Contents

Clarifying correlation

Efforts underway to improve transparency

The number of first-time investors entering the super-senior space is rising, but not everyone has a full understanding of correlation risk. Consequently, market participants are looking for new, more intuitive ways to measure that risk.

As UniCredit director and senior strategist Philip Gisdakis notes, while movements in correlation were consistent during the 2005 and 2007/8 crises, it is difficult to translate the parameters of default correlation into a real-world economic sense about the market. "Intuitively you can recognise when realised correlation is high compared to historical data, but what does this actually tell you? Many people were surprised by the volatility of spread movements this time around; correlation is essentially driven by liquidity, so you have to be constantly in the market to really understand it," he says.

Single-tranche synthetic CDOs have predominantly three-dimensional risk profiles, so investors should be cognisant of the risk angle they wish to assume - default risk, spread volatility or correlation risk. "Investors in super-senior tranches do need to be aware and understand the correlation risk embedded; they're getting paid for something and, although it may not currently be default risk, it is still a risk," argues Eugene Yeboah, head of credit structuring at Schroders.

He adds: "Yes, the current market conditions make it attractive for real money investors to invest in new credit opportunity funds [see separate news story], but the fundamental question is: if I am getting paid, what are the risks? Understand your risk and make sure you're getting paid accordingly - it is that simple."

Pricing bespoke synthetic CDO tranches in particular remains problematic. Traditionally, they have been priced by identifying their equivalent index-based tranches and then applying the standard Gaussian copula pricer to the bespoke portfolio with the base correlations of the equivalent index tranche.

"But much of the risk information is missed by taking this approach: as we know from statistics, it is possible to have two distributions with different shapes, but the same expected loss (EL). This approach is used by some practitioners; however, there are other approaches - such as the Inverse-Normal - where there are two additional inputs, the skew and kurtosis, that have been used recently to calibrate the market prices," explains Yeboah.

Other methods being put forward include matching the degree of 'in the moneyness', probability and equity/super-senior spread of a position - but again these don't capture all the risks involved. Yeboah says that some market participants are consequently looking to develop what is called the Omega function - a way of measuring relative performance by capturing the fatness of tails and the skew of distributions, as well as the volatility and the mean in one number.

This could be applied to CDOs to estimate spread per unit of omega across the capital structure for relative value. The Omega function for a given spread (or EL) captures a number that in essence incorporates the shape of the return/loss distribution analysis (see next week's issue for more on this application).

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Further setbacks?

GICs could pose new threat to monolines

Shortfalls in GIC businesses could be the next episode to hit financial guarantors. Potential shortfalls caused by early redemption payments and collateral requirements upon downgrades could force liquidations of GIC assets, ultimately forming an additional source of claims-paying demands on the resources of monolines.

"In our view, issues associated with the GIC businesses have the potential to threaten monolines such as FSA, which have carefully avoided writing protection on ABS CDOs, and thus have so far been immune from downgrades," says Gregory Peters, md of Morgan Stanley credit research. "Others such as Ambac and MBIA have significant GIC businesses, which only add uncertainty to their outlooks."

According to Morgan Stanley's estimates, MBIA, Ambac and FSA together have written about US$15.46bn of GICs into different CDO vehicles. The firm also notes that FSA's parent Dexia has provided a credit line of US$5.1bn exclusively to FSA's GIC business - an indication, it says, that FSA's GIC assets may not be adequate to meet the monoline's GIC liabilities, especially those coming due because of events of default and early redemptions of ABS CDOs.

"The early redemption payments and collateral requirements upon downgrade (as MBIA has already experienced) are likely to force liquidations of some of the GIC assets, which in turn will put pressure on the prices of these securities," says Peters.

However, FSA asserts that its financial products business has ample liquidity to meet its GIC obligations under a wide range of stress scenarios. "Dexia provided the US$5bn committed, standby liquidity line to remove any doubt - within the context of highly nervous financial markets - that we have the resources to hold investment assets to maturity," says Robert Cochran, chairman and ceo of FSA Holdings. "Our liquidity resources are more than sufficient to meet both expected and unexpected liability withdrawal scenarios without forced asset sales."

An FSA spokesperson adds that for CDO GICs, FSA may have early withdrawals for prescribed reasons, such as credit losses that pierce the credit-linked note attachment point. However, she points out that the monoline's exposure is limited to the return of cash provided to the GIC holder and that the company is not subject to the credit risk embedded in the original transaction.

Following MBIA's insurer financial strength (IFS) downgrade to A2 by Moody's last month (see SCI issue 94), the monoline was required to post additional eligible collateral and fund potential termination payments under its outstanding GICs. The company stated on Monday, 30 June, that following a portfolio rebalancing within its asset/liability management (ALM) business - which included sales of approximately US$4bn of investment assets during the second quarter - it now has sufficient eligible collateral and cash to satisfy additional requirements.

"As a result of these activities, the company's entire remaining GIC portfolio will be fully collateralised, to the extent all GIC holders exercise their right to collateralisation," MBIA says.

The monoline's cfo, Edward Chaplin, adds: "Contrary to recent statements in the media, MBIA is not in a 'tenuous situation'. Our ability to quickly reposition the assets underlying our ALM business in a difficult market demonstrates the high quality and liquidity of the portfolio. The holders of our insurance policies, GICs, medium-term notes and other debt instruments can rest assured that MBIA will meet its obligations to them as it always has - on time and in full."

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Managers on their mettle

Best execution gains in importance

Amid the current market's shifting sands, CDO managers are under increasing pressure to perform as efficiently as possible. At the same time, a wary eye is being cast over the respective futures of cash and synthetic deals.

CDO managers and small to mid-sized banks are finding increasing opportunities in advisory work, as investors look to secure best execution. Many of these accounts have experienced difficulties in the structured credit sector, but understand why and want to re-enter the market with a manager that can deal with new rating agency methodologies and are able to secure a fair price for the risk.

Investors are looking for best execution in terms of liquidity and pricing, but are selective about which banks they trade with, notes Philip Gisdakis, director and senior strategist at UniCredit. "Many investors were disappointed during the crisis with respect to the service, support and accuracy they received from their counterparts," he notes.

Gisdakis adds: "If you have a good relationship with a smaller bank, you may decide to use them over a larger bank because they can't force you to trade at a certain level. Many small and mid-sized banks are therefore adopting a back-to-basics business strategy, where the emphasis is on developing sustainable relationships with their clients."

Another concern for both investors and managers is how cash and synthetic CDO methodologies will perform in the coming months. Predicting their respective future paths is fraught with difficulty, given that the two sectors are so segmented and the investor base is typically only interested in one or the other.

"The smaller real money accounts are generally interested in basic cash CDO and CLO product, and want to buy into the credit origination process. As part of this process, with respect to smaller companies where there is little public information about them but you know the origination process is sound, it is possible to co-invest - particularly if it is a bank balance sheet deal and so only a portion of each loan is securitised," explains Gisdakis.

On the other hand, investors can also do their credit work on a CSO, but the advantage of the product is that it can be easily hedged and the underlying is liquid. "The emphasis is nonetheless on simple transactions - demand is there for both cash and synthetic product, providing the structure is right," adds Gisdakis.

The synthetic market should, in general, remain stronger than the cash market in the coming months, according to Eugene Yeboah, head of credit structuring at Schroders. "Cash and synthetic CDO methodologies are driven by two different risk factors: a cash CDO is binary, so the question is whether there is enough cash for the cashflow waterfall; whereas the underlying reference entities in synthetics are unlimited. With default risk expected to increase over the next few years and given the current state of structured credit, synthetics are likely survive relatively speaking - especially where liquidity and ease of execution are concerned."

But one portfolio manager reckons that synthetic CDOs will become increasingly difficult to manage because managers have legacy positions in so many downgrade candidates. "Talk about S&P changing its CSO methodology is gaining momentum; S&P is dominant in the market, so if there is a change and it's applied retroactively, there could be a real fall-out in the synthetic CDO sector. The scale of corporate downgrades is already making it difficult for synthetic CDO managers to operate, given that they are typically overweight monolines and financials," the manager concludes.

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Correlation trader hired ...

The latest company and people moves

Correlation trader hired ...
Barclays Capital has hired Alex Pointer. It is understood that he will take up a role in the correlation trading team, having previously worked at Deutsche Bank as head of correlation trading.

... and negative basis trader resigns
Chris Walters, head of negative basis TRS at Barclays Capital, resigned from the bank last Friday.

Workout firm acquired
UniCredit Group and NewSmith Capital Partners have announced a strategic agreement. Subject to regulatory approvals, UniCredit will acquire NewSmith Financial Products (NSFP) and become an investor in NewSmith funds. UniCredit will also assume a 5% stake in NewSmith Capital Partners.

All partners and employees of NSFP will move to the UniCredit Markets & Investment Banking Division (MIB) to be part of its global credit business line. NSFP ceo TJ Lim will join the MIB executive committee and will be appointed co-head of markets with specific responsibility for fixed income and currency, global credit and sales. His co-head is Mike Hammond, who has responsibility for equities.

Given UniCredit's broad geographical distribution, the move is expected to provide NewSmith with a platform from which to enhance and expand its workout and advisory business, as well as capitalise on other opportunities arising from the current market turmoil. Lim knows Sergio Ermotti, UniCredit's deputy ceo, and Edoardo Spezzotti, head of its markets & investment banking division, from his previous role at Merrill Lynch.

NSFP is understood to be planning to launch a special situations fund in Q3, which will focus on secondary CDOs/CLOs and distressed opportunities, likely under the UniCredit platform.

Risk management head departs
BNP Paribas' Olivier Vigneron is moving to JPMorgan in September this year. He is understood to be joining as head of credit hybrids trading.

At BNP Paribas he held the post of global head of structured credit risk management. Prior to that, he was head of structured credit trading at UniCredit.

Moody's initiates CPDO disciplinary proceedings ...
Moody's has initiated employee disciplinary proceedings that could lead to staff dismissals, following an investigation into its CPDO rating error (see SCI issue 89). It has also accelerated measures to strengthen its rating and monitoring processes, following a comprehensive review of its ratings process for European CPDOs.

Moody's found that its personnel did not make changes to the methodology for rating European CPDOs to mask any model error. However, it has concluded that members of a European CPDO monitoring committee engaged in conduct contrary to Moody's Code of Professional Conduct.

Specifically, some committee members considered factors inappropriate to the rating process when reviewing CPDO ratings following the discovery of the model error. According to Moody's Code of Professional Conduct, a committee may consider only credit factors relevant to the credit assessment and may not consider the potential impact on Moody's or on an issuer, an investor or other market participant.

The ratings involved 11 CPDOs with an aggregate value of slightly less than US$1bn. Testing of the CPDO model's output, after correction for the error and without consideration of qualitative factors, indicated that an initial rating of Aaa would have been in the Aa range.

During 2008, Moody's withdrew ratings on four of the 11 CPDO securities due to the repurchase or restructuring of the notes, or at the request of the issuer and investors. The agency has also taken various rating actions on the seven remaining transactions due to extraordinary market conditions, including spreads far outside of historical experience.

To confirm the integrity of existing CPDO ratings, Moody's has conducted a review of all outstanding static CPDOs, including the seven affected by the model error. The agency is also reviewing ratings of certain other structured finance securities, in which employees subject to the disciplinary process participated substantively. To date, the review effort has found no indications that the rating process for those securities violated Moody's Code.

... and replaces global structured finance head
Andrew Kimball has been appointed acting head of Moody's global structured finance business, replacing Noel Kirnon, who is leaving the agency at the end of this month. A comprehensive search for a permanent head of structured finance is underway. Richard Cantor will assume acting responsibility for the role Kimball previously held as the cco of Moody's and as chairman of its credit policy committee.

Kimball has held various senior positions at Moody's, including senior managing director for global corporate finance and md for Moody's risk management services. He joined the firm in 1987 as a senior analyst, and soon after was promoted to associate director in Moody's structured finance group.

Cantor was most recently md of the credit policy research group. He is a member of Moody's credit policy committee and co-chairs Moody's academic advisory panel. He joined Moody's from the Federal Reserve Bank of New York, where he held a variety of positions in the research group and was staff director at the discount window.

Stark to head up Markit index service
Markit has hired Scott Stark as a director in its index division, based in London. Stark will lead a new bespoke index service within Markit that will offer index administration, calculation and publication to third parties. The new index service will span synthetic credit, structured finance, equities, bonds, interest rates and foreign exchange. Additional asset classes will be added to the service as required.

Stark joins Markit from EuroMTS, where he was ceo of its index division for five years. In this role, he was responsible for the launch of a series of pan-European government bond indices, which have over €1trn benchmarked against them.

Assured hires risk management md
Assured Guaranty has appointed Michael DiRende as md of risk management. He reports to Andrew Pickering, md and chief surveillance officer at Assured Guaranty.

DiRende has 14 years of experience in credit and capital markets. His most recent experience was in remediation and restructuring for both debt and equity exposures.

Prior to joining Assured, DiRende was a director in the special situations group at MBIA, where he focused on both municipal and structured finance credits.

ETGAM's manager rating removed
Fitch has withdrawn and removed from rating watch negative E*Trade Global Asset Management's CAM4 structured finance CDO Asset Manager rating, following the transferral of its entire managed CDO portfolio to Citadel Investment Group (see SCI issue 67).

Ambac and MBIA ratings removed
Fitch is also withdrawing all of its outstanding ratings on MBIA and Ambac. In addition, the agency will be withdrawing all ratings based on insurance policies from both MBIA and Ambac's insurance subsidiaries.

The rating action follows decisions by MBIA and Ambac's managements to cease providing substantive non-public portfolio information used in Fitch's capital analysis model, to discontinue previous full interactive dialogue with Fitch analysts and to request withdrawal of Fitch's ratings.

Many key credit issues have developed recently, prompting Fitch's decision to withdraw MBIA and Ambac's ratings. "Negative rating actions by S&P and Moody's impact the companies' business prospects, and the companies' reactive strategic and capital management planning creates a volatile credit variable," it says. "In addition, credit risk developments continue and Fitch's ability to analyse credit strength needs to shift to utilising public information only."

Fitch says it will consider reinstating coverage and assigning new ratings based only on public information if there is continuing investor interest. In the interim, the agency may continue to offer commentary and research on developing credit events at MBIA and Ambac.

BNPP reorganises
BNP Paribas has made some organisational changes in its CIB division. Two new business lines have been created, one of which is Global Structured Finance - headed by Dominique Remy, who is assisted by Jean-Louis Duguit. The division now includes the structured finance activities of origination, structuring, execution and syndication for all business sectors.

Sky Road teams up with T-Zero
Sky Road has announced a partnership with T-Zero, whereby Sky Road clients will now benefit from improved straight-through processing of credit derivatives trades via T-Zero Auto Affirmation. Firms can now book trades through Sky Road's hosted offering and then affirm and confirm the trade with the DTCC through T-Zero.

By automating affirmation, Sky Road clients can eliminate manual processes, thereby reducing operational risks while improving efficiency. The core technology infrastructure for the Sky Road platform is provided by Calypso.

Realpoint gets NRSRO status
Realpoint has been granted Nationally Recognized Statistical Rating Organization (NRSRO) status by the SEC. Realpoint will be the only rating agency specialising in the structured finance sector that uses a subscription-based investor model, as opposed to the traditional issuer-paid model.

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EODs top 200

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

EODs top 200
The number of event of defaults (EODs) experienced by 2003-2007 vintage ABS CDOs has reached 200 - the equivalent of US$220.1bn of issuance. New research from Wachovia Capital Markets breaks this figure down into one impacted deal (accounting for US$700m) from 2003, three (US$1.3bn) from 2004, four (US$2.2bn) from 2005, 86 (US$92.1bn) from 2006 and 106 (US$123.8bn) from 2007.

Total CDO issuance during the period comprised 1611 transactions worth US$1.12trn, of which 664 deals (worth US$610.1bn) were ABS CDOs. Of this number, 30.1% (representing 36.1% of ABS CDO volume) have experienced EODs so far - equal to 12.4% (19.3%) of total CDO issuance, according to the Wachovia research.

The most severe defaults occurred in 2006 and 2007, with 37.6% (39.9%) and 63.1% (69%) of ABS CDOs - accounting for 16.9% (23.4%) and 25.3% (36%) of total CDO issuance - experiencing EODs respectively. Of these affected transactions, 75 are in acceleration and 50 have either been liquidated or are in the process of being liquidated.

More CPDOs face Moody's rating action
Moody's says it has taken rating actions on 13 series of static CPDOs, with a combined volume of approximately €690m, based on the application of updated surveillance tools that take into account the new dynamics brought about by the current market crisis.

The resulting rating actions include eight downgrades of between one to three notches, which reflect ongoing vulnerability in light of underlying fundamentals. The affected transactions are Castle Finance I Series 7, 8 and 9; Castle Finance II Series 2; Thebes Capital Series 2006-1; R-Evolution Series 2007-2, 2007-3 and 2007-5.

There were also two upgrades of one notch (affecting the Artemis DPI Series 2007-1 and RIDERS Series 2006-3 transactions) and three confirmations (RECIPES Series DE, Artemis DPI 2007-2 and RIDERS 2006-18), reflecting relatively better transaction performance since the last rating actions taken. All 13 CPDO transactions were previously downgraded on 10 March and left under review for further possible downgrade.

"The dramatic widening of spreads that started in summer 2007 and developed into the first half of 2008 has introduced exceptional volatility," says Nicolas Weill, Moody's group md and chief credit officer.

The agency's approach relies on two different tests that the monitored transaction must pass. These tests assess the performance of the CPDO, both in the short term and in the long term, and are based on parameters that vary according to the rating level.

When monitoring CPDO transactions, Moody's has identified two main risks. The near-term risk is that of a cash-out event, due to a rapid and significant spread widening. The second is a long-term risk that the CPDO proves unable to rebuild its net asset value and consequently to repay principal and interest due at or before maturity.

Moody's surveillance of CPDOs considers the degree of spread widening - occurring over periods of one day, one week and one month - that the transaction is able to sustain without cashing out. The agency applies these levels of widening starting from the current NAV level of the transaction.

Moody's also takes into account the specific leverage formula of the deal. Consequently, any relevant de-leveraging transaction-specific feature that would kick in during the week or the month has been accounted for in the analysis.

In addition, those transactions that have incurred reductions in NAV are exposed to risk of not rebuilding it to par. When analysing the long-term risk that the transaction fails to pay all amounts due at or before maturity, Moody's models the future evolution of the NAV from the current level under specific scenarios consistent with various ratings. The scenarios used for this test were devised to simulate two extreme paths in which spreads either tighten or widen sharply.

The resulting ratings are usually based on the worst outcome of the three scenarios (short-term cash out, long-term spread widening and long-term spread tightening).

Credit crunch impact on investment managers analysed
KPMG International, in cooperation with the Economist Intelligence Unit, has released a report that examines how the fund flows, returns and reputations of investment managers have been impacted by the credit crisis and the economic conditions of the past 12 months. The report investigates how, in the light of the challenges presented by the credit crisis, fund management firms are managing the increasing complexity of the instruments they use and the strategies they adopt.

The survey reveals that 57% of mainstream fund management firms use derivatives in their portfolios. The figure is even higher within large mainstream fund management firms: nearly one-third of those with assets of at least US$10bn use derivatives to a major extent. Even more fund managers (61%) now manage hedge fund strategies, which in many instances are complex.

The survey also found that half of mainstream fund management firms manage private equity strategies; nearly half manage asset-backed securities and more than one-third manage CDOs. Fund managers still believe that with the exception of CDOs, all the above strategies and asset classes will rise over the next two years. On the other hand, 70% of the investors who answered the survey say that the credit crisis has reduced their appetite for complex products.

Well over half of mainstream fund managers say investment returns have fallen and about the same proportion report falling subscriptions. But the damage potentially goes further than short-term losses in funds: six out of ten respondents believe trust in fund managers has been eroded due to the effects of the credit crisis.

Lack of skills and experience is a key concern. There is evidence, in the light of the credit crisis, that some aspects of fund management require urgent attention. The skillsets of staff, for instance, have to some degree failed to keep up with growing sophistication.

One in five fund managers that have invested in complex financial instruments, such as derivatives, CDOs or structured products, admit to having no in-house specialists with relevant experience. Investors are at greater risk still, with about one in three of the institutions investing in such instruments saying they have no in-house expertise of these.

Rating agencies are seen as providing little support. One third of the respondents agree that rating agencies provide an accurate assessment of whether an instrument will default and just 1% of respondents think rating agencies are very accurate in predicting defaults.

Risk management, valuation methods and governance structures are all being shaken up. There is a widespread feeling that fund management firms need to re-evaluate what kind of business they are conducting and the risks they are running.

Four out of ten firms surveyed for this report say they have already formalised risk frameworks in the past two years, as a result of managing more complex strategies, with a similar number planning to do so over the coming two years. Valuation methods have come under intense scrutiny during the credit crisis and a third of firms have reviewed this activity, while a further third will do so in the next two years. An even higher proportion, 38% of respondents, have reviewed governance arrangements - particularly relevant in the cases of funds that used risky instruments to enhance returns on supposedly low volatility funds - and a further quarter will do so in the next two years.

The findings of the report are based on the online answers of 333 respondents from 57 countries and 16 executives who were interviewed separately.

CDS portfolio compression platform launched
Creditex and Markit have announced a joint initiative to launch an industry-wide portfolio compression platform for the credit derivative market. According to the two firms, this process is the first of its kind and represents a significant improvement over previous tear-up processes. The platform supports commitments made by major market participants to the Federal Reserve Bank of New York relating to improved operational efficiency and risk reduction.

Developed in response to a request by ISDA on behalf of major credit derivative dealers, the platform will reduce operational risk and improve capital efficiency by reducing the number of trades and the gross notional outstanding value of single-name CDS held by dealers. This will be achieved through a multi-lateral portfolio 'compression' or 'tear-up' process that is scheduled to launch in Q308.

The new compression approach improves on previous tear-up processes by delivering significantly better compression results while leaving market risk profiles unchanged. The process involves terminating existing trades and replacing them with a far fewer number of new 'replacement trades', which have the same risk profile and cashflows as the initial portfolio, but with less capital exposure. The initiative, available to both the US and European CDS markets, will be managed jointly by Creditex and Markit and has the support of 13 major CDS market participants.

"ISDA is pleased to play an important role in this industry effort to improve operational efficiency," says Robert Pickel, executive director and ceo of ISDA. "Portfolio compression, as well as efforts to hardwire the settlement mechanics into the credit derivatives definitions, will continue to be an area of focus for ISDA throughout 2008."

Discussions on portfolio compression began in early May. Since then, an ISDA working group looked at the most efficient way to implement a portfolio compression process.

On 11 June ISDA issued an RFP to coordinate the selection by 13 institutions of a third-party vendor that would facilitate the compression service. ISDA then organised a selection committee comprised of business representatives from the institutions that ultimately selected the combination of Markit and Creditex to provide the initial portfolio compression service.

The industry is working against aggressive timelines. The 13 institutions that have committed to participate in the first round of portfolio compression are expected to start the process by the end of July. In the meantime, ISDA has set up several working groups to look at business, legal, tax, operational and other considerations for portfolio compression.

Won-denominated CDS brokered
GFI Group has brokered an interbank single-name Korean Won-denominated CDS. The counterparties were major international banks and the trade comprised a three-year swap on KRW10bn notional of a quasi-sovereign name.

The move marks the entrance of an inter-dealer broker to the Korean Won-denominated CDS market and GFI is already quoting prices on other names. "The emergence of an inter-dealer CDS market is a natural development for the growing and liquid local market in Korean corporate bonds," says Timothy Mariano, GFI's head of Asia-Pacific credit brokerage. "Basel II will spur this even more with its sophisticated risk management requirements, along with new regulations allowing financial institutions to invest in CDS."

Fitch suggests new rating scales
Fitch has announced potential new rating scales and indicators for global structured finance (SF). The agency emphasises that the proposed new scales and indicators would complement, not replace, its existing SF rating scale.

In an exposure draft entitled, 'Fitch Proposals for Complementary Ratings and Indicators to Structured Finance Ratings', the agency calls for feedback regarding its proposals. The proposals are the culmination of an exercise to devise new measures to add value for investors, which Fitch first announced on 29 April.

"The additional indicators are designed to improve transparency for users of SF ratings and provide market participants with additional information regarding rated securities. Additionally, the proposals seek to address any perceived shortcomings of SF ratings," says Ian Linnell, head of Fitch's EMEA SF rating group. "There remains ongoing discussion, particularly with the regulatory community, as to whether SF securities should have a separate primary rating scale or include asset class descriptors in the existing primary rating scale. As this dialogue progresses, Fitch may make further proposals and comment in this area. However, the agency's focus at this time has been on complementary scales that should improve the understanding and transparency of existing SF ratings."

The agency is seeking feedback on its proposals over the next 30 days. It will then review feedback and decide which, if any, of the proposals should be pursued further.

The proposals include a number of new, simple additional indicators which Fitch believes can add value in the following areas:

• Loss-given default/loss severity - a loss severity rating scale at the security level to accompany traditional ratings. "We believe additional disclosure in this area would add the most value, given the difference in loss-given default between traditional corporate debt and most structured finance debt," says Glenn Costello, US SF risk officer at Fitch. "In structured finance, given different priorities of payment and the relative 'thickness' of tranches, the extent of loss-given default can vary significantly and is an important consideration for investors that Fitch's SF ratings have not traditionally addressed."
• Collateral quality assessment - the agency proposes assigning the underlying collateral an opinion grade alongside the transaction rating. This proposal would draw on views already developed as part of the SF rating process, but is designed to isolate opinion on collateral from opinion on the rest of the transaction structure.
• Rating transition probability and volatility - Fitch has recently committed to an extension of 'Rating Outlooks' to all structured finance areas globally. Fitch believes that meaningful scales giving indications of the potential for a particular security to suffer rating transition or volatility would be difficult to develop in isolation from factors captured by traditional debt ratings. However, the agency agrees that additional transparency regarding the likely medium-term path of a credit rating would be useful information for investors to have.

Exchange rate divergence signals increased volatility
Diverging views between the US Federal Reserve and European Central Bank on the euro-dollar exchange rate could signal increased volatility in the financial markets through the summer, according to a new S&P report entitled 'European Economic Forecast: Central Banks Zero In On Inflation'.

"After a series of interest rate cuts to preserve growth in the US, the Federal Reserve is rebalancing its priorities and expressing concerns about the weakness of the dollar," says Jean-Michel Six, S&P's chief economist for Europe. "In Europe, meanwhile, the central bank is indicating that that the next move for its main interest rate will be upward."

S&P's forecast is for the dollar to initially weaken against the euro over the next four months, possibly to US$1.65 to €1.00, before bouncing back in Q408 as the probability of a Fed hike increases. In that scenario, the US currency could strengthen toward less than US$1.50 per euro.

As the report points out, tighter monetary policies among the central banks will force countries whose current account deficits have been widening to reduce the growth differential with their main trading partners. This readjustment will likely be painful in the short term because unilateral devaluation is no longer an option for countries such as Spain (whose current account deficit reached 10% of GDP in 2007), Portugal (9.4%) or Greece (14.0%).

And, while membership of the European Monetary Union is shielding these countries from a severe recession, this protection is temporary. The shortage of funding of their deficits by the rest of the world will need to be offset by a rise in their domestic savings rates. GDP growth trends are therefore likely to diverge within the Eurozone in the next 18 months.

Consumer demand will likewise diverge. In countries with high levels of household indebtedness much lower credit growth and higher consumer price inflation will weigh heavily on consumer spending. This is true of Spain and Ireland.

The position in the UK is more uncertain, however, owing to the relative resilience of the labour market and recent retail sales performance. France, with its relatively small current account deficit, should be less affected by tighter monetary policy. Although inflation will weigh on real income growth, the high level of savings and continued improvement in the French labour market lead S&P to expect that consumption will only be slightly below its long-term trend.

"Our greatest uncertainty relates to the outlook for consumption in Germany. Past experience shows that, faced with a surge in inflation, German households tend to increase their precautionary savings and cut back on nonessential spending. However, there is sufficient pent-up demand in the economy to expect that this won't entirely be the case," said S&P.

ECB-eligible conduits increase
Salome Funding last week became one of the first ABCP conduits to become eligible for European Central Bank (ECB) funding facilities. Investors in ABCP debt can now use commercial paper as collateral for central bank funding activities, thereby helping to support stabilisation within the European commercial paper market, note analysts at UniCredit. They suggest that investors will feel more confident with the new central bank funding options for ABCP and might even benefit from potential carry benefits.

To qualify for the ECB programme, a conduit needs to be based in the EU and, amid other requirements, needs to be listed on a European stock exchange. ECB eligible ABCP will attract more investors as they can now more easily borrow against the commercial paper with the central bank. The more investors are attracted by the new 'high quality' stamp for commercial paper issuance, the more funding costs for conduits will decline.

Other conduit operators like German Landesbanks or Deutsche Bank are reportedly trying to achieve ECB eligibility for their ABCP issuance as well. Tension in Europe's short-term lending markets has risen once again over the last few weeks, as end-of-the-quarter effects have led to a tightening of short-term credit supply.

Kestral Funding downgraded ...
S&P has lowered and kept on credit watch with negative implications its issuer credit ratings (from AAA/A-1+ to A-/A-2) and its CP and MTN ratings (from A-1+ and triple-A to A-2 and single-A minus respectively) on Kestrel Funding. At the same time, the ratings on the income notes remain unchanged.

The rating actions follow the expiry of the previous subscription facility and the execution of a new liquidity facility agreement with WestLB. The new liquidity facility covers the repayment of all senior debt.

Whereas under the previous subscription facility the obligations of WestLB were cash collateralised, under the new facility these obligations are not backed by collateral - hence the ratings on Kestrel's senior debt are now linked to WestLB's rating. The ratings remain on watch negative because after all the senior debt is repaid, WestLB as liquidity provider will need to be repaid and that repayment will be reliant on the SIV's asset portfolio.

Kestrel is a SIV structure managed by Brightwater Capital Management, which has responsibility for purchasing assets, managing the portfolio and overseeing the issuance of CP and MTNs.

... while Sedna enters restricted funding
Citi announced that Sedna Finance has completed its scheduled transition into the operating state defined as restricted funding on 1 July 2008.

Fitch reviews fair value disclosure
The need for better fair value disclosures in financial statements is a key element in the ongoing fair value debate, as discussed in a Fitch review. Specifically, the degree of reliability and assumptions around fair value measurements has been an important topic of discussion for financial institutions analysts looking at 2007 and 2008 financial reporting to date.

Fitch's analysis was based upon a review of 2007 annual reports and 10-Ks of the world's largest banking groups. In particular, the agency reviewed notes to the financial statements and critical accounting policies relevant to fair value measurements. The report highlights specific disclosures that Fitch considers helpful to credit analysis in evaluating fair value measurements and identifies areas where more extensive disclosure would assist the reader in understanding the results.

Fair value disclosure is a topical area this year, given that the implementation of new fair value accounting standards has coincided with sharp declines in values of sub-prime and related debt instruments.

"The new fair value disclosures are obvious improvements compared to prior disclosures, but do not go far enough," says Olu Sonola, a director in Fitch's Credit Policy Group. "Investors and analysts need better and more extensive disclosure around fair value measurements."

The tabular format required by Statement of Accounting Standards (SFAS) 157, distinguishing between level 1, 2 and 3 valuations, is clear and easy for readers to understand. This disclosure format is not yet required under International Financial Reporting Standards (IFRS), but Fitch found it encouraging that most of the IFRS reports reviewed used the format anyway.

The agency notes, however, that information about fair value measurement in IFRS reports outside the group of institutions it reviewed is limited. The SFAS 157 tabular format would be a helpful way to disclose information for any company with a high proportion of assets/liabilities at fair value.

Rating actions for European ABS CDOs ...
S&P has taken credit watch actions on 28 tranches issued by several European ABS CDOs. Specifically, ratings on two tranches were affirmed; four tranches were lowered; eight tranches were lowered and removed from watch with negative implications; 11 tranches were lowered and kept on watch negative; and three tranches were removed from watch negative and affirmed.

Most of the affected tranches were originally placed on watch negative on 7 May, reflecting the deterioration in the credit quality of the underlying portfolio due to the exposure to US ABS CDOs and (RMBS, and the potential decrease in the break-even default rates (BDRs) as a result of the agency's revision to its recovery assumptions for certain CDOs. The rating actions reflect the negative rating migration in the transactions' portfolios following recent negative rating changes on US ABS CDOs in the underlying portfolio. This has led to an increase in scenario default rates (SDRs).

The rating actions also reflect the effect on the CDOs following the revisions to S&P's recovery rate assumptions for CDOs. The revision has led to a significant fall in the BDRs when subject to its cashflow analysis. As a result, current credit enhancement cannot support the rise in SDRs at existing ratings levels.

... and synthetic CDOs
S&P has also taken credit rating actions on 110 European synthetic CDO tranches. Specifically, the ratings on 89 tranches were lowered and removed from watch with negative implications; 20 tranches were lowered and remain on watch negative; and one tranche was removed from watch with positive implications and affirmed.

Of the 109 tranches lowered 29 reference US RMBS and US CDOs that are exposed to US RMBS, which have experienced recent negative rating actions; and 80 have experienced corporate downgrades in their portfolios.

Remittance reports climb
Remittance reports for June were released today, showing monthly aggregate 60+ day delinquencies climbing by 69bp, 149bp, 150bp and 159bp (compared with the 99bp, 201bp, 154bp and 176bp rises last month) for ABX Series 06-1, 06-2, 07-1 and 07-2 respectively. Analysts at Barclays Capital forecast last week for 60+ day delinquencies to rise 74bp, 157bp, 156bp and 165bp.

The analysts note that index collateral performance was mixed across series by delinquency bucket, with two exceptions - loans that were 90+ days delinquent or in foreclosure (both of which rose across all indices), and loans that were 30-59 or 60-89 days delinquent (both of which declined or were nearly flat). Nevertheless, on a deal-by-deal basis, the growth rate of 60+ delinquencies fell for just over half of the trusts tracked.

In the aggregate, total prepayments fell slightly for Series 06-1 and 06-2, and inched higher on Series 07-1 and 07-2. Default rates continued to rise for all four index series, while voluntary prepayments continued to decline.

NAV decrease but interest received for Carador
As at the close of business on 31 May 2008, the un-audited net asset value per share for permacap Carador was €0.646. While the vehicle's NAV decreased by 14% in May, an estimated €722,478 worth of net cash flow interest was received in the month (to be allocated between capital and income), which equates to €0.0144 per share.

SROC results in
S&P has lowered its ratings on 20 Asia-Pacific synthetic CDOs (three of which remain on negative watch) and 23 tranches relating to 20 Japanese transactions, following its SROC review for June. At the same time, the agency affirmed its rating on one Japanese tranche and raised the ratings on three Asia-Pacific CDOs, took seven CDOs off watch negative and took two CDOs off watch positive. Additionally, the rating on one Asia-Pacific CDO was revised from watch with negative implications to watch with developing implications.

Regarding the downgrades of Japanese deals, S&P removed its ratings on 16 tranches from watch with negative implications, where they had been placed before these rating actions. The ratings on the other seven downgraded tranches remain on watch with negative implications.

S&P has also taken credit rating actions on three European synthetic CDO tranches. Specifically, the rating on one tranche was lowered and remains on credit watch with negative implications; and two tranches were removed from watch negative and affirmed.

These rating actions and the credit watch updates follow two reviews. The first review was of the credit watch placements made on 12 and 17 June. The second review was of the ratings on tranches that have been on credit watch negative for more than 90 days.

In addition, the agency has taken rating actions on various US synthetic CDO transactions. It lowered its ratings on 97 classes, 18 of which remain on credit watch with negative implications; raised its ratings on three classes; and affirmed its ratings on 19 others and removed them from watch negative.

The CDOs that had their ratings lowered have SROC levels that are less than 100%. This indicates that they have insufficient credit support to retain their former ratings, following negative rating migration within their reference portfolios.

For the transactions that had their ratings raised, their SROCs have stayed above 100% at the higher rating level. For the transactions that had their ratings affirmed and removed from watch with positive implications, the review indicated that they had insufficient credit support to be raised to the higher level.

Finally, transactions that had their ratings removed from watch with negative implications have SROC levels that are more than 100% at the current rating, due to positive rating migration in their portfolios. The revision of the watch status from negative implications to developing implications is a result of scenario analysis on defaulted entities referenced in the CDO portfolio.

Loan pricing behaviour changing
The ongoing dislocation in the credit markets appears to be changing pricing behaviour in Europe's leveraged loan market, according to a research report published by S&P. Entitled 'Europe's High-Yield Loan Market Shifts Its View On Credit Risk In Secondary Pricing,' the report reveals that speculative-grade loans traded in the secondary market are now tracking credit risk on a linear basis.

"This is a substantial shift in sentiment from that of a year ago when most loans traded above par value, regardless of credit risk," says S&P leveraged finance research analyst Taron Wade. "In a market struggling to recover from a liquidity crisis, a differentiation in secondary pricing based on credit risk is an encouraging sign."

The report outlines the findings of a study of more than 100 institutional term loans. In the secondary market, the effective yield spread increases by a minimum of 50bp at each rating level as credit quality declines. This is a substantial shift in sentiment from that of a year ago when most loans traded above par value, regardless of credit risk.

Such a shift has yet to occur with regard to primary pricing in Europe, however. For the year to date, according to S&P LCD, the primary weighted average institutional spread across all European leveraged loan transactions stands at 327.1bp over Libor, a slight increase of 62bp over the 2007 average spread of 264.9bp. But these are small changes compared with the US, where the average spread year-to-date in June was 413.2bp over Libor, compared with 270.4bp at the end of 2007.

"One of the reasons the primary European leveraged finance market has failed to recover as quickly as its US counterpart is because of the absence of a link between credit risk and pricing," adds Wade. "The US secondary market is far more liquid, providing a benchmark for pricing new transactions. Therefore, the US loan market is able to function as an efficient capital market; one where underwriters can quickly adjust pricing to reflect risk as well as respond to investor demand."

BIS annual report points to excessive growth in credit
The fundamental cause of today's problems in the global economy is excessive and imprudent credit growth over a long period, says the Bank for International Settlements (BIS) in its 78th Annual Report. This always threatened two unwelcome outcomes: a rise in inflation and an accumulation of debt-related imbalances, which would at some point prove to be unsustainable.

In the event, both unwelcome phenomena are being experienced at the same time. Leaning against current inflationary pressures should imply a significantly less accommodating bias to global policy overall, even though this could create some short-run difficulties in some countries.

The BIS notes that the experience of the recent financial turmoil shows the need for a new macro-financial stability framework to resist actively the inherent pro-cyclicality of the financial system. This would require a primary focus on systemic issues and a much more countercyclical use of policy instruments. It also demands closer cooperation between the central banking and regulatory communities in trying to identify the build-up of systemic risks, deciding what to do to mitigate them and agreeing in advance on steps that might be taken to manage periods of stress.

BIS general manager Malcolm Knight notes that "central banks face a difficult dilemma because inflation pressures have come to the surface just when downside risks to growth have increased". Moreover, important aspects of central bank functions have come under consideration, including how they provide liquidity to banks and their role in financial system oversight.

"The BIS looks forward to working closely with both central banks and regulators in developing better analytical frameworks for addressing these important questions," Knight adds.

The 78th Annual Report was presented at the Bank's Annual General Meeting held on 30 June in Basel, Switzerland. The Bank's balance sheet grew to US$511bn-equivalent at end-March 2008. Official foreign currency reserves deposited with the BIS rose from SFr222bn to SFr236bn.

This corresponds to a year-on-year increase of around 6%. The BIS's 55 shareholding central banks will receive a dividend of SFr265, around 4% higher than that for the previous financial year.

Transparency initiative furthered
Nine European and global trade associations have released 'Ten Industry Initiatives to Increase Transparency in the European Securitisation Markets' in response to the European Council of Finance Ministers' (ECOFIN) call, in its October 2007 Roadmap, to "enhance transparency for investor, markets and regulators" by mid-2008. These initiatives are the deliverables that the associations had committed to deliver to the European Commission in their 8 February letter and have been delivered on schedule.

The ten initiatives are broad in scope. The first two are in direct response to the ECOFIN Roadmap. They are:

• Draft Industry Good Practice Guidelines on Securitisation Disclosures under Pillar 3 of the Capital Requirements Directive (CRD), and
• the creation of a new industry Quarterly Securitisation Data Report, which provides comprehensive, frequent and relevant statistical data on EU and US securitisation markets.

However, the industry initiatives go beyond the transparency requests specifically listed in the ECOFIN Roadmap, with eight additional issuer and investor focused initiatives designed to standardise issuer disclosure practices, broaden and facilitate investor access to transaction information, enhance usability and comparability of information, and strengthen investor good practice. These additional initiatives (some of which are now also complete) include:

• a finalised ABCP Issuer Disclosure Code of Conduct;
• development of draft RMBS and CMBS Issuer Transparency and Disclosure Principles;
• measures to enable further opening of access to transaction information;
• development of Industry Data Portals to create centralised access to prospectuses and investor reports;
• a new ESF RMBS and CDO Issuer/Manager website directory;
• establishment of globally coordinated task forces to improve standardisation and granularity of RMBS and CMBS reporting templates;
• development of standardised definitions to enhance comparability of terms in a global investor marketplace; and
• development of investor principles for credit assessment and valuations.

While all of the associations are committed to improving transparency and have actively coordinated their efforts, they have separate memberships with differing expertise. Hence, different associations have been leading in specific initiatives and will thus take separate responsibility for the implementation of their respective initiatives.

In addition, the associations are committed to continued implementation of such initiatives, which will provide a robust framework for delivering greater transparency and should contribute to increased long-term investor confidence in the European and global securitisation market. These initiatives are being coordinated on a global basis with other industry groups to the maximum extent possible and are also consistent with recommendations of the Financial Stability Forum and the International Organization of Securities Commissions on transparency.

The nine associations are: Commercial Mortgage Securities Association; European Association of Co-operative Banks; European Association of Public Banks and Funding Agencies; European Banking Federation; European Savings Banks Group; European Securitisation Forum; International Capital Market Association; London Investment Banking Association; and the Securities Industry and Financial Markets Association.

Benchmark pricing for loans
Markit has announced that it has provided benchmark pricing for investment grade corporate loans arranged by two of the world's biggest banks. JPMorgan and Citi have used Markit's CDS data to provide a new market-based pricing (MBP) for revolving credit facilities arranged for corporate borrowers.

MBP is a reference spread over Libor and represents a departure from the traditional method of pricing such transactions, which establishes a set spread over Libor at transaction launch that may not reflect market-based spreads if and when the borrower decides to draw down on the facility. Markit is working with other key industry players to establish this pricing method as a market standard.

Thomas Cassin, head of high grade loan capital markets at JPMorgan, says: "We developed the market-based pricing structure in order to meet our clients' needs for liquidity in the bank market, while ensuring that lenders are compensated at market-based rates for the capital employed."

CS

CSO restructuring: what are my options?

The pros and cons of CSO restructurings are discussed by John Schofield of RBS' structured credit strategy team

'Fallen angels' are quite common in static CSO portfolios, due to the use of ratings arbitrage at issuance. Names with spreads wider than their ratings would imply were included in order to bump up the yield without harming the structure's rating. Monolines, financials (particularly mortgage-related) and credits at risk of LBOs were popular choices.

As a result, what were once IG portfolios may well contain several credits trading at or near distressed levels. If the investor is concerned that these credits may deteriorate further and ultimately default, they can trade out of those names and into credits they are more comfortable with.

Why do this now?
Our strategists have a bearish outlook for corporate credit spreads into the end of this year. Tightening consumer credit and rising input costs will squeeze profit margins, pressurise corporate earnings and ultimately cause corporate health to deteriorate. The time to prepare for this is now, rather than when the sell-off is in full swing, spreads are wider and liquidity reduced (see SCI issues 89 and 92).

Swapping wide credits, which one may consider more vulnerable in a downturn, for defensive, tight ones will come at a cost - the size of which depends on the number of credits substituted, the spread differential, the trade's tenor and the tranche's current subordination. We look here at some ways of paying for this cost and demonstrate its effect with an index-based example.

Option 1: reduce subordination
By moving down the capital structure, the investor effectively crystallises the loss involved in trading out of the wide names. The PV of the new, 'good' tranche with lower attachment is the same as the PV of the old, 'bad' tranche with higher attachment.

The coupon and note price will be unaltered by the switch (ignoring bid-offer or fees). The affect on note rating is uncertain.

Trading out of wide names will benefit the rating, while reducing subordination will harm the rating. It is likely that the latter effect will dominate, so this approach needs an investor with flexibility (or disregard) for ratings.

Option 2: reduce coupon
The current attachment can be maintained by deferring the cost of the switch over the lifetime of the transaction by receiving a lower spread. The rating on the new tranche will improve, as poor credits are replaced.

The problem with this method is that the PV difference could be so big as to necessitate a negative spread. Of course, this depends on the number and quality of the credits removed.

Option 3: increase tenor
With the same attachment, this has a similar effect to reducing subordination. Longer tenor tranches have greater risk because the expected loss of the portfolio is greater. As with our first option, the effect on the rating is uncertain and depends on the relative benefit of moving out of poor credits and moving further down the capital structure (relative to expected loss).

Option 4: reduce tranche thickness
The tranche thickness is one kind of leverage - the thinner the tranche, the greater the breakeven spread. By decreasing the tranche detachment (and therefore tranche thickness), while leaving the spread unchanged, the investor can pay for the trading losses.

One advantage of this method is that it will not damage S&P ratings, despite the increase in leverage. Moody's ratings will be affected though, as they work on expected loss rather than the first dollar of loss.

One problem here is that many CSOs were just 1% thick to begin with. Reducing this further creates many problems with pricing and will likely result in expensive restructuring costs.

Option 5: create a CDO-squared
Our final option is quite different to those suggested previously. Rather than trade out of poor credits, an investor with several CSOs could bundle them all up together in a CSO portfolio and write protection on a senior tranche. This could be a X%-100% position (i.e. the investor is buying first loss protection on their CSO portfolio) or it could be a thinner tranche, which may be a way of reducing the restructuring cost.

We have heard anecdotally of these sorts of trades being done. The problem we see with this solution is that it adds complexity, reduces liquidity and the dealer bid-offer for it will likely be larger than for a simpler structure. Ratings are most likely to improve in this scenario, so some investors may feel the benefit is worth the cost.

Other considerations
The most important consideration for the end investor is likely to be the restructuring cost (the bid-offer, rather than the PV adjustment). As the dealer that initially structured the trade will, by definition, have a good match to the trade on their book, it is likely they will be most competitive on fees.

On the other hand, many correlation desks have been severely constrained and may not have the ability or appetite to carry out restructurings. This may leave open the opportunity for third party desks to get involved. Also, this sort of investor-initiated request is only really relevant for static deals, as owners of managed tranches have delegated credit selection to their manager (and have paid fees for their ability to trade out of credits before they deteriorate too much).

For particularly distressed credits, the investor has to weigh up just what may be gained by trading out of the name. For example, with ResCap currently trading over 50% upfront, the default is pretty much priced in already and little benefit would be gained from removing that name.

Finally, the note holder may also have ratings constraints. Some of the options above may cause a downgrade, making them unpalatable to the investor - despite the fact that, in economic and risk terms, they are in a safer product. While many investors would see this as a price worth paying, some will be prevented by their mandates from holding assets below a certain rating.

Practical example
Here we run through an example portfolio to see what the above options will look like in practice. We take a 125 name, seven-year portfolio composed of half iTraxx 9 and half CDX 10. We use the widest half of the names from each index.

We take a 5%-7% tranche that is paying a spread of 300bp. The 'fair' spread on the tranche currently would be 642bp, giving a mark-to-market of -17%. We use a relatively simple method for our correlation - an average of the current CDX and iTraxx curves, normalising by portfolio expected loss.

The restructuring involves trading out of the widest five names (all from CDX, as it happens) and replacing with the tightest names from iTraxx and CDX. The seven-year WAS of the old portfolio is 161bp, which reduces to 132bp after substitution.

This would effectively crystallise a loss of 9% from the hither to unrealised 17% mark-to-market. All options are 'zero cost', in that they require no further cash from the investor.

We stress that this is a simple example used to demonstrate how a restructuring could work. Actual portfolios will vary wildly and we take no account of the restructuring fees charged (think of that as the dealer's bid-offer).

Option 1: reduce subordination
The 9% loss can be paid for by moving further down the capital structure. In our example this would be equivalent to moving from 5% attachment to 3.7% (keeping a 2% tranche width).

With regards to rating, changing the portfolio decreases the subordination required for each rating. Using S&P's CDO Evaluator model, Table A shows the 'Scenario Loss Rate' for each rating category. This is effectively the minimum amount of subordination needed to obtain that rating.

One can see that the original tranche, with 5% attachment, was a firm triple-B (subordination would need to be at least 5.25% to achieve triple-B plus). The new tranche has the advantage of being of a safer portfolio, but the drop in subordination has a bigger effect and the rating drops three notches to double-B.

Option 2: reduce coupon
The loss caused by trading out of the wide names can be recovered by lowering the spread to 130bp, from 300bp, allowing the 5% subordination of the original tranche to be maintained. Whether or not this approach is feasible clearly depends on the number and distressed nature of the removed credits.

It is possible that some very poor portfolios would have a negative spread (so would pay Libor-[X]) as a result. As the note coupon is irrelevant to rating, the tranche should improve, but the difference is insufficient to move from triple-B.

Option 3: increase tenor
If we increase the tenor from seven years to 10 years, we actually make more money from the longer tenor than we lose by trading out of the poor credits. This allows us to increase the subordination very slightly up to 5.15% (still 2% thickness).

The rating does suffer though, as a 5.15% subordination in a 10-year structure only manages double-B plus and even that by the skin of its teeth (SLR for double-B plus is 5.14%). However, double-B plus for tenor extension is better than double-B for option 1.

Option 4: reduce tranche thickness
Keeping our 5% attachment, seven-year tenor and 300bp spread, we can attempt to recover the trading losses by reducing our tranche thickness. Unfortunately, the gains from this alone are insufficient for this strategy to work.

For example, we can reduce the thickness to 1% (a 5%-6% tranche), but this will only pay for about a third of the losses. The rest could be recovered by reducing subordination (to around 4.05%) or by reducing the spread received (to around 180bp).

Conclusions
Which option to take depends greatly on the circumstances of each investor and CSO. Reducing subordination or increasing tenor enables the current coupon to continue, while improving the credit profile of the portfolio - although downgrades may put off ratings-sensitive investors.

Reducing the coupon is an attractive option, as ratings may even improve, but this limits the number of credits that can be replaced. Reducing tranche thickness suffers from the same problems and will not be possible in many CSOs. Finally, we do not view a CDO-squared type structure as a sensible trade, as the bid-offer will be substantial and subsequent liquidity will be poor.

© 2008 The Royal Bank of Scotland. All rights reserved. This Research Note was first published by The Royal Bank of Scotland on 26 June 2008.

Trading ideas: turning off the spigot

Dave Klein, senior research analyst at Credit Derivatives Research, looks at a pairs trade on CDX.NA.IG 10 and CDX.NA.HY 10

We return to the CDX IG/CDX HY decompression trade. IG and HY compressed as spreads blew out over the past year. With lending standards tightening, liquidity drying up and the economic outlook remaining bleak, we believe we are heading into a period of higher defaults.

Furthermore as bank credit is contracting, HY names (more reliant on credit lines) will face increasing difficulties drawing/revolving these facilities, causing defaults to rise. As these defaults are far more likely to hit HY harder than IG, HY should leg wider than IG, especially in the short to medium term. Despite the negative carry of the trade, we believe the expected outperformance of IG relative to HY is worth the cost of carry.

Turning off the spigot
To date, we have seen relatively few defaults in index credits. With lending standards tightening, we expect defaults to increase as companies fail to refinance debt.

Exhibit 1 charts the annual default rate for HY names against the net percentage of lenders that are tightening lending standards (according to the Fed survey of senior loan officers). Clearly, lending standards have tightened dramatically since 2005, but we have yet to see a corresponding increase in HY defaults (although defaults are trending upward).

Exhibit 1

According to a recent Moody's report, SGL downgrades outnumbered upgrades by a ratio of 14 to 4 in May. The report bolsters our view that liquidity pressure is growing on all names and especially on HY names.

In the near future, we see HY names heading into default in greater number than IG names. This is the main driver of the trade.

With the disappearance of the synthetic bid, IG has compressed relative to HY as perceived credit risk rose more rapidly in higher-rated names. Since the end of last year, market prices and equity-implied default probabilities (Exhibit 2) have implied a ratio of three HY defaults for every IG default.

Exhibit 2

This ratio has held steady, even as both indices have seen their default probabilities slowly rise. We believe conditions are right for a break to this pattern as HY legs wider.

Exhibit 3 charts the on-the-run CDX HY index against the on-the-run IG index. The market has fairly priced the indices during a time of relatively few defaults. As we experience an increasing number of credit events, we believe HY will widen more quickly than IG.

Exhibit 3

Risk analysis
This trade is weighted to reflect the historical spread volatility relationship between the CDX IG and CDX HY. The trade is not duration neutral; rather, it is weighted more towards IG than HY. If IG underperforms HY, the trade will lose money.

The trade is also a bet on timing of defaults. If IG credit events keep pace or outnumber HY ones, the trade will perform badly.

Liquidity
The CDX IG and CDX HY are among the most liquid contracts available.

Fundamentals
Since this is an index trade, we look at the relationship between IG and HY at a macro level rather than considering single-name fundamentals. We consider three scenarios.

If we see realised defaults over the next few months, we expect HY to underperform IG, as more HY than IG names default. This is the main bet of the trade.

If credits continue to deteriorate but no defaults are realised, then we would expect HY and IG to continue trading according to the relationship in Exhibit 3. In this case, the convexity of the relationship would result in IG underperforming HY. In this scenario, the trade would almost certainly lose money, both from the carry paid and from the IG underperformance.

Finally, if the credit market rallies (against our expectations), we would expect to see IG outperform HY - although we would only expect a modest profit at best on the trade.

Summary and trade recommendation
We return to the CDX IG/CDX HY decompression trade. IG and HY compressed as spreads blew out over the past year.

With lending standards tightening, liquidity drying up and the economic outlook remaining bleak, we believe we are heading into a period of higher defaults. Furthermore, as bank credit is contracting, HY names (more reliant on credit lines) will face increasing difficulties drawing/revolving these facilities, causing defaults to rise.

As these defaults are far more likely to hit HY harder than IG, HY should leg wider than IG, especially in the short to medium term. Despite the negative carry of the trade, we believe the expected outperformance of IG relative to HY is worth the cost of carry.

Buy US$3m notional CDX NA HY Series 10 5 Year CDS protection at 650bp (US$94.685 bid).

Sell US$10m notional CDX NA IG Series 10 5Y protection at 129bp to pay 66bp of positive carry.

For more information and regular updates on this trade idea go to: www.creditresearch.com

Copyright © 2008 Credit Derivatives Research LLC. All Rights Reserved.

Note: This article is intended for general information and use, and does not constitute trading advice from Structured Credit Investor (see also terms and conditions, below, section 12).