Contents

Evolutionary step

Operational goals set for CDS industry

The Operations Management Group (OMG) of 17 dealers, buy-side representatives and industry associations last week communicated in an open letter to New York Fed president Timothy Geithner its latest objectives for improving the operational infrastructure for CDS. The aim is to create an OTC derivatives processing environment that handles growing trade volumes without material systemic risk.

The operational goals set out in the letter represent an evolutionary step for the credit derivatives industry and another example of how it consistently raises the bar, according to Mark Beeston, president of T-Zero. "The targets are measurable and realistic, providing the industry with the means to move forward and become even more efficient," he adds.

The New York Fed welcomed the announcement, pointing out that the move represents the most comprehensive effort to date by major dealers and buy-side firms to improve the resiliency of the OTC derivatives market. The OMG's commitments focus on: improving trade matching to reduce counterparty credit exposures and operational risk (see News Round-up for more on this); creating a central counterparty to help reduce systemic risk associated with counterparty credit exposure and improve how the failure of a major participant would be addressed (see SCI issue 85); and hardwiring the CDS auction mechanism into the ISDA Credit Derivatives Definitions to increase the certainty of a transparent and orderly settlement process following a credit event.

ISDA plans to publish by 31 December an Auction Supplement to the Credit Derivative Definitions that applies the existing settlement auction methodology to the credit events and reference entities for most types of trades, as well as administer a protocol to bring existing trades of these types onto the new standard. The group will initially focus on an Auction Supplement that addresses failure to pay and bankruptcy credit events in respect of North American and European corporates, leaving restructuring credit events to be addressed at a later date. A separate working group is also addressing the settlement of potential monoline defaults.

One source suggests that the decision to tackle restructuring at a later date is due to the belief that Europe needs more time to get comfortable with the auction mechanism, given that European dealers trade on a different restructuring protocol to US dealers and such a credit event has yet to be tested in Europe. It is understood that the aim is to hardwire a single definition for restructuring, but include some optionality as to which version of the protocol is traded.

The Auction Supplement will be published concurrently with what is being described as a 'big bang' protocol to allow all market participants to amend their existing CDS trades in favour of the auction mechanism. ISDA has committed to circulate the first public draft of the Auction Supplement in August and the first public draft of the protocol in September.

"These efforts are consistent with ISDA's primary purpose, to encourage the prudent and efficient development of the privately negotiated derivatives business via the continued standardisation of documentation, promotion of sound risk management practices and education of the marketplace," explains Robert Pickel, executive director and ceo of ISDA.

The letter also confirms that dealers aim to establish a CDS central counterparty for index, single name and index tranche products. Each dealer in the OMG has committed to support the clearing platform and use it to clear all eligible products where practicable. Work continues on preparing the infrastructure to meet collateral, dispute resolution and operational requirements in compliance with BIS recommendations, but US CDS index products are expected to launch by year-end and expansion to other products to begin in 2009.

CS

Swapping names

Substantial change in constituents expected in new iTraxx roll

Speculation is already mounting as to which constituents could potentially enter or exit the European iTraxx indices in September, when the new series is due to roll. Structured credit practitioners are expecting higher than usual changes in all Series 10 sub-indices, provided that the roll happens at levels and ratings consistent with those seen currently.

"Assuming that the roll happens at today's ratings and levels, we could still see radical changes at the formal start of the membership determination process," says Mahesh Bhimalingam, European high yield strategist at Barclays Capital. "We believe that investors should be aware of any such changes, as names dropping out or entering an index - and particularly those experiencing cross-index migration - could be subject to powerful technicals."

In a report speculating on future constituents of the iTraxx indices, analysts at Barclays Capital suggest that a number of names are likely to leave or join the Main, Crossover and HiVol indices on 20 September. Constituents likely to leave the iTraxx Main include DSG International, given that its rating has moved below the eligibility threshold of Baa3/BBB; Reuters Group, which has experienced a sharp drop in liquidity following the merger earlier this year with Thomson and may not be eligible under the new combined entity; and GDF and/or Suez Energy (now GDF Suez). As a result of the merger, it is likely that only the more liquid of the two CDS contracts will be allowed in the iTraxx Main, if liquidity criteria are met.

A further five names are currently on the cusp of being ineligible for the Main index, notes Bhimalingham - Casino, PPR, Sainsbury, Rentokil, Clariant and Rexam all have the lowest rating of Baa3/BBB- with a stable outlook. However, BarCap analysts doubt that their outlook will be changed to negative ahead of the roll, therefore making them ineligible.

Only DSG is expected to migrate from the Main to the Crossover index, while CIR could potentially move from the Crossover to the Main or HiVol, Bhimalingam suggests. CIR is triple-B minus rated and its negative outlook has been changed from negative to stable - implying it would have to leave the Crossover.

Those constituents tipped to leave the HiVol include DSG (following the rating-based exclusion from the Main); Kelda, given its low current spread (in relation to the remaining non-financial names in the Series 9 Main); and Svenska Cellulosa, again due to its low spread. Meanwhile, those names potentially entering the index include Lufthansa and Volkswagen Autos, due to their high spreads.

The Crossover index has scope for a substantial number of changes, says Bhingalingam. At current levels and ratings, he expects British Energy, CIR, Degussa, FKI, NXP, Lyondell Basell and ONO to leave the index. Meanwhile, Corus, DSG, Fresenius, Heidelberg Cement, Pernod Ricard, Prosieben and Sol Melia could potentially enter the index.

AC

Volatility rising

Spanish SME CLO performance remains within expectations

As the Spanish real estate and construction industries brace themselves for further deterioration, market participants are predicting volatile times ahead for the performance and ratings of SME CLOs from the region. Yet transaction performance recorded so far has prompted others to suggest that current negative trends are within initial expectations.

Fitch reports an increasing trend in 90-day plus delinquencies, although it confirms that levels have not spiked. "While we view the trend as concerning, absolute levels are still within initial expectations," says Rui Pereira, md and head of Fitch's structured finance office in Madrid.

Michel Savoye, analyst at Moody's, has also noticed an increase in arrears in many Spanish SME CLOs. But he adds that a corresponding increase in defaults has not occurred yet as the default definition is rather long (between 12 and 18 months).

The influx of new Spanish SME CLOs continues at a healthy rate, however, with the issuing banks retaining such deals for use with the ECB's repo facility. Despite the heavy concentration of real estate exposure in many of the transactions, they are not exhibiting significant changes in structure or in collateral composition, given the negative outlook for the referenced sectors. However, analysts suggest that the deals are being altered gradually to cope with the deteriorating conditions.

"Recent transactions have not shown a material change in portfolio composition - banks are looking to securitise SME loans on their balance sheets and the real estate and construction sectors make up a large proportion of this currently," says Jeffery Cromartie, senior director at Fitch. "However, more recent transactions are showing higher levels of initial credit enhancement than witnessed in 2007."

Savoye adds that he has not noticed a significant change in the structures of Spanish SME CLOs, as historically the transactions have been conservatively structured. "However, there has been a reduction in exposure to real estate developers in the deals' portfolios," he notes.

According to Ganesh Rajendra, head of securitisation research at Deutsche Bank, Spanish SME CLOs can have construction/real estate concentrations ranging anywhere from 16% to 60% and on average at around 30%.

Before 2007, such transactions were one of the best performing CDO sectors, with high amortisation rates, low delinquencies and numerous upgrades driven by deleveraging. But since last year the rate of portfolio amortisation and resulting de-leveraging has slowed, and delinquencies have risen. According to Pereira, there were no upgrades of Spanish SME CLOs in 2007 and in 2008 Fitch started placing select tranches on outlook negative.

Fitch has assigned its outlook negative status to 18 classes issued from 14 transactions, which are primarily assigned to subordinated tranches from 2006-2007 vintage deals. Both Fitch and Moody's maintain their negative outlook for the sector, although few - if any - of the deals have yet been downgraded.

AC

CDO structurer joins prime brokerage

The latest company and people moves

CDO structurer joins prime brokerage
Mohit Agarwal, formerly of UBS' CDO structuring team, has joined Deutsche Bank where he is product manager in the fixed income prime brokerage team in London. Before joining UBS, Agarwal worked at JPMorgan as a cash and synthetic CDO structurer in the European CDO group.

Ex-CDO co-head re-emerges
Nestor Dominguez and Scott Logie have joined Carlson Capital, where they are understood to be setting up a structured credit business. Dominguez was formerly co-head of CDOs at Citi in New York, having left the bank in November last year alongside Michael Raynes, head of structured credit. Logie was previously head of fixed income trading at Keefe, Bruyette & Woods.

Trading head departs
Fiachra O'Driscoll, md in the fixed income department at Credit Suisse, has reportedly left the bank. While at CS, O'Driscoll headed the synthetic CDO trading desk.

CDPC to dissolve
London Diversified Fund Management is to dissolve Satago Financial Products, the CDPC it set up in June 2007 (see SCI issue 45). Amid challenging conditions for such companies, Moody's points out that Satago has no outstanding CDS trades or rated notes.

The agency has withdrawn the Aaa counterparty rating it assigned to Satago, as well as its provisional rating of (P)Aaa assigned to the Deferrable Interest Auction Rate Notes due 2047 and the provisional rating of (P)Aa3 assigned to the Deferrable Interest Preferred Perpetual Auction Rate Notes. Moody's confirms that these actions follow "a request by the directors of Satago that all outstanding ratings be withdrawn, as the company no longer intends to pursue this line of business".

Satago was incorporated for the purpose of buying and selling CDS protection on senior tranches of synthetic CDOs. It was tipped to become the first European CDPC, along with Channel Capital.

Buchta to lead investment strategies group
Guggenheim Capital Markets has hired Scott Buchta as head of a new Investment Strategies Group. Buchta, who led the mortgage products group at Bear Stearns, has experience in portfolio strategies, structured transactions, relative value trade analysis and applied research. The group will be based in GCM's Chicago office.

Kaye Scholer adds structured finance partner
Kaye Scholer has appointed Madeleine Tan to its corporate & finance department as a partner in its New York office. Tan has experience in asset-backed, tax-advantaged and structured finance transactions, including securitisation, derivatives and leveraged leasing. She joins Kaye Scholer from Brown Rudnick, where she was a partner in the structured finance group and the climate and energy group.

In addition, Tan advises corporations, financial institutions, specialised funds and the trading community on the financing of alternative energy projects, and derivatives and structured products. Her focus has been on securitisations of alternative asset classes, including legal fee receivables, illiquid assets and royalties.

Gordian clarifies Sigma status
Gordian Knot has refuted press speculation about a potential creditors' meeting for Sigma Finance. The manager confirms that it "has not been approached by any investor seeking to form a creditors' group, nor has it been approached by any third party professional adviser claiming to represent such a group". It says it is in regular contact with most investors in Sigma and encourages all investors to maintain this direct dialogue as part of its normal operating practices.

In a statement, Gordian stresses that Sigma is solvent and both the SIV's senior debt and capital notes continue to be paid in full and on a timely basis. Sigma has repaid all of its commercial paper over the past twelve months (US$11.1bn) and so has no commercial paper outstanding in either the USCP or ECP markets. In total Sigma has repaid US$48bn of senior debt in the past year (including US$5bn of debt issued during the year) versus US$52bn outstanding a year ago.

The managers has succeeded in arranging US$16bn of repo funding for Sigma's assets and continues to work to secure additional lines to facilitate the repayment of remaining liabilities. As of today, US$2.95bn of medium-term notes are due to be repaid by 30 September 2008.

Gordian continues to provide detailed disclosure on Sigma in the form of its annual and quarterly accounts. Accounts are supplemented by Sigma's monthly business report, which is prepared and distributed in the same manner as it has been since Sigma launched in 1995. The level and frequency of disclosure to investors and counterparties is in excess of that required of or provided by most banks and financial institutions, and the details in and explanatory notes for the monthly business report have been expanded over the life of Sigma, the manager concludes.

New ESF chairs appointed
Cecilia Tarrant, md and European head of agency CMBS and consumer securitisation at Morgan Stanley, has been elected chair of the ESF for 2008. Mark Hickey, md and head of financial institution debt capital markets at RBS, has been appointed vice-chair for 2008, and chair for 2009.

GFI injunction denied ...
GFI's application for a preliminary injunction against Tradition Asiel Securities and former employees of GFI has been denied by the Supreme Court of the State of New York. In denying the injunction request, the Court reasoned that because GFI's customers did not stop doing credit derivative business with GFI and GFI had filled a number of the credit brokerage positions, GFI was not irreparably harmed by its some of its staff joining its competitor (see SCI issue 85). The Court further ruled that the damages GFI sustained due to Tradition's actions are calculable and can be determined in future proceedings.

GFI says that, while it is disappointed by the Court's ruling, the company will vigorously defend its legal rights and proceed with its claims for monetary damages against Tradition, former employees and others responsible for the wrongdoing. It is also considering its grounds for appeal.

GFI further stated that it has substantially re-staffed a significant portion of its North American credit products team with experienced individuals led by Jim Higgins, a former co-head of global credit trading at Citi. The Court's ruling does not alter the rebuilding efforts of GFI's credit operations, which have been underway since April.

... while talks over merger continue
Tullett Prebon has confirmed that it is in discussions regarding a possible merger with GFI Group. However, according to a statement, discussions are at an early stage and there can be no certainty that they will result in a transaction.

Fund administrators merge
Hedge fund administrator Fulcrum Group and Butterfield Fund Services (BFS) have agreed to merge the two businesses to create Butterfield Fulcrum Group (BFG), subject to regulatory and governmental approvals. Headquartered in Bermuda, BFG will have approximately 400 employees in 10 locations across nine countries.

The firm will have close to US$100bn in assets under administration from nearly 1,000 hedge funds, fund of funds, private equity and institutional investment management clients. BFG is expected to rank amongst the top 10 independent alternative asset fund administration companies in the world.

"This is an enormous win-win for both companies that will leverage sales and operational capabilities of Fulcrum Group, and the tremendous customer relationships and global reputation of Butterfield Bank Group," comments Akshaya Bhargava, Fulcrum Group ceo. "Our vision is to create the best fund administration company in the world."

Alan Thompson, president and ceo of Butterfield, adds: "We believe that the merger of these two highly successful businesses will result in significant business growth, more services for fund administration customers and career opportunities for employees. In BFG, Butterfield and Fulcrum are creating a company that will have a powerful presence in fund administration globally."

Bhargava will become the ceo of BFG and Jill Considine, current chairman of the Fulcrum Group, will be the chairman of the BFG Board. Thompson and Graham Brooks, evp, international at Butterfield, will also join the BFG Board. Merrill Lynch acted as a third-party adviser to Fulcrum Group on the agreement, while UBS advised Butterfield.

MacNaughton joins Primus board
Primus Guaranty has appointed James MacNaughton to its board of directors. MacNaughton was elected as a Class 1 director with a term expiring in 2010 and will serve on the board's Audit and Finance and Investment Committees.

MacNaughton most recently held positions at Rothschild, working as md and global partner from 2001 to 2007, and then as a senior advisor until March 2008. Prior to that he spent over 20 years at Salomon Brothers, during which time he held a variety of positions, including md in investment banking.

Numerix partners with Pyxis
NumeriX has announced a partnership with Pyxis Systems, a provider of technology solutions and services to the global financial derivatives industry. This groundbreaking partnership will expand integration and support services for NumeriX customers throughout the Asia Pacific region.

Through the partnership with Pyxis, NumeriX customers in India and Southeast Asia will have enhanced regional support for training, integration and professional services, including system and market data integration. Additionally, clients will have the ability to work with the NumeriX-certified staff of Pyxis to design and develop new instrument types and add-ins for NumeriX's Excel-based offering, NumeriX 7.

"With the explosive growth of the derivative and structured products markets, as evidenced by the opening of new markets in the region, coupled with the need to manage and navigate the troubled credit markets, there has been a significant increase in demand for NumeriX analytics," comments NumeriX president and coo Steven O'Hanlon. "Through our partnership with Pyxis, NumeriX now offers the largest support infrastructure of any analytics provider in the region."

Pyxis is working with several large financial institutions to set up derivatives desk frameworks, implement derivatives systems, provide professional services and develop custom applications for front- and mid-office analytics.

AC & CS

Strategic roadmap released

A round up of this week's structured credit news

Strategic roadmap released
The dealers and buy-side institutions represented in the Operations Management Group (OMG) have committed to achieving derivative processing scalability through electronic matching on trade date, backlog reductions and by partnering with electronic service providers to optimise the use and development of electronic services. The Group also renewed its commitment to central clearing and auction hardwiring for CDS (see separate news story).

The OMG last week sent a letter to the New York Fed outlining its major 2008 and 2009 operational goals. With respect to electronic matching, these goals include:

• Strategic roadmap: by 31 October 2008 the participants in the credit steering committee (CSC) commit to deliver the strategic roadmap to achieve confirmation matching of electronically eligible trades on trade date. The roadmap will identify and agree upon the processes to facilitate this objective. The roadmap will include major milestones to the realisation of this goal and the timeframes for reaching each milestone.
• Matching/submission rates: by 31 December 2008 participants in the OMG commit to improve the prior DTCC matching and submission targets from (i) 90% to 92% submission to DTCC on T+1, (ii) 90% to 92% matching at DTCC without modification, and (iii) 92% to 95% matching at DTCC by T+5.
• Aged outstanding confirmations: major dealers have committed to a more aggressive target, whereby unconfirmed confirmations aged more than 30 calendar days are not to exceed one business day of trading volume based on average daily volume in February, March and April 2008.
• Electronic novation consent processing: by 31 December 2008 all market participants will be required to submit and manage novation requests for electronically eligible trades via electronic processing platforms and comply with their firm commitment under the ISDA Novation Protocol to processing requests only on the day consent is granted. After this date dealers will not consent to proposed novations where the request is sent via email. Where possible, dealers will utilise trade records contained in the Trade Information Warehouse.
• Trade compression: the methodology for compressing dealers' offsetting portfolios has been established by the CSC. A joint venture between Markit and Creditex will facilitate the compression process, which will commence this month and proceed on a continuous sector-by-sector basis. Results will be shared with supervisors.
• Index product compressions: aggressive index tear-up cycles continue. These cycles are now occurring quarterly rather than bi-annually.
• Single name compressions: dealers have developed a new process to achieve single name trade compression. Existing single-name trades will be compressed into two trades (a plain-vanilla CDS with a coupon determined by a weighted average of the coupons of and a net notional of the compressed trades, and an interest only swap (in effect, a fixed recovery swap with a recovery of 100%).

By 31 December dealers have also committed to implement with one another the provisions of the ISDA Best Practice Guidance for Collateralised Portfolio Reconciliation Between Derivative Market Professionals. The four principal elements of this guidance state that:

• Portfolios of OTC derivatives documented under an ISDA Master Agreement and Credit Support Annex will be subject to weekly portfolio reconciliation (with transitional arrangements where a weekly frequency is not immediately practical)
• Firms will have adequate resources to identify and resolve portfolio differences on a timely basis
• Escalation procedures for material differences will be maintained within each firm and, where necessary, prompt communication between the management of counterparty firms will occur
• Firms will collect and report metrics to supervisors.

In addition, ISDA's board of directors has established a working group to review the margin dispute resolution language and practices in common use across the derivative market, as well as to recommend alternative and improved approaches. The Association will work towards completion of the effort by 30 April 2009.

Underlining the progress the industry has already made with respect to CDS processing, both T-Zero and TriOptima released some encouraging figures this week. T-Zero says its clients have exceeded the OMG targets for T+5 matching of 95% of DTCC Warehouse-eligible CDS trades and 92% of trades submitted to DTCC to be submitted without amendment.

Meanwhile, TriOptima estimates that it regularly reconciles 40% of all OTC derivative transactions globally through its triResolve portfolio reconciliation service. Currently seven million live trades (double counted) representing more than 500 relationships are regularly reconciled on triResolve, up from four million trades at end-2007 - a 75% increase in reconciled trades.

The firm also says its portfolio compression service, triReduce, has terminated US$17.8trn notional principal in CDS swaps year-to-date. This represents more than 50% of the US$32trn total interdealer CDS notional principal outstandings as reported by the BIS for year-end 2007.

Ambac settles CDO exposure
Ambac has settled one of its largest CDO exposures, AA Bespoke, in exchange for a final cash payment of US$850m to its sole counterparty Citi. The US$1.4bn transaction originally comprised double-A rated ABS CDO tranches, most of which have been downgraded to below investment grade since the inception of the transaction.

Analysts suggest that it was probably reasonably easy for Ambac and Citi to find some middle ground on this transaction, given that both sides recognise that the underlying CDO had relatively little value. They note that such activity has the potential to reduce the technical demand for monoline protection, prompting CDS to tighten, as banks reduce their net exposure to the sector.

As of 31 March 2008, Ambac had recorded approximately US$1bn of mark-to-market losses - including an impairment loss of US$789m - against this transaction. As a result of the settlement, the monoline expects to record a positive pre-tax adjustment of approximately US$150m to its aggregate mark-to-market. In addition, the stress case losses in the rating agency capital models for this transaction exceeded Ambac's final payment and therefore the settlement will result in an improved excess capital position for Ambac Assurance Corp.

Michael Callen, Ambac chairman and ceo, states: "The primary benefit of this agreement is that it eliminates uncertainty with respect to future losses related to this transaction. We view the final outcome as favourable in light of the numerous widely-circulated models that assumed a 100% write-off for this transaction. This settlement also confirms our view that transaction mark-to-market adjustments are not indicative of ultimate credit impairment."

Callen adds: "This is an important milestone in our efforts to work with counterparties as we evaluate settlement, as well as other restructuring opportunities related to our CDO exposures."

Ambac is the second monoline to commute a portion of its CDS exposure, following SCA (see last week's issue).

EC consults on CRAs ...
The European Commission has published two consultation documents on credit rating agencies (CRAs), seeking views from all interested parties by 5 September. The first document relates to the conditions for the authorisation, operation and supervision of credit rating agencies. The second proposes policy options in order to tackle what is felt to be an excessive reliance on ratings in EU legislation.

European Commissioner for Internal Market and Services Charlie McCreevy says: "I am convinced, like others in Europe, of the need to legislate in this area at EU level. CRAs will have to comply with exacting regulatory requirements to make sure ratings are not tainted by the conflicts of interest inherent to the ratings business. The crisis has shown that self-regulation has not worked."

He is also convinced that excessive reliance on ratings in EU legislation might have discouraged banks and other financial institutions from exercising their own due diligence. "They should not be encouraged by law to rely solely on ratings for their risk assessment processes. I intend to present my proposals to the Commission for adoption this autumn and I look forward to receiving the views of all interested parties."

It is generally accepted that CRAs underestimated the credit risk of structured credit products and failed to reflect early enough in their ratings the worsening of market conditions, thereby sharing a large responsibility for the current market turmoil. The current crisis has shown that the existing framework for the operation of CRAs in the EU (mostly based on the IOSCO Code of Conduct for CRAs) needs to be significantly reinforced. The move to legislate in this area was recently welcomed by the Ecofin Council at its meeting in July.

The documents published by the EC aim at ensuring the highest professional standards for rating activities. They do not intend to interfere with rating methodologies or rating decisions, which will remain the sole competence and responsibility of CRAs.

The envisaged proposals also take account of existing standards and developments at international level. For example, the US has had rules on CRAs since the mid-1970s and is at present also considering changes to its rules.

The consultation paper suggests the adoption of a set of rules introducing a number of substantive requirements that CRAs will need to respect for the authorisation and exercise of their rating activity in the EU. The main objective of the Commission proposal is to ensure that ratings are reliable and accurate pieces of information for investors. CRAs will be obliged to deal with conflicts of interest, have sound rating methodologies and increase the transparency of their rating activities.

The document also proposes two options for an efficient EU oversight of CRAs. The first option is based on a reinforced co-ordination role for the Committee of European Securities Regulators (CESR) and strong regulatory co-operation between national regulators. The second option would combine the establishment of a European Agency (either CESR or a new agency) for the EU-wide registration of CRAs and the reliance on national regulators for the supervision of CRA activities.

The consultation document on reliance on ratings identifies the references made to ratings in existing EU legislation and looks at possible approaches to the issue of excessive reliance on ratings.

... while SIFMA issues recommendations
SIFMA's Credit Rating Agency Task Force has released its 12-point plan designed to improve the disclosure and transparency of credit ratings. The Association says its intention is to deal with the credit rating agency (CRA) issue with some specificity and produce actionable recommendations.

The recommendations have been crafted with the dual goals of avoiding a repetition of the credit-rating-related turmoil of the past year and strengthening the investor confidence that is vital to robust and liquid global financial markets, according to the Association. The Task Force recommends that:

• CRAs should provide enhanced, clear, concise and standardised disclosure of CRA rating methodologies;
• CRAs should disclose results of due diligence and examination of underlying asset data, and limitations on available data, as well as certain other information relied upon by the CRAs in the ratings process;
• CRAs should provide disclosure of their surveillance procedures; this will foster transparency, and allow market users of ratings to understand their bases and limitations;
• CRAs should provide access to data regarding CRA performance; this will allow investors to assess how CRAs differ both in the performance of their initial ratings, and in their ongoing surveillance of existing ratings;
• Conflicts of interest should be addressed with a sensitivity towards the difference between 'core' CRA services and CRA consulting and advisory services;
• A global SIFMA advisory board of industry participants should be established to advise regulators and lawmakers on ratings issues; this will give regulators access to industry expertise, and encourage the more fully harmonised global regulatory framework the Task Force views as essential;
• Lawmakers, regulators and law enforcers across the globe should coordinate more closely in addressing this global problem, in order to avoid counter-productive, piecemeal and inconsistent attempts at remediation;
• CRA fee structures, and identities of top payors, should be disclosed by CRAs to their regulators;
• CRAs should ensure that ratings performance of structured products is consistently in line with ratings performance of other asset classes; this will increase investor confidence in the reliability of ratings;
• Rating modifiers should not be the means adopted to create transparency; they would lead to significant unnecessary costs, while at the same time likely triggering unintended negative consequences;
• Investors should understand the limits of ratings, and use them as just one of many inputs and considerations as they conduct their own independent analyses;
• All members of the financial industry involved in the generation and use of ratings, including issuers and underwriters, should examine their processes with an eye towards improvement, including working towards standardising reporting and disclosure on underlying assets.

Fitch downgrades FGIC
Fitch has downgraded FGIC's insurer financial strength rating from triple-B to triple-C, where it remains on rating watch evolving. FGIC Corp's long-term issuer rating was also downgraded from double-B to triple-C minus, where it remains on rating watch negative.

The rating actions are based on Fitch's expectation that FGIC will experience further credit deterioration on its book of business backed by RMBS. This deterioration could lead to further additions in loss reserves, which will increase the possibility that FGIC could become subjected to some form of regulatory intervention.

Moreover, as of 31 March FGIC would have negative statutory capital if not for the US$600m 'contingent gain' the company recognised related to a structured finance CDO transaction, known as Havenrock II, that is currently being disputed in court. Fitch continues to monitor developments with respect to this dispute for potential implications to the financial condition of FGIC.

In the event that some form of regulatory intervention occurs, FGIC's exposure to CDS would be subject to immediate termination with its outstanding counterparties. In this scenario, FGIC would be required to settle the CDS contracts at their current market value - a level that Fitch believes is considerably greater than the company's existing claims-paying resources.

Given the heightened risk of regulatory intervention and FGIC's inability to date to raise additional third-party capital, either from its existing owners or externally, it is likely the company will need to pursue the commutation of some of its most capital intensive exposures, namely SF CDOs underwritten in CDS form. Such options are more likely, given the precedent set by SCA and Merrill Lynch (see last week's issue).

FAS 140 amendments delayed
At its 30 July 2008 meeting, FASB discussed the transition and effective date for the proposed amendments to FASB Statement No. 140, 'Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities', and FASB Interpretation No. 46, 'Consolidation of Variable Interest Entities'. The Board unanimously decided to change its tentative decisions reached at the 11 June board meeting regarding transition and effective date to a single effective date for fiscal years beginning after 15 November 2009. However, the Board also decided to separately issue a FASB Staff Position (FSP) that would require additional disclosures as soon as possible.

FASB clarified that the initial consolidation of a variable interest entity as a result of the initial application of the proposed amendments to Interpretation 46(R) would require an enterprise to initially measure all assets and liabilities at fair value. Any difference should be recorded as a cumulative effect adjustment to retained earnings that would be recorded as of the beginning of the first fiscal year in which the proposed amendments are initially applied.

The Board decided that many of the disclosures approved for the proposed amendments to Statement 140 and Interpretation 46(R) at the 4 June 2008 Board meeting will be included in a separate FSP. In addition, it decided that the proposed FSP will require a non-transferor enterprise that holds a significant variable interest in a qualifying special purpose entity to make certain disclosures required by the proposed amendments to the Interpretation 46(R) disclosures. The proposed FSP will be effective as soon as possible, but no later than the first interim reporting period in 2009.

The Board also decided that the proposed FSP will only be applicable to public companies and that the exposure period for the proposed FSP will be 30 days. The purpose of a disclosure-only FSP is to meet financial statement user needs for greater transparency for off-balance sheet transactions, as well as to permit preparers and others with adequate time to consider and implement the other proposed amendments to Statement 140 and Interpretation 46(R).

Second SIV bids received
Deloitte received 12 firm bids for the Rhinebridge SIV portfolio during its auction on 31 July, the highest of which values the assets at US$351.6m in aggregate. Three bidders were successful at a price of US$161.1m for a portion of the portfolio, with the remainder to be sold to Goldman Sachs and a number of senior creditors.

Structured finance analysts at Citi note that Rhinebridge's asset quality looks worse than that of the Cheyne SIV (see SCI issue 98), with the portfolio comprising 32% ABS CDOs and 62% non-prime US RMBS (of which around half is monoline wrapped) - 36% of which is rated triple-B or below. The auction proceeds amount to 45% of the senior obligations, resulting in recoveries of above 50% with cash added.

The Citi analysts suggest that this level is surprisingly high compared to that of Cheyne, given the much larger share of ABS CDOs, significant rating migration and a portfolio valuation at 63% in October (according to S&P). However, the quality of the RMBS is understood to be better than Cheyne's.

The receivers intend to make the distribution by paying each senior creditor a pari passu amount in respect of their payable senior obligations. In the case of the US and Euro CP investors, amounts will be paid pari passu between the unpaid redemption price of each note and its ongoing interest component.

Ratings withdrawn for Vetra ...
Following the repayment in full of the last outstanding senior debt on 29 July 2008, Moody's has withdrawn its ratings assigned to the senior debt programmes of Vetra Finance Corp. The SIV does not intend to issue any further debt from its senior debt programmes.

... and Hudson-Thames
Moody's has also withdrawn the rating assigned to the capital note programme of Hudson-Thames Capital. The SIV's outstanding capital notes were redeemed on 20 June 2008 at an amount consistent with the rating of single-C assigned on 14 December 2007. The rating withdrawal was requested by the issuer, following the redemption.

Default curve methodology revised
Recent data from LoanPerformance and monthly remittance reports on US RMBS transactions show that overall loss severities continue to increase (see last week's issue). Due to this increase and the rising level of delinquencies and foreclosures, S&P has modified its default curve methodology for projecting lifetime losses and its loss severity assumptions for the 2006 and H107 vintages of US sub-prime, prime jumbo and Alt-A RMBS transactions.

At the beginning of July 2008, the agency affirmed its loss assumptions for the US RMBS 2006 vintage, based on its outlook for the housing market at that time, projecting that house prices would decline by an additional 10% by June 2009. Now, however, the agency believes that the influence of continued foreclosures, distressed sales, an increase in carrying costs for properties in inventory, costs associated with foreclosures and more declines in home sales will depress prices further and lead loss severities higher than it had previously assumed.

The latest modifications to S&P's default curve and loss severity assumptions revise its loss projections as follows:

• Sub-prime: To 23% from 19% for the 2006 vintage and to 27% from 23% for the first-half 2007 vintage;
• Prime jumbo: To 0.32% from 0.31% for the 2005 vintage, to 0.81% from 0.62% for the 2006 vintage and to 1.17% from 0.70% for the first-half 2007 vintage;
• Short reset hybrid Alt-A: To 12.2% from 6.3% for the 2006 vintage and to 15% from 7.5% for the first-half 2007 vintage;
• Option adjustable-rate mortgage Alt-A: To 11.0% from 7.4% for the 2006 vintage and to 14.8% from 8.8% for the first-half 2007 vintage.

In addition, to reflect the rising level of loss severities and default frequencies, S&P has increased its loss severity assumptions across all three sectors as follows:

• Sub-prime: 50% from 45%;
• Option adjustable-rate mortgages and short reset hybrid (two and three years) Alt-A: 40% from 35%; and
• Prime jumbo: 30% from 23% for the 2006 and first-half 2007 vintages, and 25% from 23% for the 2005 vintage.

With the recent continued deterioration in US RMBS performance, S&P is adjusting its loss curve forecasting methodology to more explicitly incorporate each transaction's current delinquency (including 60 and 90-day delinquencies), default and loss trends. Some transactions are experiencing foreclosures and delinquencies at rates greater than the agency's initial projections. It believes that adjusting its projected losses, which derive from its default curve analysis, is appropriate in cases when the amount of current delinquencies indicates a different timing or level of loss.

SME CLO sells €1.4bn of triple-As
HVB has upsized and priced Geldilux-TS 2008, a German SME CLO backed by short-term Euroloans. A €964m triple-A tranche (Class A1) was originally on offer to investors, but that was subsequently upsized to €1.4bn when HVB added the €400m Class A2 tranche, bought by a single investor. Some €90m of Schuldscheine triple-As were also issued alongside Classes A1 and A2.

Over 20 accounts invested in the deal, the majority of which were in Germany (40%), the Netherlands (27%), the UK, Ireland and Iberia. Some 70% of the investors were bank treasuries and the remaining 30% from funds.

For more details on the deal, see the SCI database.

Joint Forum reports on credit risk transfer
The Joint Forum has released the final version of its paper entitled 'Credit Risk Transfer - Developments from 2005 to 2007'. Market participants provided direct feedback on the consultative draft during meetings held with Joint Forum representatives in London and New York in May.

The comments provided by participants or sent directly to the Joint Forum secretariat reflect general support for the report's conclusions. Changes to the report based on the consultation, while not substantial, contributed to an improved final report.

The main findings of the paper are summarised as follows:

• Some of the more complex credit risk transfer (CRT) instruments developed since 2004 are associated with increased leverage and - in the case of certain tranches of structured finance products - a high variance of loss or high vulnerability to the business cycle. This increased complexity, combined with a more diffuse investor base (including participants that are only recent entrants to the CRT markets), means that some investors may not fully appreciate the higher-risk nature of these products.
• A failure to understand some of these risks contributed to the market turmoil of 2007. A few fundamental tenets of sound financial judgment appear to have been violated. The originate-to-distribute model created incentives that resulted, in some cases, in weak origination standards for products such as sub-prime mortgages. Some investors placed excessive reliance on credit rating agency ratings, doing minimal or no in-house due diligence on the CRT products employed. Firms also appear to have had few, if any, risk management processes in place to address risk exposures associated with off-balance sheet entities, such as SIVs.
• Despite these shortcomings, the structured credit market is likely to survive, but will remain weak for a period of time. Market participants thought that single-layer CRT products, such as CLOs or corporate CDOs, make economic sense and will continue. Their assessment of the prospects for multi-layer securitisations was less optimistic, and a common view was that the market for ABS CDOs would either shrink dramatically or disappear.
• Supervisors remain concerned about several aspects of the CRT market: its complexity; valuation issues; liquidity, operational and reputational risks; and the broader effects of the growth of CRT. Supervisors believe that market participants must better understand the structure and risks of the CRT products in which they invest, as well as how the rating agencies assign ratings to specific instruments and what circumstances would lead them to downgrade ratings.

With continued innovation in the CRT markets, the effort and resources that firms and regulators will need to expend to properly understand these instruments increases significantly. Any future 'misunderstandings' of risks involving CRT instruments will probably involve a new and different flavour of products and may be no more likely to be detected in advance, with the current level of supervisory resources. Nonetheless, there are steps that the industry and regulatory community can take to enhance the robustness of their risk management and oversight of these products, which are described in more detail in the paper.

John Dugan, chair of the Joint Forum and Comptroller of the Currency in the US, says: "While it is critical to understand the causes of the market turmoil, market participants must also focus on actions to take to increase the resilience of markets and institutions going forward. To that end, this report provides a number of new recommendations applicable to all market participants that enhance the earlier recommendations of the Joint Forum's 2005 Credit Risk Transfer paper." In 2009, the Joint Forum will survey these participants to assess the extent to which they have applied these recommendations.

CPDO ratings under review
Moody's has taken rating actions on eight series of managed CPDOs based on the application of updated surveillance tools that take into account the new dynamics brought about by the current market crisis. At the same time, it has withdrawn the A3 rating of the Alhambra B1-E Series 2007 CPDO notes upon the request of 100% of the investors.

The transactions affected by the rating actions are Series 2007-2 Ulisse Capital, Series A-1E Alhambra Secured CLNs, Series B-1Z Alhambra Secured CLNs, Series A1-E1 Cairn CPDO I, Series A1-U1 Cairn CPDO I, Series B1-U1 Cairn CPDO I, Series 4828 M.A.V.E.N. and Series 92 Coriolanus Limited. The actions include seven downgrades of between two to six notches, which reflect ongoing vulnerability in light of underlying fundamentals. There was also one upgrade of four notches, reflecting relatively better transaction performance since the last rating actions taken.

All eight CPDO transactions were previously downgraded on 10, 11 or 20 March 2008 and left under review for further possible downgrade.

CRE upgrades outnumber downgrades
During H108, the vast majority of rating actions on US CMBS and CRE CDOs were rating affirmations, says Moody's in its half-year sector review. Upgrades outnumbered downgrades. Specifically, Moody's affirmed 1,452 CMBS and CRE CDO tranches, while upgrading 234 tranches and downgrading 123 tranches.

Looking ahead, Moody's expects fewer upgrades and maintains as its forecast that the great majority of ratings will be stable, but with upgrades outnumbering downgrades. "Despite the relatively strong first half performance, we continue to believe that the overall upgrade to downgrade ratio will moderate as the weak economy impacts commercial real estate," says Moody's svp Michael Gerdes. "However, we maintain a slight bias favouring upgrades over downgrades."

The investment-grade rated tranches should continue to perform better than the non-investment grade, says Moody's. During H108, while the overall ratio of upgrades to downgrades was 1.9 to 1, the ratio for investment-grade rated classes was 6.1 to 1 - in sharp contrast to the 0.3 to 1 ratio for non-investment grade rated classes.

In Q208, Moody's took rating actions on 80 securitisations with 912 classes, excluding notional balance classes. Affirmations and confirmations made up 79.5% of the total.

There were 140 upgrades and 47 downgrades, for an upgrade-to-downgrade ratio of 3.0 to 1. For investment-grade rated classes, the upgrade-to-downgrade ratio was 6.0 to 1, while at the below-investment grade level downgrades exceeded upgrades by a slight (27-to-21) margin.

Currently only 11 deals out of 770 rated, or 1.4%, are on watch for downgrade.

QWIL reports
Cheyne Capital's permacap vehicle, Queen's Walk Investment Ltd (QWIL), has released an interim management statement relating to the period from 31 March 2008 to 4 August 2008. The company is currently in the process of preparing its quarterly report for the period ended 30 June 2008, which is expected to be released in September 2008.

In the quarter ended 31 March 2008, the QWIL estimated cashflow for the June quarter of €12m; actual cashflow recorded in the quarter ended 30 June 2008 exceeded €12.2m. The company had a net cash balance in excess of €31m at 30 June 2008 (after taking into account payment of the dividend on 18 July 2008). Net leverage as at 31 March 2008 was 6.2%.

As at 31 March 2008, the company's NAV was €6.42 per share down from a NAV of €6.90 per share as at 31 December 2007. A significant proportion of the fair value write-downs that have been effected by the company in the quarter ended 31 March 2008 are attributable to higher market discount rates and therefore do not impact the ability of the assets to generate cash. The company reflected the expected deterioration in the UK and continental European mortgage markets in its cashflow forecasts as at 31 March 2008.

Since 18 July 2007, the company has returned in excess of €50m of capital to shareholders using a combination of on-market share repurchases pursuant to its general authority and off-market tender offers. In the past year, the company has completed two tender offers of €20m and €15m respectively.

At present, the discount in the share price to the 31 March 2008 NAV provides an opportunity for the company to continue with its share buyback programme and add value for existing shareholders (see SCI issue 98). Given current market opportunities, the company intends to balance the return of capital with new investments. QWIL will continue with its share buyback programme in the near term and will seek approval at its forthcoming AGM on 4 September for a general buyback authority to repurchase up to 14.99% of shares outstanding at that date.

Australian investor sentiment gauged
Fitch's inaugural investor sentiment survey of the Australian fixed income sector, entitled 'Australian Senior Investor Credit Survey, July 2008,' has found that a large majority of respondents saw the chances of recession in the US as high. This compares to Europe's chances of recession, which were viewed generally as 'medium', whereas Australia was largely 'low' and Asia even more.

Across asset classes, there was a general view that credit conditions would 'deteriorate somewhat', with a high expectation that non-investment grade corporates would 'deteriorate significantly'. The least negative assessments were reserved for financials and investment grade corporates.

Across industry sectors, the general view was that conditions would 'deteriorate somewhat'. The retail, leisure and consumer sector was expected to fare the worst, with the largest proportion of respondents saying that conditions would 'deteriorate significantly'. Conversely, respondents were least pessimistic about the energy & utilities sector.

Regarding the extent to which various assets classes had worked their way through the market disruption, respondents were of the opinion, broadly speaking, that structured finance was furthest through, financial institutions were still in the middle of it and the corporates sector was yet to see the peak. Of a range of possible downside scenarios, those perceived to carry the most risk were 'exposure to availability of global liquidity' and 'housing market disruptions'.

Inflation also figured predominantly here. Shareholder-oriented activity (such as share buybacks), which would have been significant 15 months ago, was now considered to be the least likely of the downside scenarios.

Interim Crosby report released
The UK Treasury released an interim report on Sir James Crosby's efforts to find ways of improving the functioning of the country's wholesale mortgage funding markets, namely RMBS and covered bonds - the full report of which is scheduled to be published in the autumn.

Among other findings, the report notes that around £115bn in UK RMBS is due to pay down in the next three years. Given the difficulty in wholesale refinancing and with retail funding unlikely to fully fill this void, lenders are expected to slow new asset growth, resulting in a shortage in mortgage finance that is predicted to persist up to 2010. Furthermore, while the analysis notes that the funding shutdown has been a primary constraint in the availability of mortgages up to now, it also cites that the end-demand for mortgages is likely to slow going forward.

According to structured finance analysts at Deutsche Bank, the most eagerly anticipated part of the report was the proposals to deal with the current funding impasse. But the analysis appears to advocate time as being the best healer, the analysts note - though securitisation/covered bonds are expected to be characterised by greater simplicity, transparency and standardisation once the wholesale markets recover.

The Crosby report also acknowledges current initiatives and proposals, including measures from various trade bodies aimed at improving reporting and disclosure, the idea of an RMBS 'gold standard', the idea of making ABS exchange-traded and the view of many market participants' that the BoE's special liquidity facility should be extended to cover bonds backed by newly originated mortgages. It also mentions the proposal for government guarantees to be provided to senior RMBS, possibly through the creation of a US-like government sponsored agency.

CS & AC

Do we need GSEs?

Jean-David Cirotteau, structured finance analyst at SG, finds that restoring market confidence lies elsewhere than in creating new government-sponsored entities

As capital markets remain stubbornly closed, we are reaching the point where regulatory authorities' policies and instruments are tested to their limit. Can they withstand the pressure of this unprecedented deleveraging period?

The week commencing 21 July was dominated by developments in the US GSE rescue plan promoted by US Treasury secretary Henry Paulson and its ratification by the government. Three weeks ago, the most original proposal by UK lenders' organisation CML (Council of Mortgage Lenders) to rekindle the UK RMBS market was the creation of a state agency.

In Australia, where discussions on this subject are more advanced, a recent intervention by the Reserve Bank of Australia (RBA) opposed the creation of such an agency. The funding situation in that country suggests this is fairly logical in order not to contribute to moral hazard.

Why isn't an Australian GSE necessary?
Before the crisis, the Australian RMBS market was among the most prominent. But it was one of the most severely impacted by the disruption - especially the primary market.

Existing structures continue to show resilience, but with a complete absence of liquidity. This resilience is reflected in S&P's latest data on the SPIN index for May 2008, published on 22 July (see Exhibit 1). Last week, the RBA clearly declared its opposition to the creation of a GSE-type entity.

Exhibit 1

Interestingly, discussions on the possibility of creating a new entity are more advanced in Australia than in the UK. It is proposed to create a government-sponsored agency along the lines of the Canadian model. Second-tier and non-bank originators, which rely heavily on the capital markets - and in particular on the securitisation market - to continue and develop their business, are for the idea.

However, the large banks, which are cash-rich thanks to the deposits they hold, are against it. Within this second group, some companies are more impacted by the RMBS market disruption than others, but this is offset by their perception that the crisis could actually help them cope with competition on mortgage lending, which has been growing constantly in recent years.

The second group received strong backing from the authorities last week, with the Reserve Bank of Australia's statements in a submission to the House of Representatives. The bank said it did not consider the creation of a state agency necessary in the current market.

In order to understand the RBA's position, it is important to consider its behaviour during the crisis. The regulatory body was very proactive as the crisis was developing, and reacted strongly on each of the several occasions when liquidity almost disappeared. Exhibit 2 shows the combined evolution of the amount of liquidity the RBA injected into the system and the cash rate against the cash rate target.

Exhibit 2

Clearly, despite some very sharp peaks where volumes awarded to the banks reached levels up to 8x-9x the average levels registered before the crisis (from A$750m on average pre-crisis to A$6.25bn-A$6.5bn at various quarter-ends), the RBA managed to maintain its target rate. At the same time, the reserve bank has to face strong inflation pressures driven by the part of the economy which is dependent on soaring commodity prices and activity.

The bank widened the type of collateral it would accept in repo as early as October 2007, along with other initiatives concerning maturities, with the RBA providing longer maturity repo facilities to lenders. At that time, RMBS and ABCP securities were included from both Authorised Deposit Taking Institutions (ADI) and non-ADI: this covers all members of the two groups mentioned earlier.

Exhibit 3 shows the evolution in collateral accepted by the RBA. It is clear that RMBS has taken an important market share of these assets.

Exhibit 3

Another very significant measure was the RBA's easing of the criteria for eligible assets. Particularly, in cases of very severe stress, counterparties have been allowed to bring assets whose origination they themselves had been involved in.

This breaks the RBA rule about accepting only collateral with no link whatsoever to the financial institution asking for liquidity. Eight such cases have been registered so far.

The RBA's proactivity has so far been very effective in preventing any bankruptcies among originators within its scope. As part of the market is feeling the pain of combined risk and liquidity premium repricing, these companies have pushed for the development of a GSE which could help them cope with the market distortion for low-yielding mortgage loan portfolios and high refinancing costs.

But the problem of the securitisation market lies elsewhere - in the confidence of market participants - and for second-tier lenders, the business model based on securitisation refinancing may remain broken for some time. Central banks cannot intervene to the point of preventing individual private lenders from failing as long as this phenomenon is limited to these entities.

We would suggest that one possible solution to the problem of restoring confidence would be to facilitate access to important amounts of data, which - unlike in the US - are not made public in Europe or in Australia. Although this has not prevented the US market slump, solid comprehension of mortgage market mechanisms combined with restrictive origination criteria could restore confidence in the business, which is what people need most. A first significant step could be full disclosure of market data held by rating agencies.

We consider that the creation of government sponsored entities is not a priority for restoring investor confidence. Besides, its potential impact would only be felt in a medium-term horizon, as it would take quite a long time between the agreement of a possible creation and the entity effectively operating in the market.

© 2008 Societe Generale. All rights reserved. This Research Note is an excerpt from ABS Snapshot, first published by Societe Generale on 28 July 2008.

Trading ideas: against the grain

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at a short 3%-7% CDX Series 9 10Y tranche trade hedged with the index

After a couple of dry months in the tranche market we are finding several opportunities. We recommend buying protection on the CDX IG9 10Y 3%-7% tranche hedged with the index.

The trade makes use of two technical trading models. Both models look to take advantage of mean-reverting behaviour of correlation skews and the relationship between tranche and index spreads. The tranche market tends to trade in a technical manner and we believe that using these models is the best way to generate consistent profits.

The 3%-7% base correlation skew steepened dramatically in recent weeks. The steepening is a sign that the tranche is trading rich. Due to the tranche's lower subordination and longer tenor, the trade also has a significant short correlation position.

We are comfortable with this, since implied correlations currently sit at historical highs and we think the odds are favoured towards lower correlation. The trade does have a large negative carry position; therefore, we plan to exit the trade in a short timeframe.

How high can we go?
Correlation has risen along with the growing uncertainty in the credit market (Exhibit 1). Though we are cautious on taking outright correlation bets, we believe the current levels are too high.

Exhibit 1

The CDX IG9 index has significant tail risk. As the economy grinds further into the credit crunch, the probability of these credits defaulting grows.

And when credits do default and the first-loss tranche is hit, correlations should plummet. Therefore, taking a short correlation position at levels near 50% is a good bet in our eyes.

Skewed behaviour
In order to choose the best tranches to find relative value, we turn to the skew fair-value model. 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 10-year 3%-7% has steepened dramatically in recent weeks (Exhibit 2). Though it's hard to gauge when to step in and go against the flow, we think the steepening has been overdone and now is a good time to short the 3%-7% tranche.

Exhibit 2

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, this tranche comes out as the best relative value trade opportunity across the capital structure. With a z-score of 2.55, the base correlation skew of the 3%-7% is much steeper than what we have seen in the recent past. Exhibit 2 demonstrates visually how the skew has steepened over the past few weeks.

Tranche index multiple (TIM) model
Another effective way to gauge an index tranche's richness/cheapness is by looking at its relationship with the index itself. For our TIM model, we regress the tranche spread on the index level and the index level-squared, allowing for a non-linear fit.

Currently, we see a fair value of 735bp for the 3%-7% tranche, which leaves plenty of room to cover the bid/ask spread and create some positive P&L. Exhibit 3 demonstrates how the difference between the actual tranche spread and the TIM model-implied spread mean reverts over time.

Exhibit 3

The historical implied spreads are based on a window-expanding regression using out-of-sample data. The biggest risk to the model is that it relies on mean-reverting behaviour of tranche and index spreads, which does not necessarily have to happen.

Risk analysis
A short 10-year 3%-7% tranche is short correlation and short skew. For a 1% increase in the skew, the trade will have a negative P&L between US$48,000 and US$96,000 (see Exhibit 4). An increase in equity correlation of 1% will have a negative P&L impact of US$48,000.

Exhibit 4

Because we are hedging the trade with the index, the initial delta of the position is zero. The biggest risk to the trade is a continued increase in both correlation and skew.

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

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
After a couple of dry months in the tranche market we are finding several opportunities. We recommend buying protection on the CDX IG9 10-year 3%-7% tranche hedged with the index.

The trade makes use of two technical trading models. Both models look to take advantage of mean-reverting behaviour of correlation skews and the relationship between tranche and index spreads. The tranche market tends to trade in a technical manner and we believe that using these models is the best way to generate consistent profits.

The 3%-7% base correlation skew steepened dramatically in recent weeks. The steepening is a sign that the tranche is trading rich.

Due to the tranche's lower subordination and longer tenor, the trade also has a significant short correlation position. We are comfortable with this, since implied correlations currently sit at historical highs and we think the odds are favoured towards lower correlation. The trade does have a large negative carry position; therefore, we plan to exit the trade in a short time frame.

Buy US$10m notional CDX Series 9 10Y 3%-7% tranche protection at 710bp.

Sell US$32m notional CDX Series 9 Index at 132bp to pay 287.6bp 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).