension fund/insurance company on the leverage and then for the equity to be taken by a principal, which will also manage the pool.

Unlike traditional SME senior secured/unsecured bank lending, mezz CLO platforms originate mezzanine capital with an explicit securitisation exit. Conventional German SME CLOs hold both senior secured and unsecured loans to the Mittelstand, with markedly better credit performance than their mezz cousins.

CS

KBC steps up

Unusual European synthetic arbitrage CDO launched

KBC Investments has closed an unusual self-led investment-grade synthetic arbitrage CDO. The €500m Lancaster Place Finance I includes CLNs that step up upon a downgrade event, with a premium paid to the junior tranches at maturity.

The deal consists of two elements: a privately-placed senior CDS, representing the most senior portion of the credit risk; and €107.75m of CLNs, representing the junior portion of the credit risk. KBC is believed to have retained the equity portion.

Rated by Moody's only, the CLNs comprise €66.25m Aaa rated Class A1 notes (which printed at 100bp over three-month Euribor), €20m Aaa Class A2s (180bp over), €11m Aa2 Class Bs (240bp), €6m A2 Class Cs (400bp) and €4.5m Baa2 Class Ds (625bp). All tranches priced at par and have an expected maturity of July 2015.

Classes A1, A2 and B feature an undisclosed step-up coupon in the case of a downgrade event, while Classes B, C and D will be paid an additional premium at the end of the life of the transaction. Moody's ratings do not address these two aspects of the deal.

Lancaster Place is exposed to a portfolio of 242 corporate reference obligations at closing. The largest two industry concentrations are in banking and buildings & real estate, with a participation of 12.5 % and 12.3 % respectively. The lowest rating of an individual corporate reference obligation is Baa3.

The proceeds from the CLN issuance will be held in an investment agreement guaranteed by KBC Bank. The transaction permits the issuer to switch the collateral, in which case the guaranteed investment may be replaced by a repurchase agreement or a total return swap. Eligible investments are securities with a rating not below Aa3 issued by governmental and corporate entities, as well as asset-backed securities rated at least Aa3.

As portfolio swap counterparty, KBC Investments Cayman Islands V Ltd, will identify the initial portfolio and may subsequently replace any of the reference entities included in it. Such activity will be subject to certain investment guidelines and, in particular, the satisfaction of a maximum Moody's Metric test computed by Moody's CDOROM model.

The global CDO market has had a quieter time of late, after experiencing relatively heavy issuance in the run up to quarter-end. No CDOs priced in the US last week, while Europe saw US$363m-equivalent in issuance.

Together with Lancaster Place, London Wall 2008-1 hit the market. Deutsche Bank's self-led balance sheet CLO issued a single US$192m-equivalent equity tranche. It carried a 3.1-year average life, priced at par and was reportedly fully subscribed.

In Japan, meanwhile, one balance sheet CLO (SFCG SME Loan Securitisation 2008) and an investment grade CSO (Pacific Capital International 2008-02) contributed US$122m-equivalent to last week's issuance. The global pipeline stands at US$9.7bn, predominantly made up of CLOs (US$8.8bn), according to JPMorgan estimates.

CS

Structured credit hedge fund index plummets

Latest figures driven by massive hit from single fund

Both gross and net monthly returns for February 2008 in the Palomar Structured Credit Hedge Fund (SC HF) Index show a worst-ever negative return. The decline was primarily the result of one fund's performance, however.

The latest figures for the index were released this week and show a gross return of -17.03% and a net return of -17.15% for February, with 14 of 24 funds reporting positive results. The negative performance was mainly due to the collapse of the largest index member, on a capital-weighted basis, Peloton ABS.

Only the two relative value sub-strategies produced a significant positive contribution to the indices, in what was the worst month so far for the index. In general, the dispersion and range of returns increased compared to the data observed in January, as results varied widely, even within each sub-strategy. For more Index data click here.

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

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

CS

SGCIB restructures

The latest company and people moves

SGCIB restructures
Société Générale Corporate & Investment Banking is reorganising its global fixed income, currencies & commodities division, which will be headed by Olivier Khayat. The bank says the move will ensure that it will "be best positioned in the current market environment" and "meet investor needs by building on its franchise, structuring skills and origination to distribution business model, while implementing a reinforced risk management approach".

As a result of the reorganisation, SGCIB has made a number of managerial appointments. Chico Khan-Gandapur is promoted to global head of flow business, with Serge Topolanski as his deputy. They will be responsible for driving the bank's flow activities, including credit, FX and rates.

Ines de Dinechin will become global head of structured products, with two deputies – Hubert Le Liepvre covering credit, and Bertrand Fitoussi supervising interest rates and FX. David Coxon, with Jean-François Despoux as his deputy, will oversee the bank's global capital markets financial engineering activities.

Bruno Dejoux also joins fixed income, currencies & commodities management and will help optimise transversal activities and enhance further overall risk management to accompany business development.

Semerci arrives at Duet
Osman Semerci has this week joined alternative asset and private equity firm Duet Group as its ceo and managing partner. As well as the day-to-day running of the business, Semerci will oversee the build up of the firm's structured product business, which is expected to incorporate credit opportunities.

Semerci left Merrill Lynch in October last year, following the firm's major sub-prime related write-downs. At Merrill he was global head of fixed income, currencies and commodities, responsible for the firm's trading and sales activities in fixed income, currencies, commodities, principal investments and real estate globally, and co-president of EMEA global markets and investment banking.

Ferguson to head up TIAA-CREF
The Trustees of the Teachers Insurance and Annuity Association (TIAA) have hired Roger Ferguson as president and ceo, and appointed current presiding trustee Ronald Thompson as chairman of the TIAA board. Ferguson and Thompson succeed Herbert Allison, who is retiring with effect from 14 April.

Ferguson comes to TIAA-CREF from Swiss Re, where he was head of financial services, a member of the executive committee and chairman of Swiss Re America Holding Corporation. He was responsible for Swiss Re's proprietary asset management unit and oversaw the capital management and advisory group, as well as the credit risk underwriting unit.

Swiss Re has appointed David Blumer as head of financial markets and member of the executive committee effective from May 2008. Blumer was previously ceo of asset management at Credit Suisse and a member of its executive board.

Phoenix hires Mitchell
Toby Mitchell has joined the New York office of Phoenix Partners Group, the inter-dealer broker specialising in OTC derivatives. He arrives from Bank of America, where he had been since 2004 – initially in credit derivatives sales covering hedge funds before transferring to structured product sales, focusing on CDS, CDO, correlation, RMBS, ABS and CMBS products.

Meanwhile, Phoenix has promoted Sean McNally and Ezra Lunde to the role of partner. McNally is responsible for building the firm's investment grade single name business and Lunde has the remit to further develop its investment grade and high yield index franchise.

SIV-lite receivers appointed
Kris Beighton of KPMG in the Cayman Islands and Richard Heis and Mick McLoughlin of KPMG (UK) have been appointed joint receivers of the Mainsail II SIV-lite. Following the direction of a majority of the senior secured creditors, the appointment of receivers was made by The Bank of New York as security trustee.

Beighton comments: "Owing to the ongoing liquidity and confidence crisis in financial markets, the value of the company's investment portfolio has been adversely affected. This breached various triggers, and has led to our appointment as receivers. Over the coming weeks we will work closely with the creditors and other parties to develop and implement an appropriate restructuring strategy."

MBIA turns on Fitch too
MBIA has become the latest monoline to publicly disagree with Fitch (SCI passim). The move follows the agency's downgrading of its insurer financial strength (IFS) ratings on MBIA Insurance Corp and its subsidiaries to double-A from triple-A, and the long-term rating of parent holding company MBIA Inc. to single-A from double-A (see News Round-up).

"We respectfully disagree with Fitch's conclusions. MBIA has a balance sheet that is among the strongest in the industry, with over US$17bn in claims-paying resources, and has a high quality insured portfolio – factors which we believe enable MBIA to meet severe economic stress scenarios," says Edward Chaplin, the firm's cfo, in a statement.

Law firm adds structured finance specialist
Mark Dola has joined King & Spalding's Washington, D.C., office as counsel. He will focus his practice on structured derivatives and securitisation transactions, and will participate actively in the firm's sub-prime and capital markets special task force.

Dola advises issuers, underwriters, and placement agents in securitisation transactions involving a variety of assets classes, including credit card and trade receivables and has considerable experience with CDOs, CLNs and CDS. Dola joins from McKee Nelson, where he was counsel.

OTC Val and ValueLink join forces
OTC Valuations (OTC Val) and ValueLink have announced that independent OTC derivative pricing from OTC Val will be available to ValueLink clients via their established delivery platforms.

Clients who currently receive dealer counterparty data for OTC derivatives via ValueLink products will now also be able to access independent valuations for these instruments generated by OTC Val. This is a significant extension of the current OTC data service provided by ValueLink, which has previously concentrated on counterparty pricing, the firms say.

Ross buys US$250m of Assured
Assured Guaranty has announced that investment funds managed by WL Ross & Co have purchased 10,651,896 shares of Assured's common equity at a price of US$23.47 per share, resulting in proceeds of US$250m. The commitment to purchase these shares was previously announced on 29 February 2008, as was WL Ross' remaining commitment through 8 April 2009 to purchase up to US$750m of Assured's common equity, at Assured's option (see SCI issue 78).

In addition, Assured announced that Wilbur Ross, president and ceo of WL Ross, has been appointed to the board of directors of Assured to serve a term expiring at the company's 2009 annual general meeting of shareholders.

MP

Tricadia preps CDPC

A round up of this week's structured credit news

Tricadia preps CDPC
Moody's has assigned a provisional counterparty rating of Aaa to Harbor Road Financial Products, Tricadia CDPC Management's new CDPC. The vehicle will invest in a diversified portfolio of high attachment point tranches referencing corporate or sovereign credits through the CDS market.

Moody's provisional rating relies on Harbor Road being managed with a capital model that restricts its ability to trade. The capital model examines the impacts of potential counterparty defaults and changes in market rates on the calculation of required resources. In addition to the required resources suggested by the capital model, a buffer will be added to reflect non-quantifiable sources of risk, such as operational failures.

In reaching its ratings, Moody's took into consideration the expertise of Harbor Road's manager, a subsidiary of Tricadia Holdings. Tricadia and its affiliates have approximately 40 professionals focused on the administration, analysis and trading of credit-related products. The Tricadia team currently manages approximately US$8.3bn in hedge funds, managed accounts, CDOs and permanent capital businesses.

Moody's ability to monitor Harbor Road will be enhanced by agreed upon procedures conducted by an independent auditor, which will report on a regular basis on the CDPC's compliance with certain provisions of the operating guidelines, including the processing of transactions, the maintenance of required resources and the various capital and cashflow calculations.

Fitch downgrades MBIA
Fitch has downgraded the insurer financial strength (IFS) ratings on MBIA Insurance Corp. (MBIA) and its subsidiaries to double-A from triple-A, and the long-term rating of its parent company MBIA Inc. to single-A from double-A. At the same time, MBIA has been removed from rating watch negative – although the rating outlook is negative.

This action is based on Fitch's current views on capital adequacy, the company's updated business plan, consideration of various qualitative ratings factors, an update on Fitch's current views of the portfolio quality of MBIA's insured portfolio, and an analysis of MBIA Inc.'s investment management service (IMS) operations and holding company activities.

As a key basis for the rating action, Fitch believes that MBIA's pro-forma claims paying resources at year-end 2007 of US$16bn now fall below Fitch's triple-A capital targets by a range of US$3.4bn to US$3.8bn, but are consistent with Fitch's updated standards for double-A capital. These figures fully consider the US$2.6bn of capital already raised by MBIA earlier this year.

Fitch notes that MBIA's updated business plans include several improvements to its risk management framework for its operating financial guaranty companies. For example, the permanent exit of several riskier capital intensive structured finance businesses, including CDS execution, and a re-dedicated commitment to focus on its lower-risk core municipal franchise.

In addition, MBIA's suspension of underwriting all structured finance exposures for a six-month period will result in the build up of capital (assuming relative stability of underlying ratings in the existing insured portfolio), as the company will benefit from the amortisation of existing insured obligations – some of which exhaust a material amount of targeted capital resources. This will possibly aid MBIA's return to triple-A capital standards in the future and, more importantly, limit the risk of volatility in the insured portfolio over the intermediate term.

Looking ahead, Fitch believes it will be difficult for MBIA to stabilise its credit trend until the company can more effectively limit the downside risk from its structured finance CDOs through reinsurance or other risk mitigation initiatives. This is a key consideration in the negative rating outlook that presently applies to MBIA's ratings.

Furthermore, assuming sub-prime risk can be stabilised, Fitch does not believe it will be possible for MBIA to significantly improve its credit profile until the company can more fully re-establish momentum in the financial guaranty market, especially in the core US municipal finance sector. To date, on a relative basis, Fitch notes that MBIA's franchise has been less impacted than those of several other sub-prime exposed financial guarantors.

The agency also believes that MBIA's credit profile will be influenced by clarification on its future corporate structure, which may include separation of its operations into segregated municipal finance and structured finance businesses. The credit profile will also be sensitive to management's ability to demonstrate that it can successfully execute its strategic business plans, and that its board of directors can provide effective oversight in a very challenging operating environment. Going forward, these qualitative business, management and franchise-related factors will take on added consideration in future ratings reviews of downgraded financial guarantors.

OCC reports on bank losses
Insured US commercial banks lost US$9.97bn trading cash and derivative instruments in the fourth quarter of 2007, down US$12.3bn from third-quarter revenues of US$2.3bn. For the full year, banks recorded US$5.5bn in trading revenues, down US$13.3bn from the record of US$18.8bn in 2006, the Office of the Comptroller of the Currency has revealed in its Quarterly Report on Bank Trading and Derivatives Activities.

"The large losses in the fourth quarter are the result of well-publicised write-downs on the super-senior tranches of collateralised debt obligations backed by sub-prime residential mortgage securities," says deputy comptroller for credit and market risk Kathryn Dick. "We expected to see an adverse effect on trading results, given current turbulent conditions in the credit and capital markets, particularly in light of the deterioration in market liquidity."

Commercial banks reported credit trading losses of US$11.8bn in the fourth quarter, compared to losses of US$2.7bn in the third quarter. Revenues from interest rate contracts decreased US$3.3bn to a loss of US$357m. Revenues from foreign exchange transactions decreased 7% to US$1.9bn.

The report shows that the notional amount of derivatives held by insured US commercial banks decreased by US$8trn in the fourth quarter to US$164tr. The fourth quarter derivatives total is 25% higher than a year ago. Credit derivatives increased 3% during the quarter to a notional level of US$14.4trn, 60% higher than a year ago.

The OCC also reports that the net current credit exposure – the primary metric it uses to measure credit risk in derivatives activities – increased by US$57bn, or 22%, during the quarter to US$309bn. The measure is 67% higher than at the end of 2006.

"The decline in interest rates and widening credit spreads have caused sharp increases in derivatives fair values, and netting benefits have not kept pace the past two quarters," comments Dick. The percentage of gross fair values offset by netting, which reached a peak of 86.4% in the second quarter of 2007, has declined to 83.8% in the fourth quarter.

The report also notes that derivatives contracts are concentrated in a small number of institutions: the largest five banks hold 97% of the total notional amount of derivatives, while the largest 25 banks hold nearly 100%. Credit default swaps are the dominant product in the credit derivatives market, representing 98% of total credit derivatives.

The number of commercial banks holding derivatives increased by 18 in the quarter to 955.

Sigma downgraded
Moody's has downgraded Sigma Finance's Euro and US MTNs from Aaa and Prime-1 to A2 and Prime-2, and its CP programme from Prime-1 to Prime-2. The ratings have been left on review for downgrade.

Continuing uncertainties surrounding the SIV's ability to absorb the heightened and unprecedented levels of stress in the credit markets, coupled with further deterioration in its asset prices caused the rating actions. Although unusual, the combination of an A2 long-term rating and a P-2 short-term rating reflects the high credit quality of the company's assets and the liquidity challenges it faces.

Sigma's pre-crisis business model relied on the issuance of commercial paper and medium-term notes. Subordinated debt in the form of capital notes was also issued, with the proceeds used to fund a portfolio of diversified and highly rated assets.

Severe disruption in the new debt issuance market for commercial paper, medium term and capital notes caused Sigma to rely instead on repurchase agreements, ratio trades and outright asset sales in order to repay its maturing debt. Gordian Knot has been successful in establishing new repo lines, taking the number of counterparties to 17 and the outstanding amount of repos to US$14bn as of 2 April. Both figures increased sharply from their low pre-crisis levels.

A further positive feature of Sigma's repos is the length of the commitments, currently averaging seven months. Ratio trades involve the sale of assets at par to Sigma's senior debt investors in exchange for cash and the extinguishing of Sigma's debt held by the investor. A total of approximately US$4bn of assets have been sold in ratio trades, with the majority of assets (US$3.9bn) being structured finance securities (including auto loans, credit cards, CDOs and RMBS), and the remainder financial institutions debt.

While ratio trades and repurchase agreements provide much needed liquidity to the company, investors and repo counterparties could themselves come under liquidity pressure under current or worse market conditions, potentially forcing Sigma to rely on asset sales in a scenario of precipitous price declines. With respect to repos, counterparty asset prices are in some cases lower than those sourced by Sigma. This has the effect of reducing the amount of cash expected to be received by Sigma.

The other funding tool for Sigma is asset sales and the company has liquidated a total of US$9.5bn (excluding ratio trades) since June 2007. The sales have been representative of the asset portfolio in terms of industry and rating composition and, at 50bp below marks on average, trade execution has so far revealed robust pricing policies and procedures pursued by Gordian Knot. Nevertheless, the prices have themselves been declining steadily and, on occasions, precipitously since July 2007.

The average price that was 100.2% of par on 27 July 27 declined to 96.99% on 15 February 2008. As of 28 March 2008 portfolio market value was 95.59%. Sigma's net cash outflow profile up to 30 September 2008 shows that approximately US$20bn of debt must be financed using one or a combination of the above funding tools.

In addition, the company has committed liquidity of US$3.8bn in the form of bank facilities (US$1.5bn), breakable deposits (US$1.6bn) placed with a syndicate of Prime-1 rated banks, and puttable assets (US$688m).

The company's asset portfolio remains diversified and is of a high credit quality. Financial institutions comprise 59% of the portfolio, split into bank direct obligations 34%, bank holding companies 10%, captive finance companies 6%, investment banks 5%, monoline insurance companies 3% and insurance companies 1%.

The balance is made up of ABS, with the following important asset classes: CDO 15%, Prime UK, Dutch and Australian RMBS 11%, credit cards 5% and CMBS 5%. The portfolio has limited exposure to ABS CDOs and monoline wraps, and no direct exposure to US sub-prime RMBS.

The average life is fairly short at 3.48 years. In terms of credit quality, 44% of the portfolio is Aaa rated, 43% Aa rated, 9% A rated, 2% Baa rated and 1% rated Ba-B.

The company does not have market value or ratings-based enforcement triggers (except in the event of a withdrawal of all ratings). Instead, breaches of certain liquidity or capital adequacy tests would place the company into the 'no-growth' operating state. Sigma is currently operating in the no-growth state and has effectively been in this state since the beginning of August 2007.

Continued weakness in its liquidity position, crystallisation of mark-to-market losses or deterioration in portfolio credit quality could trigger entry into the 'natural amortisation' phase, whereby the company would be required to wind down following asset amortisations or redemptions. In natural amortisation, no payments are made to capital note investors and no performance fees are paid to the manager. Both operating states are reversible were the company to find more stable and dependable sources of funding in the future.

CDO credit migration analysed
The credit performance of CDOs showed some unprecedented deterioration in 2007, but deterioration almost wholly contained to a single sector – US dollar-denominated resecuritisations, reports Moody's in its annual CDO credit migration study. Outside of this sector, rates of rating downgrades in 2007 were lower generally than their historical averages.

"A review of the CDO market's credit performance in 2007 underscores its diversity," says Moody's svp Danielle Nazarian. "While sub-prime RMBS-backed resecuritisation CDOs underwent widespread and severe downgrades, other key CDO sectors performed well, including those tied to the US and European corporate credit markets."

In all, Moody's downgraded a total of 1,331 tranches of US dollar-denominated resecuritisations in 2007. These accounted for 92% of the 1,448 downgrade actions for all CDOs during the year.

Within the dollar-denominated resecuritisation category, downgrades were heavily concentrated in the 2006 and 2007 vintages. Actions from these two vintages alone constituted 87% of the 1,448 total downgrades.

Looking forward through 2008, the rating agency projects even greater ratings volatility among US dollar resecuritisation CDOs, as signalled by the nearly 2,000 tranches currently under review for downgrade.

The rates of downgrade in other sectors for 2007 were fairly comparable to those observed in 2006. The two exceptions were the market value CDO category – whose downgrade rate increased from 0% in 2006 to 7.5% in 2007 – and the investment grade arbitrage cash flow CBO sector, whose downgrade rate dropped from 10% in 2006 to 0% in 2007.

In this year's report, Moody's also examines for the first time cumulative downgrade ratings transitions for each vintage of CLOs from issuance through to the end of 2007. This analysis highlights the sector's long-term stability, as only one of the 589 CLO tranches assigned a Aaa rating at issuance has ever been downgraded.

CDO liquidations on the rise
As of 31 March, S&P reported 141 events of default (EODs) in SF CDOs, with all but two coming from the 2006/2007 vintages. By volume, US$157bn or 44% of 2006/2007 SF CDO issuance is in technical default.

Thirteen CDOs are reportedly currently in liquidation, while 15 deals have been liquidated. A total of 8% of 2006/2007 issuance is in some form of liquidation (14% mezzanine, 4% high grade and 12% CDO-squared). Those in the acceleration phase tally 16% (27% mezzanine, 11% high grade and 6% CDO-squared).

S&P says it has lowered its ratings on 33 classes of notes – worth US$3.6bn – from across four ABS CDOs (Ansley Park ABS CDO, Arca Funding 2006-II, Kefton CDO I and Markov CDO I) transactions to single-D. The rating actions follow notices from the trustees that the transactions have liquidated the portfolio collateral and have distributed or are in the final stages of distributing the proceeds to noteholders.

All four transactions had previously experienced EODs based on their failure to maintain EOD overcollateralisation ratios that were above minimum threshold values. The EOD overcollateralisation ratios for Ansley Park and Markov incorporate ratings-based haircuts.

The trustees for the four CDO transactions have indicated that they anticipate the proceeds from the sale of the collateral and in the principal collection account – along with any proceeds in the super-senior reserve account, CDS reserve account and other sources – will likely not be adequate to cover the required termination payments to the CDS counterparty, and that it is likely that proceeds will not be available for distribution to the notes junior to super-senior swap in the capital structure of the CDO transactions.

US ABCP programmes reduce CDO exposures
Traditional US ABCP programmes significantly reduced exposures to CDO and residential mortgage collateral throughout 2007 and into 1Q08, according to a Fitch analysis of its rated multi-seller and securities-backed ABCP programmes.

Results show overall exposures to CDOs and residential mortgage collateral contracting at a much faster pace than the overall ABCP market since year-end 2006 and non-mortgage consumer assets, along with corporate exposures growing substantially. Throughout the period, which has been marked by exceptional volatility and uncertainty, the ratings of these traditional ABCP programmes have proven stable – despite credit pressures across numerous sectors.

In addition to a dearth of mortgage and CDO originations in the current environment, the declines can be attributed to the termination and unwinding of ABCP programme types with high concentrations of these assets, as well as sponsors' proactive efforts to reduce or remove certain exposures in an effort to ease investor concerns in the current market environment.

Results of Fitch's portfolio composition analysis indicate total residential mortgage exposure declining by 59% on a dollar basis to US$9.4bn since end-2006. Over the same period, CDO exposures across Fitch's rated US multi-seller and securities-backed universe fell by 24% to US$13.9bn.

Student loans exhibited the largest increase in dollar terms, more than doubling to US$27.8bn, while corporate/commercial/bank exposures grew by 71.5%. Auto-related loans and leases jumped by 23% to US$37.5bn.

Overall ABCP outstandings have declined by more than 27% during the same period and 35% since peaking in July. Meanwhile, Fitch-rated multi-seller and securities-backed programmes increased approximately 4.7% on a like-for-like comparison since end-2006, with Fitch-rated multi-sellers growing 14.3%.

CPPIs downgraded
Moody's has downgraded six CPPIs: the Series 2007-19 and 2007-20 Greenwood Notes, and the Series 2007-22 Credit Pill 1 Notes from B1 to Caa1; the Series 2007-04 and 2007-23 Alpaca Notes from Ba3 to Caa2; and the 2007-24 Alpaca Notes from Ba3 to Caa1. The notes have been left on review for possible downgrade.

CPPI transactions protect the investment by only putting at risk a certain proportion of the proceeds from the sale of the notes. The remainder is available, at all times, to purchase a zero-coupon bond for the full principal repayment, should the rest of the proceeds be lost in the credit strategy. Therefore, the investors' principal is protected, but not their future coupons.

The Greenwood and Credit Pill transactions, issued by Magnolia Finance VI, are currently not invested in any credit strategy; the cushion amount available above the value of a zero-coupon bond is now small relative to its initial value. The Alpaca Series 2007-24 transaction still has proceeds invested, but currently the value of this investment is a small fraction of its initial value. Moody's believes there is significant probability that these four transactions will not pay all their coupons to the investors.

The Alpaca Series 2007-04 and 23, meanwhile, have permanently reverted to the zero-coupon bond and hence were rated taking into account the fact that no further coupon will be paid to investors.

S&P calls for greater transparency in leveraged finance
European investors are increasingly focusing on the true credit risk within their portfolio, but primary market prices have not followed suit, according to a report entitled 'A Call For Greater Transparency In The European Leveraged Finance Market' published by S&P.

"Against the backdrop of rising default risk, investors are increasingly looking for conservatively structured transactions, demanding covenant headroom of less than 25% and – crucially – appropriately priced risk," says S&P research analyst Taron Wade.

However, although there has been a very sharp repricing of risk in the secondary market in recent months, there has been only a limited change in primary pricing in the leveraged loan market. "We believe that the European market's failure to differentiate between loans according to credit quality in the primary market underlies the pricing imbalance," Wade adds.

It could be assumed that European primary margins are lower than those in the US because of an increase in credit quality across new issues, but the credit quality of new issues is in fact falling across Europe. In 2007, S&P assigned public ratings of single-B minus to 10% of issuers, representing a dramatic change in risk profile across the leveraged loan market compared with five years ago.

In the US, meanwhile, there has been a significant flight to quality, with prices moving very quickly and abruptly to reflect the change in demand – akin to the volatility seen in 1991. Risk-versus-reward prospects therefore seem much better for US investors, further emphasising the need for change in Europe.

Notably, new-issue US institutional spreads widened by between 75bp and 100bp in the second half of 2007. Moreover, the credit curve between double-B and single-B credits has steepened.

In Europe, however, institutional spreads only widened by between 40bp and 50bp in the second half of 2007. And the risk premium for buying single-B over double-B rated new issue paper had actually fallen to 16bp at year-end 2007, 5bp lower than in the six months to June.

Markit responds to the CMSA
In responding to the Commercial Mortgage Securities Association's letter regarding increased CMBX transparency (see last week's issue), Markit has made the following points. With regard to publishing daily volume data to assess the merits of using CMBX spread levels to value cash positions:

• As the CMBX trades on the OTC derivatives market, Markit does not have access to trading data (volumes and number of daily trades). It is therefore unlikely that the daily provision of trading volumes could be achieved nor the consistency of this data be guaranteed.
• Trading volumes have never been published for other OTC derivative products (e.g. rates, FX, commodities), apart from high level surveys conducted by ISDA.

Proposed EU regulation examined
FRSGlobal, provider of worldwide risk and global regulatory reporting solutions, has examined some of Commissioner Charlie McCreevy's key points on strengthening EU regulation.

• Disclosure regime change for structured products – The changes indicated are likely to result in increased frequency and volume of reporting in relation to structured product exposures.
• Roll up of special purpose entities – There are considerations as to whether the special purpose entities used in structured products should not be consolidated onto financial institutions' balance sheets. If such a proposal were to be made, the perceived standing of many institutions could change, even if in reality the economic impact is low.
• Changes on the definition of the significance of risk transfer – The fact that this has been mentioned suggests that the regulator is concerned with the current rules relating to when a securitisation has properly transferred risk. The likely impact of any change is a tightening of the current rules and the exclusion of some trades that are treated favourably under the current rules.
• New rules to limit the risk stemming from large exposure – The profile of large exposures allowed to be held by institutions will likely become more restrictive. The focus on understanding exposures and risk could also indicate more extensive reporting.

Selwyn Blair-Ford, senior regulatory domain expert, UK and Ireland, for FRSGlobal, says: "One should keep in mind that the key to this financial crisis is securitisations. Securitisations have the effect of weakening the traditional role of banks in the financing process, as it links funders to borrowers more directly."

He adds: "As a result, the exercising of monetary policy, either by increased liquidity or interest rate changes, has become less effective – especially when it operates solely on regulated banks. Central banks will need to address this problem and, consequently, an environment in which a wider range of institutions comes under their gaze is perhaps inevitable."

CIBC confirms participation in conduit plan
The Pan-Canadian Committee for Third-Party Structured ABCP has announced that satellite trusts of Structured Asset Trust (SAT) Series E and Structured Investment Trust III (SIT III) Series E have reached an agreement with CIBC concerning the termination of one of CIBC's CDS (related to SAT Series E) and the inclusion of CIBC's two other CDS (related to SAT Series E and SIT III Series E) as part of the Committee's Companies' Creditors Arrangement Act restructuring plan.

Reaching a mutually satisfactory agreement on the three swaps was a condition of CIBC's participation in the margin funding facility, which is integral to the Committee's restructuring plan. The agreement resulted from negotiations that began several months ago among CIBC and investors who own a substantial majority of the outstanding SAT Series E notes.

As part of the agreement, a CDS transaction with Nemertes Credit Linked Certificate Trust (Commerce - LSS II) Series 2006, which is a satellite trust of SAT, has been terminated. The termination resulted in a loss to noteholders of SAT Series E of approximately US$163m, or approximately 23% of principal. The maximum recovery of funds for SAT Series E investors as a result of this unwinding is now approximately 77%.

"We are pleased to see the successful restructuring of these swaps," says Purdy Crawford, chair of the Committee. "This restructuring is a long and complicated road comprising many steps, and [this] announcement represents further progress towards successful implementation of the overall restructuring plan."

CIBC is one of the financial institutions working with the Committee to resolve liquidity issues attached to the ABCP market in Canada and, together with a number of other Canadian Schedule I banks, has agreed – subject to certain conditions – to participate as a lender in the margin funding facilities that have been proposed upon implementation of the restructuring plan.

Under provisions of the Companies' Creditors Arrangement Act, the plan must be approved by a majority of noteholders (regardless of the size of their holdings) that vote at the meeting, as well as by noteholders representing not less than two-thirds of the total aggregate principal amount of affected ABCP that vote at the meeting. If the plan is approved by the noteholders at the meeting, a further hearing will be held before the Court for its final sanction of the plan.

IMF reports on sub-prime crisis
The widening and deepening fallout from the US sub-prime mortgage crisis could have profound financial system and macroeconomic implications, according to the IMF's latest Global Financial Stability Report (GFSR).

At present, the issuance of most structured credit products is at a standstill and many banks are coping with losses and involuntary balance expansions, the report says. The report examines this and other forces that could push the current credit crisis into a full credit crunch, as well as offering policy recommendations to mitigate the impact.

"Financial markets remain under considerable stress because of a combination of three factors," says Jaime Caruana, head of the IMF's monetary and capital markets department. "First, the balance sheets of financial institutions are weakening; second, the de-leveraging process continues and also that asset prices continue to fall; and, finally, the macroeconomic environment is more challenging because of the weakening global growth."

The crisis has weakened the capital and funding of large systemically important financial institutions, raising systemic risks. Such financial institutions need to raise capital or cut back assets to cope with the strains, the report explains. The continued stress increases the downside risks for global financial stability and potentially forces institutions to further curtail credit, meaning that the macroeconomic effects could be severe.

CS

When opportunity knocks, should you open the door or duck?

CLO relative value analysis using Great Depression-era stresses is discussed by JPMorgan's structured finance research team

After the slowest two-month period since January and February of 2004, evolving CLO structures and historically cheap loan prices are spurring new transactions to market. The return of (a few) triple-A buyers has allowed well-capitalised and well regarded CLO managers to tap the market.

Although structured product spreads broadly are still weak, tranched LCDX spreads firmed after several successful market value CLO restructurings. These restructurings lessened the need for CLO desks to hedge and stabilised CLO relative value.

What does equity yield?
Our Funding Gap measure of indicative equity returns became dated when loan prices diverged from par beginning in H207. We revise our US and European assumptions from August 2007 onwards to include:

• Lower leverage – we assume that equity takes the bottom 15% of the capital structure, rather than the typical 8%-10%. This means that either junior tranches are not structured (frequently, double-B) or taken down by the equity investor (frequently, triple-B).
• We increase base case loss estimates to 3.5% CDR (3% in Europe) and 68% blended recovery.
• Asset mix remains at 25% double-B, 70% single-B and 5% second liens in the US; and in Europe, 90% first liens loans and 10% mezzanine loans.

We illustrate two possibilities:

• First, we calculate equity returns based off discounted loan spreads as provided by S&P LCD. S&P increases the nominal spread by the average loan price discount amortised over a three-year period.
• Second, we calculate equity IRRs based off average nominal spreads and loan price discounts. We assume equity invests at a discount dollar price (which reflects the loan price) and receives a modest running spread, with a large back-ended payoff when the transaction matures in year 10. This generally results in a lower IRR than above, because the equity price discount is received in a back-ended lump sum rather than amortised gradually.

Finally, we also estimate rough 'call upside' by assuming the equity purchase price discount is received back at year three (10% probability) and year four (10% probability).

These revisions suggest a current base case IRR in the low 20s, but with upside to the mid-30s based on call prospects or gradual amortisation of the loan price discount (see Figure 1). At any particular time, call upside will be higher or lower depending upon market prices (and the manager's investment decisions).

We also note that these spot-in-time yields are based on current spreads, but do not account for the prospect that loan spreads tighten over time and excess spread gradually narrows (although equity might be likely to call the transaction in that case). As in secondary transactions, reinvestment assumptions can be as important as 1%-2% changes in CDR assumptions.

The (re)emerging primary/secondary basis
Although we hesitate to read too much from a handful of transactions (some of them warehouse liquidations or market value restructurings), a few trends are apparent in primary. New issue triple-A CLOs concede roughly 25bp-75bp to vintage transactions available in secondary; we explore some of the reasons for this growing divergence.

Table 1 shows leverage and subordination levels of selected arbitrage CLOs thus far in 2008. In several cases equity share of the transaction is significantly increased, and when not, equity investors have also participated in junior debt tranches, so that effective equity leverage is about half. On average, triple-As have a few percent more subordination, varying by collateral strategy.

Structurally, there is greater choice over maturity and call options. Some jumbo static transactions have priced and others offer 2-5 year reinvestment periods rather than the standard seven (e.g. Camulus, CELF, Galaxy 10). Such structures provide triple-A WALs from 2-5 years in a no call scenario, even under conservative loan repayment assumptions.

Regarding call optionality, new issue portfolios with discounted assets pools are better positioned to take advantage (via an equity call) of call upside than vintage transactions in secondary. For equity in new-issue transactions, limited excess spread and deep discount prices make the return more back-ended, so that a call is more attractive than in seasoned transactions (where tight funding is locked in).

For debtholders, coupons inside indicatives and moderate pricing discounts are a way of sharing loan price upside (although the larger the price discounts, the less the chance of equity finding it favourable to call). In one example, projected triple-A to double-B spreads increase by 31bp-48bp, 79bp-123bp, 120bp-188bp, 164bp-257bp and 355bp-560bp over indicatives when equity exercises a call at four and three years respectively. On the other hand, for investors preferring to lock in wider spreads, non-call periods can be extended to 4-5 years from three or two (ECP, Denali).

Turning to credit, a back-to-basics approach is evident. Asset buckets dedicated to second liens, triple-C loans, structured products (other CLOs) and covenant-lites have been slimmed down or eliminated. A good example is the Emporia Pure CLO, which packages 100% first lien and covenanted loans.

Babson and Camulos limit second liens to 10%; others limit covenant-lites to 10%, while many earlier transactions invested from 15%-25%. This approach makes the credit pool less barbelled and arguably less exposed to idiosyncratic risk. That said, these structures are more likely to make use of greater leverage, thereby offsetting the lower credit risk.

Perhaps the greatest advantage in new-issue transactions, considered broadly, is customisation and choice of manager. Block sizes are larger – US$100m-US$300m in a fell swoop – rather than incremental US$10m-US$20m pieces (or smaller) in secondary.

Also, managers active in the new issue space are likely to be higher tier – with large and self-sustaining platforms – than what might otherwise be available in secondary. Investors basically have their pick of managers and should consider which fits best strategically with their credit outlook; after that structure can be customised based on investment preferences.

Relative value – how robust is robust, exactly?
There are so many ways to illustrate the robustness of CLO tranches to high levels of losses that one is at risk of suffering an 'analysis paralysis'. And it is not clear that this matters in the short term; the dislocated structured finance market means technicals will continue to dominate the value conversation. But credit fundamentals will be the long-run driver of performance.

Deteriorating loan standards during the bull market implies that future loan performance may be more similar to high yield bond performance of the past – and that the CLO 'cushion' to collateral losses is not as large as market participants have traditionally thought. In the end, we do think that CLOs are fundamentally cheap, but recommend up-the-capital-structure tranches as a yieldy but still defensive investment in leveraged loans.

We all know loans are cheap – don't we?
Leveraged loan issuance has been aggressive over the past few years, with many issuers using proceeds to finance mergers, LBOs or equity dividends; others have refinanced to take advantage of tight spreads and to loosen covenant restrictions. Easy financing tends to obscure credit risk and high default volumes follow periods of exuberant underwriting (Figure 2). This is especially apt now as we face a recession and a credit crunch (perhaps worse from a flexibility perspective).

By late 2007, first lien leverage in US loans had crept to almost an all-time high of 4x (Figure 3); this portends high future defaults and stressed recoveries. The short-term positives are that interest coverage remains strong (even before the large plummet in Libor, Figure 4); HY earnings growth is solid (+13.6% in the fourth quarter); and 85% of issuance is from 2006 and 2007, meaning few issuers need to tap the market soon.

We do not mean to be alarmist; our point is that historical default and recovery rates may not be the best guide to future performance in an environment of over-leverage, -30% housing growth, a softening economy and immense bank losses. Severe stress cases should be considered as prudent, not outlandish. To us it appears that the (synthetic) loan market is pricing in 55% recovery rates and a Great Depression-like default scenario (Figure 5); the recovery swaps market is also implying somewhere near 50%-55% senior secured recoveries. (Note that Figure 5 plots HY bond default rates, not loan default rates which tend to be somewhat milder).

We think this is overly pessimistic, especially considered across the market and over an extended time period; there is at least some risk of economic performance to the upside. Cash loans are even cheaper than LCDX, reflecting stringent cash funding costs. The takeaway is that leveraged loans as an asset class are cheap, but not all of the loan sell-off is technical; there is probably less cushion in loans (and CLOs) than historical experience indicates.

Single-As are the 'sweet spot'
In this spirit, we attempt to quantify the most attractive spot in the CLO capital structure, looking at relative risk and reward under fairly severe stress cases. Below we present three items: a simple calculation comparing tranche yields against subordination; risk-adjusted returns based on simulated and historical default performance; and tranche break-evens under a 'Great Depression' loan scenario.

Single-As appear to be the sweet spot, with a minimal chance of loss, even in a stressed environment. After that either double-As or triple-Bs are most attractive, depending on one's credit outlook.

In all likelihood triple-Bs are money-good, but we expect more mark-to-market volatility at that level of the capital structure and do not think the extra spread is compelling in exchange for 4%-5% less subordination. For the super risk-averse, we think double-As are an obvious pick.

1. A simple value metric
Table 2 presents the all-in nominal yield of each tranche using indicative spreads and Libor at 2.5%. Based on a sampling of recent vintage CLOs, we calculate the CDRs that cause a tranche to lose principal under a 55% recovery assumption. Next, we multiply the nominal yield by the breakeven CDR.

There is no fundamental rationale for this, but it is a simple comparative metric which gives credit for both higher yield and higher subordination. Double-As and single-As look best; note that an increase in Libor would make the spread component of yield less important and make senior tranches look relatively more attractive.

2. Maximising risk-adjusted returns
However, this metric doesn't mean anything in a financial sense. We move on to calculate risk-adjusted returns, starting with the nominal yields but adjusting by assumed default probability and loss-given-default (LGD). This approach makes more fundamental sense, but requires a number of assumptions.

We look to a couple of sources for inputs. First, we revisit a CLO analysis in which we simulated bottom-up CLO performance, over a variety of scenarios. We choose the most severe scenario we used in this exercise (our 'kitchen sink' scenario), which assumed 5% annual CDR, 55% recoveries, 25% annual prepayments, 25% average portfolio overlap and 25% average asset correlation.

Average collateral loss under this scenario corresponds to roughly 1.7x the worst five-year loss experience in historical data. This gives us our simulated default probability and LGD assumptions in Table 3.

Second, using Moody's historical default data (Figure 5), we simply count the number of years, out of total observations, in which the HY bond default rate equalled or exceeded the breakeven CDR. We note several ways in which we attempt to be conservative here.

First, we use HY bond rather than loan default rates. Second, the breakeven CDRs are determined using a 55% recovery assumption, so we are implicitly accounting for poor recovery and default performance occurring simultaneously. Lastly, for triple-A to triple-B tranches, there have never been multi-year cumulative defaults high enough to breach the tranche subordination.

But we count the occurrence of high default rates whether they are consecutive or not. (In a few five-year periods, namely the Great Depression and the 1990 and 2001 recessions, average HY bond defaults were high enough to hit the double-B tranche.) For triple-A and double-A tranches, we assign a de minimis default probability, since their breakeven CDRs have never been experienced, even in a single year.

Then we calculate two risk-adjusted yield measures according to:

Return = p*Y+ (1-p)*(Y*T – LGD)/T

where p is the probability of default, Y is the yield and T is the assumed years until a PIK event. This simplifies to:

Return = Y - (1-p)*LGD/T

Intuitively, to maximise risk-adjusted yield, one wants to invest as far down the curve as is safe, given one's credit outlook. Under our severe 'kitchen sink' scenario, the single-A returns nearly as much as the triple-B and, while the triple-B outperforms the double-A, one wouldn't choose the triple-B over the double-A (given that single-A returns are nearly as good).

Under the more benign historical default assumptions, the single-As and triple-Bs look best. Double-Bs look passable, but are inferior from a risk-reward perspective, given the fairly steep cliff in performance.

3. Cushion to the 'Great Depression'
We define a default scenario based on HY default rates seen in 1930-1936. We also create a matching recovery ramp; historically, when defaults rise, recoveries deteriorate (Figure 6). Under this scenario, defaults rise to 8% by 2009 and peak at 16% in 2011; loan recoveries hit bottom at 40%.

We use Intex to solve for the multiple of the default curve which typical CLO tranches can withstand. Figure 7 shows breakeven rates (to first principal loss) for four late-2006/early-2007 transactions. Single-A and above is generally secure; triple-B and double-B are at risk.

We caveat these results by adding that, like all CDO analysis, results are sensitive to assumptions. For instance, we left reinvestment assumptions at their original level.

But allowing discount asset purchases and wider coupons cushions debt performance considerably; for instance double-B breakevens increased up to 20% for reasonable scenarios (even with loan repayment rates at a lowly 10%). Under a flat 70% recovery assumption, triple-A coverage nearly doubled from the 200% area to 400%-500%.

We think it is important to keep in mind that manager performance is likely to differ from the average. For instance, if HY defaults average 7% annually, some managers will experience higher loss rates and others lower.

Thus, even though some of our assumptions might be overly harsh on average, we view the extra cushion as a sort of insurance for manager underperformance. On the whole, this exercise reinforces our view of CLO structures as robust to fundamental stress, and our preference for single-A and double-A rated tranches.

© 2008 JPMorgan. This Research Note is an excerpt from JPMorgan's CDO Monitor, first published on 26 March 2008.

Trading ideas: name that tune

Dave Klein, senior research analyst at Credit Derivatives Research, looks at a capital structured arbitrage trade on RadioShack Corp.

Credit and equity risk are unambiguously linked, as the risk of debt holders not receiving their claims is akin to the risk of equity prices falling to zero. Both credit and equity risk are directly tradable with liquid instruments, such as CDS and equity puts. In this trade, we analyse hedging CDS directly with equity.

The trade exploits an empirical relationship between CDS and equity and an expectation that equity drops precipitously in the case of default. For certain names, the payout from buying CDS protection and buying equity behaves like a straddle.

If equity sells-off, we expect CDS to sell-off more in dollar terms. If CDS rallies, we expect equity to rally more (again in dollar terms). This is also the basis for the so-called 'wings' trade, where CDS is financed using equity dividends.

For this trade, we choose our hedging ratios based on a fair-value model that derives CDS levels from equity prices and implied volatility. Given the straddle-like payout, we are going long volatility and taking advantage of a non-linear relationship between CDS and equity.

The trade on RadioShack Corp. (RSH) takes advantage of this relationship by buying equity shares and buying CDS protection.

Delving into the data
When considering market pricing across the capital structure, we compare equity prices and equity-implied volatilities to credit market spreads. There are a number of ways to accomplish this, including the use of structural models that imply credit spreads (through an option-theoretic relationship) from equity prices and the analysis of empirical (historical) relationships between the two markets. We refer the reader to a CDR Trading Technique article – Capital Structure Arbitrage – for more detail.

The first step when screening names for potential trades is to look at where equity and credit spreads stand in comparison to their historic levels. Recently, RSH's CDS has outperformed its equity and this trade is, partially, a bet on a return to fair value. In order to judge actual richness or cheapness, we rely on a fair value model and consider the empirical relationship between CDS, implied volatility and share price.

Exhibit 1 plots five-year CDS premia versus an equity-implied fair value over time. If the current levels fall below the fair value level, then we view CDS as too rich and/or equity as too cheap. Above the trend line, the opposite relationship holds.

Exhibit 1

At current levels, RSH CDS is rich (tight) to fair value. This bolsters our view of buying protection on RSH.

Exhibit 2 charts market and fair CDS levels (y-axis) versus equity prices (x-axis). With CDS too tight when compared to equity, we expect a combination of shares rallying and CDS widening. The green square indicates our expected fair value for both CDS and equity when implied volatility is also considered.

Exhibit 2

Hedging CDS with equity
Our analysis so far has pointed to a potential misalignment between the equity markets and credit spreads of RSH. It would appear that we should buy protection (sell credit) against a long equity position.

As default approaches, we see CDS rates increase (to points upfront) and equity prices fall close to zero. In this situation, our equity position will drop in value (bad for us), but this loss should be more than offset by our gain due to the CDS sell-off. If equity rallies, we expect CDS to rally as well.

Exhibit 3 charts the P&L for the trade after two months for various CDS-equity price pairs. The green square shows the expected P&L for a return to fair value.

Exhibit 3

The longer we hold the trade, the more difficult it will be to make money, given the negative carry/negative roll-down we face. However, given the volatility RSH is currently exhibiting, we believe we can exit profitably in a reasonably short time period.

The main trade risks are that RSH volatility drops and we are unable to unwind the trade profitably or that RSH begins trading under a different regime and the current vol-equity-CDS relationship no longer holds.

Risk analysis
This position does carry a number of very specific risks.

Recovery and 'default' stock price assumption: In the default scenario the cheapest-to-deliver CDS obligation may have a higher than expected market value and the stock price might not fall as assumed.

CDS present value (PV): The CDS PV is an expected value, but not necessarily a realised outcome. In practice, the CDS may trade on an up-front and/or running basis.

Corporate actions: Spin-offs and private equity buyouts, for instance, could radically change the equity-CDS relationship, leaving investors with a mis-hedged position. It is our expectation that an LBO (however unlikely) would be a positive event for this trade, as we would expect CDS to sell-off and equity to rally.

Mark-to-market: In our view, credit and equity markets operate largely independently and this can lead to trade opportunities. At the same time, however, any relative mis-pricing may persist and even further increase, which could lead to substantial return fluctuations. Additionally, the trade faces a fairly substantial bid-offer to cross in CDS. The negative carry and rolldown hurt us the longer we hold the trade.

Negative carry: As constructed, this is a negative carry trade. We go long equity and buy protection, both of which cost us. The longer we hold the trade, the more difficult it becomes to recoup our costs.

Overall, frequent re-hedging of this position is not critical, but the investor must be aware of the risks above and balance that with the negative carry. If dynamic hedging is desired, this is best achieved by adjusting the equity position, given transaction costs.

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

RSH is a reasonably liquid name and bid-offer spreads are around 10bp. RSH is also liquid in the equities market.

Fundamentals
This trade is based on the relative value of RSH's CDS and equity and is not motivated by fundamentals. CDR's MFCI model assigns a neutral score to RSH and indicates that it is fairly priced when compared to similarly ranked peers.

Summary and trade recommendation
As we watch the credit market's continued rally with a combination of disbelief and awe, we go hunting for relative value opportunities where equity has not kept pace with credit. This trade finds RSH far too tight when compared to its share price and implied volatility.

Given how much RSH has rallied (along with the rest of the market) and how quickly, we are betting on two possible outcomes. First, if the current market rally is more technical than fundamental in nature, we'd expect to see RSH CDS sell off and underperform equity. If, on the other hand, happy days are here again, we expect to see an equity rally to catch up with CDS.

Our relative value CSA trade is designed to profit from either scenario and we recommend buying RSH CDS protection and stock.

Buy US$10m notional RadioShack Corp. 5-Year CDS at 144bp.

Buy 30,000 RadioShack Corp. shares at a price of US$16.76/share to pay -144bp 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).