Contents

Worsening case?

Monoline credit event speculation increases

The worst-case scenario in the monoline saga - where the market value of underlying assets drops at the same time as a financial guarantor's CDS widens or claims paying ability fails - looks set to play out imminently. However, amid negotiations to commute certain insurance contracts, the market has been left guessing as to when a credit event could finally be called on a monoline entity.

Ambac, FGIC and MBIA are in talks with a number of banks to commute US$125bn of CDS contracts on ABS CDOs. Banks have so far taken around US$20bn write-downs on these positions.

"The cynical interpretation is that investors in the wrapped notes are marking down their positions with the view that the wrap hasn't worked. But the fee that the monolines will have to pay to terminate the contract will enable them to recoup some of the losses," says one lawyer away from the situation.

But the problem is how to value the position. According to Jeremy Jennings-Mares, partner in Morrison & Foerster's UK Capital Markets Practice: "It'll be a long, drawn-out negotiation process. Each credit default swap has to be 'valued' individually by the parties. If there's no agreement, there's no commutation and the CDS will usually remain in place - even if there are any additional monoline downgrades."

The legal issues surrounding the commutation of the CDS contracts fall into two groups: the structure of the specific CDO; and the CDS written on the monoline itself. Depending on the terms of the notes, termination of the wrap may trigger an event of default - meaning that the formal agreement by the noteholders, the trustee and potentially the collateral manager will need to be obtained as prescribed under the transaction documents.

In terms of CDS written on monoline entities, the lawyer suggests that buyers of protection may be wondering if they are getting any closer to a credit event being triggered. At this stage, however, it doesn't appear that a credit event will have occurred for a number of reasons.

First, the amendment of the transaction documents should mean that no inadvertent failure to pay will occur. Second, restructuring isn't relevant, since a reduction of the interest and principal hasn't occurred. Bankruptcy is more of a difficult issue, however, as there have been some suggestions that the monolines' reserves may be insufficient for them to meet their obligations. But the lawyer points out that monolines are regulated by New York statute, so any insolvency actions will have to be initiated by the State Insurance Department - and the regulators appear to view them as solvent at the moment.

Regulators won't be keen to allow CDO CDS policyholders to 'extract value' from a monoline to the possible detriment of municipal bond insurance policyholders, says Jennings-Mares. "The only way this will happen is if it's clear it's a good deal for the monoline, based on a perceived high risk of the relevant CDO defaulting. Even if commutation payments are permitted by regulators, CDO CDS policyholders would need to get legal advice on the risks of an insolvency official of the monoline being able to claw back amounts paid to the policyholders as a result of commuting the CDS. However, they may feel that cash in hand is worth any 'risk'," he comments.

The lawyer notes that the wider issue for Ambac and MBIA is not necessarily whether they're insolvent, but that the foundation for their business (their triple-A rating) has disappeared. "Why would anyone do business with them now?" she asks. "Even the idea of setting up separate municipal insurance companies is unlikely to help - investors are likely to view them as simply the lesser of two evils."

The monoline downgrade process is expected to accelerate from now on, with many guarantors effectively being left to slip into run-off mode. And banks will almost certainly need to take higher marks in Q2 earnings - particularly if the monoline exposure falls into the trading book category where mark-to-market accounting is compulsory.

"If the monolines have sufficient claims paying resources to meet their claims as they fall due, and the bank has the capacity to continue to hold the position, then the marks should be more modest," says Corinne Cunningham, head of financials research at RBS.

However, the maximum loss for a bank would be incurred when both the underlying asset defaulted with zero recovery and the monoline failed concurrently, again with no recovery. "That scenario is highly unlikely in the case of wrapped bonds, but the chances are higher with respect to ABS CDOs - particularly those involving sub-prime assets, especially those involving mezzanine risk," Cunningham warns.

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Resilient assets

SME CLOs to buoy new issue pipeline

The pipeline for European SME CLO deals is building (see SCI pipeline), with investors also pointing to a number of private transactions in the marketing stages. Structured credit market participants suggest that the asset class is likely to be one of the main sources of new issuance in the coming months.

One SME CLO investor confirms that he is being shown a number of new private SME CLOs, two from Germany - one of which is a mezzanine deal - and another from Belgium. He is also being shown a number of small deals from Eastern European countries, including Bulgaria.

The investor notes that the size of the deals being marketed is much smaller than they were in the past. In addition - due to limited triple-A demand for the transactions - he is now looking at senior tranches, whereas previously he had invested predominantly in mezzanine paper. "It's quite a good market for us, as we have plenty of choice," he adds.

Ganesh Rajendra, head of securitisation research, Europe & Asia at Deutsche Bank, says he sees deal flow in SME CLOs as being "relatively resilient in the post-crisis primary market, not least given issuer capital-related motivations".

An example of such a transaction is the recent €453m German SME CLO, launched and priced by DB last Friday. S-CORE 2008-1, the second issue from DB's S-CORE programme, references self-originated Schuldschein loan agreements.

The deal was placed with a "good handful" of investors, both new and existing in the SME CLO space. Demand was seen at the top of the capital structure, with classes rated triple-A down to single-A being pre-placed or sold publicly to end investors. However, DB retained the remaining classes rated from triple-B downwards on its own balance sheet, as demand was not strong enough for these tranches.

"S-CORE worked in the current market because spreads were offered at very attractive levels, plus they were offered at discounted prices," says a source close to the deal. Indeed, discounts were offered on all tranches, bringing the pricing level for the triple-As to 120bp over three-month Euribor, with a weighted average life of 4.2 years.

The deal priced slightly inside of current secondary market spread levels, with Geldilux 2007-TS A - a German SME CLO from HVB - seen at the most comparable level at 130bp, although with a slightly shorter WAL of 3.8 years. According to HSBC research, the deal tightened in from a mid-level of 164bp a week earlier. A secondary CDO trader reports that SME CLOs are seeing more trading activity than other CLOs, due to the nature of the underlying collateral - with a particular emphasis on names from the UK and Holland.

The Spanish SME CLOs that have joined the pipeline recently include Caixa Tarragona's debut transaction, a €2bn deal for Empresas Banesto 2 via JPMorgan and the €768m Foncaixa FTGENCAT 6. The likelihood is, however, that these deals will be privately placed or retained for use as repo collateral with the ECB.

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Tipping point

Uncertainty in correlation prompts replication strategies

Correlation appears to be at a tipping point, set to increase or decrease depending on the monoline fallout. Such uncertainty is prompting some analysts to recommend replication strategies instead of taking outright long positions on the CDS indices.

John McGoff, correlation portfolio manager at Credaris, confirms that the correlation market is waiting to see what the impact of the monolines will be before it decides which way to move. "The monolines recently got downgraded [see News round-up], so there is concern they won't be able to sell super-senior protection again going forwards. Further worries about potential unwinds of this risk is keeping correlation at the highest level we've seen for some time," he notes.

McGoff adds: "However, as they become increasingly more distressed, correlation may decrease due to the emergence of jump-to-default risk. At some point, this situation will be resolved as the monolines either default or go into run-off and potentially begin liquidating their portfolios."

Correlation could consequently move either way - though some traders expect it to increase, particularly in junior mezz where the tranches are not yet saturated with losses as dispersion pushes the equity tranches wider. Correlation is currently at around 47% in equity tranches (having reached almost 60% in March).

Idiosyncratic risk is nonetheless likely to increase as defaults begin to come through. Priya Shah, structured credit strategist at Dresdner Kleinwort, agrees that some significant names are expected to default by the end of the year.

"It will only take one or two big defaults to lead to a sudden drop in correlation; therefore, investors should be cautious about taking on long correlation trades," she notes. "The senior end of the capital structure is more attractive, benefiting from being short in correlation, higher subordination and attractive carry due to the current higher correlation regime."

Shah adds that investors interested in super senior tranches should, as an alternative to outright longs, also consider replication strategies via going long the index and short the 0%-22% or 0%-30% tranches. "The super-senior part of the capital structure isn't very liquid, has high bid/offer spreads and so the idea of replicating such a tranche could make sense for some investors. However, funding the equity short position is problematic. One option is to convert it to a full-running spread: rather than paying upfront plus a coupon of 500bp, this would cost around 1500bp for iTraxx five-year."

But McGoff warns that idiosyncratic risk soon becomes systemic risk if a number of defaults occur at the same time. "Just one of the products insured by the monolines is US$75bn of sub-prime CDOs. A default would force some of these notes to incur mark-to-market losses. So in the current environment, bankruptcy of one entity is unlikely to occur without it impacting other entities," he says.

The start of June saw Markit iTraxx and Markit CDX correlation remaining relatively range bound. However, following the downgrades of a number of US brokers together with MBIA and Ambac, correlation peaked marginally in both the CDX and iTraxx indices due to a temporary rise in systemic risk. All downgraded names were US entities and, therefore, the effect on CDX correlation was stronger.

This increase in correlation was short-lived and both CDX and iTraxx correlation fell a few days later. The drop in CDX correlation was slightly more pronounced than iTraxx, which saw some unwinding of bespoke positions keeping iTraxx correlation slightly elevated.

In the last week, however, spreads have overall widened again - with correlation increasing significantly across both indices. "Over the last three to four months, we've seen a trend whereby - because of all the uncertainty, lack of liquidity and low volumes on the CDS indices - even smaller trades are having a more pronounced effect on technicals and correlation," concludes Shah. "Q2 earnings will be released imminently and are likely to increase volatility in the indices, as the risk of corporate defaults increases."

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Pamplona hires Bear staff to run new fund

The latest company and people moves

Pamplona hires Bear staff to run new fund
Pamplona Capital Management has hired a number of ex-Bear Stearns staff to run its Pamplona Credit Opportunity Fund (PCO), which is due to launch in September.

Yves Leysen, previously Bear Stearns' head of fixed income in Europe, is joining Pamplona as a partner and will be responsible for managing the new fund. He brings with him Sheil Aggarwal, who ran European CLO and mortgage trading at the bank, and Joseph Pigott, who co-headed its leveraged loan warehouse and proprietary trading activities in Europe.

PCO is a multi-strategy credit opportunity fund, with US$250m of committed capital. It will have an initial focus on corporate and asset-backed credits, and a longer-term interest in the distressed debt market.

US CDO head leaves bank
Following the departure of Deutsche Bank's US head of CDOs, Michael Lamont, Fritz Thomas has taken over his duties. Thomas will now be in charge of CDOs in the US and Europe, a division within the structured products group, and has relocated from London to New York.

Global credit head returns to Lehman ...
Lehman Brothers has announced that Michael Gelband and Alex Kirk are rejoining the bank as global head of capital markets and global head of principal investing respectively, reporting to Herbert McDade, president and coo.

Gelband first joined Lehman Brothers in 1983. He held several senior roles, most recently as global head of fixed income from 2005 to 2007. Prior to that position, he was head of fixed income liquid markets, with responsibility for interest rate products,
FX and securitised products.

From 1994 to 2008, Kirk was part of LB's fixed income division. Most recently he was co-coo for the fixed income division and was head of global credit products, with responsibility for the CDO, high grade, high yield, structured credit and emerging markets credit businesses.

... while Lehman hires research specialist
Lehman Brothers has hired Anthony Morris as md in the fixed income research team, focusing on structured product research and development. Previously, Morris worked at UBS, where he was most recently executive director in structured product research with a focus on credit, commodities and FX. Prior to that, Morris was director of global credit derivatives at the bank.

UBS hires credit trader
Jose Mosquera is understood to have joined UBS as a financials credit trader. He was previously at Barclays Capital.

Daiwa sets up derivative shop in Europe
Daiwa has launched a new global derivatives practice based in London. The new initiative will span across the full spectrum of derivatives, including credit derivatives, and will be headed by Dominique Blanchard, who joined the bank in May from Calyon. The business is expected to extend across Europe, the US and Asia, including Japan.

Daiwa has also hired Clarke Pitts from Mitsubishi UFJ Securities to head up equity derivatives and Matthew Hargreaves, formerly at Calyon, to build the derivatives infrastructure team.

"The growth of derivatives is regarded as an essential part of Daiwa's global expansion. It is intended that we will offer a full range of high quality fixed income, equity and hybrid products, and will be utilising the best people in Europe, Japan and Asia to help us achieve this," says Toshinao Matsushima, head of global markets in Tokyo.

Carador in reverse merger with Abingdon
Carador is to merge with Abingdon, subject to the approval of shareholders of both companies. Shareholders in Abingdon will receive shares in Carador, with the merger ratio being fixed by reference to the relative net asset values of the two companies.

Based on current relative net asset values, it is expected that Abingdon shareholders will hold in excess of 50% of the enlarged Carador share capital. Accordingly, the transaction will be treated as a reverse takeover of Carador by Abingdon.

GSO Capital Partners International is the investment manager of Carador. GSO Debt Funds Management, an affiliate of GSO Capital Partners International, is the investment manager of Abingdon.

Assuming shareholders vote in favour of the merger, it is anticipated that the merger will take effect in Q408. The board of Carador has therefore requested that the UK listing authority temporarily suspends the listing of Carador's shares from today, 25 June.

Structured finance specialist joins Orrick
Orrick, Herrington & Sutcliffe has hired Howard Altarescu as a partner in its structured finance practice in New York. He moves over from Goldman Sachs, where he had worked for more than 20 years.

Altarescu was head of GS' mortgage finance group, co-head of its mortgage and asset-backed finance group, was responsible for structured finance in the emerging markets, with a focus on Latin America, and served as coo for Goldman's mortgage principal finance business. Most recently, he was responsible for capital markets coverage of some of Goldman's premier residential mortgage origination clients.

Altarescu has been involved in many of the seminal transactions in structured finance, including the first CMO transaction, the first IO/PO transactions, the first public auto receivable securitisation, several of the first senior/sub mortgage and credit card receivable securitisations, the first commercial mortgage non-performing securitisation and several innovative future flow and World Bank-guaranteed transactions in the emerging markets.

Sidley Austin promotes structured credit lawyers
Sidley Austin has announced promotions to partnership of several structured credit lawyers. Jonathan Brose will be a partner in the tax practice, practicing in all areas of tax law, with an emphasis on representing investment funds and investment advisors. He also has experience in securitisation and structured finance, including the structuring of CDS and synthetic securitisations.

Stuart Koonce will be a partner in the investment funds, advisers and derivatives practice. He advises and represents clients in domestic and international offerings of hedge funds, fund of funds, private equity funds, structured derivative and principal-protected transactions and fund-linked notes. He also represents managers in structured finance transactions.

Xiaowen Qiu will be a partner in the structured finance and securitisation practice. Her practice includes credit, equity, interest rate and foreign currency derivatives, and she routinely represents international financial institutions participating in securitisation and structured finance transactions as placement agents, providers of liquidity and credit enhancement, issuers and investors. She also provides legal advice on various OTC derivative products.

Ambac drops Fitch ratings
Ambac has announced that it is terminating its ratings contract with Fitch. "Our decision to refocus and realign our business around our core expertise in the public finance and infrastructure sectors has led us to re-evaluate our ratings needs," says an Ambac spokesperson. "As part of this review, we have asked Fitch to remove its ratings on Ambac and all its subsidiaries, effective immediately."

Ambac follows in the footsteps of MBIA, SCA and CIFG which requested the removal of Fitch's insurer financial strength ratings on a number of their companies in March (SCI passim).

Numerix and RiskVal announce new partnership
NumeriX and RiskVal have announced a strategic partnership whereby RiskVal has integrated NumeriX enhanced market standard analytics to enhance the breadth of its trading and risk management solutions, providing users with the ability to manage derivative products across all asset classes.

RiskVal will offer NumeriX's set of industry standard models. In addition to NumeriX's cross analytic solutions, fixed-income and credit users will also have access to NumeriX's dynamic credit model - a two-dimensional Markovian model introduced last year, which values complex CDOs.

The dynamic credit model incorporates the market risk related to the volatile spread movements that typically occur even in the absence of defaults. Users will also have access to NumeriX's new pricing tools for LCDS and LCDX.

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Monolines downgraded

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

Monolines downgraded
Moody's upped the pace of its re-rating of the monoline sector last week. While the lowering of its insurer financial strength ratings on XLCA and FGIC were expected, the rating agency surprised the market with the magnitude of its downgrade of Ambac and MBIA. The actions have impacted the market in several notable ways (see separate news stories).

Moody's downgraded from triple-A the insurer financial strength ratings of Ambac and MBIA to Aa3 and A2 respectively, reflecting what the agency describes as their limited financial flexibility and impaired franchise, as well as concerns over the monolines' portfolios. Specifically, Moody's notes that MBIA has substantial risk within its portfolio and is moving towards more aggressive capital management within the group, while Ambac's expected and stress loss projections among its mortgage-related risk exposures have increased relative to previous estimates.

MBIA responded by saying it is disappointed to learn of Moody's decision and baffled by its analysis, while believing that the fundamentals of the company support a higher rating. "Moody's states in its release, for instance, that '...the group remains strongly capitalised, estimated to be consistent with a Aa level rating, and benefits from substantial embedded earnings in its existing insurance portfolio'. Yet that fact would seem to support sustaining a Aa rating while satisfying triple-A minimum capital requirements. With US$16bn in claims-paying resources, as the company has made clear in numerous public statements, we have more than enough capital to meet obligations to policyholders. This is an issue of ratings and not solvency," the monoline comments in a statement.

The outlook for the two monolines' ratings is negative, reflecting uncertainties over their future strategic plans, as well as the possibility of further adverse developments in their insured portfolios. Moody's noted, however, that these risks are mitigated somewhat in the case of Ambac by the company's substantive capital cushion at the current rating level and that this was an important consideration in arriving at the Aa3 insurance financial strength rating.

Nonetheless, as a result of the rating action, the Moody's-rated securities that are wrapped by MBIA and Ambac are also downgraded to A2 and Aa3 respectively, except those with higher public underlying ratings.

Moody's followed these downgrades by lowering its ratings on FGIC and XLCA from Baa1 and A3 to B1 and B2 respectively. The rating action concludes a review for possible downgrade that was initiated in March, reflecting the companies' severely impaired financial flexibility and their proximity to minimum regulatory capital requirements relative to Moody's estimations of expected case losses. The outlook for both ratings is negative.

If either of the two monolines' capital were to fall below the regulatory minimum, there could be material adverse effects on their financial condition. A meaningful portion of their 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. A breach of minimum regulatory capital requirement heightens the risk of regulatory intervention, which could trigger a market value termination of the CDS contracts.

According to Moody's, the negative outlook on XLCA's ratings reflects continued uncertainty with respect to the amount of losses that will ultimately arise from the company's insured portfolio and attendant risks that could occur if losses develop adversely, including the potential of regulatory intervention. SCA has stated that it continues to work toward mitigating the financial stresses impacting the company, including the commutation, restructuring or settlement of its obligations with its CDO counterparties and the commutation or settlement of various reinsurance arrangements with XL Capital.

The negative outlook on FGIC's ratings also reflects continued uncertainty regarding losses that may arise on the insured portfolio and attendant risks that could occur if loses develop adversely, including the potential for regulatory intervention. In addition, the negative outlook considers the uncertainty regarding the ultimate impact of FGIC's potential restructuring efforts on its residual portfolio.

In other monoline-related news, Dexia has announced that it will grant its monoline-subsidiary FSA a five-year US$5bn committed unsecured standby line of credit to its financial products segment. The move is designed to address concerns about liquidity that have been circulating for the last few weeks.

Finally, ACA Capital Holdings has entered into a fifth forbearance agreement with its structured credit and other counterparties. The forbearance will remain effective through to 6pm (New York City local time) on 15 July 2008.

Asian HY CLO launched
Lehman Brothers Asia has closed Kingfisher Capital CLO, a US$1.31bn managed cashflow CLO. The portfolio comprises corporate high-yield bonds and loans, including convertibles, mostly domiciled in Asia.

Rated by Moody's and due in 2016, the transaction comprises US$795m Baa1 Class A notes, US$240m B2 Class Bs and US$275.1m unrated subordinated notes. The portfolio will be dynamically managed by Lehman Brothers Asia and is fully ramped-up at closing. There will be a reinvestment period of two years.

As the ratings of the CLO notes are linked to LB, which is the guarantor to both the counterparty to the asset swaps and the grantor in the sub-participation agreements, Moody's quantitative analysis of the CLO notes takes into account the risks of LB. On 13 June, LB's long-term ratings were put on review for possible downgrade. The agency's sensitivity analysis shows that should LB be downgraded by one to two notches, the risk of the notes would still be consistent with their respective ratings; if its ratings are downgraded by more than two notches, the ratings on the notes may be affected.

QWIL plans new investments
Queen's Walk Investment Ltd (QWIL) has reported operating income of €7.7m or €0.25 per share for the quarter ended 31 March 2008, compared to €9.7m or €0.28 per share in the previous quarter. The fall in operating income reflects the expected run-off of the company's investment portfolio and the higher cash balances that it maintained in the quarter.

Cash generation for the quarter was robust, with €16.6m of cash proceeds received. This was ahead of the company's internal forecasts and further strengthens its free cash balances. As at 31 May 2008, the company had in excess of €30m of free cash on its balance sheet, up from €22m as at 31 December 2007.

Fair value write-downs of the company's investment portfolio for the quarter totalled €22.1m, compared with €8.3m for the period ended 31 December 2007. A significant proportion of fair value write-downs are attributable to higher market discount rates and therefore do not impact the ability of the assets to generate cash.

After accounting for fair value write-downs, the company recorded a net loss of €17.1m for the quarter compared to €1.2m in the previous quarter. The company's net asset value at quarter end was €6.42 per share, compared to €6.90 per share in the previous quarter.

Queen's Walk's Board of Directors has declared a dividend of €0.15 per share for the quarter, resulting in full year dividends of €0.60 per share. At 31 March 2008, after allowing for all declared dividends, the company had €0.34 cents per share in excess of this dividend still available for distribution.

The company intends to boost shareholder value both through further share repurchases and by making fresh investments to exploit market dislocations. In the coming months, it plans to make a further tender offer for a minimum of €10m of Queen's Walk shares.

At this point in the credit crisis, Queen's Walk sees opportunities to generate attractive returns from dislocations in the ABS market. First, certain mezzanine ABS securities trading at historical lows could offer returns of 15%-20%.

Second, returns of approximately 20% are on offer from re-packaging triple-A rated securities that are being de-consolidated by banks. Finally, the company is looking to buy assets at substantial discounts from distressed sellers.

Following an extensive review of mortgages underlying the residual investments, the company intends to mitigate losses on existing investments by encouraging mortgage originators to buy back certain loans that do not satisfy representations and warranties provided in the relevant securitisations.

RBI delays introduction of CDS
The Reserve Bank of India (RBI) has decided to delay the issuance of final guidelines on the introduction of credit derivatives in India. "The decision has been taken so as to be able to draw upon the experience of the financial sector of some of the developed countries, particularly in the current circumstances, in which the entire dimensions of the recent credit market crisis have not yet been gauged," the bank explains in a statement.

RBI had issued the 'Draft Guidelines for Introduction of Credit Derivatives in India' on 26 March 2003, inviting comments from banks and other stake holders. However, taking into account the status of the risk management practices then prevailing in the banking system, the issuance of final guidelines had been deferred.

Subsequently, it was announced in the Annual Policy Statement for 2007-08 that, as part of the gradual process of financial sector liberalisation in India, it was considered appropriate to introduce credit derivatives in a calibrated manner. Modified draft guidelines on CDS were, therefore, issued on 16 May 2007. Based on the feedback received on draft guidelines, these were revised and a second draft of the guidelines was issued on 17 October 2007 for another round of consultation.

Moody's reviews Alt-A sector
Moody's has announced that it is currently reviewing deals in the Option ARM Alt-A RMBS sector, as part of its on-going RMBS surveillance process. The agency will begin releasing rating actions from this review imminently.

According to Amita Shrivastava, avp of Moody's RMBS Surveillance Group: "The actions are part of a wider review of all RMBS transactions, in light of the deteriorating housing market and rising delinquencies and foreclosures. Moody's will continue to announce results of reviews on an on-going basis over the coming weeks."

Many Option ARM pools are exhibiting higher than expected rates of delinquency, foreclosure and REO (Real Estate Owned), which is the main driver of the current review. Deals within the Option ARMs sector exhibit significant variation in performance and the magnitude of rating actions will vary based on current ratings, level of credit enhancement, deal-specific historical performance, quarter of origination, collateral characteristics and other qualitative factors.

Fitch calls for equity disclosure
In an initiative to improve transparency in the global structured finance markets, Fitch has published an exposure draft on disclosure of retention of equity piece risk. The agency is seeking comments regarding its proposals to invite transaction originators, sponsors, servicers and asset managers to disclose whether they retain the economic risk of the equity piece in Fitch-rated structured finance transactions, in which they are a transaction party.

"This is an area that has been highlighted by some commentators as lacking in transparency and this initiative seeks to address that issue," says Paul Taylor, head of global structured finance at Fitch. "For example, the European Securities Market Expert Group recently recommended that credit rating agencies should seek to disclose information regarding an originator's or sponsor's retained interest in the transaction. They recognise that this will require co-operation by key transaction parties, who may be reluctant to disclose such information. Market participants across the industry, including rating agencies, have, however, been urged by regulators to foster greater transparency within the structured finance markets."

In making this proposal, Fitch is not advocating retaining the risk as a preferable model over it being transferred to a third party. Indeed, there are clear potential conflicts of interest that arise when the equity risk is either retained or not retained that could adversely impact bond performance for noteholders. For this reason, Fitch does not currently make specific analytical adjustments with respect to retention or non-retention.

Stuart Jennings, md at Fitch, says: "The intention of the initiative is to allow for more disclosure and information such that investors can make an informed decision and form their own view on whether this issue impacts their investment decisions and assessment of performance."

Where the originator or sponsor is also the servicer of the securitised assets, ownership of the equity piece can be seen by investors as an incentive to perform well in that role, given the originator's position in suffering the first loss should they fail to perform well. The development of a market in equity pieces therefore began to erode this comfort. To date, there has been little transparency as to which originators still retained the risk associated with the equity piece and which did not.

The report examines the incentives, advantages and disadvantages for investors associated with key transaction parties retaining or not retaining the economic risk of the first loss equity piece. It also outlines Fitch's proposals to introduce transparency on this subject by inviting key transaction parties to disclose on Fitch's transaction surveillance pages whether they own or have sold the equity piece; or have obtained credit protection or not with respect to the equity piece risk.

Where the key transaction parties opt not to make these disclosures, Fitch proposes that this be stated on the relevant surveillance web pages. The agency notes that the ultimate success of this transparency initiative depends entirely on the degree of co-operation received from such transaction parties.

EVVLF MTNs affirmed ...
Moody's has affirmed the Aa3 long-term rating of Eaton Vance Variable Leverage Fund (EVVLF)'s US$470m MTNs, but withdrawn its short-term ratings on the SIV's CP and MTN programmes. These ratings were previously Prime-1, on review for downgrade.

Continued deleveraging, stabilised market conditions and a restructuring of its enforcement event triggers have helped reduce the likelihood and severity of an enforcement event. As a result, Moody's believes that the expected loss associated with the MTNs is consistent with the current Aa3 rating.

In addition, the agency has withdrawn the short-term Prime-1 ratings assigned to both the CP programme and to MTNs with a maturity of less than 365 days at the request of the issuer. There are currently no such short maturity MTNs or CP outstanding. Furthermore, EVVLF has stated that it no longer intends to issue such obligations.

The actions do not affect the Caa3 rating assigned to the vehicle's capital notes.

... while S&P withdraws PACE rating
S&P has withdrawn its ratings on the issuer credit rating (ICR) and senior ratings on Premier Asset Collateralized Entity. At the same time, the rating on the SIV's capital notes was removed from credit watch with negative implications and lowered to single-D.

The withdrawal of ratings follows the repayment of all outstanding CP, MTN and amounts owed under the liquidity facility, using proceeds from the sale of the portfolio. Following this sale, PACE no longer has any assets - resulting in the breach of, and failure to cure, its liquidity (MCO) and interest rate limit tests. This means that the SIV has entered into an enforcement mode of operation.

At the same time, the asset sale and repayment of all senior obligations means that there were insufficient funds to repay the remaining capital noteholders on the 16 June 2008 payment date. Therefore, the rating on the capital notes is lowered to single-D.

Commercial real estate prices decline
Commercial real estate prices as measured by Moody's/REAL Commercial Property Price Indices (CPPI) decreased 3% in April from the month before, lowering the CPPI to a level 2.8% below what it was a year earlier. This is the first time the CPPI has shown a year-over-year decline since its launch.

"April's drop was steeper than the 2.8% decline in March, which had been a record for the index," says Moody's vp Andrea Daniels. The agency notes, however, that the CPPI still shows a 9.1% increase in prices over the last two years.

The three leading office markets continue to show strength compared to a year ago, with prices up 12.2% in New York, 11.7% in San Francisco and 10.8% in Washington DC. Overall, offices in the East showed a strong 14.3% increase in prices from the year before.

Moody's notes that monthly transaction volumes continued their decline of the last few months. Nonetheless, sales levels are still over ten times the level needed for the CPPI's statistical accuracy.

Moody's/REAL Commercial Property Prices Indices are based on the repeat sales of the same properties across the US at different points in time. Analysing price changes measured in this way provides maximum transparency and methodological rigor. This approach also circumvents the distortions that can occur with other commercial property value measurements such as appraisals or average prices, Moody's says.

CEBS reports on valuation of complex instruments ...
The Committee of European Banking Supervisors (CEBS) has published its findings on issues relating to the valuation of complex and illiquid financial instruments. The report puts forward a set of issues that should be addressed by institutions and accounting and auditing standard setters in order to improve the reliability of the values ascribed to these instruments.

CEBS has prepared this in response to a request set out in the October 2007 roadmap of the ECOFIN on the financial market situation. The analysis focuses on the following valuation-related aspects:

• challenges for the valuation of complex financial instruments or instruments for which no active markets exist;
• transparency on valuation practices and methodologies, as well as related uncertainty;
• and auditing of fair value estimates.

The work has been based on the experience gathered by its members in the course of their supervisory responsibilities. It also draws on work carried out in other forums, such as the Basel Committee on Banking Supervision (BCBS) and the Senior Supervisors Group (SSG), as well as on discussions with industry representatives.

CEBS has ensured that its findings are consistent with the recommendations of the Financial Stability Forum report on 'Enhancing Market and Institutional Resilience' - which CEBS fully endorses - as well as with the findings of the Senior Supervisors Group in its report 'Observations on Risk Management Practices during the Recent Market Turbulence'.

On valuation challenges, CEBS recommends that accounting standard setters should consider the need for further guidance on measuring fair values when there is little market activity in the instruments concerned (or other instruments relevant to pricing). Equally, institutions should enhance their practices and governance surrounding the use of modelling techniques; ensure that all appropriate risk factors are considered when determining a fair value; and improve risk management practices to ensure adequate risk assessment of transactions and appropriate management of exposures.

On transparency aspects, meanwhile, institutions should enhance their disclosures on fair values and on valuation techniques; and accounting standard setters should review the disclosure requirements to enhance the information to be disclosed on fair values and valuation techniques. Finally, on auditing aspects, auditing standard setters should pursue their efforts to enhance the guidance for the audit of fair value estimates.

... and reviews banks' transparency
CEBS has also published the findings of an assessment of banks' transparency with regard to the activities and instruments affected by the recent market turmoil. This assessment has been carried out in accordance with the roadmap of the ECOFIN issued in October 2007 in response to the financial markets situation.

CEBS analysed the disclosures made by 22 large banks - 19 of which originate from the EU - in the context of their Q407 and preliminary results and 2007 audited annual reports. The assessment not only covered disclosures on exposures and their impacts on results, but also looked at information on business models, risk management practices and accounting and valuation practices.

The main findings of the analysis showed that institutions made:

• limited disclosures on the business models underlying the activities affected by the sub-prime crisis and the related risk management practices (especially liquidity risk);
• diverse disclosures on exposures and on the impact of the crisis;
• generic disclosures on the valuation of exposures affected by the market turmoil and their accounting;
• and varied presentations of disclosures.

CEBS believes that these observed good practice disclosures contribute to the improvement of disclosures on exposures and activities affected by the market turmoil. The practices are consistent with the recommendations made in the report of the Financial Stability Forum (FSF) 'Enhancing market and institutional resilience'. They are also in line with the 'Leading practice disclosures for selected exposures' identified by the Senior Supervisors Group (SSG).

As disclosure practices will develop over time, as will the 'high risk' areas that require specific attention, CEBS will investigate how the good practices should be applied in the longer run. CEBS will also closely monitor the disclosures by institutions in their forthcoming (i.e. half-year) reports before deciding on any further measures.

S&P reports on Australian recovery expectations
Mirroring global trends, recovery expectations are becoming increasingly important for investors in Australian debt markets. For many investors, recovery has historically been a secondary consideration in corporate credit. Several factors, however, are converging to encourage a more comprehensive analysis of recovery prospects: the requirements of Basel II and other risk-based capital-adequacy management regimes, as well as the prevalence of CDO and CDS. More than ever, these factors are forcing investors to decompose credit into its key components - default and recovery.

Accordingly, S&P has started assigning recovery ratings to unsecured loan and bond issues of Australian speculative-grade rated corporate issuers. This follows the launch of unsecured recovery ratings in North America and Europe in March this year. Recovery ratings are indicators of estimated recovery prospects for creditors in the event of a debt issuer's payment default and serve as inputs to S&P's traditional issue-level ratings.

Recovery ratings assess a debt instrument's ultimate prospects for recovery of estimated principal, given a simulated payment default. S&P's recovery methodology focuses on estimating the percentage of recovery that debt investors would receive at the end of a formal bankruptcy proceeding or an informal out-of-court restructuring. Lender recoveries could be in the form of cash, debt or equity securities of a reorganised entity, or some combination thereof.

We view the development of recovery expertise and the dissemination of recovery information as key to the Australian market's development, not least to keep pace with global developments. In the global market, S&P is increasingly being asked to provide information and analysis on Australian recovery levels: for example, banks want empirical data on actual loss-given default (LGD) levels in Australia; CDO investors and arrangers want loan-specific recovery ratings for corporate loans; and US private-placement investors want the agency's views on the relative ranking of creditors in the wake of court decisions, such as in the Sons of Gwalia case.

Given that the Australian corporate-rated universe is predominantly investment grade, only a handful of speculative-grade recovery ratings have been assigned so far. However, S&P expects more speculative-grade corporates to be publicly rated in the future, as reduced lending capacity in the banking sector drives bond market volumes.

It is, therefore, timely to have an enhanced focus on recovery because as the market heads down the credit curve to where the default probability is significantly higher, recovery becomes a more important part of the investment equation. Recovery ratings will be important for these companies, as they will be a key determinant of the rating assigned to the debt issues.

New law to change French structuring landscape
A new French law will significantly change the structuring landscape, allowing more complex deals backed by higher yields. While it isn't expected to improve volumes significantly in the near term, it may allow more interesting deals as the market improves, according to analysts at SG.

The amendment of the legal framework of the French SPV was driven by the passage in to French law of the European Directive 2005/68/CE on reinsurance, which led to the directive 2008-556 of 13 June and released on 23 June. The essence of the European Directive was to equip all the national jurisdictions within the EU with a legal framework to enable securitisation of insurance risk and also served as an opportunity to update the existing framework.

There will now be two types of SPV, the first of which remains fairly close to the former Fonds Communs de Créances (FCC), as it is a fund but takes the name of Fonds Communs de Titrisation (FCT). On transfer, the insurance risk will not be classed as an asset, nor as a "créance".

The second type, named Societe de Titrisation (ST) is a company with restricted status and objectives. The ST will have a particular mandate, comparable to the French SICAV (UK unit trust/US mutual funds). Importantly, the directive provides that the insolvency law will not apply to the ST.

Together these two forms of SPV are jointly designated as "Organismes de Titrisation" (OT). Contractually-agreed limited recourse and payment allocation rules are also expressly recognised. The FCT and ST can be made subject only to civil enforcement measures in accordance with such payment allocation rules.

The new framework offers a greater range of possibilities in terms of sales of assets and authorises the transfer of assets under foreign law which will be deemed effective, the SG analysts say. Moreover, thanks to its company status, the ST will be able to benefit from a non-double tax treaty.

A distinction between active and passive management remains; the former requiring the establishment of a so-called activity programme seeking agreement from the AMF regulator. The new OT structures will still require two entities - a managing company and a depository. An OT can now be managed by a portfolio management company, whose activity is not necessarily dedicated solely to the management of OTs.

Previously licensed management companies of FCC can continue their activity (or apply for a new license as a portfolio management company). This activity is therefore no longer restricted to French entities.

Markit to distribute investor reports
Markit has announced that it is working with leading dealers to facilitate the distribution of European ABS prospectuses and investor reports in a freely available manner. The solution aims to encourage best practice and comes in response to calls by the European Commission for greater transparency in the European ABS markets. Dealers involved in this initiative include BNP Paribas, Citi, Deutsche Bank, Goldman Sachs, JPMorgan, Lehman Brothers, Morgan Stanley, RBS and UBS.

Markit will consolidate prospectuses and investor reports for European ABS transactions on a single website and will make the information freely available to all buy-side and sell-side firms and third parties, as permitted by local regulation. The initiative dovetails with Markit's plans to launch Markit Valuations Manager, which it says is the first global, multi-bank, cross-asset client valuations platform. Scheduled to go live in the second half of this year, it will offer clients increased transparency in OTC derivative and cash valuations by providing accurate and consistent third-party valuations on a single electronic platform.

S&P calls for coordinated CRA oversight
Deven Sharma, president of S&P, has called for a globally co-ordinated approach to the oversight of credit rating agencies in order to ensure consistency for investors and issuers operating in international markets.

"We must focus on preserving a consistent approach across borders," he states. "A coordinated response from policymakers and a common approach to overseeing ratings firms - along the lines proposed by the European Union's ECOFIN, the Financial Stability Forum and IOSCO - would be in the best interests of international users of ratings."

The agency says it welcomes any initiative that works in the interests of the market as a whole, preserves the independence and global consistency of ratings opinions and rating methodologies, and avoids unintended disruption, costs and inefficiencies for investors, issuers and other users of ratings. To that end, any regulatory initiative in Europe should:

• focus on the integrity and transparency of the rating process
• not seek to determine the content of ratings and methodologies, or become involved in reviewing individual ratings, as that would risk limiting market innovation, call into question the independence of ratings and potentially create moral hazard, as overseers may be perceived to endorse ratings opinions.

S&P says that investments and capital flows are more global than ever - and this trend will only accelerate - so investors need common measures of assessing risk across the world's various markets.

CS 

Restructuring Cheyne Finance - another myth?

The likelihood of Cheyne Finance being successfully restructured is discussed by Tim Brunne, quantitative credit strategist at UniCredit

According to a recent report by S&P, there are currently six major structured investment vehicles in default (see Exhibit 1). The total senior debt outstanding of these defaulted SIVs amounts to US$28bn, S&P says.

Exhibit 1

In comparison to that, the outstanding senior debt of SIVs that have not defaulted (yet) amounts to US$149bn (including the 'limited purpose finance company' Sigma Finance). These SIVs have received additional subordinated capital, liquidity support from their sponsoring financial institutions, have been restructured successfully or have had particularly low leverage.

The total amount of outstanding debt is hence US$177bn (this comprises the universe which has been rated by S&P). Thus, the amount of senior debt outstanding from still-existing SIVs has decreased by roughly 50% since the first troubles appeared in this sector during last summer, due to unwinding and banks taking the assets of their SIVs onto their balance sheets after redeeming commercial paper investors.

Nonetheless, restructuring SIVs is still on the agenda. Last week's announcement by Deloitte & Touche - the receiver of the (former) SIV Cheyne Finance - and Goldman Sachs about another debt restructuring attempt (see last week's issue) highlights this fact. It is by no means the first attempt since Cheyne Finance defaulted on its senior debt in October last year.

SIV assets expected to remain illiquid
Certainly, the great illiquidity of SIV assets and the absence of any distressed debt investors was and still is the main obstacle to winding down the vehicles (Exhibit 1). SIVs were not able to refinance their assets when the commercial paper market froze last year. The outstanding amount of ABCP has been decreasing worldwide since last summer.

Meanwhile, this trend has come to an end at least in the US, although not reversed, but not in Europe (see Exhibit 2). A fire sale of SIV assets in an illiquid market would come at the expense of the creditors of the SIVs. Thus, it has to be avoided.

Exhibit 2

The scheme that Goldman and Deloitte presented last week is another attempt to restructure the defaulted SIV Portfolio Plc (in receivership), formerly known as Cheyne Finance. A breakdown of the asset pool by security type is shown in Exhibit 3. Only 12% of the assets are super-senior tranches, distributed approximately equally among CLOs, ABS CDOs and CRE/CMBS CDOs.

Exhibit 3

Again the key success factor will be the price determination for the assets of the collateral pool, for which an auction mechanism is proposed this time. The subordinated debt holders will not have any recovery of their debt within this scheme. Senior creditors will be repaid partially or their debt is transformed into commercial paper of a newly established SIV.

The deal between the receivers Deloitte and the firm that sets up the new SIV, Goldman, includes a temporary sale of the majority stake of Cheyne's collateral pool to Goldman, based on the auction prices. Their restructuring agreement states that the transaction is to be carried out on around 17 July, however, subject to several conditions (according to the Irish Stock Exchange).

The new SIV is apparently not bank-sponsored again and static, without any equity capital involved. Goldman is going to bid for the assets, while Deloitte is managing the auction.

But one bidder doesn't make an auction! Hence, how will it be possible to ensure that all asset types in the SIV collateral pool receive bids from 'alternative bidders' as the restructuring agreement suggests?

It will be difficult to find alternative bidders for some of the assets in heterogeneous pools. Alternative bidders must not cherry-pick their assets. Investment banks will reportedly be invited to bid on buckets of the assets, as well as on the whole portfolio. Deloitte has the option to delay the auction if difficulties are anticipated, but it is by no means clear whether the proposed portfolio sale will finally succeed.

Options of the senior debt holders
Bidders, including Goldman, intend to buy the whole portfolio of Cheyne Finance, with the subordinated debt being wiped out. Senior creditors will be paid out from the proceeds of the portfolio sale.

So called 'eligible creditors', which are US senior creditors and liquidity providers, will have further options that are exclusively offered by Goldman Sachs. Since Goldman will have to find new investors for the newly established SIV, which is reportedly called Gryphon, it is going to offer the corresponding commercial paper to those eligible investors that have registered for this option before the auction takes place.

Therefore, the conditions of the cash payments must be less attractive than the immediate exchange of Cheyne Finance senior debt for Gryphon senior debt. Cheyne Finance senior creditors may also receive a pro-rata slice of the asset pool to manage themselves, which is usually always an option.

Presumably, Goldman will have to provide funding for Gryphon if there is not enough interest in its debt. This provides an incentive not to pay too high a price for the Cheyne Finance assets, which at the same time cannot fall behind the bids by alternative bidders.

Our view
"The disease is the cure." The SIV Portfolio Plc (Cheyne Finance) is replaced by the new static SIV Gryphon, a 'default remote investment vehicle' (which was the initial characterisation of SIVs). Current investors will realise their losses and investors in Gryphon senior debt are provided with the upside potential of a recovering asset pool. Despite some enthusiastic reports in the media, it remains questionable whether the whole transaction will succeed and not lead to litigation by investors who aren't satisfied with the outcome of the auction.

Clearly, for Goldman it is a business case. Gryphon may serve as the blueprint for further transactions of this kind, as there are enough other SIVs that are looking for restructuring opportunities. Reportedly, Goldman has put a lot of resources into the restructuring project.

Finally, creditors will be satisfied mainly if the liquidation of the assets does not happen at firesale prices. Alternative bidders will need to show up, who are willing to buy a minority stake of the buckets of the portfolio at better prices than those that would be expected in case of a firesale of all assets.

© 2008 UniCredit Markets & Investment Banking. All rights reserved. This Research Note is an extract from Structured Credit Update, first published by UniCredit on 20 June 2008.

Trading ideas: kiss it goodbye

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at an outright short on Hershey Foods' Corp

Hershey Foods' present situation does not look good. Commodity costs are rising, squeezing Hershey's margins. Its leverage has increased right into the depths of the credit crisis.

The situation could be helped by a buy-out; however, we don't believe any suitor will be enticed to buy the company. The Hershey Trust, which maintains majority voting rights, has made it clear that they will retain ownership. They are determined to hold onto control.

We see two potential outcomes: a much talked-about joint venture with Nestle or a fall from grace into economic despair. We believe that, while the first option may be slightly more probable, the potential widening of Hershey CDS spreads caused by the second outcome makes buying CDS protection a good bet. We recommend taking an outright short exposure on Hershey Foods.

Basis for credit picking
Our credit model attempts to replicate how a fundamental credit analyst thinks. While this is extremely arduous, 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 1 lists all the factor scores for Hershey Foods. We see a 'fair spread' of 98bp for its weak margins and market-implied factors.

Exhibit 1

Losing combination
Business fundamentals do not look so hot for Hershey. Decreasing margins and increasing leverage combine to create a rather difficult situation. Exhibit 2 shows the increasing leverage that Hershey has been taking on since 2003.

Exhibit 2

It has increased its debt levels during the 'easy' credit days and we are now in a different regime - one that is not credit friendly. In addition to the increase in leverage, Hershey is also getting hit by falling margins (Exhibit 3).

Exhibit 3

The economy is experiencing unprecedented food inflation, which hits directly at the bottom line for Hershey. The combination of the two weak fundamentals will have a dramatic effect on the future profitability of Hershey Foods and will most likely cause a painful slide into credit deterioration.

Positive expected payoff
For this trade we break the future outcomes down into two simple scenarios. Without trying to oversimplify Hershey's current predicament, we believe that either the company will fall victim to its fundamentals or a joint venture will take place, with Nestle helping it remain alive to see another day.

Given all the talk and the Hershey Trust's unwillingness to surrender control of the company, the joint venture is more likely to happen than not. The venture would not cause any sudden change in Hershey's balance sheet or have an immediate earnings impact; therefore, this would be slightly positive for Hershey's CDS. Nestlé's CDS trades 30bp and we do not think a joint venture would push Hershey's spread much tighter than 50bp.

Now, if our favored credit deterioration outcome were to take place, its spread will widen through our expected spread level of 98bp (Exhibit 1). The payoff of the negative outcome is 2x greater than the payoff for the joint venture.

This more than compensates for its lower probability. The trade has positive economics from an expectation standpoint (Exhibit 4).

Exhibit 4

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

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

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

Liquidity
Liquidity should not be an issue for this trade since it is an investment grade issuer. The credit has a historical bid/offer of 5bp-10bp for the five-year tenor and, depending on the market environment, trading out of the position should not have a large negative P&L impact.

Fundamentals
This trade is based on our negative outlook for HSY CDS. Taking a short 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 bearish view on the credit drives this trade.

Hershey Foods (analyst: B. Craig Hutson) Credit Score: 0 (Stable)
Global confectionery leader. Weak operating results in recent periods. Major changes in composition of board and senior management. Major global supply chain transformation underway. Historically has shown little regard for bondholders.

Summary and trade recommendation
Hershey Foods' present situation does not look good. Commodity costs are rising, squeezing Hershey's margins. Its leverage has increased right into the depths of the credit crisis.

The situation could be helped by a buy-out; however, we don't believe any suitor will be enticed to buy the company. The Hershey Trust, which maintains majority voting rights, has made it clear that they will retain ownership. They are determined to hold onto control.

We see two potential outcomes: a much talked-about joint venture with Nestle or a fall from grace into economic despair. We believe that, while the first option may be slightly more probable, the potential widening of Hershey CDS spreads caused by the second outcome makes buying CDS protection a good bet. We recommend taking an outright short exposure on Hershey Foods.

Buy US$10m notional Hershey Foods Corp 5 Year CDS protection at 71bp.

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).