Contents

Rich pickings?

Time to take advantage of ABX weakness

Widening in the Markit ABX index has been seen over the past few weeks as a renewed bout of market disquiet takes hold. Structured credit strategists agree that ABX valuations are currently particularly cheap relative to the underlying risks and suggest a number of strategies to take advantage of the widening.

Structured credit strategists at JPMorgan confirm that too much risk has been priced into the ABX index. Given the resulting fundamental value, they recommend positions in ABX.06-2.AA, 07-2.PENAAA and 07-1.PENAAA indices, which offer excess returns over Libor of 16.95%, 10.81% and 10.04% respectively in a scenario of house prices being -15% over the next 12 months, -3% the year thereafter, flat for the following two years and +3% for the remainder.

"While we are in no way calling a bottom in the housing market, we see signs in enough markets to say that limitless price declines are not to be expected or reflected in prices," says Christopher Flanagan, head of global structured finance research at JPMorgan. "For a variety of technical reasons, the ABX market has gone too far in pricing in risk. We think it offers a great buying opportunity for value-oriented investors."

Glenn Boyd, head of US structured finance research at Barclays Capital, agrees that many ABX classes look attractive on a fundamental basis, but says an outright long is highly directional with broader credit concerns. On the other hand, he says that PENAAA swaps are far less directional. He suggests that 06-1 PENAAAs versus triple-As should be attractive to investors with limited risk appetite and that 06-2 PENAAAs versus 06-1 triple-As offer more value for those with somewhat higher risk tolerances.

He explains that the price differential between 07-2 triple-As and PENAAAs declined by US$1.99 on the week (ending 13 June) and the spread between 06-2 PENAAAs and 06-1 triple-As declined even more, at US$2.58. In contrast, the 06-1 PENAAA swap appreciated by US$1.27 and has held remarkably steady since inception.

"At first glance, this might suggest that the 06-1 swap has richened, but price spreads can be misleading when comparing bonds with different durations," says Boyd. "While the 06-1 swap increased in price, both the PEN and triple-As decreased in price (by US$1.50 and US$1.90 respectively in four weeks). Because the PEN is a shorter bond (0.8-year WAL, in our model), the US$1.50 drop in price gets amortised in less than a year, resulting in a sizeable increase in yield. The US$1.90 drop in triple-A price, on the other hand, is amortised over a nearly threefold longer period (WAL of 2.2 years), resulting in a lower yield enhancement."

When first launched 06-1 PENAAAs yielded 80bp less than triple-As, but yielded 180bp more as of the close on 13 June. The 07-2 swap picked up 40bp in yield at inception, yet currently picks up 330bp.

The 06-1PEN/06-2.AAA yield spread rose slightly more, from 200bp at inception to 570bp now. "For comparison, the 07-1Pen/AAA swap offers 180bp in yield - the same as the 06-1 swap but for a riskier series. The 06-2 swap gives up 140bp in yield, which strikes us as fair," adds Boyd.

Analysts suggest numerous explanations for the recent weakness in the ABX. Some cite the sharp increase in the unemployment rate to 5.5%, along with the rise in crude oil prices that are putting pressure on consumer budgets - which, in turn, pose a new risk for those already having trouble with outstanding mortgages.

"Mortgage rates themselves have been moving up on the back of global inflation pressures," concludes Aneta Markowska, US market economist at SG. "30-year conforming mortgage rates now at 6.30% are matching the highest levels of 2007. Higher mortgage rates will reduce refinancing options for current mortgage holders and may delay the recovery in housing demand and home prices."

AC

Biting the bullet

LCDS contracts set to improve, while European activity flounders

Efforts are underway to find a method of determining succession events in LCDS contracts caused by loan refinancing that is fair to both the buy- and sell-side. However, traders report starkly different levels of LCDS index activity on either side of the Atlantic.

A small ad hoc group of buy- and sell-side firms are working on proposals to create bullet LCDS contracts, whereby the CDS would be paid out if the referenced syndicated loans were terminated or transferred to a successor. The LCDS trading community has historically been divided between protection buyers - who want fully cancellable contracts - and protection sellers, who prefer bullet structures (see SCI issue 71). But BlueMountain Capital Management is believed to have initiated the project and so the hope is that the resulting documentation will take into account the views of both dealers and investors.

"The firms involved have been active in previous LCDS working groups and so are familiar with the issues," notes one source. "And because the buy-side is being represented, the draft should be friendly to both sides."

Law firm Richards Kibbe & Orbe is understood to have been hired to work on the draft documentation, with the aim of publishing it next month. Though the intention is to eventually rework the ISDA successor definitions in order to accommodate a bullet structure, the draft has yet to be passed on to the Association.

Meanwhile, LCDX traders report that market activity has increased dramatically since March, with LCDS and cash loans outperforming their peers on the strength of fundamental analysis. One says: "This has been helpful for trading flows and the development of the LCDS product in general. Prior to this, there had been a technical sell-off in the sector."

He adds that, while technical flaws in the LCDS contract are currently preventing the market from reaching its potential, trading activity is expected to pick up in anticipation of the new bullet-style contracts being launched.

However, European LCDS traders paint a starkly different picture to their US counterparts. According to one, the "LevX party is over".

He adds: "Unfortunately, the LevX index was given too small a window to develop and so traders moved on - it never really had chance to get going in the bull market and so liquidity is even worse now, in spite of the improvements on the documentation side. It is still ticking over, but liquidity has disappeared."

Consequently, a number of houses are beefing up their European high yield CDS trading capabilities, with some transferring their LCDS expertise across because there is more activity in that market. "The high yield market is a more established market than the loan market in Europe," another trader confirms.

In terms of the high yield sector, traders are aware that defaults are coming, but they haven't yet figured out when or where. There are yet to be any real casualties, though some names are obviously performing better than others.

"The market is pricing in defaults to hit at end-2008 or the beginning of 2009. This is when the crisis is expected to filter down and begin impacting consumers and corporates," the trader concludes.

CS

Opinion division

Mixture of responses to potential index launch

Six months on from the originally projected start of the ERMBX index (see SCI issue 72), its launch still appears a remote possibility. However, traders report that activity is going on behind the scenes and work continues on finding broad-based agreement on structure and documentation.

At the same time, ABS traders remain divided in their expectations for the potential launch of ERMBX. One notes that there is the feeling that some dealers now want to proceed with the index, although he does not expect to see any concrete developments before the end of the summer.

"It is not a question of if the index will launch, it is a question of when it will launch," he says. "Now is perhaps not the right time to launch it, but the time may be right in six months."

Another maintains his stance that the launch of the index will be a negative for the market because it isn't as balanced as the players who would like to use it, adding that the index is not useful to those who want to take a view on a particular vintage. "Launching the index at this stage would also bring the ire of the regulators," he suggests.

However, a further trader - who was vehemently against the launch of the index in January - has modified his opinion. "I can understand why traders might be willing to give the index a go now, following a sustained period where spreads on UK prime RMBS CDS names have been range-bound," he says. "I'm less averse to the launch of an index than I was, although I still think that it would be fragile and could potentially bring a lot of misfortunes."

Since the rejection of the ERMBX in January, prime RMBS CDS spreads have risen to record highs. In mid-April, for example, CDS on names such as HBOS' Permanent RMBS climbed to around the 170bp mark. They have since receded and are currently trading at the 80bp-90bp level, having been in the 80bp-100bp bracket since the end of April.

ERMBX will consist of two sub-indices - euro-denominated triple-A and triple-B indices - and will reference single name CDS referencing UK prime RMBS. The index is expected to roll on a semi-annual basis. It was originally slated to launch at the beginning of this year before being put on hold by Markit, due to highly volatile market conditions and a split within the trader community over the planned launch.

Meanwhile, the European CMBS market remains fragile and illiquid - both in the primary and secondary market - according to market participants, meaning that the launch of the ECMBX index is potentially further off than that of the ERMBX. Nonetheless, a trader remarks: "I have no doubt that this index will eventually launch too and be used by many market players." A Markit official states that both the ECMBX and ERMBX indices are still on hold.

AC

Structured credit head appointed

The latest company and people moves

Structured credit head appointed
Benjamin Jacquard has joined BNP Paribas as global head of structured credit and arbitrage trading. Jacquard moves over from Calyon, where he was global head of structured credit. He reports to Guillaume Amblard, global head of fixed income trading at BNP Paribas.

He effectively replaces Stephane Delacote, who left the bank several months ago. Delacote held the post of head of structured credit trading and arbitrage at the bank.

Portfolio manager leaves Cairn ...
Jenna Collins, portfolio manager at Cairn Capital, is understood to be moving to Merrill Lynch where she will work on the prop trading desk transacting US and European ABS long/short trades. Before joining Cairn, Collins was a member of Merrill Lynch's ABS research team.

... while portfolio manager joins BlackRock
BlackRock has hired Curtis Arledge as md and co-head of US fixed income, within the fixed income portfolio management group. He will be responsible for managing fixed income portfolios, with a sector emphasis on non-agency ABS and MBS. Arledge will report to Scott Amero and Peter Fisher, co-heads of BlackRock's fixed income portfolio management group.

Prior to rejoining BlackRock, Arledge was with Wachovia Corporation for 12 years, most recently as global head of the fixed income division and a member of the corporate and investment bank's executive and CIB risk/return committees. He had oversight for various business lines in the US, Europe and Asia, including leveraged finance, investment grade, global rates, structured products, corporate loan and commercial real estate portfolios, and financial institutions investment banking. He joined Wachovia's proprietary trading desk in 1996.

Schüler joins Markit
Markit has appointed Marcus Schüler as md in sales and marketing, based in London. He will be responsible for Markit's relationships with regulators, central banks, trade associations and accounting firms - a mandate that spans all of the firm's products and services, as well as geographic regions. He will report to Shane Akeroyd and Mike Rushmore, global co-heads of sales and marketing.

Schüler joins Markit from Deutsche Bank, where he was md and head of integrated credit marketing in Europe for nearly four years. In this role he led marketing and product development for flow and lightly structured credit products. Prior to Deutsche Bank, Schüler was responsible for credit derivative marketing at JPMorgan, where he was involved in the creation of the iTraxx credit derivative indices.

Russian hires for DB
Deutsche Bank has added two structured credit personnel in its Moscow office. Alex Bronin has been appointed head of emerging markets structuring for Russia and CIS, and Diana Nikolova joins the bank as a senior structurer focusing on Russian structured credit.

Bronin is returning to Deutsche Bank after two years at Goldman Sachs in its FICC structuring team. He previously spent over eight years at Deutsche Bank in emerging markets structuring.

Nikolova joins Deutsche Bank from Merrill Lynch, where she was a vp in the emerging markets illiquid credit structuring team, focusing primarily on the CIS region. She was at Merrill Lynch for five years and was previously a member of the leveraged finance team at UBS for two years.

Solidus takes on ACA's CDOs
Solidus Capital, a subsidiary of FSI Capital, has taken over the collateral management of 18 ABS CDOs formerly managed by ACA Management. This is understood to be the largest single CDO management acquisition to date.

The transfer of the management of these CDOs required the consent of most of the senior debt investors in the market, as well as the rating agencies. With the completion of this transaction, FSI Capital, through its affiliates and subsidiaries, manages over 25 CDOs totalling over US$15bn in assets under management.

Last month, Apidos Capital Management took over the management of four CLOs, also formerly managed by ACA Management (see SCI issue 89).

New CLO trading desk opened
Morgan Joseph has created a new analytics and trading group that will initially trade CLOs, RMBS, CMBS and ABS. Darren Wolberg and Dale Hoffman have been hired as mds and heads of the new group, reporting to Matthew Stedman, head of sales.

Hoffman and Wolberg previously worked in the structured products group at BB&T capital markets. Wolberg was md of the alternative spread products trading desk, while Hoffman was primarily responsible for trading and marketing CLOs and TRUPs.

Also joining Morgan Joseph's fixed income structured products group is Jay Bisarya, who was named director, fixed income, and who will be chiefly involved in marketing. Bisarya has previously been involved in the structured credit groups at RBC Capital Markets, ABN AMRO and Deutsche Bank, as well as equity trading at Wedbush Morgan Securities.

GSO takes on Carador
Investment management of permacap Carador has been transferred from Washington Square Investment Management (WSqIM) to GSO Capital Partners International, a subsidiary of The Blackstone Group. However, the key WSqIM executives with responsibility for the vehicle's portfolio have also been transferred to GSO.

The move follows a Novation Agreement signed yesterday, 16 June, to the existing investment management agreement between Carador, WSqIM and GSO, which sees the new investment management arrangement continuing on identical terms. The two firms say that agreement will enable Carador to benefit from the experience and continuity of the WSqIM team, while enhancing its ability to take full advantage of the opportunities currently present in the structured credit market by leveraging the further skills and opportunities available through GSO's global investment management and financial advisory operations.

Carador is understood to have been transferred to GSO due to liquidity issues. WSqIM's IG CDOs and credit fund will remain within the WSqIM group, however.

Old Lane restructured
Citi has closed its US$9bn Old Lane hedge fund and will bring the assets onto its balance sheet at fair value, with the negative effect on capital only being 4bp. The firm says the move will help "maximise efforts to retain talent and create synergies among trading platforms". Following poor performance and the promotion of key executives from the fund to other positions at Citi, Old Lane notified investors in Q1 that they could redeem their investments in the fund - without restriction - on 31 July.

As part of the restructuring of the fund, certain strategies - convertible equities, credit fixed income and structured credit - will be integrated into the proprietary activities of Citi's Securities and Banking business. Old Lane will then establish a number of single-strategy funds, with future offerings designed to meet client demand as part of the Citi Alternative Investments client platform.

KBCFP opens Dubai branch
KBC Financial Products is opening an office in Dubai. The office will operate from the Dubai International Financial Centre (DIFC), with an initial focus on sales and marketing of KBC-managed investment products to MENA-based institutional clients, sovereign investment authorities and selected ultra-high net worth individuals. In addition, the office will arrange or advise on structured credit and fund products, corporate finance transactions and international brokerage.

Wassim Slama has been appointed senior executive officer for the DIFC office. He is relocating from KBCFP's Tokyo branch, where he was in charge of the Middle East Business Development Unit within the company's asset management division.

SPSE and SuperDerivatives team up
S&P's Securities Evaluations (SPSE) and SuperDerivatives have signed an agreement to establish a strategic sales and marketing alliance to combine their valuation offerings for fixed income securities (cash and structured products) and all major OTC and exchange-traded derivative asset classes into one sales and marketing channel.

The new platform will provide both companies' models and market data-based pricing services to provide independent valuations for global instruments, including government, municipal and corporate bonds, syndicated loans, asset- and mortgaged-backed securities and money market instruments. Additionally, the services will cover vanilla and exotic OTC derivatives, as well as exchange-traded derivatives on major asset classes including foreign currency, interest rates, commodities, energy, equities and credit.

"This commercial venture between SuperDerivatives and Standard & Poor's Securities Evaluations is aimed at enabling our customers from developed and emerging markets to effectively value the widest range of products in a single offering," says David Gershon, SuperDerivatives ceo. "Whether they are from the buy- or sell-side, our customers will benefit from a 'one-stop-shop' experience with the objective of delivering the most accurate and reliable valuation service with significant economy of scale advantages. I believe that this alliance will form a new global standard for independent valuation service."

Markit and ZM Financial link up
Markit has integrated its cashflow models with asset/liability management (ALM) analytics provider ZM Financial Systems' newly launched onlineALM website.

Banks and institutional investors use Markit's cashflow models to evaluate CMOs and ABS, and to manage interest rate, prepayment and default risk in fixed income portfolios. The integration of Markit's cashflow models with ZM Financial Systems' onlineALM solution creates a powerful tool that will allow ALM professionals to assess balance sheet risk accurately over a range of interest rate assumptions.

NumeriX opens Hong Kong office
NumeriX has opened a new office in Hong Kong, which will be led by NumeriX and derivatives veteran Stephen Cheng. "With the explosive growth of the derivative and structured products markets, as well as the opening of new markets in the region, there has been a significant increase in demand for NumeriX analytics," says NumeriX president and coo Steven O'Hanlon.

AC & CS

Cheyne to provide template for other SIV restructurings

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

Cheyne to provide template for other SIV restructurings
The restructuring of Cheyne Capital's SIV, Cheyne Finance, is close to completion. Goldman Sachs has been mandated to carry out the restructuring, which is due to be completed by August at the latest.

According to Mark Fennessy, a partner at Orrick, Herrington & Sutcliffe, Cheyne provides the template for all other SIV, SIV-lite and ABCP restructurings going forward. However, he notes that Cheyne's restructuring has taken longer than expected due to unforeseen problems in unravelling the structure.

The restructuring process will entail GS auctioning off a portion of the SIV's assets in order to gauge the correct market price. The remaining assets will then be sold into a new SPV set up by the bank, using price levels from the auctioned assets. Existing senior SIV investors from Cheyne Finance will be invited to invest in the new structure.

A spokesperson for Cheyne adds: "We're gratified that measures we took more than a year ago to ensure the quality of the assets in the SIV and the high level of cash are enabling this transaction to proceed on favourable terms. We are pleased that Goldman Sachs and Deloitte now appear to have got this deal done."

It is believed that the restructuring model used for Cheyne Finance will also be applied to the Rhinebridge, Mainsail and Goldenkey SIVs, the restructuring of which GS has also been mandated for. Another bank is understood to have the mandate for the Whistlejacket restructuring.

Analysts at RBS suggest that such restructurings should further underpin the already orderly nature of the unwinding process of SIVs. They add that the market-clearing sale price may give banks somewhere to mark such level 2 and level 3 assets, based on a wider roll-out of the GS structure.

No rating actions following S&P CPDO rating error
S&P has confirmed that there were no erroneous ratings assigned as a result of a fault in a CPDO rating model. The agency admitted to the SEC that it discovered an error in a trial version of one of its models that was used in connection with the initial ratings on five public CPDOs, and that was briefly used for surveillance analysis.

"This error did not result in a ratings change and was caught and remedied by our ratings process," says an S&P spokesperson. "In the interest of full transparency and openness, S&P has disclosed this situation to the SEC." The incident comes three weeks after it emerged that a computer coding error led Moody's to mistakenly assign a triple-A rating to a CPDO.

CDOs hit by monoline downgrades
S&P has placed 111 tranche ratings from European, 192 from US and 15 from Asia-Pacific synthetic CDO transactions on credit watch with negative implications and lowered those of two others. The move follows a review of the European synthetic CDO transactions with exposure to Ambac, FGIC, MBIA and XLCA, whose financial strength ratings were either lowered or placed on credit watch negative on 5 and 6 June (see last week's issue).

This review is outside the normal month-end batch run review for synthetic CDO transactions and incorporates current ratings in the underlying reference portfolios. Specifically the credit watch negative placements on the CDO tranches are thanks to negative rating migration in their portfolios. This is due to, but is not limited to, the downgrades of Ambac and MBIA, and the watch negative placements of FGIC and XL in the respective portfolios and the resultant fall in each tranche's SROC ratio below 100%.

The number of transactions referencing the affected monolines is broken down as follows: Ambac 829; FGIC 132; MBIA 969; and XLCA 695. In total, 1017 European synthetic CDO transactions had exposure to at least one affected monoline. In addition, the majority of the deals had more than one of the affected monolines referenced in its portfolio: 119 transactions referenced all four; 302 transactions referenced three; 482 transactions referenced two; and 114 transactions referenced one.

In total, 144 public and 67 confidential Asia-Pacific synthetic CDO transactions are exposed to at least one affected monoline. MBIA is the most commonly referenced.

CDR brings counterparty risk index
Credit Derivatives Research has launched a counterparty risk index that tracks the credit risk of major credit derivatives dealers in which CDS counterparty risk is particularly concentrated (see Data section).

The group includes ABN AMRO, Credit Suisse, Merrill Lynch, Bank of America, Deutsche Bank, Morgan Stanley, Barclays Capital, Goldman Sachs, UBS, Bear Stearns Companies, HSBC, Wachovia Corp, BNP Paribas, JPMorgan, Citi and Lehman Brothers. The index averages the market spreads of the CDS of these credit derivatives dealers, producing a market-based measure of the default risk.

EU to regulate CRA internal governance?
European Commissioner for Internal Market and Services Charlie McCreevy is to move ahead with a regulatory solution to reforming the internal governance of rating agencies, after referring to IOSCO's Code of Conduct as a "toothless wonder".

"Many of the recent IOSCO task force recommendations do not appear enforceable in a meaningful way and I am now convinced that limited but mandatory, well targeted and robust internal governance reforms are going to be imperative to complement stronger external oversight of rating agencies," he explained to delegates at the inaugural Global Financial Services Centre Conference in Dublin.

In recognition that the views of EU Member State governments on corporate governance diverge, McCreevy stressed that he won't be proposing a template for rating agency governance that would create or could be seen as a precedent for other businesses that do not play such a central role in the financial market regulatory system or have such embedded conflicts of interest in their business models. "External oversight is absolutely necessary in respect of, for example, the policies and procedures of CRAs. But on the substance of ratings and design of models it would be inappropriate," he said.

Rather, the solution is likely to focus on robust, ring-fenced internal governance of rating content, including statistical modeling, and of the quality and remuneration structures of analysts and the promulgation of appropriate corporate culture. McCreevy hopes to propose appropriate measures in a few months' time, which are intended to encourage entry to the market by new players working perhaps on a different business model.

Outlook negative for Spanish SME CLOs
Fitch has assigned negative rating outlooks to 14 classes from 11 Spanish SME CLO transactions. The negative outlooks reflect rapidly increasing arrears, exacerbated by current concerns regarding portfolio credit quality and industry concentration in real estate and related sectors.

The current levels of credit support for the classes on negative outlooks compare unfavourably with the 90+ day delinquency trends when projected forward over the next 24 months. In addition, industry concentration to real estate, construction and building materials companies remains a long-term concern.

Fitch reiterates that these negative rating outlooks are not downgrades, nor are tranches being placed on rating watch negative. The current levels of credit support are sufficient to justify the current ratings in Fitch-rated Spanish SME CLOs; however, in select instances, the agency has a negative view on the long-term performance of certain classes.

Fitch rates CLO
Fitch has assigned sole double-A ratings to the €830m Class A notes of Betula Funding 1, a static European CLO arranged by Lehman Brothers. The transaction priced at 250bp over Euribor and includes a first-loss piece worth €310.8m.

A portion of the proceeds from the issuance of the subordinated notes is to be used to pay certain initial expenses of the issuer and is therefore not available as subordination. The net proceeds from the note issuance are used to purchase a portfolio of at least €1.14bn of primarily European senior secured loans and to fund certain initial expenses. At the closing date, the issuer purchased 100% of the target portfolio.

The rating also takes into account the quality and diversity of the portfolio of assets. Although the portfolio is static, Landsbanki Islands, as liquidation agent has the right to sell assets subject to guidelines. The said guidelines limit Landsbanki Islands to sell defaulted and credit-impaired obligations below par value only after offering each obligation to the senior noteholders and obtaining bids from independent dealers.

Basel reports on initial assessment of valuation practices ...
Recognising the critical importance of sound valuations to risk management, financial reporting and regulatory capital adequacy, in early 2007 the Basel Committee on Banking Supervision initiated a project to gain a deeper understanding of approaches used to determine valuations of complex financial instruments. Within the context of existing accounting standards, the Committee's work focused on the use of valuation methodologies for risk management and financial reporting purposes. It also assessed the related control, audit and governance practices surrounding fair value measurement.

In response to the market turmoil that emerged during mid-2007, the scope of the work was subsequently expanded to include coverage of how banks responded to the market stress and initial lessons learned. Drawing on the work of the Committee's Accounting Task Force and Risk Management and Modelling Group, Basel has released a paper summarising the Committee's initial assessment of valuation practices.

To strengthen practices and promote greater transparency regarding valuation processes, the Committee is undertaking further work to develop guidance that supervisors can use to assess the rigour of banks' valuation processes and promote improvements in risk management and control practices. The Committee will also work with accounting and auditing standard setters and auditors to promote standards and practices that enhance the reliability, verifiability and transparency of fair value estimates.

These initiatives will build off existing Basel Committee and industry guidance. They are also part of a broader effort by the Committee and national supervisors to strengthen firm-wide risk management practices.

The Committee says it is critical that banks have robust valuation and accounting classification processes in place to address the challenges that arise from valuing products that are either inherently complex or illiquid. It suggests four key areas where practices can be improved: governance and controls; risk management and measurement; valuation adjustments and uncertainty; and financial reporting.

... and issues RFC on liquidity risk management principles
The Basel Committee on Banking Supervision has issued for public comment its enhanced global 'Principles for Sound Liquidity Risk Management and Supervision'. The principles support one of the key recommendations for strengthening prudential oversight set out in the 'Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience', which was presented to G7 Finance Ministers and Central Bank Governors in April 2008.

"The Basel Committee's goal in developing these global standards is to significantly raise the bar for the management and supervision of liquidity risk at banks," states Nout Wellink, chairman of the Basel Committee and president of the Netherlands Bank. "The Committee fully expects banks and supervisors to implement the enhanced principles promptly and thoroughly. We will vigorously assess the degree to which the principles are implemented."

The draft principles represent a substantial revision of the Committee's liquidity guidance that was published in 2000 and reflect the lessons of the financial market turmoil. The work was drawn from recent and ongoing work on liquidity risk by the public and private sectors and is intended to strengthen banks' liquidity risk management and improve global supervisory practices.

"The principles are based on the fundamental premise that a bank's liquidity risk framework should ensure it maintains sufficient liquidity to withstand a range of stress events, including those that affect secured and unsecured funding," notes Nigel Jenkinson, co-chairman of the Basel Committee's Working Group on Liquidity and executive director of the Bank of England.

Arthur Angulo, the other co-chairman of the Working Group and svp of the Federal Reserve Bank of New York, adds: "Supervisors, for their part, should assess the adequacy of both a bank's liquidity risk management framework and its liquidity position. In order to protect depositors and to limit potential damage to the financial system, supervisors should take prompt action if a bank is deficient in either area."

The principles underscore the importance of establishing a robust liquidity risk management framework that is well integrated into the bank-wide risk management process. The primary objective of this guidance is to raise banks' resilience to liquidity stress, including raising standards in the following areas:

• Governance and the articulation of a firm-wide liquidity risk tolerance;
• Liquidity risk measurement, including the capture of off-balance sheet exposures, securitisation activities and other contingent liquidity risks that were not well managed during the financial market turmoil;
• Aligning the risk-taking incentives of individual business units with the liquidity risk exposures their activities create for the bank;
• Stress tests that cover a variety of institution-specific and market-wide scenarios, with a link to the development of effective contingency funding plans;
• Strong management of intraday liquidity risks and collateral positions;
• Maintenance of a robust cushion of unencumbered, high quality liquid assets to be in a position to survive protracted periods of liquidity stress; and
• Regular public disclosures, both quantitative and qualitative, of a bank's liquidity risk profile and management.

The principles also strengthen expectations about the role of supervisors, including the need to intervene in a timely manner to address deficiencies and the importance of communication with other supervisors and public authorities, both within and across national borders.

Fitch Solutions launches credit risk analytics platform
Fitch Solutions has launched a new platform providing market-based credit risk analytics, CDS pricing and fundamental ratings content. The platform, called 'Fitch Risk and Performance Platform', is an extension of Fitch's market-implied ratings platform and incorporates new tools for reviewing credit entity performance within a user's portfolio.

"Fitch's new platform provides an integrated view of credit market pricing and best-of-breed single-entity credit risk models," says senior director Jonathan Di Giambattista. "A critical added component to the Fitch Risk and Performance Platform is the inclusion of deltas over user-defined time periods. This allows the front and middle-office functions to quickly ascertain how each individual entity in a portfolio has performed over time, and whether implied ratings signals are converging across debt and equity markets and fundamental ratings."

MBIA pursues 'Newco' plans
Jay Brown, MBIA's chairman and ceo, has written to shareholders saying that a key action item for the monoline is to continue pursuing opportunities to support the bond insurance market as a whole in conjunction with the New York State Insurance Department and other stakeholders. In addition, the monoline will assess what would be required of it by the rating agencies and regulators to use one of its two fully licensed subsidiaries as a triple-A subsidiary for new public finance business.

"We have received a wide variety of third-party interest in providing capital directly to such a 'Newco' and we have a substantial amount of liquidity available provided by our shareholders, so having adequate capital is not an obstacle," Brown states. "The real issue will be whether the agencies will establish and articulate clear capital and other requirements that will allow both our shareholders and outside investors to earn an acceptable return. While we think the investment opportunity remains compelling, we fully intend to review it against the alternatives we have available at this point in time. It is not inconceivable that the agencies could establish a non-economic level of required capital or impose other qualitative factors in the ratings analysis, which would make this alternative unattractive."

In the short term MBIA expects that its de-leveraging will accelerate as more issues are refunded and its liability is extinguished, more installment policies are cancelled and minimal new business is added to the portfolio. Brown suggests that the actions of the rating agencies will accelerate the speed with which the monoline exceeds the target levels of capital required for a triple-A rating. In addition, he continues to believe that rating agencies' stress cases will begin to move down over the next 12 to 18 months as more hard data demonstrates the actual severity of projected mortgage-related losses. "Bottom-line, we believe that the capital required to support our existing insurance company portfolio will continue to decrease over the next few years in a dramatic fashion."

MBIA has confirmed that it is no longer considering transferring US$900m from its holding company to its operating subsidiary.

European SROC results released
After running its month-end SROC figures, S&P has taken credit watch actions on 51 European synthetic CDO tranches. Specifically, ratings on 28 tranches were placed on credit watch with negative implications and 23 tranches were removed from watch negative and affirmed.

Of the 28 tranches placed on watch negative, 25 reference US RMBS and US CDOs that are exposed to US RMBS, which have experienced recent negative rating actions. Three have experienced corporate downgrades in their portfolios.

Portfolio reconciliation increases
TriOptima estimates that its triResolve portfolio reconciliation service is regularly reconciling 40% of all OTC derivative transactions globally. Currently seven million live trades (double counted) are reconciled regularly on triResolve, up from four million at the end of 2007 (a 75% increase in reconciled trades). This represents trades from more than 200 institutions, including 13 of the Fed 18 banks.

"During recent periods of market turbulence, triResolve subscribers were able to monitor credit exposures with their counterparties and report to senior management on a daily basis. Experience with the service during the sub-prime market disruptions in late 2007 and then the Bear Stearns situation brought new subscribers into triResolve, as well as accelerated the number of reconciliations being done on the service. Both of these factors contributed to the significant growth we've seen in triResolve in the last few months," comments Viktor Johannsson, global business manager for triResolve.

CS & AC 

Trading ideas: hedged against headwinds

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at an outright long trade on Southwest Airlines

It's a brave new world, with crude oil trading above US$130/barrel. Gazprom has speculated a further doubling in price  (reminds us a bit of the book Dow 36,000 published back in 2000). High fuel costs are here to stay and will continue to reshape the airline industry.

Southwest Airlines is positioned well above its competitors, due to its low-cost structure and aggressive fuel hedging program. It started hedging fuel costs back in 1999 when crude was trading at US$11/barrel. It has 71% of its fuel costs for 2008 hedged at US$51/barrel, 55% of 2009 fuel costs hedged and over 25% of 2010 fuel costs hedged.

Southwest took a bold bet on the direction of crude and it was right. This flexibility gives it the ability to hold fares down when other airlines seem to be searching for creative and not-so creative ways to pass costs down to the consumer.

We recommend selling CDS protection on Southwest Airlines. At current levels, we believe the risk/reward ratio of the trade is heavily favoured to the reward side, with the spread compensation level reaching multi-year highs. Our fair-value credit model indicates Southwest Airlines' CDS spread to be cheap by over 60bp due to its strong earnings quality.

Spread compensation
A measure we use to find desirable risk/return profiles is SPD (Spread Per unit Default probability). As its name suggests, SPD is the amount of spread (in basis points) that we earn for each unit of default risk that we take.

This simple risk-to-reward ratio is akin to the complete MFCI model but limits its scope to only one factor used within the model - equity-implied default probability (EiPD). The SPD for Southwest Airlines has increased consistently since late 2006 and even more recently it shot upwards on the back of airline industry woes. The spread compensation an investor receives for taking on a long credit exposure to Southwest is back at its highs (Exhibit 1).

Exhibit 1

Basis for credit picking
Our credit 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 way to select long/short trades.

The model ranks each issuer on a scale of 1 to 10 using seven factors (1 = poor credit, 10 = good credit). Exhibit 2 lists all the factor scores for Southwest. We see a 'fair spread' of 104.5bp due to its high ranking accruals, leverage and free cashflow factors.

Exhibit 2

We use accruals to measure a company's earnings quality and its ability to generate consistent earnings going forward. Accruals are the portion of income directly attributable to cash inflows rather than phantom accounting tricks. Academic research has shown a strong correlation between positive accruals and negative equity returns due to possible accounting manipulation that is not sustainable.

Exhibit 3 shows the time series for Southwest's rolling four-quarter average accruals. Negative accruals are a positive sign of earnings quality. The accrual levels for Southwest remain well in negative territory, making us very confident in its ability to produce quality earnings in the future.

Exhibit 3

Limited downside
After finding trades that make fundamental sense, 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 to.

The CDS spread for Southwest recently widened on the back of crude oil price rises and airline industry woes. Its spread is 50bp tight of the wide it hit back in March (during the BSC bailout) and is 70bp wide of its one-year average spread (Exhibit 4).

Exhibit 4

Risk analysis
This trade takes an outright long position. It is not hedged against general market moves or against idiosyncratic curve movements.

Additionally, we face about 5bp-10bp of bid-offer to cross, which is not too onerous given LUV's current levels. The trade has positive carry and positive curve roll-down to offset any spread widening. We believe that the challenge is worthwhile, given LUV's current levels and our outlook for the credit.

Entering and exiting any trade carries execution risk, but SHW has good liquidity in the CDS market at the five-year tenor.

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 based on our positive outlook for LUV CDS. Taking a long outright exposure means we are placing a lot of faith in our fundamental view of the credit. While we have chosen a security and tenor that we believe offers the best opportunity for profit, our bullish view on the credit is the driver of this trade.

Southwest Airlines (analyst: B. Craig Hutson) Credit Score: 0 (Stable)
We believe over the long term that Southwest will be the beneficiary of capacity cuts, extra charges by competitors and the best customer service and on-time record in the industry. We believe it will be prudent with its balance sheet and avoid any possible M&A activity. Only single-A rated issuer in a very tough industry. It has outperformed its peers because of its low cost structure, including a very successful fuel hedging programme. Continues to expand its nationwide network. Liquidity is solid.

Summary and trade recommendation
It's a brave new world, with crude oil trading above US$130/barrel. Speculation of a further doubling in price has been predicted by Gazprom (reminds us a bit of the book 'Dow 36,000' published back in 2000). High fuel costs are here to stay and will continue to reshape the airline industry.

Southwest Airlines is positioned well above its competitors, due to its low-cost structure and aggressive fuel hedging programme. It started hedging fuel costs back in 1999 when crude was trading at US$11/barrel. It has 71% of its fuel costs for 2008 hedged at US$51/barrel, 55% of 2009 fuel costs hedged and over 25% of 2010 fuel costs hedged.

Southwest took a bold bet on the direction of crude and it was right. This flexibility gives it the ability to hold its fares down when other airlines seem to be searching for creative and not-so creative ways to pass costs down to the consumer.

We recommend selling CDS protection on Southwest Airlines. At current levels, we believe the risk/reward ratio of the trade is heavily favoured to the reward side, with the spread compensation level reaching multi-year highs. Our fair-value credit model indicates Southwest Airlines' CDS spread to be cheap by over 60bp due to its strong earnings quality.

Sell US$10m notional Southwest Airlines 5 Year CDS protection at 165bp.

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).