Contents

Sustainability counts

European CLO manager profitability results in

The number of European CLO managers is likely to decline by 20% over the next three years, according to new estimates. Greater divergence in leveraged loan credit performance is expected to reveal differences between managers' capabilities and, ultimately, business viability in the coming months.

Rising portfolio defaults could lead to a diversion of principal and interest away from CLO equity and junior tranches, thereby resulting in a potential loss of revenue for managers from subordinated fees. This is significant because these fees typically represent two-thirds of a manager's income.

Based on a profitability study, Fitch notes that two to three European CLOs of average size are just enough to break even in a benign credit environment. But in challenging environments even managers with three CLOs under management will likely only have mediocre returns or make losses.

"Four CLOs under management create a scalable, sustainable business, which is expected to remain profitable in an environment of rising defaults," explains Manuel Arrive, director in Fitch's fund and asset management rating group.

US CLO managers that opened an office in Europe represent a particular case for manager consolidation. Out of over 60 European CLO managers, 50% have only one or two CLOs under management, while 60% entered the market in 2006-2007 - half of which were US managers. Fitch believes that about half of the US managers will close their European operations in the next three years, either preferring to manage the deals from their US headquarters to reduce costs or simply to resign as manager.

Indeed, Arrive expects only a handful of mergers to occur between managers; they can achieve better critical mass through the acquisition of replacement mandates - though these are problematic in terms of reputation risk. "What is more likely to occur is smaller managers clubbing together via a resource-sharing agreement, which is more flexible than a merger. Manager replacement is nonetheless more likely to result from a manager resignation than an investor-led action because investors recognise that it's a cumbersome process," he says.

The latest example of manager consolidation concerns the Robeco CDO II transaction, which is being acquired from Robeco Investment Management by Deerfield Capital (see Job Swaps). Rather than purchasing the CDO outright, however, it is understood that the two managers will share future fees (albeit Deerfield will retain the majority).

The critical strengths of managers remain largely the same pre- and post-credit crunch, although managers can now opportunistically create value through active secondary trading. An ability to avoid defaults will reveal the differences between those that selected well-balanced portfolios and those who bought the market under pressure to ramp up deals quickly in 2006-2007. Certainly European CLO managers have broadened their risk management focus recently, enhancing the monitoring of portfolio credit risk, as well as liquidity and volatility risk.

"Managers have also strengthened their cash flow modelling capabilities to stress test CLO structures, formalised credit and market risk indicators as well as committee review processes. Others are preparing to actively manage distressed situations: workout capabilities are critical for those who believe they can achieve a recovery rate higher than the distressed loan market sell price. Some managers have hired workout specialists to create a dedicated function in this area," Arrive adds.

One of the first publicly measurable examples of European CLO manager style differentiation occurred last week when vodka maker Belvedere filed for bankruptcy protection following a covenant breach. According to structured credit analysts at JPMorgan, this is the first public default in the European CLO market in several years - though it is largely a non-event. In the analysts' 120 CLO overlap universe, Belvedere's senior secured FRNs appear in only three CLOs.

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Alternative states

Different jurisdictions offer CDO investors procedural advantages

As the number of CDO-related claims being filed increases, a new trend whereby a prosecuting party chooses an alternative jurisdiction over the US to take legal action is also expected to accelerate. These different jurisdictions would, in some cases, speed up or slow down processes, or offer investors other procedural advantages.

"At present, mandatory forum-selection clauses do not exist in deals stating where or where not the associated parties will be sued. There is an elastic concept of jurisdiction," says Jayant Tambe, partner at Jones Day.

He adds: "But once the dust settles and new deals are structured, people will have to think about learning lessons from this crisis - and providing mandatory forum-selection clauses that state where a structure will be litigated may be one feature that will be taken into consideration."

He suggests that one way for CDO issuers to preserve their litigation advantage, on an ongoing basis, would be to provide for mandatory forum-selection clauses that would require investors to bring their claims in New York State and federal courts. Previous cases litigated in the US courts, including BESI vs. Citibank (2003) and SNS Bank vs. Citibank (1996) saw claims clearly rejected by the court, posing a hurdle for other investors seeking to recoup investment losses by pursuing claims against either the SPV or the placement agent and other intermediaries.

"These two cases will be a valuable and binding precedent in any New York litigation in seeking dismissal of investor claims premised on theories of fiduciary duty, third-party beneficiary standing and oral and written representations outside the offering memoranda, provided appropriate disclaimers were provided," adds Tambe.

A recent example of an alternative jurisdiction being chosen by investors over the US for legal procedures is the Bank of New York vs. Montana Board of Investments case, concerning US-based SIV Orion, which was litigated in the English High Court (see last week's issue for more). Tambe says that he doesn't believe broader themes can be taken from this case yet, but he confirms that alternative jurisdictions are being chosen in certain cases in order to speed up or slow down processes, or to gain some procedural advantage, for example.

Meanwhile, the number of CDO-related claims being filed has seen an increase in numbers - a trend that is expected to accelerate over the coming months, with certain vintages and types of CDOs more likely to go to court than others. In the past two months an uptick has been seen in asserted claims, with a number being filed within New York State. A handful of sales practice claims alongside indenture claims by trustees concerning the waterfall structures are also appearing.

"The odds are that the majority of claims will concern synthetic CDOs of recent vintage - especially those CDOs of the 2007 vintage," concludes Tambe.

AC

Proposal pending

CRD changes criticised

The EC's proposed changes to the originate-to-distribute (OTD) model under the Capital Requirements Directive (CRD) last week resulted in a flurry of industry objections. While it is generally acknowledged that some improvements to the model need to be made, the main criticism is that the proposal doesn't accurately capture the products/markets associated with it.

Specifically, the EC has proposed restricting European banks from investing in tranches of transferred credit risk unless the relevant originator, arranger or manager/servicer has retained at least a 10% interest in those tranches (see last week's issue). But in its current form the proposal would make the originate-to-distribute model practicably uneconomic, according to analysts at RBS.

"The reality is that at this stage it will further torment an already moribund ABS market and that any hopes of releasing the ECB from hundreds of billions of euros of these assets which have been used as repo collateral will be turned to dust," the analysts say. However, they concede that "at the end of the day, there will likely be some kind of risk retention imposed, albeit it may be watered down".

The ESF, ISDA, SIFMA and five other industry associations last week submitted a letter to the EC, pointing out that the proposal has a number of fundamental flaws. Not only will the proposal reduce the availability and increase the cost of credit in the EU, but it will also damage its competitiveness. Equally, it will impair credit risk transfer mechanisms, while failing to achieve the EC's intended objective to better align the interests of originators with those of investors.

The eight associations "agree with the Commission that there have been difficulties with certain loan origination practices, as well as weaknesses in risk management procedures at a number of financial institutions, but note that unprecedented credit market conditions have also played a critical role". They also "appreciate the Commission's motivation to increase industry and regulatory focus on some aspects of the OTD model".

But the associations believe there is merit in considering some of the alternative proposals being considered by EU Member States and financial institutions in response to the concerns around the OTD model because they more accurately capture the products and markets associated with such a model. "Simple proxy methods mandating quantitative measures are unlikely to affect the behaviour of the different participants who operate in these markets. Instead, we believe the significant improvements already underway will, taken together, address the fundamentals of the Commission's concerns."

These improvements include an enhanced supervisory review process, as well as the development of transparency principles in relation to securitisation exposure reporting and an industry market data report. "All of these initiatives are designed to assist investor-side credit assessment of securitisation structures, so that investors can make investment decisions on sounder foundations," the associations note. They also request that an appropriate timeframe be given in line with ECOFIN and Financial Stability Forum recommendations.

Fitch broadly concurs with the industry associations' arguments. Stuart Jennings, risk officer for EMEA structured finance at the agency, notes that - while enhanced transparency regarding originator/sponsor retained interests could allow for better evaluation of this risk by investors - the EC's proposals in their current form could prove overly prescriptive and have the potential to put European banks at a competitive disadvantage as investors.

"Furthermore, if implemented in their current form, the cost of the proposals could render the economics of some European structured finance transactions unviable. This could limit available funding options for European originators," he adds.

Fitch believes that the practical aspects of application also require further definition, particularly with regard to how retained interests would be monitored, as well as the remedies for breach and the extent of intended reach. Should these proposals become law, it could encourage European banks to seek new off-balance sheet investment techniques to circumvent the rule, the agency concludes.

CS

Illiquid credit head leaves DB

The latest company and people moves

Illiquid credit head leaves DB
Antonio di Flumeri, global head of illiquid credit at Deutsche Bank in London, has left the bank. During his time at Deutsche Bank, he also held the post of co-head of structured credit trading, alongside Bertrand des Pallieres. He reported to Rajeev Misra, global head of credit and commodities at Deutsche, who left the bank in June to set up a credit opportunities fund.

Yuri Gruzglin, a senior correlation trader based in DB's New York office, has also left the bank.

Ex-CDO structurer hired
Orestis Millas is understood to have joined the National Bank of Greece. He was formerly in the CDO structuring team at Citi, working with Andrew Godson and Sarah McMullen, having left the bank at the end of April.

Tokyo credit trading head hired
Ted Lo, head of Morgan Stanley's Asia debt syndicate, is understood to have left the bank in order to take up a new role at RBS as head of its credit trading desk in Tokyo.

Ex-Bear staff join financial services firm
Guggenheim Capital Markets is launching a Midwest sales office that will operate out of Guggenheim Partners' headquarters in Chicago. The new team will enhance and expand coverage currently being handled from GCM's New York and West Coast offices.

The Chicago sales team will be led by David Connelly, who has spent the past 24 years with Bear Stearns and was head of fixed income sales there for the past 17 years. He will be joined by Tom Unger, previously with UBS, as well as JP Gagne, Robert Pritchett, Kevin Smith and Brian Vanselow - all of whom were previously at Bear Stearns.

Guggenheim has also hired Lenny Blasucci, Matthew Perkins and Nicholas Smith, all of whom will be based in the New York Office. They will expand the scope of GCM's ABS business.

Blasucci joins Guggenheim from Clinton Group and Sherman Financial Group. Perkins was co-head of the ABS group at Bear Stearns, while Smith previously traded on Bear Stearns' ARM desk.

Manager begins CDO acquisition strategy
Deerfield Capital has taken on the management contract for Robeco CDO II, a CDO previously managed by Robeco Investment Management (see also separate news story). The CDO is collateralised primarily by high-yield corporate bonds.

As of 17 June, the aggregate principal balance of the CDO was approximately US$201m. The CDO has a stated maturity of 20 August 2013 and is subject to customary early amortisation provisions.

Commenting on this transaction, Jonathan Trutter, ceo says: "This is the first transaction in our previously announced strategy to acquire CDO management contracts. We were able to acquire the majority of the ongoing management fee stream from the CDO without the payment of any purchase price to the prior manager. We see significant revenue and earnings growth potential in the CDO management contract roll-up strategy and believe Deerfield is well positioned to execute additional transactions going forward."

Including this contract acquisition, Deerfield now manages 31 CDOs and structured products and has total assets under management exceeding US$13bn.

Highland beefs up Asia presence
Highland Capital Management is opening an Asia Pacific regional office in Singapore on 8 August. Paul Adkins, an md at the firm currently based in Dallas, will be relocating to Singapore to manage the new operation.

Jack Yang, partner at the firm, says: "We have seen considerable interest from Asian investors in our hedge funds over the past two years, alongside our longstanding regional investor base in structured products."

Adkins has spent more than 12 years in a variety of significant business assignments in Asia, having been based in Singapore, Bangkok, Hong Kong and Tokyo. He began his career at Morgan Guaranty Trust Company. Since then, he has had roles as a consultant in the financial services industry and as a private equity fund manager specialising in telecommunications, media and technology investments.

Additionally, the firm announced that John Mackin, Christopher Harrison and Elizabeth Goldstein have joined the firm as mds. As of 1 August, they will be based in the firm's New York office and report to md and head of institutional sales Maureen Mitchell. Their focus will be on sales and investor relations for Highland's institutional clients.

Mackin joins Highland from Pardus Capital Management, where he worked from 2005 to 2007 as the hedge fund's director of investor relations. Goldstein joins Highland from Bear Stearns, where she was a senior md in the leveraged finance group for nine years.

New force for CDS processing
Markit and the DTCC are forming a new jointly-owned company that will combine the strengths of Markit's front- and middle-office trade processing services with DTCC Deriv/SERV's back-office leadership in post-trade confirmation and matching services. The two firms say that the objective is to eliminate duplicative infrastructure and better enable the industry to deal with high OTC derivatives volumes and complexity.

While OTC equity derivatives and interest rate swaps are the asset classes that need the most work in terms of improving processing, the two firms acknowledge that turn around times for credit derivatives could also be improved. It is hoped that the infrastructure will eventually be expanded to include commodity derivatives.

Ownership of the as yet unnamed company will be equally split between Markit and the DTCC, with around 250 members of staff divided between London and New York. It will be governed by an 11-member board of directors (including representatives from seven banks) and will have Michael Bodson, executive md for DTCC's business management and strategy, and Jeff Gooch, evp of Markit, at its helm as chairman and ceo respectively. The two firms initially expect over US$7m in transaction volumes, arising from around 1100 clients on both the buy- and sell-side.

The new company will comprise Markit's recently acquired Markit Wire platform (formerly SwapsWire), as well as its other trade processing services such as Markit Trade Manager, Markit Tie Out and Markit PortRec. DTCC will contribute its Deriv/SERV matching and confirmation engine, and its AffirmXpress, MCA Xpress and Novation Consent services. Additional services that will not become part of the new company include Markit's data and valuation services and DTCC's downstream Trade Information Warehouse, centralised settlement and payment netting services.

In addition to facilitating greater industry adoption of electronic confirmation, the new company will offer automated trade affirmation, trade allocation and novation consent solutions to the market on a cross-product basis. It will initially support both DTCC's and Markit's confirmation platforms.

The DTCC-Markit agreement will become effective following completion of due diligence, regulatory filings and approval by relevant global regulators, including those in the UK and US. The name of the new company will be announced at a later date.

Tritto joins Primus
Primus Guaranty has appointed Vincent Tritto as general counsel. He will work on the company's operating committee and reports to Thomas Jasper, Primus guaranty's ceo. Tritto joins Primus from BlackRock, where he was md and senior counsel in the firm's legal and compliance department.

Two SIV restructuring lawyers hired ...
Kaye Scholer has hired William Cullen and Janet Barbiere to work in its corporate & finance department, as partners in its New York office. The two new hires will be involved in restructurings of structured investment vehicles which have high concentrations of MBS.

Cullen and Barbiere concentrate their practice in securities and corporate finance, with an emphasis on CMBS and structured finance, including securitisations, secondary market transactions, real estate syndications and the purchase, sale and workout of commercial real estate debt. They both join Kaye Scholer from Thacher Proffitt & Wood, where they were partners in the firm's structured finance practice group.

... while Baker & McKenzie adds CLO pro
Baker & McKenzie has hired Hans Montag as partner. He joins the firm from the New York office of Clifford Chance, where he worked for almost ten years.

Montag's practice focuses on representing financial institutions, large corporate issuers, funds and other clients in complex securitisation, warehousing and related transactions. This includes MBS, asset acquisitions, CLOs, private equity financings, project finance transactions and other types of financings. In addition, he has experience in both domestic and cross-border transactions.

Calyon restructures
Calyon is simplifying the organisation of its business plans and putting in place a new governance structure, which will come into effect at the end of July. Under the new structure, the fixed income markets division will report globally to Guy Laffineur. The division comprises treasury, FX, commodities, interest rate derivatives, debt and credit markets and structured credit markets.

Laffineur has spent most of his career at Crédit Lyonnais, having held the role of head of fixed income activities since 2005. The structured finance division will report globally to Gilles de Dumast, deputy general manager. Alain Massiera, deputy ceo of the bank, will be directly in charge of structured finance, equity brokerage and derivatives, and fixed income divisions.

AC & CS

Loan refi concerns emerge

A round up of this week's structured credit news

Loan refi concerns emerge
Consolidation among CLO managers (see also separate news story), together with the departure of CLOs as principal syndication targets for leveraged loans pose a threat to the refinancing of these instruments in 2010 and beyond when substantial debt amortisation requirements will arise, according to Fitch.

"Looking at the base case financial forecasts, very few LBO business plans factored in some cyclicality - they're predicated on similar organic growth as seen historically and continuing expansion, which is now unlikely to be sustainable given the bleak economic outlook," explains Pablo Mazzini, senior director at Fitch. "The expectation is that there will be limited free cashflow to reduce senior debt in a meaningful way, so the main risk for the European leveraged finance market is the ability to refinance the bullet maturities that will become due in 2010 and beyond."

Deals characterised by low debt amortisation schedules and initially structured with covenant headroom are likely to mitigate against spiking leveraged loan default rates in the short term. But Fitch concludes that, in order for this refinancing wave to be absorbed in an orderly manner, the CLO business model will need to be restored or, otherwise, arranging banks and sponsors will have to consider making leveraged loans attractive to alternative long-term institutional investors.

FSA and Assured on downgrade review
Moody's has placed FSA and Assured Guaranty and their associated insurance operation companies under review for possible downgrade. The agency says the rating actions reflect elevated risks within the financial guaranty insurance market.

It notes that the two monolines' insured portfolios may no longer be consistent with their current Aaa rating, given the materiality of the stress faced by the firms in their insurance and asset management operations, uncertainty about the firms' portfolio risk profile, material shifts in the demand function for financial guarantees and potential sensitivity of their franchises and financial flexibility if losses continue to rise.

However, Moody's adds that, while the outcome of the review is uncertain at this time, a downgrade of FSA's or Assured's insurance financial strength ratings to below Aa2 is currently seen as unlikely.

Commenting on the rating action, Dominic Frederico, president and ceo of Assured Guaranty, says: "We are concerned by Moody's announcement at a time when Assured is experiencing broad market acceptance and investor demand for our insured paper. We believe it is important for investors to know that Moody's action is not at all reflective of a deterioration in Assured's capital base, credit exposures or earnings outlook."

Robert Cochran, chairman and ceo of FSA, adds: "We take note of the concerns Moody's has expressed, and we will work closely with them to reestablish our Aaa-stable claims-paying ratings."

Basel Committee issues RFCs
The Basel Committee on Banking Supervision has issued for public comment two documents: 'Guidelines for Computing Capital for Incremental Risk in the Trading Book' and 'Proposed Revisions to the Basel II market risk framework'.

"Major banking organisations have experienced significant losses over the last year, most of which were sustained in banks' trading books," states Nout Wellink, chairman of the Basel Committee and president of the Netherlands Bank. "Against this backdrop, the Basel Committee's incremental risk proposal will better align regulatory capital requirements with the risk exposure of banks' trading book positions."

The guidelines support one of the key recommendations for strengthening prudential oversight set out in the 'Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience', which was presented to G7 Finance Ministers and Central Bank Governors in April 2008.

These proposals were developed jointly by the Basel Committee and the International Organization of Securities Commissions (IOSCO). Christopher Cox, chairman of IOSCO's technical committee and chairman of the US SEC, notes that the proposed requirements will also apply to investment firms. He adds: "The market turmoil has had a severe impact on many commercial and investment banks. The incremental risk guidelines and related changes to the Basel II framework will contribute to a safer and sounder financial system."

In October 2007, the Basel Committee consulted on proposed guidelines for computing capital for incremental default risk, or the risk that is incremental to the default risk already reflected in a bank's value-at-risk (VaR) model. The application of such an incremental default risk charge, however, would not have captured recent losses in ABS CDOs and other resecuritisations held in the trading book. The losses that materialised during the market turmoil have not arisen from actual defaults but rather from credit migrations, combined with widening of credit spreads and the loss of liquidity.

Given this and other observations from the market turmoil, as well as comments received through the consultative process, the Committee decided to expand the scope of the capital charge. The proposed incremental risk charge (IRC) would capture price changes due to defaults, as well as other sources of price risk, such as those reflecting credit migrations and significant moves of credit spreads and equity prices.

The Basel Committee also proposes improvements to the Basel II framework concerning internal VaR models. It has further aligned the language with respect to prudent valuation for positions subject to market risk with existing accounting guidance. In addition, it has clarified that regulators will retain the ability to require adjustments to current value beyond those required by financial reporting standards, in particular where there is uncertainty around the current realisable value of a position due to illiquidity.

Once the Basel Committee has finalised the revised requirements, it expects firms to comply with them by 1 January 2010. However, firms will be allowed an additional year to incorporate into their IRC models all risks covered by the proposed IRC beyond default and migration risks for positions subject to credit risk.

Until the IRC is implemented in 2010 and to ensure that firms hold adequate capital for resecuritisations, an interim treatment will apply. This interim treatment will be specified in a separate proposal that will be issued by the Basel Committee later in 2008. Over a longer-term horizon, the Committee also intends to review the VaR approach for the trading book, including the specific risk capital charges under the standardised approach.

In conjunction with this proposal, the Basel Committee will conduct a two-stage quantitative impact study of the IRC on firms' capital requirements. In the first stage, the Committee plans to rely largely on data collected in connection with the 2007 incremental default risk proposal to examine the impact of incorporating default and migration risk into the IRC. In stage two, additional data will be collected to examine the impact of incorporating other risks.

ABX write-downs set to accelerate
ABX.06-2.BBB- constituent SAIL 06-4 M8 (currently rated single-C by Moody's) is expected to be completely written down next month, after 25.57% of the tranche was written down at end-June - becoming the first ABX constituent to experience a principal write-down. The SAIL 06-4 M7 tranche - which is referenced in the ABX.06-2.BBB index - is likely to be the next constituent hit by a write-down, according to structured credit analysts at JPMorgan.

They note that there are three deals in the SAIL 06-1 series, five in the 06-2 and three in the 07-1 that have started experiencing write-downs on their bonds. Four of these deals have no tranche between the series' ABX constituents and the tranche that will take a loss.

The JPMorgan analysts are projecting another 10%-15% drop in US house prices (which are down almost 20% from their peak in July 2006) and losses in the range of 17% (for ABX.06-1) to 36% (ABX.07-2). In that scenario, the 07-1 and 07-2 triple-B minus index up through the single-A index are wiped out; the 06-1.PENAAA is the only tranche that is projected to receive 100% principal back.

FAS 140 revisions criticised
The ASF and SIFMA have issued a letter expressing concerns with revisions to Financial Accounting Standards Board (FASB) Statement No. 140, 'Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities', and Interpretation No. 46, 'Consolidation of Variable Interest Entities', to the FASB and federal regulatory bodies. The letter notes that hasty revisions to FAS 140 and FIN 46(R) may pose detrimental consequences, including abrupt consolidation of securitisation SPEs, capital constraints and burdens associated with waivers for financial covenant breaches.

The letter also discusses how the changes associated with FASB's tentative decisions regarding FAS 140 and FIN 46(R) may require banks, finance companies and other entities that currently do not consolidate to do so, and may affect large markets that provide substantial funding for US businesses and consumers. Additionally, the letter notes that the ASF supports full deliberation of a linked presentation as part of the current round of accounting policy changes, and the consideration of approaches that enable users of financial statements to differentiate between assets that are truly controlled by the consolidated reporting entity and those that have been isolated from that entity and its creditors.

Both industry assocations have followed closely the Board's recent deliberations relating to Statement 140 and Interpretation 46(R). They note that they are writing at this time to register serious concerns about these projects, based on public Board deliberations and information on the Board's website.

"We recognise that the Board and other policy makers believe that speedy and decisive actions are necessary in response to the recent credit crisis and related events. We fear, however, that the Board's current course of action may have serious unintended consequences," the two associations explain.

In particular, they do not believe that a year-end 2008 deadline is a necessary response to current market conditions. They say that the risks of too much haste are high:

• To the extent that accounting standards changes result in the abrupt consolidation of securitisation SPEs, this outcome is likely to swell the balance sheets of the affected entities, impairing financial ratios and financial covenant performance and regulatory capital tests.
• Without time to consider the appropriate regulatory and rating agency response to such changes in accounting: regulated entities will face capital constraints; both regulated and unregulated entities will face substantial challenges (and their capital raising efforts will be complicated) by explaining the dramatic changes in their financial statements to investors and lenders; and in some cases, regulated and unregulated entities will be further burdened by the need to seek waivers for financial covenant breaches triggered by accounting changes in an environment where lenders may be unreceptive to these requests.
• Policy changes without international convergence will prolong the drain on the Board's and constituents' time, as further changes to derecognition and consolidation policies are virtually certain to result from the convergence process.

A more measured and realistic but still aggressive deadline (such as 1 January 2010) that permits full deliberation of policy alternatives, time for possible field testing of the proposal so that the Board and constituents can fully gauge the outcome of the proposal, and a public comment period commensurate with the importance of the changes under consideration will be better for accounting policy, the economy and the markets in both the short and long term.

As of 31 December 2007, the aggregate outstanding balance of potentially affected transactions included: US$7,210.3bn mortgage-related securities; US$2,472.4bn other asset-backed securities (excluding ABCP); and US$816.3bn ABCP.

SIV capital notes downgraded
Moody's has downgraded the capital note programmes of Beta Finance, Centauri Corp and Dorada Corp from Caa3 to single-C. The action affects approximately US$2.7bn of debt securities.

The SIVs' capital note programmes were placed on review for downgrade by Moody's on 16 May. The actions reflect declines in portfolio market values for all three vehicles and Moody's view that further price declines and loss crystallisations are imminent as Citi proceeds with its plan of asset liquidations to repay maturing senior debt in these vehicles. Capital net asset values for all three vehicles are negative, indicating that expected losses are consistent with a rating of single-C.

RFC on credit stability factor
S&P has requested comments on a proposal to incorporate credit stability as an important factor in its ratings. The purpose of the proposed change is to more closely align the meanings of the agency's ratings with its perception of investors' desires and expectations in the wake of the high degree of credit volatility recently displayed by certain derivative securities.

"Under the proposal, when assigning and monitoring ratings, we would consider whether we believe an issuer or security has a high likelihood of experiencing unusually large adverse changes in credit quality under conditions of moderate stress. In such cases, we would assign the issuer or security a lower rating than we would have otherwise," says Mark Adelson, md and chief credit officer at S&P. "The proposed change is an extension of our previously-announced initiative to include 'what-if' scenario analysis in rating reports."

The new framework is intended to function as a limiting factor on the ratings assigned to credits that S&P believes are vulnerable to exceptionally high instability. If S&P adopts the proposed change, it intends to implement it over a period of roughly six months.

The agency expects that the proposed change would have very little, if any, effect on corporate and government ratings. It is anticipated to have a more pronounced impact in certain areas of structured finance, particularly ratings on derivative securities such as ABS CDOs, CPDOs and leveraged super-senior structures.

Eurex plans OTC clearing platform
Eurex plans to build a European CCP platform for clearing services in OTC derivatives, which would complement its current US initiatives. The European OTC CCP platform, scheduled to launch in H109, will utilise existing Eurex Clearing functionality, as well as new functionality for trade and risk management.

According to the firm, it is in discussions with several infrastructure providers concerning their involvement in a new platform. The initial product scope will be the CDS market, focusing on iTraxx index exposures that are mainly traded out of Europe.

"The benefits of our service extension would be increased market stability and capital efficiency. Customers would profit from straight-through processing, enhanced collateral management and multilateral netting for OTC trades - which currently account for 84% of all derivatives traded," says Thomas Book, responsible for clearing on the Eurex executive board.

Monoline industry analysed
Fitch has updated its viewpoints on the monoline financial guaranty industry. In a special report, the agency explores recent developments, recent financial performance and takes a fresh look at the industry from this point forward.

Among other topics discussed in the report are: the near and intermediate term rating outlooks for the industry; an overview of potential future changes in ratings methodology; views on how companies may need to better manage their sensitivity to ratings; capital adequacy; liquidity; and relative ratings and competitive positioning of the various financial guarantors. The report also includes appendices discussing recent sub-prime analysis, as well as a summary of key credit issues for each of the financial guarantors that carried a triple-A rating at the beginning of 2007.

Specifically, Fitch is concerned that continued erosion in underlying RMBS could cause further deterioration in monolines' insured portfolios over and above current expectations and even Fitch's most stressed assumptions. Such occurrences are expected to put further pressure on existing ratings and could potentially result in insolvencies for some of the weaker players.

In looking ahead, Fitch believes there are three divergent challenges impacting the monoline industry:

• How healthy, ongoing industry participants effectively deal with the rapidly changing industry landscape, as well as with other healthy new market entrants which may enter the sector in the future. This includes how these companies react to any possible changes in ratings methodology or capital guidelines put forth by any of the rating agencies by which they are rated.
• For the guarantors that no longer carry triple-A ratings but are still highly rated, a question remains as to the degree these players will balance their commitment to maintaining the highest financial strength possible for their policyholders against the needs of shareholders. Fitch believes this question is of paramount importance, since several companies are engaged in ancillary businesses - such as the sale of guaranteed investment contracts (GICs) - that could be materially impacted by downgrades to low investment grade by either Moody's or S&P. (Fitch believes a ratings withdrawal by either agency could also equate to a downgrade that could trigger acceleration or termination of these businesses.) Once ratings have been downgraded below triple-A for these companies, there appears to be an increased willingness on the part of management to reduce efforts to "maximise" the financial condition of its insurance subsidiary, but instead to focus on maintaining "adequate" degrees of financial strength. While Fitch is not questioning the reasonableness of management's judgments in making these difficult decisions, they highlight the growing tension between shareholders and existing policyholder interests within the industry.
• For others that are now lower rated, the risk of technical insolvency is also real, as rising losses deplete statutory capital levels - adding to the risk of regulatory intervention. Regulatory intervention, in the case of financial guarantees executed in CDS form, could result in onerous settlement claims due to termination triggers embedded within CDS contract documentation. Each company's core challenge is to remain solvent and evaluate if they best serve their stakeholders as ongoing operations or by entering voluntary run-off.

Fitch believes that the near-term rating outlook for the financial guaranty industry is negative. This outlook primarily reflects lingering uncertainty as to ultimate sub-prime-related losses and questions as to whether companies have or will maintain the necessary level of capital to support their given ratings, particularly in times of stress.

The negative industry outlook incorporates a risk several guarantors face that statutory capital levels may be depleted due to increasing losses as insured portfolios deteriorate, which could in turn result in both regulatory intervention and a possible termination settlement claim on various CDS positions. This could result in a steep "ratings cliff", as was most recently seen with the downgrade of CIFG. Fitch expects it will be very difficult to stabilise the ratings of recently downgraded companies until they can more effectively limit the downside risk from their SF CDOs through reinsurance or other risk mitigation initiatives, or until the passage of time has provided greater clarity regarding the ultimate performance prospects for these exposures.

Fitch also believes that further deterioration in real estate markets or the economy could expose financial guarantors to additional ratings downgrades. In addition, it believes that recent actions announced by several management teams to redirect claims-paying resources away from the current policyholders will add further pressure to the ratings.

Outstanding CDS confirmations drop
Markit has released its Metrics trend report for the quarter ending in June. The statistics show that average monthly CDS volumes dropped from around 25,000 contracts to just below 20,000 over the quarter. An average 90% of this volume was transacted electronically.

Additionally, average outstanding confirmations dropped from just below 6,000 to around 3,500 over the quarter. While the average number of pre-netted settlements rose from just over 250,000 to just below 300,000 over the quarter, the average number of post-netted settlements remained fairly constant at just below 25,000.

QWIL begins another share repurchase ...
Cheyne Capital's Queen's Walk Investment Limited (QWIL) sent a circular on Friday 18 July to eligible shareholders detailing its proposed tender offer to purchase up to three million ordinary shares and thereby to return a maximum of €15m in cash to shareholders. The tender offer will be open from 18 July to 8 August 2008 and is being made at a price per existing ordinary share in issue of €5. The tender price represents a premium over the middle market closing price (as derived from the Daily Official List of the London Stock Exchange) of €0.60 per ordinary share on 17 July.

The tender offer is conditional on the approval of shareholders at the extraordinary general meeting of the company to be held on 12 August.

QWIL has undertaken two tender offers in the preceding 12 months, under which it repurchased for cancellation a total of 7,282,271 ordinary shares. In addition, the company has a policy of buying back its ordinary shares in the market for cancellation.

However, the number of ordinary shares that it has been able to repurchase has been constrained by applicable limits on the number that can be purchased on any particular day and by the price at which they can be repurchased. The shares continue to be priced at a discount to their underlying net asset value, the company notes. In arriving at the maximum number of shares to be repurchased this time around, QWIL's board has taken account of current market conditions which have increased the volatility surrounding the fair value of the company's portfolio.

Cheyne ABS Opportunities Fund, with the support of its largest investor, Cheyne Special Situations Fund, intends to participate in the tender offer. Cheyne ABS Opportunities Fund is the holder of 17,900,756 ordinary shares, representing approximately 59.3% of the issued ordinary shares.

... while NAV increases for Carador
As at the close of business on 30 June 2008, the unaudited net asset value per share of permacap Carador was €0.6493. This represents an increase in NAV of around 0.48% during the month.

Calculations for June include an estimated €882,452.84 worth of net cash flow interest received in the month (to be allocated between capital and income), which equates to €0.0164 per share.

Regulation Z amended
The US Federal Reserve has amended regulation Z. The most significant change was the new definition of a "higher-cost" loan, according to structured finance analysts at Wachovia Securities.

Under the new definition, any loan with a spread greater than 150bp above the average prime index (FHLMC Composite Rate) is considered to be a "higher-cost" loan. The analysts note that this effectively captures almost all sub-prime loans. "Our analysis suggests that any loan with a FICO score of 660 and lower will most likely fall into this category," they say.

Second, the new rule extends to all mortgage lenders, not just those that are supervised and examined. "The good news is that sub-prime lending is not banned and the underwriting guidelines basically bring this market back to full verification of assets and income. In other words, we are back to hard equity lending rather than collateral-based lending," the analysts conclude.

Upgrade/downgrade ratio continues decline
Fitch says in a new study that European structured finance rating performance remained strong in 2007. However, the upgrade to downgrade ratio has been steadily declining since a peak in 2005.

"Despite the hostile global economic environment in the second half of last year, structured finance ratings performed well, with ABS and RMBS performing above their long-term average. However, downgrades of CDOs exposed to US sub-prime RMBS acted as a drag on the sector," says Rodney Pelletier, md in Fitch's European structured finance group.

"The overall European structured finance sector recorded a 2.4 to one upgrade to downgrade ratio in 2007," adds Charlotte Eady, associate director in the agency's performance analytics team. "This compares to 4.9 to one in 2006 and 16.4 to one in 2005." In 2007, there were 383 upgrades (2006: 366) and 161 downgrades (2006: 83).

Nearly all (99.1%) of investment grade CMBS tranches remained in the same or moved to a higher rating category. This resulted from stable overall markets in the first half of 2007 and a continued stability in the occupational markets in the second half.

ABS was the best-performing sector, with only one downgrade at the modifier level; 100% of its investment-grade observations in 2007 maintained the same or moved to a higher rating category. RMBS performed above its long-term average, with just seven downgrades at the modifier level; 100% of its investment-grade tranches remained the same or moved to a higher rating category, compared to its long-term average of 99.7%. Dutch structured finance bonds (dominated by prime RMBS) were again the strongest performers by country, with no downgrades.

In contrast, the CDO sector performed below its long-term average; 89.5% of investment-grade tranches remained the same or were upgraded to a new rating category, compared to a long-term average of 94.2%.

TRUP CDOs under review
Moody's has placed under review 182 tranches across 72 Trust Preferred (TRUP) CDOs. The review was prompted by the substantial increase in the number of banks that are deferring on their TRUP coupon payments.

Moody's notes that currently there are 31 banks deferring payments, which represent 4% of the underlying collateral held in TRUP CDOs. In addition, three of the 31 banks that are deferring payment have gone into receivership (IndyMac being the latest).

Although banks that are deferring payments can defer such payments for a period of up to five years without being considered a default, each TRUP CDO treats deferring banks as defaulted securities for enhancement level test purposes. While historically most banks that deferred payment in these TRUP CDOs have come back to pay current, Moody's expects that in the current environment more banks deferring payments may eventually default.

Furthermore, in the current environment, the agency anticipates that the future number of banks deferring payments could increase in these TRUP CDOs. It will continue to monitor the potential increase of banks deferring payments, as well as the default rate of the banks.

According to Moody's, a tranche was placed on review if it met one or both of the following criteria:

• The subordination level of a rated TRUP CDO tranche is less than two times the current par amount of bank deferrals in the TRUP CDO;
• The subordination level of a rated TRUP CDO tranche is less than the sum of a) par amount of TRUPS currently deferring, b) the par amount of TRUPS issued by banks that Moody's believes are likely to defer, c) TRUPs issued by REITs and d) bonds or loans issued by homebuilders.

BIS reports on innovations in credit risk transfer
BIS has released a paper that aims to explore the design, prevalence and effectiveness of credit risk transfer (CRT). The focus is on the costs and benefits for the efficiency and stability of the financial system.

After an overview of recent credit risk transfer activity, the following points are discussed: motivations for CRT by banks; risk retention; theories of CDO design; and specialty finance companies. As an illustration of CLO design, an example is provided showing how the credit quality of borrowers can deteriorate if efforts to control their default risks are costly for issuers.

In order to stimulate a productive debate, the report comprises discussions around the following opinions (some of which the BIS acknowledges are speculative and deserve to be the subject of more research):

• CRT makes the distribution of risk among investors more efficient.
• Innovations in the design of CRT securities - especially default swaps, credit derivative product companies, CLOs and specialty finance companies - increase the liquidity of credit markets, lower credit risk premia and offer investors a broader menu of assets and hedging opportunities.
• Even specialists in CDOs are currently ill equipped to measure the risks and fair valuation of tranches that are sensitive to default correlation.
• Loans that are sold or syndicated tend to have better covenant packages; CRT is nevertheless likely to lead to a reduction in the efforts of banks and other loan servicers to mitigate default risk.
• Risk-sensitive regulatory capital requirements improve the incentives for efficient CRT. Financial innovations designed for more efficient credit risk transfer appear to have facilitated a reduction in the degree to which credit is intermediated by banks relative to hedge funds, credit derivative product companies and speciality finance companies.
• While the gross level of credit derivative and CLO activity by banks is high, the available data do not yet provide a clear picture of whether the banking system as a whole is using these CRT instruments to shed a large portion of the total expected losses from defaults on loans originated by banks.

Retaining financial interests analysed
The credit implications of an originator retaining a financial interest in a structured finance transaction vary from transaction to transaction and are generally limited, says Moody's in a new report. The potential credit impact must be assessed in the context of the interests of all parties and the details of the transaction. In addition, the impact may change over time.

"The presence or absence of a retained interest, in and of itself, generally has a limited impact on ratings," says Moody's team md David Teicher, one author of the report. "This is the case not only because the potential credit impact of a retained interest can be either positive or negative, but also because of the originator's other incentives, such as wanting to maintain its reputation through positive performance."

An originator, servicer or collateral manager may retain an interest in the pool of assets underlying a transaction, typically the most junior or equity tranche, says Moody's. This investment may or may not more closely align the interests of such parties to those of the senior tranche investors.

In general, these interests are aligned when asset performance is strong, but are more likely to diverge when performance is weak. In these circumstances, the originator might have an incentive to maximise cashflow to the tranche that it retains, thus reducing the cashflow or credit protection that may be available to the more senior tranches.

"Across transaction types, the interests of an originator holding a retained junior interest may conflict with those of holders of more senior classes, should the assets backing the transaction perform poorly," says Teicher. "If such a situation occurs, the holding of a retained interest may become a negative factor for the outstanding ratings on the senior notes."

Other considerations for credit quality include whether the originator has the ability to sell its retained interest, or whether its financial interest is hedged, limiting the originator's concerns over financial performance.

Moody's new Assumption Volatility Scores for structured products, which are due to be introduced this quarter, will include a sub-component that addresses 'Alignment of Interests'. These scores will consider not only whether an economic interest is retained by the originator, but additional indicators of alignment such as the originator's history of honouring representations and warranties and the importance of the transaction to the originator's funding strategy.

GFI launches Webview
GFI Group has launched CreditMatch Webview - a light version of CreditMatch, its electronic trading platform for bonds and credit derivatives. CreditMatch Webview provides non-interactive access to CreditMatch via web browsers and internet-enabled mobile devices.

"GFI's brokerage clients want to be able to view the credit markets other than solely through CreditMatch's desk top application and CreditMatch Webview delivers exactly this: access anywhere for CreditMatch clients", says Matt Woodhams, Webview's chief engineer. "Its availability on mobile devices anywhere significantly increases its value for people on the move."

CreditMatch Webview will be rolled out first in the Asia-Pacific region.

ASF launches Project RESTART
The American Securitization Forum (ASF) has launched its Project on Residential Securitisation Transparency and Reporting (RESTART) to restore investor confidence in mortgage- and asset-backed securities. Restoring this confidence and thereby restoring over time institutional investor capital to the securitisation markets should ultimately increase the supply and lower the cost of mortgage and consumer credit in the US.

The Project has sought to identify areas of improvement in the process of securitisation and refashion, in a comprehensive and integrated format, the critical aspects of securitisation with market-based solutions and expectations. Each of the Project's phases has been sequenced to be developed and released for comment throughout the remainder of 2008 for implementation at specific recommended times in 2009. Although the initial focus of the Project has been on the private-label RMBS market, similar efforts are expected to be pursued in other major asset classes, such as student loan, credit card and auto ABS.

In addition to announcing the broad direction of each of the phases of Project RESTART, the ASF has also released the first major deliverable of the Project - a request for comment on granular recommendations of an ASF RMBS Disclosure Package. Although principle-based topics of transparency, disclosure and diligence have played a critical role in the Project's discussions over the course of the past year, the request for comment on the ASF RMBS Disclosure Package reflects the Project's intense focus on developing specific and detailed market standards and practices that, through market-imposed incentives, will likely result in widespread implementation by applicable industry participants.

Throughout the autumn of 2007, a number of market participants began meeting in earnest under the auspices of the ASF to explore market challenges and identify areas of improvement, beginning the process of developing specific market-based consensus solutions in those areas. In particular, there has been unprecedented industry attention on transparency and disclosure in mortgage-backed transactions and the processes, controls and procedures associated with these transactions. In February 2008 at ASF's annual industry conference, a broad-based group of ASF members comprised of critical transaction parties came together to develop the core concepts and objectives of Project RESTART.

CS & AC

Equity versus debt: which is Prom Queen?

Who is financing the bailout game is discussed by Jochen Felsenheimer and Philip Gisdakis of UniCredit's credit strategy & structured credit research

Bear Stearns was the first warning signal for shareholders, while the latest bailout news surrounding the GSEs is supporting this view: the bailout will be financed by the shareholder. This makes the shareholder (besides the taxpayer) the major loser of the sub-prime meltdown. However, what does this mean for credit?

The potential (since not finally approved) Freddie and Fannie rescue actions will have two effects on credit:

• The direct impact on credit is positive, as reflected in the strong tightening of iTraxx indices last Monday. However, the wisdom that monetary authorities will protect the senior bondholder by all means is clear since the Bear Stearns bailout and, hence, has no fresh impulse. In the end, the impact will be sentiment-driven rather than a fundamental one.
• The indirect impact on credit via improved sentiment/declining risk aversion is, at first glance, positive in the short term. The rescue plan reduces fears of an immediate liquidity squeeze of the GSEs, but it does not remove medium- to long-term capitalisation fears, which are closely linked to the development of the US housing market.

The crucial question is: how long will a potential bear market rally last? On the one hand, credit proved to be a very good indicator for turning points in the market, while a pronounced drop in stock markets will bring equities back into the leading position. Credit will not be able to withstand rising pressure from this side. However, what will be the impact on credit if we enter a prolonged 'bailout period', i.e. the Fed (or other central banks) are forced to rescue more and more players in the financial universe due to ongoing liquidity and capitalisation pressure?

A prolonged bailout scenario is obviously a burden for risky asset classes as a whole, especially if we assume that not 100% of the costs can be passed on to the shareholder only. Finally, such a scenario would most likely result in a problem that does not leave the upper part of the capital structure unaffected. How likely is such a scenario?

We still think that credit markets will remain in a long-lasting bear market. Nevertheless, we do not think that there will be a final shoot-out soon (followed by a long lasting recovery).

We expect the bear market to be interrupted by recovery and stabilisation phases, while the problems we have seen for quite a while will continue to pop up in an irregular manner. We do not think that the bailout discussion will find an end soon and we would not be surprised if it remains a topic going into 2009.

This depends on the success of measures implemented to stop the US housing slump. If these measures prove less efficient than anticipated, the risk that we see further bailout-like actions increases strongly.

Where we stand in the equity-debt cycle
To know where we are in the equity-debt cycle is crucial to identifyng the leader and the imitator. Correlation patterns between equities and credits changed fairly often since the start of the sub-prime crisis. This is a pretty normal correlation pattern between both asset classes during times of crises.

The latest underperformance of stocks is underpinned by the course of the crisis but also by the backlog stocks we have had versus credits in 2007. While we do not expect equity and debt to head in the opposite direction in the short term, credit has proved to be the better indicator of turning points.

Relative performance of the DAX versus the iTraxx X-Over
When the sub-prime crisis started in summer 2007, credit spreads reacted immediately, while equity markets remained almost unimpressed. Many global stock indices reached fresh highs in the course of H207, while credit continuously remained under pressure.

In Q108 equities also lost ground and credit spreads overshot, reaching all-time highs in the synthetic universe. However, this overshooting was driven by many technical factors, like hedging activities from correlation desks and forced selling out of the structured credit universe.

That said, this short-term decoupling in March 2008 was driven by technicals rather than by a fundamental reason. Since then, equities underperformed credits, which was especially true during April and May.

Comparing DAX and iTraxx Crossover levels, it appears that since the surfacing of credit concerns, credits underperformed equities (see left-hand chart below). This contradicts the 'felt' relative performance as equity markets hit fresh lows while credits held up pretty well (see right-hand chart below, the iTraxx trades 'only' at 80% of the recent peak level, while the DAX is already below the March low).

However, the iTraxx widened from 390bp in May to above 560bp in the first week of July. At the same time, equities lost 'only' around -15% (DAX). Hence, our indicator shows an underperformance of credits since then.

We think the last crisis in 2001/2002 should prove to be a good indicator for the equity-debt decoupling during a crisis, although the course of the current crisis is exactly the opposite of what we have seen some years ago (2001/02: balance sheet leverage; hitting the banking system; spilling over into the real economy). However, credit spreads peaked in October 2002, while European stock markets reached the bottom in March 2003. We expect this pattern to repeat itself during this crisis (although we do not expect it soon).

Also in 2008 so far, credit has been the better indicator. That said, another significant downward leg in global equity markets will not leave credit unimpressed, but a lasting turning point will, in our view, be reflected in credit spreads first. Good news for stock markets; bad news for credits.

Volatility of stock markets ...
The recent deterioration in global markets hit stocks (volatility-wise) significantly more than credits. With stock indices jumping up and down and showing several 2% moves per day, one can really feel the current vulnerability of global markets.

With the implied volatility in the S&P 500 (measured by the VIX index) reaching the 28% level, markets seem to confirm this. However, current 30-day historic volatility is not very high (below 20%) compared to the level during the Bear Stearns bailout in mid-March (at almost 30%). Also, the implied volatility was higher (above 32%) a few months ago.

However, comparing the time series of the 30-day historic volatility with the implied one, we find that the historical one tends to be below the implied one. Nevertheless, with both time series recently spiking to the 30% area, we can see below that this is quite an exceptional situation.

In the right-hand chart below, we show a histogram of the 30-day historic volatility (annualised) of the S&P 500 since 1970. According to this histogram, the volatility bucket with the highest frequency over the last 38 years has been 12%.

However, on only 250 trading days out of almost 9700 since 1970, one could measure a 30-day historic volatility higher than 30%. That corresponds to only 2.5% of all trading days since 1970 (see also the cumulated function in the right-hand chart below on the lower x-axis).

These quite rare days include 19 October 1987 (Black Monday), on which the S&P 500 dropped by more than 20%. This means that - at least measured by 30-day historic volatility - the worst housing crisis since the Great Depression (as it is sometimes called in the press) has not yet lead to extreme spikes in volatility.

Nevertheless, a historic volatility of 30% corresponds to two times the standard deviation away from the average historic volatility of 14%. Such a two-sigma level was reached only eight times in history, including five times during the technology boom and bust period between 1997 and 2002. There had been 4-5 three-sigma events and two four-sigma events (including autumn 2002, which was the turning point in the technology crisis), while Black Monday corresponds to a nine-sigma event in this measure (stock market returns are clearly not normally distributed).

... and of sentiment of stock investors
But how does this volatility affect investors' sentiment? We refer to two classical indicators of sentiment: the AAII (American Association of Individual Investors) Bull/Bear survey and the Put/Call ratio.

With a current bull/bear ratio of lower than -31% (i.e. bear exceeds bull by more than 31%), this index has stood at two sigma since 1987. There have been only 12 surveys out of almost 1100 surveys (about 1%) since 1987 which show a more bearish sentiment. This includes March this year, July 2007, 2003, 1992 and 1990.

Typically, such a weak bull/bear ratio is seen as a technical buying signal. However, this time it appears to reflect more the bleak economic outlook.

The put/call ratio shows a similar picture at the moment. The figure is standing above two sigma, while on 17 March 2008 it was at five sigma.

With put/call ratios at around 0.9, there have only been about 90 occurrences from a total of 2900 (about 3%) since 1987 where the put/call ratio had been higher. All three indicators suggest that the current situation appears to be quite exceptional.

On the other hand, investors have also seen much more shaky phases in the last decades. However, this leaves some room for a further deterioration, when the 'worst housing crisis since the Great Depression' fully impacts the global economy.

© 2008 UniCredit Markets & Investment Banking. All rights reserved. This Research Note is an extract from Structured Credit Update, first published by UniCredit on 15 July.

Trading ideas: great expectations

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at a long/short trade on CDX Series 9 seven-year 7%-10% tranche versus 10%-15% tranche

The recent credit market turmoil caused significant shifts in risk allocation in the standardised tranche market. Equity correlations have risen to all-time highs.

We like finding hidden opportunities during such times, as extreme volatility lends itself to relative mispricings. We use our skew fair-value model to spot such trades.

We recommend selling US$10m protection on the CDX IG9 7Y 7%-10% tranche and buying US$17m protection on the CDX IG9 seven-year 10%-15% tranche. The trade looks to profit from a divergence in the tranche's base correlation skews. Overall, the trade is flat delta, flat correlation and positive carry.

This is a technical trade and does not take an outright fundamental view. Historical payouts for the trade exhibit a straddle-like payoff and therefore we believe the trade's expected value is positively skewed.

Skewed behaviour
In order to choose the best tranches to find relative value, we turned to the skew fair-value model to point us in the right direction. The model takes a z-score of the base correlation skew for all tranches as a way to find potential mispricings. The output is highly sensitive to the data sample and therefore we have restricted the set to include only data points since early November 2007, as this is when we believe the correlation market entered a new regime.

The base correlation skews for the seven-year 7%-10% and 10%-15% tranches have diverged from one another in recent weeks, pushing the differential close to this year's widest level (Exhibit 1). Though it's hard to gauge when to step in and go against the flow, we think this divergence has been overdone and now is a good time to short 10%-15% and buy the 7%-10%.

Exhibit 1

The skew FV model looks to take advantage of the mean-reverting behaviour of the base correlation skew. While each tranche has varying sensitivity to the absolute level of the base correlation, they also have a different sensitivity to the skew or the slope of the base correlation curve.

The base correlation skew for a tranche is equal to the difference of the detachment correlation and the attachment correlation. Generally, mezzanine tranches have the greatest sensitivity to correlation skew.

Base correlation skews provide another good way to identify potential relative value opportunities. For instance, if the skew is too flat for the 10-year 3%-7% tranche relative to the seven-year 3%-7% tranche, this could be an opportunity to go long the 10-year tranche and short the seven-year, as the 10-year tranche is undervalued relative to the seven-year.

After running the z-scores for all the CDX tranches, the two tranches come out as the best relative value trade opportunity across the capital structure. With a z-score of 0.6, the base correlation skew of the 10%-15% is steeper than what we have seen in recent past. Exhibit 1 demonstrates visually how the skew has steepened over the past few weeks.

The opposite is true for the 10-year 7%-10% tranche. The 7%-10% skew has flattened as indicated its z-sore of -0.6. Although in their own right each would not be efficient tranches to trade against the index, when combined as a relative value trade the recent divergence of skews has created a significant technical opportunity.

Positive expectations
We like to look at historical carry positions for a trade as a way to get a sense of the potential payoff structure. Exhibit 2 is a graph of the historical carry positions plotted against the index reference spread. If recent history has any bearing on the future (which it very well may not), the future profit potential of the position exhibits a straddle-like payoff.

Exhibit 2

What we mean is that regardless of the direction of the overall credit market, the trade will profit if there is a decent sized index move either way. The biggest risk to this trade is if the past relationship between the two tranches breaks down.

We don't think this is likely, but still consider it a possibility as we are in uncharted territory in the correlation market. Exhibit 3 shows the time series of the carry position and provides a sense of its historical performance. Clearly we are entering the trade near a recent bottom.

Exhibit 3

Risk analysis
A long seven-year 7%-10% tranche is slightly long correlation and long skew. For a 1% increase in the skew, this leg will have a positive P&L of around US$112,000 (see Exhibit 4). The short 10%-15% position is slightly short correlation and has a significant negative skew position of US$125,000 per skew %.

Exhibit 4

The overall delta position of the trade is flat, as the unequal notional weighting hedges the exposure. The biggest risk to the trade is a continuation of the diverging base correlation skews.

Liquidity
The liquidity of the CDX tranches has returned; however, during 'illiquid' times the tranche bid-offer spreads widened out considerably to 10bp-20bp.

Fundamentals
This trade is not based on fundamentals and if we continue to see increased credit volatility, we believe this trade will outperform.

Summary and trade recommendation
The recent credit market turmoil caused significant shifts in risk allocation in the standardised tranche market. Equity correlations have risen to all-time highs.

We like finding hidden opportunities during such times, as extreme volatility lends itself to relative mispricings. We use our skew fair-value model to spot such trades.

We recommend selling US$10m protection on the CDX IG9 seven-year 7%-10% tranche and buying US$17m protection on the CDX IG9 seven-year 10%-15% tranche. The trade looks to profit from a divergence in the tranche's base correlation skews.

Overall, the trade is flat delta, flat correlation and positive carry. This is a technical trade and does not take an outright fundamental view. Historical payouts for the trade exhibit a straddle-like payoff and therefore we believe the trade's expected value is positively skewed.

Sell US$10m notional CDX Series 9 7Y 7%-10% tranche protection at 367bp.

Buy US$17m notional CDX Series 9 7Y 10%-15% at 189bp to receive 45.7bp in 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).