Contents

EOD litigation rises

Advisor and investor responsibility questioned

Around 150 CDOs are now believed to have breached their event of default (EOD) triggers. As liquidation of these deals gathers pace some subordinated investors are turning to litigation, but there is also a case for greater investor responsibility.

Lawyers report that a handful of junior investors affected by CDO liquidations have filed lawsuits in relation to EOD clauses. The details of the suits haven't been disclosed, but it is thought that a case would be made on the basis of an investor claiming that their advisor misrepresented the terms of the transaction. The assumption held by most investors – whether junior or senior – was that EOD triggers were extremely unlikely to be breached and that current market conditions were completely unexpected.

"With portfolio values falling so dramatically, it's not surprising that an increasing number of investors are looking at their litigation options. But these cases will be difficult to prove – although it obviously depends on the individual deal and the representations made," comments one lawyer.

While glancing through an offering circular for a random CDO, he says that EOD triggers were mentioned in three places – the summary, the risk factors and the terms and conditions. "It begs the question of what investors look for in CDO documentation and whether risks are being highlighted in the best manner. Is it realistic to expect investors to wade through a 250-page OC? Perhaps documentation will have to be made clearer in the future," the lawyer adds.

"It could be said that investors have been too relaxed about analysing CDO documentation," concurs one portfolio manager. But, he adds: "It could also be said that litigation is a pretty cynical attempt to try and recoup losses, given that the whole concept of a CDO is the tranching of risk – a subordinated note serves as the protection for the senior notes."

Nevertheless, he says: "I accept that EODs are complicated and it perhaps isn't always clear whether the portfolio will run-off or be liquidated when the triggers are hit. Equally, it's not easy to understand the potential economic impact of EOD triggers – especially when you believe that triple-A rated notes won't default."

EODs are typically triggered when a fall in value of the underlying portfolio causes the deal to breach its overcollateralisation test. In such a scenario, the holders of the senior notes can choose to liquidate the portfolio or let it run-off. Usually, in order to try to preserve what little value is left, the deal is liquidated – thereby wiping out the junior tranches.

The issue of selling unsuitable investments to investors such as municipal councils can't be ignored either, according to the portfolio manager. But, he says, while advisors and the rating agencies have to take some of the blame for the losses, investors should also take some responsibility for their investment choices.

"They are supposed to earn their fees – based on recognising relative value and understanding complicated structures – after all. What may happen as a result of all this is that mandates could be outsourced more frequently – although, again, investors should scrutinise the fee structure and track record of the manager," he concludes.

CS

Looking up?

Systemic risk diminishes, but spill-over effect is possible

Dealers report that the European index markets have begun to show signs of settling down over the past week – levels in the indices and their tranches have regularly closed down on recent highs, albeit amid continuing intra-day volatility. This early indication of a move toward stability is a result of diminishing concerns about systemic risk, but the market is nowhere near being out of the woods yet.

"There has been a clear message from the authorities – most recently from the Bank of England – and the market recognises that it's dangerous to trade against this," says Gennaro Pucci, head of trading at Credaris. "The actions of European regulators and central banks are similar to those of the US Federal Reserve, and so it's clear that the crisis has arrived on this side of the Atlantic. But the market isn't pricing in the risk of the crisis spreading from financials into the rest of the economy – potential write-downs related to the consumer credit sector should be thought of as a potential concern."

Poor funding conditions also remain a significant issue for market participants. The news of a £5.9bn write-down and possible £12bn capital raising plan from RBS – the first significant disclosure of losses from a UK bank – seemingly confirms this.

Yet the market was aware that RBS might have had exposure to some problematic structured finance activity, a risk increased with the acquisition of ABN AMRO. "The surprise is that the bank managed to handle it for so long before it disclosed. Europe seems to be lagging the US in terms of dealing with the crisis – at least in terms of what the market is looking at right now," notes Pucci.

Consequently, while new signs of risk taking in some areas of the structured business are emerging – such as in the CLO sector (see separate article) – synthetic CDOs are lagging behind. Primarily this is due to continuing concern about a potential structured credit unwind.

"Banks are still trying to resolve their exposures in the conduit space in terms of restructuring these vehicles or taking the assets back onto their balance sheets," explains Pucci. "It is clear that attempts to hide losses no longer work in this environment and so there is lingering investor caution around potential unwinds – although it appears that banks are waiting for conditions to improve before attempting to cover their losses."

There is nonetheless significant value to be captured in this market. Gamma trades are an example of how the crisis can be exploited in a tightening environment in a similar manner to that experienced when it widened – although this activity is mainly being undertaken by trading desks, since there is still no bid from synthetic CDOs.

Sources warn that it's too soon to believe that the worst of the crisis is over, however. Financials could still suffer due to increasing pressure in the consumer sector, for example.

"The market has a way to go before the crisis is resolved," agrees Pucci. "The risk is that we're approaching the summer and many investors could find themselves long the market just because they know someone is going to save them; they should be taking risk on fundamentals instead."

CS

Clearing house mooted

Facility to ease CDS counterparty risk concerns

Dealers have begun discussing plans to create a credit derivatives clearing house. The move will help allay rising concern over counterparty risk – though some unease remains about the potential for such a facility to inhibit innovation.

"Dealers feel that the credit derivatives market is now large enough that it's worth trying to establish a SwapClear type of system for clearing CDS contracts. The idea would be to give up the trade to a central counterparty, building on the DTCC Warehouse infrastructure in terms of trade confirmations, and posting collateral as necessary," explains a source close to the situation.

Richard Metcalfe, global head of policy and senior regulatory adviser at ISDA, confirms that interest has increased in the industry to explore central clearing for credit derivatives. "What central clearing shares with the OTC market is the insight that, when netted out, mark-to-market values are a fraction of gross values; moreover, those residual amounts can then be collateralised. The important thing is that these systemically important techniques of netting and collateralisation are recognised," he says.

A further motivation for dealers is that central clearing attracts a zero risk-weighting under Basel. The intention is to limit participation in the facility to a small number of appropriately capitalised financial institutions, with hedge funds excluded, for example.

A derivatives operations manager at one fund says that moving CDS onto a central clearing platform is a natural progression and one that is logical for the market as a whole. "It is perhaps something that should have happened a few years ago. Now, with volumes being so large, the transition to such a mechanism will be that much more difficult," he observes.

He adds: "Initial collateral and regular margining will help mitigate counterparty failure and no doubt protect others against systematic risk – it would provide a safety blanket that doesn't currently exist and reduce the mutual suspicions out there with regard to counterparty exposures."

But the source suggests that some unease remains among a few dealers about centralised clearing for OTC product, given residual fears about potential over-regulation by the CFTC. There is also some concern that central clearing reduces the ability to innovate – albeit the new facility will be limited to index contracts initially, with the possibility of adding single names at a later stage.

Developing the risk management side of the clearing house could prove to be difficult, due to the potential for a credit risk feedback effect (whereby no-one knows who's lending to whom) to occur. "There will undoubtedly be some careful analysis about how much cushion there is in the interest margin for this effect. It is necessary to ensure that the collective membership isn't overexposed to one counterparty," the source notes.

Dealers will have to partially fund the clearing house via collateral and margin. Given that total open CDS contracts are estimated at around US$500trn, the operations manager suggests that the facility could therefore be phased in for new contracts – though this won't help ease short-term counterparty risk issues.

"Another interesting potential implication is that there could be an initial liquidation of CDS contracts. But in the long term perhaps it is a necessary step for the integrity and stability of the market as a whole?" he asks.

CS

Tolk joins 3 Degrees

The latest company and people moves

Tolk joins 3 Degrees
Jeffrey Tolk has joined 3 Degrees Asset Management as a principal. He will focus on distressed debt and special situations.

Tolk was previously the Asian head of structured credit at HSBC, where he established the business and was widely recognised as one of the region's top structured credit bankers. Headquartered in Singapore, 3 Degrees is a private investment firm with more than US$400m of assets under management.

GFI warns off competitor
GFI Group has released a statement confirming the resignation of Donald Fewer, formerly its head of North American credit product brokerage. The firm says it believes that Fewer's departure is part of a concerted effort by one of its competitors to raid GFI's North American credit product brokerage business by hiring members of GFI's New York credit brokerage staff.

The statement continues: "GFI believes that approximately two dozen of its North American credit brokers may be in the process of defecting to its competitor, notwithstanding contractually binding obligations on Mr. Fewer and others against unlawful competition and soliciting employees...GFI intends to respond aggressively to this situation, while continuing to provide effective service to clients in North America for credit products. GFI will defend its contractual and legal rights against unfair competition to the full extent of the law."

Market sources suggest that the competitor in question is Tradition Financial Services (TFS). TFS declined to comment.

Standard Chartered hires three from Lehman
Standard Chartered Bank has announced three senior appointments in its financial markets division. The aim is to add critical mass to efforts to build its fixed income and structured products trading capability, the bank says.

Remy Klammers was appointed as global head of fixed income trading. This is a newly created position with responsibility for FX, rates, credit and structured products trading. Klammers comes to Standard Chartered from Lehman Brothers, where he was head of structured products Asia, based in Tokyo.

Alexis Suzat has been appointed global head of structured products trading. Again, this is a new unit that will pull together all of Standard Chartered's structured equity, commodities, FX, interest rate and credit products. Suzat was previously md responsible for structured products trading in Asia at Lehman.

Marten Agren joins as global head of modelling and analytics group, financial markets. Agren also joins from Lehman, where he was md, structured products trading Asia and was responsible for the implementation of a quant modelling, trading and risk management platform. Standard Chartered is also making five other appointments in the modelling and analytics group to further build out this capability.

Babson buys into distressed debt
Babson Capital Management has acquired Murray Capital Management (MCM)'s distressed debt management business as the firm selectively expands its platform of client investment offerings. Terms were not disclosed.

New York-based MCM specialises in distressed debt, transitional and stressed high yield, special situation equities and private-claims investing. The firm was founded in 1995 by Marti Murray, its current president, portfolio manager and senior research analyst. MCM serves as one of the five underlying managers of the Dow Jones Hedge Fund Strategy Benchmarks for Distressed Securities.

Murray and her investment team will join Babson Capital and follow the same investment process and philosophy. The team will no longer use the Murray Capital Management name. Murray will report to Cliff Noreen, head of Babson Capital's corporate securities division and vice chairman of the firm.

Three exit Citi
Citi's former head of CDO syndicate Europe, Andrew Godson, along with two colleagues from the CDO structuring group are leaving the bank. Godson and Sarah McMullen have already gone, while Orestis Millas is leaving at the end of the month.

Neale leaves BoA
Heather Neale has left her role as principal in the CDO team at Bank of America in New York. Her future destination is not known.

Mayer Brown to advise Golden Key receivers
Law firm Mayer Brown has been instructed by Neville Kahn, Nicholas Dargan and Mark Adams of Deloitte & Touche to act for them as joint receivers of Golden Key (in receivership), a SIV-lite.

Structured finance partner Stephen Day and restructuring partner Ashley Katz are leading the Mayer Brown team. This is the most recent in a string of instructions for Mayer Brown in relation to the establishment and restructuring of SIVs. These include Carrera Capital Finance, Rhinebridge, Cheyne Finance and the Master-Liquidity Enhancement Conduit (MLEC).

MP

Market value criteria report issued

A round up of this week's structured credit news

Market value criteria report issued
Fitch has issued an updated criteria report that discusses its approach for rating market value structures (MVS). This criteria update is in response to ongoing dislocations in the credit markets, which began in July of 2007 and have continued to place unprecedented stresses on the liquidity and market values of credit instruments.

Market prices have come under pressure, even for assets that are not undergoing a credit stress. As a result, many prevailing assumptions about funding access, asset liquidity, and risk have been re-examined.

Some of the highlights of this report include the following:

• Fitch will use its existing ratings scale to rate market value structures. Fitch will also use the new criteria to surveill and re-evaluate its ratings on all existing MVS transactions;
• Fitch will apply both quantitative and qualitative considerations when analysing MVS. Quantitative factors will include new updated advance rates/overcollateralisation ranges for various asset types, based on data that includes the recent stress that has occurred beginning in latter half of 2007. Qualitative factors will include structural market changes that may render past performance data less relevant, manager skill-set, pricing procedures and any data limitations;
• Ranges of advance rates (ARs) at each ratings level are established by classifying asset types into a limited number of categories. Assets will be assigned to these categories based on their expected liquidity and volatility, particularly with respect to their performance throughout this current market crisis and other stressed market conditions, as well as their structural complexity and transparency. Within this framework, Fitch will evaluate transactions on a case-by-case basis, taking into account the nature of the assets and any unique structural features.
• MVS that are backed by less liquid asset types will not be eligible, in most cases, to receive ratings above single-A. MVS with illiquid assets will not be eligible, in most cases, for investment;
• Traditional MVS can continue to be rated as high as triple-A, subject to additional stresses. Traditional MVS are those structures with de-leveraging/protection-based triggers which are set "outside of the tranche", such that the transaction may be able to undertake an orderly de-leveraging/unwind without loss to the rated notes;
• Ratings for 'knock-out' MVS, in most cases, will be capped at triple-B. Knock-out MVS are those structures with high loss triggers set "inside of the tranche", such that the transaction may unwind with a significant/total loss to the rated notes.

Ratings that may be impacted by Fitch's updated MVS criteria include approximately US$23.8bn in issuance across 52 transactions. Transaction types include: corporate market value (MV) CDOs, guaranteed investment contracts (GIC) facilities, mortgage MV CDOs, collateralised funding obligations (CFOs), leveraged super-senior (LSS) notes and total rate of return (TRR) CLOs.

Fitch says it will continue to communicate its views on MVS on an ongoing basis and will provide more detailed commentary on different aspects of MVS criteria as the market evolves.

Credit portfolio practices surveyed
The International Association of Credit Portfolio Managers, ISDA and The Risk Management Association have announced the completion of the 2007 Survey on Credit Portfolio Practices, conducted jointly with McKinsey & Company.

The survey explores credit portfolio management practices during the height of the current credit crisis and finds that 95% of credit portfolio managers believe their reputation for managing risk has strengthened during the crisis. At the same time, the results reveal that institutions take significantly different approaches to portfolio management and that affects how managers view additional action steps.

"The current credit crisis is the most dramatic test of active credit portfolio management since the system began to be practiced," comments Som-lok Leung, executive director of IACPM. "We conducted this survey to fuel informed discussion over what should or should not be done to better manage risk and return."

Robert Pickel, executive director and ceo of ISDA, adds: "Risk managers are taking a hard look at the new market realities and are attempting to reorient portfolio management to address new circumstances. Not surprisingly, credit derivatives remain an important risk distribution tool for active credit portfolio managers."

Credit portfolio managers at more than 60 banks and insurance companies in the Americas, Europe, Africa, Asia and Australia participated in the survey, representing more than half of all global banking assets. Traditionally, many of these institutions were buy-and-hold, which means they made loans and held them until maturity or default. Active credit portfolio management (originate, manage, sell), on the other hand, seeks to achieve the optimal risk managed return through influencing origination, as well as the existing credit portfolio and capital consumption.

"We are very pleased to conduct this survey because portfolio management can create significant value for financial institutions," notes Uwe Stegemann, partner at McKinsey & Company, which conducted the survey. "The industry's interest in the survey reinforces the importance of the credit portfolio management function, in particular during the events of the recent crisis. Furthermore, participants see significant additional benefits in further strengthening an effective credit portfolio management function in their institutions."

Importantly, while risk professionals overwhelmingly believe that portfolio management under stress is critical, they disagree on how well prepared their firms are in the event of another crisis. Of the survey respondents, 50% are concerned that their institutions do not have systematic and sufficiently rigorous analytical cycle management in place and many of these managers advocate spreading active portfolio management throughout their firms to cover most or even all of their institutions' assets.

On the other hand, a significant number of managers argue that current coverage and approaches are sufficient and that developing contingency plans is difficult, given the unique natures of different crises. Other important areas for discussion emanating from the survey are performance measurement of the portfolio management function, its value proposition for the institution, as well as the allocation of functional responsibilities and governance.

"The survey has helped clearly define differing views and approaches (e.g. regarding mandate and power of portfolio management units)," says Kevin Blakely, president and ceo of RMA. "Now, using this information, each of our associations is scheduling sessions to be held at our upcoming meetings to discuss and debate the merits of the different approaches."

Survey results also indicate that risk professionals are additionally focusing on several tools that many believe should be improved. The tools include scenario analyses and stress tests, action plans to deal with unexpected events such as unforeseen contagion, quick reaction and execution to handle adverse market conditions, risk transparency of complex instruments, and independent risk analysis separate from the rating agencies.

McKinsey's Stegemann concludes: "This survey marks only the beginning of a discussion within the industry on how the function should develop over the next three to four years."

CMBX5 roll delayed
The Markit CMBX index, which was initially due to roll on 25 April 2008, will now roll on 13 May 2008 following a majority dealer vote. This will allow the inclusion in Series 5 of newer deals of a higher underwriting standard and ensure that the new series is representative of the current market.

Collateral use increases
Use of collateral in privately negotiated derivatives transactions grew significantly in 2007, with the amount of collateral in circulation now estimated at US$2.1trn, according to preliminary results from the 2008 ISDA Margin Survey. The results show an increase of almost 60% over the estimated US$1.335trn of collateral in the 2007 Survey. Cash continues to grow in importance among most firms, and now stands at over 78% of collateral received and 83% of collateral delivered.

"ISDA's 2008 Margin Survey reflects continued importance of collateralisation as a risk mitigation tool and the effectiveness of collateral agreements," says Robert Pickel, executive director and ceo, ISDA.

The 2008 Survey reports that collateral agreements in place grew to over 149,000, of which 74% are two-way agreements. Among firms that responded both in 2007 and 2008, collateral agreements grew by 18%. Respondents forecast further growth of 20% during 2008.

The 2008 Margin Survey also finds that collateral coverage continues to grow, both in terms of trade volume subject to collateral agreements and of credit exposure covered by collateral.

For all over-the-counter derivatives transactions, 63% are subject to collateral agreements, compared with 59% last year. Furthermore, 65% of credit exposure for privately negotiated derivatives is now covered by collateral, compared with 59% last year.

Of the 107 firms responding to the 2008 ISDA Margin Survey, 85 are banks or broker-dealers and the remaining are institutional investors and end users.

Meanwhile, ISDA has announced that, jointly with the European Central Bank (ECB)'s European Financial Markets Lawyers Group (EFMLG), it has submitted a letter to the European Commission, in which it proposes harmonisation of netting laws across the EU. The proposal is for an EU instrument on netting by way of either amending the EU Directive on Financial Collateral Arrangements or by drafting a separate directive, and it is based on ISDA's law reform work in Central and Eastern Europe (CEE) countries and across the EU.

European Central Bank president, Jean-Claude Trichet, endorsed the idea of EU-wide netting harmonisation at ISDA's 2007 Annual General Meeting in Boston. In December 2006, the EU Commission in its evaluation of the implementation of the Collateral Directive acknowledged the need to improve the EU legal framework with regard to netting and set-off.

One way of addressing the aforementioned suggestion would be to expand the scope of the Collateral Directive by adding substantive provisions on netting. Alternatively, an EU instrument on netting only could be considered.

On the global level of law reform beyond the EU, ISDA has expressed its support for the proposal on a Convention on Netting in Financial Services, as made by International Institute for the Unification of Private Law (UNIDROIT).

Working paper released on financial turmoil
Bank for International Settlements (BIS) has released a working paper entitled 'The financial turmoil of 2007-?: a preliminary assessment and some policy considerations'.

The unfolding financial turmoil in mature economies has prompted the official and private sectors to reconsider policies, business models and risk management practices. Regardless of its future evolution, it already threatens to become one of the defining economic moments of the 21st century, the paper says.

This report seeks to provide a preliminary assessment of the events and to draw some lessons for policies designed to strengthen the financial system on a long-term basis. It argues that the turmoil is best seen as a natural result of a prolonged period of generalised and aggressive risk-taking, which happened to have the sub-prime market at its epicentre. In other words, it represents the archetypal example of financial instability, with potentially serious macroeconomic consequences that follows the build-up of financial imbalances in good times.

The significant idiosyncratic elements, including the threat of an unprecedented involuntary 're-intermediation' wave for banks and the dislocations associated with new credit risk transfer instruments, are arguably symptoms of more fundamental common causes. The policy response, while naturally taking into account the idiosyncratic weaknesses brought to light by the turmoil, should be firmly anchored to the more enduring factors that drive financial instability. The BIS report therefore highlights possible mutually reinforcing steps in three areas: accounting, disclosure and risk management; the architecture of prudential regulation; and monetary policy.

Derivatives processing continues to improve
ISDA has announced the preliminary results of its 2008 Operations Benchmarking Survey. The initial results show that, despite significant growth in monthly volumes for most OTC derivative products, post-trade processing has been able to keep pace and in many cases improve over previous years.

Monthly OTC derivative volumes grew by 38% across all products, with credit derivatives showing the strongest growth at 73%. Large firms experienced even greater increases, reporting 87% growth in credit derivative volumes.

In the main asset classes, business days' worth of outstanding confirmations is lowest for credit derivatives at 6.6 days, followed by interest rate products at 9.9 business days and 13.3 for equities. In interest rate and credit derivatives, 90% of electronic confirmations are normally sent by T+1 (within one day of trade date); equity derivatives reach those levels by T+4.

Trade data transfer from front office to operations is now highly automated for all products, averaging 79% across respondents. The highest level of automation of confirmation matching is in credit derivatives, averaging 62% across all respondents; the lowest is in equity derivatives at 23%.

Settlement volumes more than doubled in the main asset classes as a result of the increase in overall trade volumes, as well as the ongoing need to settle recurring payment obligations. Automated solutions for payment netting and central settlement services, particularly for credit derivatives, have helped firms handle the increases in settlement volumes.

Data submitted by participants cover the calendar year 2007. This year's survey saw the highest level of participation since the creation of the survey in 2000, with 79 respondents – including all major OTC derivative dealers. It is also the first survey that includes a provider of processing services to hedge funds and other buy-side clients.

Calypso upgrades trading application
Calypso Technology has announced the annual major version release of its integrated trading application suite to the capital markets industry. The new version, Version 10, incorporates significant enrichment of front office tools for structuring products and managing real-time intraday risk and P&L analysis; more robust risk management capabilities on a desk and enterprise level; and new capabilities to the Calypso Fast-Track product, shortening time-to-value during implementations.

"Today, financial services firms are struggling with processing backlogs created by the growing volume of increasingly complex products including treasuries and derivatives. In addition, continued manual processing is slowing innovation and creating additional costs and errors," states Stephen Bruel, analyst at TowerGroup.

Charles Marston, ceo of Calypso, comments: "Version 10 is designed to enable Calypso users to successfully manage current market challenges and innovate to stay competitive. Additionally, clients can implement Calypso's solutions faster than ever, as we continue to build upon our Calypso Fast-Track solution with additional pre-configured environments for multiple asset classes."

Carador share performance rises
Permacap Carador's share performance has increased by 2.27% month-on-month. As at the close of business on 31 March 2008, the unaudited NAV per share for the vehicle was €0.68.

Carador's NAV decreased by 7.37% in March. Adjusting for the payment of the dividend in the month of 0.05 cents per share, the NAV decreased by 0.26%. This month's calculations include an estimated €451,933.79 worth of net cashflow interest received in the month (to be allocated between capital and income), which equates to €0.009 per share.

Fitch analyses rating transitions
Fitch has released a new study, analysing in depth the 2007 and long-term rating transition and default experience of its rated global structured finance securities.

As the US housing crisis continued to deepen in 2007, Fitch's global structured finance rating actions took a decidedly negative turn, driven by the unprecedented credit deterioration in the US sub-prime mortgage sector, the agency says. More than three-quarters of the year's downgrades, which overall affected 14% of its global structured finance ratings, were related to the downturn in the US sub-prime mortgage sector. Upgrades, in contrast, affected 6% of Fitch's global structured ratings in 2007.

"The overall excess of structured finance downgrades to upgrades marked the first year in recent history to see such a trend," says Stephanie Mah, senior director of Fitch Credit Market Research. "However, the non-mortgage ABS and CMBS sectors reported more upgrades than downgrades."

The US sub-prime downturn also pushed up the global structured finance default rate to 1.19% in 2007 from 0.37% in 2006. The average annual global structured finance default rate over the 17-year period ending in 2007 subsequently moved up to 0.77% from 0.68% in 2006.

"Similar to long-term patterns, global structured finance default rates in 2007 varied greatly, depending on rating levels," adds Mariarosa Verde, md and head of Fitch Credit Market Research. "The default rate on Fitch-rated investment grade structured bonds was 0.52% but 4.8% across the universe of speculative grade issues."

The report – entitled 'Fitch Ratings 1991-2007 Global Structured Finance Transition and Default Study' – provides details on the year's rating activity by rating category, product and geography.

BoE SLS to drive issuance
Fitch says that it expects the Bank of England's (BoE) Special Liquidity Scheme (SLS) to result in a sharp increase in both RMBS and covered bond issuance out of the UK in the coming six months. The agency further underlines that the scheme is far from a taxpayer 'bail-out' of banks, as claimed by some, with significant protection for the BoE built into the scheme and only the highest-rated securities eligible for swapping.

Under the terms of the SLS, UK banks and building societies have only a six-month window in which to swap their currently illiquid RMBS, covered bonds and credit card ABS for liquid UK Treasury bills. The terms of the SLS stipulate the bonds must not only be rated triple-A at the outset, but also that if they lose this rating the bank must replace them with other appropriately rated bonds.

"Losses can only occur to the BoE, and therefore the taxpayer, in the event that the bank becomes insolvent and is unable to replace collateral following a downgrade – and if the significant protection accorded in terms of in-built transaction credit enhancement, mark-to-market discount and generous haircuts prove insufficient to absorb losses on the securities. Fitch regards these circumstances as remote in the extreme," comments Philip Walsh, md in the agency's structured finance department with overall responsibility for its RMBS and ABS ratings.

Prior to the onset of the credit crunch, the originating bank would have issued triple-A rated RMBS to investors with 5-10% of credit enhancement as protection, depending on the credit quality of the underlying loans, which would typically be sold at their par value. It is worth noting that to date, given these levels of protection, there have been no losses to triple-A investors in any Fitch-rated UK RMBS deals since the market's inception. RMBS eligible for swapping under the SLS would attract similar levels of credit enhancement to obtain the desired triple-A rating.

The 12% haircut for floating-rate securities compares to a 2% haircut applied by the European Central Bank to its valuation of floating-rate securities for use as collateral for its repo funding facilities, which accept collateral rated single-A minus or above. In Fitch's view, the aggregate of the inherent credit enhancement and the various haircuts stipulated would mean that any bank using the scheme would effectively be required to provide capital or subordinated funding for anything it swaps under the scheme at a significant multiple of its regulatory capital requirements for the same assets and considerably higher than that required for a triple-A rating.

Under the SLS, the BoE has significant protection on top of the in-built transaction credit enhancement. The scheme requires that bonds swapped are valued at current market value, somewhat lower than a year ago and largely reflective of fear of mark-to-market value losses rather than concerns regarding underlying credit risk.

In addition, a further substantial haircut to the valuation is stipulated by the BoE of at least 12% (for a short maturity fixed-rate bond and floating-rate) or as much as 22% for a fixed-rate bond with a maturity of more than 10 years. Further haircuts of 5% each are applied to own-name (that is, self-originated) RMBS, credit card ABS and covered bonds, as well as if the RMBS or ABS provided as collateral have no observable market price.

CS

Reaping the benefit?

European central bank policies, changes to Basel 2 and their impact on ABS CDS spreads are discussed by the European securitisation research team at RBS

ABS CDS spreads began to stabilise at the end of last week, with the exception of the UK non-conforming sector. We believe that ABS CDS spreads will remain somewhat defensive as market optimism gets stopped out by participants looking to hedge positions.

ABS CDS spreads widened dramatically to mid-March, as fears of a lack of regulatory and political will grew in the market. Once those fears abated with the rescue of Bear Stearns and the announcements of more liquidity provided by the central banks, CDS spreads began to tighten in European ABS – finally reaching their tight levels on 2 April. Despite the tightening, we have seen little relief in bid-offer spreads in ABS CDS markets.

Since their widest levels this year in mid-March, UK prime RMBS CDS spreads tightened by over 100bp, while other markets tightened between 45bp for low LTV Spanish RMBS to 105bp for Greek RMBS (see Figure 1). Dutch RMBS tightened the most, with mid-level spreads contracting by almost 135bp.

We expect that the market is not yet through the worst of the news, and that the market remains vulnerable to widening again. Given concerns over deterioration in the reserves at Caja Madrid's high LTV Madrid RMBS II, we do not expect high LTV Spanish RMBS to see much spread contraction until confidence returns in Spain's real estate outlook.

Our outlook for Ireland, for example, is that house prices will remain relatively weak, having fallen as much as 8.8% year-on-year – though the credit enhancement in the RMBS transactions look fairly robust in light of expected losses. ABS CDS spreads for Irish RMBS trade at levels slightly weaker than low LTV Spanish RMBS. However, house prices have fallen further in certain parts of Italy, yet the market prices Italian RMBS CDS at comparatively tight levels.

But we believe that these levels remain very cheap relative to the intrinsic value in many of these securities. Market technical biases from overhanging secondary supply will likely hold these levels wide of their intrinsic value until more of that supply is absorbed and investor confidence returns to the market.

Repo, TAFs and ABS: differences among central bank policies
At this moment there are a number of ideas, proposals and frameworks out in the market attempting to solve the credit crisis that has spread well beyond US mark-to-market risk. Many of these ideas have merit in our view, and several responses are already in place, including the Term Auction Facilities (TAFs) put in place by the central banks.

For the Bank of England, the TAFs allowed a wider selection of eligible collateral to be accepted, at least on a temporary basis. Banks and building societies that have reserves accounts or access to standing facilities at the BoE are permitted access to the funding.

Under the terms of the TAF announced in December, banks may repo acceptable securities collateral, including:

• Bonds issued by sovereigns rated Aa3/AA- or above (in addition to those currently eligible), subject to settlement constraints.
• Bonds issued by G10 government agencies guaranteed by national governments, rated triple-A.
• Conventional debt security issues of the Federal Home Loan Mortgage Corporation, the Federal National Mortgage Corporation and the Federal Home Loan Banking system, rated triple-A.
• Triple-A rated tranches of UK, US and EEA ABS backed by credit cards; and triple-A rated tranches of UK and EEA prime RMBS.
• Covered bonds rated triple-A.

Securities must be denominated in sterling, euro, US dollars, Australian dollars, Canadian dollars, Swedish krona, Swiss francs and, in the case of Japanese Government Bonds only, yen. Ratings must be provided by at least two agencies, but may only be from Moody's, S&P or Fitch. Additionally, the Bank of England accepts prime mortgage collateral in the TAFs; but all the mortgages must meet fairly strict criteria.

The first TAF announced in September allowed double-A rated UK, US and EEA RMBS and credit card-backed ABS as well, but that provision was dropped in the December announcement. The hope was that this facility would stimulate buying by bank participants in an effort to purchase now-cheap ABS and MBS, but there needed to be sufficient liquidity to sop up some of the liquidations from SIVs, CDOs and other structured portfolios.

The ECB, meanwhile, requires that ABS used for repo follow certain prescriptions, including that notes must:

• rank senior in the capital structure,
• be denominated in euros,
• be issued from the EEA,
• be considered true-sale,
• be enforceable against any third party, and
• be structured to remain outside the reach of the originator and its creditors in the event of the originator's solvency.

Furthermore, cashflows behind the ABS must not be backed by credit-linked notes or similar claims resulting from the transfer of credit risk via credit derivatives. However, many Dutch RMBS transactions were considered eligible. We are intrigued by the fact that the ECB has no minimum ratings requirement, but only requires that the bonds to be senior in ranking.

The US Federal Reserve accepts a broad range of collateral, including private label and agency MBS, non triple-A rated ABS, German Pfandbriefe, CDOs and CLOs. This collateral has been accepted at the discount window for many years.

Interestingly, haircuts are similar for floating rate securities between the Federal Reserve and the European Central Bank. Compared with the MBS and ABS haircuts of the Federal Reserve Bank and the ECB, the Bank of England's TAF looks decidedly less generous (see Figure 2).

For example, the Federal Reserve has accepted triple-A rated CDOs through its discount window, and has done since 2002. The programmes detailed below for the Federal Reserve and ECB are for long-standing programmes, whereas the Bank of England has historically only accepted MBS and ABS during the TAFs.

Eligible securities must have been held on balance sheet at end-December 2007 or be backed by loans held on balance sheet at this date. This seems to effectively prevent any institution not able to access BoE facilities directly from accessing this facility via other banks.

For master trusts where collateral may include loans originated after this date, 100% of the value of the securities/loans at the end of December will be eligible for the first year, falling to two-thirds in year two and one-third in year three. The haircuts seem very conservative, with RMBS, ABS and covered bond haircuts starting at 12% for maturities under three years.

However, if the calculation is based on legal final, nearly all RMBS would fall into the over 10-year category with a 22% discount. The haircuts are based on observable market prices, with extra cuts of 3% for non-sterling securities, 5% for own group collateral and 5% for not having an observable market price – giving a possible haircut of 35%.

Stronger support for RMBS could enable UK banks to gain confidence in funding to open the mortgage origination flow and to lower home loan rates. A number of lenders have stopped or significantly slowed mortgage origination, likely precipitating further declines in house prices as borrowers face fewer funding options.

Without an increase in lending, the market risks a vicious cycle of declining house prices and lenders further retracting from the market. One proposal on the table was to expand the eligible institutions to include UK lenders without direct access to the Bank of England.

Expect changes to Basel 2 and other regulations
Although Basel 2 has just begun its implementation, the Bank for International Settlements announced last week that the Basel Committee will make changes to the Basel 2 rules for banks. Work had begun on the next iteration of Basel 2 (presumably Basel 3), and we expect that regulators will temporarily abandon that work in order to develop the changes necessary for the version of Basel 2.
The main tenets of the proposal include: raising the capital required for complex structured credit products (such as resecuritisations, but principally ABS CDOs), liquidity facilities to support ABCP conduits and credit exposures held in the trading book.

The Committee does not consider VaR sufficient to capture the complexity and liquidity of a number of instruments. It will also raise the bar for liquidity risk management and supervision, but subject to public consultation. These efforts are intended to strengthen banks' risk management practices and supervision, especially with regard to stress testing, off-balance sheet management and valuation practices.

As a result of the findings, the Committee intends to review the minimum capital requirements over a full credit cycle and to "ensure Basel II provides a sound capital framework for addressing banks' evolving and complex risk profiles". These new proposals map to many of the recommendations from the Financial Stability Forum's previous report: no surprise as BIS and Basel Committee sit on the FSF committees.

How the EU will adopt its Capital Directive to reflect the changes is unknown, as are the details, but we would expect to see changes before the end of the year. We expect that these changes will result in higher risk weights for asset-backed and mortgage-backed securities, for both back-book and trading book portfolios. These increased risk weights could push up holding costs for banks.

The Financial Stability Forum's report recommended actions designed to enhance 'market and institutional resilience'. Among the recommendations related to securitisation were a push to implement the Basel 2 capital framework and a more bespoke assessment of individual banks' capital and assessments as to whether additional capital buffers were required at a supervisory level.

Directly relating to securitisation were recommendations to:

• raise banks' capital requirements on complex structured credit instruments, such as ABS CDOs;
• lift banks' capital for liquidity facilities for ABCP conduits;
• harden the capital and regulatory framework for guarantees and enhancements on structured credit by monoline insurers;
• raise more risk management oversight of off-balance sheet entities;
• strengthen requirements for regulators of institutional investors to assess processes for investing in structured products;
• demand more visibility and disclosure around 'selected exposures', all of which seemed targeted toward structured credit or securitisation;
• examine accounting standards around off-balance sheet entities; and
• review fully credit rating agency practices around structured products.

The report may have served as a blueprint for other regulators beyond the recent actions by the Basel Committee for banks. We expect further tinkering with Solvency 2 and for IOSCO to recommend changes to rating agency practices, many of which seem negative in our view. All of these recommendations likely will serve to make securitisations more expensive, if more transparent.

© 2008 The Royal Bank of Scotland. All rights reserved. This Research Note was first published by The Royal Bank of Scotland on 18 April 2008.

Trading ideas: fuzzy reception

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at a pairs trade on Comcast Corp. and Time Warner Inc.

With the market rallying on the back of some seriously disappointing numbers hitting the newswires (more write-downs, foreclosures, bad earnings, layoffs), we feel more confident putting on beta-neutral type trades. Though the MFCI model consistently picks the media sector as one of the better sectors to select longs from, this trade finds value in taking offsetting positions in two similar companies: Comcast and Time Warner.

The pairs trade return is limited to purely idiosyncratic risk and recently Time Warner has sold off, creating what we believe to be a short-term technical trading opportunity. Heading into the end of March TWX rallied, pushing the spread differential of the two close to zero – and with the recent TWX spread widening, the executable level is 39bp.

On the risk side, the MFCI model puts both issuers in comparable risk buckets and therefore gives them similar expected spread levels. A closer look at both the fundamental and market-implied factors confirms the MFCI's view on the two and therefore we recommend buying protection on Comcast and selling protection on Time Warner.

Short-term technicals
Though fundamentals tend to dominate price discovery in the long run, we all know that the market can remain irrational as long as it needs or wants to and this trade is driven by both sides of the equation. Over the past couple of weeks TWX underperformed relative to Comcast, pushing their spread differential back to over 50bp after coming close to zero (Exhibit 1). We believe this is a temporary dislocation and presents a good opportunity to initiate this pairs trade as our MFCI model shows both issuers to have similar credit risk levels.

Exhibit 1

Buckets of risk
On the fundamental side, we turn to our MFCI model to give us an indication of the relative risk between the two companies. The MFCI model attempts to replicate the thought process of a fundamental credit analyst. We know this is an extremely arduous task; however, the model is a great means to producing intra-sector pairs trades.

The MFCI model ranks each issuer on a scale of 1 to 10 using eight factors (1= poor credit, 10=good credit). Exhibit 2 lists all the factor scores for both Comcast and Time Warner.

Exhibit 2

The MFCI overall risk levels for both issuers are almost the same (4.8 and 5.1 respectively), and thus both have roughly equivalent expected CDS spreads in the 130bp-150bp range. A more detailed look into the factors demonstrates how similar they truly are based on the MFCI factors, as all ranks are within two notches of one another.

A closer look at one of the fundamental factors from the model clearly demonstrates how similar the credit profiles of the issuers are. Both companies have had very stable debt to EBITDA ratios over the past few years, with Comcast holding almost 50% more debt relative to its earnings than Time Warner (Exhibit 3). We see this as another positive for Time Warner.

Exhibit 3

Volatility matters
One of the forward-looking factors within the MFCI model is equity-implied volatility. The implied volatility is backed out from current equity option prices and gives a clean estimate of the market's view on a company's future risk or volatility level. Since we find the equity derivatives market to have good forecasting power for a firm's relative performance, we decided to delve a bit deeper into the history of this factor from a time series perspective due to the difference in ranks (Exhibit 4).

Exhibit 4

Comcast and Time Warner's implied volatility levels have traded within a tight range over the past two years, with Comcast at a slight premium to Time Warner. We view this as the equity market seeing more risk in Comcast than Time Warner; however, at current credit spread levels we receive more spread for taking on Time Warner's risk. Therefore, we believe the equity market gives us another strong reason for entering the trade.

Risk analysis
This pairs trade carries a direct risk of non-convergence. In other words, there is the possibility that the names will not tighten and widen as expected. However, based on historical performance of the technical indicators, the cushion provided by the positive carry and the conviction of the fundamental analysts, we believe these risks are well mitigated.

Liquidity
Liquidity should not be an issue for this trade, as both names are investment grade issuers. The credits have historical bid/offers of 5bp-10bp for the five-year tenor and, depending on the market environment, trading out of the pairs trade should not have a large negative P&L impact.

Fundamentals
While Gimme Credit provides more of a long-term credit view, this trade has a shorter-term horizon and goes against the current GC recommendation. For more details on the fundamental outlook for each of CMCSA and TWX, please refer to Gimme Credit.

Comcast Corp. (analyst – Dave Novosel) - Credit Score: +1 (Improving)
Although subscriber growth is likely to weaken overall, Comcast should still deliver high single-digit revenue growth. We expect margins to remain stable as marketing investments offset cost efficiencies. Free cashflow should expand in 2008. We think event risk is minimal.

Time Warner Inc. (analyst – Philip C. Adams) - Credit Score: 0 (Stable)
Leverage has been increasing because of massive share repurchases. The event risk associated with the potential for a restructuring of its assets overshadows the solid operating performance stemming from the company's well diversified portfolio of businesses.

Summary and trade recommendation
With the market rallying on the back of some seriously disappointing numbers hitting the newswires (more write-downs, foreclosures, bad earnings, layoffs), we feel more confident putting on beta-neutral type trades. Though the MFCI model consistently picks the media sector as one of the better sectors to select longs from, this trade finds value in taking offsetting positions in two similar companies: Comcast and Time Warner.

The pairs trade return is limited to purely idiosyncratic risk and recently Time Warner has sold off, creating what we believe to be a short-term technical trading opportunity. Heading into the end of March TWX rallied, pushing the spread differential of the two close to zero and, with the recent TWX spread widening, the executable level is 39bp.

On the risk side, the MFCI model puts both issuers in comparable risk buckets and therefore gives them similar expected spread levels. A closer look at both the fundamental and market-implied factors confirms the MFCI's view on the two and therefore we recommend buying protection on Comcast and selling protection on Time Warner.

Sell US$10m notional Time Warner Inc. 5 Year CDS protection at 150bp.

Buy US$10m notional Comcast Corp. 5 Year CDS protection at 111bp to receive 39bp 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).