Contents

Price is right

Dollar price set to take precedence over discount margin

The current discount margin of around 200bp over Libor is assumed by many to be an attractive level for triple-A CLO paper. However, with impairments in underlying portfolios expected to rise in the coming months, consensus appears to be growing that discount margin is irrelevant - rather, investors should be focusing on the dollar price of the assets.

"There is tremendous value to be had in the CLO asset class predicated on dollar price rather than discount margin," confirms one US-based portfolio manager. "Triple-A CLO tranches with subordination of around 10% are typically perceived to be money-good assets, but investors should be looking for subordination of around 30% (based on a dollar price of 70 cents to the dollar) to give themselves enough cushion in the case of an unwind. While the true cashflow protection will still exist in an unwind, the market value of the position will be much lower."

Certainly, the senior CLO tranche pickup has remained remarkably resilient during the recent period of credit and ABS market widening. But the near-term outlook is fraught with continued widening and selling pressures, according to structured credit analysts at JPMorgan. Indicative CLO triple-A to double-B spreads widened throughout the course of last week, for example, to 185bp, 400bp, 600bp, 875bp and 1350bp from 175bp, 375bp, 560bp, 775bp and 1250bp.

"Liquidity premia should collapse in the long run, but we need to see the banking system and bank funding levels recover. The rise in oil prices and the economic implications likely pushes that recovery period out further," the analysts note.

Sources indicate that a few 2007-vintage CLOs could already be experiencing some losses at the triple-A level, although holders of these positions aren't necessarily disclosing them. A major market shock could act as a catalyst for these losses to be revealed, however.

At some point it could become difficult to keep these positions on balance sheet. And if one CLO is forced to liquidate, other investors will likely be pressured to begin selling and prices will deteriorate even further.

"In the case of CLO forced selling, the potential supply is so significant in relation to the pockets of demand that prices will spiral downwards," the portfolio manager says. "There is no natural buyer for such a raft of triple-A assets - although insurance companies and sophisticated investors who can absorb the mark-to-market volatility could take a portion down, they wouldn't be able to absorb all of it."

That such a scenario represents a great buy-and-hold opportunity is well recognised. But many investors are unlikely to have the resources necessary to analyse the supply, meaning that any differentiation between good and bad assets is set to diminish. The flipside of this situation is that managers who can provide appropriate liquidity and have the infrastructure to analyse/select the right assets will benefit.

The JPMorgan analysts suggest that, for CLO investors, "balancing patience and immediacy" is warranted. "In other words, the opportunity cost of waiting for wider spreads must be weighed with what may well prove to be a challenge of obtaining the very best paper along with other bidders."

In terms of new CLO issuance going forward, meanwhile, the portfolio manager believes that the market could begin to see "kitchen sink" CLOs - for example, CLO-squareds or CMO-type structures (see also separate news story) - where banks/managers attempt to repackage their impaired CLO positions. However, the caveat is that the analysis of such transactions would take up even more investor resources.

CS

Illiquidity strikes again

Weak market technicals continue to dominate

Liquidity issues - on both sides of the Atlantic - once again grabbed the headlines last week. While the US Treasury's proposed rescue of the GSEs underscores the agencies' crucial role in the country's housing sector, the ABX index fell to record lows amid weak market technicals. At the same time, consolidation in the European banking sector is expected to force some counterparties out of the CDS sector altogether.

Estimates of GSE capital requirements reach as high as US$75bn - a huge number in the context of the agencies' market capitalisation (US$10bn for Fannie Mae and US$5bn for Freddie Mac). The Treasury's plan for the GSEs involves extending its line of credit to as much as US$300bn (and potentially transmuting it into opening the discount window if short-term refinancing doesn't take place), injecting equity/capital-qualifying certificates and bolstering regulatory oversight in conjunction with the OFHEO.

One structured credit investor suggests that the GSEs have replaced the role that RMBS used to play in the US - because it is almost impossible to raise funding via securitisation, the slack has been taken up by the Federal Home Loan banking system. He says: "The GSEs are perfect vehicles for propping up the housing market in the US: only mortgages that fit the GSE's criteria are being originated. So we're in a strange situation where there is no way that the government can let the GSEs default, yet the market has been hammering their CDS."

Equally, Markit ABX index prices continue to fall - finally, according to some players, appropriately reflecting the deteriorating cashflow of the underlying bonds. "Sub-prime and Alt-A collateral continues to weaken, but we haven't seen the bottom of the market yet," the investor adds. "Triple-A yields are currently at 15%-20% and some distressed funds are buying at this level (with perhaps a maximum leverage of 2x), but others are holding out for yields to rise above 20% to allow them to participate in the market without any leverage."

Meanwhile, regulators' desire to prevent institutions from collapsing was also apparent in Europe last week. The Danish central bank was forced to bail Roskilde Bank out, due to liquidity issues following asset write-downs.

The fact that Roskilde is now up for sale - combined with Stantander's acquisition of Alliance & Leicester and the potential for another takeover bid to be made for Bradford & Bingley - has forced M&A activity in the banking sector back onto the agenda. "I expect to see more consolidation taking place among banks in the coming months," one ABS trader confirms.

He says that the number of smaller players pulling out of certain markets is likely to increase as a result. "The consequent risk for the CDS sector is of going back to where the market was in the late-1990s, where only six or seven banks were involved. This will inevitably focus minds on the issue of central counterparties: if there are fewer than 10 CDS counterparties out there, many players would rather face the LCH or DTCC and pay the fees than always have to trade with the same few banks."

CS

ECB eligibility

Esoteric deals take advantage of repo facility

A European CDO backed by US dollar-denominated student loan ABS received a triple-A rating from Moody's last week. The €1.25bn retained transaction, which market experts say has all the hallmarks of a deal structured specifically for use as repo collateral, is just one of many that banks are putting together to take advantage of the ECB's facility.

The student loan CDO, named Sirrah Funding I, was arranged for Depfa by Hypo Real Estate Bank and is the first to come out of a €4bn shelf programme. At closing part of the proceeds of the notes from the CDO were used to purchase seven FFELP ABS tranches, all rated triple-A by Moody's, while the remaining portion of the proceeds were invested in short-term low risk eligible investments and will be used subsequently to acquire further US student loan ABS notes.

Other deals being structured specifically as ECB collateral include further CLOs from Icelandic banks Glitnir and Landsbanki, following two other transactions launched in May (see SCI issue 89 for more).

According to Angus Duncan, partner at Cadwalader, Wickersham & Taft, a number of banks are focusing their attention on structuring deals specifically for use as collateral with the ECB. He says that the market is likely to see changes in the structure of CLOs because of this. "Even deals that could potentially go into the public market will be structured so as to try to enable the most senior tranches to be ECB-eligible."

For example, the inclusion of synthetic buckets in CLOs will diminish, as the ECB won't accept synthetic exposure - and deals that have been issued over recent months are backing up this theory. For example, the recently-closed Gresham Capital CLO V does not contain any synthetic risk, unlike Gresham CLO IV that was issued in July 2007.

Deutsche Bank research also confirms that synthetic exposure has been removed entirely in any CLO structured for ECB eligibility, pointing out that synthetic securities buckets have been reduced in other recent transactions - halving from 20% to 10% in a comparison carried out between CLOs Avoca VIII (from September 2007) and Avoca IX (from June 2008).

But one structured credit investor warns that the new issue market is unlikely to open up before the end of the year, due to the ease with which deals can be repoed with the ECB. "The facility helps short-term money markets as it is a cheap source of funding, but it doesn't solve the problems in the term securitisation sector," he says. "Spreads just aren't encouraging enough for issuers to come to the market."

However, Duncan says that it is not particularly helpful for banks to be accused of being too reliant on the ECB. "There are continuing issues in the interbank funding market and the ECB collateral facility is vital for the continued wellbeing of the banks. For the markets to emerge from the current crisis, the interbank markets will need to re-establish themselves at a level which means there will be less need to rely on ECB funding. In the meantime, the facility is extremely important."

AC

Broadening horizons

Jack Lowe, ceo of BlueOrchard, answers SCI's questions

Jack Lowe

Q: When, how and why did your firm become involved in the structured credit markets?
A: We decided to enter the structured credit market in 2004, when the company was relatively small. The idea was to use classic finance instruments to bring private funding to microfinance businesses.

The first microfinance CLO, BlueOrchard Microfinance Securities (BOMS), offered US private and institutional investors the opportunity to acquire notes collateralised by microfinance institutions' debt obligations. The first phase closed in 2004 and the second in 2005. This was a fairly primitive model, however, that has since evolved.

Then we completed two more sophisticated microfinance CLOs in 2006 and 2007 to a total of US$220m: BOLD 1 and BOLD 2. While BOLD 1 was not rated by the agencies, BOLD 2 was, becoming the first rated microfinance CLO.

We are also planning on launching a further microfinance CLO this year. We try to add refinement in our CLOs as we go along. We introduced the idea of fully swapped local currency loans in CLOs, which means the geography of our reach can expand exponentially.

We also plan on bringing more of these deals. It is a fantastic opportunity for the microfinance institutions and the cost is not overly expensive for them. What's more, it is bringing institutional investors to microfinance institutions.

I believe that microfinance CLOs are a true alternative investment. If investors are looking for real alternative assets to invest in, the microfinance CLOs are definitely one to look out for. There is very little risk and it is likely that currently investors will get better spreads than for deals in previous years.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: Between 2004 and 2007 local markets had easy money, easy liquidity, provided by local banks and development institutions. A large number of funds were operating, but credit analysis standards slipped or stopped taking place all together.

Some lenders assumed that if BlueOrchard was operating there, then they wouldn't necessarily have to do credit analysis. But at the end of 2007, as liquidity tightened up, interest rates also went up for microfinance institutions - meaning that the need for international lenders increased.

Q: How has this affected your business?
A: As the amount of local market liquidity has been stemmed, the market has had to come back to competitive interest rates, rather than subsidised rates. To promote sustainability, we would prefer to see market rates apply, so institutions can get used to a broader market context.

Q: What is your strategy going forward?
A: Our strategy is that we continue to be a provider of funds and financial services to microfinance institutions around the world, be it via our Dexia Micro Credit Fund, through structured credit products or through financial services. We have also just launched an equity fund.

We want to remain specialists in the microfinance space. Our social objective is to expand our reach as far as possible, to as many poor people with borrowing needs as possible. We also intend to expand our activity. The microfinance market is growing very quickly and we want to keep ahead of that.

Our debt team currently covers 40 countries and we employ 30 people. We also have some local employees for credit analysis on a regional basis.

Q: What major developments do you need/expect from the market in the future?
A: I expect that the market will continue to grow very quickly. It may be constrained somewhat by liquidity limits, however.

Sustainable institutions will continue to have good results. I'm very bullish on the sector and also on the institutions being opened up. I believe it is an exceptionally well-run nascent industry, with good ethics, governance and efficiency.

There are a few naysayers who say there will be no more microfinance CLOs, but I disagree. I suggest they should watch this space.

About BlueOrchard
BlueOrchard Finance is a Swiss company specialising in the management of microfinance investment products. It assists banks and financial intermediaries who wish to invest in the microfinance industry by offering a comprehensive package of services designed to invest efficiently in the sector. This includes initial identification of, and due diligence on, microfinance institutions, as well as continuous monitoring and reporting on their activities and portfolios.

Broker takes on HY CDS trader

The latest company and people moves

Broker takes on HY CDS trader
Brian Murphy has joined the New York office of Phoenix Partners Group, the inter-dealer broker specialising in OTC derivatives and related securities, where he will be broking high yield CDS. Murphy joins from KBC Financial Products, where he had worked since 2000, initially trading equity options before becoming a CDS market-maker in 2003 and subsequently moving to the prop desk (which was moved into KBC AIM) in 2005 to run the US credit book.

ML hires ex-CDO pro
Tim Beaulac is understood to have been hired by Merrill Lynch in New York, where he will work on distressed debt portfolios. Beaulac was formerly co-head of European CDOs at Citi.

CLO manager moves to private equity
Florus Plantenga, former director of CLO manager Egret Management, has joined Houlihan Lokey as a director in the firm's London office. In his new role he is responsible for leading the firm's European private equity coverage.

Portfolio analytics head hired
Norbert Jobst, former svp of quantitative analytics at DBRS in Europe, has joined Lloyds TSB where he will be a director of portfolio optimisation and head of portfolio analytics. He reports to Casey Campbell, head of portfolio optimisation at Lloyds.

Trader moves to hedge fund
Ronnie Dick is understood to have joined Richmond Park Capital in London. He moves over from Dresdner Kleinwort, where he was global head of credit trading.

Research head moves to buy-side
Gyan Sinha, former head of ABS research at Bear Stearns, is understood to have joined KLS Diversified Asset Management.

Credit hires confirmed
Bank of America has confirmed that Charlie Cho, head of sales and trading for global credit products EMEA, made some appointments in his team within the past two months. Amit Bhagat has joined the credit trading team as a vp in the high grade and crossover corporates group, focusing on retail, consumer products and utilities.

Bhagat has worked at Bank of America for over four years. Prior to this recent appointment, he worked in the bank's portfolio management group in the UK and India as a credit manager in the gaming and leisure, business services and packaging industries.

Douglas Crawford has also joined the credit trading team as a vp in the high grade and crossover corporates group focusing on industrials and autos. Crawford has worked in the credit markets for the past eight years, most recently as a credit analyst at Eiger Capital, covering auto, industrial and media credits in the investment grade and crossover space. Prior to this, he was a high yield analyst at ING Financial markets and an analyst in the leveraged finance group at UBS.

Omar Ghalloudi has joined the credit trading team as a principal and credit trader in the bank and finance group. Ghalloudi has worked in the credit markets for over seven years, most recently at Bear Stearns, where he oversaw the asset swap business. Prior to this, he worked at Credit Suisse.

Bhagat, Crawford and Ghalloudi report to Mayur Jethwa, head of investment grade and crossover trading.

Meanwhile, Edgar Leibovici has joined the flow credit sales desk as a principal and, with Cedric Authier, is responsible for the bank's coverage team. Leibovici has worked in banking for 13 years, most recently as a senior salesperson at Bear Stearns. He reports to Alex Smith, head of EMEA credit sales.

Orion SIV dispute resolved
The senior subordinated noteholders of the Orion SIV have succeeded in the English High Court against the senior noteholders in the Bank of New York vs. Montana Board of Investments case.

The court considered a variety of factors, including the fiduciary duty of a security trustee in these circumstances under New York law, in concluding that the security trustee of the defaulting SIV did not have to, and should not, take direction from the Orion senior noteholders regarding the manner time and place of a sale of the SIV's assets in what is now a distressed market.

Julius Finance fundraising tops US$1m
Julius Finance, the research and technology firm, has announced that it has topped up its seed round to over US$1m. According to the firm, it has been subscribed to by "some of the brightest minds on Wall Street".

The seed-stage funding is being used to drive core development of the underlying technology and commercialisation of JuliusProp, an enhanced analytic data service for end users which provides a full range of market-implied risk metrics, exotic prices and forward-looking analysis derived using next-generation unified credit models.

Harper to run Lewtan London office
Jamie Harper has been promoted to vp of EMEA regions at Lewtan. In his new role, Harper will be responsible for the day-to-day running of the London office in addition to responsibility for business development within the Europe, Middle East and Africa regions.

Harper has 18 years' experience in the financial services industry. Prior to joining Lewtan, he held positions as head of sales and marketing at Thomson IFR, business development at Moody's RMS, sales & marketing director at IFex and svp at Demica.

Misys hires Smith
Misys, the software and services company, has appointed Charles Smith as vp, solutions management for Misys Treasury and Capital Markets. In this role, Smith will be responsible for managing the ongoing strategy, development and deployment of Misys' treasury and capital markets solutions globally.

He joins Misys from Fiserv (formerly CheckFree Corporation), where he was most recently the vp of product development for the investment services division.

AC

Schuldscheine debut

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

Schuldscheine debut
HVB is marketing Geldilux TS-2008, the fourth CLO under its Euroloan programme. The €1bn transaction differs from its predecessors in that the portfolio contains a portion of loans denominated in Swiss francs and that Schuldscheine will be issued alongside the Class A notes. Schuldscheine are likely to be attractive to those investors looking for low volatility assets in their portfolios, as the notes do not need to be marked to market.

S&P has assigned preliminary ratings to the deal, which comprises €3m triple-A rated liquidity notes above the €964m triple-A rated Class A notes and Schuldscheine. There are also €10m single-A rated Class B notes, €10m triple-B rated Class Cs, €3m double-B rated Class Ds and €13m unrated Class Es.

The transaction aims to provide funding for and transfer the credit risk associated with a €1bn pool of short-term Euroloans, which have a maximum tenor of 368 days and repay as bullets. These loans are advanced to selected customers of HVB from several customer segments. Historically, Euroloans have shown only minimal losses.

The risk to investors is that Geldilux will write down the principal on the notes during the life of the transaction if there are losses on the reference portfolio. If cumulative losses exceed the credit support for any given rating level, the principal on the outstanding rated notes will be reduced, starting with the unrated notes. However, additional cash is expected to be injected into the transaction through the interest rate swap, paying base plus a margin.

EC seeks comments on CRD change
The European Commission last week released a consultation paper on a proposed change to Article 122a of the Capital Requirements Directive. The proposal is intended to address the risk of moral hazard in the structured finance market and could limit investors to buying securitised assets from originators that hold 10% of the exposure. It is a refinement of an earlier proposal that was aimed at bank investors and would have meant that they could only buy securitised assets in which originators retained 15% exposure.

Analysts at UniCredit point out that, while such regulation does not prevent an originate-to-distribute business model on the originators' side, it may be a competitive disadvantage for European banks acting as originators. European banks that are investors would also have to ensure that non-EU originators comply with this requirement, in case they seek investments in corresponding securitisation tranches. Such a rule would apply to all credit exposures incurred by credit institutions after December 2010.

New negative watch assigned to CDPC
Moody's has put the counterparty and debt ratings associated with Athilon Asset Acceptance Corp and Athilon Capital Corp on review for downgrade. According to the agency, the rating actions are the result of significant deterioration in the credit quality of two ABS CDOs against which Athilon has written protection.

"As a result of the increased credit risk, Athilon's capital may be insufficient to limit expected losses to levels commensurate with its current ratings," says Moody's. The remainder of the CDPC's portfolio is comprised of static bespoke tranches referencing corporate and sovereign entities.

The move follows that of Fitch, which put Athilon on credit watch negative on 3 July (see last week's issue).

GIC impacts CDO
Moody's has placed its ratings on 24 Aaa to A2 rated tranches of the Newport Waves CDO on review for possible downgrade. The move reflects the agency's downgrade of the insurance financial strength rating of MBIA Insurance Corp - which acts as GIC provider in the transaction - to A2.

Shortfalls in GIC businesses have been identified as a potential new threat to monolines (see SCI issue 95).

The watch placement is being interpreted by analysts as a ratings issue rather than an economic problem, as the assets underpinning GICs are mainly municipal bonds and agency RMBS. The Newport Waves collateral is consequently not expected to suffer a principal loss.

The CDO, originated in April 2007, is a managed synthetic deal referencing a pool of corporate bonds.

MTN downgrades hit Sigma ...
Moody's has downgraded Sigma Finance's Euro and US MTN programmes from A2/Prime-2 to A3/Prime-2 on review for downgrade, with around US$10.9bn of debt securities affected. The rating of the Euro and US CP programmes remains unchanged at Prime 2, on review for downgrade.

Approximately US$143m of debt securities are currently outstanding under the ECP programme. While Sigma has no USCP outstanding, and the last ECP matures on 24 July 24 2008, Moody's rating on these debt programmes indicates the agency's view of the credit quality of debt that may be issued out of the programmes at a later date.

Moody's downgraded the ratings of the above debt programmes on 4 April 2008 and kept them on review in order to monitor price movements in Sigma's asset portfolio and the company's ability to continue to execute ratio trades and repurchase agreements. The agency is maintaining the company's ratings on review due to ongoing volatile market conditions, both in terms of sourcing funding and in the market value of assets in Sigma's portfolio.

During the review, Moody's will continue to monitor the market value of Sigma's portfolio, assess Sigma's ability to transact in repos and weigh the risks and rewards that such transactions portend for the company. It will also monitor Sigma's ability to continue to execute ratio trades that have become an important funding tool for the company.

... and Cheyne Finance
Moody's has also downgraded Cheyne Finance's Euro and US MTN programmes from B2 to Ca.

The agency says it downgraded these ratings to B2 on 30 November, reflecting the fact that - although in default - the company would hold its assets to maturity, thus avoiding forced asset sales and making a recovery of par likely. The new rating action reflects Moody's understanding that the trustee, after consultation with senior noteholders, has approved certain actions to liquidate and restructure the remaining asset portfolio (see SCI passim). It estimates that losses from such a 'fire sale' will be of a magnitude consistent with a rating of Ca.

Under the proposal, MTN investors are expected to have the option of accepting a cash payment representing their pro-rata share of the sale proceeds or an exchange for the equivalent face amount of notes issued by a newly formed special purpose company (Gryphon). The new notes would have maturity dates longer than those of the transferred portfolio and so would be insulated from market value risk, although still exposed to the risk of default.

While recoveries may be expected to be high on final repayment of the new notes, Moody's analysis of Cheyne considers only the position of noteholders exposed to losses from the company and does not take into account potential reinvestment opportunities in determining the expected loss posed to investors.

Cheyne's asset portfolio has experienced severe price declines in the last year. The vehicle's average portfolio price dropped from 99.52% on 27 July 2007 to 62.94% on 4 July 2008.

This precipitous decline resulted from the vehicle's exposure to US RMBS (61%, 15% of which is wrapped by monoline insurance companies) and ABS CDOs (7%) that have themselves experienced severe market-to-market losses during this period. In addition, Moody's has taken into account the expectation that prices achieved at auction may be significantly lower than prices that may be expected through an orderly and selective liquidation of the portfolio.

Credit derivatives netting success
The DTCC has announced significant strides in reducing risk in the OTC credit derivatives market by successfully executing payment netting for the industry. Over the past three-quarterly payment cycles, the company has reduced 1.62 million gross payments valued at US$72.5bn gross to 823 net payments valued at US$3.5bn, achieving an average 95% netting factor.

DTCC's central settlement service, launched in late 2007 and provided in collaboration with CLS Bank International, addresses one of the major concerns outlined by the Federal Reserve Bank of New York and US Treasury Secretary Henry Paulson - the need for further enhancements to the post-trade processing infrastructure for OTC derivatives to reduce operational risks in this market. Among the commitments that industry participants have made to enhance this infrastructure is the implementation of centralised settlement.

"By replacing manually generated bilateral payments with automated, netted payments processed through our Trade Information Warehouse, DTCC has addressed a significant area of risk that concerns our customers and their regulators," says Frank De Maria, DTCC md and ceo of DTCC Deriv/SERV. "Our vision has been to simplify and streamline the payment process for bilateral contracts, as well as create a global centralised repository for OTC derivatives contracts that automates record-keeping and enhances trading parties' ability to track their contractual obligations."

The 17 dealers now participating in DTCC's central settlement service - up from 14 when the service was launched - represent the vast majority of the dealer volume in the global OTC derivatives market. The service will be opened to buy-side clients starting in 2009.

In the most recent quarterly settlement cycle, on June 20, the 17 participating dealers had 66 bilateral settlement relationships among themselves. Since that time, the number of bilateral relationships has climbed to 107.

By comparison, when the settlement service was launched the 14 participating dealers had 19 bilateral relationships. The sharp increase in bilateral relationships in less than seven months has contributed substantially to the volume growth on the service and demonstrates the industry's progress in meeting its commitments regarding centralised settlement.

Based on the schedule of periodic coupon payments for OTC credit derivatives, payment activity volume for these contracts spikes on the quarterly settlement dates - which occur on March 20, June 20, September 20 and December 20 of each year. Because of the high volumes, DTCC focuses its central settlement reporting on the quarterly roll results as a way to assure market participants that netting is reducing risk. DTCC, working with CLS Bank, also performs payment netting and central settlement for OTC credit derivatives on a daily basis.

S&P updates its approach to European leveraged loans
Following consultation with more than 50 collateral manager groups, arranging banks, private equity firms and regulatory bodies, S&P has refined and finalised its proposal for the provision of ratings and credit estimates for Europe's leveraged finance market (see SCI issue 88). The original request for comment focused on certain aspects of the agency's approach to rating CLOs, particularly the determination of the credit quality of leveraged loans comprising a CLO's asset pool.

If a leveraged loan issuer is not publicly rated, S&P's current practice is to perform a credit estimate (CE) on the entity. In essence, the agency proposes changing certain procedures that would affect how CLOs are rated by:

• Restricting the provision of CEs for newly underwritten leveraged loans;
• Providing additional analysis on certain underlying assets that are not publicly rated;
• Expanding the sphere of S&P's recovery ratings; and
• Assigning issue and recovery ratings throughout the capital structure of rated issuers.

S&P says it believes that these measures will benefit lenders as well as debt and equity investors in CLOs.

Based on responses to the agency's request, the market considers that the use of CEs may be appropriate in certain circumstances. And for larger, more complex and more widely syndicated transactions, it accepts that ratings improve the transparency of transaction structures.

However, the market also raises the concern that public ratings could adversely affect the quality and frequency of information provided by borrowers, particularly for mid-range transactions. Comprehensive information is regarded by transaction participants as one of the main strengths of the European leveraged loan market.

In response, and as the main modification to the request, S&P will now offer private ratings for purely private European mid-range deals. Such ratings will supplement the full information package given to private lenders and therefore enhance the disclosure of information across the whole syndicate group.

Recognising the lead times required to prepare transactions for syndication, these changes will take affect from 1 December 2008. From that date, these measures will apply to newly underwritten transactions for European speculative-grade corporations.

ARM modifications strengthen
Servicers of sub-prime residential adjustable rate mortgage (ARM) loans have stepped up efforts to modify troubled loans, according to a new Moody's survey. These loan modifications could modestly lower cumulative losses on loan pools backing some mortgage securitisations, although the survey also shows that approximately 40% of the loans modified in the first half of 2007 were 90 or more days delinquent as of 31 March 2008.

Moody's says the high delinquency rate among the modified loans reflects that the majority of the modification activity in early 2007 was principal deferment and arrearage capitalisation on seriously delinquent loans. Recent modification efforts have shifted focus to interest rate reductions and about half of these more recently modified loans have been less than 60 days delinquent at the time of modification. Moody's believes these factors could possibly lower re-default rates.

Even with the observed level of re-default rate on modified loans, Moody's says the increase in efforts by servicers to modify sub-prime ARM loans may modestly lower cumulative losses of the loan pools backing securities. In its survey, Moody's found servicers had modified, as of the end of March 2008, 9.8% of the sub-prime ARMs with interest rate resets in the preceding 15 months. In December, a similar survey found only 3.5% of resetting loans being modified.

In addition, the percentage of delinquent loans that were either modified or on workout plans had increased to 35% as of 31 March, up from 24% in December.

"The rise can be attributed to a number of factors, such as increased outreach to borrowers on the part of servicers and non-profit third parties, increased attention from legislative bodies, the media and advocacy groups, and attempts across the industry to streamline the modification process," says Moody's md Warren Kornfeld.

The recently enacted Mortgage Forgiveness Debt Relief Act, which provides tax relief on forgiven debt for borrowers, may further increase the level of modifications going forward.

Pending legislation such as the American Housing Rescue and Foreclosure Prevention Act might decrease the need for modifications, however. These measures would assist borrowers in refinancing into more affordable mortgages in conjunction with current mortgage holders forgiving a portion of the outstanding loan.

This third Moody's survey on loan modifications includes information from ten servicers with a total servicing volume of approximately US$550bn. These servicers constitute roughly 50% of the total US sub-prime servicing market.

More SF CDOs on review
With US RMBS bonds continuing to experience credit deterioration that has led to widespread downgrades across the sector, Fitch recently undertook a review of 89 US structured finance (SF) CDO transactions that were not previously placed on rating watch due to exposure to what had been better performing vintages of sub-prime RMBS bonds. Upon completion of the review, the agency has placed US$7.9bn US SF CDO tranches on rating watch negative.

While much emphasis has been placed on the negative credit migration of 2005-2007 sub-prime RMBS, significant negative credit migration has also affected Alt-A RMBS bonds along with 2003-2004 sub-prime RMBS. The watch negative actions affect 160 rated tranches from 49 of the 89 SF CDO transactions examined in the review. Of the 160 tranches placed on watch negative, 52 were previously downgraded and 108 tranches maintained their original ratings until being placed on watch negative in this action.

Fitch's rating action affects 36 tranches currently rated triple-A and 101 additional classes that are rated investment grade. The remaining 22 tranches placed on watch negative at this time are currently rated below investment grade.

In determining which tranches to place on watch negative, Fitch looked at the composition of the underlying portfolio to assess potential impairment based on asset type, vintage and original and current rating level. Sub-prime and Alt-A RMBS assets issued prior to 2005 and all other assets that have been downgraded to the single-B rating category and lower were assumed to eventually default and generate a total loss to the portfolio. For 2005-2007 sub-prime and Alt-A RMBS and SF CDOs, expected losses were assigned based on their original rating and vintage.

For each portfolio, losses were aggregated and subsequently compared to the capital structure. Tranches that had losses greater than their credit enhancement and tranches with low remaining credit enhancement after projected losses were applied were placed on watch negative. Fitch notes that credit deterioration of the underlying RMBS securities may be amplified at the SF CDO level due to the use of leverage as well as structural features, such as overcollateralisation (OC) haircuts and OC-based events of default (EOD), which may adversely impact certain rated notes and SF CDOs containing these notes.

This review marks the third full portfolio review of SF CDOs resulting from deterioration in the RMBS markets. This review included SF CDOs not placed on watch negative during the February 2008 portfolio review. The transactions in this review can generally be grouped into three categories:

• The first category consists of 56 SF CDOs backed primarily by RMBS-related assets issued between 2002 and 2006;
• The second category includes 10 transactions issued during the same 2002-2006 period where the portfolios consist primarily of non-RMBS assets, such as CMBS and other ABS;
• The third category is comprised of 24 transactions issued between 1999 and 2001 with significant exposure to manufactured housing (MH) and aircraft securitisations remaining in their current portfolios. At issuance, these transactions were highly diversified across multiple structured finance sectors including RMBS, ABS and CMBS, but the higher quality assets have been paying off - leaving the remaining portfolios with a much higher concentration of distressed and defaulted assets often from the MH and aircraft sectors. Many of the transactions in this third category had experienced downgrades previously when aircraft securitisations and MH had initially come under distress.

Of the 49 transactions placed on watch negative, 39 transactions come from the 56 SF CDOs described in the first category whereby 129 rated tranches totalling US$6bn are directly attributable to the negative credit migration of the aforementioned RMBS bonds. There are 13 classes totalling approximately US$.5bn that are from two transactions in the second category. Approximately US$1.4bn consisting of 18 rated classes from eight early vintage SF CDOs described in the third category have been placed on watch negative due to credit deterioration attributable to non-RMBS credit migration, as well as the negative selection that occurs when performing assets pay down and distressed and defaulted assets comprise a larger portion of the portfolio.

Of the 40 transactions that were reviewed and had no classes placed on watch negative, 17 are from the first category, seven are from the second category and 16 are part of the third category of deals. These transactions were not placed on watch negative as Fitch's current portfolio loss projections are offset by sufficient credit enhancement or have small outstanding principal balances and are expected to pay off in the next two years.

Additionally, Fitch is reviewing its SF CDO approach and will comment separately on any changes and potential rating impact at a later date.

The resolution of this watch negative action will reflect the rating actions taken on the underlying RMBS assets and will incorporate Fitch's most current view on SF CDOs. The characteristics of the exposure (size, vintage, seniority, borrower quality, country of origination) of each portfolio, as well as the structural features of the specific SF CDO, will ultimately determine the magnitude of rating downgrades.

Securitisation Consulting adds to transparency efforts
Securitisation Consulting has launched a new web-based B2B platform that provides risk transparency for buyers and sellers of ABS, CDO, CMBS and RMBS structured products by combining communication with information.

In times of financial crisis on the non-transparent securitisation markets, it is difficult to access reliable and accurate data on structured deals, as well as on market participants. With instiLink, the Institutional Investors Network, the company has found a way to close the gap between lack of trustworthy information and investors' demands.

"The idea is to make the contact between a buyer and seller more efficient and provide investors with high quality data," says the company's chief executive Yury Menchinskiy.

Issuers and underwriters will be able to announce new deals in the instiLink Deal Pipeline, a database of all deals recently issued, and investors can then check out potential purchases. The business network, which is an integral part of instiLink, allows interested parties to contact directly the relevant contact persons.

instiLink is updated daily and also offers to its users the latest news on the securitisation market. These are provided both by various reputable contributors and by active members of the platform. Furthermore, users of the site can browse the instiLink Directory, a database of institutions involved in the structured finance business, and find out more about the companies' products and services.

Higher CRE delinquency rate for June
The maturity default of one participated loan secured by a hotel/condominium development was the primary contributor to a higher US commercial real estate loan (CREL) CDO delinquency rate for June 2008, according to the latest CREL CDO Delinquency Index from Fitch. The index increased to 1.58% from last month's rate of 1.08%. The delinquency index includes loans that are 60 days or longer delinquent, matured balloon loans and repurchased assets.

The CREL CDO Delinquency Index (CREL DI) of 1.58% is approximately four times the Fitch CMBS Delinquency Index (CMBS DI) of 0.39%. Although the CREL DI continues to be higher than the CMBS DI, it is not unexpected.

First, the assets securing the loans in a CREL CDO are either transitional in nature or highly leveraged. In addition, the CREL DI covers 35 transactions with 340 assets, while the CMBS DI covers many more (500) transactions with significantly more (42,000) loans. As a result, because of the smaller number of loans in the index, one loan can have a big impact on the delinquency percentage.

In fact, this month, one loan contributed 38bp out of the 50bp rise in the index. This newly matured loan is secured by a hotel/condominium development in South Florida.

The whole loan was split into two pari-passu senior participations and two sequential junior participations. The two senior interests and one of the junior interests were contributed to three separate CREL CDOs.

Of the 20 loans in the June 2008 CREL delinquency index, over one-third are land loans. It is generally acknowledged that land loans are expected to be more difficult to refinance in today's capital constrained market. Fitch-rated CREL CDOs are rated with the expectation of higher default probabilities for land loans.

Similarly, hotel loans - which make up the next highest property type in the index at 26% - are also, in general, modelled with higher default probabilities. Two loans secured by retail properties make up the third largest component by property type at 20%.

Fitch anticipates delinquencies in this category to increase, given the current stress on the US economy. Retail property loans represent approximately 6% of the CREL CDO loan universe.

While repurchases are a smaller percentage of the overall index compared to six months ago, asset managers continue to repurchase assets from their CDOs. For this reporting period, asset managers repurchased three assets (12bp), including two from one CDO. The repurchased assets consist of a whole loan secured by a multifamily property and a mezzanine loan secured by an interest in an office property.

Fitch notes 20 reported loan extensions in June 2008, which is up from last month's total of 14. Approximately half of the extensions were a result of options contemplated at closing, while the other half were modifications from the original loan documents. These loan extensions continue to reflect the lower available liquidity for CRE loans, especially those typically found in CREL CDOs, which tend to be backed by transitional and/or highly leveraged CRE collateral.

European SROC action
After running its month-end SROC figures, S&P says that it has taken credit watch actions on 139 European synthetic CDO tranches. Specifically, ratings on 60 tranches were placed on watch with negative implications, 52 tranches were removed from watch negative and affirmed, one tranche was removed from watch negative and placed on watch positive and 26 tranches were placed on watch positive.

Of the 60 tranches placed on watch negative, 28 reference US RMBS and US CDOs that are exposed to US RMBS, which have experienced recent negative rating actions. 32 have experienced corporate downgrades in their portfolios.

CS & AC

Trading ideas: not so sharpie

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at an outright short on Newell Rubbermaid Inc

Newell Rubbermaid's website claims it is "transforming into a consumer-driven marketing company". The emphasis on the consumer sector concerns us, given the weakness in the economy and continued housing slump. We recommend buying CDS protection on the issuer, since its credit spread does not accurately reflect its current fundamentals.

Even though recent increases in margins and sales have erred to the positive side, we do not think this will continue into the foreseeable future as the global consumer gets squeezed. The equity market shares our conviction. Its stock price is down almost 50% over the past 12 months.

This drop has increased Newell's implied default probability. However, its credit spread has not widened enough to account this change in risk.

Buying CDS protection at 104bp gives us limited downside and provides an excellent way to gain a short exposure to the consumer sector. We see potential for more than 70bp of spread widening for Newell.

Basis for credit picking
Our credit model attempts to replicate how a fundamental credit analyst thinks. While this is extremely arduous, the output provides a great way to select long/short trades.

The model ranks each issuer on a scale of 1 to 10 using seven factors (1 = poor credit, 10 = good credit). Exhibit 1 lists all the factor scores for Newell. We see a 'fair spread' of 174bp for its low-ranking EiPD, leverage and accruals factors.

Newell's stock price has dropped by almost half over the past year. We take that as a serious sign of an increase in credit risk.

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

This simple risk-to-reward ratio is akin to the complete MFCI model but limits its scope to only one factor used within the model - equity-implied default probability (EiPD). The SPD for Newell has decreased to yearly lows, making this an ideal short candidate (see Exhibit 2).

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

Exhibit 3 shows the time series of Newell's rolling four-quarter average accruals. Positive accruals are a negative sign of earnings quality. Newell's accruals have been oscillating around zero, making us concerned that it will not produce quality earnings in the future.

Risk analysis
This trade takes an outright short position. It is not hedged against general market moves or against idiosyncratic curve movements. Additionally, we face about 5bp of bid-offer to cross.

The trade has negative carry and negative curve roll-down. We believe that the challenge is worthwhile, given NWL's current levels and our outlook for the credit.

Entering and exiting any trade carries execution risk and NWL's liquidity is good in the CDS market at the five-year tenor.

Summary and trade recommendation
Newell Rubbermaid's website claims it is "transforming into a consumer-driven marketing company". The emphasis on the consumer sector concerns us, given the weakness in the economy and continued housing slump.

We recommend buying CDS protection on the issuer since its credit spread does not accurately reflect its current fundamentals. Even though recent increases in margins and sales have erred to the positive side, we do not think this will continue into the foreseeable future as the global consumer gets squeezed.

The equity market shares our conviction. Its stock price is down almost 50% over the past 12 months. This drop has increased Newell's implied default probability.

However, its credit spread has not widened enough to account for this change in risk. Buying CDS protection at 104bp gives us limited downside and provides an excellent way to gain a short exposure to the consumer sector. We see potential for more than 70bp of spread widening for Newell.

Buy US$10m notional Newell Rubbermaid Inc 5 Year CDS protection at 104bp.

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).