Contents

CDS

CDS stress-testing

Opportune time to review market infrastructure

The market had been bracing itself for further sub-prime losses to hit, but recent events suggest that a second-wave of losses could be more likely to arrive in the form of CDS counterparty claims. While such surprise credit events could put a number of investors off the CDS sector, they could prove beneficial to market infrastructure in the long run.

"The CDS market continued to be liquid throughout the crisis, but some investors will inevitably be put off by recent events," confirms one portfolio manager. "However, the sector is pragmatic and so these defaults could be used as an opportunity to review certain aspects of its infrastructure. My opinion is that CDS contracts should move on exchange, for example."

Credit derivatives strategists at JPMorgan suggest that investors may also call for changes to CDS contracts such that credit events are triggered only when there are actually losses on bonds and loans. They explain that there were no missed payments on any of the Fannie May and Freddie Mac debt, yet the terms of CDS contracts treated their conservatorship the same as if the GSEs had actually failed to pay on their obligations. Equally, initial uncertainty about the deliverability of some principal-only securities into Fannie and Freddie CDS contracts reinforced the fact that it is impossible to foresee all scenarios for credit events and deliverable obligations.

"If an end-user is trading a contract on the basis that value can move around, they should expect to trade it whether a default occurs or not," says Prytania Investment Advisors ceo Malcolm Perry. "However, it's reasonable to amend contract documentation going forward, providing the market isn't retrospective about it. Each new credit event stress-tests a different market issue, but we should be careful not to overreact - a few people have taken irresponsible risks and are now paying the penalty."

He points out that the market's current problems are not due to the trading of standard CDS instruments, but to the abuse of mark-to-market books, where more complex products were being booked in order to generate upfront p&l. "Many of these structured products were never tradable, liquid securities and this should never have been allowed to happen, but it highlights the tension at investment banks where traders push at the edges of acceptability," Perry suggests. "Bonus schemes could be adapted to deal with this tension directly, whereby traders' bonuses are paid over the life of complex products."

Consequently, traders would either lose interest in such products or a better linkage would be created between risk and incentives. Banks that don't improve this linkage could conceivably be forced to hold higher capital against their positions.

Nonetheless, Perry concedes that the recent surprise credit events could serve to put investors off certain assets like financials. "It's less about the CDS instrument per se and more about the underlying risk. Investors aren't losing money because of the CDS, but because the reference entities have deteriorated or even gone bankrupt - it's ultimately the fundamentals at fault," he concludes.

CS

Regulation

Rescue plan rescued?

All eyes on congress as TARP faces second vote

Any positive effect that the troubled asset relief programme (TARP) looked set to bring to the structured credit market was in danger of being wiped out as political risk surrounding the bailout reached critical levels this week. The revised version of US Treasury Secretary Paulson's original plan, dubbed the Emergency Economic Stabilisation Act of 2008 (EESA), is to be put to the vote in the Senate today (1 October), following its initial failure in the House of Representatives on Monday.

Congress' surprising refusal of the plan earlier this week saw gains that had been recorded in the Markit ABX and CMBX indices on the back of TARP's announcement wiped out. Market participants across the board bemoaned congress' seeming incomprehension of the state of the US economy, with structured credit analysts at JPMorgan going as far as to say that its lack of understanding of the magnitude of the problem "is nothing short of stunning".

But the market now appears fairly confident that the plan will be passed second time around in the House tomorrow, 2 October, provided there is a successful outcome to the Senate vote. No major changes are expected to be made to the Act, although minor tweaks are likely in order to appease wavering Democrat and Republican politicians, such as the increase of government insurance on bank deposits from US$100,000 to US$250,000.

Uncertainty still surrounds many aspects of the plan, not least the mechanisms for purchasing, pricing and valuing troubled assets, as well as doubts as to whether the US$700bn will be sufficient to solve the problem. Structured credit analysts at Citi are concerned that, should a version of the plan manage to get through congress, it will become emasculated to the point where banks do not use it.

Meanwhile, strategists at Credit Derivatives Research point out that EESA provides capital to the banks in trouble, but reduces transparency of bank balance sheets, slows the de-leveraging process and in no way guarantees the expansion of credit/lending in the near future.

However, most observers agree that the plan is better than nothing. Should it pass, the ABX index is expected to find a firmer footing and gain ground, even if US house prices continue to decline, as the assets will have found a floor.

Details of the plan outlined earlier this week suggest that the full US$700bn will be available, either to purchase assets, insure troubled assets or avert the potential systemic risk from the disorderly failure of a large financial institution. The amount will, however, be granted in tranches of US$250bn, US$100bn and US$350bn - with the latter requiring a written report to congress outlining how it will be spent before it is sanctioned.

Eligible assets will include mortgage-related assets and other 'troubled assets' issued on or before 14 March 2008. Paulson will also establish a programme to guarantee the troubled mortgage-related assets under a scheme called the Troubled Assets Insurance Financing Fund, into which all banks taking part in the scheme must opt.

AC

Structuring/Primary market

Overexposed

Restructuring could avert CSO tipping point for now

The overexposure of CSOs to sectors and names with cyclical features came into increasingly stark focus over the last week, as the list of bank failures/rescues continued to grow. Analysts suggest that the sector is close to the edge, but renewed restructuring activity could bring some relief in the short term at least.

The mezz CSO sector, in particular, is close to a tipping point and any further defaults could take it beyond that point, warns Dresdner Kleinwort's head of structured credit strategy Domenico Picone. "This would have a devastating affect on the correlation market already dominated by protection buyers."

He adds: "Mass liquidations of senior and mezzanine investments - due to mark-to-market losses, note downgrades or simply because major players leave this market and liquidate their holdings - would be difficult for the market to absorb. On one side investors who sold senior protection are exposed to higher systemic risk and on the other side long correlation trades are taking significant hits, due to the defaults wiping out the first-loss piece."

In terms of the broader CSO market, given recent and expected future defaults, some investors could decide that their positions aren't worth holding anymore. But, with credit quality deterioration now becoming significant, restructuring continues to be an option for noteholders - though it is likely to be more expensive and the benefits may not be as easy to obtain as a few months ago.

"The benefits of restructuring are certainly reduced since the defaults hit, but I still believe it is better to restructure a CSO than incur the inevitable losses caused by an unwind. Investors would likely only receive distressed prices these days," says Picone.

Rated synthetic CDO notes where Lehman Brothers acted as arranger and protection buyer are mostly expected to unwind because the swap counterparty has disappeared. "There are, however, investors trying to restructure their CSOs, and some dealers are also providing arrangements that should prevent further liquidation," notes Picone. "Ironically, the Lehman default kick-started a new wave of CDO restructuring in the sector. Previous restructuring was instead driven by the notes' mark-to-market and downgrades, as well as concerns regarding the underlying names."

Jeff Meli, structured credit strategist at Barclays Capital in New York, reckons that mezzanine tranches will likely widen further as bespoke deals continue to be unwound or restructured. He recommends selling five-year CDX.IG.9 10%-15% protection and delta-hedging (0.3x) with the seven-year 3%-7% tranche in the short to medium term.

"We prefer going long this tranche as it has the least structure on it and, thus, less exposure to widening technicals - bespoke tranches were more junior, while no-delta sellers of protection usually demand more subordination and focus on more senior tranches," he says.

CS

Poised for action

Jason Pratt, md at Peritus Asset Management, answers SCI's questions

Jason Pratt

Q: When, how and why did your firm become involved in the structured credit markets?
A: Peritus Asset Management got involved in the structured credit markets in the wake of Enron and Worldcom in 2002. We're predominantly a high yield bond shop, and we put together our first HY cash bond-backed CDO in 2003, and then our second CDO in 2005.

These were unique deals at the time as they were done as cash bond cashflow CDOs. In terms of our conversations with the rating agencies at that time, our deals were the only two pure cash bond-backed CDOs in the wake of the events in 2002 and 2003.

After the issuance of our first CDOs, and with the market changing shape and focusing on credit derivatives, for example, Peritus also shifted its focus - taking CDO technology and creating portfolios which mimicked the point of a CDO, in that there was significant cashflow to be had. But we were a bit concerned with the leverage profile in the marketplace, so we started to evaluate opportunities to do market value-type transactions, because those sorts of deals were more reflective of our total return efforts as an absolute returns manager.

We shifted our focus to tie it more into how we operate as managers. However, that effort has been postponed when the credit crunch started to show its face in late 2007.

We have a balanced business between total return-clients and the structured credit business. We also have other projects in the pipeline - it's just a matter of finding the right distribution channels.

One of our projects is a closed-end fund, which to the broader market might sound crazy, but our asset class has something that everyone else lacks - unlevered coupon cashflow. We are using that to our advantage as we put our new portfolios together.

We have also recently launched an offshore fund. In speaking with my partner who has been involved in high yield from its beginnings in 1984, the current environment has similarities to both 1990 and 2002. Sophisticated investors recognise that high yield is an asset class where dramatic spread widening generally occurs about one year before the peak in defaults, so we are seeing tremendous interest in putting monies to work in the space.

We are also keeping our eyes and ears open for opportunities in structured credit tranches, where we can evaluate the underlying risk. But if we were to look there now I think we'd still be a little early.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: The simple answer is the advent of credit derivatives. In my view credit derivatives really facilitated an expansion of the market.

There used to be limits on how much risk people could take on, and I think the advent of negative basis trading is a good example of that: being able to go out and buy financially engineered triple-As and then theoretically hedge that risk. This created a tremendous demand for securitisation and really served to upset the balance that you would normally see in a market, where there would be a finite number of issues that you could buy or sell.

Not only did credit derivatives provide an easier way to transfer risk, it also meant that you didn't have to take on the risk of an issuer. Correlation trading further expanded this.

While people have been jumping up and down about a central clearing house and counterparty risk, I don't think enough attention has been spent on the fact that the pure balance of taking on and laying off risk has truly been upset by bringing a lot more players into a market where they previously didn't exist.

Q: How has this affected your business?
A: Credit derivatives never took hold to the same extent in the high yield market as they did in the investment grade mortgage market. But, on the other hand, our universe of opportunity has certainly expanded.

As we focus on high yield bonds, we've got the attractive feature of coupon cashflow. That's been a net positive for us in comparison to others in the marketplace.

As an absolute returns manager, not a relative value manager, we need to be in positive territory. Liquidity is a problem for the whole market. Still, we feel strongly that we're being paid more appropriately for the risk today.

Q: What are your key areas of focus today?
A: We are a secondary player in HY cash bonds, so we're looking for something in excess of market yield. As for our investment strategy, we're currently very wary of any company that may truly need liquidity in the next year or so.

We simply cannot take on exposure to an asset class to take advantage of a directional trade, either long or short. That's been a hard lesson for people to learn over the past couple of years.

We are going to continue to build our portfolios with lots of attractive yields in the marketplace, but at the same time we have to be cautious of what we can and cannot analyse. The financials are a great example of how un-analysable some market risk is in the marketplace today.

Q: What is your strategy going forward?
A: If we can break down the risk to understanding that if our point of entry makes sense versus the asset side of a particular credit - for example, if something is trading today at 70c on the dollar - there are a lot of people that bought that bond at 100. Today, that price point makes a lot of sense in trying to assess what your downside is. Unlike most of our competitors, we view discounts as improving our margin of safety, not increasing risk.

Being absolute return managers, that's something we can take advantage of at the moment. If we are taking on this risk at a discount today and we're getting paid a very attractive coupon cashflow, there's a big difference to having a problem where you get out of a situation six points lower, when you initially bought it at such an attractive level in the first place.

In terms of our strategy going forward, we're seeing good opportunities. Our profile clearly sets us apart because we get paid so well for taking on that lower quality risk versus the coupon cashflows and balance of the credit markets.

Because things were so good for so long, those risk premiums got squeezed down to levels where the existing yield profiles on a lot of bonds today are just not as attractive because of the coupon profiles. That's a big part of our strategy going forward.

Q: What major developments do you need/expect from the market in the future?
A: I'm curious about the central clearing house for credit derivatives specifically and how the issue of counterparty risk will be managed.

I would also say that Wall Street has lost its biggest and best client with regard to securitisation, and one of the biggest buyers of risk. Filling that void with some new mechanism without re-inflating the credit bubble is the big question. You're either going to have to be really good at credit pricing, which we think we are, or you're going to be sitting on your hands for the near term because there's nothing for you to do.

Once the US$700bn question is answered, then I think we can assess how companies will begin to gain access to financing again. I'm interested in seeing liquidity return, but our expectation is that we'll not see the same pace of participation anywhere near what we have seen over the past five years because of the lack of securitisation as buyer of risk. We believe we are poised to take advantage of this market, whereas others are paralysed.

About Peritus Asset Management
Peritus Asset Management is a value-based active credit investment manager providing services to institutional and qualified retail markets. The Peritus investment philosophy relies on value-driven analysis within a less-travelled segment of leveraged finance - with an emphasis on the secondary market.

Three hired for new credit business

The latest company and people moves

Three hired for new credit business
Alternative investment firm Ramius has hired three new employees to take advantage of market opportunities and dislocations in the credit markets. Kenneth Grossman, former partner and portfolio manager at Del Mar Asset Management, has been named md of distressed investments. Additionally, Norman Milner, former partner, portfolio manager and head of trading at Arx Investment Management, and Rick Dowdle, former partner and portfolio manager at Arx Investment Management, have been named mds and co-portfolio managers of the newly formed credit trading business.

Credit head appointed
EIM USA, the US affiliate of the international fund of hedge funds EIM Group, has hired Vincent Matsui as head of credit. This is a new position at EIM USA, and Matsui will be responsible for all credit-related investment opportunities and is joining the Investment Committee. He will report to Antonio Muñoz, ceo of EIM USA.

Prior to joining EIM, Matsui was global head of CDO asset manager ratings for Fitch Ratings, where he chaired manager rating committees and led a global team that developed over 100 credit manager profiles. Before Fitch, he was global co-head of structured credit for Swiss Re.

NewOak line-up announced
NewOak Capital has appointed a number of new members to its integrated advisory/asset management/structured product firm.

The senior appointments include mds Jess Saypoff, formerly of Barclays Capital, as chief counsel, James Dougherty, formerly of Deutsche Post Bank and JP Morgan Investment Management; Ross Heller, formerly of JP Morgan Securities; Neil McPherson, formerly of ABN Amro and Credit Suisse; Shanker Merchant, formerly of Wachovia; and Precilla Torres, formerly of Citigroup and Lehman Brothers.

"With our new team of highly experienced and respected structured finance credit professionals, NewOak Capital is strategically positioned to help clients successfully overcome the unprecedented challenges brought about by the current global financial crisis. NewOak's 18 specialised investment professionals collectively have more than 150 years of experience in structuring, valuation and credit risk analysis of securities backed by residential/commercial real estate mortgages, consumer, and corporate credits," comments Ron d'Vari, ceo of NewOak Capital.

Other recent appointments include Arjun Kakar from NIBC; Peter Heintz from UBS, Alex Razumny from Bear Stearns as director and Max Marquardt from Citigroup; Irina Shulmanovich from Fortis Securities as associate director, respectively.

Credit strategy head leaves
Jochen Felsenheimer has left UniCredit, where he was md and head of credit strategy & structured credit research.

SF head appointed at WestLB
Volker Brühl has been appointed head of corporate and structured finance products at WestLB. He also becomes a member of the divisional board of the corporates & structured finance division.

Brühl joins WestLB from Dresdner Kleinwort, where he was head of strategic advisory Germany, co-head of M&A & corporate finance and co-head of large & mid cap origination. He began his professional career in investment banking at Deutsche Bank, before moving to management consultants Roland Berger, where he latterly worked as a partner in the field of restructuring.

In his new role Brühl will have responsibility at WestLB for driving forward the closer integration of the corporates, financing and capital markets businesses.

Conduit structurer hired
Lloyds TSB Corporate Markets has hired Patrick Cogan as a director in its securitised products group, headed by Kate Grant. He joins the UK bank in a structuring role, specifically working on the bank's ABCP conduit, Cancara, reporting to Chris Rigby, head of conduit structuring. Cogan will be based in London.

Cogan was previously at XL Capital Assurance, where he worked for seven years as a director within its structured finance group with responsibility for the origination, underwriting and execution of ABS transactions, covering London and New York. Prior to that, he was at Fitch Ratings in New York for three years, in a similar role.

CMBS opportunity fund launched
NIBC Bank, in cooperation with Dutch multi-family office Common Wealth Investments, has closed a €64m European mezzanine CMBS opportunity fund. The new fund focuses on investments in securitisations backed by Benelux and German real estate loans, with a range of ratings from triple-A to double-B, but most emphasis on the mezzanine double-A to double-B bracket. Subscriptions were raised from 25 private investors and the fund managers - Hans Starrenburg and Dirk van den Beukel - will focus on discounted bonds, but not distressed bonds.

UBS FICC co-head announced
UBS has appointed Jeffrey Mayer as joint global head of the Fixed Income, Currencies and Commodities (FICC) business. With the recently announced joint global head of FICC Carsten Kengeter, he will have responsibility for all fixed income products including credit fixed income, rates, structured products, emerging markets, foreign exchange, commodities, securitised products, client coverage and research.

Mayer will be based in New York and Stamford and report to Jerker Johansson, chairman and ceo of UBS Investment Bank. Mayer will also join the Investment Bank Executive Committee and the UBS Group Managing Board.

Mayer was most recently global co-head of Fixed Income at Bear Stearns and a member of Bear Stearns Management Committee. Mayer was additionally a member of the Board of Directors of Bear Stearns and Co., Inc. Prior to becoming co-head of Fixed Income in 2002, he headed Bear Stearns' mortgage and asset-backed securities department. He began his career at Bear Stearns as a senior mortgage trader.

CDS clearing platform expected by year-end
The Clearing Corporation (TCC) and its clearing participants are moving aggressively to launch a CDS clearing platform by the end of this year. System testing, which is proceeding according to plan and validating the design and operation of the CDS clearing platform, is nearing completion, it said in a statement. The move has been prompted by recent unprecedented events in the CDS market and in anticipation of receiving required regulatory approvals, TCC says.

Managers pledge free help for TARP
Fixed income asset managers are rallying behind the US government's proposed troubled asset relief programme scheme by offering their services free of charge. Babson Capital Management is the latest firm to offer its support, following PIMCO's Bill Gross' indication yesterday that his firm would offer services at no charge, as long as other firms did the same.

Roger Crandall, chairman and ceo of Babson Capital Management, says that the firm supports a no-management-fee arrangement to help assist the proposed US$700bn federal TARP.

"We support the call for investment managers to provide their expertise for no fee to support this most critical event for our country," says Crandall. "The relief plan proposed by Treasury Secretary Paulson is an excellent opportunity to address the problems being created by these troubled mortgages and other assets. Babson Capital is committed to providing our expertise in these matters for no fee, provided other managers do the same, to help stabilise financial markets and prevent further economic problems."

Permacap to liquidate
Permacap Caliber Global Investment is to enter into voluntary winding-up following a majority vote at an EGM held on Friday. Michael Fayle has been appointed liquidator.

Lehman FI division sale falls through
Lehman Brothers is to cut 750 jobs in its European fixed income and personal investment management units after talks to find a buyer were unsuccessful. The cuts will come predominantly from the fixed income arm.

AIMA appoints new council
The Alternative Investment Management Association (AIMA) announced its new council at its AGM in London yesterday.

AIMA's membership has elected three non-executive directors, responsible for representing the following regions for a two-year period. These are: Europe, Middle East and Africa - Doug Shaw, md of Proprietary Alpha Strategies, BlackRock Investment Management (UK); the Americas - Sean Simon, co-president of Ivy Asset Management Corp; and Asia-Pacific region - Peter Douglas, principal of GFIA.

Also appointed to the council for a one-year term are: Paul Sater, partner of UK Financial Services at Ernst & Young, and Christopher Fawcett, chief executive of Fauchier Partners.

AIMA will appoint an independent, non-executive chairman in 2009. Fawcett, who has served as AIMA's non-executive chairman for six years, will act as interim chairman until such time as a new one is appointed.

Remaining on the council as executive directors are: Florence Lombard, ceo; Andrew Baker, deputy ceo; and Emma Mugridge.

AC & CS

CDS notional declines ...

A round up of this week's structured credit news

CDS notional declines ...
The notional amount outstanding of credit derivatives decreased by 12% in H108 to US$54.6trn from US$62.2trn, but the annual growth for credit derivatives was 20% from US$45.5trn at mid-year 2007, according to ISDA's Mid-Year 2008 Market Survey of privately negotiated derivatives. For the purposes of the survey, credit derivatives comprise CDS referencing single names, indexes, baskets and portfolios, with notional amounts adjusted for double-counting of inter-dealer transactions.

"The derivatives business overall showed consistent growth over the first half of 2008, but what we are beginning to see in credit derivatives is a downturn in the notional volumes - the total amount of trades that are outstanding," comments ISDA executive director and ceo Robert Pickel. "This decrease primarily reflects the industry's efforts to reduce risk by tearing up economically offsetting transactions, and demonstrates the industry's ongoing commitment to reduce risk and enhance operational efficiency. We expect to see more effects of this over time."

The notional amount, which reflects both new and existing transactions, is a measure of activity, not a measure of risk. The BIS collects both notional amounts and market values in its derivatives statistics and so it is possible to use the BIS statistics to determine the amount at risk in the ISDA survey results, the Association says.

As of December 2007, gross mark-to-market value of all derivatives classes was approximately 2.4% of notional amount outstanding. In addition, net credit exposure (after netting but before collateral) is 0.5% of notional amount outstanding. Applying these percentages to the total ISDA Market Survey notional amount outstanding of US$531.2trn as of 30 June 2008, gross credit exposure before netting is estimated to be US$12.7trn and credit exposure after netting, but before collateral, is estimated to be US$2.7trn.

... due to successful tear-ups
TriOptima confirms that the 12% decline in CDS notional outstandings announced by ISDA is primarily due to its triReduce tear-up cycles in H108. Despite robust trading activity in the first six months of the year, the firm's termination of US$17.4trn in inter-dealer CDS notional principal during this period contributed to the overall decline.

"As the sole provider of portfolio compression services in the first half of 2008, we can confirm that tear-ups were a positive factor in stabilising the growth in notional principal levels that had attracted the attention of regulators, " comments Brian Meese, group ceo. "We have long believed that aggressive use of tear-ups is one of the most effective ways to manage risk and a vital complement to central counterparty activities. We include all dealer counterparties, not just a few and we eliminate, rather than mitigate, the risk associated with those trades."

Negative rating action for US ...
S&P has lowered 100 US CSO ratings, 21 of which remain on watch with negative implications and 47 of which were removed from watch negative. At the same time, the agency placed 313 ratings on watch negative and removed three from watch positive.

The actions reflect the impact of the following events that have occurred since the start of September on the relevant portfolios:

• The placement of Fannie Mae and Freddie Mac under regulatory conservatorship;
• Lehman Bros. Chapter 11 bankruptcy filing; and
• Negative rating migration that reflects, but is not limited to, the downgrades and CreditWatch placements of American International Group (AIG), Bank of America, and Washington Mutual.

Transactions with exposure to either Fannie or Freddie that had ratings placed on watch negative were failing their SROC ratio tests regardless of recovery rates. In addition, S&P reviewed the ratings on all of the classes that it had previously placed on watch negative to determine the appropriate rating action.

... and European synthetic CDOs
S&P also took the following rating actions - for the same reasons as above - on various European CSO transactions: it placed 328 ratings on watch with negative implications; and lowered 68 ratings, 36 of which were placed on watch negative.

Transactions with exposure to either Fannie Mae or Freddie Mac that had ratings placed on watch negative were failing their SROC ratio tests regardless of outcome of final recovery valuations. Transactions with exposure to either Fannie Mae or Freddie Mac that had ratings lowered were failing their SROC ratio tests based on a fixed recovery as documented at closing.

Primus ICR on watch negative
S&P has put CDPC Primus Financial Products' issuer credit rating, senior debt issues, senior subordinated debt issues and preferred shares on credit watch with negative implications. The rating action reflects the potential losses associated with Primus' exposure to Freddie Mac, Fannie Mae, Lehman Brothers Holdings and Washington Mutual.

As Primus absorbs the losses associated with these entities in its credit derivative portfolio, S&P may lower its ratings on the company. If it shows low recoveries, the agency could lower its issuer credit rating into the double-A category, depending on how high or low the recoveries are upon final settlement. In addition, S&P could potentially lower its senior subordinated debt rating by the same magnitude and its subordinated debt rating by a greater magnitude, again depending on how high or low the recoveries are upon settlement.

Last week S&P also placed its triple-B plus counterparty credit rating on Primus Guaranty on watch with negative implications (see last issue).

Primus responded by issuing a statement indicating that it has approximately US$820m in cash and liquid investments to meet any counterparty claims. Primus Financial's US$300m of debt and preferred securities is long-term or perpetual capital, with the first maturity occurring in 2021. A downgrade of Primus Financial's triple-A rating does not trigger a credit event, or require the company to post collateral or allow a counterparty to terminate its CDS transactions with Primus Financial.

Additionally, in anticipation of Washington Mutual filing for bankruptcy, the company provided the following information with regard to the CDS portfolio of Primus Financial. As of 25 September, Primus Financial's net single name CDS notional exposure that references Washington Mutual totalled US$16.1m. The company anticipates that, as a result of a Washington Mutual bankruptcy credit event, it will have to make cash settlement payments to its counterparties on these transactions, less recoveries.

Primus Financial also has CDS exposure to Washington Mutual in its bespoke tranche portfolios, which are not subject to first loss due to existing subordination levels. The company does not anticipate that it will have to make cash settlement payments on its bespoke tranche transactions as a result of a Washington Mutual credit event. However, the capital requirements associated with each tranche will increase as a result of a reduction in tranche subordination.

CDO model released
Dresdner Kleinwort's structured credit research team has released an excel-based CDO model - in the standard version, as well as a version using the Gauss-Hermite Integration technique - for finite homogenous pools, following the launch of one for large homogenous pools on 16 September. The models are accompanied by guides that focus on how to apply the models in a first step that allows the user to appreciate the impact of key parameters, such as correlation, recovery and spread on the value of a specific tranche.

The guide for finite pools looks at how the loss distribution is constructed for a finite pool of homogenous assets, as well as addressing some important factors that must be considered when using the Gauss-Hermite integration technique in combination with binomial distribution.

ISDA updates on protocols ...
ISDA has launched the 2008 Fannie Mae and Freddie Mac CDS Protocol, which is open until 2 October in preparation for an auction on 6 October. Meanwhile, the adherence period for the Lehman Brothers Holdings Protocol will run from 6-8 October, with the first list of deliverable obligations now available on the ISDA website and the auction date scheduled for 10 October. A protocol for Washington Mutual is tentatively scheduled to run from 14-17 October, with a tentative auction date of 23 October.

The protocols offer institutions the ability to amend their documentation for various credit derivatives transactions in order to utilise the auctions that determine the final price for certain obligations. Markit and Creditex administer the auctions.

"ISDA's protocol mechanism is playing an important role in ensuring stability in the credit derivatives industry by helping to provide participants with an efficient and reliable settlement process in the event of a reference entity default," says Robert Pickel, ISDA executive director and ceo. "The success of these efforts reflects the industry's ability and determination to continue to strengthen the infrastructure for privately negotiated derivatives."

... while SIFMA develops MBS protocol
SIFMA's Asset Management Group (AMG) has worked with Lehman's court-appointed Securities Investor Protection Corporation (SIPC) Trustee to develop an industry protocol that will provide guidance to firms terminating outstanding trades with Lehman. The protocol, 08-01, applies to To-be-announced MBS trades that were expected to settle in October, November and December.

"This protocol provides welcome certainty and a way to terminate trades in an orderly fashion," says Joe Sack, SIFMA md. "By working with the SIPC and SIPC Trustee, buy-side firms have come up with a solution to terminate billions of dollars in trades that would have otherwise required firms to navigate the bankruptcy system."

The protocol contains the essential components that provided a level of comfort to asset managers wishing to terminate forward-settling trades done with Lehman that do not clear through the Fixed-Income Clearing Corporation (FICC).

SEC clarifies FAS 157
There are a number of FAS 157 practice issues where there is a need for immediate additional guidance, according to the SEC. Its staff, together with FASB staff, have consequently jointly provided clarifications on a number of areas in order to help preparers, auditors and investors address fair value measurement questions that have been cited as most urgent in the current environment.

The SEC's Office of the Chief Accountant recognises and supports the productive efforts of the FASB and the IASB on these issues, including the IASB Expert Advisory Panel's 16 September draft document, the work of the FASB's Valuation Resource Group and the IASB's upcoming meeting on the credit crisis. To provide additional guidance on these and other issues surrounding fair value measurements, the FASB is preparing to propose additional interpretative guidance on fair value measurement under US GAAP later this week.

FBIC mooted as TARP alternative
An alternative to the troubled asset relief programme has been put forward by Chris Ricciardi, ceo of Cohen & Company (see also separate news story). In an open letter to Henry Paulson, Ricciardi suggests the creation of a federal programme that would support the financing of the troubled assets, rather than the purchasing of the assets by the government.

"Rather than have the US government directly purchase up to US$700bn of illiquid mortgage-backed securities, it would be far better for US taxpayers and our nation's economy to create a federal programme that supports financing rather than purchasing these securities," he writes. "Such a solution would jumpstart the significant participation of private capital in this market."

Ricciardi points out that there are billions of dollars held by major institutional bond managers, hedge funds and distressed funds that are already available to purchase mortgage assets. He says that vehicles could be created that are authorised to purchase troubled assets and issue obligations under currently contemplated legislation to more efficiently address the crisis and establish a programme which he dubs the 'Federal Bond Insurance Corporation' (FBIC).

"FBIC would work in a way similar to how Ginnie Mae works," he explains. "It would provide a government guaranty (for a fee) to triple-A rated senior classes of securitisation of a variety of assets, and could also optionally require that bond insurance from a double-A or triple-A rated monoline bond insurer first be secured (with a lower government guaranty fee)."

If implemented properly, Ricciardi says the FBIC programme would have the following key benefits over direct government purchases of mortgage-related securities:

• Invigorating private capital
• Lower cost to US taxpayers
• Lower risk for US taxpayers
• Precedent and infrastructure already exist
• Opportunities for ratings reform

Steady performance for European ABS CDOs
According to a report from S&P, European cash ABS CDOs have shown steady performance in H108. That is in spite of the agency lowering its ratings on 76 classes of notes, placing one on credit watch negative and withdrawing ratings on seven classes of notes within those six months.

ABX-linked CLNs downgraded
Moody's has placed one CLN on review for downgrade and downgraded the ratings of 35 others, as well as three CDS and one CDO. The action affects approximately US$1.54bn and €85m of securities. The transactions' reference obligations are ABX.HE Series 07-1, 06-2 and 06-1 or TABX.HE Series 07-1 and 06-2.

Remittance reports in
Remittance reports for the September ABX distribution date show monthly aggregate 60+ day delinquencies climbing by 57bp, 98bp, 159bp and 152bp (compared with rises of 29bp, 117bp, 158bp and 142bp last month) for Series 06-1, 06-2, 07-1 and 07-2 respectively. Barclays Capital securitisation analysts are negative on ABX PENs and triple-As; thus, at current levels they believe these tranches are overvalued.

"In our view, yields on the PENs and triple-As across all series do not reflect the risks present in the market, particularly since the future of Treasury's bailout plan is far from certain," they note.

PACE ratings withdrawn ...
Moody's has withdrawn ratings assigned to the senior debt and the capital note programmes of Société Générale's SIV, PACE. All outstanding senior debt of PACE has been repaid in full, using proceeds of a sale of assets to SG in June and draws under a liquidity facility provided by the bank as part of the restructuring of the vehicle in December 2007. The vehicle therefore has no assets left to repay principal or interest due to capital noteholders and is being unwound.

... while Sigma is downgraded
Moody's and S&P have taken ratings action on Sigma Finance Corp. S&P lowered its issuer credit and senior debt ratings from single-A to triple-C minus and from A1 to Not Rated respectively. Moody's has downgraded Sigma's MTNs to Ca and Not Prime, and withdrawn its CP ratings.

On 30 September, Sigma notified Moody's of a notice of default served by one of its repo counterparties. This has resulted in a close-out of all repo contracts entered into by one counterparty, and may lead other counterparties to follow suit.

The notional amount of Sigma's assets is approximately US$27bn. Sigma notified Moody's that its actual collateral held under repo agreements is a total of US$25bn, a figure which includes US$17.4bn of notional of repo liabilities and overcollateralisation of approximately US$8bn (approximately US$4bn of initial margin, and approximately US$4bn of variational margin).

Moody's Ca rating therefore reflects the fact that Sigma has a total of US$2bn of assets that has not been pledged under repo contracts supporting US$6bn of MTNs. While margins pledged under repo agreements could be returned to Sigma, Moody's views significant loss to the MTNs as a likely possibility, given the difficult market into which counterparties will liquidate assets to recover amounts owed by Sigma.

Sigma's asset portfolio market value had declined to 92.8% on 19 September 2008 from 94.3% on 4 July 2008. The company's available committed liquidity of US$3.5bn on 4 July 2008 was reduced to US$14m on 19 September 2008.

The company's ability to transact in further repos was hindered by this price decline, as well as a reduction in the types of assets favoured by repo counterparties. Available committed liquidity facilities from banks have been drawn down and breakable assets have been liquidated. These have, in some instances, been used to meet margin payments, causing the company to breach its minimum liquidity covenants, thus triggering entry into natural amortisation on 19 September.

A depletion of cash reserves, entry into natural amortisation and increasing demand for margin payments by repo counterparties resulted in a close-out of repo contracts by one counterparty. The effect for MTN investors will be an acceleration of the notes and likely failure to pay when due.

Index constituents replaced, ABX.HE 05-2 postponed
Based on liquidity polls, nine constituents have been replaced in the Markit LevX Senior index, while the constituents of the Sub index remain unchanged in the index roll on Monday (29 September). In addition, the following changes have been made to the iTraxx Europe family of indices:
1. Six constituents were replaced in the iTraxx Main index.
2. Seven constituents were replaced in the iTraxx Crossover index.
3. Three constituents were replaced in the iTraxx HiVol index.

Meanwhile, the following changes have also been made to the iTraxx Asia family of indices:
1. Two constituents were replaced in the iTraxx Asia ex-Japan IG and one in the iTraxx Asia ex-Japan HY.
2. Four constituents were replaced in the iTraxx Japan Main index.

Due to market conditions, the roll of the Markit CDX IG, HiVol and XO Series 11, EM Series 10 and EM Diversified Series 8 has been postponed to 2 October. Based on liquidity polls, 10 constituents have been replaced in the CDX.NA.IG index, as well as eight in the CDX.NA.HiVol, three in the CDX.NA.XO and five in the CDX.NA.HY.

The launch of the ABX.HE 05-2 index has also been postponed. Index dealers voted to postpone the launch due to market conditions. The index was scheduled to launch on 2 October, but a new launch date is yet to be determined.

Liquidity principles endorsed
Bank supervisors from central banks and supervisory agencies have endorsed the Basel Committee's Principles for Sound Liquidity Risk Management and Supervision. The principles underscore the importance of establishing a robust liquidity risk management framework that is well integrated into the bank-wide risk management process.

Key elements of a bank's governance of its liquidity risk management are also emphasised. The document also sets out the principles to strengthen the measurement and management of their liquidity risk. Among other things, a bank should:

• conduct regular stress tests for a variety of short-term and protracted institution-specific and market-wide stress scenarios, and use the outcomes to develop robust and operational contingency funding plans;
• ensure the alignment of risk-taking incentives of individual business lines with the liquidity risk exposures the activities create;
• actively manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis under both normal and stressed conditions, and thus contribute to the smooth functioning of payment and settlement systems; and
• maintain a cushion of unencumbered, high quality liquid assets as insurance against a range of stress scenarios.

The principles support one of the key recommendations for strengthening prudential oversight set out in the 'Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience', which was presented to G7 Finance Ministers and Central Bank Governors in April 2008. The guidance focuses on liquidity risk management at medium and large complex banks, but the sound principles have broad applicability to all types of bank.

The document notes that implementation of the sound principles by both banks and supervisors should be tailored to the size, nature of business and complexity of a bank's activities. Other factors that a bank and its supervisors should consider include the bank's role and systemic importance in the financial sectors of the jurisdictions in which it operates.

FSA Holdings downgraded ...
S&P has lowered its long-term counterparty credit rating on FSA Holdings to double-A minus from double-A, following a similar downgrade of Dexia's core units on 29 September. The outlook on the Dexia core units has been revised to stable from negative.

The outlook on FSA Holdings is stable. As Dexia owns 99.7% of FSA Holdings, S&P views the credit quality of the bond insurance holding company as essentially equal to that of Dexia.

S&P also lowered to double-A minus from double-A the ratings on FSA Holdings' senior unsecured debt, and to single-A from single-A plus the rating on its junior subordinated debt. The monoline FSA's triple-A rating is unchanged, although it remains on outlook negative.

... and FGIC's counterparty credit rating lowered
S&P has lowered its rating on FGIC Corp's counterparty credit rating and senior unsecured notes to triple-C from single-B and removed them from credit watch, where they were placed with negative implications on 6 June. The outlook is negative, reflecting the agency's belief that additional losses are possible and management's near-term priority is to bolster the statutory surplus at FGIC.

Although management states that FGIC Corp has cash resources to fund its obligations as they come due for at least the next 12 months, its monoline subsidiary is currently unable to pay dividends to FGIC Corp without the approval of the New York State Insurance Department. In addition, FGIC's double-B financial strength rating and the single-B preferred stock ratings on its Grand Central Capital Trust securities remain on watch with negative implications.

S&P says it believes that FGIC's capital position is fragile as, relative to the regulatory minimum statutory surplus requirement of US$65m, FGIC reports US$285.6m of statutory surplus as of 30 June 30. Capital may be further reduced in view of the agency's estimates for losses on FGIC's ABS CDO and non-prime RMBS exposures, which are a multiple of FGIC's current loss reserves.

Another development that we believe may stress policyholder surplus in the near term is the potential bankruptcy of Jefferson County, Ala. FGIC has US$1.2bn of exposure to Jefferson County sewer revenue bonds.

However, the successful closing of the reinsurance transaction between FGIC and MBIA - whereby FGIC would cede US$184bn of municipal par exposure to MBIA - would benefit statutory surplus, the agency says. While the ultimate economic benefit of transferring about US$900m of future earned premium on this well-performing book of business is questionable in S&P's view, management's near-term objective is to bolster statutory surplus to avoid regulatory intervention.

Company projections show resulting contingency reserve transfers and ceding commissions positively contributing to management's pro-forma policyholder surplus projection of US$853m for the period ending 30 September. FGIC also has the ability to bolster statutory capital by up to US$300m by drawing against its Grand Central Capital Trust contingent preferred stock security.

Further central bank coordination ...
In response to continued strains in short-term funding markets, 10 central banks announced further coordinated actions to expand significantly the capacity to provide US dollar liquidity.

Actions taken by the Federal Reserve include:

• an increase in the size of the 84-day maturity term auction facility (TAF) auctions to US$75bn per auction from US$25bn, beginning with the 6 October,
• two forward TAF auctions totaling US$150bn that will be conducted in November to provide term funding over year-end,
• and an increase in swap authorisation limits with the Bank of Canada, Bank of England, Bank of Japan, National Bank of Denmark, ECB, Bank of Norway, Reserve Bank of Australia, Bank of Sweden and Swiss National Bank to a total of US$620bn, from US$290bn previously. All of the temporary reciprocal swap facilities have been authorised until 30 April 2009.

These steps are being undertaken to mitigate pressures evident in the term funding markets both in the US and abroad, according to the Fed. By committing to provide a very large quantity of term funding, it is hoped that its actions will reassure financial market participants that financing will be available against good collateral, lessening concerns about funding and rollover risk.

... while ECB conducts liquidity operation
The ECB on 29 September conducted a special term refinancing operation to improve the overall liquidity position of the euro area banking system. The operation was settled on 30 September and will mature on 7 November 2008.

The ECB says it will continue to steer liquidity towards balanced conditions in a way which is consistent with the objective to keep very short-term rates close to the minimum bid rate. The special term refinancing operation will be renewed at least until beyond the end of the year.

Speculative default rates to rise
Based on S&P's estimates of a worst-case scenario, the three-year US cumulative default rate between 2008 and 2010 among speculative grade non-financials will rise to 23.2%, the worst on record since 1981. If realised, this estimate suggests that 353 speculative grade rated non-financial firms could default between 2008 and 2010, with potentially more than 200 of these defaults materialising in the second half of 2009 and in 2010.

Consumer-sensitive sectors - such as consumer products, media and entertainment, and retail and restaurants - will be among the worst hit, in line with what happened in 1990-1992. This estimate is drawn from observation and analytical judgment about past peaks in the default cycle over three-year periods; it is separate from the one-year forecast the agency updates quarterly.

IDC adds GlobalRating Group
Interactive Data Corp's pricing and reference data business has added credit ratings from the GlobalRating Group to its Credit Ratings - Emerging Markets service. IDC's credit ratings services offer a comprehensive and integrated resource of credit ratings from a variety of sources that can assist customers in calculating capital adequacy under Basel II and the Capital Requirements Directive, the firm says. IDC's Credit Ratings - Emerging Markets service is a comprehensive source of credit information for more than 80 emerging market economies, containing over 8,000 issuer ratings from over 35 international and local rating agencies.

Anthony Neville, divisional director, Interactive Data (Europe), says: "We are pleased to enhance our Credit Ratings - Emerging Markets service with the addition of credit ratings from the GlobalRating Group. The service now covers the increasingly important markets of Russia, Kazakhstan, Armenia and Azerbaijan to complement the existing wide range of credit information from many other established contributors."

Derivatives valuation survey released
PRMIA and OTC Val have released the results of a global derivative valuations survey entitled 'Transparency and Independence of Derivative Valuations - Current Practices, Trends, Challenges and Recommendations'. While the survey highlights the significance of derivative valuations, only 5% of the respondents were 'very satisfied' with their current valuation solution. Some of the reasons cited for the dissatisfaction with the current solution are inconsistent methodologies being used to price instruments, the need to use multiple valuation sources as the primary solution cannot price the entire portfolio, and valuation and risk systems unable to keep pace with the growing diversity and complexity of derivatives products entering the market.

Respondents came from 77 countries and represent numerous specialties, including risk practitioners, regulators responsible for derivative valuation practices, consultants and/or vendors working in derivatives solutions, and PRMIA members in other related professional roles.

TARP valuation call
Julius Finance has called for the use of standardised house price appreciation scenarios in the valuation of mortgage-backed CDOs to be included in the TARP. "The old saying about the whole being greater than the sum of its parts does not apply to CDOs", says ceo Peter Cotton.

"For years, banks have been able to tranche up CDOs and sell the slices for more than the cost of the pie - with inconsistent valuation and ratings models not exactly standing in the way. Now, there is the possibility of the entire financial community playing that game on a vast scale with the taxpayer on the other end of the deal," he explains.

Julius Finance's solution involves a set of agreed standardised scenarios for home price appreciation, combined with detailed loan-level modelling of prepayment and default based on millions of historical data points. A precedent is provided by the American Academy of Actuaries which provides standardised equity return and interest rate scenarios used by insurance companies in the calculation of risk based capital.

The procedure ensures that securities cost the same as the sum of the constituent parts. "If that sounds like Finance 101, it's because it is," says Cotton. "What's required is a rigorous approach, in the sense that one cannot magically create value by slicing, dicing and re-arranging alone. This provides an important constraint on what might otherwise become a free-for-all."

LSS transactions downgraded
Moody's has downgraded the ratings of approximately €282m of leveraged super-senior transactions (LSS) with spread plus loss triggers. The affected LSS represent 100% of the existing LSS with spread plus loss triggers rated by Moody's in Europe.

Moody's applied its updated LSS monitoring tool in the analysis of these transactions, taking into account the spread volatility brought by the current market crisis. The spreads on the underlying portfolios have widened significantly in the last month, with the weighted average credit spread of the underlying portfolios now ranging between 131bp and 535bp, while the spread triggers range from 421bp to 800bp. Moody's notes that the average credit rating on the underlying portfolios is in the Ba3 to Baa3 range.

CS & AC

European default outlook 2009

Mahesh Bhimalingam and Eugene Regis, high yield strategists at Barclays Capital, expect defaults to tick up next year, based on a slow erosion of fundamentals

The limitations of macro approaches and the fact that we have only seen two defaults in Europe this year means that forecasting a default rate using top-down analysis becomes a very imprecise science. Given that defaults are predominantly a fundamental event, it is important to look for signs of deterioration in company financials to arrive at a meaningful forecast.

As Figure 1 shows, of the high yield corporates that Barclays Capital analysts cover, 50% have reported falling EBITDA for the results period reported in Q3 to date, a complete reversal of the situation in the Q2 reporting. Also, 21% of names are reporting results below expectations.

While this is a drop compared to the 36% in Q2, note that there is a significant proportion (29%) of names reporting declining top-line growth that is above expectations. Clearly, corporates have been guiding their earnings downwards. This is beginning to feed through into adverse ratings actions for European high yield corporates.

As at the end of Q2, Moody's downgraded 14 more Western European borrowers over upgrades, which in a historical context is going back to the annual numbers of 2003. Continuing on from Q2, July and August saw 12 downgrades versus five upgrades. Given this deterioration in earnings growth, Moody's is clearly being stricter in the current environment (see Figure 2).

Defaults in overall high yield universe
Current ratings in the universe should also be seen as a leading indicator of defaults, although the timing of ratings moves can be debatable. Currently, Moody's has assigned 183 corporates in Europe a rating at Ba1 or below.

We are using Moody's universe as a guide to measuring default intensity, given that the rating agency's historical default rate is the most widely followed. Thirty of them (16.4%) are rated at B3 and below. We will concentrate on B3 and below rated names with a negative outlook, of which there are 12 (see Figure 3).

Why at that level? One key reason is that the probability of default within one year of a B3 company is nearly twice that of a B2 rated company. We expect such names to be running at tight fundamentals already, given that they are one notch away from Caa1 and on negative outlook and companies that have just been cut to Caa1 will find it hard to issue, should they need to refinance down the line when they get into trouble.

As such this universe forms the weakest links of the high yield universe. We first investigate the weakest links before looking for potential surprises.

Weakest links
We would expect covenant breaches and defaults to become more of a concern through 2009 if EBITDA levels among high yield borrowers start to drop in the region of 25%. Given that many private LBO borrowers (a large proportion of the European high yield market) do not publicly disclose loan maintenance covenants (and are generally purely incurrence-based covenants at bond level), it is difficult to gauge the level of comfort that most of the private high yield companies have at present.

However, given the fairly muted financial performance of companies and the fact that covenants traditionally tighten over the life of an LBO, we expect headroom to be declining. However, history has taught us in Europe that covenant breaches are usually met with waivers and/or additional sponsor funding at the equity level so as not to cause a default immediately. But, in this poor economic environment, we feel that getting waivers will be challenging and sponsors would ultimately begin to value the opportunity cost of investing more equity versus the cost to them of pushing their investments into default, notwithstanding reputational risk.

Liquidity issues are more likely to affect the fallen angel corporates rather than the LBO company (which has invariably secured long-term funding), as they rely on more short-dated bank funding and have greater short-term debt to roll over. With bond markets effectively closed for high yield bond issues, any contraction/unwillingness for banks to refinance upcoming bank (or more likely bond) debt will push default levels higher.

Our bullish issuer default forecast for the next year (by issuer) on a fundamentals view is up to around 3.3%, with a bearish forecast of around 5%, based on this group alone and assuming all our selected names default. This is illustrated in Figure 4, where we highlight if names have covenant or maturity issues.

The second section of names covers those that might get into difficulty if the tough macro environment persists for longer and intensifies. Although our analysts do not cover all the names listed, from a strategist's perspective these names look most vulnerable to a further downturn in fundamentals compared to the rest of the universe.

We are capped in our expectations in that many names are LBO names with term funding. For defaults to occur, we would expect them to come more from deterioration in fundamentals than any maturity issues. For some names, we would need a consistent deterioration in fundamentals to reduce credit quality and push them to default.

Possible surprises
The cycle could turn out to be much worse than even we expect and there are always companies that surprise to the downside in such an environment. If fundamentals deteriorate at a more rapid pace than foreseen, then names rated at B2/B1 levels with negative outlooks or on review for downgrades will be particularly vulnerable to a classic death spiral move, where a breach of covenants/coupon default combined with a lack of short-term funding pushing some names through multiple downgrades and subsequent default.

In addition, some of the current B3 and Caa names with stable outlooks can be immediately downgraded. So we include both of these cohorts in our possible surprises section (see Figure 5).

However, if we see a very pessimistic scenario dragging all names among the possible surprises as well, then we would see up to 19 names defaulting - resulting in a 10.4% issuer default rate, which is a bit outlandish. On balance, we believe that default rates could be in the 3.3%-5% band, as all weakest links will not default and one or two of the surprises might.

The key will be how names manage their fundamentals - given that we expect bondholders to be more reluctant to loosen covenants via waivers and deferrals, and companies more likely potentially to breach covenants. Realistically, we would expect the current course of downgrades to continue and many names, particularly 'pessimistic' and 'potential surprises', running at risk of possible default to survive at lower ratings. Then, the key question becomes whether such names can take enough remedial action to maintain or improve fundamentals over the post-2009 cycle and avoid a refinancing crunch once they hit their maturities.

Defaults in Crossover S9/potential S10 names
We analysed the iTraxx Crossover index separately as it is a traded index and we would expect defaults of constituents to have more of an impact on markets. By contrast, the high yield market contains both names in the Crossover and cash bond borrowers who do not have a quoted CDS contract. We would expect default risk to be lower, given there are no Caa rated credits in the Crossover and the greater presence of credits in the index rated within the Baa group, as shown in Figure 6.

However, this does not imply that the Crossover is free of default probability by any means. We would argue that if the current environment deteriorates we could see some surprise defaults among Crossover credits.

Of the 56 Crossover credits (50 current plus six potential new entrants) that we are including in this analysis, 23 are fallen angels, five additional names are fallen angels due to being acquired in LBO transactions (or in the case of Pernod Ricard making a transformative leveraged transaction) and 21 are original issue high yield borrowers, while seven names still have an investment grade rating with Moody's. With regards to maturities, it is the 23 fallen angels that we are most concerned about.

Why? Some have a two-pronged attack from maturities and fundamentals. These 23 names have been downgraded but arguably have sub-optimal capital structures for the high yield universe.

Unlike the five names that were LBO'd or entered into transformative leveraged transactions (Alliance Boots, BAA, ISS, NTC and Pernod Ricard) and termed out their debt, some of these fallen angel names have regular maturities coming through in the rest of 2008, 2009 and 2010, as they did not refinance or change their capital structure upon downgrade. Given the prevailing credit climate, with banks tightening lending standards for corporates - combined with the closure of Lehman Brothers and takeover of Merrill Lynch (though not commercial banks, which are still providers of liquidity to the corporate market) - we would expect to see such names having difficulty in refinancing their upcoming maturities.

Fundamentals come into play after maturities. This brings the original high yield borrowers into play, as well as fallen angels. As we illustrated earlier in Figure 1, high yield borrowers are seeing slippage in their results in terms of EBITDA growth and high input costs, and slowing growth takes its toll on fundamentals.

Possible surprises rather than weakest links
Ultimately, as Figure 7 shows, the headline default risk from Crossover names is lower than that of the wider high-yield market. While we would see fundamentals come under pressure - based on a combination of heavy maturities in relation to the size of the balance sheet, high leverage and lower coverage - we don't see any of these six names with numbers so poor such that they are close to default. They are more potential surprise candidates than weakest links.

Rather, such names would probably trade at stressed levels and be candidates for downgrade to B3 and below if their fundamentals erode. Overall we believe that in our optimistic scenario there will not be a single default in the Crossover. In the pessimistic scenario, one or two of the surprises might default, leading to a default rate of 2%-4% for that universe.

Default risk in LevX Series 2
While we have covered default risk in the public bond markets, what of the 75 names that are members of the LevX index, especially those that do not have a public bond issue? Many of these names trade in a private documentation basis and we do not have an accurate gauge as to where credit metrics on such names are right now.

Only 19 names in the LevX index have a public rating (from S&P). Hence, it is hard to quantify an estimated default rate for LevX credits.

However, we would argue that default risk among LevX credits is higher than that of high yield and crossover credits. Why? A recent piece by S&P ('New European Series 2 Leveraged Loan Index Representative of Market, Despite Some Shortcomings', May 2008) pointed out, for example, that around 45% of credits in the LevX were rated at single-B and around 25% at single-B plus.

As Figure 8 shows, the distribution of ratings between LevX and S&P's European Leveraged Loan Index (ELLI) is fairly similar. Median and mode for both the distributions is single-B. This compares adversely to the median/modal rating on the Crossover of double-B minus and even the overall HY universe, B1.

As such, we believe that defaults in LevX will be a lot higher than in the Crossover and slightly higher than the overall high yield universe. By how much? It's very difficult to give a number, given that almost all the names are private, but we think it would be slightly higher than our HY forecast of 3.3%-6%. And there are reasons to believe that other than just ratings.

Given the private information deficit, we can use ELLI as a proxy to track fundamentals of leveraged loan credits as S&P reports them on a monthly basis at an aggregate level. Clearly, we can also see in Figure 8 that coverage is decreasing and leverage (partly a result of the LBO boom of 2004 to 2007) appears to be peaking.

On an index level, an average interest cover ratio of 2.4x does not appear to ring any alarm bells, but - if this trend continues - we can only assume that there will be some credits in the index getting closer to default. This is especially the case, given the absence of refinancing options and expected reluctance for covenant waivers, with the opacity of the market compressing the time it takes for such names to default.

© 2008 Barclays Capital. All rights reserved. This Research Note is an extract from 'European default outlook 2009', first published by Barclays Capital on 24 September 2008.

Trading ideas: planting seeds

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

During extreme volatile times in both the credit and commodity markets we look for well-placed companies with managements that are strategic and active. Forest Oil's management aggressively pursues acquiring higher quality and more focused assets while dumping non-core, non-strategic assets. We like this approach, allowing for a more streamlined and cost-conscious organisation.

Forest Oil has a US$1.2bn credit facility in place that enables it to make purchases while finding suitable buyers for its non-core assets. The flexibility makes it easier for the company to execute its growing asset strategy effectively and, with crude remaining above US$105/BBl and natural gas at US$7.60/MMBtu, the company's cashflow generation has benefited - decreasing the impact of its increased capital expenditures.

Forest Oil's credit metrics are strong. With debt to LTM EBITDA at only 1.7x and the majority of its notes not due until 2019, we do not see any significant reason for it to be unable to service its debt.

As a final note, after adjusting for unrealised losses due to its derivatives book, our quantitative credit model shows Forest's credit spread to be trading 100bp too wide, due to fantastic margins, low leverage and strong interest coverage levels. We recommend selling protection on Forest Oil.

Planning for the future
Forest Oil's management looks to the future and plans accordingly. Over the past year and a half it purchased significant producing acreage in the Ark-La-Tx area and the Houston Exploration Company. The two purchases helped expand revenue by more than 100% in one year, with a corresponding growth in adjusted EBITDA.

And most recently Forest announced the purchase of another 118,000 acres in strategic areas which will be funded through the sale of non-core, non-strategic assets in the neighborhood of US$500m-US$600m. While the company looks for the best bid on the assets, it will use its available US$1.2bn credit facility to fund the US$708m cash portion of the purchase (Forest also used 3.5m shares for the remaining balance of the purchase).

The company's increased and existing capital structure will lead to a significant drop in its credit risk priced by the market. Exhibit 1 shows the existing capital structure of Forest Oil, as of June 2008, and does not include the recent addition to its credit facility as we expect the sale of non-core assets to eventually repay the credit line.

Exhibit 1

Forest Oil's main debt obligation is a US$1bn note due in 2019 and its next significant debt is not until 2011 when the 8% senior bond matures. This combined with solid EBITDA growth and low interest expense makes us confident in its ability to keep current on debt payments over the next few years. As long as the company keeps a handle on capital expenditures relative to cashflow, we see its credit risk dropping in the medium term.

Fully covered
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 2 lists all the factor scores for Forest Oil. After adjusting for unrealised losses due to mark-to-market swings in Forest's derivatives book, we see a 'fair spread' of 230bp for its solid margins, leverage, interest coverage and equity-implied default probability factors.

Exhibit 2

Interest coverage is one of the best determinants of an issuer's ability to meet future liabilities. Forest Oil's interest coverage ratio is 10.3x adjusted LTM EBITDA. If Forest Oil comes under any strain in the near future, it will certainly not be coming from interest payments.

Oil and gas
Even though Forest Oil actively hedges its commodity risk, it is still exposed to price swings of both crude oil and natural gas. This is most evident from the correlation of either crude or natural gas and Forest Oil's stock price. Exhibit 3 is a scatter plot of crude and Forest's stock, and clearly the relationship is strong.

Exhibit 3

However, Forest's risk management has in place outright hedges and costless collars on both commodities, which we believe has a more direct effect on the company's ability to fund future credit obligations. Exhibit 4 is a scatterplot of crude oil and Forest's CDS spread, and the relationship is not nearly as strong as with its stock price.

Exhibit 4

With its relatively low leverage and hedging in place, Forest's credit profile remains insulated from severe volatility in the commodity market. Also, with crude oil remaining above US$105/BBl and natural gas at US$7.60/MMBtu, the company's cashflow generation has benefited, decreasing the impact of its increased capital expenditures.

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 20bp 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 FST's liquidity is good in the CDS market at the five-year tenor.

Summary and trade recommendation
During extreme volatile times in both the credit and commodity markets we look for well-placed companies with managements that are strategic and active. Forest Oil's management aggressively pursues acquiring higher quality and more focused assets while dumping non-core, non-strategic assets. We like this approach, allowing for a more streamlined and cost-conscious organisation.

Forest Oil has a US$1.2bn credit facility in place that enables it to make purchases while finding suitable buyers for its non-core assets. The flexibility makes it easier for the company to execute its growing asset strategy effectively and, with crude remaining above US$105/BBl and natural gas at US$7.60/MMBtu, the company's cashflow generation has benefited - decreasing the impact of its increased capital expenditures.

Forest Oil's credit metrics are strong. With debt to LTM EBITDA at only 1.7x and the majority of its notes not due until 2019, we do not see any significant reason for it to be unable to service its debt. As a final note, after adjusting for unrealised losses due to its derivatives book, our quantitative credit model shows Forest's credit spread to be trading 100bp too wide due to fantastic margins, low leverage and strong interest coverage levels. We recommend selling protection on Forest Oil.

Sell US$10m notional Forest Oil Corp 5Y CDS protection at 330bp.

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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).