Contents

Second time around

CDS tailored for current market environment

Concern about counterparty risk has focused investors' attention on previously-ignored variants of CDS contracts, such as contingent CDS and CDS with fixed coupons. At the same time, others are looking to benefit from the current environment via constant maturity CDS.

Contingent CDS contracts – whereby an investor can enter into a bespoke transaction with a third party that replaces an existing CDS if the original counterparty fails – currently appear to be in vogue, following a lacklustre introduction of the instruments last summer. Increased interest in the product is being driven by rising concern about counterparty risk and the emergence of more counterparties for such trades.

"Demand has risen for contingent contracts over the last few weeks, with certain investors buying protection on their monoline exposures. Contracts may have also been written on some of the brokers," confirms Alberto Gallo, md credit derivatives strategy at Bear Stearns.

Contingent CDS cost a fraction of the price of the original CDS and are anonymous contracts, which enables investors to be discreet about their protection buying. While growth in contingent contract volumes is not expected to be exponential, the number entered into is likely to increase going forward on a case-by-case basis.

"It is a good development because it adds to the robustness of the market. Contingent contracts give investors an extra option on top of buying CDS: they can reduce the volatility associated with the initial CDS because they involve hedging only one transaction (the solvency of the issuer related to a particular deal)," adds Gallo.

Another hitherto generally unwanted variation on the CDS contract that is also expected to see increasing interest are constant maturity structures. Dealers have been pitching them to clients, but few investors have so far entered into such trades – even though they make sense in the current environment.

As Gallo explains: "Constant maturity CDS have limited duration (typically shorter than one year) and exposure to volatility, yet monetise higher coupons in the future in a spread widening environment. They allow investors to sell protection at a lower mark-to-market exposure."

The carry in CMCDS is a percentage of current and future spot spreads, depending on the current shape of the curve. At the moment, most curves are flat – which means that such a trade will monetise around 100% of the future spot spread.

Meanwhile, the anticipated trend towards simpler structures (see separate article) has renewed the market's focus on the potential of fixed coupons for CDS contracts, in particular single names. "The introduction of fixed coupons could be an interesting development, especially for real money investors or holders of synthetic CDOs, because they simplify the exposure in terms of trading and modelling the price. But in a volatile spread environment, fixed coupons could mean that investors are forced to pay a large upfront payment to enter into the swap – which obviously decreases the liquidity of the trade. Like any new market convention, once it is adopted it is positive for some players and negative for others," notes Gallo.

Indeed, sources say that an important aspect of the CDS contract as it currently stands is its transparency and accessibility. The value of a swap at inception is zero; therefore, participants don't need an upfront payment (other than the margin) – which makes the contract easier to enter into and means that neither the buyer nor the seller of protection has an advantage at the outset. Introducing a fixed coupon in the current volatile environment could thus create anomalies in some names.

"A challenge nonetheless remains for investors who want to monetise their long or short positions because dealers are asking them to pay the full mark-to-market amount rather than unwinding the position for them. So investors are being forced to enter into an opposite contract and monetise their positions on a running basis by keeping the difference in spread. But this means that they continue to be exposed to counterparty risk," concludes Gallo.

CS

Compensation conundrum

Rating agencies in the spotlight again

The Financial Stability Forum (FSF)'s recommendations to the G7 for enhancing the resilience of markets and financial institutions have reignited the debate about rating agency compensation. At the same time, S&P released a progress report on its efforts to strengthen its ratings process, while Fitch announced that it will finalise over the next few weeks its organisational changes.

"Rating agencies have done a better job of managing conflicts of interest than, say, equity analysts, because a customer pays the same whether their deal gets a good or a bad rating. Even so, there is still the fundamental question of who should actually pay for the rating. The fact that arrangers foot the bill is a moral hazard: this might make me unpopular, but I think that investors should pay for ratings," says one structured credit consultant.

But compensation at an individual level has become problematic for the rating agencies – and by extension, the market – too. A fund manager suggests that the high turnover of ratings analysts before the credit crisis struck gave rise to the possibility of ratings being executed by unsophisticated staff.

"The rating agencies generally did a good job in terms of transmitting intellectual knowledge to their staff and I'm not sure how they could have done it better. Unfortunately, some analysts seemed to view their time at rating agencies as a training exercise before leaving to work at a financial institution. It was tough for rating agencies to compete because investment banks offered better compensation and career opportunities," he explains.

The FSF's proposals regarding the role and uses of credit ratings stipulated that agencies should adopt IOSCO's revised CRA Code of Conduct Fundamentals (see SCI issue 75); clearly differentiate – either with a different rating scale or with additional symbols – the ratings used for structured products from those for corporate bonds; and enhance their review of the quality of the data input and of the due diligence performed on underlying assets by originators, arrangers and issuers involved in structured products. Equally, investors should reconsider how they use credit ratings in their investment guidelines and mandates and for risk management and valuation, the FSF says.

Crucially, while IOSCO's revised code of conduct states that rating agencies should implement periodic employee remuneration reviews and disclose whether any one client accounts for more than 10% of their annual revenue, there appears to be no guidance as to who should actually pay for the ratings.

Meanwhile, S&P says it has already made progress on the 27-step plan to improve its ratings process (see SCI issue 75). Specifically with regard to ratings analysts, the agency has developed an enhanced training curriculum and increased its annual analyst training requirements by 25%. It is also evaluating third-party firms to establish an independent credit analyst certification programme, which is expected to begin by year-end.

Another of S&P's stated action items is to implement by mid-year 'look-back' reviews to ensure the integrity of prior ratings, whenever an analyst leaves to work for an issuer. A rotation programme has also been implemented for analysts, which limits structured finance analysts' exposure to specific arrangers, and potentially issuers, based on a number of factors.

Meanwhile, the rating agency anticipates engaging by year-end an external firm to periodically conduct an independent review of its compliance and governance processes, and issue a public opinion that addresses whether S&P is effectively managing potential conflicts of interest and maintaining the independence of its ratings. Additionally, tri-annual review meetings have begun with the Audit Committee of the McGraw-Hill Board to discuss S&P's overall governance and compliance functions, while an independent Policy Governance Group has been established to develop and approve all new ratings' policies and procedures.

Fitch has also issued a statement confirming that it is responding to various recommendations that have been made to rating agencies by the FSF, IOSCO, CESR and the US President's Working Group on Financial Markets. "In the coming weeks, Fitch expects to finalise a variety of changes to our criteria, organisation and practices, in response to these various recommendations and designed to enhance the independence, transparency and quality of Fitch's credit rating process," comments the agency's president and ceo Stephen Joynt.

CS

New underlyings

Further innovation emerges in CPPI-land

Further innovation has emerged in the credit CPPI space, as predicted in SCI issue 62. A trio of deals, two of which feature what are thought to be new underlyings, has hit the market.

Rabobank was first off the blocks, with a €160m 10-year privately-placed transaction linked to multiple asset portfolios across the credit, hedge fund and commodity sectors. As is typical for CPPI trades, the hedge fund exposure consists of a fund of funds strategy and the credit exposure of a long/short correlation strategy. The commodities strategy is exposed to a broad range of underlyings, including some soft commodity and energy product.

"The idea is to diversify across asset classes rather than focus purely on credit," explains Nicholas Gibbins, structurer at Rabobank in London. "The portfolio is initially fairly equally split across the three strategies, although there is a limited amount of discretion to adjust the allocation, and the hedge fund portfolio is lightly managed."

The transaction is a bespoke deal structured for a specific client. To make it clear how each underlying asset class interacts with the others and the situations in which the portfolio can be impacted, the documentation takes a modular approach to the three strategies and highlights their complementary features.

Rabobank is currently working on two other CPPI deals, with the first one expected to launch in a couple of months and the other towards the end of the summer, depending on market conditions. "CPPI does have the benefit of being fully principal-protected and so the structure makes sense at the moment. We're focusing less on publicly offered deals and more on targeted structures: Rabobank's smaller size actually gives some advantage in terms of responding to reverse enquiry deals and having niche client contacts," notes Gibbins.

Meanwhile, ABN AMRO is thought to be prepping a CPPI linked to emerging market credits – a first for the sector – and BNP Paribas is marketing a multi-strategy correlation CPPI dubbed Klimt. The transaction will be managed by Fortis Investment Managers and features a long/short portfolio structured to express its view in the current volatile environment.

CPPI deals that feature both short buckets and variable leverage have been better able to mitigate the convexity arising from the credit crunch. Indeed, the last nine months have proved to be a strong test of the CPPI structure, highlighting one of its shortcomings – negative gamma. As VaR has increased, some managers have been forced to de-lever their trades to ensure that principal protection remains robust (see last week's issue).

The challenge in the current environment is to make money in a bear market without giving away carry and rolldown. The credits that typically suffer the most in a recessionary environment often already trade at wide spreads and are therefore expensive to short. So a good strategy could be to focus short positions on credit direction in order to find names that will experience meaningful fundamental deterioration from a starting point of tighter spreads.

CS

Conference detailed

SCI's second annual London conference announced

Structured Credit Investor has announced initial details of SCI '08, its second annual conference. The investor and manager led event will take place on 26 June 2008 at London's One Great George Street.

SCI '08 will offer debate and analysis of the new challenges and opportunities in the global structured credit markets and examine how the industry will develop going forward. Buy-side experts speaking include representatives from Channel Capital Advisors, Intermediate Capital Group, New Bond Street Asset Management, P&G Alternative Investments, Principia Partners, Schroder Investment Management, Unicredit and Washington Square Investment Management. A full line-up will be announced in due course, but for regular updates and reservations click here.

Conference sessions cover the full range of cash and synthetic structured credit products. CDO pricing and valuation, cash versus synthetics, bespoke products, synthetic loans and manager selection are among the topics that will be discussed.

Meanwhile, SCI is also offering a two-day master class on the practical applications of cash and synthetic structured credit products. Led by Robert Reoch and Hor Chan of Reoch Credit Partners, the training course will take place on 18-19 June in New York and on 24-25 June in London.

This course examines the structure of recent innovations and how these can be applied by practitioners in trading and investment scenarios. It will also address reasons behind the recent credit market fall-out and opportunities that arise from market turmoil. For more information, please visit here.

Flight to simplicity

In this Provider Profile, we talk to Sasha Rozenberg, head of credit derivatives at software and pricing vendor SuperDerivatives

Sasha Rozenberg

 SuperDerivatives offers a multi-asset pricing product suite developed out of the company's original offering in the FX markets in 2000. During a period of high growth for dot.com businesses, company founder David Gershon delivered a business model for the time - a web-based product for corporate customers. Unlike other internet firms, however, SuperDerivatives relied on a healthy core: a proprietary derivatives pricing model, which uniquely addressed market needs by providing transparent prices of exotic instruments to all customers.

The company now supplies pricing models for interest rates, equities, commodities, FX and credit derivatives; in fact, all mainstream tradable asset classes. The reasons for this, says the company's head of credit derivatives Sasha Rozenberg, is to provide institutional buy- and sell-side and corporate customers with a multi-asset pricing platform suited to model complex deals, coupled with a relative simplicity of use that means virtually any practitioner can access the product with confidence.

Rozenberg explains the appeal of the product: "We serve a diverse range of clients wanting a turn-key solution to their derivative pricing needs; we offer services to banks, hedge funds, asset managers, prime brokerages, and large corporations such as airlines and transport firms, to name a few. As the credit crunch has taken effect, people have been able to use our services confidently to mark to market, given that there has been both a 'flight to simplicity' and a 'flight to transparency' in terms of products invested in."

This is good news for a company such as SuperDerivatives, whose independent pricing models are, the firm claims, in demand during this period of market uncertainty. The middle office departments of prime brokers and hedge funds increasingly need independent marks to revalue their books, says the company. The trading community also has a need for independently obtained prices for more complex structures relying on complicated models.

A revaluation service is currently one of the core of market services supplied and so has to be based on accurate market prices. "With so many desks revaluing their books, they look to us to supply audit prices derived from multiple sources of data from multiple participants. We aim to provide accuracy, product coverage, convenience and quality in this respect," comments Rozenberg.

SuperDerivatives' prices are derived from a variety of market participants and are based on observed, tradable prices; consensus-based prices are not offered. "The problem with consensus data, in our view, is that it does not necessarily represent recent trading activity. While consensus data may appear more complete, a lot of marks in this data are, in fact, spurious," says Rozenberg.

Declining confidence has resulted in thin trading volumes in structured credit. "There may be a lot of value out there in some peoples' minds, but the markets are still myopic, given the shortage of liquidity and confidence. Very few have the nerve to buy cheap in such a market and sit and wait. Others still do not have the necessary extra collateral required today," he adds.

Pension funds and other mainstream asset managers have shied away from the complex assets they were once holding because of their attractive yields. Rozenberg explains that the negative headlines of recent times have contributed to damaging confidence in the more complex credit securities, something the US Federal Reserve could possibly have helped avert.

"It might have helped to calm an already confused market if the Fed had released highly influential market news on a more regular basis instead of making dramatic one-off announcements – such as the unexpectedly large reductions in interest rates," claims Rozenberg.

"It would appear that it has instead been the more recent news from the Tier One banks that the greatest write-downs are behind us which has led to a recent tightening of credit spreads. Markets may look sophisticated, but in fact they are driven by a far less complicated factor – sentiment," he continues.

And so what of the more complex structured credit products of recent years that have borne the brunt of the losses stemming from the sub-prime mortgage collapse? Rozenberg has clear thoughts on the direction of the market from this point: "Complex debt securities were in demand as a way of generating yield. If investors can get the desired yield from more vanilla CDOs and directly from the CDS markets, then there will be less demand for riskier structures where recent losses have been so bad."

He believes that plain vanilla and synthetic structured credit products will be the norm for the foreseeable future. "Exotic products were in demand before the sub-prime problems took hold because they offered attractive spread in generally low-yield environment. Propelled by the healthy economy, raising stock markets and real estate, investors took a greater risk, often on both transparency and liquidity, to achieve greater return. The requirement for exotic product has now disappeared in an environment of wider spreads for simple products," says Rozenberg.

Given that investors can now achieve desired returns via CDS, he believes that this will actually give the credit derivatives market a long-term spur as investors become more sophisticated users of basic synthetic products and traders increase their knowledge by 'playing with curves'. There will, however, be a supply of relatively exotic products after the market stabilises; Rozenberg sees a renewed interest in exotic products, albeit based on simple underlying instruments.

And of the CDO backed by ABS? "Originally these were products with basically good proportioning of risks, but they were perhaps overused. There is also a lot of debate over the role that rating agencies played, and of the assumptions behind their models. There are calls from the industry to address the way rating agencies are compensated and maybe this could also help the market regain confidence," concludes Rozenberg.

JW

Credit Suisse re-shuffles European credit

The latest company and people moves

Credit Suisse re-shuffles European credit
Credit Suisse has made a series of appointments within its European credit business, which follows on from the bank's merging of leveraged finance and investment grade globally.

Credit Suisse's European high yield and investment grade public sales and trading teams are being combined. Derrick Herndon will lead the flow trading teams and will be responsible for best execution for clients and leveraging the bank's derivatives expertise across the franchise.

Asif Mohamedali will be responsible for integrating the high yield cash and CDS business. Zahra Peerbhoy will continue as head of short-term products and Stuart Firth will head backbook trading across the credit spectrum. All three will report to Herndon.

Jonathan Moore will continue to head the firm's expanded structured credit business, while Nick Kyprios will head European credit sales across the European credit product range. Credit repo will continue to be headed by Mike Bekefi.

The previously separate private-side capital markets businesses covering loans and high yield will be combined in leveraged finance capital markets under the joint leadership of Mathew Cestar and Thibaut Parayre.

Michael Guy and Dermot Murphy will continue to co-head the special situations group, which Credit Suisse believes is well positioned to capitalise on the increased investment opportunities expected in the near future. Guy will also retain his role as head of private credit sales.

Ted Lowe will continue in his role as head of par loan trading, incorporating both cash loans and private side CDS. Finally, David Morley, previously coo for European leveraged finance, will be coo of the European credit business unit

Two exit BarCap
Andrew Whittle, head of European credit trading, and Heikki Monkkonen, head of European credit structuring, are both understood to have left Barclays Capital. The resignations are believed to be unrelated and for personal reasons.

Domenico Azzollini, Conor Brown and John Mahon will share their former responsibilities.

Salary survey results released
Credit executive search firm Credent Partners has released the results of its third annual compensation survey. Credent says that, judging by the comments it received from respondents, it was a mixed year.

Those comments included: "Bonuses were slashed to a third of last year's level" from an investment banker; "Tough year for structured credit. No bonuses were paid firm-wide" from a hedge fund; and, perhaps more surprisingly, "2007 was a very good year", according to one prop desk.

However, the survey's average compensation figures show a far from mixed result. Year-on-year changes at the md level were as follows: structured credit trading -58%; structuring -29%; credit research -38%; sales & marketing -31%; prop trading -27%; and portfolio management -70%.

The survey utilised a web-based questionnaire sent to over 2,500 market professionals and achieved a response rate of 10%.

Calyon promotes Lainé
Calyon has promoted Frédéric Lainé to the position of head of fixed income markets for Asia ex-Japan. In his new role, Lainé will lead the overall business development and strategy of the bank's fixed income markets activities, which comprise six product lines: interest rate derivatives, FX, commodities, debt & credit markets, structured credit markets and treasury.

Lainé has held various senior positions during his long career at Calyon, which began when he joined Credit Lyonnais in 1991. Most recently he was head of fixed income, currencies & commodities for Asia ex-Japan.

ISDA elects new chairman
ISDA has announced that its board will elect Eraj Shirvani, md and head of European credit and European and Asia Pacific credit sales and trading at Credit Suisse, as chairman with effect from 17 April.

Shirvjani succeeds Jonathan Moulds, president, EMEA and Asia, Bank of America, who has chaired the ISDA Board since November 2004 and has been a Board member since 1998. Shirvani has been a member of the ISDA Board since 2004.

FGIC explores alternatives
FGIC has announced that it has begun discussions with potential investors and other parties regarding strategic alternatives that would enable FGIC to both enhance its capital position and protect its policyholders. The company is optimistic that within the coming weeks it will have a course of action to propose to its board of directors.

FGIC said that the strategic alternatives it is exploring include raising capital for a newly established triple-A guarantor dedicated exclusively to the global public finance business. This company would also assume FGIC's existing public finance and international infrastructure business. Other alternatives include, but are not limited to, the sale of all or part of the company and a bulk reinsurance transaction on all or parts of FGIC's in-force business to a third party.

FGIC said it believes that its strategic alternatives are consistent with the goals of the New York Insurance Department (NYID) with regard to the company and its policyholders. The company said it continues to work closely with the NYID as it progresses with its negotiations.

SIV-lite receivers appointed
Neville Kahn, Mark Adams and Nick Dargan of Deloitte have been appointed joint receivers of the Avendis-managed and BarCap-arranged SIV-lite Golden Key. The appointment was made by Bank of New York, the security trustee, acting under the directions of the majority secured parties of the company.

Kahn comments: "This vehicle suffered an acceleration event back in August 2007 and has been the subject of detailed restructuring negotiations amongst its creditors since that time. The appointment of receivers is intended to provide a platform to resolve certain outstanding issues and to implement a restructuring."

The receivers said they will update investors during the course of this week.

Paladyne and NumeriX partner up
NumeriX and Paladyne Systems have announced a strategic partnership that combines the NumeriX trading, pricing and analytical toolset with Paladyne's hosted front-to-back office hedge fund platform. Paladyne customers may now leverage NumeriX to analyse and price complex product types both on a pre- and post-trade basis.

"The ability to properly analyse and value complex derivatives and structured products is a significant challenge facing today's hedge fund managers," says Sameer Shalaby, ceo of Paladyne Systems. "By integrating NumeriX into our suite of products, managers now have the tools and infrastructure to not only gain competitive trading advantages, but to satisfy the operational demands of regulators and institutional investors as well."

MP

PPP CLO launched

A round up of this week's structured credit news

PPP CLO launched
NIBC Bank has closed a €1.1bn transaction dubbed Adriana Infrastructure CLO 2008-1. The deal is backed by PPP loan and infrastructure bond obligations.

Rated by Moody's, the transaction comprises €962.8m Class A1 and £100,000 Class A2 notes, both rated A3 and due in October 2044. There is also a £54.9m unrated Class B piece.

The CLO will be managed by NIBC and pools UK and non-UK infrastructure debt obligations. The sectors with the highest principal outstanding in the initial portfolio are schools (43%) and hospitals (12%).

Approximately 70% of the portfolio had been acquired by the closing date, and the remaining portion will be acquired during the 365-day ramp-up period. The issuer can buy or sell infrastructure debt securities, subject to a number of portfolio criteria, including a WARF test and a Moody's Asset Correlation test.

The underlying assets are mainly drawn from the UK, but they can be originated in other EU countries/candidates or OECD countries, each with a minimum foreign currency rating of Aa3 and with a requirement that at minimum 50% in the aggregate outstanding be comprised of UK infrastructure PPP loan obligations. The collateral will be predominantly denominated in sterling, but may also consist of assets denominated in euros and US dollars. The FX risk related to all the non-sterling assets will be hedged via perfect asset swaps with eligible counterparties.

CDS notional outstanding hits US$62.2trn
ISDA has announced the results of its Year-end 2007 Market Survey of privately negotiated derivatives.

The notional amount outstanding of CDS grew by 37% to US$62.2trn in the second half of 2007, from US$45.5trn at mid-year. CDS notional growth for the whole of 2007 was 81% from US$34.5trn at year-end 2006. The survey monitors credit default swaps on single names and obligations, baskets and portfolios of credits and index trades.

"As ISDA's Year-end 2007 Market Survey highlights, the privately negotiated derivatives business continues to grow. While the amounts at risk are just a fraction of notional amounts, these give us a good sense of market activity," says Robert Pickel, executive director and ceo, ISDA. "Developing tools to manage counterparty credit is an important feature of ISDA's work. Equally important are our efforts to reinforce the operational infrastructure to enable scalable growth and improve liquidity for the continued development of these important risk management tools."

The total notional amount outstanding across credit, interest rate and equity derivatives – US$454.5trn – is an approximate measure of derivatives activity, and reflects both new transactions and those from previous periods. The amount is a measure of activity, not a measure of risk. The Bank for International Settlements (BIS) collects both notional amounts and market values in its derivatives statistics, and it is possible to use the BIS statistics to determine the amount at risk in the ISDA survey results.

As of June 2007, gross mark-to-market value was approximately 2.2% of notional amount outstanding. In addition, net credit exposure (after netting but before collateral) is 0.5% of notional amount outstanding. Applying these percentages to the total ISDA Market Survey notional amount outstanding of US$454.5trn as at 31 December 31, gross credit exposure before netting is estimated to be US$9.8trn and credit exposure after netting is estimated to be US$2.3trn.

All notional amounts have been adjusted for double counting of inter-dealer transactions. In this survey, 91 firms provided data on interest rate swaps; 81 provided responses on credit derivatives; and 83 provided responses on equity derivatives.

Leveraged loan sales
Deutsche Bank is apparently trying to sell US$5bn of its own leveraged loan exposure, after Citi announced that it would sell US$12bn of leveraged loans and bonds at what is thought to be less than 90 cents to private equity firms. Both firms are reportedly lending prospective buyers about 45% of the purchase price of the loans. This leverage is needed to generate returns that are sufficiently equity-like to make them palatable to private equity firms, analysts at BNP Paribas suggest.

In theory, the sales could shield the banks from the 25% initial losses on the leveraged loans. However, this is highly dependent on how the transactions are structured. As the structure of the sale will affect the residual risk exposure at the level of the bank, it is difficult to gauge the extent – if any – of capital relief for the banks as a result.

If the structure takes the form of an SPV, with the banks effectively retaining the senior tranche (with a 25% attachment point), this could be viewed as equivalent to a triple-A exposure, the analysts explain. It would significantly reduce capital requirements under Basel 2, potentially from as high as 15-20% for leveraged loans to probably less than 1%.

Meanwhile, Lehman Brothers is believed to be undertaking a similar balance sheet exercise by packaging unsold leveraged loans into a new jumbo CLO dubbed Freedom CCS 2008-1.

Basel 2 framework enhanced
The Basel Committee has announced a series of steps to help make the banking system more resilient to financial shocks. These include enhancing various aspects of the Basel II framework, including the capital treatment of complex structured credit products, liquidity facilities to support ABCP conduits, and credit exposures held in the trading book. At the same time, the Committee notes the importance of prompt implementation of the Basel II framework, as this will help address a number of the shortcomings identified by the financial market crisis.

The following measures will be introduced in a manner that promotes long-term bank resiliency and strong supervision, while seeking to avoid potentially adverse near-term impacts as the re-pricing of risk and deleveraging process continues in financial markets:

• Strengthening global sound practice standards for liquidity risk management and supervision, which the Committee will issue for public consultation in the coming months.
• Initiating efforts to strengthen banks' risk management practices and supervision related to stress testing, off-balance sheet management and valuation practices, among others.
• Enhancing market discipline through better disclosure and valuation practices.

The Committee's actions also are in support of the Financial Stability Forum's Working Group on Market and Institutional Resilience (see below). "A resilient banking system is central to sound financial markets and growth," states Nout Wellink, chairman of the Basel Committee on Banking Supervision and president of the Netherlands Bank. "Supervisors cannot predict the next crisis, but they can carry forward the lessons from recent events to promote a more resilient banking system that can weather shocks, whatever the source. The key building blocks to core bank resiliency are strong capital cushions, robust liquidity buffers, strong risk management and supervision, and better market discipline through transparency."

FSF reports
The Financial Stability Forum (FSF) has presented to the G7 Finance Ministers and Central Bank Governors a report, which makes recommendations for enhancing the resilience of markets and financial institutions.

The recommended actions are in five areas:

• Strengthened prudential oversight of capital, liquidity and risk management
• Enhancing transparency and valuation
• Changes in the role and uses of credit ratings (see separate news story)
• Strengthening the authorities' responsiveness to risks
• Robust arrangements for dealing with stress in the financial system.

Both public and private sector initiatives are underway in these areas. The FSF will facilitate coordination of these initiatives and oversee their timely implementation, thus preserving the advantages of integrated global financial markets and a level playing field across countries.

To restore confidence in the soundness of markets and institutions, it is essential that steps are taken now to enhance the resilience of the global system, the FSF says. At the same time, it recognises the strains under which the financial system is currently operating and will pursue implementation in a way that avoids exacerbating stress in the short term.

The FSF will report on progress in June, followed by a fuller follow-up report in September. The FSF will continue to closely monitor implementation thereafter.

Markets reacted rather disappointedly to the outcome of the G7 statement, according to analysts at Unicredit, as "proposals were too cosmetic to have a substantive impact". "Although some officials underlined that many market participants already expect the worst and that the associated costs might be smaller than broadly anticipated, this is in sharp contrast to what the IMF said in its recent stability report [see last week's issue]," they note.

Berkshire Hathaway Assurance rated
S&P has assigned triple-A financial strength and financial enhancement ratings to Berkshire Hathaway Assurance Corp (BHAC). At the same time, the agency assigned tripe-A financial enhancement rating to Columbia Insurance Co. The outlook on both these entities is stable.

The ratings on BHAC are based on a guaranty from Columbia in favour of BHAC that extends the Columbia triple-A rating to BHAC. The rating is also based on an FER representation letter from Columbia that requires timely payment of BHAC's financial guaranty obligations. Columbia owns 51% of BHAC and National Indemnity Co (NICO) owns 49%. Both Columbia and NICO are wholly owned indirect insurance operating subsidiaries of Berkshire Hathaway (BRK).

BHAC has a surplus of nearly US$1bn as of the first quarter of 2008 and is licensed as a financial guaranty insurer in 48 states and the District of Columbia. BRK has an extremely strong competitive position, insurance and reinsurance capitalisation, and financial flexibility, says S&P. In addition, the company had shareholders' equity of about US$121bn at year-end 2007.

Offsetting these positives are concerns about BRK's exposure to large loss events, investment concentrations and exposure to adverse reserve development due to the assumption of retroactive risks.

European ABS CDOs downgraded
S&P has lowered its ratings on 14 tranches issued by a number of European ABS CDO transactions. Of these tranches, six issued by Bantry Bay CDO I remain on credit watch with negative implications. At the same time, one tranche issued by G Square Finance 2006-1 was removed from credit watch negative and affirmed.

The rating actions reflect the negative rating migration that has occurred in the underlying portfolios of the affected transactions, primarily from US RMBS and CDOs. Additionally, the actions incorporate the revised assumptions that S&P uses to assess US RMBS held within CDO portfolios. Both of these factors have resulted in an increase in the scenario default rates for the CDOs, so that they are not supported by current cashflows and credit enhancement.

SROC figures in for Europe and Asia
After running its month-end SROC figures, S&P has taken credit watch actions on 105 European and 22 Asian synthetic CDO tranches.

For the European deals, ratings on: 89 tranches were placed on credit watch with negative implications; two tranches were placed on credit watch with positive implications; and 14 tranches were removed from credit watch with negative implications and affirmed.

Of the 89 European tranches placed on credit watch negative: 38 reference US RMBS and ABS CDOs, which have experienced recent negative rating actions; and 51 have experienced corporate downgrades in their portfolios.

With respect to the Asian CDOs, S&P has placed its ratings on two CDOs on credit watch with positive implications. Additionally, the ratings on 15 other CDOs have been placed on credit watch with negative implications and the rating on one CDO on credit watch with developing implications. Ratings on five CDOs have also been affirmed and taken off credit watch negative.

The SROC levels for the ratings placed on credit watch positive rose above 100% at a higher rating level during the end-of-month SROC analysis for March 2008, indicating positive rating migration within the reference portfolio. For those transactions that have been placed on credit watch with negative implications, the SROC decreased below 100% at the current rating level.

Equity default obligations hit
Moody's has placed under review for possible downgrade 37 classes of notes issued by seven CDOs backed by equity default swaps, following recent volatility in the equity markets. The transactions affected are CEDO Series 1 to 5 and Edelweiss Capital Series 07-1 and 07-2.

This review for downgrade is the result of a downward trend across allequity markets combined with a highly volatile environment since the beginning of the year, Moody's says. The S&P 500 fell by more than 9% and in dollar terms, the MSCI EAFE (Europe, Australasia and Far East) index of non-US developed markets fell by more than 8%.

Caliber restructures, while QWIL launches buyback
Caliber has entered into a further restructuring agreement for its subsidiary Crown Woods Funding. It has been agreed with the funding bank that all portfolio limits and tests – including rating and credit enhancement – will no longer apply and that all principal, excess spread and proceeds from sales of assets will be used first to repay interest and principal on the borrowings from the bank.

Accordingly, cash payments will only be made to Caliber once the borrowings have been repaid in full. Additionally, the sale of assets from the portfolio requires consent from the bank, and the bank has the right to direct Crown Woods to sell assets. It is the intention to repay borrowings in full by 1 September.

The investment manager and the Board of Directors continue to consider the options available to the company with respect to the returning of capital to shareholders in accordance with its investment objective. If market conditions do not improve materially over the second half of 2008, Caliber may conclude that the best option will be to extend the timing of the return of capital, in which case it will seek shareholder approval. At current market levels any distribution of capital may be delayed beyond March 2009, when a contingent liability expires.

Meanwhile, Queen's Walk Investment Ltd (QWIL) has entered into an irrevocable, non-discretionary arrangement with Citi and JPMorgan Cazenove to repurchase on its behalf ordinary shares in the company for cancellation during the close period commencing on 17 April and ending on 17 June 2008. The maximum price to be paid shall be not more than 105% of the average of the middle market quotations for the company's shares for the five business days before the day on which purchase is made.

JPM Caz and Citi will have the authority to consider, on each trading day, repurchasing more than 50% of the average daily trading volume of the company's shares traded over the 20 trading days preceding that date. The sole purpose of the share buyback is to reduce the capital of the company.

JPM Caz and Citi, as independent third parties, will make their trading decisions in relation to the company's ordinary shares independently of, and uninfluenced by, QWIL.

CS

The sub-prime collapse, credit crunch and recovery timeline

A timeline of events that have occurred and actions that have been taken to help borrowers and restore liquidity in the markets is reviewed by Glenn Schultz, John McElravey and Erin Walsh, senior analysts at Wachovia Capital Markets, LLC

Starting in late 2006 with mortgage originators' shutting down operations, the past year and a half has been tumultuous for the credit markets. Delinquencies on sub-prime mortgage loans began escalating, with some borrowers not even making a first payment on loans. The pace of downgrades on residential ABS and CDOs has quickened, adding stress to the many arbitrage vehicles established over the past few years.

The US Federal Reserve, government agencies and the private sector stepped in – starting in the second quarter of 2007 – with several plans to mitigate the severity of the fallout. In addition, rate cuts and capital injections have been introduced to try to reduce the impact of the credit crunch that resulted from fear as investors in sub-prime home equity ABS revealed details about their holdings.

Liquidations and mark-to-market write-downs have been severe and significant – so much so that we think we are currently in a state of a speculative downside bubble. The domino effect that occurred in the fall of 2007 – sub-prime losses, unwinding of SIVs, monoline insurers in trouble, auction rate securities' failing, municipalities and student loans' being affected – seems to have slowed somewhat.

Current sentiment in the market seems to be stabilising. The Fed implied last week that, after several significant and swift rate cuts, the pace of cuts would slow. Plans to help out borrowers, that are currently under way, need time to reveal how successful they will be in improving the condition of the housing market.

The crisis of sub-prime mortgages of 2006 has wounded the capital markets. We think the time has come to sort through the debris of this sub-prime wildfire that spread to other credit markets. Restructuring and consolidation of businesses are under way for Wall Street firms and are likely to take most of this year before normalcy returns.

We review a timeline of events that occurred and actions that have been taken to help out borrowers and restore liquidity in the markets.

Sub-prime fallout timeline

© 2008 Wachovia Capital Markets, LLC. All rights reserved. This Research Note was first published by Wachovia Capital Markets, LLC on 11 April 2008.

Trading ideas: inn to the wild

Dave Klein, senior research analyst at Credit Derivatives Research, looks at a capital structured arbitrage trade on Marriott International Inc.

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 Marriott International Inc. (MAR) 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, MAR'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, MAR CDS is rich (tight) to fair value. This bolsters our view of buying protection on MAR.

Exhibit 2 charts market and fair CDS levels (y-axis) versus equity prices (x-axis). With CDS too tight when compared to equity (with volatility set to our expected fair value), we expect a combination of shares rallying and CDS widening.

Exhibit 2

The green square indicates our expected fair value for both CDS and equity when implied volatility is also considered. Note that these levels fall below the green line as we expect a combination of spread widening, equity rally and implied vol movement to bring MAR back to fair value.

Hedging CDS with equity
Our analysis so far has pointed to a potential misalignment between the equity markets and credit spreads of MAR. 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, we believe we can exit profitably in a reasonably short time period.

The main trade risks are that MAR volatility drops and we are unable to unwind the trade profitably or that MAR 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. A company bail-out (à la Bear Stearns) would have a massively negative impact on the trade, as credit would rally and equity value would be destroyed.

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.

Earnings surprise: MAR is due to announce earnings later this week. A positive surprise could send equity higher and credit lower. A negative surprise could send equity lower and credit higher. If the two markets do not react according to their past history, the economics of the trade could break down (or up).

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 MAR and the bid-offer spread costs.

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

Fundamentals
This trade is based on the relative value of MAR's CDS and equity and is not motivated by fundamentals.

CDR's MFCI model assigns a negative score to MAR and indicates the company is trading too tight when compared to similarly ranked peers. MAR has low to middle ranks for most MFCI factors, except for its high accruals rank. The MFCI-expected fair value for MAR is 253, in line with our CSA-implied fair value of 232bp.

Summary and trade recommendation
With MAR due to announce earnings later this week, we find its CDS trading too tight and its equity too low. MAR's share price has wilted and is trading well below its highs from earlier in April. This equity underperformance has led to a substantial disconnect with the company's CDS levels.

It can be a dangerous business to try and anticipate earnings, especially given the interesting economic times we currently face, but this CSA trade is aimed to take advantage of a relative-value disconnect rather than putting on an outright fundamental bet. We believe that MAR equity and CDS should converge with a combination of CDS sell-off and equity rally and are heartened to see MAR's MFCI score point in that direction as well. We recommend buying five-year MAR CDS protection and hedging by buying equity.

Buy US$10m notional Marriott International Inc. 5-Year CDS at 188bp.

Buy 110,000 Marriott International Inc. shares at a price of US$33.13/share to pay 188bp 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).