Contents

Microfinance momentum

Africa and Asia to benefit from new CLO

Standard Chartered and the IFC will close a microfinance CLO within the next couple of weeks. Backed by loans to institutions in Sub-Saharan Africa and South Asia, MILAA (Microfinance Institutional Loans for Asia and Africa) is believed to be the first microfinance deal involving these jurisdictions.

MILAA forms part of the 2006 Clinton Global Initiative, to which Standard Chartered committed a US$500m microfinance facility over a five-year period. Details on the size of the deal and collateral specifications are yet to be made publicly available, although the IFC has said it will invest US$45m in the equity tranche.

Jack Lowe, ceo of microfinance investment managers Blue Orchard, is confident but realistic about the coming year for the sector. He suggests that launching microfinance CLOs in the current market is possible, but it will not be the easiest of tasks.

"Recent market turmoil does affect the ability to market microfinance CLOs, not only because of the blackening of the CLO name, but also because it is difficult to achieve the spreads on this type of deal that the CDO market wants," he says.

He continues: "Current CDO spreads do not necessarily need to come down for us to market a deal, but it would help. The market needs to get used to the idea that some structured finance deals do have good underlyings. For example, from Blue Orchard's total loans made to date from all our funds and CLOs, none have defaulted."

Lowe is confident that there are enough investors who are comfortable with MFI CLOs and who will still invest - although he says future MFI CLOs may be rebranded as 'microfinance securitisations'.

But, despite a cautious outlook for MFI CLOs in the months ahead, activity appears to be gathering pace. Citi is currently in the market with a US$165m microfinance CLO, dubbed MFI CDO 1, for Peru-based Cyrano Management.

A spokesperson for Citi confirms that the senior tranche is currently being marketed, while the junior and mezzanine notes have already been placed. The deal is expected to close in the summer.

S&P also says it has received a number of requests for microfinance securitisation ratings (see SCI 80). S&P was the first rating agency to rate a microfinance CLO in April 2007 (BOLD 2). "Future deals should be able to achieve higher ratings, that in turn will attract new investors to microfinance CLOs," notes Lowe.

Meanwhile, the IFC and KfW have announced the formation of Microfinance Initiative for Asia (MIFA). The initiative will focus on Central Asia, East Asia and the Pacific, as well as South Asia (including Pakistan and Afghanistan) where IFC and KfW intend to jointly commit over US$950m through structured finance, debt and equity and projects over the next three to five years. MIFA will also leverage up to US$50m in advisory services for Asian microfinance.

AC

Funding needs

Icelandic CDOs raise questions over ECB collateral criteria

"If these deals are being used as repo collateral with the ECB, it underscores the concerns expressed by Yves Mersch - who said he is very concerned about the quality of collateral being presented," says Meyrick Chapman, derivatives strategist at UBS. Mersch, governor of the Central Bank of Luxembourg, said last Thursday at the ICMA AGM and conference in Vienna that the type of collateral now being accepted by the ECB was "a matter of high concern".

A number of CDOs have been structured specifically for repo with the ECB, which accepts collateral rated as low as single-A minus, in the last few months. This would mean that both Glitnir deals, which were rated single-A, could potentially qualify for the exchange.

"I think the ECB has been concerned for some time about the collateral used and that those with access to basis swap facilities can also arbitrage the central banks. In my opinion the ECB will try to apply the margin/haircut rules more rigorously - which may have implications beyond Icelandic banks," says Chapman.

However, he adds that if the CDOs meet the ECB's criteria, there is not much the ECB can do short of retrospectively changing the rules, which they will not do.

The static €890m Holm Capital and €174m Holt Funding transactions were structured by Lehman Brothers. Holm is rated by Moody's and contains one single-A rated tranche, which priced at 235bp over three-month Euribor.

The portfolio backing the deal consists of structured finance bonds including CMBS, RMBS, CLO, ABS and corporate bonds. Most of the assets were originated in Europe, with triple-A rated assets contributing to more than half of the portfolio.

Holt contains a senior tranche of €585m, rated single-A by S&P, and an unrated equity tranche of €305m. The loans backing the deal were 80% senior secured, 6% mezzanine/second lien and 15% senior unsecured.

The majority of the assets were concentrated in the UK (35%) and Iceland (37.5%), with some loans originated in Canada and the US. The single-A tranche priced at 300bp over three-month Euribor.

Icelandic banks are not believed to have issued any CDOs in the past, so it was unusual to see two deals from Glitnir in the same week. Although sentiment has improved towards the Icelandic banks in recent weeks - particularly following the move by Sweden, Denmark and Norway's central banks to provide emergency credit to the central bank of Iceland - the sector still has some way to go.

As Sunil Kapadia, economist at UBS, explains: "Icelandic banks are generally very highly leveraged, with Glitnir currently the most highly leveraged. In order to improve investor sentiment towards it, it will need to be seen to be deleveraging itself, so this could explain the selling off of some of its assets via the CLO."

Funding needs may also come into the equation. "Glitnir does not have an immediate need for funding, as its liquidity is safe-guarded for the next 12 months," concludes Kapadia. "However, there are funding risks once that period has lapsed."

AC

Performance enhancement

Synthetic CDO restructurings gather pace

The recent rally in the CDS market has given synthetic CDO investors the opportunity to restructure their exposures. Activity is revolving around efforts to stabilise some less robust structures in an effort to realise their value long-term.

"It appears that a good chunk of activity in the synthetic CDO space is being driven by restructurings stemming from increasing concerns about credit quality and potential mark-to-market volatility," confirms Nicolas Gakwaya, CDO analyst at Merrill Lynch in London.

The activity is being driven by investors who believe their holdings still have intrinsic value, and want to avoid unwinding their positions and thus crystallising current losses. They are therefore attempting to make their positions more stable until market conditions improve. "With the market rallying since mid-March, it seems like an appropriate time to consolidate such exposures – especially as many investors believe that credit deterioration or another round of sell-offs is possible," adds Gakwaya.

He continues: "There may also be an element of trying to stabilise ratings involved, given the uncertainty about ratings in light of Fitch's recent actions. Investors can add another rating opinion as part of the restructuring, which reduces their dependency on one agency when it comes to a potential downgrade of their tranche."

Depending on the motives for restructuring, the process typically involves a combination of portfolio re-composition, maturity reduction/extension or an increase in credit enhancement. Portfolio re-composition usually entails buying back protection on the troubled names and selling protection on other more suitable credits.

A smoother way of achieving this re-composition may be to re-weight the pool rather than substitute any of its constituents. The costs involved are smaller, given that only part of the protection has to be bought back, but the exposure to the undesired credit remains – albeit in smaller quantities.

In terms of restructuring maturity, the life of the deal can either be reduced or prolonged. With credit curves being significantly flatter, investors can take advantage of the new shape of the term structure to shorten the length of their exposure.

Alternatively, pushing the term of the synthetic tranche further back in time will lead to an increase of the present value leg of the contract. With relatively flat curves, this will be only partly offset by a benign increase in the value of the default leg of the transaction.

By keeping the coupon constant, the resulting gain can then be used to fund any additional operation, such as name substitution or reinvestment in additional credit subordination. Otherwise, the improvement of credit subordination will likely involve either a reduction or a complete sacrifice of the coupon, with the actualised value of all foregone future cashflows being used to provide additional cushion to the structure.

All restructurings have to be analysed by the rating agencies to ensure that they are consistent with their criteria. However, depending on the specific concern being remedied, some investors will be happy to have lower ratings in return for better subordination.

The operation is usually funded either upfront or by a coupon sacrifice. If the restructuring involves dealers buying back a portion of the position from their client, it may result in them sharing a portion of any losses too. Sources suggest that, consequently, some restructuring activity could also be being driven by clients wanting to recoup a portion of their losses.

CS

CDO trio leaves RBS

The latest company and people moves

CDO trio leaves RBS
Vincent Dahinden, Roberto Silvotti and Matteo Mazzocchi have left RBS. Dahinden and Silvotti were co-heads of exotic credit derivatives in Europe and reported to Mazzocchi, head of structured credit derivatives & alternatives.

Dahinden was in charge of cash CDOs, principal investments and structured client solutions within Europe, while Silvotti headed up trading and structuring of synthetic products and index strategies.

While the departure of Dahinden was confirmed by RBS, a spokesperson at the bank was unable to deny or confirm the departures of Silvotti and Mazzocchi.

MS' Zola resigns
Matt Zola, global head of structured credit products at Morgan Stanley, has resigned for personal reasons. He will be replaced by Brian Neer, head of structured credit in the US and Asia.

It is understood that several members of Morgan Stanley's European CDO team, including Neil Servis, Priya Arora and Tim Armstrong, have also left the bank – although Morgan Stanley would not confirm the departures. The bank did, however, deny rumours that its European CDO unit had shut down.

Servis joined MS a year ago from DB, where he was global head of managed synthetic CDO origination and distribution. Arora, a senior CDO structurer, was previously head of cash CDO structuring at Calyon before moving to MS in January last year. Armstrong is believed to have worked on CDO marketing.

PIMCO expands European credit business
PIMCO has appointed Rick Ford as senior credit portfolio manager in its credit portfolio management team. He will report to Luke Spajic, svp and head of pan-European credit portfolio management, and to Emanuele Ravano, md and co-head of European strategy. Ford will be a senior member of the global investment grade team and will be based in London.

Ford joins PIMCO from Morgan Stanley Investment Management, where he was credit fund manager and executive director. He originally joined Morgan Stanley as a fixed income controller and was subsequently promoted to executive director in credit trading. Prior to Morgan Stanley, Ford was an auditor for Ernst & Whinney.

Ivy AM's Simon joins AIMA
AIMA has appointed Sean Simon of Ivy Asset Management as the new AIMA council representative of its US members and as a member of the AIMA board of directors.

Simon has been co-president of Ivy Asset Management since January 2006. He is responsible for the firm's strategic planning and the management of its overall business.

Wilmington Trust expands CCS business
The Wilmington Trust is expanding its Corporate Client Services (CCS) business in Europe with the formation of Wilmington Trust SP Services (Amsterdam).

The new company will perform specialised trustee and corporate administrative services in the Netherlands, including CDO transactions, asset-backed securitisations and holding company services. Wilmington Trust's services in the Netherlands will be provided through an alliance with ANT-Trust, an independent Amsterdam-based supplier of corporate trust and administrative services.

Wilmington has been expanding its CCS business in Europe since 2002, when it acquired a London-based provider of entity management services. More recently, Wilmington has established a presence in other European jurisdictions, including Dublin, Ireland; Frankfurt, Germany; and Luxembourg. It also offers services in the US and the Caribbean.

Apidos takes on four CLOs
Resource America's subsidiary, Apidos Capital Management, has been assigned the management contracts of four CLOs totalling approximately US$1.3bn. Apidos Capital Management is the US leveraged loan investment arm of Resource America and is an affiliate of Resource Europe Management Ltd (the London-based subsidiary managing euro-denominated leveraged loans). With the completion of this transaction, Apidos and Resource Europe will now manage 13 CLO vehicles, representing approximately US$4bn of assets.

Gretchen Bergstresser, president and senior portfolio manager of Apidos, comments: "Although these transactions that we will be assuming management of have experienced many challenges in this uncertain economic environment, we believe that we are very well-suited to maximise the returns for all investors."

Euroclear and DTCC link up
Euroclear has launched a link between its DerivManager OTC derivatives service and the DTCC Trade Information Warehouse, a service offering of DTCC's Deriv/SERV unit that currently covers OTC credit derivatives contracts. DerivManager aims to both minimise counterparty disputes involving trade valuation and optimise collateral usage to cover exposures arising from all types of OTC derivatives contracts.

With the launch of the DerivManager link, Euroclear Bank clients that are also customers of DTCC's Deriv/SERV and the Trade Information Warehouse may elect to transmit relevant credit derivatives trade data automatically from the Warehouse's trade database to DerivManager in order to compare and manage exposures with their trading counterparties.

Based on the Deriv/SERV Warehouse's trade data and on valuation data supplied by Euroclear Bank clients for all types of derivatives trades, DerivManager identifies and reports on a daily basis any exposure discrepancies between counterparties to these trades. DerivManager also provides clients with aggregated views of all their derivatives trade exposures, facilitating the allocation of collateral to cover these exposures.

DerivManager clients may outsource the management of collateral needed to fulfil obligations determined by DerivManager to Euroclear Bank, Europe's leading triparty collateral management agent.

AC

CPDO review sparked by alleged mis-rating

A round-up of this week's structured credit news

They added: "In addition, Moody's has adjusted its analytical models on the infrequent occasions that errors have been detected. However, it would be inconsistent with Moody's analytical standards and company policies to change methodologies in an effort to mask errors. The integrity of our ratings and rating methodologies is extremely important to us, and we take seriously the questions raised about European CPDOs. We are therefore conducting a thorough review of this matter."

Moody's takes action on SIV capital notes
Moody's has downgraded or placed on review for possible downgrade the capital note ratings of seven SIVs, due to continuing funding and market illiquidity issues. The vehicles affected by these actions are: Premier Asset Collateralized Entity, Links Finance, Nightingale Finance, Asscher Finance, Beta Finance, Centauri Corp and Dorada Corp.

PACE, sponsored by Societe Generale, has not sold any assets since the onset of the credit crisis thanks to a liquidity support facility provided by Societe Generale. However, with an average portfolio price of 87.4% as of 9 May 2008, capital net asset value is negative, thus minimising the likelihood of a recovery were assets to be sold.

The rating action regarding Links reflects losses already suffered by capital notes following asset liquidations and the deterioration in market value of the remaining portfolio assets. In addition, liquidity support provided by the sponsor, Bank of Montreal, has been beneficial primarily to senior debt investors.

Links' portfolio market value declined to 89.71% as of 9 May 2008 from 95.02% since Moody's downgraded the mezzanine capital notes on 22 February 2008. Links' capital NAV as of 9 May 2008 was 22.8%, while mezzanine capital notes, which comprise 2.1% of total paid-in capital, had a NAV of 65%. This figure could decrease further if more losses are crystallised through asset sales or if the market value of the portfolio continues to decline.

Nightingale's senior debt programmes benefit from liquidity support provided by AIG Financial Products (AIGFP). This support has ensured that no assets have been liquidated (other than transfers in connection with vertical slicing) and so no losses have yet crystallised for capital note investors.

However, Moody's rating action reflects the deterioration in market value of Nightingale's asset portfolio, with average market value declining to 90.25% of par as of 14 May 2008, corresponding to a capital net asset value of 20.58%. AIGFP has indicated its intention to continue to provide liquidity to Nightingale in order to support senior debt. This may lead to the avoidance of asset sales that would otherwise crystallise losses for capital note investors.

Avoidance of asset sales is currently not a contractual obligation. However, were the manager to continue to pursue this strategy even after all senior debt has been repaid, the ratings assigned to the capital notes would likely be investment grade due in part to the high credit quality of Nightingale's asset portfolio (Aaa 88.1%, Aa 10.5%, and A 1.4%).

By contrast, were Nightingale to liquidate its assets, the rating of capital notes, as implied by the low capital net asset value, would be C. The assigned rating of Caa3 therefore gives credit to the manager's intention to avoid asset sales, but recognises that the manager does not have a legal obligation to do so.

Meanwhile, Asscher Finance offered to exchange its capital notes with those of a new vehicle, Malachite Finance, established by its sponsor as part of the restructuring of the company (see SCI issue 80). Of the 25 investors in the capital note programme, 24 agreed to the exchange. Pursuant to an asset sale agreement between Asscher and Malachite, Asscher's assets were sold to Malachite for an average price of approximately 94% on 17 December 2007.

Assets corresponding to the mezzanine capital note net asset value of approximately 8% remain in Asscher as collateral for the remaining capital note investor. Moody's rating action therefore reflects losses suffered by the remaining capital note investor in Asscher. The action also reflects the fact that liquidity support provided by the sponsor, HSBC, applies to Malachite only, and does not benefit the remaining capital note investor in Asscher.

Finally, with regard to Beta Finance, Centauri Corp and Dorada Corp, Moody's review will focus on the decline in capital net asset values, which incorporate both crystallised losses following asset sales and unrealised losses. The agency will also review the impact on capital notes of Citibank's liquidity support and the manager's intention to utilise repurchase agreements as an alternative funding tool. Judicious use of repos could reduce losses to capital notes that would otherwise result from outright asset sales.

Fitch clarifies TRR CLO stance
On 18 April 2008 Fitch published its criteria report entitled 'Rating Market Value Structures (MVS)'. As part of the criteria, the agency outlined its approach to evaluate transactions on a case-by-case basis and to provide more detailed commentary on different aspects of its MVS criteria as the market evolves.

Over the past month, Fitch has received inquiries from a number of market participants regarding the application of the MVS criteria to the evaluation of total rate of return (TRR) CLOs. These include application of the criteria in the review of previously rated transactions, evaluation of proposed/executed amendments, restructurings or recapitalisations within existing transactions and evaluation of proposed new transactions.

In response to these inquiries, Fitch would like to emphasise that it will continue to analyse transactions on a case-by-case basis with a strong focus on the nature and quality of the assets within each transaction, as well as any unique structural features. Furthermore, all MVS transactions will be evaluated by a market value standing committee.

Per Fitch's MVS Criteria, the lower rated classes in TRR CLOs, as currently structured, are considered knock-out structures. As such, ratings for these tranches will be no higher than triple-B, given appropriate collateral characteristics and structural features. Knock-out MVS are those structures with high loss triggers set 'inside of the tranche', such that the transactions may unwind with a substantial loss to the rated notes.

Fitch's analysis of these transactions will include a categorisation of assets within the respective portfolios. For example, US senior secured leveraged loans are generally consistent with Category 2 and Category 3 assets. Given the long exposure period of these transactions (up to 12 years), Fitch will review the transactions' ability to withstand market value declines that are consistent with this longer risk horizon. These long-term market value declines will generally exceed the values implied at the lower end of the agency's 20-day advance rate ranges (as published in its MVS criteria) and may incorporate further stress to account for the difference in exposure periods.

In the context of the current market dislocation, Fitch has observed that a large proportion of the market value risk exists within the short-term; that is market values are likely to decline rapidly in a stressed environment as opposed to gradually in a benign environment. As a result, the additional stress to the 20-day advance rates will be limited, although Fitch will analyse a transaction's ability to withstand a stressed market value decline of an immediate nature, without triggering a liquidation event.

For example, a new transaction referencing all Category 2 assets and structured such that it could withstand an immediate market value decline of approximately 10% before triggering a liquidation, would most likely be consistent with a single-B rating category. A similar transaction which was structured to withstand the market dislocation experienced during 2H07 and 1Q08, representing a peak to trough decline and liquidation premium of approximately 18%, would most likely be consistent with a double-B category rating. For a knock-out tranche to be rated triple-B, Fitch would anticipate the structure's ability to withstand a combined market decline and liquidation premium of approximately 35% or greater before breaching a liquidation trigger.

The agency looked to the Loan Syndications and Trading Association's (LSTA) Index as a reference point (which declined to approximately 86% in 1Q 2008), and added an additional liquidation haircut of 4% to represent the difference in liquidation value versus marks. It is important to note that the market value stress witnessed in leveraged loans occurred in a relatively benign credit environment for this asset class. As a result, while the LSTA benchmark can be viewed as a baseline, additional stresses may be analysed for portfolios with covenant light or less liquid loans.

For existing transactions which have already experienced market value declines beginning in 2H07 and which are looking to amend, restructure or recapitalise, Fitch will analyse those transactions' abilities to withstand, on an immediate basis, a further market value decline equivalent to the advance rates discussed above, applied as a percentage of the current market value. For example, to achieve a triple-B rating, it is anticipated that a portfolio priced at 90% would be able to withstand an additional market decline of approximately 32% (35% of 90%) before breaching a liquidation trigger.

Moody's downgrades CIFG
Moody's has downgraded the insurance financial strength ratings of CIFG from A1 to Ba2 and kept the ratings under review with direction uncertain. The actions reflect the high likelihood that, absent material developments, the firm will fail minimum regulatory capital requirements in New York and Bermuda, due to expected significant increases in modelled loss reserves on ABS CDOs.

The breach of such regulatory capital requirements would put the firm in a precarious position, especially in light of the solvency provisions embedded in its CDS exposures. The review with direction uncertain reflects potential changes in the credit profile of the firm that could occur over the next couple of months as CIFG attempts to implement capital strengthening plans.

Moody's ratings on securities that are guaranteed by a financial guarantor are generally maintained at a level equal to the higher of the rating of the guarantor or the published underlying rating. However, as CIFG's rating is downgraded below the investment grade level, and reflecting current rating agency policy, Moody's will withdraw ratings on CIFG-wrapped securities for which there is no published underlying rating. Should the guarantor's rating subsequently move back into the investment grade range or should the agency subsequently publish the underlying rating, Moody's would reinstate the rating to the wrapped instruments.

Moody's says that CIFG employs a loss reserving approach for its insured ABS CDOs that uses as inputs the lowest available ratings of any of three rating agencies on underlying CDO collateral. With further downgrades of RMBS securities by different rating agencies occurring since the beginning of the year, Moody's believes CIFG will experience sizable increases in reserves and could breach regulatory capital requirements in the near future. The agency notes that the company has failed to meet certain regulatory filing deadlines in both the US and Bermuda, including 1Q08 results for CIFG Assurance North America and year-end 2007 financials for CIFG Guaranty.

Moody's believes that the firm's loss reserve methodology may result in a substantial conservative bias by using the lowest rating on the underlying exposures of its ABS CDOs, given the material differences in average collateral ratings across rating agencies. In March, Moody's had estimated CIFG's expected loss on ABS CDOs at US$433m and stress losses, consistent with a 21% cumulative loss on 2006 vintage sub-prime first lien pools, at US$1.3bn.

The rating agency adds that the expected substantial increase in loss reserves, despite their potential conservativeness, could have material adverse effects on the firm's financial condition. A large part of CIFG's credit exposure was written in CDS form and contains a clause that exposes the firm to mark-to-market termination in the event of insolvency. The current mark-to-market value of such CDS contracts is a multiple of the expected economic loss on the exposure (as estimated by Moody's and CIFG) and well in excess of the firm's claims paying resources, says Moody's.

A breach of minimum regulatory capital requirement may not in itself mean that the firm is insolvent and therefore trigger a market value termination of the CDS contracts, but it does expose the firm to possible regulatory actions and other risks that could trigger such termination, given the lack of specificity as to what would qualify as insolvency under the terms of the contracts. CIFG is pursuing various strategic options, including a recapitalisation or a commutation of its ABS CDO exposures that, if successful, would essentially remove the risk of market value termination.

However, until such a solution is implemented, CIFG remains exposed to a heightened risk of extreme financial distress. CIFG's parents, Caisse Nationale des Caisses d'Epargne Prevoyance (CNCEP) and Banque Federale des Banques Populaires (BFBP), are expected to play a decreasing role in the firm's future and Moody's believes it is unlikely that they will provide significant additional support to their subsidiary beyond their recent US$1.5bn capital infusion.

In the unlikely event that a market value termination of CIFG's CDS exposures is triggered, the firm's rating would likely fall to the Ca-C range, due to its inability to fully meet such obligations out of its financial resources. Under the most likely scenario, where the firm is able to substantially remove the risk of market value termination, the ratings could go up, but are likely to remain below investment grade - reflecting Moody's serious concerns about the insurer's operational effectiveness and governance. It will continue to closely monitor the evolving credit profile of CIFG and will update its opinion as material changes occur.

CIFG responded to Moody's action in a statement. "While we are very disappointed by this action, we continue to work aggressively to protect our policyholders," comments John Pizzarelli, ceo of CIFG. "We are currently in negotiations to develop strategic alternatives for problematic credits with the goal of CIFG emerging with a clean balance sheet and significantly improved capital position."

Kamakura launches sovereign default probability service
Kamakura Corporation has launched what it says is the world's first default probability service for sovereigns. The sovereign default probabilities will be an additional service delivered alongside the public company default probabilities offered via the Kamakura Risk Information Services (KRIS) since November 2002.

The new service, which has been under development for more than two years, has been developed in conjunction with a steering committee consisting of major financial institutions in North America, Asia and the EMEA region. The steering committee has been chaired by one of the largest life insurance companies in the world.

The new service will offer default probabilities updated daily on 180 countries with historical default probabilities available monthly back to 1980. The KRIS Sovereign Default Service models have been estimated using a monthly data base back to 1980 under the supervision of Kamakura's md for research, Robert Jarrow, and Kamakura's senior research fellow Jens Hilscher.

"Kamakura's public firm models have now been firmly established as the state of the art in corporate default risk assessment," says Warren Sherman, Kamakura president and coo. "We are very pleased to offer sovereign default probabilities in a dramatic expansion to the KRIS product line in response to strong demand from our existing KRIS clients. We are very grateful to the KRIS Sovereign Default Service Steering Committee and many other financial institutions around the world, which have provided us with invaluable guidance during the development process."

The KRIS Sovereign Default Service models are estimated using a term structure of logistic regressions on a monthly data base with more than 24,000 observations and more than 160 defaults going back to January 1980. The models are of the state-of-the-art 'reduced form' type, which base the default prediction on macro-economic factors and financial ratios relevant to sovereign default. The default definition used in the development of the KRIS Sovereign Default Service is consistent with the Basel II default definitions put forth by the Basel Committee on Banking Supervision.

S&P reports on LevX
The second series of the European leveraged loan derivatives index - Markit iTraxx LevX Index, launched mid-March in an effort to grow the fledgling European LCDS market - is broadly representative of the market as whole, but does have some minor deviations, S&P says in a new report.

"For one, in the senior index, there is a high concentration in telecommunications credits and to a lesser degree in the food and beverage sector, when compared with the larger market," says S&P research analyst Taron Wade.

In addition, the index - which contains deals done from 2005 to 2007 - is highly skewed toward deals completed in 2007, unlike the market as a whole, where deals are more evenly spread over the three-year timeframe. Moreover, the index has a slightly weaker credit profile than the entire European universe of sub-investment-grade credits (excluding deals originated in the CIS).

"And, in terms of deal size, it deviates substantially, leaning instead toward the largest, more liquid credits and hence typically the most frequently traded credits," says Wade. "Yet, this comes as no surprise, as tradable indices are often constructed to contain the most liquid credits, which are typically the largest and therefore most frequently traded loans."

The LevX Series 2 has 75 credits in the senior index and 45 credits in the subordinated index. This is a considerable expansion on its predecessor, the LevX Series 1, launched back in October 2006, which contained 35 credits in the senior index and 35 credits in the subordinated index. Its new composition should help to increase liquidity and boost the continuing development of the leveraged loan market in Europe into a mature capital market for large and upper mid-market transactions, and serve to attract new investors to the asset class.

Since it started trading on 17 March 2008, the LevX Series 2 index has enjoyed mixed success. After dropping as low as 96.62 on its first day of trading, it broke through the 100 barrier for the first time in early April.

Trading volumes, however, have exceeded targets. The first day of trade saw volumes of €2.8bn, more than double the €1bn daily average of the LevX Series 1. Figures on trading volumes since then are unavailable.

In general, market participants have been somewhat disappointed by the lack of trading in the index as there was an expectation that the expanded LevX Series 2 would result in a more liquid LevX, S&P says. The lack of trading, however, could be explained by the credit crunch, which has slowed trading of credit products across the board.

Markit offers RED to the buy-side
Markit has announced a new freely available license for the Markit Reference Entity Database (RED), aimed at smaller buy-side firms. Under the terms of the new license, asset managers with light CDS trading volumes that use DTCC Deriv/SERV for trade confirmation will gain access to market best practice in CDS trade processing.

Markit RED is the industry standard for reference entity and reference obligation identifiers used throughout the CDS market to reduce legal and operational risk in trading, documentation and trade settlement. The service uses legal representatives in over 100 countries to source and scrutinise all relevant documentation to provide subscribers with a complete understanding of each entity.

This initiative aims to support the commitments made by the Operations Management Group (OMG) to the New York Fed in March this year, and reinforces Markit's commitment to bring greater operational efficiency to the OTC derivative markets. The OMG, which represents the major market participants, has pledged to improve OTC derivative trade processing by taking steps such as the universal use of standard reference data.

"Markit RED plays a critical role in the CDS markets. The service is used by all major market makers and the vast majority of large buy-side firms, and we are keen to encourage the broad buy-side community to adopt RED. We recognise that one size doesn't fit all and have now developed a new license for the smaller firms. This will allow them to operate consistently with the rest of the market and will help the industry achieve the commitments made to the Fed in March this year," says Ed Chidsey, director of Markit RED.

CMA/Julius Finance to provide tranche term structures
CMA has announced a partnership with New York-based research and technology firm Julius Finance to provide term structures for CDX and iTraxx index tranches. The deal combines observed data from CMA's buy-side consortium with the mathematical modelling capabilities of Julius Finance's JuliusBridgeTM service. The full data set will be accessible through CMA DataVision.

Ongoing volatility in the OTC credit market has lead to an increased demand from buy-side institutions for a market standard pricing model and this will be the first time that a consistently accurate, independent model for calculating notoriously complex tranche values has been made widely available, the two firms say.

Credit risk management systems analysed
Chartis Research has released a new report, entitled 'Credit Risk Management Systems 2008 - Catching the Next Wave', which suggests that an enhanced form of Basel II will be introduced in 4-6 years' time. The firm further forecasts that the worldwide credit risk management systems market will grow to US$8.63bn by 2012.

The increasing number of regulations and the growing sophistication of new financial products and instruments, such as credit derivatives, have led to financial institutions sleepwalking into complex environments of silo-based processes and risk systems, the report says. This fragmented approach to compliance and risk management has resulted in many firms looking for the 'Holy Grail' that is integrated enterprise risk management.

Furthermore, the credit crisis - coupled with high profile operational and business losses - have pushed governance, risk and compliance (GRC) further up the agenda for many boards. The traditional silo-based 'box-ticking' approach to risk management is no longer valid, according to the report.

Chartis predicts that an enhanced form of Basel II, possibly named 'Basel III', will be introduced between 2012 and 2016, requiring national regulators to address many of the limitations and gaps in the current Basel II standards. For example, banks will be required to set aside more capital against complex structured credit derivative products and off-balance sheet vehicles. This will result in a new wave of expenditure in risk technology between 2012and 2018.

Forward-looking banks in the EU, the US and Asia-Pacific have finished implementing the core of their Basel II systems and processes, and are now shifting their attention to opportunities for reducing cost and complexity. In addition, work continues on some of the Pillar II functionalities, such as stress testing and model validation, particularly in the area of credit derivatives and hedge-fund portfolios. At the same time, financial institutions are looking to gain additional value from their investment in Basel II, through better usage of data management, risk-based performance and integrated compliance.

Basel II is still fuelling demand for credit risk management systems in emerging regions, such as the Middle East, Africa, Eastern Europe, Asia-Pacific and Latin America. Financial institutions in these regions can learn some important lessons from European banks and the early movers in other parts of the world.

Lessons learnt include:

• Avoid having a piecemeal approach to regulatory reporting
• Look beyond Basel II to define data requirements
• Define the final target architecture based on an integrated set of business requirements
• Define key metrics upfront
• Consider the most complex asset classes in detail
• Consider a step-by-step approach, giving due emphasis to data integration, stress testing and model validation steps
• Choose vendors with deep domain knowledge and experience.

Chartis forecasts the worldwide credit risk management systems market to grow to US$8.63bn by 2012, at a steady 7% compound annual growth rate. As previously predicted by the firm, credit risk systems expenditure is coming in a series of overlapping waves.

On the supply side of the market, there are a handful of vendors who are leading the way, according the report. These include Algorithmics, Fermat, SAS and SunGard. The common factor amongst the leaders is the ability to offer multiple solutions across the ERM (enterprise risk management) spectrum and coverage across multiple assets/products.

Fitch analyses rating actions
Fitch says that rating actions by the agency for US and EMEA structured finance transactions during Q108 were dominated by downgrades amongst US sub-prime RMBS, as well as others amongst tranches guaranteed by downgraded financial guarantors. The agency also notes in a new quarterly rating review that US and EMEA structured finance issuance declined substantially in Q108 compared to previous quarters.

"Rating downgrades have been driven primarily by two principal sets of circumstances. Firstly, Fitch undertook a further review of its loss expectations for 2006 and 2007 vintage first lien US sub-prime RMBS transactions during Q108, which saw a substantial upward revision across the board," explains Stuart Jennings, md and EMEA SF risk officer at Fitch. "Secondly, Q108 saw rating reviews and subsequent downgrades of the Insurer Financial Strength ratings of a number of financial guarantors with extensive US sub-prime related exposures."

A full rating review of all transactions within these cohorts resulted in extensive downgrades of tranches in affected transactions. Transactions impacted by downgrades of financial guarantor Insurer Financial Strength ratings were concentrated in the US ABS sector, where a number of senior tranches were guaranteed by the affected financial guarantors. The number of rating actions in the EMEA region was more limited; however, most downgrades that did occur related to financial guarantor Insurer Financial Strength downgrades.

Fitch-rated US structured finance issuance declined 84% in Q108 to US$52.9bn (from US$319.7bn in Q107). Similarly, issuance in the UK market dropped 60% over the same period (to US$29.8bn from US$75.8bn), while the rest of the EMEA region saw a slightly smaller drop of 45%.

Fitch reports that performance problems initially demonstrated in the US sub-prime RMBS sector have spread, via the credit crunch, to other asset areas and regions, impacting investor sentiment and their appetite for new structured finance issuance. The more limited decline in EMEA issuance is mostly driven by originator-retained transactions, which have been structured to be eligible for use as repo collateral with the European Central Bank.

Principia unveils Version 5.2
Principia Partners has launched of Principia SFP (Structured Finance Platform) Version 5.2. The firm says that the new release delivers enhanced, market-ready functionality providing a framework for due diligence, risk oversight and operational control of both on- and off-balance sheet structured finance portfolios. These fully automated workflow processes aim to completely integrate all stages of the portfolio lifecycle, from trade capture to accounting.

"In the past, the treatment of ABS and MBS assets in bank treasuries has been a highly manual process with deal-capture, accounting and monitoring carried out by disparate bespoke systems. This is no longer sufficient. Version 5.2 will provide our clients with a single environment and a set of workflow processes which mitigate operational risk and ensure adherence to compliance requirements. In addition, the products flexibility allows managers to adapt the system to meet any new compliance reporting, accounting or operational needs as the market evolves," states Douglas Long, evp business strategy, Principia.

Carador announces April NAV
Permacap Carador reports that at the close of business on 30 April its unaudited net asset value per share was €0.6672. This means Carador's NAV decreased by 1.49% on the previous month. April's calculations include an estimated €590,447.73 worth of net cashflow interest received in the month (to be allocated between capital and income), which equates to €0.0118 per share.

Hedge fund valuation paper published
Hedge funds - now an important component of most institutional investor portfolios - are again coming under scrutiny, this time for their lack of transparency in pricing and valuation. In April, the President's Working Group on Financial Markets (PWG) called for changes to valuation policies, disclosure and accounting practices at hedge funds.

Paladyne Systems and its partners Thomson Reuters and NumeriX have published a white paper responding to April's call for changes to valuation policies, disclosure and accounting practices at hedge funds by President's Working Group on Financial Markets (PWG). The new paper aims to address the issues hedge funds face with pricing, operational transparency and fiduciary leadership.

The paper takes the position that it is not just the hedge fund manager's responsibility to define and adhere to valuation and pricing standards; service providers, data and technology vendors and software analytics providers should all participate in a concerted effort to effect achievable change across the industry. This goes beyond the PWG's recommendations which, while sound, put the onus back on the hedge fund managers, the papers authors say

Key points in the paper include:

• Current pricing methodologies are clearly flawed. Any two hedge funds can price the same portfolio differently, and in both cases, the approach can be considered fair and accurate. This high degree of variance by individual managers means the underlying securities in a hedge fund's portfolio may not reflect the most accurate market values.
• This challenge is further complicated by the need for robust technology and operational processes to accurately and consistently value these securities across the industry.
• Of all the pricing methodologies, the most problematic is mark-to-model. By nature, proprietary models differ from one hedge fund to another, especially given that the same model can be interpreted differently based on assumptions, or a model can have multiple variations for the same asset.
• Mark-to-broker comes with problems as well. Despite complex and sophisticated approaches, sell-side prices are often seen as biased because a broker's exposures, performance and financing relationships are tied into the same price.
• Fund administrators must establish their own pricing procedures, valuation methodologies and hierarchies in order to be a true partner for their hedge fund clients.
• The alternative investment industry is making advances, but the most basic element of portfolio valuation "science" is still elusive to most. Well-documented and communicated operational and pricing processes and methodologies will take the mystery out of pricing.

AC & CS

Should structured products be rated differently?

The proposed separation of structured finance ratings from corporate bond ratings is discussed by Ratul Roy and Michael Hampden-Turner, structured credit research strategists at Citi

G7 Finance Ministers and central bankers issued a statement on 11 April recommending - among other issues to do with the current challenges in the global financial markets - that structured product ratings be differentiated from other ratings (see SCI issue 84). They also provided a broader code of conduct for the agencies. The panel was reinforcing the work that was done by their task force, namely the Financial Stability Forum, and a central body for different national securities organisations, namely the International Organization of Securities Commissions (IOSCO).

We think some of the conclusions (and musings) of IOSCO - which did most of the groundwork related to the credit rating agencies - in their document (comments were due by 16 May 2008) make sense. To summarise the comments as they related to ratings, IOSCO argued that certain tranches of structured finance products exhibited a high variance of losses and severe vulnerability to the business cycle.

Investors had chosen to rely on the ratings and ignored these possible return characteristics. Furthermore, they had invested in structured products with little understanding of the underlying collateral or the methodology that the agencies used in deriving the ratings of structured products.

IOSCO recommended that market participants should "differentiate between credit ratings on structured products and credit ratings on corporate bonds". It suggested that an agency rating a structured product should provide investors with greater disclosure and sufficient information about the product's loss and cashflow analysis for the investor to make an informed choice. More importantly, it even proposed that a credit agency should disclose whether it uses a separate set of rating symbols for rating structured finance products and "its reasons for doing so or not doing so".

There were several reasons the IOSCO (and the subsequent report from the Financial Stability Forum) argued for differences in rating scales - though not necessarily meant to show structured products in a worse light. Structured products are more complex; however, here too, they argued there was more systematic modelling than some of the more difficult-to-quantify subjective factors in corporate ratings.

The modeling assumptions, in many cases, were not backed up by robust historical data. Investors unable to replicate or even judge the merits of the analysis chose to take the rating as a "seal of approval".

Finally, structured products can evidence much more vulnerability to systemic risk and a 'cliff' type profile, especially in products where pooling of assets eliminates any diversification and leads to a large number of correlated defaults. In our view, 'cliff' risk is not a unique property of structured products - corporate bonds, such as those of ACA, quite occasionally show such behavior.

We agree with more disclosure, but disagree with separate rating scales. We think structured products have, on average, behaved similarly to non-tranched products and sometimes better. As we argue in the next section, a subset of structured products - the 'two-layer' securitisation - has shown much worse performance, but this is because of the return distribution of tranched products (the 'cliff' problem is especially worrying for this subset).

IOSCO has highlighted the problem of 'two-layer' products, but the message has been lost in the G7 ministers' later summary statements. We think ratings could have an additional dimension that spells out the difference in loss distribution, but the simplicity of having comparable ratings - namely, the extent that one product is better than another on average - should not be sacrificed.

The 'dual-layer' problem
Market participants recognise the change in loss distribution that tranching brings, even as expected losses may remain unchanged. Tranching can increase the variance, although unlevered portfolios too have a distribution of returns (based on eventual loss rates). Portfolio losses remain below the tranche subordination level and the tranche is unscathed; losses increase a little more (depending on tranche thinness) and all is lost.

As early as 2005 we had stated that ratings provided valuable insight to investors as a way of comparing across asset classes, but investors needed a second measure of risk. Such a measure should try to capture dispersion of risk around expected losses for tranched products. Our note, entitled 'The Ball in the Bowl' (see SCI issues 49 and 50), used rating transition data to show that tranched products - like CDOs - are less likely to receive small downgrades than corporate bonds, but are more likely to suffer big downgrades.

CDOs are less volatile in normal market conditions, but can be more erratic in infrequent stress periods. Even among CDOs, CDO-squareds and CDOs of mezz ABS collateral - both of which contain two layers of tranching - are more vulnerable to multiple downgrades.

Recent events have only proven our earlier hypothesis. It is the 'two-layered' product that has put the brightest spotlight on the structured product market.

Although recent analysis of IOSCO's March report has glossed over the details, the original note made a clear distinction between one-layer securitisations (such as CDOs backed by corporate leveraged loans or CMBS) and dual-layer securitisations such as ABS CDOs (which re-securitised the securitisation products, namely the ABS, of underlying mortgage loans). The prospects for the former, albeit currently weak, were much better than the latter (which could disappear). In the report, supervisors expressed the view that the double layering of the ABS CDO product initially removed it too far from trading developments of the underlying mortgage market and prevented early warning signals.

Subsequently, as loan losses increased in different mortgage pools, most 2006-07 triple-B ABS tranches lost principal - showing a high degree of correlation - ultimately leading to downgrades and losses even in ABS CDO super-senior products. This is in contrast to the single-layer CLO product, for example, whose senior tranches have seen few or no downgrades for many years.

Even during the recent downturn, much single-layer product has performed similarly, with few if any downgrades: There is simply too much subordination built in. Our general impression is that the 'crisis' in structured credit ratings has been much more narrowly confined to ABS CDOs than the casual observer might have thought.

So we repeat the plea that we made in an earlier note when discussing rating agencies' proposals for reforming their criteria in light of substantial ABS CDO downgrades. We see the emphasis on expected loss - and the comparability this creates between structured and flow credit ratings - as a tremendous advantage.

Unquestionably, give analysts greater powers and create governance procedures to make them more independent. By all means, add additional dimensions (or even pictures of return distributions) to capture tail risk. (We were thus more supportive of Moody's proposals for providing an additional 'volatility' dimension, leaving the 'core' rating still intact yet providing important new information. We are also pleased that most buy-side investors agree with us - in a survey published last week, Moody's reported that 73% of buy-side respondents wanted no change to the rating scale, of which two-thirds just wanted more information and the remainder wanted to have that information in a scaled format.)

But, to our minds, agencies should not feel compelled to abandon the rulebook completely over the unpredictable behaviour of any one team player. Fitch's proposals risk doing just that in corporate CDOs.

Fitch - confusing possibility with expectation?
After a long time period where - based on anecdotal evidence from structurers and investors - subordination requirements in Fitch-rated deals were possibly lower than those required from its peers, the agency announced new criteria in February. It has just recently affirmed the criteria, seemingly despite a host of objections from multiple market participants.

The effects may be quite draconian, particularly for synthetic deals. In this category, close to 50% of existing tranches that are currently rated triple-A and more than 90% of tranches currently rated double-A would, according to the new model, be vulnerable to downgrade (see last week's issue). This conclusion applies even in the case of some deals with very little time left to maturity.

The new penalties are aimed particularly at deals that are viewed as having high tail risk because of either high single-obligor concentrations or a preponderance of credits that are on watch negative. In some cases, the agency proposes to use CDS spreads to derive an implied (downgraded) rating.

Moreover, Fitch has appeared to focus less on average historical default rates and more on newly introduced peak stress parameters. As we discussed in our previous note, both are extremely contentious.

Changes in liquidity, combined with a bear market sentiment, can make spreads swing dramatically and result in rating volatility. Likewise, requiring triple-B and single-A rated tranches to have protection up to peak-default scenarios would not be compatible with investors' expectations of similarly rated unlevered corporate risk.

Finally, Fitch also modified its recovery assumptions. The desire to penalise tranches (especially senior tranches) of portfolios with excessive concentration risk is laudable, but we wonder about the timeliness and motivation of these proposals. Investment-grade credit risk is still sound and by all accounts most of the tranches above would not have seen such possible downgrades without the change in model assumptions. The nature of a tranched product - as we have mentioned earlier in this article - means that extreme losses are possible.

However, these losses should be seen as the 'tail' event in the distribution of the tranche return profile and not as its 'expected' loss. By requiring these much higher levels of subordination, the agency risks overcompensating for structured product risk distributions.

Reaction of Moody's and S&P
Like Fitch, S&P has wanted to preserve the same rating scale across asset classes. Moody's had been more mixed until last week when it published a report stating it would adhere to the original rating scale, but produce more information in a scaled format (see last week's issue).

As we detailed in our earlier piece, S&P first issued a statement of broad objectives in February ('Detailed Descriptions of S&P's New Actions Aimed at Strengthening The Ratings Process', 7 February 2008) noting, among other points, its intention to provide greater transparency and insight to market participants, as well as to enhance the quality of ratings analysis and opinions.

Since then, S&P has been issuing regular progress reports on its various objectives. In the February 2008 report, S&P said that it would better explain the comparability of ratings across asset classes (structured versus corporate versus government).

The agency felt that, while its ratings have generally performed consistently across asset classes regarding default experience, recent events have highlighted the need for more research and discussion with the market about possible ways to provide even greater clarity. Like us, S&P felt that additional information would help the market. While S&P intended to maintain the primary focus of its credit ratings on default risk, it wanted to research ways of providing additional analytics and benchmarks to cover significant elements of creditworthiness, such as recovery, as well as other elements of risk, including the liquidity or price volatility of rated instruments.

Moody's had been more ambivalent and offered a series of proposals (including abandoning the rating scale altogether and adopting something new only for structured credit or even adding 'sf' to the end of its usual symbol used for corporate ratings). Our preferred choice - adding an additional dimension - and thus providing further depth than a single rating looks like the path it will be taking. The agency will introduce two additional measures.

The first - 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. On this measure CLOs look much better than RMBS CDOs, as good as non-prime auto ABS and worse than prime bank auto ABS.

The second, which is a downgrade sensitivity measure called Loss Sensitivity, will provide investors with 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.

Other financial associations have responded similarly. The Commercial Mortgage Securities Association (CMSA) stated that, contrary to IOSCO's suggestions, agencies should not have to justify rating structured finance products in the same way as corporates or munis (see SCI issue 86).

In summary, we believe that market participants universally acknowledging a simple letter rating does not capture the full range of risks that a financial risk (structured credit in particular or even a piece of corporate debt) carries. Nonetheless, the benefit of a uniform rating scale across asset classes - albeit complemented with additional qualitative and quantitative information - will continue to remain helpful to participants being presented with myriad investment opportunities.

By formally acknowledging the other risks, such as liquidity, 'cliff' risk and ratings volatility, present in the structured finance premium, we would like to think that the agencies may even clear the air and help the recovery of the structured credit markets. However, there is a real fear that by drawing attention to only the structured markets - wrongly, in our opinion, given the variance in performance across the structured markets - agencies achieve the opposite and the world's balance sheets remain as clogged as ever. It would have been more honest, we think, if the agencies had also pointed out the extent these risks are present - history has enough evidence - in other non-structured markets.

© 2008 Citigroup Global Markets. All rights reserved. This Research Note is an excerpt from Global Structured Credit Strategy, first published by Citigroup Global Markets on 13 May 2008.

Trading idea: services and a smile

Dave Klein, senior research analyst at Credit Derivatives Research, looks at a capital structure arbitrage trade on R. R. Donnelley and Sons

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

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

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

For this trade, we choose our hedging ratios based on a fair-value model that derives CDS levels from equity prices and implied volatility. Given the straddle-like payout, we are going long volatility and taking advantage of a non-linear relationship between CDS and equity. The trade on R. R. Donnelley & Sons Co (RRD) takes advantage of this relationship by buying equity shares and buying CDS protection.

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

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

Exhibit 1 plots five-year CDS premia versus fair value over time. If the current levels fall below the fair value level, then we view CDS as too rich or equity as too cheap. Above the line, the opposite relationship holds. At current levels, RRD CDS is rich (tight) to fair value.

Exhibit 1

Exhibit 2 charts market and fair CDS levels (y-axis) versus equity prices (x-axis). The green square indicates our expected fair value for both CDS and equity; the orange square indicates the current market values for CDS and equity. With CDS too tight when compared to equity (with volatility set to our expected fair value), we expect a combination of shares rallying and CDS widening.

Exhibit 2

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

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

Exhibit 3 charts the expected P&L for the trade after two months for different CDS spreads. The green line shows the expected P&L if RRD returns to fair value and its current credit-equity relationship holds. The blue line shows the expected P&L if the current credit-equity relationship holds, but RRD does not return to fair value.

Exhibit 3

We expect our P&L to fall between the two lines for a given spread level. Clearly, as long as RRD moves closer to fair value over the next two months and continues to trade in a manner consistent with the recent past, we can expect to exit the trade profitably. The longer we hold the trade, the more difficult it will be to make money, given the negative carry/negative roll down we face. However, we believe we can exit profitably in a reasonably short time.

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

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

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

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

Corporate actions: Spin-offs and private equity buyouts, for instance, could radically change the equity-CDS relationship, leaving investors with a mishedged position. A company bailout (à la Bear Stearns) would have a massively negative impact on the trade, as credit would rally and equity value would be destroyed. If the company alters its capital structure by issuing more stock, we would expect equity to underperform credit and hurt our position.

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

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

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

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

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

Fundamentals
This trade is based on the relative value of RRD's CDS and equity, and is not motivated by fundamentals. Given RRD's massive rally since March and the straddle-like payout of the trade, it is important to look at how the underlying credit is expected to perform.

Dave Novosel, Gimme Credit's business services expert, maintains a deteriorating fundamental outlook for RRD. Dave believes that falling expenses have been overshadowed by pricing pressure and declining margins. He further believes that, although the company generates excellent free cashflow, event risk and integration risk still threaten RRD's credit profile.

CDR's MFCI model assigns a mid-range rank of 4.8 to RRD, with the company ranking well on implied volatility but poorly on accruals. The MFCI fair value CDS is 123bp, exactly in agreement with our CSA fair value CDS.

Summary and trade recommendation
We exited our RRD outright short in the beginning of March, noting that all signs pointed to a credit rally. To be honest, we were not expecting the entire market to rally so dramatically but, as they say, Bear happens.

The continued credit tightening makes putting on short positions feel like trying to catch falling knives, but with RRD now hovering near 100bp, our MFCI and CSA models point to a CDS sell-off. Our purchase of RRD protection is offset with a long position in the company's stock, providing a straddle-like payout that profits if RRD CDS continues to rally or sells off as expected.

Buy US$10m notional R. R. Donnelley & Sons Co 5-Year CDS at 107bp.

Buy 12,000 R. R. Donnelley & Sons Co shares at a price of US$33.27/share to pay 107bp 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).