Contents

Conservative capital

CDPCs relatively immune to future ratings volatility

The placement last week of Athilon on rating watch negative (see News Round-up) sparked concern about the potential vulnerability of CDPCs to CDO/CSO downgrades. But, while some observers characterise the move as a knee-jerk reaction by Fitch, others believe that CDPCs' conservative capital models mean that they should be relatively immune to future ratings volatility.

"Fitch has taken quite a draconian view on the downgraded ABS CDOs in Athilon's portfolio," says one structured credit investor. "It is trying to forecast what could ultimately happen, amid concerns that the CDPC doesn't have the resources to protect its capital cushion. Having been criticised for reacting too slowly, rating agencies now appear to have swung completely in the other direction."

Banks aren't expected to have to take provisions against CDPC counterparty risk, as they have done with monolines, nor re-hedge the exposure on which they had bought protection as a result of Athilon being placed on watch negative. John Schofield, structured credit strategist at RBS, notes: "We view this rating action as an isolated event, as long as corporate defaults and downgrades do not dramatically increase. As Athilon is the only CDPC with substantial exposure to structured finance, this action (while possibly severe for Athilon) should not be repeated across the sector."

Invicta and Primus Guaranty are the only other CDPCs that could write protection in the ABS space, but Invicta has confirmed that it has no ABS/RMBS exposure. While Primus has never written protection on ABS CDOs, it has written CDS on US$80m notional of single name RMBS bonds (out of a total portfolio of US$23bn). The firm wrote down the value of its ABS CDS portfolio by about US$40m in Q407 when the underlying bonds were downgraded to triple-C (see SCI issue 74).

Given that the majority of CDPCs' investment mandates focus on tranched corporate risk, there is nevertheless some residual concern about how potential future CSO downgrades could impact the sector. Tom Jasper, ceo of Primus Guaranty, points out that CDPCs and CSOs are distinctly different business models. But to the extent that Moody's and S&P decide to change their CSO methodologies and apply certain aspects of them to CDPCs, it could potentially require firms to put up additional capital to support their CDPC businesses.

"Over the course of our six-year history, rating agency models for CDPCs have evolved," says Jasper. In some instances, this has enabled Primus to enhance its operating flexibility and in others it has required additional capital to support the business. He views changes to CSO methodologies as another step in the evolution of the way that rating agencies assess credit risk in a structured credit portfolio.

Primus discloses in its SEC filings that a change in rating agency methodologies is one of the risk factors related to its business. Jasper adds that the company has always worked closely with S&P and Moody's, and that based upon past experience it would have the opportunity to model the potential impact before the rating agencies implement any new methodologies.

With respect to Athilon and Fitch, the CDPC can reposition its portfolio and remove the affected exposure or introduce new capital to restore the appropriate cushion in order to stabilise its rating. "Relative credit quality is crucial to CDPCs and so a downgrade would impact their ability to write new business," explains John Olert, md at Fitch. "Should Athilon be downgraded, whether any of its counterparties would have to write-down the exposure would depend on their individual guidelines. Some counterparties may nonetheless face additional capital charges."

Equally, whether Athilon would enter into a restricted state upon a downgrade is a function of when the losses from the impacted ABS CDOs have to be realised. Given that credit events on the CDOs can only be called in 2014, this is unlikely to happen for several years - and Fitch would take into consideration any capital building that occurs in the meantime.

Olert says that CDPCs were, in general, very proactive during Fitch's consultation over its updated corporate CDO approach and so understand the implications of portfolio deterioration. "In any case, most companies have attached conservatively to CSOs," he concludes.

CS

Unlocking illiquidity

Restructuring investment portfolios takes centre stage

The restructuring of structured investment portfolios is set to play an important role in unlocking current illiquidity in the structured credit markets. As Goldman Sachs prepares to roll out the Cheyne SIV restructuring template across a further four vehicles, structured finance professionals are seeking to identify new restructuring opportunities in other areas of the credit business more broadly.

"As restructuring deals generally result in market solutions which mean portfolios are carried closer to market values rather than model or book values, it is easier to find strategic players willing to commit capital to these sorts of transactions," explains TJ Lim, co-head of markets at UniCredit. "I see restructuring as an area of growth for the credit business, which should replace the much slower growth of new CDO activities."

The Cheyne SIV restructuring experience underscores the fact that structured finance professionals now have a new area in which to apply their expertise, agrees Orrick, Herrington & Sutcliffe partner Mark Fennessy. A number of conceptual difficulties had to be dealt with to get the deal over the line; for example, getting to grips with the redemption methodology clauses and finessing the auction process.

At first glance, valuing the Cheyne portfolio was like trying to nail jelly to a wall because spreads were so volatile. Previously, the portfolio was valued for the purposes of various court applications last year by Houlihan Lokey using a blend of mark-to-model and mark-to-market methodologies.

But then in October/November the receivers (Deloitte) decided that a portfolio sale was the best method to maximise the return for investors. Regulatory rules for achieving fair market value differ across jurisdictions and so - against the backdrop of worsening asset prices - they opted for a sale to Goldman Sachs and for the value of the portfolio to be determined by an auction process (see SCI issue 93).

"The receivers have to achieve the 'best price reasonably obtainable' and will attempt to do so by asking a number of investment banks to bid for individual buckets of assets or the whole portfolio," explains Fennessy. "Goldman Sachs will then purchase the whole or part of the portfolio at a price determined by the auction. If the other banks purchase any assets, the cash will be passed on to the receivers and then to investors requiring a cash payout."

Goldman will then sell all of the assets it purchases to an off-balance sheet vehicle called Gryphon, which will in turn issue pass-through notes, zero coupon notes or vertical asset slices to Cheyne senior creditors to pay for the portfolio. In time new investors may be invited to invest in Gryphon super-senior and capital notes, essentially forming a static CDO.

The auction for the Cheyne SIV assets is expected to be on 17 July, with settlement shortly thereafter. The receivers anticipate that net cash proceeds will be insufficient to make any payments to the holders of the capital notes.

Goldman is using a similar template for the other SIV restructurings it has been mandated for (Rhinebridge, Whistlejacket, Mainsail II and Golden Key), but the senior creditors may not require the same optionality in terms of note format because the banks participating in the auctions may want to establish their own Gryphon-equivalent SPVs. Furthermore, the other restructurings will have their own peculiarities as a result of each series of SIV notes reflecting the requirements of individual senior creditors.

The Cheyne template is said to represent the leading edge of financial restructuring techniques, requiring a unique blend of structured finance and restructuring tools. Other such restructuring opportunities are believed to be available in the ABCP conduit sector, as well as across debt restructuring more broadly (see separate news story). However, Fennessy concludes: "Few firms can actually provide a one-stop-shop for restructuring because structured finance, tax and US/European securities expertise is necessary."

CS

Shifting risk

CDPCs expand remit while banks explore other risk-mitigation options

As banks look to shore up their balance sheets over the coming months, a number of options are being explored by market participants as to the best way to mitigate risk. While it is anticipated that some institutions will offload capital intensive assets to hedge funds or private equity funds, CDPCs are emerging as a potential counterparty to help banks manage their regulatory capital issues.

Walter Gontarek, ceo of Channel Capital Advisors, confirms that a clear business strategy for CDPCs could be to establish separate vehicles to hold credit risk associated with corporate loan and SME loan warehouses, for example. "The list of untainted balance sheets is getting smaller, which means that Channel - and other CDPCs - are becoming increasingly more relevant as counterparties," he says.

LBBW has chosen an already-tested method to lessen the risk taken on when it bought Sachsen LB earlier this year. Some €16bn of structured finance assets will be transferred off balance sheet to an SPV, with a "risk shield" being provided by the Free State of Saxony. Lehman Brothers Asset Management has been selected to manage the portfolio, which mostly consists of US and European triple-A and double-A rated structured finance securities.

The move follows a similar action taken by WestLB earlier this year when it transferred €23bn of its structured credit portfolio into a ring-fenced, off balance-sheet SPV to be managed by PIMCO.

According to structured credit analysts at JPMorgan, one of the most cost effective practices for banks will be selling capital intensive assets in order to release capital. "The rationale for selling assets is simple," they explain. "Even if there is limited risk of principal loss, the assets are not cheap on a capital-adjusted basis, and capital is scarce."

The analysts continue: "Over the coming year, a dominant theme for mortgage credit will be the ongoing shift of capital intensive assets/securities from the banking sector to hedge funds and/or private equity. This process will take the form of asset sales, but the proposal to lift controlling interest rules for private equity investments in banks is another way this transfer can occur."

Another structured credit analyst explains that, while banks may be cutting dividends and curbing lending to improve their balance sheets, banks cannot escape from the fact that they are still too leveraged. "Value at risk has increased for the majority of them and they must get rid of assets to counter this," he explains.

He comments that private equity houses have taken on a significant number of leveraged loans from banks. "There are incentives for bidders to take on a whole package of loans from the bank's balance sheet and in these cases the chance of purchasing the better loans is increased."

But the analyst concludes that in some cases the assets are simply unsellable. "A number of deals are at risk of producing real losses now, and banks are going to have to continue to take write-downs on these assets until an alternative can be found."

AC

Structured credit hedge funds inch up

May sees first positive index returns for eight months

Both gross and net monthly returns for May 2008 in the Palomar Structured Credit Hedge Fund (SC HF) Index are positive - for the first time since the September 2007 figures were released.

The latest figures for the index were published this week and show a gross return of 0.51% and a net return of 0.35% in for the month of May, with 18 out of 23 funds announcing positive monthly results. The moves mean that the gross and net indices continue to show negative annualised returns since outset of -6.22% and -8.07% respectively, however.

All sub-strategies, with the exception of 'long investment grade leveraged', achieved a positive performance. The dispersion and range of returns decreased compared to the data observed in April. For more Index data click here.

The objective of the Palomar SC HF Index is to produce an index that represents the risk and return of investable hedge fund investments in the structured credit area. It is currently comprised of 23 member funds, representing over US$10bn of assets under management.

The index aims to provide a monthly measure of the performance of the universe of open, investable structured credit hedge funds. The Palomar SC HF Index is calculated in two formats - as gross asset value and as net asset value.

The Palomar SC HF Index is compiled and run by Palomar Capital Advisors and published exclusively by Structured Credit Investor. Palomar Capital Advisors is a financial advisory firm specialising in structuring, managing and placing alternative investment products, specifically credit-related securities. It is an independent firm based in Zurich, Switzerland, owned and controlled by its investment professionals.

Weighing up CDO tranches using Omega functions

The application of the Omega function to structured credit is discussed by Gene Yeboah, head of credit structuring, fixed income, at Schroders

Investing in structured credit products, especially collateralised debt obligation (CDO) tranches, can be an extremely challenging endeavour given the degree of complexities in their risk profile. CDO investments have highly skewed return distributions: either you'll get paid the promised rate, or the debt will default and you'll take a loss (this is termed negative skew).

Rational investors detest large losses more than they lust after large gains. Therefore, credit spreads almost always price in more interest than is warranted by default expectations alone. A CDO can consequently buy a portfolio of credit instruments and, if the correlation of defaults is relatively low, make arbitrage profits on the investors' disdain for negative skew.

Given the nature of CDO returns or losses, it does not make sense to use the standard relative measure analysis of the Sharpe ratio, as it is done on a risk adjusted return basis. The Sharpe ratio is a rankings function - the higher the value, the better.

By definition, the Sharpe Ratio equals:

Where Rp is the portfolio's return, Rf is the risk-free rate and σp is the portfolio's standard deviation.

This measure is heavily dependent on the return standard deviation. In the case of looking at expected losses, the measure would be expected loss per unit standard deviation - which is what some of the rating agencies are planning to promote.

This approach ignores the higher moments that are extremely sensitive to the shape of the distribution, which is a function of the default correlation of the underlying credits. The tail of the distribution in the case of CDOs contains vital information about the risk embedded, for which the variance is a poor proxy. In many ways this approach should be adopted by the rating agencies instead of focusing on rating volatility for structured credit transaction that are multi-name dependent.

Here we're introducing the concept of the Omega function¹, which allows one to capture all the information in the distribution. Comparing the Omega functions for two more assets - in this case CDO tranches - over a range ranks their performance and risk profiles without estimating any moment. By looking at the daily changes of the iTraxx index (see Figure 1), we can clearly see that it is not symmetric and the concept of using variance underestimates the tail of the distribution.

Figure 1: Histogram of daily changes of the iTraxx (Q2:2008)

The weakness of this measure is that it assumes that the standard deviation of the return distribution of a financial instrument provides the full description of risk and assumes that returns are evenly distributed. However, returns from financial instruments - and particularly the returns from structured credit, especially CDO tranches - are not normally distributed.

The Omega function, by its mathematical definition, captures the expected return/loss, standard deviation, skew, kurtosis and all higher moments of the distribution:

For returns

(1)

For losses

(2)

In equation (1) and (2), F(x) refers to the cumulative distribution function of the investment and r or L is the selected threshold for return or expected loss respectively.

In the case of the expected loss Omega, the lower the omega, the better the investment. Therefore, if we have investments like tranches we could compare their omega function.

In the case of relative return analysis, the higher the omega score, the better the omega risk-adjusted returns; conversely with losses, lower is better. An Omega value of less than one indicates that the investment is not of good quality with respect to achieving the respective threshold.

The fact that the Omega function is using the distribution function in its formula shows that it is using all of the distribution information. Notice that the Omega function does not necessarily have to use historical returns (see Figure 2).

Figure 2

If one wishes to use a simulated or modelled distribution, then one can do so; all the Omega function needs for its calculations is a return series. However, one should be very careful if choosing not to employ the historical returns.

The measure of risk in any investment has been the degree of uncertainty associated with the potential deviation from its expected return/loss. For this reason, it has been expedient to use standard deviation as a good proxy for such a measure.

However when it comes to credit, especially credit portfolios, the tail risk seems more important than the standard deviation with assumed normality in distribution. The Omega function is an excellent measure in dealing with the non-normal distribution of CDO returns or losses.

The Omega function may also be a useful tool in determining the portfolio allocation to CDOs via omega optimisation and, by comparing Omega graphs and Omega scores, will give a more accurate measurement of performance, which does not neglect the higher statistical moments.

Using the Omega function in analysing investment funds that trade in CDOs can support the decision about which fund/tranche to choose. Neglecting the higher statistical moments and merely assuming a Gaussian distribution when conducting analysis of CDOs is incorrect because CDOs typically demonstrate non-normal behaviour.

¹The Omega function, invented by mathematicians Con Keating and William Shadwick in 2002, referenced an original paper, 'Modeling Non-Normal CDO Returns with the Omega Function', by Ranjan Bhaduri, PhD CFA CAIA, and Gunter Meissner, PhD

Important Information:
The views and opinions contained herein are those of Gene Yeboah, head of credit structuring, fixed income, and do not necessarily represent Schroder Investment Management Limited's house view. For press and professional investors and advisors only. This document is not suitable for retail clients or private investors.

This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA, which is authorised and regulated by the Financial Services Authority. For your security, communications may be taped or monitored.

Structured credit marketer joins hedge fund

The latest company and people moves

Structured credit marketer joins hedge fund
Cheyne Capital has appointed Jane Privett as head of client development. In her new role she will be working closely with Andrea Bonafe, who heads the marketing and business development team.

Privett joins from Barclays Capital, where she was head of UK and Ireland structured credit sales. She has previously worked at Deutsche Bank and Morgan Stanley in sales, structuring and product management.

CLO manager appoints US head
Alcentra has appointed Paul Hatfield to lead its business in the US. Hatfield, an md with Alcentra's London team, is to relocate to New York in September and will be responsible for developing its business in the leveraged loan market. Hatfield joined the firm in 2003 as a portfolio manager for Alcentra's European CLO funds.

He will be replaced by Graham Rainbow, who joins as executive director from Barclays Capital, where he spent 13 years, most recently as a director in leveraged finance syndicate. Rainbow will act as portfolio manager, with David Forbes-Nixon remaining as senior portfolio manager for Alcentra's European CLO funds.

Alcentra is also increasing its US product offering with the addition of two New York-based specialist managers to its group - BNY Mezzanine Partners, a specialist US mezzanine loan manager, and Hamilton Loan Asset Management, a leveraged loan manager. Both businesses were divisions of BNY Mellon Capital Markets.

BNY Mezzanine Partners comprises a team of eight professionals headed by Paul Echausse and manages a US$210m US mezzanine fund. Hamilton Loan Asset Management comprises a team of nine professionals headed by Dean Stephan and manages US$1.6bn of leveraged loans across five investment vehicles.

Portfolio analyst hired
Karine Lorin has joined Credaris as a portfolio manager. She moves over from UBS Asset Management.

Wilson promoted to structured credit head
GFI has appointed Scott Wilson as head of structured credit products, reporting to Jim Higgins, GFI's newly-appointed head of North American credit brokerage. Wilson has been at GFI for five years and was previously responsible for new business development in structured credit. Higgins is a former co-head of global credit trading at Citigroup in New York and will report to Colin Heffron, GFI's president.

Since mid-April, eleven credit brokers, in addition to Higgins, have contracted to join GFI's credit brokerage operation in New York. Also, four senior GFI derivative brokers have transferred internally to its New York credit operation.

Institutional sales head hired
Highland Capital Management has hired Maureen Mitchell as md and head of institutional sales globally. Mitchell will report to Jack Yang, partner and head of business development, and will manage sales professionals focused on the full range of institutional channels - including endowments and foundations, public funds, insurance companies, corporations and fund of funds, as well as investment consultants around the globe.

Mitchell will continue to build the institutional client team in the coming months with additional hires. Prior to joining Highland Capital, she was a senior md at Bear Stearns Asset Management for ten years, where she led the global institutional distribution efforts.

UBS' counterclaim rejected
The High Court of Justice in London has rejected UBS' counterclaim against HSH Nordbank in relation to the North Street 2002-4 CDOs. In February HSH Nordbank started a US$500m claim in New York against UBS relating to the mis-sale and mis-management by UBS of its North Street CDOs (see SCI issue 77). On the same day, UBS filed a counterclaim against HSH Nordbank in the High Court of Justice in London.

Rune Hoffmann of HSH Nordbank says: "Today's decision is welcomed by HSH Nordbank. It confirms that UBS's actions were nothing more than a transparent attempt to confuse and delay the proceedings. In addition, Mr. Justice Walker's decision to refuse UBS's request to appeal confirms that UBS's case is spurious and has no reasonable grounds for success."

He continues: "HSH Nordbank is fully committed to pursuing this important legal action against UBS, which includes claims of breach of contract, fraud, breach of fiduciary duties and unjust enrichment. HSH Nordbank is confident of the strengths and merits of its case and is looking forward to having this matter heard in New York at the earliest possible date."

Structured product research head moves
Brian Lancaster, head of structured products research at Wachovia, is moving from his current position to the real estate division as head of portfolio strategy and chief investment officer. Senior analysts Tony Butler, Greg Laughton and Steve Mayeux will be moving with Lancaster. A new head of structured products research is expected to be named shortly.

New group formed to revitalise structured finance markets
SIFMA, the ASF and the ESF have formed a global joint working group that will create and publish actionable, industry-developed recommendations designed to help revitalise the securitisation and structured credit markets, and bolster investor and broader public confidence in those sectors.

The initiative will be co-led by Sanjeev Handa, head of global public markets at TIAA-CREF, and Jeffrey Perlowitz, md and co-head of global securitised markets at Citi. Other senior-level working group members represent a cross-section of these markets globally, and include investors, issuers, financial intermediaries and other stakeholders.

The goals of this initiative include improving the operation and function of these markets in ways that enhance market discipline and transparency, while preserving the essential role that securitisation plays in funding consumer and business credit needs. In developing its recommendations, the joint working group will consult closely with industry participants and interface with regulators, legislators and policymakers worldwide.

The Joint Securitisation Markets Working Group will also leverage extensive research and industry dialogue in order to arrive at substantive recommendations that have a global impact, including an implementation roadmap. This group will conduct in-depth interviews of senior business leaders and a survey of securitisation market participants worldwide.

Additionally, it is responsive to the President's Working Group on Financial Markets' recommendation regarding the establishment of a private-sector group through which vital industry best practices, including those related to disclosure, can be formulated.

Slow reporting leads to CWN on CLO
S&P has put the Class A notes issued by KC CLO I and KC CLO II on credit watch with negative implications due to delays in receiving information on the transactions from the collateral management group. Credit Suisse is collateral manager, although a new team (within Credit Suisse) has been in place since mid-April.

The Class B notes in both transactions remain on credit watch negative. Those notes were placed on credit watch negative on 31 March following the sudden changes in the collateral management team and subsequent delays in reporting of performance information for the transactions.

LBAM wins Sachsen mandate
Lehman Brothers Asset Management has been awarded a mandate to manage a portfolio of structured finance securities formerly owned by SachsenLB (see separate news story for more).

Fitch withdraws ratings of Nelson Finance 1 & 2
Fitch has downgraded Nelson Finance 1 and 2 to double-A minus from triple-A and removed them from rating watch negative. The downgrade is a result of Fitch's view on the credit risk of the rated notes following the release of its new corporate CDO rating criteria.

The ratings have been withdrawn as Fitch will not receive ongoing portfolio information. The portfolio manager is Scottish Widows Investment Partnership.

Ambac board adds one ...
Paul DeRosa, a principal of hedge fund management firm Mt. Lucas Management Corporation, has joined Ambac's board of directors. The addition of DeRosa to the Ambac Board increases its membership to seven.

During the past 30 years DeRosa has worked in a variety of positions, starting as a research economist at the Federal Reserve Bank of New York. In 1975 he joined Citibank, where he was responsible for developing its business in financial derivatives in the early 1980s and was also the head of the bank's proprietary bond trading. In addition to his line responsibilities, DeRosa authored Citibank's interest rate risk management system, which subsequently became the model for the system adopted by the BIS.

... and progresses with capitalisation of Connie Lee
Ambac has announced that it has had positive discussions with the Office of the Commissioner of Insurance for the State of Wisconsin (OCI) regarding a plan to capitalise its Connie Lee subsidiary with a US$850m contribution of capital by Ambac Assurance Corporation (AAC).

Ambac intends to seek formal approval from the OCI for capitalisation of Connie Lee and believes that it will obtain OCI's approval of the plan. A contribution of capital of US$850m to Connie Lee would bring its total capital to slightly over US$1bn. The new capital will support the claims paying resources for Connie Lee's financial guarantee business, which will focus solely on US public finance and global infrastructure transactions.

Ex-employee blamed for mis-marked securities
TD Securities has identified incorrectly priced financial instruments in its London office. According to a statement from the company, an examination has determined that the expected one-time impact will be approximately US$96m pre-tax. "This situation is associated with the activities of an individual who is no longer with the company," it states.

"We are very disappointed that this has occurred," says Ed Clark, president and ceo, TD Bank Financial Group. "Our company has a strong risk culture and we deeply regret this incident. We take this very seriously and will make every effort to ensure that this doesn't happen again." The company has advised the appropriate regulatory authorities and is cooperating with them fully.

AC

Liffe to launch CDS contracts

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

Liffe to launch CDS contracts
Liffe is planning to launch CDS contracts on Bclear in Q408. The Liffe CDS contracts will be based on the Markit iTraxx European indices.

According to a statement from the firm, Liffe CDS contracts on Bclear will combine the security of central counterparty clearing with the flexibility that OTC market participants demand. Pre-negotiated trades that are agreed off exchange will be booked into a proven OTC clearing solution, addressing the operational and systemic risk concerns that are at the forefront of discussions between regulators and industry bodies.

"Liffe is the first exchange to work with the market by launching CDS contracts rather than credit futures or options, and by allowing business to be pre-negotiated and booked into a secure exchange and clearing house environment," says Garry Jones, executive director of business development and strategy at Liffe. "The proven success of Bclear for other derivatives puts Liffe in a unique position to offer this exciting service for CDS."

Athilon on watch negative
Fitch has placed the issuer default ratings (IDRs) of Athilon Capital Corp and Athilon Asset Acceptance Corp on rating watch negative, due to concerns regarding the CDPC's exposure to structured finance CDOs for which it sold protection (see also separate news story). These transactions have experienced significant negative ratings migration.

The smaller of the two CDOs is rated by Fitch, with the rating of the most senior tranche downgraded to triple-C from triple-A. The second transaction is not rated by Fitch, but the agency's expectation for losses in the underlying portfolio indicates an increased probability of impairment of the relevant class of notes.

Resolution of the watch negative status will focus on the amount and timing of losses from the SF CDOs to Athilon - both in expected and elevated stress scenarios - and the overall net effect on its capital base, as well as any plans by the company to replenish capital. The increased expectations for losses related to these exposures have resulted in concern over the equity cushion ultimately available to support the rating of the notes and the total capitalisation available to support the respective IDR.

The CDS confirmations for the impacted transactions only allow for the payment of floating amount events prior to 2014. Credit events may only be called beginning in 2014, which may delay the payments for losses on the underlying ABS CDO positions.

LBO default risks to rise
The risk of a significant increase in LBO firm defaults in the next few years may have risen substantially, according to the BIS. A report, submitted by a working group established by the Committee on the Global Financial System (CGFS), notes that LBO volumes declined by more than 15% globally in the second half of 2007 and that several deals have been withdrawn or postponed. Meanwhile, riskier second-lien and pay-in-kind loans are attracting little investor interest, with borrowing costs having risen sharply.

"This, together with the prospect of moderating corporate cashflows in the light of weaker macroeconomic growth, has arguably increased the default risk of LBO firms - particularly for cyclical firms that face substantial refinancing needs in the next few years," it says. Overall, it is estimated that more than US$500bn of leveraged loans and high yield bonds will have to be refinanced between 2008 and 2010.

CGFS proposes CRA improvements ...
In a related report, the BIS Committee on the Global Financial System (CGFS) has proposed a number of ways in which credit rating agencies (CRAs) should improve the information provided on structured finance products. The first of these is by enhancing the clarity and accessibility of existing rating information and documentation on structured finance (SF) products.

The second is by improving the information available to investors on the key risk factors that drive SF ratings, in particular on model risk and the sensitivity of ratings to assumptions about macroeconomic and sectoral developments. Third is through periodic provision of information on the robustness of a CRA's ratings criteria for classes of SF instruments to changes in system-wide market developments; and fourth, by expanding the ratings framework for SF products to include information on the risk properties of individual issues and their rated tranches.

The CGFS has also set out a number of specific recommendations to address weaknesses and improve investor confidence in the rating of SF products. These include:

• Investment fund trustees and managers should review their internal procedures and guidelines concerning how ratings information on SF products is used in their investment mandates and decisions.
• Rating reports should be presented in a way that facilitates comparisons of risk within and across classes of different SF products.
• Rating agencies should provide clearer information on the frequency of rating updates.
• More user-friendly access to CRA SF models and their documentation should be provided. Rating models made available by CRAs should facilitate 'what-if?' analysis or stress tests by users on key model parameters.
• CRAs should document the sensitivity of SF tranche ratings to changes in their central assumptions regarding default rates, recovery rates and correlations.
• CRAs should clearly and regularly disclose to investors their economic assumptions underlying the rating of SF products.
• Where only limited historical data on underlying asset pools are available, this should be clearly disclosed as a source of model risk, as should any adjustments made to mitigate this risk.
• CRAs should monitor more intensively the performance of the various agents involved in the securitisation process (from origination to sale and subsequent servicing and administration).
• CRAs should periodically consider the wider systemic implications of a rapid growth of similar instruments or vehicles, or of new business undertaken by existing vehicles, for the continued robustness of their original ratings criteria. CRAs should consider how to incorporate additional information on the risk properties of SF products into the rating framework.

... while CFA Institute polls on CRAs
The results of a CFA Institute member opinion poll has found that 211 (11%) of the 1,956 respondents had witnessed a credit rating agency (CRA) change its rating in response to pressure from an investor, issuer or underwriter. A staggering 51% of the respondents who witnessed a ratings change believed that this was motivated by the prospect that issuers would take their business to a competing CRA, while 17% were of the opinion that the promise of future business from the issuer motivated a CRA to change ratings.

"These results are disturbing; they point to serious deficiencies in professional conduct at CRAs," says Charles Cronin, head of CFA Institute Centre EMEA. "CRAs need to take prompt action to manage or eliminate conflicts of interest in the ratings business. Reputations take years to build and moments to shatter. I hope that on the back of this data that the CRAs will redouble their efforts to restore confidence in the professionalism of their business."

Many respondents note that the payment structure between CRAs and issuers present the largest conflict of interest. One respondent says: "The fundamental flaw is that the agencies are paid by issuers, not by investors. No amount of regulation can fix that conflict of interest."

Another respondent adds: "Exchanges are self-regulating. Ratings can be as well. But the incentives should be established, so that their interests are aligned with investors."

The poll also revealed that 55% (1,070 responses) of all respondents agreed with the statement that CRAs should group themselves into an international standard-setting and monitoring self-regulatory body, of all stakeholders, with powers of enforcement. "We are very pleased with the result, which reaffirms the position we strongly expressed to CESR in its CRA consultation earlier in the year," says Cronin.

Finally, the issue of using different rating symbols for structured products showed that nearly half of all respondents, 47% (911 responses), were in favour, with 42% (827 responses) against. 11% (216 responses) did not express an opinion.

The concern is that not all triple-A securities are created equal. As demonstrated in the current credit crisis, structured products typically perform very differently from traditional corporate bonds, despite the identical symbols.

As one of the respondents comments: "Whereas corporate default is for the most part binary, default on structured debt is dependent on hundreds or thousands of individual defaults that are estimated given some distribution. They are not the same analysis, so they should not be the same ratings."

"We feel that a different rating scale is an essential aid to trustees and fiduciaries, to help them evaluate and quantify the amount of structured product exposure they desire in their portfolios," notes Cronin. "We have expressed this thought to the rating agencies, CESR and IOSCO." The CFA Institute Centre is also preparing a response to the current US Securities and Exchange Commission's proposals on CRAs.

Corporate default rates reviewed for longer maturities
In April, Fitch released its updated CDO methodology for corporate CDOs, which primarily invest in assets with maturities of 10 years or less. A critical component of the revised corporate CDO methodology was access to robust data on corporate default rates for maturities of ten years and less, and the benchmarking of CDO performance against these historical default rates. At that time, Fitch indicated it would continue to review other CDO sectors, as necessary, in order to refine existing assumptions and continue building on efforts to restore confidence across structured finance.

Since default rate assumptions play a critical role in CDO analysis, Fitch is reviewing its corporate default rate assumptions for assets with terms of greater than 10 years. "Certain specialised CDO sectors may be exposed to underlying assets with default risk in excess of ten years, making assumptions about the term structure of default probabilities for longer tenors a meaningful factor," says John Olert, md and global head of structured credit for Fitch.

For assets with maturities beyond 10 years, however, historical default data may not be as readily available. While increased cumulative defaults over these extended maturities have been part of the analysis, further refinement may be appropriate. In addition, prepayment risk arising from call features further complicates the analysis of default risk over a portfolio's life, as well as assumptions about yields to maturity and excess spread.

There are several options for making reasonable assumptions about the term structure of default for terms beyond 10 years. In some instances, Fitch may be able to rely on independent studies of default for a specialised sub-sector.

In those cases where independent studies are not available or appropriate, other options are to rely on the limited corporate default data available related to observations beyond 10 years, apply a mathematical process to the 10-year data to extrapolate the curve beyond 10 years, or simply apply existing rating transition matrices to approximate the default propensity for terms beyond 10 years. All three approaches have potential strengths and weaknesses.

Fitch welcomes comments from investors and other market participants on various ways to gauge the risk for longer-dated assets, and will share its findings and recommendations once all work is completed. For certain CDO sectors, such as trust preferred (Trups) CDOs, any revisions to the default curve beyond ten years could be material. It should be reiterated, however, that the vast majority of Fitch's corporate CDO ratings involve portfolios with risk profiles of ten years or less, and as such are expected to remain unaffected.

S&P refines re-REMIC approach
S&P says that it is refining and adapting its methodology and assumptions for rating resecuritisations of outstanding US RMBS. In a newly published report, the agency discusses its approach to reviewing resecuritisation proposals.

Market participants are increasingly interested in RMBS resecuritisations, sometimes also known as re-REMICs (resecuritised real estate mortgage investment conduits). To help these participants better understand S&Ps rating methodology for these transactions, the report addresses the following questions:

• What types of US RMBS resecuritisation proposals has S&P received?
• What is S&P's rating methodology for US RMBS resecuritisations?
• If the rating on a security underlying a proposed US RMBS resecuritisation is on credit watch with negative implications, will S&P rate the resecuritisation?

Ambac discloses collateral requirement information
In response to persistent and unfounded speculation regarding its liquidity situation, Ambac has released information about collateral requirements and terminations of its investment agreement business related to recent actions by the rating agencies.

"Despite the challenging current environment, it is important for us to continually communicate that we have ample liquidity to manage our commitments going forward," says Ambac's chairman and ceo Michael Callen. "Our company-wide resources available are a multiple of any conceivable collateral or termination requirement in our financial services businesses."

Rating agency actions affecting Ambac Assurance Corp (AAC) during June resulted in US$506m of increased collateral posting requirements in the investment agreement business and investment agreement terminations of US$270m:
• The downgrade of AAC by S&P to double-A on 5 June 5 resulted in an incremental collateral posting requirement of approximately US$76m.
• Moody's downgrade of AAC to Aa3 on 19 June resulted in an incremental collateral posting requirement of approximately US$70m and investment agreement terminations of approximately US$270m.
• The action by Fitch to withdraw the ratings of AAC on 26 June 26 resulted in an incremental collateral posting requirement of approximately US$360m.

The book value of investment agreement liabilities at 31 May amounted to US$6.9bn (down from US$7.7bn at end-December). The market value of the investment agreement asset portfolio, including cash of approximately US$400m, as of 31 May, is approximately US$5.6bn. In addition, the market value of interest rate derivative contracts held by the investment agreement business is positive at US$160m.

Based on 31 May investment agreement asset portfolio market values:
• Upon a downgrade of AAC to A+ or A1, which Ambac believes is unlikely, the monoline estimates that the investment agreement asset portfolio has sufficient value to meet projected cumulative collateral requirements and terminations.
• Upon a downgrade to A or A2, which Ambac believes is unlikely, it estimates that the investment agreement asset portfolio is insufficient to cover the projected cumulative collateral requirement and terminations by approximately US$1bn.
• Upon a downgrade to A- or A3, which Ambac believes is unlikely, it estimates that the investment agreement asset portfolio is insufficient to cover the projected cumulative collateral requirement and terminations by approximately US$1.1bn.

In the event of cash and/or security shortfalls in the investment agreement business, management anticipates utilising the resources of AAC (through inter-company transactions). Utilising the resources of AAC would allow time for the assets in the investment agreement asset portfolio to recover in value and would preempt claims on insurance policies issued by AAC and prevent the realisation of losses in the investment agreement asset portfolio, the monoline says.

Ambac is currently in discussions with the Office of the Commissioner of Insurance of the State of Wisconsin (OCI) with respect to its strategies for managing the collateral posting and termination obligations of the investment agreement business (see also Job Swaps). The monoline believes that it will obtain OCI's approval of its plans to address the collateral posting and termination obligations of the investment agreement business in the event of downgrades to the A/A2 rating level.

AAC's investment portfolio is valued at approximately US$12bn with over US$1bn in cash and short-term securities as at 31 May. At the A/A2 rating level, Ambac management would evaluate its various resources and utilise those considered most appropriate to satisfy the contractual obligations of the investment agreement business.

Both Ambac and Radian on 3 July had their shares suspended on the New York Stock Exchange as they fell below US$1.05 a share. The suspension meant that the stocks would not be traded on the exchange unless they trade above US$1.10 for a full day on a different trading platform.

IRGs for European ABCP conduits
Fitch has launched issuer report grades (IRGs) for European ABCP conduits. The grades indicate the quality of post-issuance performance reports for the European ABCP conduits publicly rated by the agency.

"The aim of this initiative is to enhance the quality of post-issuance reporting standard in this sector," says Andy Brewer, head of EMEA structured finance performance analytics at Fitch. "When Fitch rolled out IRGs for European structured finance the grades had an immediate positive impact on transparency in the sector; we expect a similar impact in the ABCP sector."

"IRGs highlight good reporting practices and encourage certain financial sponsors of deals to improve their reporting standards," adds Emma-Jane Fulcher, director in Fitch's European structured finance team. "The post-issuance reporting standards that underpin the grades give clear guidance for issuers, originators and servicers on how they can make their reports more useful to investors and Fitch."

The scoring system for ABCP IRGs will take into account tangible information obtained in servicer reports, such as liquidity support information, credit enhancement details and information on underlying assets and liabilities. The grades also take into account factors relating to the delivery format, timeliness and usability of servicer reports.

IRGs are awarded on a scale of 1 to 5, with 1 being the lowest available score. The scores will reflect the level of information provided, as well as its underlying quality and the timeliness of the reporting.

Trups CDOs on review
Moody's has placed on review for possible downgrade 17 tranches issued by seven CDOs with exposure to REIT Trust Preferred Securities (Trups), especially residential mortgage REIT Trups, and homebuilder securities. The affected transactions are: Taberna Preferred Funding VIII and IX; Trapeza CDO XI; US Capital Funding V and VI; and Preferred Term Securities XX and XXI.

The rating actions were prompted by credit deterioration and defaults in the REIT and homebuilder sectors. The rating actions also reflect the expectations that the final workout values are expected to be low for defaulted REITs and homebuilder assets in the underlying collateral pool. Moody's outlook for REIT Trup CDOs is negative for 2008.

In the coming weeks, Moody's will be reviewing all Trups CDOs, especially those with exposure to bank Trups. The agency's outlook for bank Trup CDOs is stable to negative for 2008.

Spanish SME loans under pressure?
A weakened Spanish economy may be putting pressure on the performance of securitisations backed by loans to small to midsize enterprises (SMEs), although to date S&P has not changed any ratings, according to a new report it has published.

Spanish SME portfolios have generally experienced an acceleration in delinquencies since the beginning of the year. Furthermore, loan delinquencies are a key indicator of SME securitisation performance and in particular act as a forward gauge of defaults.

After conducting a review, however, the agency has not to date changed any ratings due to these higher delinquencies. It is, however, further considering the effect of the concentration of the underlying assets in real estate and construction, and the effect that a default of the biggest obligors may have on credit quality.

The report presents a summary of the current performance and portfolio composition of the Spanish SME transactions S&P rates and provides insights into the factors that could potentially affect future performance. In addition, it provides an overview of the rated Spanish SME market as a whole and the characteristics of a typical SME transaction structure.

CS & AC

Unsurprisingly bearish

The results of Fitch Ratings' June 2008 European Senior Credit Investor Survey are discussed by Richard Hunter and Jonathan Cornish, analysts at the agency

Fitch Ratings' European Senior Credit Investor Survey for June 2008 features 62 responses from the top 100 investing institutions across the continent. The survey posed 16 questions, including a number which were also used in Fitch's regular US Senior Credit Investor Survey, carried out in conjunction with the Fixed Income Forum.

Fitch asked respondents to identify whether they were investors predominantly in corporate debt, structured debt or with a shared focus on both areas. The June 2008 report continued to see a balance between respondents covering "corporate debt only" and "combination" investors focused on either structured or both structured and corporate debt. The survey responses were received in the weeks beginning 16 June and 23 June.

Questions 1, 2 and 3 - Description of respondents
The number of respondents was marginally up on the January 2008 survey and the mix of respondents remained broadly similar in terms of both institution type and size. The June 2008 report continued to see a balance between respondents covering corporate debt only and those focusing on both structured and corporate debt.

Respondents by investment focus were of a broadly similar size in terms of assets under management. Respondents listing "Other" typically covered emerging market or government debt.

Questions 4 and 5 - Current market expectations
Questions 4 and 5 posed the question, "Are we at the beginning, the middle or the end of the credit crunch?" Responses were force-ranked across asset groups to heighten distinctions. The questions also distinguished between market disruption and loss-taking.

A clear pattern emerged that corporate debt was perceived as still being exposed to future market disruption and losses. However, corporate-only investors took a less pessimistic view compared with investors looking at both corporate and structured finance debt: 50% of corporate-only investors believed that corporate debt was yet to see the peak of market disruption, compared with 83% of combination investors.

Conversely, corporate-only investors were not as optimistic regarding developments in structured finance debt - responses were split roughly a third on each of "yet to see the peak", "in the middle" and "past the peak" of market disruption. Among combination investors, only 6% saw structured finance as "yet to see the peak" of market disruption, with a further 56% estimating that structured finance was currently "in the middle" of market disruption.

Opinions converged with regard to disruption affecting the bank sector, with views almost equally split between "in the middle" and "past the worst". Respondents made only a modest distinction between market disruption and loss taking.

Combination investors were more optimistic on loss-taking by banks, with only 5% indicating the peak of loss-taking was yet to come, while corporate-only investors indicated a more bearish 20%. Fitch's own house view tends toward the "middle"' view on disruption in the structured finance and corporate sectors, and "past the peak" in the banking sector.

Question 6 - Response to current investment opportunities
Investment strategies noted only a small percentage of respondents investing aggressively, despite the widely-held belief that negative pricing activity had overreached fundamental developments in many areas. Consistent with the January 2008 survey, the majority of respondents indicated selective investment, with a more aggressive stance among the corporate-only investors (with 81% indicating a significant increase in investment activity) compared with combination investors (at 64%).

Only a small minority of respondents reported constraint by the concern that trading activity on their existing portfolios would necessitate a (potentially negative) mark-to-market of the wider portfolio. This number was concentrated in the combination investor group, where it covered 23% of responses to this question.

Question 7 - Likelihood of recession taking place in the following regions over the next 12 months?
Respondents were substantially more bearish on the prospects for recession. When the additional category "already in recession" is incorporated into the June 2008 survey, those believing the US was either "already in recession" or had a "60%+" chance of going into recession jumped from 28% in January to 71% in June.

Responses expecting the same probability for developed Europe rose from 2% to 19%, although responses for emerging Europe remained in single figures at 6%. Responses did not significantly vary by investment focus, although combination investors tended to be more bearish on the US than their corporate-only counterparts.

Fitch continues to forecast a recession in the US during 2008, but a low chance of recessions in major developed European markets over the same time horizon. In turn, the agency considers recessionary pressures in emerging Europe as conspicuously lower still than in developed Europe.

Question 8 - Fundamental credit conditions
Negative expectations on fundamental credit conditions rose almost across the board - from an average of 60% in January to 76% among June 2008 respondents. Those showing the least relative deterioration included investment grade corporate debt and emerging market fixed income. The highest expectations for deterioration remained those for speculative grade corporate debt, which posted aggregate expectations of deterioration of 98%, with 100% of corporate-only respondents expecting deterioration in this area.

While aggregate expectations on banks deteriorated by 15% between the two surveys, it is a measure of the widespread bearish tone of the survey that, relative to other sectors, banks actually dropped from "third least concerning" to "second least concerning", with only emerging markets showing a lower aggregate expectation of deterioration. Combination investors were notably more bearish on banks (with 78% expecting deterioration, compared with 56% among corporate-only investors), but otherwise relative expectations of deterioration did not substantially differ by investment focus.

Question 9 - Default rate in the following 12 months
Expectations on corporate default rates slightly polarised, with more votes both for significant worsening and for stabilisation than noted in January. Expectations of structured finance defaults were broadly flat relative to the January response.
In the breakdown, expectations on corporate default rates were similar across respondents. Combination investors, however, tended to respond more favourably with regard to structured finance, with only 68% anticipating further increases in the default rate for structured debt, compared with 96% among corporate-only investors.

Question 10 - Fundamental credit conditions by sub-sector
The sectoral breakdown for fundamental credit trends showed further across-the-board deterioration. Energy/utilities remained the one "safe haven", with less than 20% of June 2008 respondents expecting deterioration, compared with a 93% expectation of deterioration for retail, leisure & consumer products (RLCP) - versus 88% in January. Industrials also remained a focus of concern, with an increase in aggregate deterioration to 74% of responses.

Responses were broadly comparable across respondents irrespective of investment focus. Respondents' views do not coincide with Fitch's own outlooks/watches, given the difference between investors' relative expectations 'from today', compared to through the cycle ratings, which may already incorporate expectations of stress. Whereas most respondents expect further deterioration in credit trends across the RLCP sector, taking into account past downgrades and rating headroom, Fitch has just 10% of its (developed) European RLCP portfolio on outlook or watch negative.

The greatest expectations of negative rating trends (as opposed to investors' expectations of relative pressure) among corporates were focused on industrials (20% of portfolio listed on negative watch or outlook) and energy/utilities (19%), with the latter concentrated on event risk-driven factors (including acquisition activity) rather than deterioration in fundamentals. Equally, in relative terms, investors appear more bearish on bank fundamentals than the implied Fitch rating volatility, with a very modest - albeit rising - proportion of European bank ratings on outlook or watch negative.

Question 11 - Expectations on financial ratios
Responses to specific expectations for leverage/capital adequacy developments broadly indicated an expectation that more bank capital would be raised. The net deterioration expectation for bank capital adequacy dropped from 22% in January's survey to 4% in June.

Views on corporate and insurer financial leverage remained broadly unchanged, with an overall trend to weakening in line with macroeconomic expectations. Views on leverage were broadly consistent across respondents irrespective of investment focus.

Questions 12, 13 and 14 - Respondents' usage of credit derivatives
The June 2008 respondents indicated a more extensive use of derivatives than the January sample. The intensity of usage was broadly consistent between corporate-only and combination investors, although all those responding that they used derivatives "not at all" belonged to the corporate-only segment. Employment of derivatives remains varied, with no single usage predominating, and was consistent across respondents irrespective of investment focus.

Given the systemic fears of a seize-up in the credit derivatives market - notably concerns regarding counterparty risk - it is interesting to note that the majority of respondents still intended to increase derivative usage, but that the size of the majority had shrunk slightly (61% in June 2008, compared with 74% in January). The June survey marked the first European survey responses indicating any reduction of usage, albeit a modest 6% (previously ±0% in January 2008 and June 2007).

Question 15 - Thematic risks to the European credit market
The June 2008 survey included a new thematic concern - inflation - which immediately ranked higher than all of the categories featured in the January survey. Fitch has identified inflation as a source of concern for emerging market exposure; categories of corporate debt susceptible to raw material, investment expenditure and consumer creditworthiness pressures; and for structured finance asset classes exposed to the above factors.

The remaining thematic concerns were largely unchanged relative to January's survey, with one significant exception. Concerns regarding global liquidity had receded from 51% of responses posted at "High" in January 2008 to 31% in June.

The combination of "Moderate"' and "High" for liquidity concerns nonetheless remained close to 90%. Concerns regarding the European housing market accelerated marginally, with 50% of respondents to the June 2008 survey now regarding this as a "High"' risk. Interestingly, concerns over hedge fund and major bank collapses had not accelerated between the two surveys, although both remained significant concerns for respondents.

Corporate-only and combination investors were equally concerned about inflation, but differed in their views regarding the risks posed by a potential hedge fund collapse (where corporate-only investors registered less acute concerns) and geopolitical risk (which 66% of corporate-only respondents judged to be at least a moderate risk, compared with only 38% for combination investors).

Question 16 - Respondents' views on credit rating agencies
This question was included to track how respondents view ratings, taken at a turning point in the cycle. The question also serves as a marker of the degree to which investors and others form independent opinions regarding the obligations rated by Fitch and the other major agencies.

Consistent with the January survey, on an unweighted basis respondents continued to agree and disagree with the agencies in a roughly 60:40 balance. Perhaps unsurprisingly, agreement with the agencies remained stronger on corporate finance (averaging 81% agreement, again on an unweighted basis) than on structured finance, where agreement averaged 41% of responses. Of note, however, was the increase in disagreement on financial institution ratings, which rose from17% in aggregate in the January survey to 28% in June.

Agreement levels with structured finance ratings declined fractionally in RMBS and CMBS sectors, most likely as negative newsflow increased around those sectors in Europe during the first half of 2008. A substantial fall in "strongly disagree" responses for CDO ratings nonetheless hinted at a modest, selective improvement in agreement levels, in particular among combination investors - 58% of whom registered "mostly agree" for non-structured finance CDOs, compared with 11% among corporate-only investors.

Overall, combination investors disagreed less with rating agencies on structured finance rating levels - although, interestingly, their expectations of deterioration in structured finance fundamental credit (per Q.8 above) mapped almost completely with those of corporate-only investors. Otherwise, combination and corporate-only investors demonstrated broadly comparable levels of agreement with the agencies for both corporate and structured finance ratings.

© 2008 Fitch Ratings. All rights reserved. This Research Note was first published by Fitch Ratings on 1 July 2008.

Trading ideas: Horton here's askew (again)

Tim Backshall, chief credit derivatives strategist at Credit Derivatives Research, looks at a pairs trade on DR Horton Inc. and Lennar Corp.

With spreads driving wider across much of the credit landscape, the builders credit has outperformed their equity in recent months and (until very recently) traded near their 52 week tights in many cases. The somewhat unprecedented rally we had seen in builders appeared to be another fishing trip by many of the bottom feeders in the market, but - with the last few weeks indicating that the situation is likely to get worse before it gets better - we feel a relative-value position among the builders provides a great opportunity to benefit from continued stress while being somewhat sector neutral. We have recently taken advantage of our recessionary view through pairs trades across cyclical and non-cyclical sectors, but this pair focuses on the builder space specifically and picks two recently weak credits that offer generous carry and idiosyncratic divergence potential if the homebuyer remains under pressure.

Just to be clear, we see at least three major signs pointing to a consumer-led recession in the US. First, year-on-year growth of consumer spending is in a downward trend.

The American homeowner used easy credit from home equity loans, car loans and credit cards to fight off a recession in early 2002. Year-on-year growth of consumer spending rebounded in mid-2001 and since late 2003 has been on a steady decline.

Second, over the next few years, the American consumer will be hit with over US$800bn worth of ARM resets. If homeowners do not default, then they must pay additional money to finance their homes, which must have a substantial decrease on overall consumer spending in the coming years.

Last, due to the ongoing credit crunch, tighter lending standards will become the norm, causing refinancing and new loans to be more difficult to acquire than in the recent past. Unfortunately, compared to the 2001-2002 recessions, the American consumer is highly leveraged and does not have the capacity to take on further debt to increase their spending. Continued stress in the financial system is only exacerbating this, as slowing GDP and home price drops have a much more direct and significant pro-cyclical impact on aggregate bank credit than interest rates.

We believe that a consumer-led recession is inevitable, as the consumer has become severely impacted and - with inflation rising - rate resets are unlikely to be any lower in the short to medium term as waves of ARMS refix in not just sub-prime but also Alt-A mortgages. Personal bankruptcies and delinquencies continue to rise and our 'enhanced' Misery Index indicates that the US public is at its most 'miserable' since the late 1980s, thanks to rising inflation, rising unemployment and falling home prices.

The builders are extremely sensitive to this, as the massive inventory hangovers need to be worked through before any equilibrium growth can be realised again. Many of the builders are way off of their recent wides at current levels and we feel we will be revisiting some of them in the not too distant future.

However, some of the builders are faring better than others as they conserve cash, run down inventory, lay off staff, sell assets and 'deal' with JV exposures. The two credits we choose for this pair are DHI and LEN, both in the middle of the range of quality for builders but having very different trends in JV exposure write-downs, impairments, margins and liquidity.

Building our case
Many of the builders appear to be disturbingly similar at first glance, with new homes being forced down in price, revenues falling, new orders falling and cancellation rates rising to stable at high levels - and all report equally grim 2008 outlooks. Facing the same business risk, the builders are being hit by a slumping housing market, tighter credit conditions (to borrow corporately as well as for the consumer) and the overall weak economic environment. Recent results, however, show increasing divergences between many names and in particular DHI and LEN, given their respective spread levels.

Fundamentally, LEN has been weighed down by its relatively larger exposure to JVs - the Landsource deal being the most prescient. With its recent bankruptcy, much of the speculation over the exposure and moreover the ongoing drain in liquidity that the operation was causing has been put to bed.

LEN's leverage is among the lowest of the builders and with over US$1bn cash on its balance sheet, it can handle the exposure to liabilities from the Landsource deal at around US$200m. LEN has stronger margins, better leverage and a higher cash balance than most - and, while expectations are for continued weakness among builders, it certainly appears (given LEN narrowed its loss in the fiscal second quarter) that it is better value than DHI in the current environment.

DHI faces a number of issues, not least of which is the large amount of debt coming due and its need/desire to tender and exchange to term out that exposure. DHI's recent tender pushes bondholders to give up 'nicely' restrictive covenants (stock buybacks, new issuance, guarantees, CoC protection and subordination) for a 1% consent fee and, given the company's rapidly deteriorating fundamentals, we would be nervous about whether they can achieve this.

Tangible net worth covenants remain under pressure, while newly imposed interest coverage covenants on bank loans put more pressure on unsecured bondholders. DHI's last quarter was one of its worst ever and, with impairment charges mounting, we feel the equity market's view of DHI (rising vol, underperforming stock) is correct and that LEN is set to outperform.

Add to this idiosyncratic fundamentals - our recently highlighted analysis that bank credit is contracting rapidly (-10% per year), thanks to the ABCP conduits being dragged back on balance sheet at the banks. A pro-cyclical tightening of the belts by the banks, rising Libor costs, falling new issue demand and rising risk aversion do not bode well for DHI to succeed with its tender nor garner loans from banks. The fundamentals are divergent, but it is our models that provide more of an insight into the real relative value between these two divergent credits.

Building an RV
Interestingly DHI and LEN have exactly the same MFCI rank at 2.2 (note that lower is a weaker credit). This generates an expected spread level of around 662bp for both of these credits (considerably different from their current very divergent levels).

Most of our MFCI factors are weak for both names, with DHI's default risk slightly better than LEN's, but LEN's leverage factor better than DHI's. Both companies have relatively strong accruals (earnings quality) and FCF/debt figures, with LEN slightly better in the latter. All in all, the large divergence in spreads between DHI and LEN is unjustified in our view and both should trade wide with DHI underperforming.

While our market factors in MFCI are very similar, in recent weeks LEN's implied vol has dropped below that of DHI (a relatively positive step for asset vol estimates) and further evidence of the divergence being overdone is seen in Exhibit 1. The spread per unit of default risk (SPD) of the two names have diverged significantly recently, as LEN's spread risk premium has risen considerably relative to DHI. This relationship has traditionally been mean-reverting and we would expect (based on the MFCI model output) that this is likely to revert once more, with the two SPDs converging - driven by DHI underperforming LEN.

Exhibit 1

The spread differential between the two credits is considerable and provides a healthy cushion against short-term swings and mark-to-market losses, but we feel the CDS market will switch back to its pre-October 2007 level of spread differential (with DHI underperforming LEN) in recognition of the stronger balance sheet of LEN and reduced JV uncertainty.

Risk analysis
This pairs trade carries a direct risk of non-convergence (divergence should we see the DHI tender be successful and LEN stress increase). In other words, there is the possibility that the names will not tighten and widen as expected. However, based on historical performance of our models, significant carry cushion and roll-down, and the conviction of the fundamental analysts, we believe these risks are well mitigated.

Liquidity
Both LEN and DHI offer good liquidity in the CDS market. Bid-offer spreads are not unreasonable for such wide trading names. We see no concerns with execution of this trade.

Fundamentals
This trade is significantly impacted by the fundamentals. For more details on the fundamental outlook for each of DHI and LEN, please refer to Gimme Credit.

Gimme Credit's homebuilder industry expert, Vicki Bryan, holds a negative view on DHI, citing the following: DR Horton has reported worsening trends in several consecutive quarters and the deterioration seems to be accelerating relative to the group. Its advantage as a cost leader has narrowed considerably and its order trends are among the worst reported. The company can't seem to get its inventory, its lot supply or its debt load down as fast as its operations are deteriorating.

She also sees LEN's fundamentals deteriorating, with the following underlying view: Lennar is focused on maintaining the strength of its balance sheet and reducing risk as the housing market continues to swoon. The company recently secured amendments to its credit agreements that compel it to cut its joint venture exposure. It has also built a significant cash hoard, which should provide a strong cushion as its operations continue to founder.

These fundamental views reinforce our model-based views of LEN outperforming DHI as the homebuyer remains on the sidelines.

Summary and trade recommendation
Homebuilder credits have significantly outperformed their equity peers over the past three months, with many trading at or close to six month tights. In the case of DHI and LEN, these swings have been very aggressive and we feel, particularly in the case of the latter, are overdone.

LEN's exposure to LandSource was a heavy weight around its neck, but it is becoming increasingly clear that the bulk of that exposure (and the ongoing liquidity drain it caused) is less than expected. LEN's leverage and cash position is among the best in the industry and, with its margins remaining relatively strong, our expectations are for LEN to outperform.

The sector exposure of an outright is just too much to bear here and so we attempt to beta-neutralise it with a short in a name we expect to underperform. DHI's recent tender efforts are an attempt to skirt the covenant restrictions of the short-dated bonds and, with impairment charges rising and its last quarter its worst ever, we see DHI's tight spread as too positive for this name.

On a model basis implied vol is inverted, with DHI 'more risky' than LEN in equity land. Our MFCI framework indicates that DHI is likely to underperform LEN and, focusing on default risk, DHI's SPD is significantly lower than LEN (reinforcing DHI's underperformance). The considerably positive carry position also helps and protects us from MTM losses in the short-term, but we feel that the CDS market will switch back to its pre-October 2007 levels in recognition of DHI's weakening balance sheet as the homebuyer remains on the sidelines.

Sell US$10m notional Lennar Corp. 5 Year CDS protection at 695bp.

Buy US$10m notional DR Horton Inc. 5 Year CDS protection at 468bp to gain 227bp 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).