Contents

Pre-placement activity

CDPCs bring some liquidity to the market

"Channel has been active in accumulating risk within the super-senior global corporate risk space during March and April," confirms Walter Gontarek, chief executive of Channel Capital Advisors. Notable activity includes portfolio CDS transactions in three-year, five-year and seven-year maturities in US dollars and euros on both bespoke and index tranches.

One area that Channel wants to focus on further is participating in what it hopes to see as a growing interest in high quality, managed CSOs with leading investment managers. "Arrangers are selectively open for business in this product space, but want to place the full capital structure rather than take correlation risk associated with retaining the super-senior corporate tranche. Operating companies like Channel or its competitors are playing an important role in facilitating full capital structure execution in this risk-adverse environment. We hope to play a constructive part in the eventual re-opening of the credit market for portfolio transactions," Gontarek adds.

According to Eugene Yeboah, head of credit structuring & strategies at Schroders, risk in the synthetic sector is being driven by two factors - actual credit risk and uncertainty among investors. "Uncertainty is currently dominating the market, causing huge volatility, so anyone with insight into fundamentals can capitalise on the situation. Value in super seniors is higher than two years ago, with there being an imbalance between the supply and demand of tranched risk. The market is therefore paying up the uncertainty and causing huge dislocation at the moment," he notes.

But, while CDPCs are capitalising on the value that currently exists in the super-senior space, there is awareness that they have an important role to play in the market. CDPCs are necessary for liquidity to return across the capital structure, says Yeboah.

Douglas Long, evp - business strategy at Principia Partners, agrees that CDPCs are helping bring back some stability to and confidence in the structured credit market by taking super-senior risk off banks' balance sheets. "More market constituents are looking to become capital efficient and hedge their exposure to mark-to-market volatility, due to constraints on their balance sheets - and CDPCs are an effective way of achieving this," he observes.

However, CDPCs still face a challenge in terms of ensuring that the market understands their business model. A 'Catch-22' exists in that they need a rating to engender confidence from banks, while investors need confidence in that rating. Consequently, some CDPCs are providing high levels of transparency in portfolio reporting in order to re-enforce their counterparty credit worthiness and their triple-A credit rating.

"Transparent portfolio reporting is important to Channel vis-à-vis its counterparties and investors," says Gontarek. "Our investors receive full disclosure of not only key portfolio metrics but also disclosure of portfolio obligors, so that they can drill down and aggregate risk exposures, if needed. This is something we decided to do on our placement of our 30-year term debt exercise last July and have not looked back."

Some CDPCs are also understood to be pushing the rating agencies to be more transparent about the models and assumptions - both qualitative and quantitative - they use to rate CDPCs.

There are a number of new CDPCs in the pipeline (Moody's latest estimates are 10-15), but only a few have gone live so far, as the barriers to entry are high. The issues are securing funding and extending counterparty lines. Most focus on single names and super-senior tranches in the corporate space - although some could extend their mandates to offer ABS CDS protection if demand and liquidity return.

CS

At a crossroads

Idiosyncratic risk to spur iTraxx trading?

Correlation appears to have reached a crossroads in Europe. Traders report that the market is waiting for the re-emergence of idiosyncratic risk to spur increased activity on the iTraxx Main index.

"Correlation has already decreased significantly from around 55% to 38%, yet it is expected to tighten further once negative issuer-specific news begins to hit the market. Everyone's waiting for the opportunity to buy equity protection because correlation is still high at the bottom of the capital structure, but there needs to be a default for the equity tranche to benefit," explains Julien Turc, head of quantitative strategy at SG.

However, investors need to be careful about the timing of this trade. Buying equity protection too early could prove expensive due to negative carry and cost of roll-down.

So far during the credit crisis, equity tranche trading has been dominated by hedge funds taking on positive gamma positions. This strategy has worked well because, while it involves exposure to jump-to-default risk, the positive convexity of the position has resulted in significant mark-to-market gains.

For as long as the news flow remains quiet, there are two alternative trades to equity, according to Turc. The first is attaching at the mezzanine part of the capital structure: when idiosyncratic risk emerges, the trade will benefit from risk moving into the bottom of the capital structure.

"We'd recommend selling protection on the 6%-9% or 9%-12% tranches to take advantage of being long jump-to-default risk," he says. "The position makes sense at this point in the crisis: mezz tranches are unlikely to be hit by defaults, yet there is significant value at this level."

The other alternative to equity tranche trading has largely been adopted by bank portfolio managers – taking outright positions in super seniors. But there appears to be a psychological barrier of 30bp on the iTraxx 10-year at this level: when the index trades wider than 30bp, banks sell protection; when spreads tighten below 30bp, they will macro-hedge the position.

"If spreads begin tightening, it is an indication that systemic risk is decreasing – everyone expects the crisis to become issuer-specific at some point soon. Super seniors make sense in such a scenario, but not many can play at this level because they've already been burnt by mark-to-market volatility," notes Turc.

Meanwhile, another sector that could see increased trading activity as a result of rising default risk is the iTraxx Crossover index. There had been doubts about how representative the index is of market flows, given its stability over the last nine months. For example, before the crisis the bid/offer spread on Crossover positions was 7bp-8bp and now it is around 2bp-3bp.

"High yield bond issuance has declined recently and it seems that if players want to take a fundamental view on the sector, they're doing it through single names rather than via the Crossover index. But the index could see more trading activity once the crisis turns issuer-specific and defaults start to hit. Until now the crisis has been about de-leveraging, not about corporate credit quality – and the products most affected by this were based on the iTraxx index," Turc concludes.

CS

Questions, questions

Uncertainty grows over how other agencies will approach CSOs

The structured credit market has, on the whole, welcomed Fitch's refinement of its corporate CDO methodology. However, as the agency begins its review of the sector, questions are inevitably being asked about what Moody's and S&P's next steps will be.

Schroders' head of credit structuring & strategies Eugene Yeboah argues that, in order to reduce some of the uncertainty still felt by the market, Moody's and S&P also need to clarify their stance on CSOs. "We welcome the steps being taken to implement new standards that are clear," he says.

But, he adds: "We would caution that rating agencies historically become quite strict after negative investment events, given the corporate downgrades of early 2003 when leverage fundamentals were actually beginning to recover. So, while many industry areas need to change after the excessive leverage of 2005-2007, we urge agencies to take a measured and long-term cyclical view."

Fitch's rating review will cover 501 tranches (411 European and 90 US, 430 synthetic and 71 cash) and is expected to last 4-6 weeks, with the intention of resolving watch negative placements by the end of the summer (see Round-up for more). In terms of impact, the CDO tranches of concentrated (by sector, industry and/or obligor) and adversely selected portfolios that are the most vulnerable to downgrade.

Indicatively, for the 183 triple-A rated tranches of the European synthetic collateral, 54% is expected to be affirmed, 13% downgraded to double-A and 33% downgraded to A/BBB. When split by less and more than 30% industry concentration (147 and 36 deals respectively), the vulnerability of concentrated portfolios becomes apparent. Namely, the above percentage figures become 67.5% (affirmed), 13.5% (to double-A) and 19% (to A/BBB) for non-concentrated pools, but 0%, 11% and 89% respectively for concentrated pools.

In terms of tenor, deals with less than 12 months left to maturity aren't expected to be affected by the change in methodology. 53% of triple-A rated notes with up to three years still to run are expected to be affirmed, while for those with more than three years left this figure will likely be 27%.

Yeboah notes that, while Fitch's new methodology is not as bad as feared, year-on-year it still equals downgrades. "From a modelling perspective, Fitch has done a good job," he says. "I have been critical of the rating agencies for a long time because the risks in structured credit product were not being properly captured. They are three-dimensional risk profile products – credit risk, spread risk and correlation risk – and Fitch has captured these risks well. However, the impact on existing deals could be brutal."

Gregorios Venizelos, structured credit strategist at RBS, estimates the size of a potential 'forced unwind' at US$14bn. However, he points out that a number of factors will affect the final outcome.

Among the positive factors is that the impact study Fitch draws its conclusions from is based on model output only and does not include the subjective element in the process (namely the views of the oversight committee). In addition, remedial action by CDO managers – particularly for non-concentrated portfolios – may be successful in averting downgrades.

But among the negative factors affecting the impact of Fitch's new methodology is that US deals may be of worse quality in terms of underlying portfolio – due to obligor concentration, for example. Indeed, most tranches of concentrated portfolios may be seen as a lost cause in terms of being restructured out of trouble by the manager.

"Taking all these factors into account, the most tempting approximation is to say that all triple-A and double-A rated tranches of concentrated portfolios will be unwound – namely, 60 out of the 319 tranches shown in the Fitch impact study (or 19%). For a US$75bn of Fitch-rated tranche notional, this would translate to US$14bn of unwinds – not a meagre figure but neither too big to absorb (market conditions permitting)," observes Venizelos.

Fitch says the aim of its new methodology is for corporate CDO ratings to perform consistently with those of other asset classes. To achieve this, it was necessary for the final model output to express a fundamental view of credit risk; capture evolving risks; and for the model limitations to be identifiable.

"To calibrate the correlation framework, we've sought to ensure that the model output results in single-A rated notes being protected against historical peak default rates. We assume a base correlation of 2% between any two assets, a further 2% if those assets are in the same country and a further 20% if they are in the same industry," explains Ken Gill, md in structured credit at Fitch.

Most CDO models divide industry concentration into two categories, resulting in inter- and intra-industry correlation assumptions. Fitch's revised methodology allows an intermediate sector level to be captured (TMT, industrials, retail leisure and consumer, energy and financials).

It isn't unusual to see 30% concentration for one industry (typically financials) in a portfolio, so the agency sought to isolate the additional protection the correlation structure provides to such a concentration. "What we saw is that for a 10-year triple-B portfolio, the model called for triple-A protection against a portfolio default rate of 15.3% in the case of a diverse portfolio, rising to 20.7% in the case of a 30% industry concentrated portfolio. In terms of obligor concentration, a 50% correlation uplift is applied to the five largest risk contributors and their recovery rate is reduced by 25%," concludes Gill.

CS

Mitsubishi buys into Aladdin

The latest company and people moves

Mitsubishi buys into Aladdin
Mitsubishi Corporation has agreed to purchase 19.5% of structured credit hedge fund Aladdin Capital Holdings. Under the terms of the arrangement, Mitsubishi will become the second largest shareholder of Aladdin Capital Holdings by investing US$39m.

At the same time, Mitsubishi will commit US$300m to a new fund of funds (FOF), which will be jointly established with Aladdin. The FOF will invest in funds managed by Aladdin and is expected to be established by late-May/early-June.

Mitsubishi says it will also provide marketing engines for Aladdin's investment products through the sales force of Mitsubishi Corporation Capital (Tokyo).

L&G IM hires Tamet
Legal & General Investment Management has appointed Christophe Tamet as head of credit, reporting to Roger Bartley, head of active fixed income. Tamet was previously with JPMorgan Chase Bank, where he was head of credit in the chief investment office. His experience covers corporate, ABS and structured credit markets, together with credit indices, tranches and options.

Stevens joins BGI
Chip Stevens has joined Barclays Global Investors (BGI) as md and head of active trading for US Fixed Income. In this newly created position, Stevens will be responsible for overseeing Fixed Income Trading in the US and managing and developing the firm's US broker/dealer trading relationships.

Most recently, Stevens was co-head of high yield trading at Deutsche Bank, where he focused on integrating the cash and credit derivatives trading businesses. Earlier in his career, he managed Merrill Lynch's high grade CDS trading desk in London and launched credit derivatives trading at Citibank.

Le Goff switches
Yves Le Goff has left Credit Suisse, where he was director, fixed income focusing on illiquid risks, and joined Goldman Sachs in a similar role.

SPM gets Smart
Structured Portfolio Management (SPM) has hired Charles Smart as svp of trading and portfolio management. He will focus on developing mortgage-backed securities derivative analytics, as well as conducting prepayment risk and credit modelling.

"As opportunities in the mortgage-backed securities space grow, Charles' understanding of the market will be extremely beneficial to SPM," comments Don Brownstein, SPM's ceo. "We don't see any immediate end to volatility in the housing market, so our ability to model and trade around data becomes of huge importance. Charles will help us to seize opportunities and further benefit from our investments."

Smart most recently spent five years as a director at Deutsche Bank Securities, where he traded agency and non-agency MBS derivatives, including IO/POs and inverses. In addition, he helped develop MBS models and risk analytics tools for the investment bank.

S&P appoints execs
S&P has announced a number of key executive appointments in the areas of risk oversight, criteria management and quality assurance. Clifford Griep has been named executive md ratings risk management; Mark Adelson is joining S&P as md, chief credit officer; and Neri Bukspan is becoming md, chief quality officer. All three will report to Vickie Tillman, evp, S&P Ratings Services.

In his new role, Griep will identify, assess and mitigate potential internal and external risk exposures in S&P's ratings business. Previously, he served as S&P's chief credit and quality officer.

Adelson joins S&P from Adelson & Jacob Consulting, a firm that provides strategic consultation on securitisation, real estate and investments. As S&P's chief credit officer, he will be responsible for leading criteria definition and governance, and for ensuring the independence, increased rigour and standardisation of criteria setting.

Assuming the role of chief quality officer, S&P chief accountant Neri Bukspan will now be responsible for the independent oversight of the quality and performance of S&P's ratings processes.

Fitch Solutions acquires stake in SF analytics provider
Fitch Solutions has acquired an equity stake in Portsmouth Financial Systems.

Portsmouth Financial Systems has developed a cutting-edge software platform that supports the modelling and analysis of structured finance transactions, with products ranging from collateral-level analytics to cash flow modelling tools. The platform has been beta-tested with a number of investment banks, asset managers and hedge funds over the last several months. Production versions will be launched within the next few months and will be distributed via Fitch Solutions.

Fitch Group launched Fitch Solutions in January of this year to provide further separation of Fitch's analytical activities from its commercial activities and to provide a focused platform for the accelerated development of fixed income data and analytics solutions.

MP

Moody's adds SF rating enhancements ...

A round up of this week's structured credit news

Moody's adds SF rating enhancements ...
Moody's is introducing two supplemental measures to its structured finance ratings to enhance transparency and information content. The first, the Assumption Volatility Score, will assess potential rating volatility based on the uncertainty of rating model assumptions. The second, Loss Sensitivity, will capture a rating's sensitivity to a change in the expected loss rate on the collateral pool backing the security.

The new measures were developed from responses to a call for comment issued in February – 'Should Moody's Consider Differentiating Structured Finance and Corporate Ratings?' – as well as from additional market discussions.

In their responses, market participants overwhelmingly rejected the idea of a separate rating scale for structured finance securities. However, they also called for more information from Moody's on key components of structured finance risk. These included the degree of certainty in the assumptions behind a structured finance rating and the sensitivity of a rating to losses in the underlying loan pools.

Moody's expects to introduce the measures gradually at the end of the current quarter, using them first on some new securitisations of vehicle-backed assets. Only new issuance will receive the measures. Moody's also remains receptive to market comments on them.

The Assumption Volatility Score, or V score, will rank transactions on a one-to-five scale by the potential for significant changes owing to uncertainty around the assumptions and the modelling that underlie the ratings. A single V score will apply across tranches to an entire transaction. The V score will be the composite score on factors including historical performance, data adequacy, the complexity and market value sensitivity of a transaction, and governance.

Loss Sensitivities will measure the number of rating notches Moody's would expect a security to be downgraded, should the expected loss rate on its underlying collateral pool increase to a highly stressed level. Specifically, the measure looks at the change in ratings that would follow the expected loss rate on the transaction's underlying collateral pool increasing to, for example, a 95% loss level stress – that is to a level expected to have a one-in-twenty chance of occurring.

... while Fitch updates on ratings initiatives
Fitch has released a comprehensive update on the range of its numerous initiatives designed to enhance the quality and transparency of its credit ratings and to restore confidence and credibility among market participants.

"As the turmoil in the global credit markets has developed over the last year, Fitch has focused primarily on ensuring the quality and appropriateness of its credit analytics," says Fitch president and ceo Stephen Joynt. "Some of the initiatives Fitch has undertaken in recent months include extensive rating reviews, updates to methodologies and models, deterministic stress analyses and publishing timely and relevant research."

The agency has also been making appropriate changes to policies, procedures and organization, and continues to engage in active and constructive dialogue with policy makers, regulators and other market participants (both individually and in conjunction with the other credit rating agencies) on various proposed modifications to the spectrum of regulatory frameworks. Going forward, Fitch will continue to update the market on its measures and on the progress of its commitments.

Second-lien performance threatens monolines
The Aaa financial guarantor rating of both Ambac and MBIA could be under threat due to persistent poor performance and the continued downward rating migration among 2005-2007 vintage second-lien mortgage risk securities to which the monolines are exposed, says Moody's.

According to the rating agency, incurred losses within both firms' direct RMBS and ABS CDO portfolios are now meaningfully higher than the rating agency's prior expected-case loss estimates, elevating existing concerns about capitalisation levels relative to the Aaa benchmark.

In recent announcements of first-quarter 2008 earnings, MBIA and Ambac both reported material credit impairment losses on ABS CDOs and loss reserve charges on direct RMBS exposures, including second-lien securitisations.
Moody's report, 'US Subprime Second Lien RMBS Rating Actions Update', notes that based on losses to date, the level of serious delinquency and the remaining unpaid pool balances on rated second-lien transactions, the rating agency has increased its loss projections on loan pools backing sub-prime second-lien RMBS.

Moody's now expects 2005 vintage sub-prime second-lien pools to lose 17% on average, 2006 vintage pools to lose 42% on average and 2007 pools to lose 45% on average. However, Moody's says expectations on individual transactions can vary significantly around these average loss estimates, based on the quarter of origination and deal- and issuer-specific characteristics – with the worst performing deals issued in 2006/2007 now expected to lose more than 60% of their original pool balance.

Fitch begins negative watch placements
Fitch has begun its review of the corporate CDO sector (see also separate news story) by assigning rating watch negative (RWN) status to 58 classes of CSOs, with a tranche notional of around US$1.25bn. The affected transactions suffer from high portfolio concentrations of over 25% in financials and broader portfolio deterioration, as evident in negative rating migration and an increase in the proportion of credits under RWN and outlook negative.

Given the credit quality of the underlying portfolios, the subordination of the affected tranches is not adequate to maintain their current ratings. Indicatively, these RWN assignments could result in downgrades of up to nine notches.

At the same time, Fitch affirmed 32 classes of CSOs of a total tranche notional of US$479m.

Most sub-prime write-downs have been disclosed
Most sub-prime related bank losses are already disclosed, according to Fitch. A new report from the agency says that global banks have already written down more than 80% of their losses from sub-prime mortgage assets and estimates total market losses from sub-prime mortgage assets at between US$400bn and US$550bn, depending on the method of calculation used.

"Sub-prime mortgage-related losses for the total market vary considerably, depending on the methodology used," says Krishnan Ramadurai, md in Fitch's financial institutions group. "Given the problems associated with methods of calculation based on ABX and TABX indices, we believe that Fitch's internal loss estimate of US$400bn is a more appropriate reflection of losses – though they are also sensitive to assumptions made on underlying loss rates."

"To the extent that institutions have effectively hedged their exposures with financially sound counterparties, these loss figures may be over-estimated," says Gerry Rawcliffe, md and group credit officer for Fitch's financial institutions group. "Nevertheless, for those institutions that did not hedge a sufficient portion of their super-senior exposures, mark-to-market losses on these residual exposures have been so large that their capital ratios have come under acute stress."

Approximately 50% of the losses, US$200bn-US$275bn, are held by banks, with the remainder held by financial guarantors, insurance companies, asset managers and hedge funds. As of May 2008, Fitch estimates disclosed losses by banks on sub-prime RMBS or ABS CDOs to be US$165bn or 83% of the banks' portion of the losses.

Negative outlook for Spanish SME CLOs
Fitch has assigned negative rating outlooks to four classes of Spanish SME CLOs: the Class C notes of BBVA-6 FTPYME, FTPYME Bancaja 6 FTPYME and PYME BANCAJA 5, and the Class Ds of Bancaja 4. The negative rating outlooks are driven by a combination of declining performance trends, as well as the worsening Spanish macro-economic environment.

These negative outlooks impact approximately 7% of the 54 outstanding Fitch-rated Spanish SME CLO transactions and approximately 2% of the 256 outstanding tranches. All affected classes are rated in the triple-B category or lower. Some of these transactions are from relatively recent vintages that have not benefited from de-leveraging to the same degree as older vintage transactions.

In a special report, Fitch discusses why it is taking a negative view on selected tranches over the next 12-24 months. The report highlights macro-economic trends and concerns specific to Spanish SME CLOs, which, Fitch believes, places these notes at increased risk for downgrade over the long term.

The agency also discusses the methodology involved in assigning these negative outlooks. They reflect concerns regarding current credit enhancement levels in the light of increasing arrears.

These notes could be under increased stress should arrears continue to increase. High recoveries and transaction-specific structural features may partially mitigate this increased risk.

ABS CDOs hit
S&P has placed on credit watch with negative implications its ratings on 24 classes in nine cashflow ABS CDO transactions. At the same time, 36 tranches in seven transactions remain on watch negative.

The credit watch placements reflect deterioration in the credit quality of the underlying portfolios and the expected increase in scenario default rates (SDRs). The deterioration in credit quality and SDR increase is due to their exposure to US ABS CDOs and RMBS that have recently been downgraded or placed on credit watch.

In addition to this expected increase in SDRs, the credit watch placements reflect an anticipated decrease in the breakeven default rates (BDRs) for the underlying portfolios when subject to S&P's cashflow analysis. The potential decrease in the BDRs is a result of the revision to the agency's recovery assumptions for certain CDOs.

S&P also continues to monitor the performance of those European ABS CDOs currently on credit watch with negative implications. It will perform further analysis on these transactions by analyzing any changes in their scenario default rates as a result of rating actions taken on assets in the underlying portfolios, and comparing them to any changes in breakeven default rates.

AIG downgrade impacts CDOs
Concurrent with the related rating announcement on American International Group (AIG) and its main subsidiaries on 8 May 2008, Fitch has placed seven CDO classes on rating watch negative. The affected notes are those rated F1+ from the G-Star 2002-1, G-Star 2002-2, Lakeside CDO I, Putnam Structured Product CDO 2001-1 and TIAA Real Estate CDO 2003-1 transactions.

The short-term rating on these classes is supported by a put agreement provided by AIG Financial Products (AIG FP). AIG FP's obligations under these agreements are guaranteed by AIG. AIG's long-term issuer default rating (IDR) was downgraded to double-A minus from double-A on and remains on RWN. AIG's short-term IDR was also placed on RWN on 8 May.

Whistlejacket ratings withdrawn
S&P has withdrawn all outstanding ratings on Whistlejacket at the request of the receiver. Whistlejacket is the SIV formed by the merger of Whistlejacket Capital with White Pine and is currently in receivership, with Deloitte & Touche acting as the receiver.

The ratings were previously lowered to single-D on 22 February 2008. This was due to that fact that following the receiver's earlier indication that maturity liabilities would not be paid, the grace period expired without the liabilities being paid. Prior to this, Whistlejacket had breached its 50% net asset value test, causing a mandatory acceleration event to occur and the SIV to enter the enforcement mode of operation.

No rating implication from earnings for Assured ...
Moody's says that Assured Guaranty's first-quarter earnings release held no rating implications for its main financial guaranty insurance operating companies. The insurance financial strength ratings of Assured Guaranty Corp (AGC) and Assured Guaranty Re Ltd (AG Re) remain at Aaa and Aa2 respectively. The rating outlooks are stable.

Assured realised a 1Q08 net loss of US$169.2m, primarily due to a US$181.4m after-tax mark-to-market loss on credit derivatives stemming mostly from pooled corporate exposures and CMBS transactions. More notably, Assured reported US$52.9m in loss reserve charges on US RMBS exposures during the quarter, primarily relating to two Countrywide HELOC transactions.

Moody's noted that Assured's total loss reserves and credit impairment charges for US RMBS securities, which stood at US$92.1m as of 31 March, are below the rating agency's prior expected-case loss estimate and the stress-case losses used to evaluate the company's capital adequacy. Assured's exposure to ABS CDOs remains modest relative to most other financial guarantors.

In addition to its mortgage-related exposures, Assured added to its closely monitored credit list two structured life insurance transactions with investment exposure to sub-prime mortgages. Assured also has US$540m in exposure to bonds issued by Jefferson County Alabama Sewer System, which is currently experiencing financial stress. Assured does not currently expect to experience ultimate losses on any of these transactions.

The competitive position of AGC has improved in recent quarters, given the downturn in business volume experienced by those guarantors with large mortgage and mortgage-related ABS CDO exposures. The present value of insurance and credit derivative gross premiums written (PVP) by AGC during the quarter totaled US$255m, representing an increase of 205% from a year ago. This increase was reflective of both significantly greater transaction volume and higher premium rates.

Assured's investment income rose by 16% as invested assets grew as a result of the company's raising US$304m through a common stock issuance in December 2007, coupled with sizable upfront premiums received on new public finance business. PVP for the reinsurance segment was down 7% from the prior year's first quarter, reflecting lower facultative business coming from third-party primary guarantors.

Subsequent to the end of 1Q08, Assured issued US$250m in common stock to investment funds managed by WL Ross & Co (WL Ross). US$150m of issuance proceeds were downstreamed to AG Re in anticipation of increased demand for reinsurance from primary financial guarantors seeking to improve their capital adequacy. Subject to certain terms and conditions, Assured has the option to issue up to an additional US$750m of common stock to funds managed by WL Ross, providing Assured with a committed source of capital to finance business growth and/or expansion.

... or MBIA
S&P says that it is not taking any rating action following MBIA's announcement of a first-quarter loss of US$2.4bn, principally stemming from a US$3.5bn unrealised loss on insured credit derivatives.

MBIA reported significant mark-to-market losses on its insured credit derivatives and a smaller amount of credit impairment on its housing-related insured portfolio; Ambac recently reported similar losses and impairments. The credit impairment that each company reported was much lower than S&P's most recent sub-prime stress test losses for each company's insured portfolio.

The agency has previously commented on mark-to-market accounting for bond insurers, explaining that it does not view mark-to-market losses or gains on credit derivatives as having a fundamental economic effect (in that they are not predictive of future claims) for the purposes of its capital adequacy and profitability analyses.

While the companies' reported impairments have come in below S&P's stress losses, given the unprecedented level of mortgage market deterioration that has occurred, the agency remains circumspect about assigning stable outlooks to insurers even if they have sufficient capital when measured against its projected stress case losses. Accordingly, S&P maintains negative outlooks on MBIA and Ambac due to their significant exposure to domestic non-prime mortgages and the credit quality of their exposures.

AC & CS

FHA rescue falters and recovers

The impact on the ABX index of a potential veto of the FHA rescue plan is discussed by Glenn Boyd, head of securitisation research at Barclays Capital

The Bush administration released a statement of administration policy (SAP) last week threatening a veto of H.R. 3221, the 'Foreclosure Prevention Act of 2008', which includes the Barney Frank FHA rescue proposal. This follows a series of Treasury meetings in which officials expressed strong reservations to many of the ideas behind Frank's plan.

As administration opposition dampened FHA rescue prospects, the sub-prime market stood up and took notice. As shown in the table below, the ABX sold off substantially in the two days since the veto threat, with roughly four-point losses in 06-2 and 07-1 triple-As and double-As in particular. Much of the rally of the past several weeks has now been erased in all but the most pristine credit classes.

This poor performance suggests that the market interpreted the Frank proposal as nearly dead. However, the bill passed in the House on 8 May with a strong showing: 266 in favour to 154 against.

While House passage was never in serious doubt, the defection of 39 republican representatives indicates significant support for the proposal. The vote is not strong enough to override a veto, which would require 290 votes (assuming the eight democrats who did not vote signed on, there would still be only 274 in favour).

In fact, republican support was weaker than expected in some Washington circles. Nevertheless, based on last week's market reaction, we suspect that many sub-prime participants will be surprised by the number of defections in light of Bush's recent veto threat.

If so, we believe that the ABX could rally in response. Given more consistent demand in triple-As and higher model-stressed yields (06-2 and 07-1 triple-As have double-digit yields even at 120% of our model), we view triple-As as the more attractive short-term classes.

In the Senate, the Dodd version of the FHA rescue bill will be marked up in committee and will progress via regular process. This will take time and it does not appear to be likely that the bill will pass the Senate before the Memorial Day recess.

Indeed, it remains an open question whether the Frank proposal will get so watered down as to have little effect on the market. To ascertain what compromises might be possible without rendering the Frank proposal moot to the financial or housing markets, we examine the key objections listed in the SAP. Many of these objections may be addressed without major implications, but some are more fundamental.

SAP objection #1: "The Congressional Budget Office estimates that the FHA loan guarantee program in this bill would produce claim rates of about 35% and, for the first time for this type of program, require credit subsidy appropriations to operate. The [US bn]$1.7 price tag would be passed on to taxpayers who are not participating in this new FHA program. This attempt to shift costs to taxpayers constitutes a bailout."

Possible revision: The original Frank proposal required first-lien holders to pay the FHA US$5 in up-front mortgage insurance premiums (UFMIP) in order to defray increased FHA risk. The revised version that just passed the House requires only a US$3 UFMIP. Assuming US$100bn in rescued loans, a return to the US$5 UPMIP would presumably lower the CBO "bailout" estimate to nearly zero. While this specific objection appears easily addressed, the FHA would still be exposed to substantial downside risk if the housing market continues to plummet. This risk is likely at the core of the administration's objection, but they have not explicitly flagged it as triggering a veto.

SAP objection #2: "The bill would prevent HUD from denying access to FHA loan guarantees solely on the basis of borrowers' payment histories and credit scores, as well as whether they had filed for bankruptcy protection. This could undercut underwriting standards that FHA has employed for years, which have proven to be an effective means of serving a wide range of homeowners while protecting taxpayers from undue risk."

Possible revision: This highlights an essential difference between the administration FHA rescue plan to be implemented in July and the Frank/Dodd proposal. For the proposal to have a substantial effect on housing, financial liquidity or the sub-prime markets, a large share of delinquent borrowers must be eligible. We estimate that roughly 5% of delinquent sub-prime borrowers will qualify under the Bush FHA rescue plan, compared with 25% under Frank's plan. In order for Frank's plan to be widely used, payment histories and credit scores must be given scant weight when deciding FHA eligibility. This is a key element of any compromise that could largely determine the effectiveness of a watered down version of Frank's plan.

SAP objection #3: "The requirements to write-down a portion of the principal balance and to waive prepayment penalties by existing lenders will likely result in only the worst loans being approved by servicers to participate in the program. This adverse selection will increase the cost ultimately borne by the taxpayer."

Possible revision: We certainly expect servicers to perform a cost-benefit analysis of FHA refi versus workout/foreclosure and preferentially forgive debt on loans with the highest expected loss severities. In most cases, this will mean loans with very high current LTVs. Such loans arguably will have higher recidivism rates after debt forgiveness, if for no other reason than being preferentially located in depressed housing areas. However, servicers can afford to pay higher UFMIP on precisely these loans, so a sliding FHA insurance premium scale could address this objection in a straightforward manner.

SAP objection #4: "The Administration also has concerns with the new exit premium proposed in H.R. 5830. The disposition of any gains realized in the property sales proceeds should be governed by terms negotiated between lenders and borrowers."

Possible revision: From the point of view of MBS investors, having a soft second as an asset (presumably, part of the liquidation proceeds) in the trust could raise legal and cashflow questions. If the second can be accommodated into the trust, increasing the UFMIP but allocating the soft second to the investor might be a net wash for the investor – meaning that servicer incentives to FHA refi might be largely unchanged. The legal and accounting issues involved in this are unclear to us, however.

SAP objection #5: "The Administration strongly opposes the establishment of a new policy-making Oversight Board (comprised of the Secretaries of HUD and the Treasury and the Chair of the Federal Reserve Board) because it would only serve to delay FHA's response to the housing market turmoil."

Possible revision: We believe the duties of the oversight board (e.g., setting fees and rates, coordinating lien holders) can be transferred to the HUD secretary with little disruption to the effectiveness of the Frank proposal.

Bottom line
Compared with a week ago, FHA rescue proposals appear likely to take longer (the new benchmark date may be the 4 July recess) and to be more heavily amended. It is very unlikely to garner sufficient support to override a veto, especially in the Senate.

Compromise to avoid the specific objections outlined in the SAP veto threat appears possible without gutting the essence of the Frank proposal and last week's House vote suggests there is modest but meaningful support even from the republican side. Even if these objections are ultimately resolved in conference, the depth of administration opposition remains unclear.

For ABX, the cloudier prospects for the Frank proposal would seem to weigh against a full recovery from the two-day sell-off. However, the House passage may generate a partial rally, particularly in the higher-quality classes in the 06-2 and 07-1 indices. We believe 06-2 and 07-1 triple-As (and, to a lesser extent, double-As) will represent attractive buy opportunities.

© 2008 Barclays Capital. All rights reserved. This Research Note was first published on 8 May 2008.

The persons named as the authors of this report hereby certify that: (i) all of the views expressed in the research report accurately reflect the personal views of the authors about the subject securities and issuers; and (ii) no part of their compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in the research report.

For disclosures on issuers in this report see: https://ecommerce.barcap.com/research/cgi-bin/public/disclosuresSearch.pl

Any reference to Barclays Capital includes its affiliates.

Barclays Capital does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Barclays Capital may have a conflict of interest that could affect the objectivity of this report.

# # #

Trading ideas: time to pay the toll

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at a pairs trade on Toll Brothers Inc and Mohawk Industries Inc

We just can't seem to get our heads around the recent rally in the homebuilders. Yes, they may receive substantial tax write-offs from the government (more of the 'socialise losses and privatise gains' idea); however, real estate 'busts' do not end quickly and are prone to being drawn out over a long time.

We believe now is a good time to take advantage of the tightening of homebuilder credit spreads and buy CDS protection on them. Therefore, we recommend a consumer cyclical pairs trade: buy protection on Toll Brothers and sell protection on Mohawk Industries.

We prefer to look for creative ways to offset the negative carry and this trade uses a long exposure on a much more diversified homebuilding-related credit. By structuring the trade this way, we remove much of the market and sector risk exposure. The MFCI model forecasts the spread differential between the two issuers to be 430bp and at current levels we are able to transact the trade for a mere 95bp of negative carry.

Basis for credit picking
The MFCI model attempts to replicate the thought process of a fundamental credit analyst. We know this is an extremely arduous task; however, the output provides a great means to selecting 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 1 lists all the factor scores for both Toll and Mohawk.

Exhibit 1

This pairs trade looks to use Mohawk as a funding tool for the short Toll exposure. Even though Toll's spread is at a significant premium to that of Mohawk, we believe the differential of 93bp is not nearly enough compensation for the difference in underlying risk of the two companies.

Mohawk's MFCI rank is far superior to Toll's. The model gives Mohawk a risk rank of 4.6 compared to Toll's low rank of 2.0. We see a 'fair differential' of 434bp, as shown by the difference between the two MFCI expected spread levels.

Where's the risk?
The glaring difference in the credit profile of the two issuers can be boiled down to the massive deterioration of homebuilder fundamentals. Though Mohawk is and will be impacted by the housing bust, they are much more diversified and able to handle the fallout, as their current fundamentals show.

Interest Coverage is one of the best determinants of an issuer's ability to meet future liabilities. Exhibit 2 demonstrates how drastically different the credit profiles of Mohawk and Toll are (when viewed through the 'interest coverage lens') since the air of the real estate bubble was let out.

Exhibit 2

Mohawk's interest coverage hovers near 6.65x. Since the homebuilders got hit with the fall in home values, Toll's interest coverage level declined steadily and is now currently negative. If the housing crisis continues through 2009, Toll will be in serious trouble.

The collapse in earnings for Toll Brothers is even more obvious when looking at the compression and then disappearance of their margins. Exhibit 3 is a time series of the EBIT/sales ratio for both Mohawk and Toll. Even as the housing market started its descent back in 2006, Mohawk managed to maintain its margins; however, Toll's absolutely collapsed.

Exhibit 3

We do not foresee much improvement for Toll over the next few years, since land values will most likely need to be devalued and will thus take a hit at their future earnings. This does not bode well for its future credit profile. Even though Mohawk is exposed to the housing sector, it is much more diversified and equipped to handle the continued slowdown.

We believe credit investors should be compensated with more than the current 95bp in spread differential for the obvious fundamental differences of these two credits.

Spread differential
After finding trades that make sense from fundamentals, we also like to ensure that the 'technicals' point in the same direction. Though fundamentals tend to dominate price discovery in the long run, the market can remain irrational as long as it needs or wants to.

Exhibit 4 visually demonstrates how wide the spread differential has gone recently and we believe the homebuilders are not out of the woods by a long shot. Though the spread differential collapsed to zero in the beginning of the credit rally, we believe now is a good time to catch the trend, as the differential will continue to widen as the housing crisis deepens.

Exhibit 4

Risk analysis
This pairs trade carries a direct risk of convergence. In other words, the spread differential may not widen as expected. However, based on historical performance of the technical indicators, we believe this risk is well mitigated.

Liquidity
Liquidity should not be an issue for this trade since both names are crossover issuers. The credits have historical bid/offers of 5bp-20bp 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
This trade is significantly affected by the fundamentals. For more details on the fundamental outlook for TOL and MHK, please refer to Gimme Credit.

Toll Brothers (analyst: Kathleen Shanley) Credit Score: -1 (Deteriorating) Toll is susceptible to the downside of the housing bubble and to shareholder pressure for improved returns.

Mohawk Industries (analyst: Carol Levenson) Credit Score: -1 (Deteriorating) The company has been hit by weaker US residential demand (both from new construction and remodelling), but its acquisitions have lessened the blow somewhat by diversifying it by product line and geography. Post-acquisition debt reduction has been slow but steady and funded with growing free cashflow. We believe the next move, however, will not be towards further debt reduction but a turn to more acquisitions or the return of cash to shareholders.

Summary and trade recommendation
We just can't seem to get our heads around the recent rally in the homebuilders. Yes, they may receive substantial tax write-offs from the government (more of the 'socialise losses and privatise gains' idea); however real estate 'busts' do not end quickly.

We believe now is an opportune time to take advantage of the tightening of homebuilder credit spreads and to buy CDS protection on them. Therefore, we recommend a consumer cyclical pairs trade: buy protection on Toll Brothers and sell protection on Mohawk Industries.

We prefer to look for creative ways to offset the negative carry and this trade uses a long exposure on a much more diversified homebuilding-related credit. By structuring the trade this way, we remove much of the market and sector risk exposure. The MFCI model forecasts the spread differential between the two issuers to be 430bp and at current levels we are able to transact the trade for a mere 95bp of negative carry.

Sell US$10m notional Mohawk Industries 5 Year CDS protection at 160bp.

Buy US$10m notional Toll Brothers 5 Year CDS protection at 255bp to pay 95bp 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).