Contents

Mastering documentation

Rehypothecated assets to delay hedge fund settlements

CDS documentation and the liquidation process have been in the spotlight over the past week, as counterparties try to come to terms with life after Lehman and AIG. Notably, it has emerged that some hedge funds will have to wait for several months before they can settle their positions.

"The European liquidator has stated that it will take months to unravel all of the rehypothecated assets in Lehman's prime broking business unit and sort out the competing claims," confirms one synthetic ABS trader. "Consequently, many hedge funds are facing uncertainty and are frustrated that they can't trade out of or settle their positions."

Indeed, the recovery of Lehman's senior debt is heavily tied in with its repo and derivatives positions. "The net position is pari passu with its senior unsecured debt; however, the recovery of net derivatives positions will usually benefit from collateral. The recovery of senior unsecured debt will be much worse that the recovery of net derivatives positions," notes Tim Brunne, structured credit strategist at UniCredit.

He adds: "Nonetheless, the market is faced with gap risk with respect to any collateral exchanges - there was an exchange on the Friday before Lehman filed, followed by large market movements which meant that by the automatic termination on Monday some counterparties' mark-to-market positions were hurting, as they may not have enough collateral to cover them."

There also appears to be confusion about whether certain Lehman Brothers entities (Lehman Brothers International and Lehman Brothers Special Financing) are in any kind of liquidation, with legal opinion on one side holding that they aren't - yet Chapter 11 for the holding company has an impact on derivatives business done with the subsidiaries if the holding acted as a credit support provider. The situation isn't helped by the complexities of differing national bankruptcy laws.

"The legal position of the subsidiaries in the UK and Germany, for example, has been made clear - an administrator has been appointed for the UK subsidiary, while the German entity is under a moratorium. So it's clear what the counterparty or reference name is," explains Brunne.

However, he says, in the US the subsidiaries aren't in a formal state of default and so counterparties can't terminate their ISDA Master Agreement, which would automatically result in netting and payment. But all entities (such as LBSF) where the holding was a credit support provider fulfil the bankruptcy event of default under ISDA Master Agreements and, consequently, all deals where these entities were a swap counterparty can be effectively terminated.

One theory as to why only the holding company filed for Chapter 11 is so that Lehman's subsidiaries could unwind in an orderly fashion and make it easier for parts of the business to be acquired (see Job Swaps for more). But this still begs the question of whether the subsidiaries will be able to make their payments during the unwind period; if not, they will be considered as bankrupt.

Another area of uncertainty and potential losses for the market focuses on the significant swap counterparty role that Lehman played in structured vehicles. "It will be difficult to find new counterparties for these various roles," confirms the trader. "Potentially the issuer/originator could step in as a stop-gap, though this depends on their rating and the transaction documents. Neither the SPV nor Lehman has the cash to pay over the odds to replace the counterparty, unless perhaps the swap is in the money."

Meanwhile, any suggestion that the AIG bailout might constitute a credit event have been quickly dismissed. "The legal discussion about whether AIG constitutes a credit event is closely tied to whether the bailout can be considered to be a conservatorship; if it is simply a takeover, then it should be OK," says Brunne. "In the long term, if AIG sells large portions of its businesses, this could constitute a succession event - but a succession event isn't a default." Similarly, the Merrill Lynch acquisition is also likely to be considered as a succession event, where Bank of America CDS succeed those of Merrill Lynch.

AIG is due to provide a list of what's for sale next week, with the bulk of the businesses expected to come from foreign operations.

CS

Correlation drop

Systemic risk fears lessen over bailout plan and ABCP resolution

Correlation looks set to be driven lower in response to a number of separate events that have taken place in recent days. While TARP (see separate news story) is expected to bring down spreads on financials and eliminate the need for hedging of super-senior tranches, the end of the Canadian ABCP restructuring saga may also have a similar outcome.

In the midst of bankruptcy, rescue packages and mergers that filled the headlines last week, the Supreme Court of Canada also announced that it had dismissed the last-gasp challenge by a group of corporate bondholders opposed to the restructuring plan of the country's C$32bn ABCP market. The ruling brings the country's ABCP saga to a near close, with several thousand retail and institutional investors likely to receive their redemptions by the end of October.

"Pre-emptive hedging against another blow out in corporate super-senior spreads in case of an ABCP unwind (they hold leveraged super-senior notes amongst other assets) may now be unwound, driving corporate super-senior spreads tighter and correlation lower," notes Gregorios Venizelos, structured credit strategist at RBS.

A CSO manager agrees that the ABCP situation is a positive development for super-senior spreads, although he does not see this event alone affecting spreads or correlation due to the size of the rescue deal, compared to the global situation affecting the correlation market. However, the US government's TARP scheme could add to - if not lead to - a sustained decline in correlation by potentially bringing down spreads on financials and eliminating the need for hedging of super-senior tranches.

"The biggest trend we're seeing in the market at the moment is a shift from systemic risk to idiosyncratic risk," comments one CDS trader. "We're not expecting CSOs to participate in the government's bailout plan, but it's certainly going to lessen systemic risk and is a positive for the market."

Venizelos says that if outstanding ABS CDOs (those that have not yet hit EOD triggers) find it easier to unwind and put their underlying RMBS paper into the TARP (in the case where CDOs are not TARP-eligible) or are simply placed into the TARP (in the case where CDOs are TARP-eligible), this could drive corporate super-senior spreads tighter in sympathy.

Meanwhile, there are two additional factors that may add to the decline in correlation. First, deterioration in financials' default and recovery rates that puts pressure on financials CDS may result in broader downgrades and unwinds of mezzanine CSO paper.

"Mezz spread widening should suck risk out of the super-senior part of the capital structure, as equity risk starts focusing on jump-to-default risk in earnest (thus not prone to tighten)," explains Venizelos.

Second is the impact of the Lehman Brothers default. "If the Lehman bankruptcy proves to be the last lightning hurled by the systemic gods, the corporate correlation market will sooner or later focus on jump-to-default risk in earnest (a matter of when and how many defaults, rather than if). This should drive correlation lower in a more meaningful way than the recent start/stop/reverse 'attempts' have managed," concludes Venizelos.

AC

Regulation redux

New York move could have wider repercussions

The New York Insurance Department's announcement on Monday that it will begin regulating some CDS caused confusion, as it was unclear whether this would apply beyond insurance firms. Although the move appears to be designed to ensure that monolines are adequately capitalised, it could herald the start of a concerted attempt to begin regulating the broader CDS markets.

"The move will likely have little impact on the CDS market, since the only trades that will be scrutinised are basis trades and not outright bets on CDS spreads," says one CDS trader. "It is aimed at ensuring that the monolines are adequately capitalised, though the regulation could spill over into other parts of the market. It is certainly worth watching because it highlights a need for increased regulation of the CDS market - and other politicians are likely to jump on the bandwagon."

Indeed, SEC chairman Christopher Cox added to the pressure to begin regulating the CDS market in his testimony to the Senate Banking Committee on Tuesday. "As the Congress considers fundamental reform of the financial system, I urge you to provide in statute the authority to regulate these products to enhance investor protection and ensure the operation of fair and orderly markets," he said.

Several aspects of the NY Insurance Department's guidelines smack of political premature intervention, according to RBS financials analyst Tom Jenkins. "One, if non-insurance Wall St firms are prevented from buying CDS on any bond that they may own, then you reduce CDS liquidity and counterparties. Two, if this is not a federal regulation, then those firms based elsewhere could be considered to have a material advantage. Three, it is unclear as yet whether the rules will apply only to insurance companies, even if the trade is on the books of a bank but still considered an insurance contract," he says.

The new regulations - beginning in January 2009 - establish that, when a buyer owns the underlying security on which they are buying protection, the swap is an insurance contract. As such, these swaps can only be issued by entities licensed to conduct insurance business. However, although the circular makes it clear that existing CDS and naked swaps won't be affected, it doesn't specify whether the rules will apply only to insurance firms.

The Department says that the goal of regulating CDS is not to stop sensible economic transactions, but to ensure that sellers have sufficient capital and risk management policies in place to protect the buyers, who are in effect policyholders. "We are providing an appropriate way for those with an insurable interest to protect themselves and we are going to ensure that whoever sells them that protection is solvent, in other words, can actually pay the claims. There is currently no such protection for policyholders," notes New York State Insurance Superintendent Eric Dinallo.

Together with increasing the minimum amount of capital and reserves that an insurer must maintain, the new best practices limit the guaranteeing of CDOs, institute risk limits, require written risk control and underwriting policies, and expand reporting requirements. But one structured credit investor says that the move is slightly redundant, given that most monolines have already stated their intention to end their structured credit activities.

He adds that the announcement alludes to CDS being responsible for the problems at Bear Stearns and AIG, as well as the monolines. "However, what ultimately caused problems for Bear and the monolines were ABS CDOs, not CDS. Mark-to-market issues with AIG's corporate super-senior portfolio arguably caused its problems, so the only valid criticism in the circular is that the insurer sold too much protection and didn't hold enough capital against it," the investor suggests.

Another potential flashpoint could be in the equating of CDS with insurance contracts. The Department ruled in 2000 that all CDS were not insurance, but the circular letter effectively reverses this decision "only to the extent that certain swaps are insurance under New York Insurance Law". Some observers point out that ISDA has long-established that CDS are financial instruments and not insurance contracts.

"There is a welcome role for regulators to review the activities of those they regulate, and in that vein the State Insurance Department can and should monitor all the activities of NY insurance companies, including their swaps business," ISDA executive director and ceo Robert Pickel comments in a statement. "However, going beyond this common sense approach threatens to disrupt global derivatives markets which have continued to function amidst the current turmoil. The State of New York should proceed very cautiously and in consultation with Federal regulators before acting in a way that may ultimately cause more harm than good."

CS

Firm hires for expansion and new funds

The latest company and people moves

Firm hires for expansion and new funds
Duet, a London-based alternative asset management firm, has launched two new funds and expanded into the MENA region and Asia with the formation of subsidiaries in Dubai (Duet MENA) and Singapore (Duet Asia). The ceo and managing partner of Duet is Osman Semerci, ex-global head of fixed income, currencies and commodities at Merrill Lynch.

A number of new hires have been made, the majority of which are from Merrill Lynch. These include Dale Lattanzio, who will be cio of the Duet European Debt Fund, which focuses on European distressed commercial real estate. Lattanzio was previously co-head of Americas fixed income, currencies and commodities, and co-head of global commercial real estate at Merrill Lynch.

Shinji Yoshikawa will be cio of Duet Japan Special Situations Fund, which will focus on distressed real estate opportunities in Japan. He has also been appointed ceo of Duet Asia. He joins from Merrill Lynch, where he worked for over nine years, most recently as head of Japan principal strategy and special situations in Tokyo.

Rob Clayton has been appointed director of Duet Private Equity and will work with Lattanzio on the Duet European Debt Fund, as well as on other Duet private equity products. He joins from the Topland Group, a private investment firm, where he was structured finance director.

Hedi Ben Mlouka is the ceo of Duet MENA. He joins from Merrill Lynch, where he was head of equity and structured products marketing for Central & Eastern Europe, Middle East and Africa.

Amit Shah becomes director of Duet MENA, moving over from Merrill Lynch where he was a vp on the Middle East and Africa desk. Yazid Ben Salem has been appointed as an associate, joining from Deutsche Bank global principal finance group where he was an analyst. Finally, Kosuke Kondo joins Duet ASIA as a senior investment analyst from Merrill Lynchin Tokyo, where he was an associate of the Japan mortgage lending business.

Duet MENA and Duet ASIA will launch and manage funds investing in their respective regions, as well as distributing Duet products. Duet MENA is also in the process of obtaining a license in the DIFC.

Credit salesmen appointed
Broadpoint Capital has hired two additional senior sales professionals in the investment grade sales department of Broadpoint's debt capital markets division. Clay Stephens, md, and Roger Weilep, vp, will report to Richard Crescenzo and Douglas Scales, co-heads of the department.

Stephens worked at Bear Stearns for 20 years, where he ultimately held the title of senior md. He has sold all products across the fixed income spectrum, including investment grades, high yields, credit derivatives, CMBS, CDOs and secured private placements.

Weilep most recently spent 11 years at Deutsche Bank, where he was a director in the integrated credit sales department. Prior to working at Deutsche Bank, Weilep was a vp of global market sales at Lehman Brothers, where he specialised in corporate bond sales.

Specialist IB hires in structured finance
Houlihan Smith & Co has appointed James Honan as an md in its structured finance group, based in New York. Honan joins the firm from LaSalle Bank, where he was responsible for building LaSalle's junior capital debt placement capability to include second lien loan origination and distribution. He has extensive experience working with hedge fund and specialty finance investors through the development of the investor base for the distribution of junior capital products.

EM CDS brokers hired
GFI Group has added five new hires in emerging markets CDS in New York. These include brokers Scott Pagano, Michael Connell and Tom Halpin. All five join GFI from BGC Partners in New York.

The new brokers will report to Nick Brown, GFI's head of financial product brokerage, North America.

Real estate credit fund launched
Investcorp, an asset management firm specialising in alternative investments, has launched the Investcorp Real Estate Credit Fund - a US$1bn credit investment vehicle that has been formed to acquire whole loans, mezzanine loans and CMBS collateralised by well performing commercial and residential real estate assets throughout the US.

CDO portfolio sold
Sovereign Bancorp has sold its entire portfolio of CDOs. The CDO portfolio has experienced significant volatility over the past year and by selling the portfolio, Sovereign says it is eliminating the risk of future volatility in its capital levels.

DCM global head announced
Deutsche Bank has appointed Miles Millard as global head of debt capital markets and the corporate coverage group. He was previously European head of both; there was no previous global head. Meanwhile, Mark Fedorcik will become global head of leveraged DCM - replacing David Flannery, who left recently.

Lehman teams on the move
Lehman Brothers has begun to re-open for business under the ownership of Barclays Capital. More than 10,000 Lehman Brothers employees have been offered jobs in the new entity. Barclays has acquired Lehman Brothers' fixed income and equity sales, trading and research; prime services; investment banking; principal investing; and private investment management businesses in North America.

Meanwhile, Nomura is set to acquire the European and Middle Eastern equities and investment banking operations of Lehman Brothers. It has not, however, acquired the fixed income arm of the business.

European headhunters are expecting teams of Lehman Brothers employees to move over the next couple of weeks, whether or not they belong to the new Nomura-owned divisions. "The big banks have approached Lehman staff direct and expect to make them offers from this week onwards," confirms one headhunter.

Death of the broker-dealers
Goldman Sachs and Morgan Stanley are, pending a statutory five-day antitrust waiting period, set to become bank holding companies. To provide increased liquidity support to the firms as they transition to such a structure, the New York Fed will extend credit to their US broker-dealer subsidiaries against all types of collateral that may be pledged at the primary credit facility for depository institutions, as well as at the existing primary dealer credit facility (the firms' UK subsidiaries can also now pledge collateral at the PDCF). The Fed has also made these collateral arrangements available to the broker-dealer subsidiary of Merrill Lynch.

The move will enable Goldman and MS to begin taking retail deposits, enabling them to compete with Citi, Bank of America and JPMorgan on the multi-platform retail/investment banking model. It will also likely delay/prevent any mergers or takeovers that had been previously mooted from happening.

However, the firms' business model will now have to operate with significantly reduced leverage - down to 10x from around 25x. This means that they will likely have to begin raising capital and posting assets into the proposed TARP (troubled asset relief programme) facility.

AC & CS

Lehman-related downgrades reported ...

A round up of this week's structured credit news

Lehman-related downgrades reported ...
S&P has taken credit rating actions on 422 tranches in European securitisations following recent rating actions on Lehman Brothers Holdings Inc and related entities. Lehman performs a wide range of roles in various structured finance transactions, some of which have a bearing on the credit risk of the rated notes in the impacted transactions.

The rating actions affect the following number of tranches in each asset class:

• 243 RMBS;
• 22 ABS;
• 92 CMBS; and
• 65 CDOs.

The rating action breakdown is as follows:

• 381 ratings have been placed on watch with negative implications.
• Two ratings have been lowered.
• 22 ratings remain on watch negative.
• 17 ratings have been affirmed.

... while ratings are assessed by Fitch ...
Fitch is assessing the potential rating impact of the bankruptcy of Lehman Brothers Holdings Inc on synthetic CDOs that it rates. The agency has placed 23 tranches of CDO transactions on watch negative.

Lehman acted as CDS swap counterparty in 27 Fitch-rated public synthetic CDOs (and 35 private CDOs); 12 (17 private) in Europe; 15 (15 private) in Asia; and three private in the US. In many of these transactions, Lehman Brothers Special Financing acted as the buyer of credit protection from the CDO as CDS swap counterparty, and LBHI acted as a guarantor or credit support provider.

The impact on CDO note ratings where a Lehman entity acts as swap counterparty will depend upon many factors, including whether the swap may be transferred to another counterparty, whether the CDO transaction faces an automatic unwind following the Lehman bankruptcy 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 (see also separate news story). Should the swap counterparty, guarantor or credit support role not be taken over by another adequately rated institution, Fitch expects early termination events to be triggered, if not immediately, then within a 30 day timescale.

If an early termination is triggered where the swap counterparty is the defaulting party, the eligible securities would be either liquidated and used to repay the CDO notes before any swap termination payment is potentially due to LBHI, or would be delivered to the noteholders. In these instances, the CDO noteholders' risk profile may shift from the portfolio of reference entities to either the liquidation value or to the ongoing credit and market risk of the eligible securities. In the liquidation scenario, the CDO noteholders will either be paid in full from proceeds of the eligible securities or will incur a shortfall if the proceeds are less than the outstanding amount of the notes, plus any accrued and unpaid interest.

In the three private US transactions, collateral-posting arrangements were in place to cover any difference between the market value of the eligible securities and the outstanding balance of the notes, should early termination occur. In such cases, the loss to noteholders would be expected to be limited. For the remaining 27 (32 private) transactions, collateral-posting arrangements were documented to come into force only following the swap counterparty's, guarantor's or credit support provider's short-term rating being downgraded below F1.

Since it is not expected that LBHI will meet its collateral-posting obligations, should early termination occur, the noteholders would be subject to market value risk on the eligible collateral, and the noteholders may lose some portion of their investment, depending on the current market value of the eligible securities. As a result, Fitch expects that an early termination may result in the downgrade of the notes to the triple-C category or below, despite the fact that recoveries may be good to high in many cases.

... and DBRS
Lehman Brothers Holdings is referenced in 28 of the 80 Canadian CDO transactions monitored by DBRS. When rating CDO transactions, DBRS typically applies a fixed recovery rate in the range of 30% to 40% to all underlying corporate obligors, depending on the rating of the CDO tranche.

To demonstrate the level of ratings stability of the 28 transactions that reference Lehman, DBRS applied two stress scenarios: (1) assume immediate default by Lehman with 30% recovery; (2) assume immediate default by Lehman with 0% recovery. Both stress tests also incorporate the recent credit events of Fannie Mae and Freddie Mac, assuming a recovery rate of 95% for both companies based on current market indications.

For the scenario assuming 30% recovery for Lehman, the model results indicated that 24 of the 28 transactions were able to withstand this scenario while maintaining their current ratings. Of the four remaining CDOs, three were for issuers of multiple CDO tranches referencing the same portfolio, with different levels of enhancement and initial ratings.

For the scenario assuming lower recovery for Lehman, the model results indicated that 23 of the 28 transactions are able to withstand this scenario while maintaining their current ratings. Due to the zero recovery assumption, an additional transaction would be downgraded under the second scenario.

While the required subordination levels have increased for all of the CDOs with exposure to Lehman, most of the transactions still have sufficient subordination to withstand the stress scenarios applied. However, further ratings migration or losses from future credit events affecting the transactions may result in negative rating actions. For the deals requiring downgrades under the scenarios above, future rating actions will depend on the final recoveries of Lehman, Fannie Mae and Freddie Mac.

S&P revises CFO assessment
S&P has revised its assessment of the systemic risk that affects its analysis of transactions backed by the performance of funds of hedge funds or by a diversified pool of hedge funds (together CFOs), to reflect its view of higher market volatility combined with reduced liquidity in the hedge fund industry. Under this revised approach, no individual CFO transactions are eligible for a triple-A rating; the highest rating a CFO may now be assigned is double-A.

Notwithstanding the hedge fund of funds sector's historical performance, the agency believes that the sector remains vulnerable to the overall rise in market risk and more specifically the following factors:

• The recent increase in market price volatility and shortage of liquidity in previously liquid and stable economic sectors and markets, in S&P's view, is evidence that price stability and liquidity can cease to exist in periods of stress. In S&P's analysis, liquidity and price stability are crucial to the performance and ratings of CFOs, and problems in these areas are likely to be exacerbated during periods of high stress. The agency believes that in periods of stress commensurate with a triple-A rating environment, the systemic problems that would necessarily be present would also likely cause investors to seek to exit investments that are perceived to lack transparency, liquidity or price stability in search of safer alternatives.
• Hedge funds valuations and reporting can be inconsistent. When hedge funds invest in illiquid assets, the reported values of their investments are estimated, since market value depends on market liquidity. In periods of high volatility and illiquidity, the reported values of their assets become highly dependent on subjective estimates and assumptions of market prices that may not be fully achievable or not fully reliable.
• The performance correlation between hedge fund asset classes and investment strategies changes over time. In particular, during periods of heightened market stress, return correlations may increase significantly, thereby reducing the diversification benefits that have historically resulted in stable returns for hedge fund of funds portfolios.

Asian CDOs downgraded
S&P has lowered its ratings on 80 tranches relating to 56 Japanese synthetic CDO transactions and placed seven tranches relating to six others on watch negative. At the same time, the agency lowered its ratings on 74 tranches relating to 60 Asia-Pacific (ex-Japan) synthetic CDO transactions, 10 of which were also placed on watch negative. Ratings on four other tranches relating to Asia-Pacific (ex-Japan) synthetic CDO transactions were placed on watch with negative implications only.

The downgrades and watch placements reflect the impact on the relevant portfolios of several events that have occurred since the start of September: the placement of Fannie Mae and Freddie Mac under regulatory conservatorship; Lehman's Chapter 11 bankruptcy filing; and negative rating migration that reflects, but is not limited to, the downgrades and watch placements of AIG, BofA, WaMu and Tembec.

Primus counterparty rating on watch ...
S&P has placed its triple-B plus counterparty credit rating on Primus Guaranty on watch with negative implications. The listing results from the agency's expectation that the company will post weak economic results in the near-to-medium term as single-name credit entities held in its portfolio default and trigger losses.

Primus Financial Products, the company's triple-A rated derivative products company, is currently holding in its single-name credit default portfolio swaps referencing US$80m in Lehman Brothers Holdings obligations. Net losses on this single position will significantly hurt Guaranty's quarterly and year-to-date economic results.

Primus Financial may also take a small loss on a notional amount of US$215m in positions referencing Fannie Mae and Freddie Mac subordinated debt, since secondary market trading levels stabilised after the Treasury stepped in earlier this month. Prevailing market conditions and events also cause S&P to be wary of an increased general potential for defaults in the future.

The agency says it will resolve the listing before year-end as it assess the impacts of both realised and potential defaults on Primus Guaranty's economic results.

... while Fitch analyses overall CDPC exposure
Subsequent to the credit events experienced by Fannie Mae, Freddie Mac, AIG and Lehman Brothers Holdings Inc, Fitch has analysed the exposure to the affected reference entities in its portfolio of rated CDPCs. Given the subordination underlying the exposed tranches, the agency does not expect any reduction in the existing capital of these CDPCs, as a result of these credit events.

Fitch currently rates five CDPCs:

• Athilon Acceptance Corporation/Athilon Capital Corporation;
• Cournot Financial Products LLC;
• Invicta Capital LLC / Invicta Credit LLC;
• Quadrant Structured Credit Products LLC;
• Aladdin Financial Products LLC.

Within Fitch's portfolio of rated CDPCs, one or more of Fannie Mae, Freddie Mac, AIG and Lehman Brothers appeared in a total of 89 tranches, with an approximate reference notional as follows:

• AIG: US$2bn;
• Lehman Brothers: US$1.4bn;
• Fannie Mae/Freddie Mac: US$800m;
• Total: US$4.2bn.

Fitch says that is currently reviewing its rating criteria for CDPCs and will be communicating proposed changes to its methodology in the near future.

Nightingale Finance on review
Moody's has placed the senior debt ratings of Nightingale Finance on review for downgrade. Nightingale was restructured by the vehicle's sponsor, Banque AIG, in January 2008. Under the restructuring, CP and MTNs are fully backed by commitments provided by AIG FP.

Moody's notes that the Aaa ratings of Nightingale's medium-term note programmes depend jointly on the market value and credit quality of Nightingale's portfolio and on the ratings of AIG FP. Significant changes to either or both of these factors could result in a downgrade of the MTNs.

The Prime-1 rating of Nightingale's CP and MTNs relies on the short-term rating of AIG FP as provider of the senior note and repo commitments. Thus, if AIG FP's short-term rating were downgraded and a replacement facility provider not found, this could result in a downgrade of Nightingale's short-term rating.

The rating action follows the downgrade of AIG FP's long-term rating to A2 on review for downgrade and the placement of AIG FP's P-1 rating on review for downgrade on 15 September 2008. The rating action is also driven by the continued deterioration in market value of Nightingale's asset portfolio. The market value of the portfolio was 84% of nominal value as at 5 September 2008, compared with 96% on 23 January 2008.

Ambac and MBIA on review
Moody's has placed the Aa3 insurance financial strength rating of Ambac and the A2 insurance financial strength rating of MBIA on review for possible downgrade. The rating action follows Moody's announcement of an upward revision to cumulative loss projections for sub-prime RMBS exposures.

Moody's reviews of Ambac and MBIA will focus on the impact of increasing cumulative loss rate projections on each guarantor's mortgage-related exposures and risk-adjusted capital position. According to Moody's, lifetime cumulative losses on 2006 vintage sub-prime first-lien pools are now projected to average 22%, considering pool performance through the July 2008 remittance reports.

Projected losses increase progressively with the 2006 quarter of origination, averaging 17% for Q106 and rising to 26% for Q406. This compares to Moody's previous projections in January, which estimated losses in a range between 14%-18%.

Moody's says that because both Ambac and MBIA are meaningfully exposed to the risk of US sub-prime mortgages and other residential mortgage products, the revised assumptions are expected to have a significant impact on the firms' capital positions and multi-notch downgrades are possible. The agency will also evaluate the effect of changing loss-rate projections on its insurance financial strength ratings of other financial guarantors, including Syncora Guarantee Inc, FGIC and CIFG.

ISDA publishes deliverable obligation list
ISDA has published the first list of deliverable obligations to be included in the CDS Protocols for Fannie Mae and Freddie Mac. The first list of deliverable obligations will be supplemented and modified following comments from market participants. The Association expects to publish the final lists of deliverable obligations, along with the final version of the associated Protocols on 29 September.

Sub-prime losses calculated
Cumulative realised losses on sub-prime mortgage loans have reached US$50bn since the beginning of 2006, according to new JPMorgan structured credit research. From May through to August this year, the average monthly loss has been close to US$5bn - a significant increase from US$1bn on average for the same period last year.

The US$50bn loss figure equals slightly less than 10% of the worldwide write-downs of approximately US$520bn to date, and highlights how mortgage securities prices (ABX, cash bonds) have already incorporated expected future losses in sub-prime credit that will likely exceed US$300bn. The JPMorgan research indicates that realised sub-prime mortgage losses will continue, with accelerating liquidations, losses and loss severity (sub-prime loss severity is at 56% compared to 65%-70% implied by the market).

BIS reports on housing and hedge funds
The BIS has published two new working papers - one on the US housing meltdown and the other on hedge fund leverage.

The report on the housing meltdown examines how the boom-bust cycle in the US housing market differed from elsewhere and what the underlying institutional drivers of these differences were. Compared with other countries, it finds that the US seems to have: built up a larger overhang of excess housing supply; experienced a greater easing in mortgage lending standards; and ended up with a household sector more vulnerable to falling housing prices.

Some of these outcomes seem to have been driven by tax, legal and regulatory systems that encouraged households to increase their leverage and permitted lenders to enable that development. Given the institutional background, it may have been that the US housing boom was always more likely to end badly than the booms elsewhere.

The report on hedge funds describes how an extension of 'regression-based style analysis' and publicly available data on fund returns yield an indicator of the average amount of funding leverage used by hedge funds. The approach can take into account non-linear exposures through the use of synthetic option returns as possible risk factors.

The resulting estimates of leverage are generally plausible for several hedge fund families, in particular those whose returns are well captured by the risk factors used in the estimation. In the absence of more detailed information on hedge fund investments, these estimates can serve as a tool for macro-prudential surveillance of financial system stability.

Moody's reports on EOD-related downgrades
Moody's has withdrawn the rating of one class of notes, downgraded the ratings of 234 classes of notes issued by 57 ABS CDOs and left on review for possible further downgrade the ratings of two of these classes of notes. The rating actions reflect continuing deterioration in the credit quality of the underlying portfolios and the increased expected loss associated with each transaction. Losses are attributed to diminished credit quality on the underlying portfolio.

Moody's explains that each of the transactions has experienced an event of default (EOD) under the applicable indenture. As provided in Article V of the CDO Indenture, during the occurrence and continuance of an EOD, certain parties to the transactions may be entitled to direct the trustee to take particular actions with respect to the collateral debt securities and the notes. The severity of losses may depend on the timing and choice of remedy to be pursued by the controlling classes of investors.

CPDOs downgraded
S&P has lowered its ratings on 21 CPDOs, where they remain on watch negative. At the same time, Moody's has downgraded and left under review for possible downgrade 20 series of CPDO notes, both static and managed (see last week's issue for more).

The recent widening of credit spreads and the level of volatility in the credit derivatives market have been unprecedented, and this has resulted in further deterioration in the net asset values (NAVs) of these CPDO structures.

The rating actions reflect the increased risk that the NAVs may not be able to build value sufficiently for the structures to cash-in. In some transactions, the NAVs are close to trigger levels; if these are breached, it would lead to those transactions being unwound.

S&P says it is keeping all CPDO transactions on watch negative to reflect the volatility of credit spreads in recent weeks and the possibility of further market disruption.

GSE-related CDOs impacted
Moody's has downgraded 22 synthetic CDO tranches that have fixed recovery exposure to Fannie Mae and Freddie Mac. The action affects US$1.2trn of notional and the magnitude of the cuts range from one notch to as many as 10, though the median is four notches.

LSS notes downgraded
S&P has lowered and kept on watch with negative implication its ratings on various spread-based leveraged super senior (LSS) notes issued by Chess II (13 series of notes), Midgard CDO (1), Omega Capital Investments (1) and Saphir Finance (1). At the same time, the agency placed its ratings on Claris Series 64/2006, Eirles Two Series 337 and the Class B7E-1 notes of Omega Capital Investments Series 12 on watch negative.

The rating actions follow a significant widening in credit default swap spreads for the underlying reference obligors over recent weeks. For spread-based LSS transactions, this has led to an increased likelihood that a breach of the portfolio spread trigger might occur.

Furthermore, some of the transactions affected have suffered defaults in the underlying reference portfolio. Consequently, the note ratings have been lowered and remain on watch negative or are being placed on watch negative.

Spanish SME delinquencies deteriorating
Delinquency levels indicate that the most recent vintages are deteriorating more quickly than the older vintages in Spanish SME securitisations, says Moody's in its new Spanish SME Q208 Index report.

"Weighted-average 90-360 days delinquencies represented 0.75% of the outstanding balance of Spanish SME transactions at Q208, compared with 0.25% in Q207 and 0.28% in Q407," says Ludovic Thebault, a Moody's senior associate and co-author of the report.

A total of 58 Spanish SME ABS transactions rated by Moody's were outstanding as of Q208, with an outstanding pool balance of €37bn. Seven transactions experienced reserve fund draws over Q1 and Q2 2008, compared with only three experiencing reserve fund draws over Q3 and Q4 2007.

"Although Moody's has not yet taken any rating actions on existing SME transactions, in a deteriorating context, the outlook for performance remains negative, particularly for the most recent vintages," Thebault cautions.

Central banks coordinate ...
Ten central banks have announced coordinated measures designed to address the continued elevated pressures in US dollar short-term funding markets. The banks say that these measures are designed to improve liquidity conditions in global financial markets.

The Federal Open Market Committee has authorised a US$180bn expansion of its temporary reciprocal currency arrangements, which will be available to provide dollar funding for both term and overnight liquidity operations by the other central banks until 30 January 2009. These larger facilities will now support the provision of US dollar liquidity in amounts of up to US$110bn by the ECB (an increase of US$55bn) and up to US$27bn by the Swiss National Bank (an increase of US$15bn).

In addition, new swap facilities have been authorised with the Bank of Japan, the Bank of England and the Bank of Canada. These facilities will support the provision of US dollar liquidity in amounts of up to US$60bn by the Bank of Japan, US$40bn by the Bank of England, US$10bn by the Bank of Canada, US$5bn by the Danish Central Bank, US$10bn by the Swedish Central Bank, US$10bn by the Reserve Bank of Australia and US$5bn by the Norwegian Central Bank.

... and SLS is extended
In view of the current disorderly market conditions, the Bank of England has announced an extension of the drawdown period for its Special Liquidity Scheme to provide additional time for banks to plan their access to the scheme in an orderly fashion. The drawdown period will now end on 30 January 2009.

The Bank says it will publish its consultation document on proposals for permanent reforms of its market operations at a later date. The features of the Scheme and the terms offered remain unchanged.

Resecuritisation approach revisited
The performance of loan pools underlying RMBS have experienced rapid deterioration, sometimes in as short a time period as a month. In light of these conditions, Moody's has announced that it will not assign a rating to any security issued by a resecuritisation transaction backed by one or more RMBS without first reviewing the ratings (and, if appropriate, taking rating actions) on the underlying RMBS, in addition to its normal surveillance of these underlying transactions.

Moody's says that this will be the case, even if the underlying RMBS ratings had been recently reviewed. The agency has undertaken and continues to undertake extensive and ongoing reviews of its ratings on US RMBS.

Moody's adds that the amount of time needed to complete any review of a rating of an underlying RMBS will depend upon many factors, including the nature and performance of the collateral pool, the complexity of the capital structure of the underlying RMBS, current market conditions and continued development of its methodologies and approaches for reviewing RMBS ratings.

CRE prices rise
Commercial real estate prices, as measured by Moody's/REAL Commercial Property Price Indices (CPPI), posted a small increase of 0.4% in July over the level measured in June, reports Moody's.

"This slight increase offers some relief from the steep declines of prior months, but may represent merely a temporary respite in a longer period of falling prices," says Moody's md Nick Levidy.

With the July increase, prices have decreased 9.7% from July 2007. The CPPI is now 1.1% higher than it was two years ago. Moody's notes that the largest decrease in prices among the annual indices examined was a 14% decline in the Florida apartment market, which also measured a decline in transaction volume in July.

Overall, commercial real estate transaction volume fell in July, after an increase in June. The July volume, however, was above the low-point reached in May.

Moody's/REAL Commercial Property Prices Indices are based on the repeat sales of the same properties across the US at different points in time. Analysing price changes measured in this way provides maximum transparency and methodological rigour. This approach also circumvents the distortions that can occur with other commercial property value measurements such as appraisals or average prices, says Moody's.

JASME to guarantee deposit refunds
Japan Finance Corporation for Small and Medium Enterprise (JASME) has announced that it will guarantee the financial institutions' obligations for deposit refunds to issuers (SPC) in three transactions - Tanpopo 2007, Cosmos 2007 and Tanpopo 2008. The guarantee will not affect to their ratings, however.

The affected deals are synthetic CLO transactions referencing corporate loans for SMEs originated by financial institutions with the intention of securitising them under JASME's 'purchase scheme' programme. The note proceeds issued by the SPC are deposited in the non-interest bearing ordinary bank accounts of each financial institution, based on the deposit agreement between them and the SPC. The deposits will be used for credit protection payments under the CDS and principal payments on the notes.

JASME will be merged with National Life Finance Corporation, Agriculture Forestry and Fisheries Finance Corporation, and Japan Bank for International Cooperation in October 2008. The new entity will be called the Japan Finance Corporation, and will assume JASME's guarantees.

QWIL reports net profit
Queen's Walk Investment Ltd has reported net profit of €0.8m or €0.03 per ordinary share for the quarter ended 30 June 2008, compared to a loss of €17.1m or -€0.56 per share in the previous quarter. The company's cash position remained strong with approximately €35.9m of cash on its balance sheet, up from €32.9m as at 31 March 2008. Cash generation for the quarter was in line with forecasts, with total cash proceeds recorded from the investment portfolio in the quarter of €12.3m.

Fair value write-downs of the company's investment portfolio were significantly lower in the quarter, totaling €4.1m compared with €22.1m for the quarter ended 31 March 2008. The company's net asset value at quarter-end was €6.32 per share compared to €6.42 per share in the previous quarter.

OTC Val expands into illiquids
Independent derivatives valuation provider OTC Val has expanded its securities coverage to address valuation for illiquid mortgage, credit card and bank loan related products. To accommodate audit and internal risk compliance requirements for securities with no market observable prices, the firm is working with market participants to address their valuation and transparency requirements by employing model-based and fair value estimation techniques.

Bob Sangha, md at OTC Val, says: "In an inactive market, we believe that market participants are as concerned about the assumptions and data behind a product's price as the price itself. Our valuation methods enable us to provide this level of transparency and disclosure. In addition, we employ a variety of reasonableness tests to ensure consistency and accuracy, while utilising [FAS 157 Level II] observable market inputs where possible."

CS

The outlook for US home prices

In an MSA-level analysis of home affordability, Deutsche Bank securitisation research analyst Karen Weaver forecasts that the US housing market still has a double-digit correction ahead

During Q208, home prices throughout much of the US continued to decline. One might expect that this 'progress' in the correction of home prices would bring us much closer to equilibrium and hence a bottom.

Alas, in our last outlook piece (which used Q108 data) we reported that home prices needed to fall another 16.6% and that the home price correction was less than halfway through. And in this, our latest home price outlook, we estimate that home prices still need to decline another 15.6% from 2Q08 levels and that we are only slightly more than halfway there.

Why so little progress towards the bottom? Two reasons: one, three months is a very short time in housing markets; and two, rising mortgage rates over the quarter have reduced affordability as much as falling home prices have boosted affordability.

Affordability is the basis of our analysis. We adopted this approach because it enabled us to look at a wide array of markets (100) on an equal footing. Our affordability analysis really is designed to answer the question "to what extent are current home prices in a given metropolitan statistical area (MSA) sustainable relative to local incomes and mortgage rates?"

In essence, the results give us a fundamental 'fair value' for housing and, when weighted and aggregated on a national level, help us to size the housing bubble in broad terms. Of course, the actual path of home prices (the extent to which they do, in fact, mean revert) in each MSA will also be impacted by many MSA-specific factors.

Our 'affordability' approach is sensitive to mortgage rates. The government's "bailout" of Fannie Mae and Freddie Mac certainly augurs well for mortgage rates in the short term, as increased investor confidence in those entities reduces funding costs. The intermediate outlook for interest rates generally and mortgage rates more specifically is less clear.

We ran our analysis assuming a mortgage rate of 6.5%. If we instead assume a mortgage rate of 6%, for example, the expected current-to-trough decline for the US changes from 15.6% to 12.3%. Said another way, a 50bp decline in mortgage rates takes 330bp off the HPA correction.

Unfortunately, a counterbalance to that might be what is happening on the income side of the affordability equation, as the unemployment rate posted a jump to 6.1% in the latest data. And, of course, affordability analysis is only about the fundamental value of housing, but there are significant supply/demand technicals - in the form of elevated inventory and distressed inventory - that are also forceful drivers of home prices.

Even if we do get some relief in mortgage rates, there is still very significant progress to be made in the unwinding of the housing bubble. When coupled with further headwinds, this does little to change our outlook for a further double-digit correction, easily stretching for another four to six quarters at a minimum, and probably longer.

Mortgage rates have not benefited from the round of rate cuts started last year. In fact, mortgage rates increased steadily through 2008 (see Figure 1).

As of the date of this analysis, the Freddie Mac 30-year survey mortgage rate was approximately 6.4%. In the immediate aftermath of the takeover of the GSEs, rates have fallen approximately 25bp.

Our model results are shown in Figures 2 and 3. We show how much home prices would need to drop nationwide, using a 6.5% mortgage rate, for the top 10 MSAs.

The entire bar shows our peak-to-trough forecast. Nationwide, for example, the total peak-to-trough expected decline is 32.2%.

The blue portion of the bar shows how much prices in the region have already declined from the peak to 'current'. The yellow portion of the bar shows how much additional price decline we expect to see before the affordability relationship is restored. Nationwide, prices have already dropped about 17% from their peak, and another 15.6% would restore affordability to rough 'equilibrium' using our analysis.

As in our previous analyses, we do not attempt to pinpoint a horizon for the correction, depending as it does on the broader economy among other factors. Our base-case is a two-year horizon. This is loosely based on past downturns, where the time from housing price peak to housing price trough ranged from four to six years.

The peak-to-trough and current-to-trough price declines calculated herein assume that affordability fully reverts to the mean. While in the past we have also considered a scenario where the affordability measure only partially reverts, it has now become abundantly clear that, for many MSAs, even full reversion may not be enough. As we did in our last report, we continue to cite the following factors that pose additional downside risk to home prices:

1. Home prices are highly auto-correlated, which can perpetuate downturns.
2. The improvement in affordability that has already occurred may be overstated; even though home prices have come down, underwriting standards have become much more stringent. That is, higher down payment requirements, documentation standards and FICO score requirements have, all else equal, reduced affordability. Our simple affordability calculation does not account for these factors.
3. If the US economy is in a recession, all else equal, that would augur for even lower home prices as it would reduce affordability.
4. There is some evidence to suggest that more borrowers are defaulting because of negative equity alone, rather than (as was traditionally the case) the confluence of negative equity and insufficient income.

What has become increasingly apparent since our May update is the negative impact on prices from sales of deeply distressed (read: deeply discounted) inventory. The impact of these distressed sales speaks to the importance of our fourth point above.

A constant stream of new defaults is adding distressed supply to already fragile markets. The ultimate size of this stream could be far larger than many envision, especially if we are indeed witnessing a sea change in how mortgage borrowers view the exercise of their option to default.

Many of the MSAs that saw the highest price increases during the 'boom', such as Las Vegas and areas in Florida, are already coping with very high short sale/foreclosure/REO volumes. In many such areas, when properties do sell, it is only at deeply discounted prices that bring down prices throughout the MSA.

According to Deutsche Bank's homebuilding analyst, between a quarter to one-third of national resale transactions are distressed units (e.g. short sale, auction, REO) and, in 'bubble' markets, it can be closer to half of all transactions. With the pipeline of foreclosures still growing (and picking up pace as the crisis moves up the credit curve - see Figure 4), the issue of distressed supply (a housing market 'technical') in our view may loom larger than the fundamentals of housing (e.g. affordability).

Different MSAs reached their home price peaks at different points in the cycle. For those MSAs in Figure 1, the respective home price peaks for each MSA are shown at the top of the bar. The home price peaks range from Q405 (in Las Vegas, NV) to Q207 (in New York/NJ and Orange County, CA). We believe this is the main reason why some of the MSAs are near bottom (at least on the fundamentals), while others, such as New York, appear to have much more correcting to come.

It also highlights, once again, the importance of looking at individual markets and the insight that is lost in nationwide figures. Looking over the 100 markets written up in this report, we see some markets clearly under siege, with rising unemployment, high inventory levels and a disproportionately high level of foreclosures (e.g. Las Vegas, Miami or Orlando). But there are also those markets (unfortunately fewer and often smaller) that have low unemployment, low inventory and never were particularly reliant on sub-prime or jumbo lending (e.g. Dallas).

For purposes of mortgage credit, the more granular one's analysis the better. That said, many users of our analysis prefer to see a nationwide figure for home prices.

To do that, we weight each MSA by its respective share of the mortgage market and arrive at a nationwide home price outlook. As in past analyses, some MSAs have already fully mean reverted. That is, there are some MSAs where our affordability mean reversion approach would indicate that home prices need to rise in that MSA to restore 'equilibrium affordability'.

For the most recent data set, 36 MSAs, representing 15% of the mortgage market, have fully mean reverted. For those markets, we simply plug in a flat home price assumption.

Between national and, in some cases, local economic deterioration, and the dramatic contraction in credit, particularly outside the prime conforming mortgage product, we think it unlikely that any major individual housing market will see meaningful appreciation, at least for the balance of 2008. Looking back at our 1Q analysis, this approach seems justified. Of the MSAs that had fully mean reverted at that time, approximately 70% were down and 25% were flat in the subsequent quarter.

This analysis uses National Association of Realtors data. It is the timeliest source of home price data for the full list of 100 MSAs. The Case-Shiller indices are arguably more robust than NAR because they are a paired-series index. The most recent comparable Case-Shiller data is only available for its 20-city composite index.

To get a sense of how much our outlook would change if we use Case-Shiller home price data, we ran our affordability analysis for just those 20 MSAs. Our outlook for those 20 MSAs is largely the same using NAR data (down another 18% from here) versus Case-Shiller data (down another 17% from here). The Case-Shiller and NAR indices have been highly correlated in this downturn, whereas indices such as OFHEO have lagged markedly.

Conclusion
Our projection for a further US home price decline of 12%-16% may seem high, on the heels of some of the actual price declines reported for the first half of 2008. But the stark fact remains that many US housing markets overshot fundamentals by a very wide margin.

Neither widespread belief in the 'foolproof' nature of real estate investing nor 'pulse-based' easy lending are driving housing anymore. A more sober view of what a home is truly worth now prevails, and today's prices still don't square with the fundamentals. Moreover, while home building may have all but halted, every month that passes adds new supply as mortgage borrowers (sub-prime, prime and every strata in between) increasingly fall behind and lose their homes.

The economic outlook has continued to sour, especially on the all-important jobs front. The outlook for credit availability brightens considerably with the GSE bailout/takeover/nationalisation.

But we would caution those who view this event as a cure for the housing downturn. For now at least, there is little indication that the government plans to bring back easy credit, though removing some uncertainty should make credit a bit cheaper.

At least under the current administration, the view is to extend and price mortgage credit prudently, with an appropriate 'risk/reward', not to turn the GSEs into a candy store. Current plans also envision systematically shrinking the GSEs (at least on a portfolio basis).

Such an approach seems aimed not at stopping what Secretary of the Treasury Henry Paulson has phrased the "necessary and inevitable" home price correction. Instead, the goal seems to be to avoid an over-correction caused by dysfunctional credit markets.

If free markets and light regulation (perhaps) got us into this mess, free markets also caused an irrational downward spiral that hopefully government can now halt. That is a good thing, but this is not a planned economy and the government cannot eradicate the painful adjustments still ahead.

© 2008 Deutsche Bank Securities. All rights reserved. This Research Note was first published by Deutsche Bank Securities on 10 September 2008.

Trading ideas: empty piggy bank

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at a short trade on Standard Pacific

For those with any appetite left for taking on risk, we find the current market to be filled with relative value opportunities. We also believe that the current financial crisis will have an even further compounding effect on the housing market. With housing starts at all-time lows and accelerating lower, permits at all-time lows and foreclosures rising, any discussion of improved affordability should be quickly diminished by the drastic contraction in credit markets.

We see no short-term bottom in housing and Standard Pacific is a credit that is certainly at risk. Standard Pacific sits on US$1.9bn of inventory, making it difficult for the company to turn a profit. It has not seen a positive gross profit in five quarters, which in simple widget terms means the company cannot sell its widgets for more than their cost.

Even though Standard Pacific was able to boost its liquidity in June, thanks to the stay of execution from MatlinPatterson Global Advisors, it carries an on-balance sheet debt load of US$1.5bn with notes maturing every year for the next eight. The maturing debt, combined with a loss-making housing environment, will put substantial strain on Standard Pacific's ability to meet its obligations. We recommend buying protection on Standard Pacific hedged with the CDX High Yield Index.

Under the covers
Looking under the covers of Standard Pacific reveals an ugly sight. Even after MatlinPatterson stepped up to the plate by purchasing convertibles and rolling its debt into warrants - giving the company its strongest cash balance in many quarters - we still see significant risk to Standard's ability to meet future debt obligations. It holds US$1.9bn in inventory.

The housing market is in free fall, putting this balance at extreme risk and also making it extremely difficult for Standard to make a profit. It has not managed to sell its homes for more than cost in five quarters.

The company has US$1.5bn of debt (not to mention off-balance sheet debt to the tune of around US$500m), with notes maturing every year for the next eight. Over the next nine months two bonds mature, which will either need to be refinanced in a difficult market or require a US$250m payoff.

The company maintains a current cash balance of US$572m and the strain of its maturing debt, combined with a loss-making enterprise, is a bankruptcy waiting to happen. We also find it somewhat telling that its long-time ceo suddenly 'retired' back in March. Uncertainty in uncertain times is never a positive.

Market-implied bankruptcy
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 Standard Pacific. We see a 'fair spread' of 1201bp for its extremely weak equity-implied default probability, implied volatility, margins, leverage and interest coverage factors.

Exhibit 1

A relative value measure we use to compare issuer risk/return profiles is SPD (spread per unit default probability). As its name suggests, SPD is the amount of spread (in basis points) that we earn for each unit of default risk that we take. This simple risk-to-reward ratio is akin to the complete MFCI model but limits its scope to only one factor used within the model, equity-implied default probability (EiPD).

Standard Pacific's spread compensation dropped to all time lows earlier this year after announcing its second quarter 'earnings' (Exhibit 2). This means that the equity-implied bankruptcy risk is not being reflected in its credit spread and therefore now is a good time to buy credit protection on Standard Pacific.

Exhibit 2

Relative value
Since Standard Pacific maintains a decent cash balance we do not think that default will happen in the near future (months rather than days); therefore, we will hedge this trade by taking a long position in the CDX High Yield Index. Exhibit 3 shows the cross-sectional relationship between the two credit instruments.

Exhibit 3

The key take-away from the chart is that the High Yield Index is trading near (or at) its wides, while Standard Pacific is near its recent tights. The market is more preoccupied with the future of finance rather than specific implications for credits such as the homebuilders. We see this as an opportunity.

Risk analysis
This trade takes a short position in Standard Pacific's five-year CDS against a long CDX High Yield position. It is hedged against general market moves, but leaves us open to a divergence of Standard Pacific's spread relative to the rest of the high yield market. The trade has positive carry, which will offset some potential spread divergence.

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

Summary and trade recommendation
For those with any appetite left for taking on risk, we find the current market to be filled with relative value opportunities. We also believe that the current financial crisis will have an even further compounding effect on the housing market. With housing starts at all-time lows and accelerating lower, permits at all-time lows and foreclosures rising, any discussion of improved affordability should be quickly diminished by the drastic contraction in credit markets.

We see no short-term bottom in housing and Standard Pacific is a credit that is certainly at risk. The firm sits on US$1.9bn of inventory, making it difficult for the company to turn a profit. It has not seen a positive gross profit in five quarters, which in simple widget terms means the company cannot sell its widgets for more than their cost.

Even though Standard Pacific was able to boost its liquidity in June, thanks to the stay of execution from MatlinPatterson Global Advisors, it carries an on-balance sheet debt load of US$1.5bn with notes maturing every year for the next eight. The maturing debt, combined with a loss-making housing environment, will put substantial strain on Standard Pacific's ability to meet its obligations. We recommend buying protection on Standard Pacific hedged with the CDX High Yield Index.

Buy US$10m notional Standard Pacific Corp 5 Year CDS protection at 743bp.

Sell US$10m notional CDX NA HY Series 10 5 Year CDS protection at 819bp (US$89.50 offer) to receive 76bp of positive carry.

For more information and regular updates on this trade idea go to: www.creditresearch.com

Copyright © 2008 Credit Derivatives Research LLC. All Rights Reserved.

Note: This article is intended for general information and use, and does not constitute trading advice from Structured Credit Investor (see also terms and conditions, below, section 12).