Contents

Seeking sophistication

New risk management techniques on the rise

As the bulk of structured finance assets move from off-balance sheet structures onto bank balance sheets, concerns have emerged over the lack of infrastructure in place to deal with systematic risk and consequent risk monitoring. While regulatory and policy bodies are united in their call for enhancements in this area, a number of large organisations are said to be already adopting more sophisticated portfolio risk management techniques.

These techniques will become all the more important not only as banks resign themselves to holding debt to maturity, but also as opportunities to invest in distressed assets increase. "The structured credit market has a great deal of good buying opportunities on offer, given where asset prices are at the moment. But investors will not be given mandates to invest in this area unless they have the appropriate controls and sophisticated risk management techniques in place," says Douglas Long, evp business strategy for Principia Partners.

Given that SIVs and conduits - which had significant inherent risk controls imposed on them by the rating agencies - are no longer investing in structured credit, the majority of assets are being bought by on-balance sheet investors, which have traditionally relied on credit ratings rather than having bespoke risk management systems in place. "We are now seeing a significant change in approach for these on-balance sheet exposures, as organisations move towards more sophisticated portfolio management techniques - meaning they will have a single system and infrastructure in place to manage the assets and monitor risk appropriately," Long confirms.

He adds that both off-balance sheet and on-balance sheet investments will need ongoing surveillance and reporting of exposures to convey how assets are performing on a timely basis. "Data providers are reinforcing standardisation in the market and they are fostering the correct environment, which is the first step to recovery."

Earlier this month the Counterparty Risk Management Policy Group III released a report entitled 'Containing Systemic Risk: The Road to Reform'. Key points covered in the report include recommendations for significant enhancements to risk monitoring and management, as well as a reconsideration of the standards for consolidation under US GAAP of entities currently off-balance sheet coming on-balance sheet and measures to better understand and manage high-risk financial instruments (see News Round-up for more).

For the time being, however, counterparty risk remains a key issue for the market, particularly in relation to CDS. A recent survey issued by Greenwich Associates shows that 85% of US institutions see CDS counterparty risk as a serious threat to global markets, and just more than 55% of institutions in Europe see CDS counterparty risk as a significant danger. The survey also shows that more than 90% of hedge funds see counterparty risk relative to CDS as posing a significant threat to global markets (see News Round-up).

AC

Model replication

ACA restructuring concept to appear elsewhere?

Ongoing monoline rating actions over the summer months have reminded the market that restructurings and potential downgrades in this space have not yet reached their conclusion. But hope for viable restructurings received a boost last week when ACA finally announced its plan of action, which has been hailed as a possible template for other already-downgraded monolines, such as FGIC and CIFG.

"We expect most counterparties to have written down exposure to ACA in full, and therefore this is not likely to have a meaningful knock-on impact on counterparties," says Michael Cox, analyst at RBS Research. "However, it is possible that it could act as a template for restructuring activity on other financial guarantors. We would suggest CIFG and FGIC as potential candidates, although the situation for these names is more complex."

Under an agreement reached by ACA and its counterparties, ACA Financial Guaranty Corporation has terminated CDS exposure on all ABS and CDOs. In return, the counterparties will receive a cash payment and surplus notes issued by ACA Financial Guaranty.

The holders of the surplus notes will share pro-rata any future dividends or distributions from ACA Financial Guaranty up to US$1bn in aggregate. Some 95% of the surplus notes have been issued to the counterparties, with the remaining 5% being issued to ACA Capital.

But Cox adds: "Both CIFG and FGIC have many more counterparties than ACA, much bigger portfolios outside structured finance and they have also wrapped a number of structured finance transactions, meaning that they are accountable to a number of investors as well as bank counterparties. ACA, on the other hand, had a more simple structure, and most structured finance exposure was in the form of CDS contracts with single counterparties that could be terminated relatively easily."

CIFG and FGIC will probably try to commute CDS contracts like SCA and Ambac have done (see SCI issue 99), suggests Cox. "If they fail, there is a real risk of them being put under regulatory control as they breach minimum capital requirements. The ACA example indicates they may be able to offer equity in a restructured entity in return for counterparties agreeing to commute exposures," he adds.

ACA Capital and ACA Financial Guaranty have also entered into a restructuring agreement that provides for a comprehensive settlement and release of all claims associated with US$100m of MTNs insured by ACA Financial Guaranty. Under this agreement, the noteholders will receive an aggregate cash payment of approximately US$47m and title to certain collateralised loan and debt obligation equity interests in full satisfaction of their claims.

ACA Financial Guaranty will now operate as a run-off financial guaranty insurance company, with exposure almost exclusively to municipal debt obligations. ACA Capital Holdings will no longer control ACA Financial Guaranty Corporation - rather, control will reside with certain former counterparties to the transactions guaranteed by ACA.

AC

Fair winds for Citi

Innovative trade finance deal in the works

Citi is marketing an unusual synthetic securitisation backed by trade finance receivables. The US$185m balance sheet transaction, dubbed Trade Winds 1, is the first in what is expected to be a programme that is credit-linked to the performance of the bank's global trade finance portfolio.

Rated by Moody's and expected to close next month, the deal comprises US$20m Aaa rated Class A notes, US$20m Aa2 Class Bs, US$35m A2 Class Cs and US$110m unrated Class Ds. It provides Citi with protection on a US$2bn portfolio consisting of 32,028 obligations - including trade finance loans, letters of credit, guarantees, commercial bonds, bills of exchange and promissory notes - to 3,121 reference entities.

According to Elaine Ng, avp-anaIyst at Moody's in Hong Kong, Trade Winds 1 has three noteworthy features - the transaction has a very granular portfolio compared to other deals, has a fixed recovery at 0% and only has two credit events. Bankruptcy and failure to pay are included, but restructuring is specifically excluded (as are other credit events common in emerging market obligors) in order to achieve cleaner credit events.

It is understood that the decision to assume a 0% recovery, rather than using the actual workout recoveries of the defaulted obligations to calculate portfolio losses and cash settlement amounts, was to facilitate a straightforward legal opinion. As such, for each credit event - once the conditions to settlement are satisfied - the portfolio loss will be increased by the total defaulted notional amount of a defaulted reference obligation. After cumulative portfolio losses exceed the aggregate notional amount of the first loss piece, the CDS notional amount and the outstanding principal balance of the notes will be written down sequentially in reverse order of the notes.

The initial portfolio has exposure to 25 countries, with geographic concentrations across Asia (55%), Eastern Europe (17.5%), South America (15%), the Indian subcontinent (8%) and Central America (4.5%). In terms of industries, exposure is concentrated across mining, steel, iron and non-precious metals (9.95%), textiles and leather (9.28%), and diversified/conglomerate services (9.16%).

None of the reference entities can have more than 0.75% exposure of the amount equal to initial maximum portfolio notional minus the sum of all defaulted and potential defaulted reference obligations. "One of the aims was to try to diversify the portfolio and include as many countries as possible," explains Ng.

She adds that the portfolio can be replenished up to the scheduled maturity date of December 2010 subject to eligibility criteria and replenishment conditions, including various concentration limits to maintain portfolio diversification and Moody's CDOROM test to maintain credit quality of the notes. "Replenishment can occur if there is a payment on an existing obligation or if Citi sells an obligation. Each obligation must have a tenor that is not longer than 366 days and on a weighted average basis the portfolio must have a maturity of no more than 90 days."

Average credit quality of the portfolio is Ba2/Ba3. Since many of the underlying obligations are unrated obligations, Moody's performed a mapping between Citi's internal credit scoring system and Moody's ratings. This process was based on a pool of obligations with either public ratings or private credit estimates, and for which Citi had also assigned an internal credit score. In addition, the agency has supplemented the analysis with an operational review of Citi's credit scoring, approval, monitoring and collection policies and procedures.

Trade Winds is the second synthetic trade finance receivables deal to be rated by Moody's, following Standard Chartered Bank's Sealane transaction from November (see SCI issue 61).

CS

SC HF Index returns revert

June sees credit hedge fund performance decline

Both gross and net monthly returns for June 2008 in the Palomar Structured Credit Hedge Fund (SC HF) Index reverted back to negative territory, having posted positive returns in May (see SCI issue 96).

The latest figures for the index were published this week and show a gross return of -0.81% and a net return of -0.93% for the month of June, despite 14 out of 22 funds reporting positive monthly results. The moves mean that the gross and net indices continue to show negative annualised returns since outset of -6.30% and -8.15% respectively.

The negative return posted by the funds investing in a 'long investment grade leveraged' sub-strategy was only partially offset by the modest gains of most other sub-strategies. The dispersion and range of returns increased compared to the data observed in May. For more Index data click here.

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

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

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

CS

Bank builds up structured credit desk

The latest company and people moves

Bank builds up structured credit desk
BNP Paribas has appointed Adnan Zuberi as a director on the structured credit desk in New York. He reports to Jerome Wong, md, head of credit structuring, Americas.

Zuberi joins from JPMorgan, where he was an executive director in structured credit since 2007 and was responsible for structuring for North American real money accounts. Prior to that, he spent five years at UBS in structured credit derivatives, most recently as head of credit derivatives structuring. He also spent three years at Credit Suisse in the CDO group.

Commenting on the appointment, Wong says: "Adnan is a great addition to the team, as we continue to expand our business opportunistically in this challenging environment."

Asia structuring head hired
Barclays Capital has hired Chak Wong, as an md, head of structuring in investment banking Asia Pacific. He will lead the Asia Pacific structuring team within investment banking on a cross asset-class basis and reports to Patrick Kwan, md, head of derivatives and financing solutions, investment banking Asia Pacific.

Wong joins Barclays Capital from UBS, where he was md and co-head of the Asia Pacific structured products group, responsible for designing and trading structured derivatives. Prior to that, he spent a number of years with Morgan Stanley and Goldman Sachs as a quant structurer and derivatives trader.

Legal head moves to banking role
Barclays Capital's UK and Europe legal head Jake Scrivens is understood to have taken up a non-legal role at the bank. In September he will reportedly become head of the structured credit portfolio. Magnus Spencer, BarCap's Asia-Pacific regional general counsel will assume the UK and Europe legal role.

Credit trading head quits
Lionel Gibert, the London-based head of European credit trading at Société Générale has resigned. No replacement has yet been appointed.

Bear trader hired...
Morgan Stanley has hired Alan Yeoh as an executive director in structured credit products, where he will trade credit options. Yeoh was previously co-head of structured credit trading at Bear Stearns in Europe, having joined the bank just over a year ago in June 2007. Before joining Bear Stearns, he worked at Credit Suisse.

...while structurer moves on
Thomas Kyriakoudis, vp and structurer on Morgan Stanley's structured credit desk, is understood to have joined Permira.

Credit prop head leaves
John Gisborne, vice chairman of the credit products group at TD Securities, has left. He ran the credit prop trading business in London. The bank is rumoured to have hired Greg Rosen from Credit Suisse to take over some of Gisborne's duties.

Private equity group buys into structured credit manager
European private equity firm Cinven has acquired a 50% stake in Indicus Advisors, an alternative investment manager focusing on European leveraged finance and global structured credit. Indicus will, however, remain a distinct firm and will continue to be managed by its current partners. Cinven will retain its own focus on its core business of private equity.

"The disruption in the debt markets over the last 12 months has produced a much healthier environment for corporate debt investors. Investing in debt through a top class manager can now deliver attractive returns with relatively low risk, and as an investment class, it is highly complementary to private equity," comments Cinven partner Andrew Joy.

David Reilly and Ujjaval Desai founded Indicus in 2006, which today has 17 professionals located in London and New York with approximately US$1.75bn of assets under management. The firm also advises on over US$2bn of structured investments for several large institutional investors.

Sorin hires coo
Sorin Capital Management has hired Matt Chasin as coo, partner and member of the investment committee. He will be responsible for all non-investment activities, focusing on the operational and financial aspects of Sorin Capital Management, as well as managing all borrowing relationships and activities for the Sorin funds.

Before joining Sorin, Chasin was a senior md and head of repo financing activities for mortgage and structured products at Bear Stearns. His responsibilities included financing Bear Stearns' global mortgage and structured product position, and all trading, hedging and risk management of the firm's mortgage matched book business. Chasin's responsibilities also included the management of Liquid Funding and Master Funding, two financing conduits utilised by Bear Stearns.

Duff hires CDO saleswoman
Duff Capital Advisors has announced the expansion of senior management with the addition of five new hires. Amongst them is Laura Flynn, who joins as md in the client advisory group. Flynn was previously vp at Lehman Brothers, where she sold single-name CDS, CDX products and CDOs.

Palatium hires from Citi
Palatium Investment Management, which was created through an MBO of Eurohypo Asset Management (see SCI issue 90), has recruited a specialist mezzanine and preferred equity team from Citi to manage its planned fund in this area. Keith Davidson and James Tarry have joined Palatium as md and director respectively, having been director and vp in Citi's London real estate debt group.

However, both had also previously worked in Eurohypo's real estate investment banking division until 2007. Prior to Eurohypo, Davidson worked in real estate structured finance in Barclays Capital and Deutsche Bank, while Tarry worked in structured asset finance at Deutsche Bank and was also a chartered accountant with KPMG.

Palatium is continuing to recruit an experienced team in order to target the opportunity rewards its clients seek through a series of highly targeted funds. Neil Lawson-May, joint chief executive of Palatium, comments: "Each appointment demonstrates our commitment to recruiting a highly experienced, proven team to pursue the opportunities that exist in real estate and real estate debt. Having worked with Keith and James in the past, I am confident that our planned mezzanine and preferred equity funds could not be in better hands. Not only do they both know these markets intimately, but they also understand how our clients like to invest."

Davidson says: "We have known Paul and Neil for many years, so know just how carefully they have planned Palatium. We are confident that Palatium will provide an enduring platform to deliver returns from mezzanine and preferred equity thanks not only to the short-term dislocations in today's market, but also to the longer-term structural changes in the banking environment. We are genuinely excited about the potential of establishing and managing these specialist funds."

Interdealer broker targets new areas
Tradition, the interdealer broker, has launched an Islamic and Capital Markets desk in Dubai and London. The desk is a joint venture between Tradition in London and Asia, and is licensed by the Dubai Financial Services Authority (DFSA). It will offer broker services for trading of sukuks, inter-bank money market transactions by murabaha (commodity-based Islamic finance), as well as CDS and global currency products.

Tradition's Islamic and Capital Markets team will report to Will Hornby, head of credit in London. Ali Merchant will lead the Dubai team. He has 28 years' experience in the market, 16 as treasurer of two Middle Eastern banks.

Joining Merchant will be Muhammad Talha, who has 29 years' experience in four banks and was previously head of international banking at Qatar International Bank for 10 years. David Barker will lead the London team. He joins Tradition from Tullett Prebon and will handle trading of sukuks, CDS and convertible bonds.

New ceo at microfinance firm
Jean-Pierre Klumpp has been promoted to ceo of BlueOrchard Finance, the Geneva-based microfinance investment advisor. Klumpp is taking over from Jack Lowe, who will remain as president of BlueOrchard USA. In this position, he will lead new financial services for the microfinance sector on behalf of the BlueOrchard group.

Klumpp has been acting as BlueOrchard Finance's coo since June 2007. He came to BlueOrchard from the private banking executive committee of Julius Baer in Zurich. Prior to this, he was ceo of Ehinger & Armand von Ernst in Zurich and coo of Ferrier Lullin & Cie in Geneva (both private banks of the UBS group).

Lowe joined BlueOrchard as its ceo in November 2004, with the mission of managing the rapid growth of the company and developing its range of products and services, as well as building up its international recognition with the institutional investor community. Under his management, the company extended its network of institutional investors; and it has proposed innovative products that have attained international recognition, such as BlueOrchard's three structured microfinance investment vehicles (see SCI issue 97 for more).

Further to retaining a role in the development of BlueOrchard's services, Lowe plans to devote more time to his existing personal businesses and to his philanthropic engagements.

Structured finance veteran joins S&P
S&P has appointed David Jacob as executive md and head of structured finance ratings. He will report to Vickie Tillman, evp, S&P Ratings Services.

A pioneer in the securitisation industry, Jacob has 25 years of experience in fixed income investment analysis and the structured finance markets. In his new role he will have oversight responsibility for all of S&P structured finance operations. He replaces Tillman, who has been acting head since January when Joanne Rose became executive md for Risk and Quality Policy at S&P.

During his career, Jacob has held a number of senior positions at financial institutions, including Nomura where he led the structuring department and was later md and head of international fixed income research. At JPMorgan he was md, head of fixed income research, and previous to that he served as vp, head of quantitative analytics at Morgan Stanley.

Most recently, Jacob was a principal with Adelson & Jacob Consulting. He began his career as an analyst at Moody's and Equitable Life Assurance.

Caliber set to liquidate
Cambridge Place Investment Managers has announced it will seek approval from its shareholders to liquidate the Caliber fund. The manager had previously stated that it would liquidate the fund by June 2008 and distribute proceeds to shareholders, but deferred a decision citing market conditions.

The company's NAV fell by US$4.6m to US$9.9m over the last three months and the EGM to approve the appointment of a liquidator is set for September. The board of directors says that this is a natural progression to achieving the investment objective of returning capital to shareholders.

Queen's Walk Investment Ltd has also announced that at the EGM of the company held on 12 August shareholders authorised its proposed tender offer, whereby the company will repurchase 2,999,981 ordinary shares.

Meanwhile, permacap Volta Finance announced that, as of the end of July 2008, its gross asset value (GAV) was €166.2m or €5.53 per share, a decrease of €0.39 from €5.92 per share at the end of June 2008. This decrease is the consequence of the decline in the value of the ABS portfolio.

The July mark-to-market variations of Volta Finance's asset classes have been: -34.4% for ABS investments; -1% for CDO investments; and -1% for corporate credit investments.

Kamakura and Zylog team up
Zylog Systems will distribute the Kamakura Risk Manager enterprise-wide risk management system in India and South Asia. Zylog Systems, a global software company, works extensively with major banks in India through its offices in Chennai, Mumbai and New Delhi.

The Kamakura Risk Manager (KRM) system is said to be the world's first risk system that analyses market risk, credit risk, asset and liability management, funds transfer pricing and liquidity risk all in a single integrated solution. The KRM system is also used for Basel II capital calculations and to meet the requirements of key accounting standards regarding hedge accounting (FAS 133 and IAS 39) and the valuation of complex structured finance instruments (FAS 157).

CME and NYMEX merger approved
Shareholders of CME Group and NYMEX have approved the proposed merger of the two exchanges.

CME group executive chairman Terry Duffy says: "The addition of NYMEX to CME Group creates an even stronger international company as we continue to grow our business globally and compete with exchanges and the over-the-counter market. The combination of these exchanges will create immediate and long-term value for our shareholders and customers, as we are now the only exchange to offer access to every global benchmark product."

AC & CS

CDS counterparty risk fears polled

A round up of this week's structured credit news

CDS counterparty risk fears polled
More than three-quarters of the institutions participating in a new study by Greenwich Associates say counterparty risk in CDS represents a serious threat to global financial markets (see also separate news story). Following the collapse of Bear Stearns, Greenwich Associates conducted a study of 146 institutions in North America and Europe to investigate how fears of counterparty risk were affecting institutional investment and trading strategies.

Survey respondents were divided between 32 hedge funds and 114 banks and traditional long-only investors, with the majority domiciled in the US (70%) and the remainder in Canada and Europe.

Among the US institutions, the proportion that sees CDS counterparty risk as a serious threat to global markets approaches 85%. Institutions in Europe are slightly more sanguine, with just more than 55% describing CDS counterparty risk as a significant danger. "At the other extreme are hedge funds, more than 90% of which said they see counterparty risk relative to credit default swaps as posing a significant threat to global markets," says Greenwich Associates consultant Jay Bennett.

Most of the institutions surveyed believe another major financial services firm will fail as a result of the ongoing crisis in global markets - and they expect it to happen sooner rather than later. Nearly 60% of survey respondents say they expect to see another major financial services firm collapse within the next six months, and another 15% think it will happen in six to 12 months. The world's largest and most sophisticated investors are the most optimistic - or at least less pessimistic than other investors.

"Only 27% of the institutions think there will not be another casualty along the lines of Bear Stearns," says Greenwich Associates consultant Frank Feenstra. "If you are looking for a silver lining in these findings, it seems that most institutions think we are currently in the most dangerous period for global financial services firms. Perhaps if the markets can make it through the next six months, the level of pessimism may begin to subside."

Nearly 80% of the institutions participating in the Greenwich Associates survey say their banks have tightened margin or collateral requirements since the outbreak of the global credit crunch. Of the institutions reporting that their banks have imposed stricter requirements, the majority - nearly 65% - say the change has not had a significant impact on their trading activities. However, more than a quarter of these institutions say the new requirements have caused them to reduce their trading activity.

Concerns about counterparty risk have caused institutions to cut back on their use of CDS. Among fixed income survey participants that employ CDS, 62% state that increased counterparty risk has caused them to limit their use.

Among all institutions participating, the most common method of managing counterparty risk (used by more than 70%) is to trade only with the most financially sound banks and broker dealers. Almost 65% of participants also say they try to limit the concentration of exposure with a single counterparty. About one-third of participants state that they make use of cross-collateral arrangements and 5% use exchange products for hedging.

Three-quarters of the institutions say they believe the establishment of a centralised counterparty would be effective in mitigating CDS counterparty risk. Hedge funds around the world and institutions of all types in Continental Europe are among the strongest proponents of this plan, with almost 85% of each saying it would help reduce counterparty risk. Almost 60% of these institutions say they would prefer a centralised clearing platform operated by an exchange over one sponsored by banks.

FSA outlines new strategy ...
Following Q208 losses of US$330.5m, FSA has announced it is exiting the asset-backed business and instead will focus all resources on the global public finance sector. The move adds a further blow to any hopes that the remaining triple-A rated monolines could continue writing negative basis business.

FSA's parent company, Dexia, has injected a further US$300m of capital into the monoline and will now assume credit and liquidity risk in relation to FSA's financial products business, which principally writes GICs. "Overall, we see the actions taken by FSA and Dexia as being positive for FSA, but the move to outlook negative from S&P does risk causing new business generation to slow, particularly given Moody's is already on review for possible downgrade," comments Michael Cox, analyst at RBS.

S&P revised its outlook on FSA to negative from stable, but affirmed its triple-A rating. The rating agency states that, had the capital injection from Dexia not been received, it believes that FSA's capital adequacy margin of safety would have fallen modestly below triple-A as a result of deterioration and projected losses in its insured RMBS portfolio and for its financial product line.

"The negative outlook reflects the possibility that the FSA franchise has been damaged by the newly announced losses, and that acceptance in the municipal market may diminish," Robert Green, credit analyst at S&P, says. "Although first-half production results for FSA were very strong, in our view, FSA's aura as one of the better bond insurance underwriters may now be tarnished. The economic losses and reserves announced for the second quarter, combined with those taken in the first quarter, may cause issuers and investors to seek alternatives," he suggests.

ACA also set out restructuring plans last week. For details see separate news story.

... while S&P affirms Ambac and MBIA
S&P has affirmed its double-A financial strength rating on Ambac and MBIA, and removed them from credit watch negative. The outlook for both monolines is negative, however, due to their significant exposure to domestic non-prime mortgages and related exposures to ABS CDOs.

In addition, the negative outlooks reflect S&P's belief that both monolines' franchises have been damaged and that the companies will face diminished new business flow. Removal of the negative outlook will be dependent on clarification of ultimate potential losses, as well as future business prospects, the outcome of strategic business decisions and potential regulatory developments.

With respect to Ambac, the rating affirmation reflects S&P's assessment of the monoline's satisfactory capital position, measured against conservative projections of potential losses; successful ongoing efforts to remediate the outstanding mortgage-related exposure; and broad refocusing of the business and risk management to position the company to take advantage of any new business opportunities as quickly as possible.

When stressed in S&P's capital adequacy model, Ambac's existing capital resources, future earnings and cashflow generated a margin of safety (based on year-end 2007 data) in the 1.1x-1.2x range. This exceeds S&P's minimum requirement of 1.0x for a double-A rated company.

S&P notes that Ambac's remediation efforts are starting to bear fruit. Together with the commutation of a US$1.4bn ABS CDO (AA Bespoke), the monoline has been actively pursuing representation and warranty claims against transaction sponsors. Loss reserves at 30 June 2008 reflect more than US$260m of estimated recoveries on these claims.

With respect to MBIA, the double-A financial strength rating on the company is supported by currently sound claims paying ability and liquidity levels. MBIA's margin of safety, as measured by S&P's capital adequacy test, is in the 1.0x-1.1x range - well above the level required for a double-A rating.

With regard to the current financial guarantee operations, management has indicated that over the next 12 to 18 months, new business underwritten will be negligible as management works toward a restructuring of the business. S&P's view of MBIA's planned restructuring will depend in large part on whether it believes management can put together a sustainable business model and demonstrate the ability to generate a profitable stream of revenue that is of sufficient volume and quality to support the capital employed in the business.

ISDA makes monoline statement
ISDA has published a statement explaining its anticipated approach to settlement of a monoline bankruptcy or failure to pay credit event. The trade organisation says it recognised early on that a credit event in respect of a monoline financial guaranty insurance company would present unique settlement challenges and the statement summarises the outcome of a long period of discussion and consideration by ISDA and its members.

ISDA says a monoline credit event would present unique and as yet untested settlement challenges, due to the wide range of obligations guaranteed by the monolines and the expected price dispersion of those obligations following a credit event. To address the monoline-specific issues, the association convened a working group of CDS dealers with input from active end-users to determine whether to use an auction to settle a monoline credit event.

One of the first tasks undertaken by the working group was to gather and disseminate information as to the range of obligations that market participants believe may be delivered upon the occurrence of a credit event under a standard monoline CDS contract. ISDA has published lists of these obligations on its website, but these lists are only indicative and the appearance or non-appearance of an obligation on a list is not determinative of whether that obligation would be deliverable under a monoline CDS.

Following this work, the consensus of the group was to use the auction methodology previously tested for corporate credit events to settle a monoline credit event, with one key difference. It was determined that the auction terms should not specify an exhaustive list of obligations that are deliverable, but that instead the deliverable obligations should be determined using the same requirements that apply to a standard CDS contract referencing a monoline.

This differs from past practice in that prior auctions had an exhaustive list of deliverable obligations that were individually specified in the relevant protocol. This difference reflects the range and number of obligations guaranteed by the monolines.

ISDA therefore anticipates that, if a bankruptcy or failure to pay credit event were to occur in respect of a monoline insurance company with a sufficiently high trade volume, including any monoline insurance company that is a constituent reference entity in any index, a CDS protocol would be published. This protocol would allow parties to cash settle certain CDS transactions at an auction-generated final price, while preserving the ability to request physical settlement on net positions for parties that wish to do so, in the same manner as for a corporate credit event.

The transactions covered by the protocol would be those that reference the relevant monoline, i.e. that specifically reference the insurance company (as opposed to a holding company) and that are documented using the 2003 ISDA Credit Derivatives Definitions and one of the two published forms of monoline supplement. The difference outlined in the paragraph above would be effected in the CDS protocol by listing the deliverable obligation category and deliverable obligation characteristics (based on standard ISDA documentation) that any deliverable obligation would need to satisfy, instead of including a list of the specific individual deliverable obligations.

ISDA is keen to stress that the statement's publication is not connected with events in relation to any particular entity and does not indicate that ISDA believes that a credit event with respect to any particular entity or class of entities is imminent or likely.

FASB reviews credit derivatives disclosures
At its 6 August board meeting the US Financial Accounting Standards Board (FASB) re-deliberated issues related to the scope, disclosures and effective date of proposed FASB Staff Position No. FAS 133-b and FIN 45-c, 'Disclosures about credit derivatives and certain guarantees'.

The board decided not to expand the FSP's scope to include all financial instruments or credit risk-related guarantees that are outside the scope of FAS 133 or Interpretation 45. The board clarified that a derivative with multiple underlyings is within the FSP's scope if one (or more) of its underlyings exposes the seller/writer to significant potential loss from credit risk-related events specified in the contract. The Board also clarified that the FSP's scope includes a credit derivative embedded in a hybrid instrument.

With respect to an entity's disclosure about a credit derivative's or guarantee's current status of payment/performance risk, the Board decided not to express a preference (for example, a higher level in a hierarchy) for the use of external credit ratings when compared to internal groupings in the way the entity manages its risk. The Board decided to include in the FSP some guidance on how an entity should group similar credit derivatives in complying with its disclosure requirements.

FASB also decided to retain the effective date in the proposed FSP. Accordingly, the final FSP will be effective for any reporting period (annual or interim) ending after 15 November 2008.

The Board directed the staff to proceed to a drafting of a final FSP for vote by written ballot.

Class action filings rise
NERA Economic Consulting has released a new report entitled '2008 Trends: Sub-prime and Auction-Rate Cases Continue to Drive Filings, and Large Settlements Keep Averages High'. Driven in large part by the current sub-prime and credit crisis, shareholder class action filings continued to increase in H108, according to the semi-annual study.

The latest edition finds that filings are on pace to reach almost 280 by year's end, which would represent a 42% increase over 2007 and the largest annual total since 2002. At that rate filings will have more than doubled in just two years, from their recent low of 131 in 2006.

According to NERA's study, the credit crisis is a significant factor contributing to the increase (see also SCI issue 98). In fact, 51% of 2008 filings through 30 June 2008 have allegations related to the sub-prime collapse (including auction-rate securities cases).

Additional factors associated with filings include market volatility and returns. Specifically, the NERA study finds that, if market volatility is higher during a quarter, filings are likely to be higher as well.

The authors note that, although filings increased through the first half of the year, average settlement values remained roughly constant at around US$30m. Excluding settlements of over US$1bn, the average settlement dropped to US$10m, representing a decline compared to recent years.

However, the average settlement amount may begin to increase as more recently-filed cases settle. Driven by the recent surge in sub-prime cases, median investor losses - a powerful determinant of settlement size - for cases filed in the first six months of 2008 are more than twice the level for cases settled from 2005 through to 2007.

New sub-prime model released
Moody's Mortgage Metrics model for US sub-prime mortgage loans will be available to investors, issuers and other market participants on 15 August. The service is being used by its structured finance analysts as an input when rating primary issuance of sub-prime RMBS. The next-generation ratings model for prime and Alt-A mortgages will be released in Q408.

Moody's Mortgage Metrics analyses loan-level data to estimate loan- and portfolio-level default rates, loss given default rates, prepayment rates and other risk measures for mortgage pools. The new sub-prime model incorporates significant enhancements, such as more robust simulation capabilities, greater transparency into the impact of various economic scenarios (including the effect of HPA and US unemployment on expected loss), explicit treatment of mortgage underwriting quality and the ability to analyse portfolio tail risk at a more granular level. The new model has been validated using data through the 2007 vintage to reflect the recent housing market dislocation.

"Moody's Mortgage Metrics enhanced simulation technology provides a greater level of precision in analysing mortgage pool risk than was available using the legacy technology," says Roger Stein, md of research and analytics at the agency. "While the current credit environment continues to evolve, the enhanced simulation tools and new econometric models we are introducing in Moody's Mortgage Metrics represent significant advancements in measuring a number of aspects of this credit risk with greater analytical rigour, while providing a greater level of transparency."

As part of its ongoing development of mortgage tools and models, Moody's intends to expand the functionality of the service for use as a surveillance tool. Furthermore, the agency will integrate it with Structured Finance Workstation (SFW), the cashflow engine offered by Moody's Wall Street Analytics.

CRMPG reports
The Counterparty Risk Management Policy Group (CRMPG) III has published its report entitled 'Containing Systemic Risk: The Road to Reform' (see also separate news story). The Group says that the document is a forward-looking, integrated framework of private initiatives that will complement official oversight to help contain systemic risk. It focuses on four key areas, which were deemed to be the most important and timely, and were the areas in which the Policy Group believed it could make the greatest contribution.

Those areas include a reconsideration of the standards for consolidation under US GAAP of entities currently off-balance sheet coming on-balance sheet; measures to better understand and manage high-risk financial instruments; significant enhancements to risk monitoring and management; and a series of sweeping measures to enhance the resiliency of financial markets generally and the credit markets in particular, with a special emphasis on OTC derivatives and CDS. The report also highlights important emerging issues, which will require close attention in the period ahead.

The report further lays out five 'core precepts', which the Group regards as relatively simple, readily understandable and forward-looking standards upon which the management of large integrated financial intermediaries must rest. The precepts are:

• Precept I: the basics of corporate governance
The Group recommends that, from time-to-time, all large integrated financial intermediaries must examine their framework of corporate governance in order to ensure that it is fostering the incentives that will properly balance commercial success and disciplined behaviour over the cycle, while ensuring the true decision making independence of key control personnel from business unit personnel.
• Precept II: the basics of risk monitoring
The Group recommends that all large integrated financial intermediaries must have, or be developing, the capacity (1) to monitor risk concentrations to asset classes, as well as estimated exposures - both gross and net - to all counterparties in a matter of hours; and (2) to provide effective and coherent reports to institutional senior management regarding such exposures to high-risk counterparties.
• Precept III: the basics of estimating risk appetite
The Group recommends that all large integrated financial intermediaries must periodically conduct comprehensive exercises aimed at estimating risk appetite. The results of such exercises should be shared with the highest level of management, the board of directors and the institution's primary supervisor.
• Precept IV: focusing on contagion
Looking to the future, the Group recommends that all large integrated financial intermediaries must engage in a periodic process of systemic brainstorming aimed at identifying potential contagion 'hot spots' and analysing how such hot spots might play out in the future. The point of the exercise is that even if the hot spots do not materialise or even if unanticipated hot spots do materialise, the insights gained in the brainstorming exercise will be of considerable value in managing future sources of contagion risk.
• Precept V: enhanced oversight
The Group recommends arrangements whereby the highest level officials from primary supervisory bodies should meet at least annually with the boards of directors of large integrated financial intermediaries. The purpose of the meeting would be for the supervisory authorities to share with the board of directors and the highest levels of management their views of the condition of the institution, with emphasis on high-level commentary bearing on the underlying stability of the institution and its capacity to absorb periods of adversity. This recommendation may have to be adapted to accommodate local legal and cultural considerations.

Commenting on the report, Gerald Corrigan, md at Goldman Sachs and co-chairman of the CRMPG III, says: "It is both necessary and urgent that the private sector, in collaboration with the official sector, begin immediately to implement these reforms, some of which will take well over a year to be fully accomplished."

TRUP CDOs downgraded by Moody's ...
Moody's has downgraded 77 tranches, all of which remain on review for further possible downgrade, across 25 Trust Preferred (TRUP) CDOs. At the same time, the agency has placed on review for possible downgrade an additional 80 tranches in TRUP CDOs, including 50 Aaa tranches and 30 Aa rated tranches, from across 19 deals.

The downgrades are prompted by the exposure of these TRUP CDOs to trust preferred securities issued by five banks taken over by their regulators in recent months. This rating action reflects Moody's assumption that that there will be zero recovery on the trust preferred securities issued by these banks.

In addition, the agency assumes that recoveries will be low on some of the other trust preferred securities currently deferring coupon payments in the collateral pools backing these securitisations. While historically many banks that have deferred payment on trust preferred securities have ultimately resumed payment, Moody's expects that many banks deferring in the current environment are unlikely to become current again.

The initiation of the additional review for possible downgrades reflects a general concern that the risk of deferrals is increasing for bank issuers of trust preferred securities. The specific TRUP CDO tranches placed on review for downgrade were selected because (1) at least 3% of their collateral pools were deferring coupons and (2) preliminary testing revealed that their ratings could be affected by a modest increase in the pool-wide default probability assumption used for trust preferred securities that are currently performing.

Moody's review will focus on the implications of adjustments that may be necessary in pool-wide default probability and asset correlation assumptions to reflect the current environment. In addition, it will seek to identify which securitisation may have unusually high concentration exposures to banks in regions in which real estate prices have depreciated the most. In light of these revised assumptions, the agency anticipates further pressure on TRUP CDO ratings, especially for the mezzanine and subordinated tranches.

... and placed on watch negative by Fitch
Fitch has placed certain classes of notes issued across 43 CDOs backed all or in part by trust preferred securities (TruPS) issued by banks on rating watch negative. The agency also maintains the watch negative status of certain classes of notes issued across 59 CDOs backed all or in part by TruPS issued by banks or insurance companies.

These classes were originally placed on watch negative on 21 May. In certain instances, the assignment of watch negative and the maintenance of watch negative affect different classes of the same CDO. In aggregate, 75 CDOs are affected by these rating actions.

Fitch's rating actions are a result of continued credit pressures facing US banks and thrifts that finance TruPS through CDOs. Since the time of the initial rating actions on 21 May, Fitch has been notified of 17 bank TruPS deferrals, totalling US$463.5m. In addition, two banks previously in deferral are now deemed to be in default following regulatory seizure.

Exposure to these two entities totals US$591.3m. Taking into account these additional defaults and deferrals, the aggregate amount of bank TruPS defaults and deferrals observed by Fitch since September 2007 is US$1.6bn. This is in comparison to US$258.5m of bank TruPS deferrals observed by Fitch over the seven years prior to September 2007.

US banks that finance TruPS through CDOs face a number of negative, yet evolving, credit pressures. That said, Fitch believes it is premature to resolve the ratings of TruPS CDOs currently on watch negative until such time as greater clarity exits with respect to the likelihood of deferral for those entities currently performing, the likelihood of default for those entities currently in deferral and the recovery rate prospects for those entities currently in default.

In identifying transactions and individual classes of notes to be placed on watch negative, observed default and deferral activity was evaluated in the context of transaction-specific characteristics, such as available credit enhancement; prepayments and credit risk sales observed to date; obligor and geographic concentration; cashflow redirection mechanisms; and other structural enhancements. In certain instances, Fitch's rating actions reach higher in the capital structure of the TruPS CDOs affected on May 21, evidencing continued collateral deterioration facing such transactions. Rating actions are primarily focused on classes rated double-A or lower, although certain triple-A rated securities are also affected due to above average levels of default and deferral activity, outsized obligor or geographic concentration, or additional credit pressures stemming from underperforming exposure to insurance companies, real estate investment companies and/or homebuilders.

Fitch revises PF CDO criteria
Fitch has revised its criteria for rating CDOs exposed to project finance (PF) loans as part of its ongoing revision of its structured credit criteria.

The complex nature of PF CDOs means that Fitch will apply its criteria in three steps. The first step is a quantitative model designed to assess the expected risks for each liability the agency rates. The second step is to test the CDO liabilities against a series of standard scenario tests, including obligor concentration and recovery rate sensitivity.

The third step is to test the structure against idiosyncratic scenario tests to evaluate risks that may not have been captured by the standard quantitative model and scenario tests. These could include stress tests for a particular industry, country or constructor concentrations that are unique to the CDO being analysed.

The agency will communicate the results of these tests in transaction-specific rating commentaries. "The detailed description of project finance CDO-specific scenario testing in this criteria demonstrates Fitch's commitment to look beyond a model, while maintaining exceptionally high levels of transparency," says Philip McDuell, md and head of European structured credit for Europe and Asia in London.

OTC Val expands
OTC Valuations (OTC Val) has expanded its derivatives coverage for credit, inflation, equity, FX and fixed income products. The valuation platform will now include synthetic and bespoke credit products, such as CDOs.

Bob Sangha, md at OTC Val, says: "We are committed to evolving our service to address the ongoing market needs for a comprehensive solution for vanilla and complex derivatives pricing. The new product coverage not only enables clients to fill their exotic derivatives valuation needs, but also offers a single independent valuation source for their portfolios."

Given the growing interest in exotic derivatives and structured products among alternative asset manager, hedge funds and institutional investors, a need has arisen for accurate, timely and transparent valuations. "Fund administrators, asset servicing firms and custodians who provide services to clients with exotic and illiquid products require either an in-house solution, or an outsourced solution to a third-party vendor like OTC Val. For those who prefer to outsource, OTC Val's broad coverage and automated service provides a comprehensive solution for all of their clients' derivative portfolios," OTC Val says in a statement.

Kamakura adds synthetic CDOs
Kamakura Corporation has released version 7.0 of its enterprise-wide risk management system Kamakura Risk Manager (KRM) to clients world-wide. Selected new features in KRM 7.0 include:

• Addition of synthetic CDOs (cashflow CDOs have been in KRM since 2003)
• Expanded reporting of counterparty attributes for the Basel II standardised approach
• Reporting of random default rates used for each counterparty in each scenario and time period used in the simulation
• Allowing a user-defined proportional shift in default probabilities across the board
• Allowing a user-defined lag in the collection of recovery amounts on defaulted instruments
• Allowing a term structure of macro factors and the age of the instrument to affect the default probability in future time periods.

Fitch releases Q2 SF review
Fitch Ratings says its rating actions for global structured finance (SF) transactions during Q208 continued to be dominated by downgrades among US RMBS, as well as US CDOs. In its quarterly rating review of global SF deals, the agency also notes that US SF issuance remained moribund in Q208 compared to previous quarters, as recovery continues to elude the sector. While there was an apparent rebound in SF issuance in the EMEA and Asia-Pacific regions, the agency warns that this is deceptive and does not mark a revival in investor sentiment.

Glenn Costello, md and US SF risk officer at Fitch reports: "CDO downgrades were also concentrated in the commercial real estate CDO sub-sector, primarily amongst re-securitisations of commercial mortgage-backed security first loss B-pieces."

Further negative rating action on the insurer financial strength (IFS) ratings of financial guarantors, as well as mortgage insurance companies also led to rating action in SF transactions featuring credit support from these companies. As a result, there were a number of downgrades in the student loan sector in the US ABS segment, as well as in the Australian RMBS sector - although in both of these cases there has not been a significant deterioration in the performance of the underlying collateral.

Fitch-rated US structured finance issuance increased by 12.3% in Q208 from its Q108 low to US$58.6bn, but remained at historical lows due to the ongoing credit crisis. The increase was driven exclusively by core non-mortgage US ABS, with other asset classes remaining largely unchanged on the previous quarter.

There was an apparent bounce-back in EMEA SF issuance in Q208 to pre-crisis levels, as volume rose by 269.9% from Q108 to US$209bn. However, Stuart Jennings, md and EMEA SF risk officer at Fitch, says: "This issuance surge did not mark a sudden return of investor confidence to the market, but almost exclusively consisted of bank issuer-retained RMBS transactions for potential use as collateral for repo funding with the European Central Bank, as well as the Bank of England's Special Liquidity Scheme."

A similar issuance bounce was seen in the APAC region, with issuance in Q208 at US$30.1bn compared to US$1.6bn for Q108. Again, this did not indicate a revival in sentiment, with the vast majority of issuance being Australian bank issuer-retained RMBS intended for potential use as repo collateral with the Reserve Bank of Australia.

S&P SROCs drive actions in Europe and US
After running its month-end SROC figures for July, S&P has taken rating actions on European and US synthetic CDOs.

The agency has taken credit watch actions on 120 European synthetic CDO tranches: 72 tranches were placed on credit watch with negative implications; 21 tranches were removed from credit watch with negative implications and affirmed; and 27 tranches were placed on credit watch with positive implications. Of the 72 tranches placed on credit watch negative: 59 reference US RMBS and US CDOs that are exposed to US RMBS, which have experienced recent negative rating actions; and 13 have experienced corporate downgrades in their portfolios.

Meanwhile, S&P took the following rating actions on various US synthetic transactions: it placed 17 ratings on credit watch with negative implications; it lowered 97 ratings and removed 12 from credit watch negative and left one on credit watch negative; and it affirmed 40 ratings and removed them from credit watch negative.

The US credit watch negative placements reflect negative rating migration in the portfolios and the fact that the SROC ratios for the affected transactions had fallen below 100% as of the July month-end run. The downgrades affected classes that had SROC ratios below 100% as of the July month-end run and at a 90-day forward run, while the affirmations and credit watch negative removals affected classes that had SROC ratios at or over 100% at their current rating levels.

Bank fined over CDO mis-markings
The FSA has fined the UK operations of Credit Suisse £5.6m for breaches relating to pricing errors on CDO and RMBS positions held by the bank's Structured Credit Group (SCG). The FSA's Principles 2 and 3 were breached, says the UK regulating body, through CS' failure to conduct its business with due skill, care and diligence, and failing to organise and control the business effectively.

In February the bank revealed that it had identified mis-marking and pricing errors by a small number of traders and that it was re-pricing certain asset-backed securities, just a few days after announcing financial results for 2007. The re-pricing involved a write-down of revenues by US$2.65bn (see SCI issue 76).

The FSA states that in breach of Principle 2, CS failed adequately to supervise the business of the SCG and did not act in a timely way on the concerns it had identified about the pricing of certain asset-backed positions. In breach of Principle 3, adequate systems and controls were not put in place by the subsidiaries, which meant that they failed to recognise, for approximately five months, that certain of the SCG's asset-backed positions were wrongly valued.

"It is imperative, particularly in more challenging financial conditions, that firms have in place appropriate systems and controls to manage their risks. The subsidiaries here failed to take appropriate steps to control the potentially high risk combination in the Structured Credit Group's holdings of exotic products, opaque valuations and high leverage," comments Margaret Cole, director of enforcement at the FSA. "The sudden and unexpected announcement of the write-down had the potential to undermine market confidence."

Roll put on hold ...
A lack of new issuance has prompted Markit to postpone the roll of CMBX Series 6. The roll was originally planned for launch on 25 October 2008, but a majority trader vote last week ruled that the roll should not take place on that date. The issue will be revisited on 27 April 2009.

The roll of CMBX Series 5 was also subject to delay, but in that instance by just over two weeks. The series launched on 13 May 2008 instead of the planned date of 25 April to allow for the inclusion of newer deals of a higher underwriting standard and to ensure that the new series was representative of the current market.

... while Markit clarifies iTraxx rules
Markit has started a process to refine and clarify some index rules for the iTraxx indices. These proposed rule changes will be approved before the end of the month and implemented during the upcoming roll of the iTraxx Europe indices on the 22 September.

"The proposed changes are minor ones in our view," say analysts at UniCredit. "Apart from clarifying some existing rules, the changes reflect mainly two aspects: spreads have widened in the speculative grade universe. Therefore, the CDS spread cut-off rule has been modified. Reflecting the elevated levels of spread volatility, the mid-spreads referenced in the membership rules are calculated as averages over 10 business days, according to the proposal."

The proposed changes are as follows:

• The iTraxx Crossover spread cut-off rule says that spreads at least twice the end-of-day five-year mid-spreads of constituents of iTraxx Non-Financial Index (effective on the roll date) on the last business day of the month prior to roll determine eligibility
• Observation date is to be changed from the last business day of the month to the average over the last 10 London trading days in the month prior to roll
• The maximum cut-off level is to be changed from a maximum of 1250bp or upfront of 35% (no running) to 25%/30% upfront plus 500bp running
• 'Entity rating' for membership determination is to be defined as the minimum of: lowest of issuer rating, senior unsecured debt rating and corporate family ratings for Moody's; long-term issuer credit rating for S&P; lower of issuer default ratings and senior unsecured debt rating for Fitch
• 'Incorporated in Europe' specification for inclusion in the liquidity poll is to be clarified, where 'Europe' would be defined as EU and EFTA countries
• The rule for incorporating iTraxx entity name changes is to be removed. This states that if the reference entity changes its legal name, the relevant index annexes containing the reference entity will be updated to the new name (without publishing a new version of the annex)
• Annexes will be updated only when the next index annex is published (due to index roll or credit event)
• Rating changes for entities to be included in the index need to be notified by 17:00hrs London time on the third business day preceding the roll date
• The rating cut-off date is to be moved earlier to the last business day of the month preceding the roll date
• Entities with more than €100m of publicly traded securities determine eligibility in iTraxx Crossover index; 'publicly traded' securities is to be replaced by 'publicly traded debt' securities to clarify rule.

Rhinebridge ratings withdrawn
Moody's has downgraded and withdrawn its ratings on Rhinebridge following the conclusion of the SIV's portfolio sales, announced by the receiver on 6 August (see last issue). The sales proceeds were distributed to senior creditors on a pro-rata basis, but the distribution amount was insufficient to fully repay Rhinebridge's senior obligations.

Following the partial redemption of senior notes, the remaining amount of funds is insufficient to make any payments to holders of capital notes. Rhinebridge entered into enforcement on 18 October 2007, following a breach of the capital loss test triggered by severe declines in portfolio market value. The vehicle's average portfolio price dropped from 99.73% on 6 July 2007 to 64.56% on 18 October 2007.

US CRE CDO delinquencies decline
Most asset managers have been proactively managing their US CREL CDOs by exercising their rights to repurchase assets (see SCI issue 99). Nevertheless, liquidity pressures will make repurchasing an increasingly difficult option, according to Fitch.

Though on the rise in recent months, Fitch's CREL CDO Delinquency Index has remained relatively low, due in part to asset managers removing underperforming loans, according to the agency's senior director, Karen Trebach. Nearly two-thirds of asset managers have repurchased non-performing or sub-performing assets from their CDOs to date. However, approximately half of those asset managers face varying degrees of capital constraints that limit their ability to continue to repurchase underperforming assets on an ongoing basis.

"Reduced CDO cushions are becoming more commonplace with the dual pressures of reduced liquidity and increased delinquencies," says Trebach. "Constrained liquidity may also lead to more managers modifying and extending loans rather than repurchasing them, which, if not merited, may only serve to delay the possible realisation of losses on these loans."

Fitch views reduced repurchases as a factor that will contribute to increased delinquencies in CREL CDO pools. In periods of economic stress and constrained liquidity, Fitch anticipates increased delinquencies, especially for the type of loans found in CREL CDOs, which inherently require a sustained period of economic growth to achieve business plans necessary to achieve loan performance.

The Fitch CREL CDO Delinquency Index rose to 1.46% in July 2008 from 0.36% in October 2007, when the agency began tracking the index. The current delinquency rate, when accounting for cumulative repurchases, would grow to 2.6%. While even this rate is considered low relative to the credit enhancement in these transactions, an accumulation of impaired assets much beyond this level may result in more bonds from CREL CDOs being placed on rating watch negative or downgraded.

AC, MP & CS

Trading ideas: planes versus trains

Dave Klein, senior research analyst at Credit Derivatives Research, looks at a CSA pairs trade on FedEx Corp and Burlington Northern Sante Fe

Both the equity and credit markets have rallied nicely over the past couple of weeks. Equities have led the way and outpaced CDS tightening.

Roughly half the names we track using our CSA model show CDS trading too wide to their equity-implied fair values. This is a dramatic change from three weeks ago, when only three in ten names traded too wide. The equity outperformance has created good long credit/short equity opportunities, while maintaining a large number of short credit/long equity trades.

In this trading idea, we pair two names in the capital goods sector, FedEx Corp (FDX) and Burlington Northern Sante Fe (BNI), in a CSA pairs trade with a bet on return to fair value in both CDS and equity. Additionally, our MFCI model points to a FDX CDS tightening and a BNI CDS widening. Putting it all together, we recommend selling FDX CDS protection and shorting FDX stock, while buying BNI CDS protection and purchasing BNI stock.

Delving into the data
Our first step when screening names for potential trades is to look at where equity and credit spreads stand compared to their historical levels. To judge actual richness or cheapness, we rely on a fair-value model and consider the empirical relationship between CDS, implied volatility and share price. Since the week before last, FDX's CDS has underperformed its equity.

Exhibit 1 plots FDX five-year CDS premia versus fair value over time. If the current levels fall below the fair-value level, then we view CDS as being too tight or equity as being too cheap. Above the line, the opposite relationship holds.

Exhibit 1

FDX equity has rallied dramatically this month even as its CDS has widened. Exhibit 2 plots BNI five-year CDS premia versus fair value. In contrast to FDX, BNI equity has dropped significantly over the past couple of days while its CDS has continued to rally.

Exhibit 2

Exhibit 3 charts FDX market and fair CDS levels (y-axis) versus equity prices (x-axis). The green square indicates our expected fair value for both CDS and equity. The orange square indicates the current market values for CDS and equity.

Exhibit 3

With CDS too wide compared to equity (with volatility set to our expected fair value), we expect a combination of shares selling off and CDS tightening. The opposite is true for BNI.

Exhibit 4 charts BNI market and fair CDS levels (y-axis) versus equity prices (x-axis). With CDS too tight compared to equity, we expect a combination of shares rallying and CDS widening.

Exhibit 4

Risk analysis
The main trade risks are a drop in the volatility of CDS and equity, or if one of the names begins trading under a different regime and the current vol-equity-CDS relationship no longer holds.

Each CDS-equity position does carry a number of very specific risks:

Recovery and 'default' stock price assumption: In the default scenario the cheapest-to-deliver CDS obligation may have a higher than expected market value and the stock price might not fall as assumed.

CDS present value (PV): The CDS PV is an expected value, but not necessarily a realised outcome. In practice, the CDS may trade on an up-front or running basis.

Corporate actions: Spin-offs and private equity buyouts, for instance, could radically change the equity-CDS relationship, leaving investors with a mishedged position. A BNI bailout (à la Bear Stearns) would have a massively negative impact on the trade, as credit would rally and equity value would be destroyed.

Mark-to-market: In our view, credit and equity markets operate largely independently and this can lead to trade opportunities. At the same time, any relative mispricing may persist and even further increase, which could lead to substantial return fluctuations. Additionally, the trade faces a fairly substantial bid-offer to cross in CDS.

Overall, frequent rehedging of this position is not critical, but the investor must be aware of the risks mentioned above. To dynamically hedge, we recommend adjusting the equity positions, given CDS transaction costs.

Liquidity
Liquidity (i.e. the ability to transact effectively across the bid-offer spread) in the bond and CDS markets drives any longer-dated trade. Our data on liquidity, created from the volume of bids, offers and trades that we see each day, reassure our trading in FDX and BNI. Both are liquid names and CDS bid-offer spreads are around 5bp for BNI and 10bp for FDX.

Fundamentals
This trade is based on the relative value of the names' CDS and equity, and is not motivated by fundamentals. However, we note that our MFCI model is bearish on BNI and bullish on FDX CDS, indicating an expected spread differential tightening. We note this trade works as a pure CDS pairs trade, as well for clients who do not wish to put on the equity legs.

Summary and trade recommendation
Both the equity and credit markets have rallied nicely over the past couple of weeks. Equities have led the way and outpaced CDS tightening.

Roughly half the names we track using our CSA model show CDS trading too wide to their equity-implied fair values. This is a dramatic change from three weeks ago when only three in ten names traded too wide.

The equity outperformance has created good long credit/short equity opportunities, while maintaining a large number of short credit/long equity trades. In this trade, we pair two names in the capital goods sector, FedEx Corp (FDX) and Burlington Northern Sante Fe (BNI), in a CSA pairs trade with a bet on return to fair value in both CDS and equity.

Additionally, our MFCI model points to a FDX CDS tightening and a BNI CDS widening. Putting it all together, we recommend selling FDX CDS protection and shorting FDX stock, while buying BNI CDS protection and purchasing BNI stock.

Sell US$10m notional FedEx Corp 5-Year CDS at 105bp.

Sell 8,400 FedEx Corp shares at a price of US$88.32/share.

Buy US$10m notional Burlington Northern Sante Fe 5-Year CDS at 46bp.

Buy 2,100 Burlington Northern Sante Fe shares at a price of US$96.41/share to receive 59bp of 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).