Contents

Preparing for action

Options for CSOs addressed as further volatility looms

Three corporate defaults over the course of one week spell another significant bout of rating volatility for the CSO sector. While the conservatorship of Fannie Mae and Freddie Mac alone were believed unlikely to lead to downgrades, the bankruptcy of Lehman Brothers - estimated to be referenced in nearly two-thirds of European CSOs and up to 80% of the CSO market globally - suggests a different outcome.

The increase in default risk prompted by Lehman's bankruptcy caused equity tranches to widen delta-adjusted on Monday morning. But, according to one CSO manager, the true effect of Lehman's default on the correlation markets is still unclear.

"At this stage of the game it's hard to tell, but generally speaking the defaults help to identify the bad apples and, once we know who they are, correlation will drop - which will help the senior part of the capital structure," he says. "The default has not yet helped to bring down correlation because of the still-unknown systematic risk in the market."

However, CDO analysts at Merrill Lynch note: "As a consequence of the large number of deals in which the entity [Lehman] was referenced, combined with already eroded subordination across the entire CSO universe, we expect the next wave of rating downgrades in the asset class to be significant."

Several outcomes for CSOs referencing Lehman have been put forward. These include novating the swaps to a different counterparty or - in a more likely scenario - the unwinding of those transactions under a mandatory redemption event.

"The best outcome would be for the swaps to be novated to a new counterparty, with sufficient ratings to satisfy the deal's conditions - usually single-A or better," says Siobhan Pettit, head of structured credit strategy at RBS. "The novating bank will pay Lehman the mark-to-market of the swap and the deal would continue as before. This would have minimal impact on the CDS and/or correlation markets."

However, Pettit explains that - although this would be in Lehman's interest, as it would receive a payment - it would be a difficult process to complete. "Finding a new counterparty willing to accept the novations (which would now be far 'off-market') will be difficult in current market conditions, not to mention getting agreement on the correct valuation of the trade. Additionally, the deal documentation may only allow a novation in the event of a downgrade - not a straight jump-to-default," she says.

Merrill Lynch analysts agree that, while collateral managers may have substituted Lehman in CSOs for other, healthier credits over the past few months, the costs involved in substituting the name at such elevated CDS spreads and the relatively large number of problematic CSO underlying credits to get out of means any decrease would have been minimal.

The most likely scenario for the CSOs - an unwind in the guise of a mandatory redemption event - could be proscribed by the documentation in the event of a counterparty credit event or it could be the fall-back option if attempts to novate fail, suggests Pettit. She explains that in this situation the swap would be valued and the SPV collateral used to pay administration costs, trustee fees, debt holders and only then any unwind MTM value to Lehman.

AC

Swallowing a bitter pill

Balance sheet CDOs set to increase in importance

As the banking community reels at the outcome of the events of the past few days, a number of market commentators now believe that the future of securitisation hangs in the balance. However, structured credit strategists argue that securitisation can help banks find a way out of the crisis - namely via balance sheet CDOs.

Balance sheet CDOs have been and will remain important tools for funding and regulatory capital purposes over the next few quarters, especially for the less liquid and more structurally complex portions of loan portfolios, argue structured credit strategists at Morgan Stanley. "Although the loan securitisation process remains difficult today given a variety of factors, we believe that balance sheet-style securitisation transactions will be an important regulatory and economic capital solution for banks as we move forward - especially in the less liquid corners of the corporate credit markets and in commercial real estate loans," confirms Sivan Mahadevan, global head of credit derivatives and structured credit strategy at the bank.

Indeed, almost US$50bn worth of balance sheet deals have been completed year-to-date - a total that will surpass 2005 levels and probably match the 2006 total of US$66bn. Several such transactions are currently bolstering the CDO pipeline, while the trickle of newly-completed deals continues. Deutsche Bank's Taunus 2008-1 - a €1bn balance sheet CLO referencing SMEs in EU countries - is the latest to hit the market.

The motivation behind the balance sheet CDOs, Morgan Stanley suggests, will range from regulatory capital relief under Basel 2 - where efficient solutions involve retaining senior risk and selling junior risk - to improving funding for loans and loan commitments. This involves posting super-senior risk as collateral in secured central bank borrowing programmes, such as those sponsored by both the ECB and the Fed.

But Larry Tabb, ceo of the TABB Group, expects a reduction - if not elimination - of the securitisation business and suggests that banks will begin to hold the loans they make. "This will force them to really analyse credit instead of offering debt to anyone capable of fogging a mirror," he comments. "We will also see more debt and derivatives products become simpler and easier to parse. These more vanilla products will be centrally cleared and traded on-exchange, enabling greater transparency and liquidity."

In the case of ABS CDOs, however, the unwinding or 'de-securitisation' of such deals may provide more capital relief. The underlying bonds in certain ABS CDOs that have been downgraded from triple-A to double-B (a rating that carries a full capital charge of 100% under Basel 2 external ratings) have not always experienced a similar magnitude of downgrades as super-senior tranches.

"It is worth noting that, in most cases, the deals are already in EOD status and only the super-senior tranches have any positive market value remaining. Under such circumstances, decomposing super-senior tranches into their underlying collateral components has the potential to be more optimal from a regulatory capital perspective. This can be accomplished either synthetically or through a cash unwind process as the controlling class of a CDO," concludes Mahadevan.

AC

Risk management strengthened

Move to accelerate as risk assets spun off into new vehicles

The credit crunch has prompted CDS end-users to strengthen their STP and risk and liquidity management systems, with the technology sector increasingly being driven by buy-side demands. The pace of this move is set to accelerate as banks spin off their risk assets into new vehicles and prop desks are assumed into their asset management arms.

Power in the technology sector appears to be shifting to the buy-side, with investors imposing standardised systems and transparency on the sell-side via requirements for regular reporting of risk and p&l positions, confirms Gerard Rafie, vp at Calypso. "Thanks to the credit crunch, there has been a shift from complex instruments to the more standardised OTC products, and the volume of trades continues to increase," he says.

He adds that the onus for technology vendors is to move towards easier implementation for hedge funds and asset managers - particularly as banks' prop trading operations are being assumed by their asset management/hedge fund arms - as well as increasing levels of visibility.

In many ways, the transition of risk assets off a bank's balance sheet has been occurring for a number of years, according to TABB Group ceo Larry Tabb. In this same vein, he suggests that many investment banks have bankrolled hedge funds and supported their growth by providing them with a home, technology, financing and even capital introduction services to move that risk and capture additional transaction flow.

"The pace of this move will only accelerate as banks try to spin off all of their 'bad bank' assets," he says. "Using a good versus bad bank scenario operating in a Glass-Steagall-type environment, the bad bank will be based on a sophisticated risk model where hedge fund-type entities hold these core bad assets until the economy picks up and the assets become solvent again. In addition, we will see these entities or other sister entities be spun off to house proprietary trading and liquidity provisioning facilities."

Meanwhile, the core 'good bank' will look like a processor, using IT investment and scale to develop significant asset gathering, agency trading and payment facilities on top of a deposit base that provides for a more significant spread between sources and uses of funds.

Together with strengthening their risk management and STP systems, hedge funds and asset managers are focusing on developing real-time liquidity management technology for their OTC derivatives businesses. Rafie says that the first step in managing liquidity risk is to distinguish between liquid and non-liquid instruments in a portfolio, and then implement a limits system that works in conjunction with powerful 'what-if' scenarios to monitor the availability of liquidity across the portfolio.

Indeed, enterprise-wide trading and risk management (ETRM) now encompasses cross-asset trading, front-to-back, VAR, operational risk and various other limits (traders' mandates, country exposures, risk and counterparty risk), as well as such 'what if' scenarios and liquidity limits. But one criticism about ETRM is that, for a larger organisation, it could stifle technological innovation. A good way of overcoming this is to build a best-of-breed enterprise infrastructure, within which each specific item moves independently, notes Rafie.

A recent survey conducted by Celent to determine key operational issues and challenges for OTC derivatives processing in North America and Europe supports this concept. According to David Easthope, senior analyst with Celent's capital markets group: "Within the boundaries of the enterprise, the buy-side is focused on flexible systems which can accommodate or plug in with existing systems and offer workflow and trade lifecycle monitoring. While some market participants may wish for an end-to-end solution, the immediate need is for point solutions which can fit the existing architecture of the enterprise and expand or adapt over time."

The survey's findings conclude that, while trade capture and confirmations constitute over 50% of OTC post-trade processing costs, the buy-side desires technology which addresses the post-confirmation process in order to reach the next level of efficiency. Celent has identified the fundamental building blocks of an OTC derivatives STP solution as: dynamic trade modelling, reference data, confirmation/affirmations, pricing and valuation, reconciliation engines and utilities, and collateral management.

CS

Credit opportunity funds launch

The latest company and people moves

Credit opportunity funds launch
Ron D'Vari and James Frischling have launched NewOak Capital, an advisory and investment management firm focused on valuation, restructuring, hedging and management of residential mortgage loans, MBS, commercial mortgage loans, CMBS, CSOs, CLOs, CDOs and distressed financial institutions and banks. D'Vari is ceo and Frischling is president of the firm.

D'Vari was previously md and head of structured finance at BlackRock, while Frischling was md and head of US structured credit at Fortis Securities.

Meanwhile, Pamplona launched its new fund - Pamplona Credit Opportunity Fund - earlier this month. It is headed up by Yves Leysen, previously Bear Stearns' head of fixed income in Europe (see SCI issue 94 for more).

Credit derivative strategist appointed
Alberto Gallo has joined Goldman Sachs as a US credit strategist within the global investment research department in New York. He was formerly at Bear Stearns, where he was head of credit derivatives strategy for both New York and London.

CDO manager sold
Sal Oppenheim (SOP) has bought Collineo Asset Management from Hypo Real Estate. According to Fitch, there will be several challenges for Collineo to overcome in the short term, principally relating to its spin-off from the HRE Group in those areas where the former parent company provided oversight, support or business.

Key challenges will include the full transfer of middle office and surveillance activities to Collineo, the renegotiation of HRE investment mandates, the establishment of an IT platform fully independent from HRE and the definition of a new corporate governance framework. These challenges will precede those associated with Collineo's eventual integration to SOP.

As of June 2008, Collineo's assets under management were €15bn, split between 13 CDOs (€8.7bn) and private mandates (€6.3bn).

Primoris' management changes
Deutsche Asset Management has replaced State Street Global Advisors as managers on Primoris SPC. Primoris is a synthetic securitisation that consists of a long portfolio, which initially referenced mostly investment-grade corporates, and a short portfolio that initially referenced mostly senior-secured bank loans at 10% of the notional amount of the long component.

AXA IM restructures
AXA Investment Managers has announced the new structure of its fixed income division, headed up by Theo Zemek. AXA IM has also appointed Chris Iggo as cio, fixed income.

The credit team will be split into two regions: US credit and credit ex-US. US credit will be led by Hannah Strasser, a veteran fixed income manager with 23 years of high yield bond experience. AXA IM is currently recruiting for the position of head of credit ex-US.

The AXA IM fixed income division will be structured into two teams: an interest rate and asset allocation team, and a team of credit specialists. The interest rate team will be headed up by Iggo, previously a senior member of the investment strategy team. He will be directly responsible for the investment process, asset allocation and performance, as well as directing the teams within the interest rate team.

The new structure will be put in place during Q408.

Asia sales head appointed
Manish Mahajan, former head of rates sales and strategic solutions for Deutsche Bank in Asia, has joined RBS in Hong Kong as head of sales for financial institutions for Asia ex-Japan. Mahajan's new role will include managing the selling of core and emerging-market products across flow and structured credit, foreign exchange and rates to fixed income clients.

Structured derivative co-heads named
Credit Suisse has expanded Christian Porath's role to include co-head of securities structured derivatives sales in Central Europe. He will focus on developing coverage of the banking sector in the region, including Germany, Austria, Luxembourg, Poland, Hungary, the Czech Republic, Slovenia, Slovakia, Bulgaria and Romania.

Harald Epple has joined Credit Suisse as an md and co-head of securities structured derivatives sales in Central Europe. Epple will be based in London and will focus on developing coverage of insurance companies, pension funds and associated asset management companies.

Epple joins from Morgan Stanley, where he was responsible for coverage of the insurance sector in Europe. Prior to this, he was responsible for global capital markets activities for institutional clients in Germany and Austria. Porath and Epple will report to Savady Yem functionally, and will have a regional reporting line into Martin Korbmacher.

New ceo for asset manager
GSC Group, an alternative asset investment manager focused on credit-driven strategies, has appointed Seth Katzenstein - currently portfolio manager and a member of its investment committee - ceo and director of GSC Investment Corp. He replaces Thomas Inglesby, a senior md of GSC Group.

Katzenstein, who has been with GSC Group from its inception, will also continue in his role as md and head of credit and portfolio management of GSC Group's US corporate debt business.

Lehman US operations snapped up
Barclays has agreed to acquire Lehman Brothers' North American investment banking and capital markets operations and supporting infrastructure. The firm will acquire trading assets with a current estimated value of £40bn (US$72bn) and trading liabilities with a current estimated value of £38bn (US$68bn) for a cash consideration of £0.14bn (US$0.25bn).

Barclays will also acquire the New York headquarters of Lehman Brothers, as well as its two data centres at close to their current market value.

Commenting on this announcement, Barclays Group chief executive John Varley says: "The proposed acquisition of Lehman Brothers' North American investment banking and capital market operations accelerates the execution of our strategy of diversification by geography and business in pursuit of profitable growth on behalf of our shareholders, in particular increasing the percentage of Barclays earnings sourced in North America. This transaction delivers the strategic benefits of a combination with Lehman Brothers' core franchise, whilst meeting Barclays' strict financial criteria and strengthening our capital ratios."

Law firms merge
Orrick, Herrington & Sutcliffe and Hölters & Elsing (Partnerschaft von Rechtsanwälten) are to merge. The partners of Hölters & Elsing and Orrick voted in favour of the merger of their two firms with the effect that Orrick will operate in Germany as Orrick Hölters & Elsing.

At the outset, the combined firm will have 55 lawyers in three offices in Germany. The firm will have 1,100 lawyers - over 250 throughout Europe alone - in 21 offices across Asia, Europe and North America. Over one-third of the firm's lawyers will work outside North America.

Omgeo buys Allustra
Omgeo has acquired Allustra, a London-based provider of collateral management solutions. Mark James, md of Allustra, will join Omgeo's executive committee as md. In addition, Omgeo has acquired a derivatives portfolio reconciliation platform designed by Global Electronic Market's (GEM).

Omgeo will continue to expand its derivatives suite of services. Next year, Omgeo Central Trade Manager will offer functionality for exchange-traded derivatives. Other enhancements will also be made over the next several months, the firm says.

Interactive Data signs agreement with Prism Valuation
Interactive Data Corp has announced an agreement between its pricing and reference data business and Prism Valuation. Under the agreement, Interactive Data Pricing and Reference Data will now have the capability to provide valuations of highly complex OTC derivatives and structured products as part of its pricing and evaluation services.

Prism Valuation, which was founded in 2006 and maintains offices in London, Melbourne and Toronto, provides valuations of complex OTC derivatives and structured products based on a wide range of underlyings including: interest rates, FX, inflation, equities, credit, commodities and hybrids.

Interactive Data's clients will be able to request valuations on a per instrument basis, which will be calculated by Prism Valuation's quantitative analysis team and then delivered via FTS Interactive Data's securities administration tool. Interactive Data already has clients who are subscribing to these valuations.

The Prism Valuation team emulates the valuation processes of a typical structured products dealer by synthesising the most important components required for valuation and analysis: up-to-date market data, appropriate valuation models and targeted calibration strategies. The service that Interactive Data will offer includes valuation transparency reports that provide a breakdown of the method to achieve a given valuation for each deal, including a detailed discussion of the models and calibration strategies selected.

Prism Valuation has a core team with many years of direct front office and quantitative experience at structured products dealers. In addition, Prism Valuation's strategic partnerships include ICAP, which provides underlying market data, and NumeriX.

As part of the alliance, Interactive Data has purchased a minority ownership stake in Prism.

AC

Structured ARS impacted

A round up of this week's structured credit news

Structured ARS impacted
An estimated US$5bn to US$10bn of structured auction-rate securities (ARS) held by institutional investors are expected to be impacted by the combined failures of Fannie Mae, Freddie Mac and Lehman Brothers.

According to Brian Weber, senior analyst at Houlihan Smith & Co, three types of structured ARS could be affected by technical triggers related to events of default of Fannie Mae, Freddie Mac and Lehman CDS. "First, ARS issued as CLNs referencing CDS indices could be wiped out if certain defaults occur - and these three names were widely referenced by index tranches," he explains.

The other two types of ARS are those issued by Lehman itself, backed by Fannie and Freddie preferred stock (which is now worth somewhere in the region of 5c on the dollar), or backed by MBS. "These structures weren't originally considered to be too risky, but the anticipated sell-off of Lehman assets is likely in general to depress MBS prices even further - thereby impacting ARS backed by MBS," continues Weber.

However, whether these developments lead to further litigation in the ARS space depends on if the structures were sold under the guise of their being safe, money market-like instruments.

ISDA outlines protocol plans
ISDA has announced it plans to launch a number of protocols created to facilitate the settlement of credit derivatives trades involving Tembec Industries, Fannie Mae and Freddie Mac.

The first protocol involves Tembec Industries, an integrated Canadian forest products company that has filed a Chapter 15 petition in the US as a final step in its recapitalisation. The Protocol is open to ISDA members and non-members alike, with the adherence period running from 17 September to 22 September 2008.

The 2008 Tembec CDS Protocol permits cash settlement of single-name, index, bespoke tranche and other high-yield credit derivative transactions. Markit and Creditex will administer the auction, scheduled for 2 October 2008, which will determine the final price for Tembec Industries bonds.

ISDA has also announced a further step toward completion of its protocol for credit derivative transactions referencing Fannie Mae and Freddie Mac. After consulting with a broad section of its membership as to the deliverability of the principal-only component of debt securities of the two GSEs, ISDA consulted its Board of Directors to bring the debate to resolution. The ISDA Board, with the benefit of advice from Allen & Overy that any component of a debt security is not a deliverable obligation under a standard CDS contract, determined that principal-only components will not be included in the list of deliverable obligations for purposes of the settlement auctions in respect of the GSEs.

ISDA expects to publish the list of deliverables, along with a draft protocol for Fannie Mae and Freddie Mac CDS, in the coming week. Due to the large number of obligations that might be identified as deliverable obligations for purposes of the auction settlement mechanism, the Association and market participants believe it prudent to establish a process for identifying such deliverable obligations.

ISDA says it is also working with all constituents across the industry to realise swift and smooth resolution in closing out bilateral derivatives positions in which Lehman Brothers Holdings is either a counterparty or reference entity. The Association expects the following procedures to apply in relation to such transactions:

• Where a market participant is facing a Lehman group entity as counterparty on an OTC derivative trade, whatever the underlying asset class, participants are expected to refer to the Master Agreements and Credit Support (collateral) documentation that they have in place covering OTC derivative transactions with one or more Lehman group entities and take advice from legal counsel as appropriate. Where participants determine that an event of default has occurred with respect to their counterparty, the terms of this documentation will allow participants to take bilateral action to: i) close out contracts; ii) determine the net amount owing between them; and iii) take into account any collateral that may have been posted. Parties are expected to determine when and how to put these provisions into practice, working with their legal counsel as appropriate.

• Where a Lehman group entity is the subject of a credit derivative trade, a decision has been made to hold an auction with respect to covered credit derivatives transactions that reference LBHI. ISDA will perform its usual role in relation to such auction. This process will follow the usual timeline, involving market participants in all the stages that normally apply in effecting a protocol.

Lehman impact assessed by Fitch ...
Fitch says it is currently assessing the potential ratings impact of the bankruptcy of Lehman Brothers Holdings (LBHI) on synthetic CDOs that it rates. Following LBHI's declaration of bankruptcy, the agency downgraded the issuer default rating (IDR) and debt ratings of LBHI and its parent, along with other subsidiaries. These downgrades are expected to adversely impact the ratings of synthetic CDOs whose credit quality is linked in some way to that of Lehman-related entities.

The participation of the Lehman entities expected to impact CDO ratings can be divided into two main categories: instances where Lehman provided credit support to the CDO, either as a CDS counterparty or as a charged asset; and instances where Lehman's debt was referenced as part of the CDO portfolio. Lehman acted as swap counterparty in 69 Fitch-rated synthetic CDOs - 31 in Europe; 35 in Asia; and three in the US. The impact on CDO note ratings where a Lehman entity acts as swap counterparty will depend upon many factors, including whether the CDO transaction faces an automatic unwind following the Lehman bankruptcy, whether the swap may be transferred to another counterparty and the extent to which noteholders may be subject to market value risk of eligible securities in the event of early termination of the transaction.

Fitch expects early termination events to be triggered for most transactions where LBHI acts as swap counterparty or credit support provider unless a replacement counterparty is found within the required time period (usually 10 to 30 days). If an early termination is triggered where the swap counterparty is the defaulting party, the eligible securities are typically liquidated and used to repay the CDO notes before any swap termination payment is potentially due to LBHI.

In these instances, the CDO noteholders' risk profile may shift from the portfolio of reference entities to the liquidation of the eligible securities. The CDO noteholders will either be paid in full from proceeds of the eligible securities, or will incur a shortfall if liquidation of the eligible securities results in a market value loss that is not offset by any overcollateralisation and collateral posting requirements of the transaction.

Additionally, Lehman debt instruments are eligible securities, or collateral, to four Fitch-rated funded synthetic CDOs and the agency expects to downgrade notes exposed to Lehman entities as the charged asset to triple-C or single-D.

Finally, Lehman-related debt is referenced in the portfolios of approximately 150 Fitch-rated synthetic CDO. LBHI was the 41st most referenced entity, appearing in approximately 25% of the portfolios of synthetic CDOs rated by Fitch.

The impact of the bankruptcy and downgrade of Lehman is expected to have a much smaller impact on these transactions, as individual entities typically account for between 0.5% and 2% of the overall portfolio. The extent of impact on individual CDO ratings will depend upon the exposure to Lehman relative to the transaction's remaining credit enhancement, the extent of recoveries on the defaulted debt and the remaining term of the transaction.

... and Moody's
Moody's downgraded Lehman Brothers' senior ratings, as well as those of certain guaranteed subsidiaries, to B3 under review for further downgrade from A2. The short-term ratings for all rated Lehman entities were lowered to Not-Prime from Prime-1.

The agency says it is presently assessing the impact of Lehman's bankruptcy and rating downgrade on all structured finance transactions that have exposure to Lehman entities. Lehman entities provide credit and/or liquidity support to such structured finance transactions through one or more of the following roles:

— counterparty under derivatives contracts;
— liquidity provider;
— repo counterparty;
— tenant;
— guarantor;
— expense provider in multi-issuers.

These and other structured finance transactions may be exposed to operational and/or credit risk through one or more of the following roles:

— servicer or back-up servicer;
— sponsor;
— cash manager;
— custodian;
— paying agent;
— remarketing agent;
— calculation agent;
— collateral manager.

In addition, structured finance transactions may be exposed to Lehman by reason of holding debt instruments issued by Lehman entities or where the bank is named as a reference entity under CDS.

The asset classes and issuers most likely to be affected by exposures to Lehman entities include:

— asset-backed securities;
— residential and commercial mortgage-backed securities;
— asset-backed commercial paper;
— CDOs;
— repackaged securities;
— CFOs;
— leveraged super-senior obligations;
— derivative product companies; and
— constant proportion debt obligations.

Moody's expects to release further statements and/or rating actions for specific regions, asset classes and transactions in the near future. The agency notes that each transaction will be assessed based on the specifics of its structure and its performance.

Fed provides additional support
The Federal Reserve Board has announced several initiatives to provide additional support to financial markets, including enhancements to its existing liquidity facilities.

"In close collaboration with the Treasury and the Securities and Exchange Commission, we have been in ongoing discussions with market participants, including through the weekend, to identify potential market vulnerabilities in the wake of an unwinding of a major financial institution and to consider appropriate official sector and private sector responses," says Federal Reserve Board chairman Ben Bernanke. "The steps we are announcing today, along with significant commitments from the private sector, are intended to mitigate the potential risks and disruptions to markets."

"We have been and remain in close contact with other US and international regulators, supervisory authorities, and central banks to monitor and share information on conditions in financial markets and firms around the world," he adds.

The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities.

The collateral for the Term Securities Lending Facility (TSLF) has also been expanded; eligible collateral for Schedule 2 auctions will now include all investment-grade debt securities. Previously, only Treasury securities, agency securities and triple-A rated mortgage-backed and asset-backed securities could be pledged.

These changes represent a significant broadening in the collateral accepted under both programmes and should enhance the effectiveness of these facilities in supporting the liquidity of primary dealers and financial markets more generally, the Fed says.

Additionally, Schedule 2 TSLF auctions will be conducted each week; previously, they had been conducted every two weeks. The amounts offered under Schedule 2 auctions will be increased to a total of US$150bn, from a total of US$125bn.

The Board also adopted an interim final rule that provides a temporary exception to the limitations in section 23A of the Federal Reserve Act. It allows all insured depository institutions to provide liquidity to their affiliates for assets typically funded in the tri-party repo market. This exception expires on 30 January 2009, unless extended by the Board, and is subject to various conditions to promote safety and soundness.

Index rolls postponed, LATAM index prepped
Following a majority dealer vote, Markit index rolls have been delayed by a week. At the same time, Markit has announced that it plans to launch a new Latin America corporate-only synthetic index, the CDX LATAM.

The new index will be comprised of 20 equally-weighted reference entities from Brazil, Mexico, Argentina, Chile and Venezuela. Additional details, such as rules and trading documentation, will be made available at a later date.

The Markit CDX.NA.IG, NA.XO, EM and EM Diversified indices will roll on 29 September, while the NA.HY index will roll on 6 October 6. The iTraxx European IG and XO indices, as well as iTraxx Asia, Japan, Australia and LevX will also now roll on 29 September. Markit says that the decision to call a vote was prompted by the exceptionally high trading and clearing activity observed in CDS markets on 14 September.

FASB issues FSP
The Financial Accounting Standards Board (FASB) has issued FASB Staff Position (FSP) No. 133-1 and FIN 45-4, 'Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161'. The FSP is intended to improve disclosures about credit derivatives by requiring more information about the potential adverse effects of changes in credit risk on the financial position, financial performance and cashflows of the sellers of credit derivatives. It amends FASB Statement No. 133, 'Accounting for Derivative Instruments and Hedging Activities', to require disclosures by sellers of credit derivatives, including credit derivatives embedded in hybrid instruments.

Over the past few years, credit default swaps have become the most dominant product of the credit derivatives market. They also have become the focus of attention for both market participants and regulators because of the turmoil in credit markets during 2007 and 2008.

During this period, some sellers of credit derivatives have seen a large number of obligations that are referenced in credit default swaps facing actual or potential defaults, resulting in large liabilities and/or potential credit downgrades. The FSP addresses concerns of financial statement users that the disclosure requirements in Statement 133 do not adequately address the potential adverse effects of changes in credit risk on the financial statements of the sellers of credit derivatives.

The FSP also amends FASB Interpretation No. 45, 'Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others', to require an additional disclosure about the current status of the payment/performance risk of a guarantee. This amendment of Interpretation 45 reflects the Board's belief that instruments with similar risks should have similar disclosures.

The provisions of the FSP that amend Statement 133 and Interpretation 45 are effective for reporting periods (annual or interim) ending after 15 November 2008.

Finally, the FSP clarifies the Board's intent about the effective date of FASB Statement No. 161, 'Disclosures about Derivative Instruments and Hedging Activities'. In deciding on the effective date for Statement 161, the Board intended that entities begin providing the additional disclosures for the first reporting period beginning after 15 November 2008. However, the use of the terms fiscal years and interim periods in paragraph 7 of Statement 161 has raised questions about whether the disclosures are required in the 2009 annual financial statements for entities with non-calendar year-ends, because an annual report generally does not include separate financial statements for the Q4 interim period.

Accordingly, the FSP clarifies that the disclosures required by Statement 161 should be provided for any reporting period (annual or quarterly interim) beginning after 15 November 2008. For example, an entity with a 31 March fiscal year-end should provide the disclosures for its Q4 interim period ending 31 March 2009 in its 2009 annual financial statements. This clarification of the effective date of Statement 161 is effective upon issuance of the FSP.

Permacap monthly NAVs released
Permacap vehicles Carador and Tetragon have reported their August NAV figures.

As at the close of business on 31 August 2008, the unaudited net asset value per share of Carador was €0.6817. The vehicle's NAV increased by 2.13% in August, with the calculations including an estimated €405,621.71 worth of net cashflow interest received in the month (to be allocated between capital and income), which equates to €0.0081 per share.

Meanwhile, Tetragon recorded a NAV per share of US$10.54. The company says NAV per share month-on-month movement reflects an increase of US$0.11 per share earned through TFG operations and a decrease of US$0.01 per share associated with the issuance of shares pursuant to its optional stock dividend plan on 26 August.

S&P downgrades Sigma
S&P has lowered its issuer credit and senior debt ratings on Sigma Finance Corp to single-A and A-1 from double-A minus and A-1+ respectively and removed the ratings from watch negative, where they were placed on 18 March 2008. The agency's outlook on Sigma is negative.

While S&P says it sees many positive factors regarding Sigma, the lowered ratings reflect its view of the ongoing challenges in the credit markets, the potential side effects of repo financing, the absence of new third-party capital investment and the updated results of its stress-case scenario analysis. In light of the current challenging debt market, the vehicle has become even more reliant on its existing repo agreements to help finance its current asset portfolio, which totalled more than US$27.5bn as of Sigma's 10 September report to S&P.

Sigma's current funding mix consists of approximately US$6.3bn in both US and euro medium-term notes with a maturity that extends to 2017 and approximately US$17.3bn in repurchase agreement funding. Its capital notes total approximately US$3.9bn and have maturity dates that range from 2008-2017.

S&P has been monitoring Sigma's performance in the following areas: selling assets, swapping existing debt for assets, seeking new repo financing and managing the gradual de-leveraging of its vehicle. So far, Sigma has succeeded in each of these areas.

Japanese SME CDOs stable for now
According to a new report from Moody's, Japan SME CDOs rated by the agency have in general exhibited some ratings stability so far, even though the number of defaults for SMEs in the country appears to be rising.

"One primary reason is that most of these transactions are backed by amortising loans; few are backed by bullet loans," says Daisuke Kitazawa, Moody's analyst and author of the report. "In this report we provide sample analyses - using hypothetical SME CDOs - showing how differing payment methods for underlying loans impact CDO rating stability."

The key finding is that the stability of a CDO deal backed by amortising loans differs significantly from that of one backed by bullet loans - even if all other aspects of the underlying pool are identical - when the default rate of underlying pool is rising gradually. A CDO deal backed by amortising loans shows greater robustness against deterioration in its underlying SME credit quality than one backed by bullet loans.

Relationship between CDS IR and future rating actions
Fitch Solutions has published a new study showing a strong direct relationship between CDS-implied ratings and future agency rating actions. Highlights from this research include:

• The degree of 'notch differential' between the CDS IR and agency rating can predict future agency rating actions better than 50% of the time over a one-year horizon, and better than 60% of the time over a three-year year horizon.
• CDS IR model output gave early warning signals for UBS's two recent agency rating downgrades and Hess Corporation's recent upgrade.
• The top 10 entities currently signalled as high-potential future upgrades and downgrades by the CDS IR model, including Hasbro, Loew's Corp and Sony Corp.

GSE impact on CDOs analysed by DBRS ...
With Fannie Mae and Freddie Mac comprising 1.6% of each series of the CDX.NA.IG Index (Series 1 through 10), the names are referenced in 51 and 43 transactions, respectively, out of 79 total deals, according to DBRS figures. All 43 transactions referencing Freddie Mac also reference Fannie Mae.

In analysing CDO transactions, DBRS typically applies a fixed recovery rate in the range of 30% to 40% to all underlying obligors, depending on the rating of the CDO tranche. Based on current market pricing, the agency expects that the recovery rates for Fannie Mae and Freddie Mac will be significantly higher than this assumption, mitigating the negative impact of these two credit events.

Under such a scenario, the credit events are not expected to materially impact the transactions. However, if actual recovery rates are much lower than current market indications, negative rating action may result for a number of the deals.

... and by Fitch
Credit events on Fannie Mae and Freddie Mac are unlikely to trigger large scale downgrades of CDOs, despite the fact that both GSEs are referenced in approximately 30% of synthetic CDOs rated by Fitch, the agency says. The impact on CDO ratings is likely to be muted because high expected recovery rates will not pass significant losses onto the CDO.

Fannie Mae and Freddie Mac are the seventh and 21st most popular reference entities in Fitch's synthetic CDO index, which tracks Fitch-rated European synthetic CDO reference portfolios. Either Fannie Mae or Freddie Mac are referenced in nearly 200 CDOs globally, while approximately 150 CDOs reference both names.

The CDO transactions most likely to be affected are CDO-squareds that reference the agencies in multiple portfolios, CDOs that reference the subordinated debt and CDOs with fixed recovery rates on the reference assets. CDOs that reference the subordinated debt are likely to be more adversely affected than those that reference the senior debt due to lower market value, and therefore expected recovery rate, of the subordinated debt. Approximately one-third of the Fitch-rated CDOs with exposure to at least one of the agencies reference the subordinated debt.

TruPS CDOs under pressure ...
Ongoing default and deferral activity with respect to US banks which issue trust preferred securities (TruPS) through CDOs continues to put rating pressure on bank TruPS CDOs, according to Fitch in a special report.

Since September 2007, Fitch has observed US$1.7bn of TruPS defaults, deferrals and credit risk sales across 38 banks. At present, 78 of 85 Fitch-rated bank TruPS CDOs have experienced at least one underlying asset default or on-going deferral, with exposure averaging 5.5% of the current portfolio balance and ranging from a maximum of 18% to a minimum of 0.6%.

"Outsized exposure to residential construction loans and home equity loans and high rates of growth prior to the onset of recent credit pressures, fuelled by above-average levels of TruPS issuance and/or brokered deposits, are among the factors consistent across the those banks which have defaulted or deferred on issued TruPS," says Fitch senior director Nathan Flanders. "Banks that issue TruPS through CDOs are likely to financially underperform through the first half of 2009, which could lead to additional default and deferral activity and subsequent negative rating pressure on bank TruPS CDOs."

... and downgraded
Moody's has downgraded and left on review for further possible downgrade 36 tranches, and placed additional 21 tranches on review for possible downgrade, across 14 trust preferred (TRUP) CDOs. The downgrades are prompted by the exposure of these TRUP CDOs to trust preferred securities issued by eight 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 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 preliminary testing revealed their ratings could be affected by an increase in the pool-wide default probability and correlation assumptions used for trust preferred securities that are currently performing.

Rise in defaults analysed
The sharp rise in defaults in 2008 comes as no surprise, given the current lackluster economic activity and financial conditions, elevated energy prices that have sapped consumer confidence, and a markedly higher cost of capital, says an article published by S&P. In the first eight months of 2008, 55 entities defaulted globally, compared with just 22 in all of 2007 and 30 in 2006. The global speculative-grade default rate has increased to 1.9%, more than double the year-end 2007 level of 0.86%.

In the US, which accounts for 53 of the 55 defaults, the default rate increased for eight consecutive months to 2.5% in August, from a 25-year low of 0.97% at the end of 2007. "We expect the default rate to continue this ascent and reach 4.9% in the next 12 months," says Diane Vazza, head of S&P's global fixed income research group.

Ownership of the 55 defaults on which the agency could gather information reveals that, generally, large shareholders of these defaulted entities are asset management firms, alternative investment funds, endowment and pension systems, and individual stakeholders. However, the complex relationships of the players within the capital markets serve to dilute the exposure of any given group.

"Of the 55 defaults, nearly 70% were involved in transactions involving private equity at one point or another, which may or may not have facilitated the default," adds Vazza.

Liquidated CDO ratings withdrawn
Moody's has announced that it has withdrawn the ratings of 261 classes of notes issued by 34 CDOs backed primarily by portfolios of RMBS securities and CDO securities because they have completed liquidation following events of default.

SROC results for Europe
After running its month-end SROC figures, S&P has taken credit watch actions on 116 European synthetic CDO tranches. Specifically, ratings on 109 tranches were placed on credit watch with negative implications; two tranches were placed on watch negative following their removal from watch positive; and five tranches were removed from watch negative and affirmed.

Of the 111 tranches placed on watch negative, 46 reference US RMBS and US CDOs that are exposed to US RMBS, which have experienced recent negative rating actions; and 65 have experienced corporate downgrades in their portfolios.

Further CPDOs under review
Moody's has put under review for possible downgrade the ratings of 10 series of CPDO notes, both static and managed transactions. The deals affected by the action are Castle Finance II Series 2, Thebes Capital Series 2006-1, Artemis DPI Series 2007-1 and 2, SEA CDO Series 2007-2, RIDERS 2006-3 and 18, RECIPES Series DE, Arlo X Series B-1Z and Coriolanus Series 92.

These actions are based on the following:

• The placement of Fannie and Freddie in conservatorship on 8 September 2008,
• Lehman Brothers Holding's filing for bankruptcy on 15 September 2008, and/or
• A substantial increase in markets spreads, which negatively impacts the performance of CPDOs.

Calypso improves Fast-Track
Application software provider Calypso Technology has announced enhancements to its Calypso Fast-Track offering. Launched in 2007, Calypso Fast-Track is a pre-configured application environment designed to expedite deployment of Calypso's trading, risk and operations application. The second generation includes enhanced accounting, reporting and additional instruments and currencies.

Because Calypso Fast-Track provides a pre-configured solution, customers are able to quickly realise the benefits of how Calypso's front-to-back, cross-asset solutions work within their enterprise. The offering also comes with full documentation and corresponding training courses to address any configuration issue. Customers can utilise the training to help teams and new hires quickly get up to speed on Calypso's trading and risk management system.

Rhinebridge makes cash distribution
The receivers of SIV-lite Rhinebridge made a cash distribution following a partial redemption of the USCP and ECP notes earlier this week. The portfolio sale distribution, which amounted to US$14m, was insufficient to fully repay the senior obligations. It was also insufficient to allow any payment to be made to the holders of the capital notes or any other party subordinate to the senior creditors.

The receivers, Deloitte, made the portfolio sale distribution by paying each senior creditor a pari passu amount in respect of its payable pre-distribution senior obligations. In the case of USCP and ECP notes, amounts paid to holders have been paid pari passu between the unpaid redemption price of each USCP and ECP note and the ongoing interest which has accrued in respect of the redemption price.

CS & AC

Where should hedge funds keep their cash?

Structured credit strategists at Citi recommend that all institutional investors insist on moving their deposits from unsecured to secured status

It may seem odd to focus on hedge funds' deployment of cash when so many of the arguments in this note apply equally well to, say, corporate treasurers. But whereas most corporate treasurers have had cash to deposit for years - and have therefore built up systems and processes to ensure that it is invested safely - hedge funds, somewhat surprisingly, have not. And even corporate treasurers are sometimes reconsidering their alternatives in the light of the credit crunch.

The recency of the hedge funds' problem has two causes. The first is the growth in their asset base. Until a few years ago, most individual funds were too small for the investment of their cash to have systemic implications.

Yet now, with more than US$2trn in cash under management, and with - at least until this year - a near exponential rate of growth (see Figure 1), the volumes have grown to the point where shifts in their investment can, by themselves, destabilise individual financial institutions. Unlevered cash of US$2trn implies investments after leverage of verging on US$7trn, and yet much of it is concentrated at a handful of broker-dealers whose balance sheets are much smaller than this.

Second, the size of hedge-fund cash deposits has increased dramatically over the past year or so. Precisely because their assets are levered, traditionally the vast majority of their funds have been pledged as collateral, or haircuts, against that lending.

While they would keep some sort of cash balance to guard against the possibility of outflows, they have typically sought to minimise that balance since the rates brokers tend to pay on it - somewhere near or below Libor - are typically far below funds' typical target returns. Cash pledged as margin loans receives similarly low rates, of course, but funds in addition receive the returns on the assets bought - and are by definition unable to move that cash elsewhere if they wish to continue to hold the asset.

Since the onset of the credit crunch, all that has changed. Dramatic increases in haircuts imposed by broker-dealers, notably in August 2007 and March 2008 (Figure 2), have forced funds to liquidate investments.

On occasion this has had catastrophic consequences. Funds like Carlyle Capital and Peloton Partners were closed down not because of redemptions (indeed, their prior performance had often been outstanding), but because of losses incurred while trying to make such margin calls. Even at today's more elevated haircut levels, the need to cope with possible further increases has led to the maintenance of much higher cash balances.

The growing likelihood of redemptions has amplified the trend towards higher cash balances in recent months. Aggregate fund performance is the worst in years (Figure 3). Year to date, more than half of the broad fund categories on Hedge Fund Research are down 5% or more, with numerous individual funds doing significantly worse than that (Figure 4).

Against such a backdrop, the maintenance of higher cash balances is not so much prudent as simply a necessity. While precise figures are hard to come by - and will vary massively from one fund strategy type to another, we estimate that the average fund has gone from holding 20% in cash prior to the credit crunch to around 30% today. This equates to around US$600bn in assets, many of which will still be on unsecured deposit with broker-dealers.

How risky are such deposits?
Of course, in more normal times, even unsecured deposits at banks and brokers would typically have been considered quite safe, and indeed in absolute terms they remain reasonably so. But the rapidity with which liquidity problems have caused unravelling elsewhere - even at seemingly well-capitalised institutions - has understandably caused concern, reflected most obviously in the dramatic rise in CDS spreads at both broker-dealers (Figure 5) and banks.

The fact that prime brokerage business (and hence broker-dealer cash) is concentrated among so few institutions constitutes a further problem. (Again, precise numbers are difficult to find, but one market estimate we have heard is that Morgan Stanley and Goldman Sachs between them have almost half of the prime brokerage market).

Not only is leverage at the broker-dealers higher than that at more highly regulated banks, but also their balance sheet reporting requirements are different from those of banks. As such, it is impossible to tell clearly just what their vulnerability is to a sudden withdrawal of cash.

What is more, the numbers concerned are extremely large. Customer payables make up US$924bn, or 15% of the total liabilities of the major broker-dealers, and more like 25% at Morgan Stanley and Goldman Sachs.

That may not sound like too much - the deposit base for most banks would often be considerably more - but again, deposits from hedge funds are probably flightier than those from individuals. Were they to move elsewhere or, worse still, to move suddenly elsewhere as a result of concern about the stability of the institution concerned, the consequences for the brokers would be extremely serious.

Perhaps the most obvious alternative to an unsecured deposit is an investment in a money market fund. Indeed, this is precisely where much money has recently been going.

Yet for institutional investors, the dynamics are probably such that we reckon this solution is less appropriate than it is for retail. While still extremely safe in the grand scheme of things, we think there are arguments in terms of size, maturity and asset mix which argue against them.

More broadly, funds should think very carefully indeed about the potential correlation between the returns on their main strategies and any money market fund holdings they have. Funds hoping to make money on short positions in municipal CDS or agencies, say, would be unlikely to appreciate the irony if the success of those very investments caused them to lose money on their cash holdings elsewhere. Conversely, funds taking long positions in those or other markets could find that they have inadvertently doubled up their exposures.

In sum, although there is no reason to question the outright safety of money market fund holdings, at the same time it remains clear that their product is one explicitly designed around the needs of a different sort of investor base, namely retail. Institutional investors in general often choose to invest elsewhere; in our view, hedge funds in particular, with their own special needs in terms of liquidity and potential correlation with the rest of their portfolios, would do well to do so.

Introducing repo
To our minds the main alternative to unsecured investments, such as deposits, CP or money market fund holdings, is repo. Repo is as widely used as it is poorly understood.

Hedge funds ought to understand it, as repo and margin loans (which are legally different, but economically similar) are the means by which they finance almost all of their assets. As such, though, they are typically more used to playing the role of the cash borrower than the cash lender.

It is also the way in which broker-dealers and investment banks finance a sizeable proportion of the assets on their balance sheet. Although we are somewhat worried about brokers' (and, for that matter, hedge funds') dependence on repo and margin loans as borrowers, the very same features and flexibility which make us concerned for the borrowers actually make the transactions safer for the lender. It is this which has allowed repo to grow to the extent it has, with more than €6trn outstanding in Europe alone, and significantly more than that globally.

How risky is it?
But can repo really compete with the likes of money market funds in terms of ultimate safety? Of course, with safe investments it is always difficult to tell, as historical records give few losses upon which to base a judgement.

But to our minds the major risks on repo are ones of liquidity rather than of default, and that even these can be mitigated by the use of appropriate haircuts. And the flexibility for individual funds to tailor their exposures in terms of maturity, collateral, counterparty and haircut levels acts as a major advantage.

How likely are joint defaults?
The safety of repo revolves around its status - unlike most CP and money market investments - as a form of secured lending. Losing money outright requires not just one, but two defaults - both of the counterparty and of the issuer of the underlying collateral. Almost by definition, such contingent probabilities of default are very low - and typically lower than those on even the safest forms of unsecured lending.

Estimating joint default probabilities in practice is always extremely difficult, mostly because it depends heavily on correlation. Consider, for example, the probability of default on the reverse repo of a triple-B corporate bond sourced from a single-A rated financial counterparty.

Consulting the rating agencies' historical default tables, the probability of the triple-B asset defaulting in a year is 0.29%, while the probability of the single-A rated counterparty defaulting is 0.022%. If the two were independent, the joint default probability would be the product of the two default probabilities, or 0.00006% - considerably safer than the unsecured purchase of a triple-A.

As Figure 6 shows, even the default probabilities for secured lending backed by high yield bonds or (by implication) equities are lower than on most unsecured lending, and can in most cases be taken to be zero. And even if we choose to remain sceptical of credit ratings' predictive powers - in particular in an era of considerable financial instability - we might still take solace from the thought that two credit ratings ought at the very least to be better than one.

But this picture requires two significant forms of modification. On the one hand, the probabilities are unlikely to prove independent in practice: the sort of economic environment required to cause the sudden default of a financial counterparty would mean that the corporate bond would likely be more at risk than these statistics suggest.

On the other, repos typically feature daily margining - effectively a form of mark-to-market reset, designed to ensure that cash lenders are only exposed to a drop in the price of the collateral since the last reset - not since the initiation of the repo itself. As such, losing money through a default requires not just two defaults over the life of the repo, but actually two defaults on the very same day.

Unfortunately, at this point the mathematics stop being so useful. Likely levels of correlation - and their effect on joint probabilities of default - can be estimated from traded first-to-default baskets (Figure 7). But estimating the probability of a joint default over such a short time period is well-nigh impossible: it seems unlikely to be simply a question of dividing the normal annual probabilities of default by 252 (for trading days) or 365, and is not really considered in the usual correlation literature.

So while we do not know what the precise probabilities are, we are still left feeling that - from a default perspective - repo of even high yield or equities is likely to prove safer than almost any form of unsecured investment. And the residual risk can in addition be mitigated by making an effort to continuously monitor the creditworthiness of the counterparty.

Collateralisation and haircuts
This conclusion, though, rests upon the assumption that reverse repo is adequately collateralised. Back in the real world, we would expect a far greater risk of loss for cash lenders as a result of trying to liquidate assets following a single, counterparty, default than following a simultaneous double-default. It is here, of course, that haircuts come in.

Much of the strength of repo lies in cash lenders' ability to tailor haircuts to their own needs. They will normally vary as a function of collateral credit quality, collateral liquidity, maturity of the repo and credit quality of the counterparty.

For example, hedge funds who are concerned that accepting a particular type of collateral from a particular counterparty might correlate unfavourably with their main portfolio strategies might simply demand extra compensation in return for accepting such collateral from that counterparty. If they are the only ones doing so, this simply means they are likely to receive different collateral instead.

The major driver of haircuts should be - and in practice tends to be - liquidity. Provided you have an appropriate haircut, many lenders are quite happy to accept very risky collateral, such as equities.

The rates received on such collateral are much better than on, say, Treasuries, especially during times of stress, when Treasuries tend to go special. If the collateral sells off significantly, the lender is fully anticipating giving it back at the end of the repo. And even if the counterparty defaults in the meantime, the lender will have been receiving variation margin every day.

What the haircut really needs to compensate for is the potential difference in value between the last variation margin payment and the level at which the lender could liquidate the position (assuming they do not want to hold it) following a counterparty default. Large-cap equities, for example, may be individually quite volatile, but can probably be sold into the market without major difficulty.

As such, their haircuts tend to be only around 20%. Collateral which is much safer from a credit perspective - such as highly rated ABS - tends to attract a similar or even higher haircut because of its current extreme illiquidity.

This emphasis on liquidity also explains why, in principle, haircuts should vary as a function of the size of the position. A €1m position in a high-yield corporate bond can be sold into the market with much greater ease than a €10m position - particularly if the sale in question is likely to take place during the turmoil immediately following the default of a major financial institution. It was greater consciousness of the importance of such considerations which led to the big rise in standard market haircuts shown in Figure 2.

Once again, though, to our minds it is the ability of an individual investor to tailor haircut, maturity, counterparty and other requirements which is repo's major strength. An investor who has little need of cash may reverse repo for a month or more; others, who are concerned that they may need such cash, might insist on lending overnight.

Moreover, by keeping maturities short, a cash lender reserves the right to change the haircut, collateral and other requirements each time the repo rolls. For the repo borrower, this is a nightmare: witness the problems the hedge funds themselves have had, with many of them closing, after trying to fund long-term illiquid assets through short-term repo, only to find their lines being pulled (or that they were unable to make increased margin payments) as markets deteriorated.

Indeed, it is this flexibility which continues to make us nervous about prospects for the broker-dealers and others whose funding depends heavily on repo. For the lender, though, these very same features are a major strength, and a reason for institutional investors to favour repo over other forms of short-term investment.

© 2008 Citigroup Global Markets. All rights reserved. This Research Note is an excerpt from 'Where should hedge funds keep their cash?', first published by Citigroup Global Markets on 2 September 2008.

Trading ideas: golden horizons

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at an outright long on Barrick Gold Corp

Right after the Fannie/Freddie bailout Barrick Gold tested the corporate bond market with a three-tranche US$1.25bn deal. The deal was absorbed at a time when most investors were more interested in watching Bloomberg for the reaction to the bailout and this piqued our interest in Barrick. After delving a bit more deeply into the company, we liked what we saw.

Barrick's management strategically acquired 94% of Cadence Energy to offset some of its energy needs the week before last. Energy costs represent 25% of Barrick's total operating expenditures and we applaud the company for thinking creatively on how to manage this risk. On top of extremely good operating cashflow, Barrick's liquidity position is strong, with a cash balance of US$1.9bn and total assets in the range of US$24bn.

From the more technical standpoint, correlation between Barrick's credit spread and Gold spot has traditionally been non-existent when gold traded below US$800/oz; however, recently its spread exhibited a positive correlation to gold (increasing spread with increasing gold price) which defies our expectation. We do not think this will continue into the future.

As a final note, our quantitative credit model shows its credit spread to be trading 40bp too wide due to fantastic margins, accruals, low leverage and strong interest coverage levels. We recommend selling protection on Barrick Gold.

Planning for the future
Barrick's management looks to the future and plans accordingly. Energy costs represent 25% of the company's total expenditure and the Cadence Energy deal will effectively hedge a quarter of Barrick's ongoing energy costs. Even though Crude dropped close to US$100/barrel in recent weeks against Barrick's expectation of an average price of US$125/barrel in the second half of this year, management's creative style of managing for the future is a sure positive.

Management also issued a US$1.25bn bond note (5-10-30 year tenors) to repay a US$1.14bn credit facility. The credit facility was used to partially fund the purchase of the Cortez property and a portion of Cadence Energy. Though the new issue went out substantially cheap to CDS-implied fair value (we also recommend buying these bonds), the fact that the bond market took down Barrick's largest corporate bond deal ever during a rather uncertain day is highly encouraging.

Cash cow
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 Barrick Gold. We see a 'fair spread' of 74bp for its solid margins, leverage, interest coverage and accruals factors.

Exhibit 1

With gold sitting at historically high levels (even with its recent drop down to US$800/oz), Barrick Gold generates substantial margins (Exhibit 2). By keeping a close on eye on its energy costs (as we noted above), we believe the company will continue to deliver high margins as its net cost per ounce of gold (depending on where it's coming from and its quality) is in the range of US$400-US$425/oz. Assuming gold prices remain close to where they are (and we don't really see any reason for this to change anytime soon), Barrick's margins should not come under any pressure.

Exhibit 2

From a liquidity and leverage standpoint, Barrick sits in a solid position. It has US$1.9bn in cash or cash-like securities, combined with leverage (total debt to total assets) in the neighborhood of 23% after adjusting for the recent bond issue. Even with the increase in interest expense from the new deal (five-year deal is T+315), all adjusted numbers still look strong relative to its peers.

Gold is gold
Barrick's future is obviously highly dependent on the price of gold. This is evident when looking at the relationship between Barrick's stock price and gold. Exhibit 3 clearly demonstrates the positive correlation between the two, and this corroborates our prior expectation.

Exhibit 3

Now, taking that same thought and extending it to the relationship between Barrick's credit spread and gold, one might expect the opposite relationship to hold - higher gold leading to a tighter spread and vice versa. Exhibit 4 actually shows that when gold traded below US$800/oz there was little if any correlation between Barrick's credit spread and the price of gold. This is likely due to the low leverage of the company and tight spread level (around 40bp-50bp).

Exhibit 4

However, when gold traded above US$800/oz an unexpected shift took place. Barrick's credit spread began to move with a significant positive correlation to gold.

As gold traded higher, so did Barrick's credit spread. This goes against our expectation and we believe it is a mispricing, furthering our decision to sell credit protection on the company.

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 10bp 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 ABX's liquidity is good in the CDS market at the five-year tenor.

Summary and trade recommendation
Right after the Fannie/Freddie bailout Barrick Gold tested the corporate bond market with a three tranche US$1.25bn deal. The deal was absorbed at a time when most investors were more interested in watching Bloomberg for the reaction to the bailout and this piqued our interest in Barrick.

After delving a bit more deeply into the company, we liked what we saw. Barrick's management strategically acquired 94% of Cadence Energy to offset some of its energy needs last week. Energy costs represent 25% of Barrick's total operating expenditures and we applaud them for thinking creatively on how to manage this risk. On top of extremely good operating cashflow, Barrick's liquidity position is strong, with a cash balance of US$1.9bn and total assets in the range of US$24bn.

From the more technical standpoint, correlation between Barrick's credit spread and gold spot has traditionally been non-existent when gold traded below US$800/oz; however, recently its spread exhibited a positive correlation to gold (increasing spread with increasing gold price) which defies our expectation. We do not think this will continue into the future.

As a final note, our quantitative credit model shows its credit spread to be trading 40bp too wide due to fantastic margins, accruals, low leverage and strong interest coverage levels. We recommend selling protection on Barrick Gold.

Sell US$10m notional Barrick Gold Corp 5 Year CDS protection at 117bp.

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).