Contents

Pressure drop

End in sight for restructured MV CLOs?

Details of two newly-launched US cashflow CLOs have emerged, both of which are restructured market value deals. But the recent loan market rally means that managers are under less pressure to restructure their MV CLOs, at least for the time being.

"I believe the pressure has been taken off market value CLOs in the past few weeks due to the rally in the loan markets, meaning that these deals now have larger cushions. However, that is not to say that it will remain like this indefinitely," says Matthew Natcharian, md and head of the structured credit team at Babson Capital.

The latest restructured MV CLOs to hit the market are the US$169m Veer Cash Flow CLO and the US$680m Vinacasa CLO (see SCI issue 77). Managed by MJX Asset Management, Veer is a restructuring of the Veer Loan Opportunities Fund that was placed on outlook negative by S&P in March, while the Babson-managed Vinacasa is a restructured version of the Beecher Loan Fund CLO – formerly managed by Hartford Investment Management.

In both cases a number of new investors took part in the deals. New accounts invested across the capital structure of Vinacasa and in the triple-As of Veer, while MJX bought the entire mezzanine tranche.

The pricing of both transactions also suggests that some spread stability has returned to the sector, with the triple-A tranches printing at 140bp over three-month Libor versus the 200bp print achieved by Bushnell Loan Fund CDO II in early March. One CLO structurer notes that spread levels achieved by the two deals are right for the risk involved.

But new CLO issuance is unlikely to come back to the US market until secondary CLO spreads tighten in, other market participants observe. Typical triple-A spreads are currently at around the 125bp-135bp area.

"While loan prices have rallied, the spreads on CLO tranches have not reflected this market move," says Natcharian. "We are cautiously optimistic that CLO tranche spreads are going to tighten somewhat, but levels must come down at the triple-A level for it to make sense to bring new deals to the market."

The restructuring of MV CLOs looks set to run its course in Europe too. "We sense that the rump of MV CLO restructuring and warehouse clearing CLOs that needed to be done has been done already," says Siobhan Pettit, head of structured credit strategy at RBS.

However, she adds: "The hung warehouses and banks' loan overhang are being worked through. We do not detect new warehouses being opened nor do we hear a great clamour of equity investors lobbying banks to do so, given where CLO liability spreads are. It is hard to see where new CLO supply will come from."

One European MV CLO that was not restructured upon downgrade, Coltrane CLO, nonetheless found buyers for its collateral last week. The loans were sold off at an average price of 86.7% of face value.

"The price, which is low compared to where the most liquid leveraged loans and the LevX S1 trade presently, is unlikely to cause any major repricing in this space," note analysts at BNP Paribas. "The Coltrane CLO contained several less well-known, illiquid loans that – although well bid, thanks to the auction's mechanism – have likely lowered the portfolio's average liquidation price."

AC

Building blocks

Russian reform hints at CDS potential

Given its burgeoning corporate bond market, credit derivatives have huge potential in Russia, yet CDS are still only traded offshore. However, there are hopes that Russia's President-elect will begin reforming the regulatory infrastructure for the instruments when he is inaugurated today.

A broader synthetic base should significantly improve Russian institutions' funding opportunities, according to Martin Bartlam, senior partner at Orrick, Herrington & Sutcliffe. "Increased CDS activity is expected in Russia as banks expand their sources of credit and the range of assets on their books," he says. "There is a lot of potential to be realised for the region in terms of the types of financial instruments institutions can use, but the political will needs to be there to create the confidence to establish a regulatory regime that is open and consistent with the international market."

Uncertainty over the legal regime for credit derivatives continues to hinder the development of the instrument in Russia. Factors such as accounting rules, non-recognition of foreign judgements, lack of standardised interbank documentation and a lack of disclosure requirements are all restricting international confidence in the country's CDS market.

"The asset class is one of the fastest growing areas of finance, yet is unlikely to thrive in the country until the infrastructure for more basic derivative asset classes – such as currency and interest rate swaps – is developed," explains Bartlam.

Russian President-elect Dmitry Medvedev has nonetheless signalled his support for the rule of law, clarity of decision-making and independence of the judiciary ahead of his inauguration today, 7 May. Sources say that, as a result, there appears to be an increased government emphasis on creating a financial infrastructure that is consistent with – or at least more understandable to – the Western environment.

But perhaps more fundamental than that is a change in legislation to clarify uncertainties regarding insolvencies in the banking sector and netting of exposures, notes Bartlam. "It is critical to improve the confidence of third parties in domestic institutions and the judiciary. There is a lack of clarity in terms of legal provisions for CDS and what the law actually says."

For example, legislation is needed to clarify whether credit derivatives are covered by the exemption to the gaming law as an acceptable form of trading on a domestic basis. Russian CDS are currently transacted offshore, but a clarification of the instrument's status would bring it onshore – and have the obvious benefits of engendering increased liquidity, better pricing and increasing the number of institutions involved in the market.

JPMorgan and Bank Zenit were able to get around the absence of an onshore CDS market when they launched Red Square – the first Russian CDO backed by local corporate debt – in December 2006 by putting together a reference portfolio of synthetic exposures replicated by physical assets (see SCI issue 20). Three more Russian synthetic CDOs have been issued since then: Sputnik CDO in March 2007, and Vityaz CDO I and II in August 2007/February 2008 respectively (see SCI issues 32, 54 and 77).

Derivatives have been traded in Russia since 1992, with the market growing at an average of 168% a year between 2000 and 2006. Volumes reached around US$50bn a month last year – indicating the sector's potential, if the necessary foundations are laid.

CS

Bullish buys?

Liquidity premiums create attractive opportunities

Benchmark ABS triple-A spreads have rallied by around 100bp since the US Federal Reserve's unprecedented intervention in the market six weeks ago. Some analysts report that, as a result, this is the most bullish they've felt on CLOs for a long time – but others point to continuing concern over fundamentals.

"We see the recent rally as a re-rating of liquidity premiums in the asset-backed universe, with the more off-the-run and/or credit intensive sectors penalised relative to benchmark, traded names," explain structured finance analysts at Deutsche Bank.

They note that the repricing of securitised product has been limited largely to the most liquid, defensive segments of the senior market. Triple-A CLOs or CMBS, for example, have not caught the better bid and are therefore trading at historically wide spreads to benchmark names. Similarly, mezzanine and subordinated paper – irrespective of asset class – has also lagged the rally, resulting in a historically steep credit curve.

But Chris Flanagan, head of global structured finance research at JPMorgan, says that this is the most bullish he's been on ABS and CLOs for the last five years. "The Fed has done its job in addressing liquidity risk, so the current liquidity premium priced in to spreads is creating extremely attractive opportunities, given that most of the trouble ahead has already been priced in (the consensus view is that house prices will deteriorate by 15%-20%). The collapse of the liquidity premium will drive spreads tighter – and, while the credit risk premium could increase, the increase will be far less than the decline in the liquidity premium," he explains.

Flanagan's top picks are buying CLOs at the single-A to triple-A level or investing at the top of the ABX capital structure, in particular Series 06-2 double-As, given that much of the value has already been extracted from the index. He notes: "Investors recognise that loan defaults will increase, but this is reflected in pricing. The Fed has essentially signalled that if more needs to be done, it will do it."

However, broader concerns about fundamentals and the outlook for the US economy remain. "While the Fed has been successful in addressing systemic risk, its monetary stimulus package isn't necessarily working," explains Peter Acciavatti, US high yield and leveraged loans credit strategist at JPMorgan. "For example, April's Senior Loan Officer Opinion Survey reflects continued tightening in bank lending, so the rate cuts aren't being passed on to consumers – indicating that there is more weakness to come in the US economy. We are concerned about where the default cycle is headed too – we expect spread tightening to continue in the short term, but a widening trend will hit going into next year on the back of increasing defaults."

High yield spreads are currently at around 658bp; the median spread for the 2000-20002 and 1990-1991 periods was 785bp and 779bp respectively, so spreads are likely to push above these levels going forward. The market has already seen nine high yield defaults this year versus 10 for the whole of last year, and 17 leveraged loan defaults versus three last year. While a 4% default rate is currently priced in, Acciavatti expects the rate to reach a range of 6%-7%.

Meanwhile in the short-term sector, the latest figures from CP dealers and central banks are also pointing towards a stabilisation of the ABCP market in recent weeks, according to structured finance analysts at SG. The leveraged unwind following the credit crunch has resulted in the riskier conduits disappearing from the market and high-quality predominantly multi-seller receivables programmes are now expected to recover.

"It seems that the 'cleaning of the market' is now complete – which is quite logical, given that in the last nine months most of the short-term debt has now amortised," the analysts observe. "Simultaneously with the credit crisis, a flight-to-quality drained huge amounts of cash to money market funds, which were at that stage specifically not invested in ABCP. We expect that – given this is generating demand for short-term paper invested in corporate and senior bank debt – at some point this money will return to the ABCP sector, with confidence in the remaining conduits restored and spreads remaining very attractive."

CS

Structured credit hedge fund fall slows

March sees deceleration in decline, but nearly 70% of funds still negative

Both gross and net monthly returns for March 2008 in the Palomar Structured Credit Hedge Fund (SC HF) Index show another negative return, albeit significantly reduced from that seen in February (see SCI issue 83). Funds using a correlation trading strategy managed to buck the trend, however.

The latest figures for the index were released this week and show a gross return of -1.58% and a net return of -1.70% respectively in March, with seven of 23 funds reporting positive results. Notably, two sub-strategies - 'long investment grade leveraged' and 'relative value, intra-credit' - reported negative performance of approximately 7%, whereas 'correlation trading' was up by the same amount.

The dispersion and range of returns decreased compared to the data observed in February. For more Index data click here.

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

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

BlueMountain hires Bryant

The latest company and people moves

BlueMountain hires Bryant
BlueMountain Capital Management has hired Jay Bryant as an md in its investor relations and marketing group focusing on pension and endowment clients. Previously, Bryant worked at Deutsche Bank in the new issue CDO group, where he was responsible for the global distribution of cash loan-backed CDO liabilities and equity, including BlueMountain's third CLO.

Before his tenure at Deutsche, Bryant spent nearly 10 years at Merrill Lynch in various credit derivative marketing roles, focused on cash and synthetic structured credit.

Longden joins Markit
Markit has appointed Charles Longden as md in fixed income and credit. He joins from ABN AMRO, where he worked for 12 years, most recently as global head of credit trading and eco-markets. He was the chief architect of the iBoxx CDS Notes.

In his new role Longden will focus on expanding the firm's fixed income and credit businesses, alongside developing new products and services designed to bring greater transparency and liquidity to the carbon markets.

Longden will be based in London, and joins Markit at the end of May.

Moody's promotes Polansky
Moody's has appointed Jonathan Polansky, currently group md of the asset finance group, to the newly created position of structured finance global surveillance coordinator. In this role, Polansky will work closely with the rating agency's surveillance and line of business managers to enhance the monitoring of outstanding Moody's-rated structured deals.

Surveillance managers across all structured finance business lines, including ABS, residential and commercial MBS, and derivatives will report to Polansky.

Before taking on the new role Polansky was an analyst in Moody's US derivatives group from 1997 to 1999 and rejoined to manage CDO Surveillance in 2003, following four years as co-head of the structured products group at Triton Partners. He was promoted to team md in 2005 and to group md of asset finance in January 2008.

Law firm adds restructuring partner
Orrick, Herrington & Sutcliffe has announced that Mark Fennessy will join the firm as a partner in its creditors' rights, restructuring and bankruptcy practice in London. Formerly the head of Hunton & Williams' Corporate Restructuring and Insolvency Group in London, Fennessy has experience in all areas of non-contentious and contentious turnaround and recovery work, including both debtor-led and creditor-led assignments for a range of stakeholders.

Over the last nine months, Fennessy has been involved in the restructuring of SIVs and has represented investment banks and funds in relation to the restructurings of Cheyne Finance, Rhinebridge and Whistlejacket. His practice also covers all types of formal insolvency appointments, including receiverships, administrations and liquidations, credit risk management in financings and commercial contracts, cross-border insolvency assignments and advice, turnarounds, workouts and solvent restructuring including debt-for-equity swaps, facilitating restructurings through Section 425 schemes and CVAs.

He focuses on security reviews and advice in respect to structuring security, antecedent transaction avoidance measures, reorganisation and corporate-based work including corporate and asset sales, and purchases out of insolvency on various bases, including pre-packaged transactions.

FGIC reports interest
FGIC has announced that it has received a significant number of indications of interest from a range of strategic partners, reinsurers and private equity providers. However, RBS analysts note that the statement comes as the 30-day deadline set by the New York Insurance Department superintendent Eric Dinallo for FGIC to raise fresh capital or face greater regulatory scrutiny expires.

FGIC said that the indications of interest were received in response to its request for proposals to enhance its capital position and protect its policyholders. The company will discuss the proposals with the potential investors over the next several weeks, while they complete their due diligence. Definitive proposals are expected to be submitted at the end of this period.

"We are encouraged to see the high degree of interest that has been expressed in FGIC," a FGIC spokesman says. "We plan to work expeditiously to finalise a transaction that is in the best interests of all of our constituents, including our policyholders."

Quantifi partners in Japan
Credit analytics and risk management solutions provider Quantifi has announced a partnership with Rickie Market Solutions (RMS) to further expand Quantifi's presence in Japan. RMS will act on behalf of Quantifi as a sales and marketing agent to financial institutions located in Japan, including banks, hedge funds, asset management companies and insurance firms.

"We are experiencing increased demand for independent market-validated pricing of structured credit products in the Japanese market and are confident that our partnership with RMS will significantly expand our existing presence in this region," says Rohan Douglas, founder and ceo of Quantifi.

Tradition UK and TFS combine
Tradition UK and Tradition Financial Services (TFS) have joined forces to create a single global player in interdealer broking. The combined entity is called Tradition and is based in London.

By joining the two companies Tradition says it leverages the expertise of Tradition UK and TFS to give greater opportunities to clients. Tradition has 680 employees providing interdealer brokerage services across a range of financial products and asset classes, including credit derivatives.

MP

BoE joins rating agency debate ...

A round up of this week's structured credit news

BoE joins rating agency debate ...
The Bank of England has published its Financial Stability Report, in which – among other areas – it sets out the lessons that should be learnt by rating agencies from the sub-prime fall-out. It also states that market-based estimates of the costs of the crisis are likely to overstate ultimate losses.

According to the BoE, prices in some credit markets are now likely to overstate the losses that will ultimately be felt by the financial system and the economy as a whole, as they appear to include large discounts for illiquidity and uncertainty. Conditions should improve as market participants recognise that some assets look cheap relative to credit fundamentals.

John Gieve, deputy governor for financial stability, says: "The unavoidable correction after the credit boom is proving protracted and difficult. However, the pricing of risk in credit markets seems to have swung from being unsustainably low last summer to being temporarily too high relative to fundamentals. So, while there remain downside risks, the most likely path ahead is that confidence and risk appetite will return gradually in the coming months."

Among the emerging lessons for rating agencies highlighted in the report, the BoE says that there should be greater differentiation between structured finance ratings and single name ratings to encourage a more discerning use of structured finance ratings within investment mandates. The information that rating agencies gather on structured finance products should also be made more accessible to investors – for example, to allow greater comparison between different classes of structured finance products – and should contain more information on the underlying drivers of, and uncertainties associated with, structured finance ratings. For example, rating agencies could highlight more clearly the particular risks inherent in resecuritisations (such as ABS CDOs) versus 'single layer' securitisations (such as RMBS or ABS).

Siobhan Pettit, head of structured credit strategy at RBS, agrees that better disclosure (e.g. releasing portfolio details) should be encouraged – not only to investors but also between agencies. "This would allow analysis by third parties, improve competition among agencies and encourage investors to analyse portfolios themselves," she says.

Better transparency on rating agencies methodologies would also help address conflicts of interest and educate investors and justify existing ratings/methodology; while there is merit in extending the current rating scale (which addresses default probability but not other key risks e.g. loss given default, rating stability) if, and only if, it can be applied accurately and introduced thoughtfully to all debt securities.

However, Pettit disagrees with singling out structured finance ratings for a volatility measure. The briefest glance at data shows greater stability in structured finance ratings than corporates e.g. over 22 years (1984-2006) Moody's global structured finance ratings exhibited greater stability (92%) than global corporate finance ratings (78%).

"To damn all SF ratings on the basis of poor performance mainly in a sub-set of SF on certain asset classes (sub-prime and sub-prime CDOs in the US) is effectively putting a health warning on SF ratings and wrongly implying SF ratings are inferior," she argues.

... while S&P supports same rating scale
S&P says it strongly believes in the usefulness of using the same rating scale across the structured finance, corporate and government sectors. It argues its traditional rating scale is designed to provide a common language for evaluating and comparing creditworthiness across all major sectors and their sub-sectors, including US municipals.

This is in keeping with its goal of providing credit ratings that are reasonably comparable measures of credit quality. For example, in assigning single-A ratings to ABS, manufacturing firms or local governments, S&P intends to connote an opinion that they have a comparable level of credit risk.

Some market participants have suggested that S&P has used or should use different rating scales for different sectors. However, most market participants, especially those that use ratings in their credit and investment processes, acknowledge the benefits of having a common rating scale, despite the challenges such a scale presents – and instead encourage rating agencies to adjust their criteria to strive for reasonably consistent credit opinions, or ratings, across sectors and regions. Such views reflect the emergence of global markets for credit and the convergence of credit factors affecting all sectors, S&P adds.

An important goal is maintaining reasonably comparable forward-looking credit opinions across the diverse types of issuers and issues that it rates, while also preserving differentiation among rating categories. The goal is to maintain a body of criteria and methodologies that, to the extent possible across diverse sectors and instruments, assesses risks in comparable ways.

The agency believes that, over the long term, comparable credit opinions are likely to result in reasonably similar average default rates for each rating category across sectors and regions. However, fluctuation in each rating category's default rates is clearly seen in historical default and transition studies, and future fluctuation is unavoidable. Moreover, meaningful variability in specific sectors' credit conditions will also be evident in the variability of their rating transition and default rates, especially as the samples measured become smaller.

The concentration of unusually high default rates in a specific industry or asset type for a year or two can skew the overall performance trends, depending on the sample size and the time frame. Although S&P aims for reasonably comparable default rates over time, it does not expect rating change frequency to be consistent across sectors.

Moreover, there is some evidence that intra-sector default-rate correlation for individual structured finance asset types is generally greater than that for individual corporate and government sub-sectors. There are also differences in the way S&P's issue credit ratings incorporate assumptions about post-default recovery. The agency says it is progressing well in enhancing its corporate speculative-grade ratings with supplemental recovery information and it is committed to providing more explicit recovery information on structured securities as well.

Credit concerns for TRUPs CDO sponsors
Recessionary pressures within the US economy, outsized exposure to residential construction loans and home equity loans, and reduced short-term profitability are among the emerging credit concerns facing banks and thrifts that finance trust preferred securities (TRUPs) and subordinated debt through CDOs, according to Fitch in a new report.

Evidencing these increasing pressures, Fitch has been notified of the deferral of 11 banks and the default of one bank since September 2007. These 12 banks financed US$644.5m in aggregate TRUPs and subordinated debt through 46 Fitch-rated CDOs. When taken in combination with pre-existing deferring or defaulted collateral, including non-bank collateral, average exposure to deferring and defaulted collateral across these 46 CDOs was 4.9% of the transactions' respective portfolio balances, and ranged from a maximum of 15.3% to a minimum of 0.1%.

"Further bank deferral and default activity is likely, given current economic conditions," says Fitch senior director Nathan Flanders.

As a result of observed and expected collateral deterioration underlying bank TRUPs CDOs, Fitch is revising both its rating and asset performance outlook on US bank TRUPs CDOs to negative from stable. The agency is currently reviewing bank TRUPs CDOs with deferral and/or default exposure or other high-risk exposure and expects to place materially affected transactions on rating watch negative in the near future.

"The magnitude of underlying collateral currently in deferral or default will likely be the most significant determining factor in Fitch's analysis," adds Flanders.

However, consideration will also be given to other individual exposures that Fitch believes are of an increased credit risk due to recent adverse developments, such as banks facing heightened regulatory scrutiny, banks which have recently reduced or eliminated dividends on common equity, or those with an above average level of exposure to high risk real estate. Additional considerations will include available credit enhancement, prepayments observed to date, obligor concentration, cashflow redirection mechanisms and other structural enhancements.

In addition to describing Fitch's current credit concerns and rating rationale for potentially placing TRUPs CDO transactions on rating watch negative, the report provides information on historical TRUPs CDO issuance and underlying collateral prepayment activity.

Sub-index added to ABX
A penultimate triple-A sub-index will be added to the existing and future series of the Markit ABX indices. Markit says that the new tranche, added by a majority vote of contributing dealers, will provide enhanced trading opportunities to institutional investors seeking exposure to an additional credit class.

The new ABX.HE.PENAAA sub-index will reference triple-A rated bonds that are second to last in principal distribution priority in the ABX.HE indices. The new constituents will reference the same pools of assets as the ABX.HE.AAA indices.

The launch of the new sub-indices for the existing ABX.HE indices – 06-1, 06-2, 07-1 and 07-2 – will take place in Q208. The first future index to include the ABX.HE.PENAAA will be the ABX.HE 08-1 index, scheduled to launch in July 2008. The ABX.HE 07-2 remains the on-the-run series until the July roll.

European LCDS protocol launched
ISDA has launched the 2008 European Loan CDS (LCDS) Update Protocol. The Protocol is designed to facilitate amendment of transactions documented using the European Loan CDS Standard Terms Supplement and form of Confirmation that were published on 30 July 2007 to reflect the new templates published on 12 March 2008. A Protocol to facilitate cash settlement of European Loan CDS (single-name and index) is currently under development.

The Protocol is open to ISDA members and non-members alike. The adherence period runs until 15 May 2008.

Defaults and restructuring hit CDOs
One company has announced a restructuring proposal and two others have filed for bankruptcy this week, impacting the CDOs in which they are referenced. The news comes as concern increases over market fundamentals and rising default rates (see separate news story).

Residential Capital's restructuring proposal involves exchanging securities at a discount (e.g. between US$80-US$100) for longer-dated obligations. This development may have a greater impact on CSOs and tranched index markets (ResCap is a constituent of Markit CDX.HY 9) than on cashflow CDOs, according to structured credit analysts at JPMorgan. A quick survey undertaken by the analysts on Intex suggests exposure to ResCap in around 30 CDOs – half CLOs and the rest investment grade CSOs or high yield CBOs.

In addition, Linens 'n Things has filed for bankruptcy – an LBO victim joining other retailers to file in recent months (Sharper Image). The analysts found this name in just six CLOs.

And Tropicana Entertainment has become the largest company to file for bankruptcy so far this year, with more than US$1.5bn of long-term debt outstanding. The tally of corporate defaults in 2008 is now estimated to have reached around US$14.8bn.

Accounting standards setters move on disclosure
IASB has released its April update on board decisions on IFRS, which discusses the steps accounting standards boards are taking in response to the credit crisis.

"When there are significant business failures or a loss of confidence in markets, it is appropriate to examine whether improvements can be made to the system in which those businesses operate. Just as securities regulators, banking supervisors and others have been assessing their roles in the crisis, it is appropriate that the boards review the requirements of IFRS and US GAAP," IASB explains.

The report says that FASB is moving to eliminate the concept of a qualifying special purpose entity and amend FIN 46R to place more emphasis on qualitative, and therefore less reliance on quantitative, factors in assessing control. Part of that project, which the FASB expects to complete before the end of this year, is a review of disclosure requirements related to securitisations and off-balance sheet activities.

IASB is giving urgency to several areas where it thinks IFRS financial reporting could be improved – fair value measurement; financial instruments; consolidation and de-recognition; disclosures about off-balance sheet items; and disclosures about fair value measurements. It had already undertaken a significant amount of work on the fair value measurement, consolidation and de-recognition projects prior to the advent of the current crisis, IASB says.

The exposure draft being developed by the consolidations project staff will include any enhancements to IFRS 7, in relation to the disclosure of information about off-balance sheet risks and fair value measurement that the IASB thinks would be helpful. The boards agreed that they should work together to align their disclosure requirements. The boards also agreed to assess whether the IASB's consolidations project could become a joint project.

Chinese CLO launched
China Development Bank has closed its third cash arbitrage CLO – Kai Yuan 2008-1. The US$539m-equivalent transaction is backed by corporate loans and was lead-managed by CICC.

Rated by Lianhe Credit Rating, the deal comprises RMB500m triple-A Class A1 notes, RMB2.7bn triple-A Class A2s, RMB343m single-A Class Bs and an unrated RMB220.2m subordinated piece.

Banking institutions are the biggest buyers of CDB's Kai Yuan CLO programme. But the bank says that it expects, with the continuous launch of such issues, insurance companies will also become important investors – thereby helping insurance companies improve their asset structures, meet the challenges of their international counterparts in terms of operating comprehensive business lines, and securing the Chinese insurance and financial sectors.

Fed expands TAF
The US Federal Reserve has announced that it will expand its TAF facility for banks by 50% to US$75bn after higher borrowing costs have blunted the impact of the four-month old programme. The Fed also increased the swap lines with the ECB from US$20bn to US$50bn and doubled the amount with the SNB to US$12bn, extending their terms through to January.

In addition, the Fed has expanded the collateral that it will accept under the TSLF facility to include other triple-A rated ABS collateral, such as student loans and car loans. As analysts at BNP Paribas note, following the Fed funds rate cut by 25bp and the hint of a pause, the central bank is now focusing on liquidity-boosting measures rather than interest rate cuts.

MCDX parsing service launched
CMA's QuoteVision price discovery service for the credit derivatives market can now parse quotes on the Municipal Bond Credit Index (MCDX). This will enable credit market professionals to act immediately on the latest and best MCDX prices and quickly analyse their exposure to risk, the firms says.

Additionally, CMA is providing independent price verification for the index via its DataVision service, which will supply aggregated end of day quotes for three-, five- and 10-year tenors. This is the first expansion into a new asset class announced by CMA since its recent acquisition by CME Group.

Financial messaging roadmap released
A group of financial market messaging standards organisations has collaborated to create a financial messaging Investment Roadmap. This collaboration – by Financial Products Markup Language/International Swaps and Derivatives Association (FpML/ISDA), FIX Protocol Ltd (FPL), the International Securities Association for Institutional Trade Communication (ISITC) and Society for Worldwide Interbank Financial Telecommunication (SWIFT) – lays the groundwork to establish one common financial messaging standard, ISO 20022, while maintaining the existing independent protocols.

The Roadmap is designed to provide market participants with a consistent and clear direction regarding messaging standards usage by visually mapping the industry standard protocols – FIX, ISO and FpML – to the appropriate business processes across the major asset classes. It also defines an agreed path for future initiatives by identifying gaps as well as areas that may overlap.

Legal protection surveyed
Norton Rose has released a survey which canvasses opinion in four main areas: the causes of the credit crunch, its consequences, market conditions and the future. The report, entitled 'Credit crunch: are you legally protected?', aims to assess the impact of the credit crunch and gauge reaction to associated legal risks.

The results of the survey show that the market is realistic about the credit crunch and is not shying away from radical measures to deal with it, Norton Rose says. Respondents, even though many of them work in the industry themselves, blamed financial institutions, especially in the US, for the credit crunch.

A majority believed that banks made poor business decisions and that they did not have adequate risk management processes in place. Many also said that poor lending regulations in the US contributed to the crisis.

One of the major consequences of the crisis will be, according to the vast majority, a rise in litigation. This is already starting to happen, principally because investors failed to understand the true nature of the complex transactions in which they were involved, and partly because of a commercial need to re-coup losses (as highlighted in SCI issue 85).

There would also be a significant need for debt restructuring in the financial services sector. A further consequence of the crisis, in the view of a large minority, is likely to be a shift in the way bankers are remunerated, away from short term bonuses and towards long term incentives.

Respondents were alive to the fresh opportunities presented by the market conditions following the crunch. Many believed that the BRIC countries (Brazil, Russia, China and India) were in the process of decoupling from the West, and emerging markets in general were seen as one of the most attractive asset classes in which to invest. Attitudes to sovereign wealth funds (SWF) varied, but significant numbers said their boards would be willing to consider offers from them, and a majority said that they would not rule out an offer from a SWF simply because of the country of its origin.

Respondents believed, however, that the market would not stabilise for some time to come. Nearly half said the credit markets would take over 11 months to settle down.

The survey revealed that many in the market were reconciled to some tough regulatory measures to resolve or alleviate the effects of the crisis. Over half agreed that lead regulators and central banks should be given more powers to intervene in the management of financial institutions.

Norton Rose surveyed 112 respondents (comprised of financial institutions and other mainstream corporate entities) during February and March 2008. The survey was conducted online and respondents were given the option to remain anonymous.

CRE CDO delinquencies decrease
A lack of repurchased loans during the month contributed to a slightly lower US commercial real estate loan (CREL) CDO delinquency rate for April 2008 of 0.69%, down from last month's rate of 0.74%, according to the latest CREL CDO Delinquency Index from Fitch Ratings. The delinquency index includes loans that are 60 days or longer delinquent, matured balloon loans and repurchased assets.

Fitch notes 25 reported loan extensions in April 2008, which is down from last month's total of 32. The majority of the extensions were again a result of options contemplated at closing.

However, approximately 40% of these extensions were modifications from the original loan documents. These loan extensions, which are typically between one to six months, continue to reflect the lower available liquidity for CRE loans, especially those typically found in CREL CDOs – which tend to be backed by transitional and/or highly leveraged CRE collateral.

Although the overall delinquency rate for CREL CDOs remains low, it is more than two times the US CMBS March loan delinquency rate of 0.33% reported in April 2008. The CREL CDO Delinquency Index is anticipated to be more volatile than the CMBS delinquency index, given the smaller universe of loans and the more transitional nature of the collateral. The Fitch CREL CDO Delinquency Index tracks approximately 1,100 loans and 330 rated securities/assets (US$23.8bn in 35 CREL CDOs), while the Fitch CMBS delinquency index covers approximately 42,000 loans (US$562bn in nearly 500 CMBS transactions).

The April 2008 delinquency index encompasses 11 loans and includes six loans that are 60 days or more delinquent and five matured balloons. No rated assets were delinquent this month. Of the loans that are 60 days or more delinquent, two loans are in foreclosure (0.08%).

Of note is one new matured balloon that previously appeared in the index in February 2008 just prior to a two-month extension. Further, two matured balloon mezzanine loans (0.21%), which are included in the index this month, were re-structured and extended during the month. These now current loans are secured by interests in the same New York City office portfolio.

There were no repurchased loans in April 2008. Given the illiquidity in the market and tighter credit conditions for issuers, Fitch continues to predict few repurchases of troubled loans and more workouts within the trust.

Although not included in the delinquency index, 11 loans representing 0.36% of the CREL CDO collateral were 30 days or less delinquent in April 2008. This statistic is lower than last month's total of 0.47%. Three of these loans were brought current after the cut-off date for this report; the other loans suggest that overall delinquencies may be higher next month.

While no rated collateral was reported delinquent this month, 12 rated assets were considered credit impaired. These assets are mostly sub-prime RMBS assets and serve as collateral for two CREL CDOs. The impaired assets are equivalent to 0.38% of all CREL CDO assets, but 7.2% and 2.8% of their respective CREL CDOs; the two most junior rated tranches from one of these CREL CDOs are on rating watch negative due to the sub-prime exposure.

CS

Trading ideas: MFCI high yield basket III

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at a long/short trade on a basket of high yield names

As spreads continue to exhibit strong directional momentum that goes against our intuition, we like to put on beta-neutral trades rather than take outright bets. This trade is a high yield basket trade taken directly from our MFCI model. The model takes into account both fundamental and market-implied factors and calculates an expected spread level for all issuers based on a peer-to-peer comparison.

Since this is a pure relative value model, it makes sense to use it to generate long/short basket trades. These trades should reduce the P&L swings to idiosyncratic and sector risk rather than overall market risk.

This basket favours the basic materials sector and takes short positions in the consumer cyclical sector, with an embedded capital goods pairs trade. Unlike previous basket trades, this basket generates substantial positive carry. Though we know that nothing comes for free, we believe this will be a major driver of the basket's return.

The process and the basket
This basket was generated by restricting the selection pool to the high yield market. The second cut was made by picking credits with either very positive (for the longs) or negative (for the shorts) MFCI scores. Intentionally, we did not tilt the longs and shorts with any sector bias for this basket.

With our decision process in place, we finalised the basket of longs and shorts after digging into all the factors and Gimme Credit's outlook for each of the potential credits. Exhibit 1 lists the issuers for the trade along with their MFCI scores. The basket has a long exposure to the basic materials sector and a short exposure to the consumer cyclical sector, with an additional capital goods pairs trade.

Exhibit 1

On the long side of the fence, Nova Chemicals was our top pick. Nova has long been a favourite long of ours, as we have had it in a pairs trade against Chemtura since last December.

Now that the pairs trade has produced great results and Chemtura is close to fair value, we would like to keep the long position of Nova going and this high yield basket presented an excellent opportunity. Nova has excellent market and fundamental factors.

Another Chemicals issuer making it into the basket is PolyOne. With solid implied vol, FCF and accrual ranks, PolyOne has an expected spread almost half of its current 515bp mid CDS spread.

United Rentals is the long credit for the Capital Goods pairs trade that is held within the basket. United Rentals' fundamental ranks are extremely impressive. Its sales margin factor has a rank of nine and its interest coverage factor (one of the most powerful MFCI factors) has a rank of ten.

Case New Holland's tight spread (less than 200bp) relative to the rest of the credits helps create significant positive carry for this basket, as well as taking the other side of the capital goods pair. The MFCI model gives Case New Holland an expected spread of almost 400bp due to its high implied vol and weak fundamentals.

Its accruals factor, which measures potential earnings manipulation, falls into the absolute worst bucket – making its relatively high EBIT/sales factor suspect. We think this issuer has significant downside potential.

ArvinMeritor is an issuer we have loved to hate this year, as it ended up in our first high yield basket. Luckily, we traded out of the original basket before ArvinMeritor began its recent rally and we think now is a great time to re-enter the position at a much tighter spread than before.

To round out the short basket, we have put in another consumer cyclical short exposure – Jones Apparel Group. Though the MFCI does not rank this as one of the best shorts, we think its weak interest coverage and market-implied factors signal room for widening, especially when combined with Gimme Credit's negative outlook. All MFCI factor ranks are shown in Exhibit 2.

Exhibit 2

Long issuers                   Positive model factors
Nova Chemicals             Implied vol, EBIT/sales, debt/EBITDA, accruals
PolyOne                            Implied vol, FCF, accruals
United Rentals                EBIT/sales, debt/EBITDA, FCF, int coverage, accruals

Short issuers                  Negative model factors
Case New Holland         Implied vol, FCF, int coverage, accruals
ArvinMeritor                      All factors (except EBIT/sales and accruals)
Jones Apparel Group     BDP, imp vol, debt/EBITDA, int coverage

With equal weighting across all names, both longs and shorts, the overall basket creates a significant amount of positive carry. In recent baskets we have used unequal notional weightings to offset any sizeable carry (which have usually been to the negative side). For this trade we are going to try something new: leave the weighting the same and allow the basket to collect all the carry.

Now we all know that nothing comes for free in life and this is certainly no exception. In return for the positive carry, we are taking long positions in three 'riskier' credits than the hedges on the short side (if we use CDS as an approximation for risk). However, Exhibit 3 shows that the two baskets track each other fairly well in both up and down markets, and the MFCI model is forecasting eventual convergence of the two sides of the basket.

Exhibit 3

MFCI economic intuition
The MFCI model, through use of a peer-to-peer comparison, quantifies how much spread investors should require to be exposed to the credit risk of a given company. We use the following factors to quantify an issuer's fundamental risk level: earnings, debt-to-earnings ratio, accruals, free cashflow level and interest coverage.

We also use market-based factors to incorporate forward-looking risk estimation; BDP (Barra Default Probability) and equity-implied volatility. The BDP is backed out from a Merton-style hybrid structural model that uses equity, credit and balance sheet data.

Use of model
We believe this model provides a quick way to scan a large universe to find credits that are trading out of line relative to one another. We recommend using our top long and short lists as a first stop for idea generation or as a tool for confirming trading ideas that have a more pure fundamental rationale.

The MFCI score can be used for both intra-sector pairs trades and outrights. Exhibit 3 tracks the previous performance of our basket and clearly the longs have underperformed the shorts into the current sell off.

Risk analysis
Due to the quantitative nature of the MFCI model, there are a few pitfalls to using the model and we would never recommend anyone to blindly execute trades from it. One potential risk to the model is that it under-weights the notion of event risk (other than inherent in the market-based factors). A potential levered event could actually cause the model to issue a long (sell protection) signal.

Also, the model is a relative value tool and therefore extremely dependent on the data and current spread levels of peers. We have tried to take this into account by having strict data requirements and manually screening the data. We highly recommend any trading ideas be judged both quantitatively and fundamentally before execution.

Entering and exiting any trade in these maturities carries execution risk, and this is a concern with these credits in these maturities as they are high yield names with large bid/ask spreads.

Liquidity
Liquidity – i.e. the ability to transact effectively across the bid-offer spread in the CDS market – 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 all of these credits and the bid-offer spread costs. The high yield market carries with it large bid/ask spreads which are of concern to us.

Fundamentals
While our MFCI model has fundamental inputs, we recognise that relying solely on model output can be hazardous. Therefore, we also screen all names using the fundamental reports from Gimme Credit.

Each credit's outlook is as follows:

ArvinMeritor (analyst – Shelly Lombard) Credit Score: -1 (Deteriorating)
Every commercial truck supplier faces the risk that the 2007 downturn will be exacerbated by a slow economy. But ArvinMeritor also has turnaround and operational risk. The company is trying to boost its weak light vehicle margins and correct operational issues that have kept it from benefiting from booming commercial vehicle demand in Europe. In its favour, ArvinMeritor has solid liquidity and attractive customer and geographic diversity. But we don't expect to see much near-term trading upside on the bonds until the commercial truck market rebounds and unless ArvinMeritor is able to fix its operations to take full advantage of that recovery.

Case New Holland – no recent comment

Jones Apparel Group (analyst – Carol Levenson) Credit Score: -1 (Deteriorating)
A faddish business, consolidation among (and price pressure from) its major customers, and steady margin erosion, as well as an ambitious capital plan, call for more financial conservatism than JNY has evidenced. Management has officially taken the company off the market for now and has not announced any aggressive shareholder enhancement plans for the moment. The threat remains, particularly if the stock price languishes, and coupled with weakening fundamentals buttresses our belief in our 'deteriorating' credit score.

Nova Chemicals Corp. (analyst – Carl Blake) Credit Score: 0 (Stable)
We believe EBITDA could remain at current levels in 2007 as cost savings from last June's restructuring and the elimination of losses at STYRENIX offset some ethylene and polyethylene margin compression as world-wide economic growth moderates. We look for leverage and coverage to show improvement over the next 12 to 18 months from moderate debt reductions. A cloud of uncertainly will linger over Nova Chemicals until the company separates its underperforming STYRENIX business from its core Olefins/Polyolefins and Performance Styrenics segments.

PolyOne Corp. (analyst – Carl Blake) Credit Score: +1 (Improving)
The global provider of specialised polymer materials is making progress with its plans for improving profitability through a combination of a mix shift toward more specialty materials, volume growth and manufacturing cost reductions. While the company is also focused on controlling overhead, these costs will be under pressure for the next few quarters from spending to support growth initiatives. We believe PolyOne will use free cashflow to nibble away at the remaining US$241m of outstanding 10.625% senior notes until the May call date, and then refinance the issue with a combination of bank debt and availability under its receivables securitisation facility.

United Rentals – no recent comment

Summary and trade recommendation
As spreads continue to exhibit strong directional momentum that goes against our intuition, we like to put on beta-neutral trades rather than take outright bets. This trade is a high yield basket trade taken directly from our MFCI model. The model takes into account both fundamental and market-implied factors and calculates an expected spread level for all issuers based on a peer-to-peer comparison.

Since this is a pure relative value model, it makes sense to use it to generate long-short basket trades. These trades should reduce the P&L swings to idiosyncratic and sector risk rather than overall market risk.

This basket favours the basic materials sector and takes short positions in the consumer cyclical sector, with an embedded capital goods pairs trade. Unlike previous pairs trades, this basket generates substantial positive carry. Though we know that nothing comes for free, we believe this will be a major driver of the basket's return.

Buy US$10m notional Case New Holland 5 Year CDS protection at 177bp.
Buy US$10m notional ArvinMeritor Inc. 5 Year CDS protection at 537bp.
Buy US$10m notional Jones Apparel Group Inc. 5 Year CDS protection at 277bp.

Sell US$10m notional United Rentals NA Inc. 5 Year CDS protection at 590bp.
Sell US$10m notional PolyOne Corp. 5 Year CDS protection at 465bp.
Sell US$10m notional Nova Chemicals Corp. 5 Year CDS protection at 475bp to receive 539bp 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).