Contents

REI Global planned

Lehman's spin-off sets example for problematic assets

Banks looking to divest themselves of problematic assets may look to Lehman Brothers for the latest example to follow. Today, 10 September, the bank confirmed speculation that it is to spin off (to shareholders) up to US$30bn of commercial real estate assets into a separate company.

In doing so, Lehman believes that the new company - named Real Estate Investments Global (or REI Global) - will be appropriately capitalised to hold the CRE assets through the current economic cycle, and that it will be able to account for its assets on a hold-to-maturity basis. Furthermore, the bank says that REI Global can manage the assets without the pressure of mark-to-market volatility and that it will not be forced to sell assets below what REI Global believes to be their intrinsic value.

At the time of formation, which is planned for Q109, REI Global will be capitalised through the transfer of common equity and provision of debt financing, which the firm may syndicate as markets normalise. REI Global's primary focus, Lehman says, will be to maximise shareholder returns by selling assets or holding them to maturity, depending on the option that provides the greatest return. However, REI Global does not intend to invest in new assets and any excess cashflow will be returned to shareholders.

The rumour mill was in full swing during the run up to the Lehman announcement, with credit analysts speculating on the potential sale of the CRE assets. Most agreed that Lehman would face a lose-lose situation with its real estate assets, suggesting that it would face losses whether it spun them off or wrote them down. However, moving the assets into the separate company might offer a way to soften the impact, some analysts suggested.

"The investment bank could structure the spin-off in a way that it would be more advantageous financially than a straight sale," one firm's strategists speculated in a research note last week. "Lehman shareholders would get stock in the spin-off and the latter could try to attract investment from third parties. The new entity might offer a chance for courageous investors to make a bet on distressed CRE assets and would in any event be a last-chance attempt by ceo Richard Fuld to keep Lehman independent."

Several other banks have taken similar approaches in the past few months in order to disassociate themselves from troublesome assets. This includes UBS' sale of US$15bn sub-prime assets to a fund managed by BlackRock at the end of June and Merrill Lynch's sale of US$30.6bn US super-senior ABS CDOs to an affiliate of Lone Star for US$6.7bn in July (see SCI passim).

Lehman has also confirmed that it is formally engaged with BlackRock to sell approximately US$4bn of its UK residential mortgage portfolio and expects to complete the sale within the next few weeks.

"Assuming a successful spin-off of the bad assets, the next challenge would be for Lehman to continue with its business in its current form - which will not be easy, given the state of the markets and the breakdown of the weaker investment banks' business model," says Andrea Cicione, senior credit strategist at BNP Paribas.

Meanwhile, AIG is allegedly considering creating a separate company to transfer billions of sub-prime securities off its balance sheet. The insurer is said to be working with JPMorgan on the project.

AC

Testing times

GSE conservatorship poses operational challenge for CDS market

CDS market practice faces its greatest test in the coming weeks as it settles more than US$1.4trn of Fannie Mae and Freddie Mac contracts, following the US Treasury's placement of the entities into conservatorship. While investors are unlikely to be greatly impacted by the move since the bonds are expected to trade at par, dealers will have to recognise the loss. The move has shifted more attention towards idiosyncratic risk, putting downward pressure on correlation.

The Treasury's action comprises four steps that it says "best meets our three objectives of market stability, mortgage availability and taxpayer protection". Under the plan, the GSEs will modestly increase their MBS portfolios through to end-2009, after which their portfolios will begin to be gradually reduced at the rate of 10% per year - largely through natural run off - eventually stabilising at a less risky size.

Additionally, Preferred Stock Purchase Agreements (contractual agreements between the Treasury and the GSEs) have been established to ensure that each company maintains a positive net worth, with the aim of supporting market stability and investor confidence. Together with making a new secured lending credit facility available to the institutions, the Treasury is also initiating a temporary programme to purchase GSE MBS.

ISDA is preparing to launch a protocol to facilitate settlement of credit derivative trades involving Fannie Mae and Freddie Mac. Tim Backshall, chief credit derivatives strategist at Credit Derivatives Research, notes that one concern is the sheer size of outstanding FNM and FRE debt. Even with an orderly auction process, liquidity would clearly be an issue with bids and offers in this size (though this is somewhat mitigated by the explicit nature of the guarantees).

In addition, he says: "The CDS trigger event implies that all mark-to-market gains/losses are wiped out. If - as we assume - recovery rates are par, all current MTM gains or losses will be negated and effectively returned. In delivery, the cheapest-to-deliver obligation may trade above par in this case, but the auction process caps the payment at par."

Given the US government's senior preferred position and the now-explicit guarantee, both senior and subordinated CDS are expected to settle at par. Indeed, it appears that the indices are trading as if the trigger had already occurred at par, according to Backshall.

One analyst suggests that, since the bonds will trade at or around par, investors are unlikely to feel much bottom-line discomfort. "Rather the Street will have to recognise the 'loss', as it will have PV-ed the future premium income from the CDS upfront and have to 'give it back'," he says. "Now that recovery will be par (or as near as makes little difference), the value of the hedge is a net negative relative to the income already recognised. We're not talking much more than low triple-digit million in the worst-case scenario on this trading 'loss', albeit those which held the prefs will have to recognise these down to effectively zero or a minimal residual value."

Cash settlement is expected to occur in part, as there is likely to be more notional outstanding than bonds deliverable. Certainly cash settlement is more likely on the sub CDS, given that there is only US$15bn (US$11.1bn Fannie, US$4.5bn Freddie) of sub bonds outstanding; the US$1.37trn (US$541bn Fannie, US$831bn Freddie) of senior bonds outstanding provides a much broader base of deliverable instruments.

Meanwhile, Markit has published new versions of all CDX indices that included either Fannie Mae or Freddie Mac as a constituent, with both entities removed. In addition, new Markit RED codes have been issued for these indices, as well as for the Fannie Mae and Freddie Mac post-credit event entities.

CS

Third time lucky?

Optimistic outlook for LevX roll as constituent change mulled

Traders are optimistic that the Markit iTraxx LevX Series 3 should see improved liquidity and an increase in trading volumes following its launch on 22 September. While activity on Series 2 has been limited over the past couple of months, the replacement of up to 10 contracts in the senior index is expected to attract more investor interest post-roll.

"We're hoping that the new roll will gain more attention," says one London-based LevX trader. "By taking out some of the hairier credits and replacing them with better names, we expect that liquidity will be enhanced and trading volumes increased."

LevX Series 1 rolled into Series 2 six months ago, when a radical overhaul of the index rules came into effect (see SCI issue 81). Such a step is unlikely for the upcoming roll, however - the replacement of 10 constituents is all but decided upon, following a recent dealer call, with final decisions from Markit expected imminently.

According to a recent UniCredit structured credit research note, the four widest-trading names are set to be removed from the present index, thereby reducing the average spread from 490bp to 451bp (based on currently available data), while the median should remain essentially unchanged. However, the analysts point out that these figures are subject to uncertainty, as LCDS spreads are missing for 17 of the Series 2 entities and for 21 of the prospective Series 3 entities. "The true average spreads should be larger than determined here, as LevX Senior Series 2 trades around 98% in price terms and the fixed spread is 525bp," the analysts add.

Tim Brunne, quantitative credit strategist at UniCredit, comments that the LevX Series 1 and 2 have been facing difficulties, as accurate data regarding the underlying single name CDS contracts has not always been provided by Markit, or quotes - if available - have been supplied by a number of different providers. "This situation is now being addressed by Markit, and it is trying to introduce more standardisation. It is also introducing new RED codes," he says. He adds that, as standardised products generally attract more liquidity, standardisation in the LevX should therefore result in better liquidity and possibly higher trading volumes.

The names expected to be removed from the index include: BAA, Carl Zeiss, Cartefiel, HCA, Hilding Anders, Invensys, Lafarge Roofing, McCarthy and Stone, Terreal and Vivarte. Expected to replace those names are: Alliance Boots, AVR, Biffa, CHC Helicopters, Conva Tec, Expro, Gartmore, Jupiters, SIG and Telnet - subject to the documentation complying with the index standards. There remain questions over some of the names, such as CHC Helicopters - a very recent deal - meaning it is not certain that it will be included.

Furthermore, other documentation issues are also still to be decided upon, such as parameters for LevX CDS that are as yet undetermined. In particular, the fixed coupons and recovery assumptions for calculation purposes have not yet been finalised for Series 3.

The sub index is unlikely to see any substitutions, but a new maturity date is expected to be set.

According to the UniCredit analysts, those investors with exposure to LevX risk in Series 2 seeking to roll over their positions to Series 3 will have to pay a premium to cancel their contracts. "It should be expected that Series 3 initially trades roughly around 100% and the fixed spread of the senior index is lower than the current fixed level of 525bp," they conclude.

AC

SC HF Index dips

July sees credit hedge fund performance decline further

Both gross and net monthly returns for July 2008 in the Palomar Structured Credit Hedge Fund (SC HF) Index saw a further decline into 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 -2.05% and a net return of -2.18% for the month of July (compared to -0.80% and -0.93% respectively in June), with 13 of 25 funds reporting positive monthly results. The dispersion and range of returns increased compared to the data observed in June.

The Index was adjusted according to the index rules as of 1 July, with three funds removed and six new funds added. 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 25 member funds, representing over US$12bn 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.

A differentiated approach

Paul Rivlin, joint ceo of Palatium Investment Management, answers SCI's questions

Paul Rivlin

Q: When, how and why did your firm become involved in the structured credit markets?
A: Palatium Investment Management grew out of the real estate investment banking business that Neil Lawson-May, Palatium joint ceo, and I set up at Deutsche Bank in 1997, which was sold to Eurohypo in 2002. Over that time, we gradually built up a mezzanine advisory business, which branched out into capital markets and asset management. Neil and I then bought out the asset management arm, which is now known as Palatium (see SCI issue 90), and so mezzanine real estate and structured credit have always been our core focus.

The two funds launched under Eurohypo's asset management arm and which were included in the MBO are Greycoat Central London Office Development and Glastonbury Finance 2007-1. Greycoat is a pure equity vehicle formed by a small group of investors, who have taken a view on a portfolio of real estate development projects in Central London over the medium to long term. Projects acquired, to date, are Collingwood House, Tower House and Crown Place.

Glastonbury was the first CRE CDO to be launched by a European institution and the first denominated in sterling (see SCI issue 30). The portfolio comprises predominantly UK retail, office, mixed use, pubs and multi-family CMBS assets. The underlying exposures are good quality and so we expect the transaction to be resilient to market dislocation.

Real estate differs to other industries because it is a specialism in itself: asset-based businesses have different profiles to operating-based businesses. While operating-based businesses focus on earnings and the repeatability of those earnings, real estate asset-based businesses look for underlying value, as well as income. Value creation is about the quality of a building, the use of a building and how it's managed.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: In the short-term it has been the credit crunch. But in the medium-term the most important development has been the introduction of Basel 2 because it has changed the playing field on an ongoing basis, creating structural changes in the banking environment. Under Basel 1, it didn't matter to a bank how it lent on a 25-year lease, for example, because they had to reserve the same amount of capital whether it was a risky project or not. Consequently, banks typically tried to maximise their return by lending on riskier projects.

However, Basel 2 ensures that different amounts of capital are reserved according to the level of risk of the project. Whereas in the past banks have been indifferent as to whether they lend on a 50% LTV project or a 80% LTV, now it is necessary for them to calculate the risk and rewards of each loan. It provides a differentiated approach to risk.

Q: How has this affected your business?
A: The new Accord means that low-risk lending is more profitable and so banks are unlikely to get involved in the 80% to 90% LTV lending segment, thereby creating opportunities for non-bank lenders to step in. Basel 2 provisions will have the most impact on the above-60% LTV area, so we see opportunities to develop a structured product fund in the 60% to 75% range and a traditional mezzanine product fund in the 75% to 90% range.

Q: What is your strategy going forward?
A: The structured product fund is likely to be aimed at the institutional market, where investors are interested in 12% IRRs, and it will fit into the real estate mix for some and a broader fixed income portfolio for others. The mezzanine fund is likely to provide either direct advances to borrowers or acquire tranches of syndicated loans.

The traditional mezzanine product has been squeezed out in recent years because banks have been willing to lend high-LTV products as senior debt. But in a more conservative climate and following the introduction of Basel 2, it will be a while before banks return to this segment.

We see investment opportunities coming from a number of sources, including from borrowers or banks approaching us for financing, or from a debt/CMBS restructuring. It is a question of reflecting the wider mood of the market.

We are positioning for when people are ready to come back to the market. Initial demand is expected to come from sophisticated investors who are able to understand the market and the risk profile, although the balance of returns and risk protection should have wider appeal eventually.

Q: What major developments do you need/expect from the market in the future?
A: It isn't clear how the future will play out: we're going through the process of understanding the pressure points in the market right now. The direction of the market is less clear than is currently predicted, so the reality is that we're likely to be bouncing along the bottom for another two or three years. Clearly, launching new CMBS or CRE CDOs will be difficult in the near term and so our funds will become one part of the solution that should help the market get back on its feet.

About Palatium Investment Management
Palatium Investment Management is a specialist in real estate funds requiring active management. Palatium works with proven asset managers to structure and operate specialist funds for institutional investors.

It provides investors with fund opportunities designed to deliver above average returns but with a strong emphasis on risk management. All funds are underpinned by robust systems, processes and transparent reporting.

Trading head moves to buy-side

The latest company and people moves

Trading head moves to buy-side
Olivier Morand-Duval has joined ICP Capital, a boutique investment firm specialising in structured credit. He will be based in London. Morand-Duval joins ICP from Calyon, where he was European head of ABS trading.

Fund hires credit analyst
Chenavari Credit Partners has appointed Atif Malik as a senior credit analyst. He was previously a senior high yield and leveraged loan analyst at BlackRock, where he was responsible for setting up the firm's London leveraged finance operation in 2007. Based on the group's top-down and sector strategies, Malik employed a generalist approach in opportunistically identifying relevant trade ideas (basis, cap structure, carry, curve, directional, event-driven, pair and switch trades using bonds, loans, CDS, LCDS and indices) for various funds (credit hedge fund, special opportunity fund, separate accounts, retail funds and CLOs).

From 2005 to 2007 Malik was a senior analyst of the London BlackRock team, with responsibility across heavy and basic industries, and was the highest performer in the analyst-run model portfolio. He also helped develop the research process and relative value scorecard.

From 2002 to 2003 he was a senior auditor for Abu Dhabi Investment Authority in Abu Dhabi. Malik began his career with PricewaterhouseCoopers' graduate programme, gaining four years' experience in audit, forensic accounting, corporate finance and management consulting across the UK and internationally.

CDPC head appointed
Steven Kahn has joined Invicta Financial Group as president and executive officer. He will be responsible for the daily operations of Invicta, a triple-A rated CDPC established in 2006, which will continue to focus exclusively on super senior corporate credit transactions.

Prior to joining Invicta, Kahn had been with Financial Security Assurance (FSA) since 1996, most recently heading the group that originates, underwrites and structures credit derivative transactions and CDOs for the firm's insured portfolio. He also oversaw sourcing and execution of arbitrage and regulatory capital-driven transactions utilising funded and synthetic risk-transfer structures backed by investment-grade and high-yield corporate, emerging market and structured credit risk.

Kahn assumes duties from Matthew Natcharian, a member of the Invicta companies' board of directors and head of structured credit products and investments at Babson Capital Management, Invicta's affiliate and portfolio manager. Natcharian temporarily replaced Invicta's initial president and executive officer, Ian Hawkins, who stepped down at the end of June.

Bank builds in structured credit
Morgan Joseph has made two senior additions to its newly created structured products group. Michael Ice moves over from HSBC, where for the last three years he was an md and senior salesperson specialising in structured credit products. Peeyush Varshney, previously a vp at Goldman Sachs' structured credit, fixed income currency & commodities division, has also joined the firm. Both will be headquartered in New York.

Calyon to exit structured credit
Credit Agricole this morning (10 September) unveiled a new strategic plan for Calyon, which will result in the bank exiting the structured credit and derivatives businesses. According to a statement, the bank will exit from capital market activities that are incompatible with the targeted risk profile.

"Consequently, structured credit and derivatives activities resulting in accumulated risks that may be difficult to cover during periods of instability are being discontinued," it says.

The bank will now focus exclusively on core activities and business lines where it has 'recognised expertise', such as structured finance, brokerage and fixed income activities.

Calyon expects to cut about 500 positions, split equally between French and international operations. In France these will be based on voluntary redundancies and internal mobility.

Wachovia appoints FI head
Wachovia has hired Craig Overlander as md and global head of fixed income, beginning 15 September. He was most recently co-head of fixed income at Bear Stearns, and has been closely involved in managing the transition during the firm's acquisition by JPMorgan. Overlander will report to Ben Williams, head of global markets and investment banking, and will be based jointly in Charlotte and New York.

Citadel builds up mortgage business
Citadel Investment Group has announced four senior hires in its mortgage and securitised products business. Glenn Perillo will join Citadel as head of securitised products research, reporting to Patrik Edsparr, head of global fixed income and ceo of Citadel Europe. Perillo was most recently with BlackRock's portfolio management group, where he specialised in residential mortgages.

Additional team members in Citadel's mortgage business include three mortgage portfolio managers: Kevin Scherer, who co-founded and served as a partner with Midway Group and was previously with Credit Lyonnais; Brian McDonald, formerly a md and senior portfolio manager with JPMorgan's ABS principal investment group; and Rajan Dabholkar, who was most recently with Proxima Alfa Investments and also held positions with JPMorgan and Credit Suisse. All three portfolio managers will join Citadel's securitised products team in New York, headed by Bill King.

Kodiak takes on Attentus CDOs
Kodiak Funding has acquired the managing member interest in Attentus Management Group, and has taken on the CDO portfolio management duties of Attentus' three outstanding CDOs. Attentus is an entity specialising in the management of CDOs backed by REIT debt and trust preferred securities. With the addition of the Attentus CDO assets, Kodiak Funding will now manage more than US$2.8m in real estate-related securities.

ACA appoints new ceo
ACA Financial Guaranty Corp has announced a new board of directors and ceo in connection with a complete restructuring of its balance sheet and obligations. Willis King, executive chairman of First Protective Insurance Company and Fidelity Fire and Casualty Insurance Company, was named chair of the reorganised board. Raymond Brooks, a former md with Alvarez & Marsal, was named ceo and a director.

This follows the Maryland Insurance Administration's approval of a restructuring plan for ACA, which took effect on 8 August (see SCI issue 101). As a result of the restructuring, ACA Capital Holdings no longer controls ACA Financial Guaranty Corp, and the control of ACA Financial Guaranty will reside with a group of certain former counterparties to the transactions guaranteed by ACA.

Brooks has more than fifteen years of experience in risk management, capital markets and portfolio management. Over the course of his career, Brooks founded Pine Creek Healthcare Capital, which was a high yield and distressed healthcare debt manager. He also held positions at Price Waterhouse, Lehman Brothers and Aubrey G. Lanston/Industrial Bank of Japan.

In addition to King and Brooks, the new members of the board of directors include Richard Caplan, formerly the co-head of North American structured credit products for RBS Greenwich Capital and Citi, and Roger Cunningham, who has had a 25-year career in the financial guarantee industry, including various senior credit and underwriting positions at RAM Reinsurance Company, FSA and FGIC.

Kengeter to join UBS
UBS has appointed Carsten Kengeter as global head of the fixed income, currencies and commodities (FICC) business within its investment bank. Kengeter, formerly a credit derivatives trader and structurer at Barclays de Zoete Wedd, joins UBS from Goldman Sachs and will relocate from Hong Kong to London in his new role. He will report to Jerker Johansson, chairman and ceo of UBS, and will join the investment bank executive committee and the UBS Group managing board.

Kengeter will be responsible for all fixed income products, including credit fixed income, rates, structured products, emerging markets, securitised products, as well as client coverage and research. He will also have responsibility for UBS Investment Bank's market-leading foreign exchange business and the global commodities group. When he joins the firm in the early part of 2009, Kengeter will assume the leadership of FICC from Johansson, who will continue to manage the business on an interim basis until then.

Global OTC derivatives head hired
GlobeOp Financial Services has appointed Jon Anderson as global head of OTC derivatives. Anderson will report to Vernon Barback, GlobeOp president and coo, and will be based in the company's Manhattan headquarters office. He will also join GlobeOp's operating committee.

Anderson brings nearly 20 years of derivatives-related trading and operational experience to GlobeOp. He was previously md and head of trading technologies at BlueMountain Capital Management, where he was also head of investment management support, building out the firm's risk and profit analytics, collateral management and operations functions.

FCS Corp acquisition completed
Markit has completed the acquisition of FCS Corporation from JPMorgan. The acquisition of FCS, a provider of syndicated loan market portfolio and risk management software and services, including the Wall Street Office family of products, will enable the firm to continue to develop new solutions to improve operational efficiency and transparency in the loan markets, it says in a statement.

Sky Road opens in London
Financial solutions provider Sky Road has opened a London office to include sales and support functions. The operations will be managed by Margaret Birch, who brings nearly 17 years of experience in the financial markets, including trading, market data training and trading system sales and support. She will act as client liaison and oversee relationship management with the firm's clients and global partners.

"We've seen growing interest in our solution from the European markets. Following trends in North America, UK-based funds employing global macro, credit derivative and other complex hedge fund strategies value the functionality and breadth of our cross-asset solution," says John Borse, ceo and founder of Sky Road. "The launch of our London office comes at a time of continued growth and expansion for the firm, and we are pleased to be extending our product internationally."

AC & CS

ABX.HE 05-2 to launch

A round up of this week's structured credit news

ABX.HE 05-2 to launch
Markit says it plans to launch an ABX.HE 05-2 index on 2 October 2008. The index had previously been unable to roll into a new series, due to a dearth of eligible underlying bonds.

The ABX.HE 05-2 index will reference 20 qualifying RMBS deals issued in the first half of 2005. Markit says that the addition of the new index, following a majority vote of licensed dealers, will provide institutional investors with a greater ability to gain or hedge exposure to an earlier vintage of US RMBS.

The underlying deals will be selected according to the rules governing the index, which were revised on 5 September to include the launch of the ABX.HE 05-2 index.

Mixed response to repo changes
The ECB amended its repo eligibility criteria on 4 September by increasing the haircut for ABS/CLOs to 12%, plus an extra 4.4% for deals that have been restructured and repacked with a theoretical value only, effective from 1 February 2009. Market reaction was mixed: some analysts expect the impact to be muted and perhaps even positive for sentiment, while others believe that the move is too restrictive.

Structured finance analysts at HSBC note that the change adds overall to the cost of bringing retained deals and, thus, reduces the attractiveness of ECB funding by way of 'fabricated' retained deals. "In a way, these statements broadly confirm the ratings and ABS model of funding via securitisation, in our view, so it could in the end even be positive for the market. ECB head Trichet in the press conference said explicitly that the ECB did not want to reduce the share of ABS in the collateral base," they add. But the analysts point out that the new rules are clearly positive for covered bonds, which are now privileged over bank bonds and ABS.

However, according to UniCredit structured credit strategists, the move is a restrictive monetary policy action because - together with making ABS funding more expensive - it limits the theoretically available amount of funding. "In our view, this can be a pretty dangerous strategy, as the ECB did not provide banks with any alternatives."

Other changes relevant to securitisations include the stipulation that any ABS which has a currency swap/hedge in place from a close-linked party will not be accepted, though distant third-party hedged securities appear to be accepted still. Additionally, for rated ABS, transactions must now have a public rating and the securities must receive at least a quarterly review.

Pair charged with ARS fraud
The SEC has charged two ex-Credit Suisse employees with defrauding their customers when making more than US$1bn in unauthorised purchases of sub-prime-related auction rate securities (ARS). The commission alleges that Julian Tzolov and Eric Butler misled customers into believing that ARS being purchased in their accounts were backed by federally-guaranteed student loans and were a safe and liquid alternative to bank deposits or money market funds. Instead, the securities that the pair purchased for their customers were backed by sub-prime mortgages, CDOs and other non-student loan collateral.

"As alleged in our complaint, these two brokers foisted more than US$1bn in sub-prime-related securities upon unsuspecting customers to illegally obtain higher commissions from their sales," says Linda Chatman Thomsen, director of the SEC's Division of Enforcement. "As always, if you commit fraud, you can expect to be held accountable by the SEC. The Enforcement Division's vigilance extends throughout our financial markets, including the sub-prime lending and credit markets."

Filed in federal court in Manhattan, the SEC's complaint alleges that Tzolov and Butler - while employed at Credit Suisse Securities (USA) in New York - deceived foreign corporate customers in short-term cash management accounts by sending or directing their sales assistants to send e-mail confirmations in which the terms 'St. Loan' or 'Education' were added to the names of non-student loan securities purchased for the customers. The pair also routinely deleted references to 'CDO' or 'Mortgage' from the names of the securities in these e-mails. As a result, the complaint alleges that customers held more than US$800m in illiquid securities after auctions for ARS began to fail in August 2007.

New CPDO coding error emerges
Moody's has placed 11 European CPDOs, worth approximately €854m, under review for downgrade following the identification of a coding error in a CPDO monitoring model that has been in use for two months. The agency expects to complete this review by 15 September and says that the most likely outcome is a one- or two-notch downgrade.

The review will also consider the further widening of spreads on investment grade reference credits that has affected these CPDOs since Moody's last review. The widening of spreads increases the likelihood of a cash-out event and decreases the likelihood that net asset value will rebuild to par by maturity.

The securities under review are: Castle Finance I Series 7, 8 and 9; SEA CDO Series 2007-3 and 2007-5; Ruby Finance Series 2007-2; Arlo X Series A-1E; Cairn CPDO I Series A1-E1, A1-U1 and B1-U1; and M.A.V.E.N. Series 4828.

Novated CDS trades to rise dramatically
TABB Group estimates that the average notional value at risk (the total value of a leveraged position's assets) of trades novated monthly will exceed US$45.2trn by 2010, an 88% CAGR (compound average growth rate) from 2005.

According to senior analyst Kevin McPartland, author of new TABB Group research 'Credit Default Swaps: The Risk of Inefficient Markets', 90% of all CDS trades are confirmed electronically, but same-day matching of new trades and novations is rare and error rates are unacceptably high. "This is a lot of money to risk on a phone call," suggests McPartland.

TABB Group forecasts that nearly US$170m will be spent in 2010 by major sell-side broker-dealers to automate the affirmation process and mitigate the potential risk resulting from trade exceptions.

Despite current available technology, details of most CDS trades are still not affirmed between counterparties on trade date. The delay is not in legally confirming or settling trades, but simply in agreeing that each party recorded the same basic trade details, such as the reference entity or notional amount. Where overnight batch jobs were once accepted solutions, with 2008 trading volumes and market volatility levels, explains McPartland, "the risk created by not understanding your market and counterparty exposure until the next morning makes this standard practice rather unacceptable".

While it is not the job of any single regulatory, technical or financial entity to solve the counterparty risk problem, all firms must create an automated, timely process ensuring decisions are based on accurate information. Technology exists to raise accuracy levels above 99% and, with so much to gain for all involved, McPartland asks: "Why not take that step? Trade processing backlogs must not simply be reduced, they must be eliminated entirely."

According to McPartland, affirmation of trade details by front-office systems on trade date will result in a positive downstream affect. Accuracy will allow for a considerably higher rate of confirmations on trade date and more timely settlement. Even more critical than for new trades, automating this process for novations will increase transparency and reduce risk for the entire industry.

"The benefits gained will far outweigh the money spent," adds Andy Nybo, senior analyst and head of TABB Group's derivatives research service. "The number of staff needed to manage the novation process will decrease dramatically. Although difficult to measure, savings will also be realised through reduced capital requirements, lower potential for costly litigation due to unconfirmed trades and a reduction in losses resulting from operational errors in the trade process."

Muted prospects for Asia ex-Japan
In a new report, Moody's is cautious on the prospects for the structured finance markets in Asia ex-Japan in 2H08 as originators continue to wait for better market conditions, while moderate growth was recorded in 1H08.

"Most activity will likely take place in Korea and India, and in addition to the traditional RMBS, auto loan and credit card receivables backed transactions, new asset classes may emerge in Korea, while interest in covered bonds has also been growing," says Dominique Gribot-Carroz, a Moody's business development executive.

The report also received contributions from Moody's affiliates in Asia: China Chengxin Int'l Credit Rating Co, Korea Investors Service and ICRA Ltd in India.

"If market conditions improve in 2H08, we may see SME loan securitisations in China, a RMBS transaction in Indonesia, as well as the resumption of real estate securitisations in Singapore; and in the regional derivatives market, we expect new balance-sheet transactions with significant Asian exposure," the report says.

During 1H08, regional issuance - exclusive of derivatives transactions - increased to US$29.3bn from US$27.9bn, the report adds.

"The rise was primarily driven by markets in South Korea, India and China, but other jurisdictions - Taiwan, Singapore, Hong Kong, Thailand and Indonesia - were quiet," says Gribot-Carroz. "Cross-border issuance - excluding regional derivatives transactions - totalled US$2.8bn and accounted for 9.7% of 1H08 cross-border and domestic issuance." All the cross-border transactions closed in Korea.

"At the same time, the regional derivatives market was quiet, except for balance-sheet transactions, while repackaged deals were done mostly privately," adds Gribot-Carroz.

Still "room for improvement" for leveraged finance
In the year since the onset of the liquidity crunch, European leveraged finance issuers have increased lender protection but there is still room for improvement, according to a report published by S&P.

"The market is slowly adopting more conservative structures to meet investor demand," says S&P research analyst Taron Wade. "Arrangers may be tailoring structures more conservatively to appeal to banks - now the dominant lenders -because they generally are more credit disciplined than institutional investors and hedge funds."

Ratings and credit estimates assigned to leveraged loans in 2008 reflect this trend. The proportion of single-B plus and double-B minus credits is higher this year than last, while the proportion of single-B minus credits is lower. The absence of recapitalisations is another sign of a less aggressive borrowing market.

Some deal features remain surprisingly aggressive, however. Total debt remains higher than the 2006 average levels, when the leveraged finance market was already aggressive.

Average total leverage in the first half of 2008 was 5.48x EBITDA, according to S&P LCD. This compares with 5.52x in 2007 and 5.43x in 2006. The last time the average total debt multiple fell below 5x was in 2004, when it was 4.54x EBITDA.

Another indicator of aggressive deal structures is the higher concentration of risk in the distribution of ratings and credit estimates in 2008 compared with 2007. In 2007, ratings and credit estimates ranged from triple-C plus to double-B plus, whereas deals completed in 2008 have been assigned ratings and credit estimates ranging from single-B minus to double-B minus.

One reason for issuers' apparent reluctance to fully embrace the necessary move to better structures for lenders could be that default rates have not yet climbed steeply, despite the worsening economic conditions the market has seen throughout 2008. "Protection for lenders on new deals, such as larger cash interest coverage ratios and significantly lower debt multiples, may not improve until the default rate in Europe starts to climb, forcing lenders - particularly banks - to face facts and demand better terms," Wade adds.

One year on since the onset of the liquidity crunch, it is quite apparent that the economic repercussions are starting to be felt by the most vulnerable industrial companies, S&P says. Yet, while the US leveraged loan default rate has risen sharply in 2008, to date there has been no discernable increase in the European loan default rate from the level seen in recent years.

Loan defaults could jump significantly
European leveraged loan issuers have remained relatively unscathed, protected by a degree of built-in defenses incorporated into their structures and the willingness of lenders and shareholders to provide support. But defaults in the region could jump significantly once both lenders and sponsors adopt a much more unforgiving stance where financial restructuring is clearly required, S&P says in an article entitled 'European First-Half Loan Default Rate Stable So Far, But A Sharp Jump Is Plausible'.

In the year to end-July 2008, globally S&P has seen 52 publicly rated companies default, driving up the trailing 12-month speculative-grade default rate to 1.79%. This compares with only 22 publicly rated companies globally for the whole of 2007, which translated into a record low 0.97% default rate.

Of these 52 companies, the only rated European company to default was the French drinks manufacturing company Belvedere, which voluntarily filed under the procédure de sauvegarde in July 2008. Furthermore, in the 12 months to the end of June 2008, not a single European publicly rated industrial company had defaulted.

However, in Europe it is misleading to review in isolation the default experience of those mainly high-yield issuers that are publicly rated, as much issuance activity occurs below the radar screen in the unrated private leveraged loan market. S&P's private credit estimate database of 648 entities (end-June 2008), comprising mainly private leveraged loans held in institutional investors' portfolios, tells a quite different story. Over the 12-month period to end of June 2008, 10 defaults were recorded in Europe, representing a default rate of 1.55%.

Defaults under its rating agency definition encompass failure to pay and bankruptcy filings, as well as restructurings involving coercive exchanges that result in material losses for creditors. Although higher in terms of the number of defaulting entities, this is not materially different from the private default rates experienced in the CE portfolio in the 2004-2007 period.

"To get a sense of how far the private European loan default rate could rise over the next 12 months, we have analysed our current distribution of rating opinions and then compared the outcome to the US loan market experience at similar stages in the credit cycle over the past decade," says S&P credit analyst Paul Watters. "Our calculations suggest a 12-month prospective European default rate of 5.8% for the private European leveraged loan market is quite plausible."

CDS compressions go live
Markit and Creditex say that the first live runs have been completed successfully for single name CDS in the North American and European markets on their industry-wide portfolio compression platform.

The first North American live portfolio compression run, which took place on 27 August with the participation of 14 credit derivative dealers, was conducted for CDS contracts referencing several widely traded North American telecommunications companies. It achieved a 56% gross notional reduction of compressible contracts and a 49% gross notional reduction across all participating counterparties.

The first European live portfolio compression run was held on 4 September with the participation of 15 credit derivative dealers. The service was run on CDS contracts referencing several widely traded European telecommunications companies, and achieved a 53% gross notional reduction of compressible contracts and a 46% gross notional reduction across all participating counterparties.

Markit and Creditex were selected by ISDA to provide infrastructure to support commitments made by major market participants to the Federal Reserve Bank of New York relating to improved operational efficiency and risk reduction.

Philip Olesen, md of credit trading at UBS, says: "We are pleased with the progress of this initiative. The new risk-neutral compression algorithm is a critical improvement which eliminates the need for involvement by front-office traders, thereby increasing the frequency of compression runs and dealer participation rates."

The new portfolio compression methodology designed by Markit and Creditex is unique in that it reduces operational risk while leaving market risk profiles unchanged. This is achieved by terminating existing trades and replacing them with a smaller number of new replacement trades that carry the same risk profile and cashflows as the initial portfolio but have less capital exposure.

The portfolio compression process will be run on a regular basis to compress the most actively traded single name CDS contracts systematically across all major sectors. This is expected to reduce the total gross notional outstanding of CDS contracts in the US$62trn market to a significantly smaller net amount.

Asian SROC results in
S&P has placed its ratings on 13 tranches relating to 12 Japanese synthetic CDO transactions on credit watch with negative implications, and one tranche relating to one Japanese synthetic CDO transaction on watch with positive implications. At the same time, it has placed the ratings on 28 Asia-Pacific synthetic CDOs on watch with negative implications and one other CDO on watch with positive implications. The ratings on four other synthetic CDOs from the region have also been taken off watch negative and affirmed.

Performance outlook even more negative
The asset performance outlooks for many global derivative asset classes have become more negative now compared to the beginning of the year, says Moody's in a mid-year update. The rating implications of these negative outlooks, however, vary significantly by region, asset class and debt instrument.

"Structural features common to the asset class, as well as Moody's initial range of expectations regarding credit performance of the underlying assets, are taken into account when considering the possible rating implications of the asset class," says Moody's md Jian Hu, author of the report. "In addition, rating implications differ for different sub-groups of securities; for example, their seniority in the capital structure."

Since January 2008 asset classes that have moved from having stable/negative asset performance outlooks to negative outlooks include, globally, corporate synthetic CDOs and, in the US, CLOs and transactions backed by loans to SMEs and trust preferred CDOs. In EMEA the asset performance outlook for CLOs, balance aheet and SME CDOs have also shifted from stable/negative to negative, as have SME CDOs in Japan.

Japanese balance sheet CDOs and Emerging market CDOs are the two products types for derivatives whose underlying assets retain a stable performance outlook.

For some asset classes, such as structured finance CDOs, the negative asset performance outlook has negative rating implications across the various debt classes of the instruments, says Moody's. The rating implications of the negative asset performance outlook on corporate synthetic CDOs is negative for all debt tranches, except any super-senior ones, but vary according to the portfolio of the underlying assets.

In the US, the rating implications of the negative outlook for the performance of CLOs/SME assets are only negative for subordinated classes of debt, with ratings on senior classes expected to remains stable. CDPCs, on the other hand, are expected to continue to have generally stable ratings, despite the negative outlook on asset performance.

S&P responds to EU oversight
S&P has published its response to the European Commission's recent consultation paper proposing registration and oversight of credit rating agencies in the EU. The agency says it recognises the Commission's desire for additional external oversight of rating agencies and shares its aim of supporting the quality and transparency of ratings opinions.

S&P believes the Commission can best meet its objectives through a globally consistent solution based on IOSCO's recently revised code for credit rating agencies, rather than prescriptive rules. This approach would also support the independence and international consistency of ratings.

Additionally, S&P believes the Commission should:

• Consider the global nature of the capital markets and credit ratings when developing new regulation, and align any new regulation with existing rules in other regions to allow for a globally coordinated approach to regulation.
• Preserve the analytic independence of the ratings process so that investors can be confident that ratings are objective and free from outside influence.
• Utilise a principles-based approach to develop any new regulation that is flexible enough to meet new innovations in the market.
• Designate a single point of registration and oversight in the EU via a lead supervisor.

"We are committed to continuing working with market participants, the European Commission, and regulators and policymakers worldwide to restore confidence in credit ratings," says Vickie Tillman, executive md and head of S&P Ratings Services. "We believe any EU oversight regime should be globally coordinated, proportionate in scope and principles-based to serve the best interests of EU markets and investors."

DerivActiv expands FAS 157 reporting
Independent derivatives valuations provider DerivActiv has expanded its services to include non-performance risk adjusted valuations for FAS 157 reporting of derivative products. The proprietary procedure evaluates non-performance risk and adjusts mid-market values to comply with the requirements of FAS 157 fair value reporting. The firm says its adjustment methodology has been used in financial reports and its process has been reviewed by national and regional accounting firms.

Johan Rosenberg, president of DerivActiv, says: "With the emphasis on exit price determination, the changing credit characteristics of each counterparty must be taken into account in determining fair value. Changes in the marketplace affect the exit price and require an adjustment to the standard mid-market valuation."

Given the growing need for independent valuations and transparency in all derivative transactions, DerivActiv will provide FAS 157 valuations for all types of derivatives, including plain vanilla swaps, swaptions, knock-outs, CMS swaps, equity swaps, foreign currency swaps, range accrual swaps and other exotic derivative structures.

CRE CDO delinquencies continue to rise
Three new delinquent and two recently repurchased loans led to an increase in the US commercial real estate loan (CREL) CDO delinquency rate to 1.79% for August 2008, according Fitch's latest CREL CDO Delinquency Index (CREL DI) figures. Although on average CREL CDOs remain adequately cushioned to absorb some credit deterioration, the agency anticipates that a few more CREL CDOs will be placed on rating watch negative as more problem loans come to the surface. A good indicator of future delinquencies is the percentage of loans that are 30 day or less delinquent, which currently totals 0.87% (by dollar balance) of all CDO collateral.

While the CREL DI is continuing a gradual upward ascent - up from last month's rate of 1.46% - it is being tempered by asset managers' flexibility to change the terms of the underlying assets through continued extensions and to repurchase credit-impaired loans. While the volume of extensions has grown, repurchases as a percentage of total delinquencies have declined in recent months. As such, the 57bp increase of new additions to the CREL DI is partially offset by the extension of one matured balloon loan (9bp) which showed as delinquent last month and the exclusion of the three repurchased assets (15bp) which were included in last month's index.

The increase in the CREL DI could also be tempered by the imminent extension of one of the newly added loans to the index. Without this loan included, the CREL DI would fall to 1.47%, which is only one basis point higher than last month's rate. This loan is classified as a matured balloon whole loan (32bp).

Per the asset manager, the borrower requested a one-year extension for this still stabilising office property. The extension is permitted in the loan documents and is currently being processed.

The number of loans extended this month totals 34 loans (0.3% by number of loans in the CREL CDO universe); roughly two-thirds were extensions that were contemplated in the original loan documents. Extensions are being exercised on matured balloon loans secured by transitional assets, as business plans are either taking longer to actualise or are stalled.

Further, favourable refinance opportunities remain scarce for all borrowers under current market conditions. While extensions have allowed delinquencies to remain relatively low, they are potentially deferring possible losses on overleveraged assets.

Summit solution upgraded
Global application software and services provider Misys has announced the latest major release of its flagship treasury and capital markets trading solution. Misys Summit FT V5.3 incorporates several new major modules, including a new solution for equities trading, a new system dedicated to structured bonds and a new market risk limits offering for extensible business-wide risk and compliance monitoring.

As many banks are issuing structured bonds to raise funding in a flooded market, there is a need to fully support structured bonds, including structuring, issuing, investing, position-keeping, hedging, swapping, credit and auditing. The new structured bonds module leverages Misys Summit MUST's technology and has been developed in cooperation with KfW to enable the processing of structured bonds in the same manner as any standard bond. The new module provides enhanced position management, call processing, capital gains, yield calculations, accounting and theoretical valuation.

To help with the volatility, high volumes and huge risks associated with today's financial markets, Version 5.3 also includes a new market risk limits monitoring solution with limit breach notifications and dashboards covering P&L, portfolio or trade sensitivity to risk factors, trader daily volume and many more. Instant notifications through emails, SMS and desktop alerts get information to the right people at the right time, providing an environment of protection and regulatory compliance, Misys says.

S&P analyses market dislocation
As in past periods of market stress, today's market dislocation is accompanied by sizable helpings of confusion and misunderstanding, according to S&P. The agency says that, while part of the confusion relates to why market distress is occurring, part also relates to the differing degree to which it has affected different sectors of the fixed income capital markets.

"On the issue of 'why', the short answer seems to be that leverage plus speculation fuelled by 'financial engineering' and derivatives, such as CDOs, were the primary drivers," says Mark Adelson, S&P chief credit officer.

Financial engineers started with essentially manageable risks from the residential mortgage sector, but then concentrated and amplified those risks, the agency says. Hindsight reveals that they created securities that were vulnerable to rapid and severe deterioration far beyond what market participants had anticipated.

The issue of how strongly the market distress has affected different sectors is trickier to assess. Many segments of the capital markets have felt the impact of stress.

However, the severity of that impact has not been uniform. It has been most pronounced in two sectors: structured finance CDOs and ABS backed by second-lien mortgage loans. In both, S&P believes there are likely to be widespread defaults of securities that initially carried ratings of triple-A.

By contrast, the first-lien sub-prime mortgage ABS sector has displayed less deterioration. In the agency's view, this sector likely will suffer widespread defaults of most securities initially rated at the triple-B and single-A levels, but few defaults of securities initially rated at the triple-A level.

The general media has blurred this distinction at times by using the term 'sub-prime securities' to refer indiscriminately to both SF CDOs and first-lien sub-prime mortgage ABS, S&P continues. That confusion may have spread misunderstanding about the true causes and triggers of the current problems in the housing and financial sectors.

In the report, Adelson explains that if policymakers misunderstand the true causes, they cannot frame effective policy responses, and if investors misunderstand the true causes, they cannot frame effective defensive strategies. "Only with a more incisive understanding of what has happened can both groups craft effective policies and strategies," he concludes.

Widespread negative effect for rating transitions
The ongoing global credit crunch is beginning to have a more widespread negative effect on European structured finance ratings. According to a transition study published by S&P, the first half of 2008 shows that there were a significant number of downgrades and relatively few upgrades - although nearly 93% of ratings remained the same over the period.

"Fundamental risks are clearly increasing across most classes of financial assets relevant for structured finance," says Simon Collingridge, md and head of European surveillance. "In our view, this deterioration is now in some cases becoming sufficient to cause negative rating actions." He adds that the contraction in credit availability has also contributed to slowing upgrade rates in some asset classes.

Key points of the study are as follows:

• Of the 11,140 ratings outstanding at the start of 2008, 93.8% remained stable or were raised in the first half of the year, but 6.2% were lowered. This compares with 97.9% and 2.1% respectively for the full-year 2007.
• These figures highlight a surge in downgrades, while the upgrade rate also moderated to 1.0% in H108 compared with 4.2% for the full-year 2007. Indeed, the downgrade rate for the first half of the year has already exceeded the downgrade rate for any full year since 2002.
• Rating transitions during H108 resulted in an average decrease in credit quality over all outstanding ratings, equivalent to a downgrade of 0.33 notches.
• For ratings that were lowered during H108, the average net downward move was 5.8 notches, significantly higher than the average 3.5 notch downward move over the full year 2007.

Correlated recovery model added
Analytics and risk management solutions provider Quantifi has extended the functionality of its credit derivative valuation software to include a new correlated recovery model, which allows calibration to a wider range of tranche prices than the traditional one-factor Gaussian copula model. Called the Quantifi Correlated Recovery model (QCR), the offering incorporates more realistic treatment of recovery in the event of default.

The QCR model allows participants to calibrate and price, even during periods of extreme market turmoil. In addition, the software more accurately prices senior tranches while providing improved sensitivities - including solving the 'negative delta' problem.

QCR is available in Version 9.1 of Quantifi RISK, Quantifi Toolkit and Quantifi XL.

Sovereign default risk analysed
Over the course of the week starting 1 September 2008, equities in the MSCI Emerging Markets Index fell by over 10.5%. Given this steep decline, CMA was asked to examine the strength of a wide variety of national economies (both established and emerging) to provide a view on members of the international community defaulting on their sovereign debt obligations over the next five years.

The company came up with a ranking that reflects market perception of the political and economic risk associated with various economies, as expressed by Cumulative Probability of Default (CPD). The CPD values were calculated by using proprietary credit data provided by CMA DataVision, with debt as a percentage of GDP sourced from the US Central Intelligence Agency.

CPD indicates the perceived likelihood of an entity defaulting on its debt -fluctuations in this value will serve as a signal to risk managers as to the changing creditworthiness of individual countries or companies. Countries listed as least likely to default are highly evolved capitalist nations with stable, democratic systems of government and diversified economies.

These nations are also insulated against regional conflict or war in the short term. Seven of the ten safest countries are Western European nations.

On the other hand, emerging market economies dominate the riskiest ten nations. Risk drivers include political instability, terrorist threats, weakened rule of law, high levels of corruption, a heavy dependency on specific industries or natural resources, and poorly developed or immature financial infrastructure.

Calypso SaaS released
Application software provider Calypso Technology has launched its SaaS (Software as a Service) offering. The solution provides a powerful enterprise trading and risk management application for treasury and capital markets in a managed, outsourced environment. The firm says it will address the needs of the increasing number of financial institutions which are focusing solely on their core business by outsourcing the management of applications and infrastructure, as well as support of their technology platforms.

For trading businesses, Calypso SaaS offers the power and sophistication of the Calypso Trading and Risk Management Platform in an environment which dramatically improves time-to-market while reducing IT and infrastructure costs. It is especially beneficial for customers seeking to achieve rapid expansion into new geographies or business areas with minimal capital outlay, the firm says.

CS & AC

Trading ideas: bridge to safety

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at an outright long on JC Penney

Retail same store sales (SSS) for August came out last week and JC Penney's decrease was in line with expectations (or slightly better), and we recommend selling credit protection on the company. JC Penney sits in an enviable position.

From a liquidity standpoint, it has roughly US$3.3bn in cash and available credit facilities, and the vast majority of its debt is due after 2014. Aside from any major capital structure changes, this makes a default in the next five years a remote possibility.

JC Penney's management is committed to maintaining an investment grade rating and has consistently reduced its leverage over the past few years. Their recent announcement of a 'bridge plan' to cut costs and inventory levels into 2009 to weather the recessionary-like environment is a further sign of the realistic mindset of the management team. Though macroeconomic conditions affecting consumer spending look downright poor heading into the close of 2008, we believe this is priced into JC Penney's credit spread.

Management's mindset
Even though JC Penney is enduring consecutive months of declines in SSS, its management has positioned the company to both expect this and maintain profitability. They announced a 'bridge plan' back in June to help the company handle the economic downturn. The plan consisted of reducing the number of new store openings, remodelling operations and inventory levels.

By going with a much more conservative mindset and erring on the side of caution, the management team put the company in a position to come out of the credit crunch alive and ready to expand. On top of decreasing capital expenditures, they signalled no further share repurchases for the rest of 2008. We only hope they will stick with this plan, especially since its stock is up over 30% in the past couple of months.

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

The model ranks each issuer on a scale of 1 to 10 using seven factors (1 = poor credit, 10 = good credit). Exhibit 1 lists all the factor scores for JC Penney. We see a 'fair spread' of 174bp for its solid margins, leverage, interest coverage and accruals factors.

Exhibit 1

When attempting to determine a credit's 'fair value' spread, one of the most basic fundamental factors to examine is the company's leverage. JC Penney's total debt to assets has been declining over the past few years, as shown by Exhibit 2.

Exhibit 2

With the market entering the second year of the credit crunch, we find this to be a significant positive for the issuer. On top of its total debt of around $3.7bn, JC Penney has US$2.1bn in cash and an unused credit facility of US$1.2bn. With less than US$1bn in debt coming due in the next five years, we believe it will be able to weather the drop in consumer spending and maintain (if not even improve) its investment grade rating.

Risk analysis
This trade takes an outright long position. It is not hedged against general market moves or against idiosyncratic curve movements. Additionally, we face 5bp-8bp of bid-offer to cross. The trade has positive carry and roll down, which will offset any potential spread widening.

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

Summary and trade recommendation
Retail same store sales (SSS) for August came out last week and JC Penney's decrease was in line with expectations (or slightly better), and we recommend selling credit protection on the company. JC Penney sits in an enviable position.

From a liquidity standpoint, it has roughly US$3.3bn in cash and available credit facilities, and the vast majority of its debt is due after the year 2014. Aside from any major capital structure changes, this makes a default in the next five years a remote possibility.

JC Penney's management is committed to maintaining an investment grade rating and has consistently reduced its leverage over the past few years. Their recent announcement of a 'bridge plan' to cut costs and inventory levels into 2009 to weather the recessionary-like environment is a further sign of the realistic mindset of the management team. Though macroeconomic conditions affecting consumer spending look downright poor heading into the close of 2008, we believe this is priced into JC Penney's credit spread.

Sell US$10m notional JC Penney Co 5 Year CDS protection at 232bp.

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).