Contents

CLO Managers

Manager performance compared

Distressed price ratio helps uncover relative value

The average flow leveraged loan bid has dropped to an all-time low of 79.88, according to S&P LCD. Comparing CLO manager performance using a distressed price ratio is therefore expected to help uncover relative value in the secondary market.

One such study undertaken by structured credit analysts at JPMorgan finds significant dispersion among managers, suggesting that the market is pricing different credit loss outcomes across the CLO market. This dispersion is likely to increase and meaningfully influence CLO credit performance in the coming cycle, should current low loan prices correlate to future credit stress.

Christopher Flanagan, head of global structured finance research at JPMorgan, suggests that these findings can be used to extrapolate relative value in a number of different ways. "In a simplified sense, equity investors can think about combinations that produce low distress ratios, as this is likely to keep excess spread flowing as long as possible."

Flanagan continues: "For non-senior debt investors, we recommend low WARF, high issuer count combinations, given that senior bonds are exposed to systemic rather than idiosyncratic risk. Finally, to the extent senior triple-A investors wish to monetise upfront discounts early, they could consider low WARF portfolios with an issuer distribution that allows for a high distress ratio - implying early amortisation and 'credit contraction' upside."

In their analysis the JPMorgan analysts defined a distress ratio for a given CLO portfolio as the percentage of assets in the portfolio trading below US$70, then normalising it by the price coverage. Their sample comprises 210 cash arbitrage US CLOs from 77 managers, with over 90% Loan Pricing Corp price coverage. The average distress ratio was found to be 10.8%, with a range from 3.5% to 22.9%.

Distress ratios to weighted average rating factors (WARFs) were compared for each transaction, showing a positive relationship. In other words, CLOs with a large amount of low dollar price assets tend to have low ratings on average. However, the analysts note that there is significant dispersion around this relationship, in that some managers are able to maintain higher WARFs yet still contain price distress.

The study also addresses whether manager size (measured as number of CLOs under management) is an indicator for the distress ratio. Large, repeat managers are often perceived to benefit from continued demand from CLO investors and ability to place paper due to outperformance or credit picking expertise. However, size might also indicate that a manager consistently buys the market, is able to place paper during a bull market while not necessarily adding value, yet still earn fees.

The findings suggest that the larger the manager, the closer the average distress ratio is to the market portfolio. But, while large managers tend to approach the market average, notable tiering exits for most other sizes, the JPMorgan analysts observe.

However, one fund manager points out a potential flaw in such an approach. "A different way of saying this is that, as the sample size increases, you get closer to the market average - in other words, there is no difference in the distressed ratio between larger managers and smaller managers other than the size of the sample," he argues. "With a smaller sample size, there tends to be more of a difference to the market average; with a larger sample size, the average is close to the market average. "

Finally, the JPMorgan analysis looks at the distress ratio as a function of average number of issuers in the portfolio and finds considerable difference in style - some managers limit their obligor selection to a relatively less diversified portfolio, while others essentially buy the market. "Like the prior example, we see significant differences around the relationship between how diversified (or undiversified) a portfolio is, versus its distress ratio, and see a convergence to the market mean in cases where the managers' portfolios are extremely diverse," explains Flanagan.

The fund manager nonetheless adds the caveat that, as cash arbitrage CLOs don't have market value triggers, it would be unwise to base manager selection entirely on a ratio that has no direct impact on the performance of a CLO.

CS

Ratings

MIR gain traction

But transparency is still lacking

Recent events have underscored the importance of including market-implied ratings (MIR) in risk models. However, they are only as good as the level of information that is made public and analysts suggest that financial institutions still have their work cut out in terms of being more transparent.

Gavan Nolan, credit research analyst at Markit, confirms that MIR are gaining traction following recent events in the financial sector. "People are increasingly recognising that market-implied ratings are complementary to credit ratings and fundamental credit analysis. This is certainly the direction that the regulatory environment is pushing in," he notes.

While a number of banks have been incorporating MIR into their risk models for some time, there has been less up-take on the buy-side - though this is expected to change now. However, Nolan points out that the efficiency of MIR ultimately depends on the level of information that is made public.

Julien Turc, head of quantitative strategy at SG, also believes it's a question of transparency: there isn't enough information out there about financial institutions' real losses and exposure to US sub-prime, and so the public has lost confidence in the banking sector. "Unfortunately, as per the current debate about relaxing mark-to-market accounting [see last week's issue], the approach being taken by some politicians/regulators threatens to make the market even more opaque," he says.

CDS-implied ratings migrations can usually signal whether an entity is in trouble well ahead of the event happening. But Fortis' CDS trading pattern was in-line with the rest of the market until three days before it was rescued, whereas Lehman Brothers was signalling severe problems more than six months before it defaulted.

According to Jonathan Di Giambattista, senior director at Fitch Solutions: "This could indicate that the bank was a victim of systemic failure rather than anything specific to Fortis' banking book or business model - and this may speak to a lack of EU-wide institutions on a par with the US Treasury, US Federal Reserve and FDIC that coordinate activities and policies across the European banking sector [see separate news story]. Certainly, the CDS median spread for triple-B minus entities has doubled over the last few months and so the market is pricing in significant credit difficulties."

Turc says the major drawback of MIR is that no matter what the credit rating of a company, for example, they tend not to fluctuate in line with each other. "A non-cyclical company with stable cashflows is therefore expected to outperform others in a downturn, so the question is whether credit ratings are important as a risk dimension - do they matter more than, say, regional or sectoral exposure?"

SG uses a model called SHARP for statistical analysis of multi-dimensional market changes. Ratings do matter in this model, but they are only one factor (among others such as directional risk, decompression risk and sectoral factors); recent events have shown that financial risk is a more important factor. By way of an example, most banks retain high ratings, yet their CDS spreads are more volatile - indicating that a major risk dimension isn't captured by the rating.

Until recently all of these market factors had been relatively stable, but this changed with the onset of the crisis as major dislocations occurred across all of the risk dimensions. "Over the past few weeks, the financial risk factor has been correlated with the market risk factor, suggesting that the market is focused on one thing - the financial crisis," explains Turc. "This in turn indicates that the financial crisis has spread to the whole of the economy and not only as priced by CDS. There is no longer any decoupling between equities and CDS, yet counter-intuitively high yield and retailers are outperforming - indicating that these sectors are a safe haven on a relative value basis."

In addition, the market is distinguishing between companies that don't have significant refinancing needs nor significant CP programmes and those that do. This suggests that ratings aren't so relevant; what is relevant is liquidity and the ability to finance on a day-to-day basis.

CS

Regulation

European TARP mooted

United European solution called for as individual measures fail to impress

Calls are mounting for a unified European approach to combat the current liquidity crisis. A number of measures have been suggested by European structured credit practitioners, including an impaired asset rescue package similar to the US' TARP (see last week's issue). But the reality of a multiparty strategy seems remote for now, as separate European governments move forward with unilateral actions.

Yesterday (7 October) Spain's government confirmed the launch of a €30bn fund that will purchase high quality assets at market prices, as well as increasing the guarantee on personal savings up to €100,000. The fund may be increased to €50bn, but whether ABS will be included as eligible assets remains unclear. Meanwhile, the UK government announced its own bank rescue package this morning (8 October).

"Individual uncoordinated measures being taken by national governments simply won't cut it. Now is the time to get ahead of markets, rather than react to them," comments Hans Lorenzen, credit strategist at Citi, who says a raft of measures is needed, as soon as possible.

"We reckon these will need to include a guarantee of short-term wholesale lending (and not just retail), along with a combination of rate cuts, reduced haircuts, widening collateral requirements and inevitably more liquidity injections by central banks," he explains. "There still seems to be a perception (with which we disagree) that the problems are much worse in the US than in Europe. Moreover, there are the obvious difficulties in coordinating such a scheme across countries. Who ends up paying for whom?"

Jean-David Cirotteau, head of structured finance research at Société Générale, agrees that government guarantees for deposits and banking debt (for a limited period in time, such as two years) are needed, but also calls for central bank intervention in open market operations on structured finance products. "The purchase of assets would be done on plain vanilla structures backed by granular pools, pushing prices higher in order to restore prices in line with underlying risk. We estimate that the cost of such a plan would be much lower than the TARP in the US," he says.

Outstanding European prime and non-prime RMBS amounted to €789.2bn in Q208, while outstanding ABS totalled €183bn, according to figures from the European Securitisation Forum. European ABS has deteriorated much less and prices, though low, have not reached levels of the US sub-prime market.

Cirotteau suggests that central bank bids could potentially be up to 10% higher than current revaluation prices. "Plain vanilla ABS, including auto loans, consumer loans and prime RMBS, are not so complex to price. But this would make a big difference for bank accounts. So a TARP-like plan in Europe would be much smaller than the US programme," he says.

Cirotteau adds that European central banks could take coordinated action in a way similar to open market operations when a currency is being attacked. "Central banks would directly announce they were buying a number of ABS assets in the market. By purchasing assets in the open market, central banks would drive prices higher than current mark-to-market levels which currently include a very high illiquidity premium. In doing so, European regulators would break the vicious circle of falling prices, markdowns and partial liquidation," he concludes.

AC

CLOs

New CLO paradigm

Structures and complexity to suit remaining investor base

European CLOs are experiencing a shift in structure and complexity in order to meet the demand of investors who are still able to part with cash for the asset class. While industry experts at this week's ESF/IMN conference on 'European CLOs, Structured Credit Products & Credit Derivatives' said that demand for CLOs remains, less leveraged, simpler two-tranche structures are expected to make up the bulk of such issuance in the European market over the next few months.

"There is still some investor demand for CLOs, but I expect to see the development of less structured products to suit particular investors who have capital available and an appetite to invest in the underlying asset class on a less levered basis," said Simon Perry, md and head of European CDOs at UBS.

Mark Moffat, md and co-head of Harbourmaster Capital Management, confirmed that he is tending to see a shift towards lower levered, two-tranche CLO structures with a triple-A and an equity piece. "If the triple-A investor base returns, I imagine demand would exist for exposure to pure credit risk, not a combination of credit risk, FX risk, market value risk, counterparty risk etc."

Shaun Baddeley, executive director of global securitisation at Santander Global Banking and Markets, added that he expects to see more reverse-enquiry bespoke deals, and possibly some plain synthetic deals and portfolios that are not vulnerable to cyclical downturns.

Concerns over where the volume of buyers for triple-As will come from over the next few years in the primary market - even in the case of the most simple structures - was discussed at the conference, although panellists were confident that investor appetite for mezzanine tranches down to equity remains. Mark-to-market CLO investors remain firmly on the sidelines, but the gradual re-emergence of some non mark-to-market accounts was seen as a positive.

However, panellists commented that it is proving difficult to persuade investors to enter the primary market while forced selling continues in secondary - where, in some cases, a pick-up of nearly 30% on an equity tranche is possible at present. Indeed, the events of the past couple of weeks have forced some holders of CLOs to sell at relatively distressed levels in order to obtain any cash or liquidity possible, with triple-As seeing the most activity.

Defaults and their impact on CLO structures were also debated at the conference. A number of attendees were of the opinion that, while defaults are expected to rise, the levels are unlikely to impact European structures too much.

"If there is not a spike in defaults in 2008/9, then I don't think we will see one at all. Defaults might reach double figures, but we're not going to see anything that breaks CLO structures, as they are designed to cope with higher default levels than we're currently seeing," David Matson, md of IKB Fund Management noted.

Harbourmaster's Moffat concluded that, in order to help broaden the CLO investor base, default and recovery data over 2009 and 2010 would need to be seen.

AC

Lehman trio joins investment group

The latest company and people moves

Lehman trio joins investment group
Citadel Investment Group has hired three members from Lehman's fixed income business, reporting to Patrik Edsparr, head of global fixed income and ceo of Citadel Europe. Timothy Bryan Wilkinson, a former head of fixed income proprietary trading at Lehman Brothers, will join Citadel's proprietary trading group along with John Alexander Goodridge. Alex Maddox will join Citadel as head of securitised products in Europe.

Structured credit md re-housed
Kai Gilkes, former md of the structured credit group at DBRS in London, has joined CreditSights as senior analyst - quantitative strategy. He spent two years at DBRS, where he ran a team responsible for the development of quantitative tools for structured finance transactions. Prior to that, he spent eight years at S&P, where he built a quantitative team to support the European structured finance business.

Structured credit veteran to head up Indian operations
Deutsche Bank has appointed Munish Varma as head of global markets India, responsible for the bank's sales and trading businesses in the country. He will report locally to Gunit Chadha, ceo of Deutsche Bank in India, and regionally to Loh Boon Chye, head of global markets Asia ex-Japan.

Varma moves over from Deutsche Bank in London, where he was head of global principal finance Europe, responsible for illiquid asset trading and principal investments undertaken by the bank in the region. He first joined Deutsche following the merger of Banker's Trust in 1999 and was instrumental in setting up its credit structuring business, covering asset repacks and synthetic CDOs.

Varma takes over from Pavan Sukhdev, who is taking a sabbatical from Deutsche Bank to focus on his work in environmental economics and conservation.

Trader hired for Middle East sales
Kelly Holloway has joined Jeffries as a svp in the firm's fixed income group, where he will focus on selling and trading US agency bonds, corporate bonds, MBS and other fixed income securities for institutional investors based in the Middle East. He joins Jeffries from Vining Sparks, a regional broker-dealer based in Memphis. He most recently focused on selling US agency bonds, corporate bonds and MBS to foreign banks, principally in Eastern Europe and the Middle East.

Canadians recruiting in credit
RBC and Scotiabank are understood to be beefing up their staff in correlation, sales and credit research in London, New York and Asia.

Structured credit portfolio gets capital injection
Following the completion of a competitive bidding process, a fund arranged by Cerberus Capital Management will invest US$1.1bn in CIBC's legacy structured credit runoff portfolio. CIBC will retain 100% of the potential upside on the portfolio following repayment of the notes, but won't provide any of the financing or any performance guarantee. Interest and principal payments on the senior notes will be paid from the portfolio only if the RMBS and ABS CDOs perform.

CDS clearing facility prepped
CME Group and Citadel Investment Group are planning to launch the first electronic trading platform that is fully integrated with a central counterparty clearing facility for CDS. CME Clearing will be the central counterparty for the joint venture.

The new platform will operate as an independent organisation with its own board of directors and management team. CME Group and Citadel have invited major CDS market participants to join as founding members by allocating up to 30% of the equity in the venture and by offering certain market-maker privileges to those founding members. The equity and market-maker incentives are designed to encourage participants to both migrate existing positions and to trade new CDS contracts on the platform.

The joint venture has also entered into preliminary licensing discussions with Markit regarding its CDS indices and RED database.

TARP manager selection procedure announced
The US Treasury has released procedures that it will follow in selecting asset managers for the portfolio of troubled assets purchased under TARP. Treasury will select asset managers of securities separately from asset managers of mortgage whole loans.

Asset managers will be financial agents of the US, and not contractors. As financial agents, they will have a fiduciary agent-principal relationship with the Treasury, with a responsibility for protecting the interests of the US. Financial institutions are eligible to be designated as financial agents of the US.

Primus Financial works to address ratings
Following the downgrade of its counterparty ratings by Moody's, Primus Financial has agreed with the agency to limit trading activities while it works on a plan addressing its current ratings profile. The company will continue to collect quarterly premium payments on its credit swap portfolio from its counterparties. The average remaining tenor on the portfolio is 3.5 years, while the total future premium receipts are in excess of US$300m.

Nomura to hire 150 Lehman FI staff
Nomura has announced that it intends to enhance the scale of its European fixed income division by hiring more than 150 former Lehman Brothers staff. The hires are in the flow and solutions businesses, and will add to Nomura's existing credit, interest rates and foreign exchange businesses. The fixed income businesses will continue to report to Zenji Nakamura, global head of fixed income.

JPMorgan to assist Syncora
JPMorgan has been engaged as an advisor to assist Syncora Guarantee in identifying and analysing strategic alternatives with respect to its portfolio of CDS and financial guarantee contracts. The bank will work directly with Syncora's legal advisors during negotiations with Syncora Guarantee's CDS and financial guarantee bank counterparties.

"Engaging JPMorgan to assist Syncora's legal advisors in their ongoing analysis of Syncora Guarantee's CDS and financial guarantee exposures is an important step in moving forward with the next phase of our strategic plan. Their expertise will help to identify and quantify the best possible solutions with our bank counterparties and aid Syncora in reaching a resolution that is in the best interest of our policyholders and our shareholders," comments Susan Comparato, acting ceo of Syncora.

On 5 August Syncora entered into an agreement with 17 bank counterparties to commute, terminate, amend or restructure existing CDS and financial guarantee contracts, including those related to Syncora Guarantee's ABS CDO insured portfolio (see SCI issue 99).

Law firm hires two
Kenneth Yellen and Demetrios Xistris have joined law firm O'Melveny & Myers' investment funds and securitisation practice. Yellen joins the firm's Washington, DC office as partner, while Xistris joins its New York office as senior counsel.

Daniel Passage, a partner at O'Melveny, says: "Our clients continue to demand more assistance with completing, analysing and, in some cases, unwinding very complex transactions."

Yellen's practice focuses on structured finance and securitisation, and his experience includes the representation of issuers, underwriters, placement agents, collateral managers and other market participants in connection with CLOs, CDOs, derivative securities, repackaged securities and other structured financial products. Prior to joining O'Melveny, he was a partner with McKee Nelson.

Xistris spent 15 years as md at JPMorgan, BNP Paribas and - most recently - Société Générale, heading the in-house legal teams advising the banks on all equity and equity derivatives activities. He has significant experience with all other derivative asset classes and with master netting and trading agreements and collateral documentation, and he has worked on a number of derivative and financial products business line acquisitions.

As O'Melveny pursues the goal of growing its investment funds and securitisation practice across all geographies, it also continues to search for additional partners with experience in all areas of finance for its New York, London and Asia offices.

Sigma receivers appointed
Ernst & Young have named the receivers of Sigma Finance. They are: Alan Robert Bloom, Margaret Elizabeth Mills and Stephen John Harris. According to a statement, once the receivers have reviewed the situation they will provide more detail in respect of the timetable for the company to provide further information on its immediate strategy.

Omicron manager ratings withdrawn
Fitch has removed its CDO asset manager ratings on Omicron Investment Management. Before removing the rating, Fitch also downgraded Omicron's CAM2 asset manager rating to CAM2 minus. Fitch will no longer provide ratings or analytical coverage on Omicron's CDO asset management activities.

The downgrade is driven primarily by the corporate instability that resulted from Omicron's restructuring and consolidation with Aurelius Capital, as well as Calyon's diminishing support for its fully owned subsidiary, Omicron, following its withdrawal from the structured credit business. The rating action also reflects the significant industry challenges facing Omicron and Aurelius in preserving and diversifying both their business franchise and client base to ensure long-term financial and business viability in extremely challenging market conditions.

However, the agency views positively the successful actions taken by new management of Aurelius to address staffing, profitability, operational and other transitional issues experienced during the consolidation, which is now largely completed. While they continue to be separate legal entities, Omicron and Aurelius now operate a common CDO management platform that shares processes, staff and most of the technology used by the two entities. Fitch believes that the combination of Omicron and Aurelius generated immediate economies of scale and increased the critical mass of operations, thereby strengthening, but not ensuring, their longer-term viability.

Numerix promotes Nakamura
NumeriX has promoted Yukiko Nakamura to md of the NumeriX Tokyo office. Nakamura, previously vp of business development for the Asia Pacific region, will oversee the company's operations in Japan and Korea.

She brings over 12 years of experience in the derivatives and structured products markets and front office systems to her new position. Most recently, she has held roles at Calypso, Sophis and Mysis.

AIG mulls alternatives for financial products arm
AIG says it is actively at work on a number of alternatives for its Financial Products business and its securities lending programme. The firm has indicated its intent to refocus the company on its core property and casualty insurance businesses, generate sufficient liquidity to repay the outstanding balance of its loan from the New York Fed and address its capital structure.

AIG plans to retain its US property and casualty and foreign general insurance businesses, and to retain a continuing ownership interest in its foreign life insurance operations. AIG's worldwide property and casualty businesses generated approximately US$40bn in revenues in 2007. The company is exploring divestiture opportunities for its remaining high-quality businesses and assets.

AC & CS

GSE auction surprises market

A round up of this week's structured credit news

GSE auction surprises market
The first stage of the FNM/FRE auction process has completed with somewhat unexpected initial results, according to analysts at Credit Derivatives Research. In both cases, the subordinated debt recovered more than the seniors and - for the first time in auction history - the net open interest has been to buy rather than sell bonds.

It appears that, given the significant disparity between senior and sub open interest, the majority of subordinated protection buyers opted for cash settlement, while in seniors it was a little more balanced. "We guess the disparity might be due to the number of index-driven FNM/FRE senior positions, which potentially are easier to allow to cash settle (since many investors may not be heavily involved in single-name analysis), whereas the sub open interest may reflect the senior-sub trades that many more sophisticated investors had on (with no natural protection seller on the other side of the subs trade)," suggest the analysts.

Structured credit strategists at Citi add that the auction was widely expected to be 'offered' and, along with the deliverability of structured credit assets, many investors were expecting a low recovery level. Protection buyers are thought to have been advised to maximise their returns by choosing cash settlement over physical, with the result that physical settlement ended up falling below expectation, thus turning the auction 'bid'.

The auction prices were decided as follows: 91.51% for FNM seniors (net open interest to buy US$12m); 99.9% for FNM subs (net open interest to buy US$608m); 94% for FRE seniors (net open interest to buy US$79m); and 98% for FRE subs (net open interest to buy US$542m). A record 651 organisations adhered to the ISDA Protocol and 13 dealers participated in the auction.

Fannie Mae subordinated protection buyers suffered in the short squeeze, according to the Citi strategists, with their contracts expiring virtually worthless (settlement of one cent in the dollar). "Freddie Mac subordinated protection buyers will also be disappointed with their final price of 98," they note. "Subordinated CDS trade in much smaller volumes than senior CDS contracts, but such skewed final prices will not increase confidence in credit derivatives at a time when confidence is low."

Auctions on Lehman Brothers and Washington Mutual are scheduled for 10 and 23 October. It isn't yet clear whether the receivership of Iceland's Landsbanki could also trigger a CDS event.

Fed launches CPFF
The US Federal Reserve has established a Commercial Paper Funding Facility (CPFF) to complement its existing credit facilities that help provide liquidity to term funding markets. The CPFF will provide a liquidity backstop to US issuers of CP through an SPV that will purchase three-month unsecured and asset-backed CP directly from eligible issuers.

The Federal Reserve will provide financing to the SPV under the CPFF and will be secured by all of the assets of the SPV and, in the case of CP that is not asset-backed, by the retention of up-front fees paid by the issuers or by other forms of security acceptable to it in consultation with market participants. The Treasury believes this facility is necessary to prevent substantial disruptions to the financial markets and the economy, and will make a special deposit at the Federal Reserve Bank of New York in support of this facility.

By eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing CP obligations, this facility should encourage investors to once again engage in term lending in the commercial paper market, the Fed says. Added investor demand should lower CP rates from their current elevated levels and foster issuance of longer-term CP. An improved CP market will enhance the ability of financial intermediaries to accommodate the credit needs of businesses and households.

The Fed has also increased the size of its term auction facility to US$150bn.

Correlation assumptions revised
S&P has revised certain correlation assumptions it uses to rate global CDOs and CDS that have exposure to financial intermediaries, reflecting its views on the effects of the recent consolidation and greater observed interdependence of institutions within the financial services sector over the past few months. The revised assumptions were developed jointly between the agency's financial institutions and structured finance CDO groups after evaluating the characteristics and expected performance of the institutions operating in this industry.

S&P believes that, for purposes of its correlation assumptions, it is no longer appropriate to classify brokers, dealers and investment houses as a distinct and separate industry from other financial intermediaries. The recent events affecting these entities, including mergers between banks and brokers/dealers and two leading US brokers/dealers choosing to become bank holding companies, combined with the lack of asset differentiation and the high level of interdependence that exists among banks, brokers/dealers and investment houses, indicate that these market segments should be classified as a single industry. Accordingly, the agency now classifies all brokers, dealers and investment houses in the financial intermediaries category.

As a result of changes to the economic drivers and competitive landscape that have occurred over time in the financial intermediaries industry, S&P believes asset co-dependence and behaviour has increased in this sector. Therefore, it has increased its asset correlation assumption among financial intermediaries to 0.25 from 0.15, regardless of the region where they operate.

The new financial intermediaries' classification assumes that these entities are affected not only by regional changes in the economic environment, but also by global changes. Accordingly, this modification also eliminates the diversification effects on S&P's analysis of CDOs and CDS that included financial institutions that operate in different geographical regions. When taken in aggregate for given rating categories, these changes should lead to higher credit enhancement levels in the agency's analysis of certain transactions exposed to financial institutions.

LevX documentation revised ...
ISDA has released a revised template for CDS referencing the iTraxx LevX index, incorporating provisions for auction settlement following a credit event and bringing the European documentation in line with the North American LCDS documentation in this regard.

"Market participants have seen the benefit of auction settlement in the North American Loan CDS market and in senior unsecured CDS and were keen to incorporate it into this product. ISDA is pleased to be able to respond to this and to have facilitated the continued evolution of this market," says David Geen, ISDA general counsel.

The 'ISDA iTraxx LevX Standard Terms Supplement for Use with Credit Derivative Transactions on Leveraged Loans' is designed to document CDS transactions where the reference obligation and the deliverable obligation are a European syndicated secured loan listed in the index. The form is primarily intended for use in the European market.

ISDA has also published a revised version of the single name 'Standard Terms Supplement for Use with Credit Derivative Transactions on Leveraged Loans'. This template has been updated to include auction settlement on the same terms as the index version, providing consistency for those entering into single name LCDS trades on reference obligations that are listed in the index.

...while LCDX index roll postponed
The Markit LCDX index roll into Series 11 has been postponed pending the launch of a market standard non-cancellable single name LCDS contract. LCDS dealers are designing such a contract to enhance liquidity by eliminating uncertainty linked to the cancellability of the current market standard contract (see SCI issue 93). If and when market participants agree on a market standard non-cancellable single name LCDS contract, Markit will integrate the language and characteristics of this contract into the LCDX.

IMF raises loss estimates
The IMF's latest Financial Stability Report substantially raises its estimate of potential financial sector write-downs and mark-to-market losses from US$945bn to US$1.4trn. The increase in estimated losses was predominantly in US unsecured loans (prime up US$40bn to US$85bn, commercial real estate up US$60bn to US$90bn and corporate loans up US$60bn to US$110bn), ABS CDOs (up US$50bn to US$290bn) and corporate debt (high grade to US$130bn from zero and high yield from US$30bn to US$80bn). However, CMBS losses were revised lower from US$210bn to US$160bn.

The report estimates that banks will bear US$725bn to US$820bn of the total estimated losses, with pension funds bearing US$125bn to US$250bn, insurance funds US$160bn to US$250bn, GSEs and government US$100bn to US$135bn, and others, including hedge funds, US$115bn to US$225bn.

SIV senior debt placed on review by Moody's ...
Moody's has placed on review for downgrade the ratings of eight MTN programmes, with a total nominal amount of approximately US$19bn, from four bank-sponsored SIVs - Carrera Capital Finance, Harrier Finance Funding, Kestrel Funding and Links Finance. The rating action was prompted by the fact that both the market value and credit quality of the portfolios, as well as the ratings of sponsoring financial institutions have been weakened by prevailing market conditions.

The agency notes that the current status of SIVs can be characterised under four categories: vehicles in enforcement (Axon, Cheyne, Orion, Rhinebridge, Victoria, and Whistlejacket/White Pine); senior debt repaid or cash collateralised (Asscher, Cortland, Cullinan, Hudson Thames, PACE, Tango and Vetra); restructured by sponsoring bank through provision of liquidity and/or repo facilities (Carrera, Harrier, K2, Kestrel, Links, Nightingale and Parkland); and restructured by sponsoring bank through mezzanine capital injection (Beta, Centauri, Dorada, Five, Sedna and Zela). This rating action affects certain SIVs whose sponsors provided liquidity facilities, rather than cash injection, as a means of support.

Portfolio market values have continued declining for almost all types of debt instruments. At the same time, financial institutions ratings have been adjusted in certain circumstances, as a result of these unprecedented market conditions. Moody's review will focus on the sponsors' ability and willingness to provide additional liquidity support to the affected SIVs, as well as the market value of assets in their portfolios.

... Fitch ...
Fitch has placed the senior notes of Five Finance, Beta Finance and Sedna Finance on rating watch negative. The actions reflect the continued decline in the market value of the SIVs' portfolios, the continuing closure of the funding markets and the recent negative action taken on Citi.

Citi has supported the SIVs that it manages by providing mezzanine capital to enhance the vehicles' mark-to-market overcollateralisation (defined as the market value of the capital divided by the portfolio credit exposure); currently, this is approximately 8%. The ratings of the SIVs are thus partially and increasingly credit-linked to Citi's willingness and ability to provide continued credit and liquidity support.

Fitch does not expect to resolve the RWN until the rating on Citi has been resolved. The agency expects that the resolution of the SIVs' RWN will be in the double-A category.

... and S&P
S&P has placed on credit watch with negative implications its ratings on the senior debt issued by Nightingale Finance. At the same time, it placed the vehicle's issuer credit rating on watch negative and kept the rating on its income notes on watch negative.

Earlier this year, Nightingale secured 100% support from AIG Financial Products to cover the senior obligations. Following S&P's rating action on AIG Financial Products, to A-/Watch Neg from A-/Watch Dev on 3 October 2008, the agency is reviewing the support provided to see whether there are any rating implications for the SIV.

Although the ratings on Nightingale could be affirmed if Banque AIG (as manager) puts in place a suitable plan, S&P does not rule out the possibility of lowering its ratings by more than one notch.

Cortland ratings withdrawn ...
Moody's has withdrawn its ratings on the senior debt programmes of Cortland Capital, following the vehicle's decision to wind down. All outstanding senior debt of the company has been repaid in full, using proceeds of asset sales executed between August 2007 and March 2008.

... while Theta is downgraded
Moody's has downgraded Theta Corp's triple-A counterparty rating to Aa2 (on review) and placed the vehicle's MTN and CP programmes on review for downgrade. The rating actions are the result of significant deterioration in the credit quality of Theta's CDS reference portfolio and a breach in one of its liquidity tests.

In particular, through its portfolio of reference obligations, Theta has credit exposure to Lehman Brothers Holdings Inc and Washington Mutual. Due to these credit events, the vehicle has breached one of its liquidity tests, which - if not cured - will result in an automatic enforcement. An enforcement event would lead to a move of management control to the security trustee and effectively result in a wind-down of Theta.

Moody's rating actions also take into account current stressful market conditions. Theta may need to liquidate portions of its bond portfolio to meet CDS credit event payments as they arise. But the unprecedented illiquidity in the market for asset-backed and financial securities may affect its ability to liquidate assets without crystallising additional losses to its capital.

Primus ...
Moody's has downgraded and kept on review the counterparty rating of Primus Financial Products from Aaa to Aa1, as well as the senior unsecured and issuer ratings of Primus Guaranty from Baa1 to Ba1. The rating actions are the result of significant deterioration in the credit quality of Primus Financial's CDS reference portfolio; in particular, recent credit events have resulted in the company not being adequately capitalised in respect of its previous ratings. Furthermore, it has failed its counterparty capital shortfall test and has substantial exposure to the financial sector, which is currently experiencing significant stress.

Moody's says that the downgrade reflects the substantial credit deterioration at Primus' main operating company, Primus Financial Products, and the adverse effect on its ability to generate incremental revenues. The rating agency adds that stress at Primus Financial may also weaken the holding company's financial flexibility and create substantial uncertainty about the group's strategic direction. Such adverse developments are only partially mitigated by the current strong liquidity position at the holding company.

... and Athilon downgraded
Fitch has downgraded CDPC Athilon from triple-A to double-A, and has also downgraded seven classes of deferrable interest notes. In addition, a negative rating outlook has been assigned to Athilon's Issuer Default Ratings (IDRs).

The actions are the result of exposure to two structured finance CDOs for which Athilon sold protection to counterparties. These transactions have experienced significant negative ratings migration in their underlying collateral assets.

Sigma-backed CDOs downgraded
S&P has lowered and placed on watch negative its credit ratings on nine synthetic CDOs issued by the C.L.E.A.R. vehicle. At the same time, Moody's downgraded the ratings of Series 48, 49 and 61 notes - worth Y6.5bn - issued by the same vehicle. The actions reflect the recent downgrade of the underlying collateral - the debt issued by Sigma Finance Corp - which the issuer purchased using note proceeds in each transaction.

Tembec settled
The credit event auction to facilitate the settlement of credit derivative trades referencing Tembec Industries was completed this week. The final price was fixed at 83%. On 6 October, Markit and Creditex will be conducting four credit event auctions in relation to the settlement of CDS contracts referencing Fannie Mae and Freddie Mac.

US$7.2bn US CDOs downgraded...
S&P has lowered its ratings on 38 tranches, representing a total issuance amount of US$7.2bn, from 13 US cashflow and hybrid CDO transactions. The downgrades reflect a number of factors, the agency says, including credit deterioration and recent negative rating actions on US sub-prime RMBS.

At the same time, S&P removed 16 of the lowered ratings from watch with negative implications and placed two additional ratings from two transactions on watch with negative implications. The ratings on 16 of the downgraded tranches are on watch with negative implications, indicating a significant likelihood of further downgrades. The credit watch placements primarily affect transactions for which a significant portion of the collateral assets currently have ratings on watch with negative implications or have significant exposure to assets rated in the triple-C category.

Seven of the 13 affected transactions are mezzanine ABS CDOs, which are collateralised in large part by mezzanine tranches of RMBS and other structured finance securities. Six of the 13 transactions are high-grade ABS CDOs, which were collateralised at origination primarily by triple-A through to single-A rated tranches of RMBS and other SF securities.

To date, S&P has lowered its ratings on 3,857 tranches from 873 US cashflow, hybrid and synthetic CDO transactions as a result of stress in the US residential mortgage market and credit deterioration of US RMBS. In addition, 1,334 ratings from 464 transactions are currently on watch with negative implications for the same reasons.

... and European CSOs impacted
S&P has taken various rating actions on a total of 43 European synthetic CDO tranches. The rating actions reflect a change in the rating of a dependent entity in the transaction - either a transaction party or an underlying collateral or obligor.

The breakdown of these rating actions is as follows:

• Ratings were lowered on three tranches;
• 17 ratings were placed on watch with negative implications;
• 10 ratings were placed on watch with developing implications;
• One rating was removed from watch negative and lowered;
• The ratings on three tranches were lowered and placed on watch negative;
• Five ratings were lowered and placed on watch developing;
• One rating was lowered and remains on watch negative;
• Two ratings were placed on watch positive; and
• The rating on one tranche was withdrawn.

BoE broadens repo collateral range
The Bank of England is extending its collateral repo operation and will broaden the range of eligible repo collateral. Included in the updated list of eligible collateral is the most senior triple-A rated tranche of UK, US and EEA: prime ABS (backed by student loans, consumer loans, auto loans and certain equipment leases); CMBS (excluding construction loans); and securitised portfolios of senior secured or on-balance sheet corporate loans (leveraged loans aren't permitted); as well as covered bonds where the underlying assets include commercial mortgages and highly rated ABCP.

Synthetic deals remain ineligible, as do those transactions that have obtained a higher rating due to a wrap. Eligible assets may be denominated in sterling, euro, US dollars, Australian dollars, Canadian dollars, Swedish krona or Swiss francs.

Japanese SROC results released
S&P has placed its ratings on 23 tranches relating to 18 Japanese synthetic CDO transactions on credit watch with negative implications. The affected tranches had SROC levels that fell below 100% during September's month-end run.

LBDP/LBFP counterparty ratings downgraded
Moody's has downgraded the counterparty ratings of both Lehman Brothers Derivative Products and Lehman Brothers Financial Products to Baa3 with direction uncertain from triple-A. The rating actions are the result of the voluntary bankruptcy filings of both entities on 5 October and the expectation that they will be unable to make scheduled payments as a result of the automatic stay caused by the bankruptcy filings.

Although both LBDP and LBFP are currently sufficiently capitalised to make scheduled payments, there is uncertainty as to when they will be made as a result of the bankruptcy proceedings, Moody's says. Factors such as the lifting of the automatic stay could have a positive impact on the ratings. Conversely, negative rating action may be warranted if there is a significant delay in issuing the payments or the capitalisation of LBDP and LBFP becomes inadequate.

CRD changes draw closer
The European Commission has firmed up its proposed changes to the Capital Requirements Directive, amongst which is a measure to improve risk management for securitised products. Originators will be required to retain some risk exposure to these securities, while firms that invest in the securities will be allowed to make their decisions only after conducting comprehensive due diligence. If they fail to do so, they will be subject to heavy capital penalties.

Lehman impacts CPDO
Moody's has downgraded the rating of the €135m Series 2007-2 note of the Ulisse Capital CPDO issued by Ruby Finance from Ba3 to Ca. The transaction is exposed to Lehman Brothers due to Lehman Brothers Special Financing being total return swap counterparty and Lehman Brothers Bankhaus being the deposit provider on the transaction. LBSF payments under the TRS are guaranteed by Lehman Brothers Holdings Inc.

CS & AC

Trading ideas: luxury tax

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at an outright short on Toll Brothers Inc

America awoke to the realities of the intersection between Wall Street and Main Street last week. With too-many-to-count references to the Great Depression and quotes from FDR, it is safe to believe that demand for higher end products will drop.

Toll Brother's bills itself as 'America's Luxury Home Builder', and that may be so; however, given the extreme unpopularity of option ARMs and rising jumbo loan rates, its homes are even more out of reach than before. Toll Brothers, after write-downs and impairment charges, has not generated positive earnings in multiple quarters.

Even with a solid cash position and cashflow generation, we believe Toll will be under continued pressure from shareholders as revenues continue to slide and earnings become more negative. Our quantitative credit model shows Toll's credit spread to be trading 300bp too tight, due to a high implied default probability, disappearing margins and poor interest coverage levels. We recommend buying protection on Toll Brothers.

Luxury tax
Toll Brother's financial situation is an interesting one. It has plenty of cash saved up for a rainy day (more than US$1.5bn in cash or cash-like instruments) and has also generated positive cashflow during tough times. However, we must also remember that that Toll sits on US$4.5bn of land/inventory and is having a difficult time selling what it owns for more than cost. Toll's revenues have dropped consistently since 2007.

Given the credit freeze, mortgage origination will continue to be a difficult task as there are not many buyers for MBS securities. Since Toll Brother's builds luxury homes which are on the more expensive side, many buyers used option ARMs to afford them; yet those products caused severe damage to many financial firms (Wachovia and WaMu) and are no longer available to assist the potential buyer.

The average national jumbo 30-year fixed rate has risen throughout 2008 (see Exhibit 1). This offsets a good portion of the drop in housing prices when looked at from an affordability standpoint.

Exhibit 1

We expect Toll Brother's revenues to decline even more in the coming quarters (if not years). This will put severe pressure on earnings, as write-downs continue.

Toll Brothers Inc has loans payable of US$731m, a US$350m subordinated note due in 2011 and its subsidiary Toll Brothers Finance Corp (a 100% owned, indirect subsidiary) is the issuer of four series of senior notes totalling US$1.15bn. Toll Brothers guarantees the bonds fully and unconditionally. With a US$1.3bn open revolving credit facility at its disposal, we do not believe Toll is at risk for an immediate bankruptcy.

However, we do not think that a credit spread of only 240bp represents the company's actual credit risk, assuming the housing and credit markets do not turn around within the next three to six months. Over the next few quarters we expect its spread to widen substantially.

Market-implied risk
Our quantitative 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 Toll Brothers. We see a 'fair spread' of 571bp for its extremely weak equity-implied default probability, implied volatility, margins, leverage and interest coverage factors.

Exhibit 2

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).

Toll Brother's spread compensation dropped recently, as homebuilder credit spreads have enjoyed a brief rally in the midst of the market meltdown (Exhibit 3). 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 Toll Brothers.

Exhibit 3

Meltdown rally
After finding trades that make fundamental sense, we also like to ensure that the 'technicals' point in the same direction. Though fundamentals dominate price discovery in the long run, the market can remain irrational as long as it needs to.

The CDS spread for Toll Brothers' has tightened to 240bp from its yearly wide of over 350bp during what must be the greatest credit crunch ever. We do not believe its CDS will trade any tighter than current levels, given the dire outlook for housing (Exhibit 4). Therefore, we see limited downside for the trade and significant widening potential, given the economic uncertainty.

Exhibit 4

Risk analysis
This trade takes a short position in Toll Brothers' five-year CDS. The trade has negative carry and negative roll down which must be offset by spread widening. Entering and exiting any trade carries execution risk and TOL's liquidity is good in the CDS market at the five-year tenor.

Summary and trade recommendation
America awoke to the realities of the intersection between Wall Street and Main Street last week. With too-many-to-count references to the Great Depression and quotes from FDR, it is safe to believe that demand for higher end products will drop.

Toll Brother's bills itself as 'America's Luxury Home Builder', and that may be so; however, given the extreme unpopularity of option ARMs and rising jumbo loan rates, its homes are even more out of reach than before. Toll Brothers, after write-downs and impairment charges, has not generated positive earnings in multiple quarters.

Even with a solid cash position and cashflow generation, we believe Toll will be under continued pressure from shareholders, as revenues continue to slide and earnings go more negative. Our quantitative credit model shows Toll's credit spread to be trading 300bp too tight, due to a high implied default probability, disappearing margins and poor interest coverage levels. We recommend buying protection on Toll Brothers.

Buy US$10m notional Toll Brothers Inc 5 Year CDS protection at 245bp.

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).