Contents

Investors

Enhanced services?

Volatility drives CDO valuations in-house

Some valuations software providers appear to have been caught out by recent volatile market conditions. While increasing numbers of end-users are consequently choosing to value their CDO portfolios internally, some investors are opting for enhanced data services to complement standardised tools.

A survey on OTC valuations undertaken by research firm A-Team Group has uncovered some dissatisfaction with the performance of established software vendors in recent months. "There were complaints about pricing being dropped without warning, a deterioration in quality in key areas such as the MBS/ABS markets, and a lack of transparency and explanation when asked to justify their pricing by users. Many respondents felt that the vendors lacked the expertise and tools to cope with volatile market conditions," says the report's author Ian Blance.

Julius Finance ceo Peter Cotton confirms that the extreme moves the market has seen recently demonstrate that some vendor frameworks are lacking. Even in normal times, however, most solutions don't map to cashflow analysis and are unable to be verified against an average over different scenarios. For example, the base correlation framework is a series of rules for assigning a price, but is not a model in the usual sense of 'Finance 101'.

"While some vendors, such as Quantifi and Numerix, have expanded their models beyond the traditional one-factor Gaussian copula framework [see SCI issue 103], vendors are in general pretty reactive. So it's not surprising that more and more people are choosing to use their own internal models," Cotton adds.

According to Eugene Yeboah, who was until recently head of credit structuring at Schroders, while software vendors obviously have technical and quantitative skills, they don't typically have strong fundamental backgrounds and so miss the elemental point. "There are currently two issues driving valuations modelling," he says. "First, if current market volatility is factored in, it would blow the model out of all proportion. Second, there is currently no way of quantifying the liquidity issue: few investors are actually willing to buy assets at the moment, which is causing values to go haywire."

As such, the only remedy is to try to get a sense of what's driving the underlying. Using MBS as an example, one way of doing this is to analyse the probability of the underlying mortgage holders paying their mortgages. So if, say, 50% of borrowers are likely to continue paying, the portfolio can essentially be marked at 50%.

The A-Team Group survey also highlights that, as a general trend, the more complex and/or illiquid the asset priced, the less likely firms are to use an independent valuations provider. "These trends are likely to reflect in part the established nature of vanilla bond coverage from the mainstream valuations vendors and the lack of coverage of more complex assets. It will be interesting to see whether the large data providers will respond to this or whether the more specialist suppliers coming into the market will find acceptability," comments Blance.

As mark-to-market analysis is currently virtually impossible, valuations have to be arrived at internally based on cashflow analysis. "Valuation models seemed to work in normal market conditions, but it appears that in stressed conditions increasingly more people are using their own models to drive risk management and regulatory capital reporting. There is also a time factor at play, in that managers need to get a sense of the value of their holdings in order to position themselves for government capital infusions or to establish investor confidence," Yeboah notes.

Nevertheless, it remains challenging for firms to come up with an internally consistent model for pricing synthetic CDOs - however obvious the breakdowns of the standard base correlation framework are. Consequently, notes Cotton, some investors are opting for enhanced data services, whereby additional data points can be used to complement standardised tools. The enhanced data is created using more advanced and internally consistent models, which firms are reluctant to invent, build or maintain themselves.

Eventually there will be a democratisation of risk, whereby investors become more risk aware and begin asking asset managers to explain the steps/inputs entailed in valuing their portfolios without introducing any unnecessary complexities, concludes Yeboah. "This will depend on investors better understanding the risk and the underlying cashflows."

CS

Regulation

Fears lessen

Government interventions to have positive implications for CDOs

Government initiatives announced over the past week are widely expected to have a positive effect on the CDO market. While counterparty risks should be effectively neutralised by government guarantees, fears over mass selling of assets into the secondary market from distressed banks have been eased - which should in turn result in spreads tightening.

Generic spreads for triple-A CLO paper were quoted as high as 500bp over the past week, having been seen at 200bp just last month. But, according to Alex Mallinson, a CDO trader at RBS, those levels are not representative of the market.

"To say that the market for triple-A CLOs is at 300bp or 500bp is meaningless," he says. "Our market has been drifting wider because of a trickle of forced sellers, usually in small volumes, which are resulting in crazy prices. The vast majority of investors are certainly not interested in offloading anything at this level."

However, Mallinson believes that the government interventions should have a positive impact on this part of the market. "Over the past year we've seen forced selling in mezzanine CLOs from the French and German funds, while the triple-As came from SIVs. Banks remained the big question mark, because if they had to start offloading into the secondary, who knows where spreads would have gone," he comments.

He adds: "But now the banks are on firmer ground there is no immediate rush for them to sell off assets. They may still want to de-lever, but they are not going to do so at levels currently being talked about," he comments.

Meanwhile, measures announced by the Spanish government (see News Round-up) are expected to result in a relatively small amount of new money that is able to pick up triple-A rated SME CLOs and RMBS.

Ganesh Rajendra, head of securitisation research at Deutsche Bank, says the revaluation of bank credit quality is a clear positive for securitisations, given that seller and/or counterparty-related risks (which were considerable in the recent past) are effectively neutralised for now. "We therefore expect securitised bonds to ultimately trade tighter off the back of this bailout plan," he says.

Additionally, CDO analysts at Merrill Lynch suggest that UK government agreements with participating banks aimed at maintaining lending to individuals and SMEs should mitigate the impact of frozen securitisation markets on lending volumes. "As a result, refinancing opportunities for individuals and SMEs should continue to be available, supporting the performance of collateral pools in existing securitisations," they note.

However, primary issuance is unlikely to pick up any time soon, as banks aren't incentivised to issue anything other than vanilla debt that is guaranteed, if not endorsed, by governments. "Retained deal flow is also likely to decline from early next year as the ECB repo rules become more restrictive and the BoE's SLS terminates - though some of this may be replaced by direct government purchases of securitised assets, such as that announced in Spain," concludes Rajendra.

AC

Trading

Switching focus

Triple-A compression trades set to find favour

European CDS spreads have, in general, tightened on the back of the global bailout of the banking sector - albeit activity currently appears to be limited to single name hedging. However, with investors now focusing on the future of the real economy rather than financials, triple-A compression trades could be one area of opportunity in coming weeks.

"European bank CDS spreads have rallied strongly over the last week, as the part-nationalisation of the banking sector got underway. Most names are trading up on the basis that they're too big to fail - indeed, it's difficult to imagine any large bank defaulting now," says one London-based CDS trader.

He adds: "It had been difficult to trade anything because all markets were softer due to liquidity issues. However, there has been increased focus recently on single name hedges on specific financial names, driven by volatile market conditions."

Following the global bailout of the banking sector, investor attention has switched from financials to non-financials and the real economy, which is in turn impacting corporate correlation. "When liquidity dried up in CLOs and ABS, the corporate correlation market remained open and you could still trade out of your positions - albeit you may take a mark-to-market hit," explains another CDS trader.

He continues: "While that is one positive for the sector, until the market sees the bottom and corporate defaults come to an end, many investors will be discouraged from entering. Super-senior paper still offers good value, for example, but spreads are unlikely to begin tightening any time soon and so everything depends on timing."

Structured credit strategists at RBS nonetheless recommend two alternative trades to take advantage of current market conditions: selling €11m of PERMA triple-A five-year CDS at 280bp and buying €10m of iTraxx HiVol five-year protection at 262bp (the notional ratio enables the trade to be spread beta neutral at inception); and buying €10m of European triple-A CLO paper at 300bp discount margin and buying €10m iTraxx HiVol five-year protection at 262bp. "We have been waiting for a while for the right conditions for a 'structured' triple-A spread compression versus high beta corporates to commence - in other words, a reversal of the last 12-18 months' price action," says Gregorios Venizelos, structured credit strategist at the bank.

One factor driving this rationale is the market's focus on the potential length and depth of the recession, and consequently on corporate credit fundamentals. In particular, refinancing concerns for non-financial corporates is likely to take centre stage as credit remains scarce and expensive.

The other factor is that triple-A spreads across structured finance/credit assets have been widening to fundamentally irrational levels as the stresses in global financial markets and de-risking technicals have overwhelmed the market. But concrete governmental/central bank support should now act as a positive catalyst towards stopping this downward spiral, leading to a sustainable retrenchment in certain default-remote structured triple-A spreads.

Venizelos explains that PERMA CDS and CLO triple-As are fundamentally money-good structured assets, which have been technically driven to severe widening by forced selling on the back of rapid deleveraging. On the other hand, refinancing risk for non-financials will be particularly acute for higher beta credits and so the iTraxx HiVol index is a prime representative of such credits in Europe.

However, the main risk for both trades is that further forced selling may drive the spread dislocation between PERMA/AAA CLOs and HiVol yet wider. "While further forced selling can not be discounted, we think that the deterioration in corporate credit fundamentals will intensify, keeping potential further widening between PERMA/AAA CLOs and HiVol capped," Venizelos concludes.

CS

Structured credit team adds one

The latest company and people moves

Structured credit team adds one
Alexander (Lex) Maldutis has joined the structured credit team at HSBC as a senior correlation trader. He was previously at Bear Stearns, where he was a senior md and correlation trader.

CPIM hires ABS veteran
Cambridge Place Investment Management has appointed Stephen White as cio for Europe. White was previously at Morgan Stanley, where he was a md in the company's securitised products group, having joined the London office in 1996.

During that time, White was responsible for the distribution and syndication of all ABS and MBS across Europe. He was also appointed co-head of mortgage origination and execution.

A CPIM spokesperson says White's experience on the buy-side and sell-side, both in the US and across Europe, will be invaluable as the organisation develops products such as the Talisman/CPIM European Property Debt Opportunity Fund (Talisman/CPIM Fund).

The Talisman/CPIM Fund has been established to invest in a range of European CMBS, RMBS and other ABS asset classes and other forms of real estate financing to provide investors with the opportunity to benefit from the current market dislocations in Europe. The Fund has been seeded with capital commitments of €50m, will target a net return of between 12% and 15%, and has a closed ended five-year life.

Quant head moves
Richard Martin has joined AHL, where he will design credit strategies. He will report to Tim Wong, head of AHL. Martin was previously at Credit Suisse, where he was head of quantitative credit strategy.

ABX trader departs
Michael Boyle has left UBS, where he was an ABX trader.

Lehman global head appointed
Millennium Management has hired Michael Gelband to manage its global fixed income business. Gelband was formerly global head of capital markets at Lehman Brothers.

Gelband had been with Lehman Brothers from 1983 to May 2007. At Lehman he held several senior roles, including global head of fixed income from 2005 to 2007. Prior to that position, he was head of fixed income liquid markets, with responsibility for interest rate products, FX and securitised products.

In June 2008, he returned to Lehman to head the entire capital markets business as part of Lehman's effort to deal with the financial crisis.

Capital markets head hired
Standard Chartered has appointed Christian Wait as global head of capital markets. He will be based in Singapore and report directly to Lenny Feder, group head of financial markets, and will join the financial markets' management committee.

Wait was previously at Lehman Brothers in New York and London, where he held positions including: European and Asian head of debt capital markets, global head of CDO and structured credit sales, global co-head of syndicate and global head of money markets. Most recently, he was global head of credit sales, based in New York.

At Standard Chartered Wait takes over from current interim co-heads, Deepak Kohli, global head of debt capital markets and Philip Cracknell, global head of syndications.

Wait will be responsible for all aspects of the bank's capital markets business and for continuing the expansion and deepening of coverage and products in newer markets across Asia, Africa and the Middle East. He will build on Standard Chartered's positions in loan syndications, local currency bonds and ABS across the bank's markets.

Fortis structured credit portfolio split
Under the new structure of Fortis announced earlier this week, Fortis will own 66% of its structured credit portfolio entity, while the rest will be held by the Belgian state (24%) and BNP Paribas (10%). The entity will contain a structured credit portfolio acquired from Fortis Bank with a carrying value of €10.4bn. It will be separately managed and is expected to be funded with €7.4bn external funding and €3bn equity.

Global CDS clearing house gains support
The Clearing Corporation, Markit Group, Risk Metrics and IntercontinentalExchange (through its subsidiaries ICE US Trust, Creditex and T-Zero) have signed a letter of intent to support a joint global CDS clearing solution that will accomplish the objectives established by the Federal Reserve Bank of New York. ICE Trust will operate as a New York limited trust company and function as global clearinghouse and central counterparty for CDS transactions as a member of the Federal Reserve System.

Meanwhile, Eurex Clearing separately announced that it has presented a CDS central clearing solution on invitation by the New York Fed, which received support from European authorities. Eurex intends to build a consortium structure aiming to provide shared governance and control. Initially, the exchange will offer a ready-to-use solution for iTraxx index contracts, as well as certain single name CDS products; CDX contracts will be added, subject to signing a license arrangement with Markit.

Primus to repurchase senior notes
Primus Guaranty is to use up to US$10m of available cash to repurchase its 7% senior notes due 2036, from time to time in the open market or in privately negotiated transactions at prices and upon terms approved by management.

EUROPACE closed
Hypoport has closed its loss-making 'EUROPACE for ABS investors' business, which had reduced the company's earnings before interest and tax by approximately €1m in the first half of this year. Write-downs on software development and provisions set aside to cover the termination of existing agreements will incur one-off charges of roughly €3m for the third quarter.

The company will continue to honour existing agreements with its ABS investor clients until at least the summer of 2009. The supervisory board of Hypoport Capital Market has also appointed Thomas Kretschmar as executive director with sole power of attorney.

Korea FI head appointed
Calyon has appointed Duke Choi as head of fixed income markets for Korea. He replaces Gin Lee, who has been promoted to senior country officer for Korea.

Based in Korea, Choi will report locally to Lee, and regionally to Arnold Kan, regional head of sales and deputy head of FIM for Asia ex-Japan. He will be responsible for overseeing the Korean fixed income markets business, including interest rate derivatives, foreign exchange, commodities, debt and credit markets and treasury.

Choi joins Calyon from Mizuho Corporate Bank in Korea, where he was country head of treasury.

AC & CS

Lehman net funds transfer estimated

A round up of this week's structured credit news

Lehman net funds transfer estimated
The final price determined by the Lehman Brothers credit event auction was 8.625%, with 14 credit derivative dealers participating. Payment calculations so far performed by the DTCC Trade Information Warehouse relating to the Lehman Brothers bankruptcy indicate that the net funds transfer from sellers to buyers of protection is expected to be around US$6bn.

The DTCC has refuted what it terms "inaccurate speculation" on a number of issues, including the overall size of the CDS market, the role of CDS in the mortgage crisis and the size of potential payment obligations relating to Lehman Brothers. "The extent to which such speculation has fuelled last week's market

DTCC also points out that less than 1% of CDS contracts currently registered in the Warehouse relate to RMBS. While mortgage-related CDS index products have some components relating to residential mortgages, as a whole they constitute a relatively small fraction of total CDS registered in the Warehouse.

ISDA clarifies positive role of CDS
In testimony before the US Senate Committee for Agriculture, Nutrition and Forestry, ISDA ceo Robert Pickel called for better understanding of the benefits of CDS and their positive role in the global financial industry.

"Both the role and effects of CDS in the current market turmoil have been greatly exaggerated," said Pickel in his testimony. "To say that CDS were the cause, or even a large contributor, to that turmoil is inaccurate and reflects confusion of the various financial products that have been developed in recent years. There is little dispute that ill advised mortgage lending, coupled with improperly understood securities backed by those loans, are the root cause of the present financial problems."

Pickel emphasised the need for prudent risk management and appropriate use of credit risk mitigation tools. He stated that CDS have continued to perform well in the wake of defaults of major market participants, both counterparties and issuers of debt. CDS participants have settled trades in an orderly way precisely according to the rules and procedures established by ISDA and market participants.

During the testimony, Pickel discussed the five major credit events that took place within the last several weeks - Tembec, Fannie Mae, Freddie Mac, Lehman Brothers and Washington Mutual. All these companies were referenced under a large number of CDS. Despite defaults by these firms, the derivatives markets - and in particular the CDS market - has continued to function and remain liquid.

Critical to this success is understanding the difference between notional values of privately negotiated derivatives and actual amounts at risk. Payment streams in connection with these events are much smaller than is commonly understood; gross market values are approximately 2% of the commonly referenced measure of notional amounts (see Lehman brief above).

Recent market events clearly demonstrate that the regulatory structure for financial services has failed. An in-depth examination of this structure is self-evidently warranted. In this examination it is ISDA's hope that the facts surrounding OTC derivatives, and the role they continue to play in helping allocate risk, in providing liquidity and helping price discovery, will highlight the benefit of derivatives and of industry responsibility and widely applied good practices recommended by ISDA.

Pickel concluded his testimony by stating that derivatives have continued to perform well during a greater period of stress than the world financial system has witnessed in decades. He is due to provide the same testimony to the House of Representatives today (15 October).

Icelandic events hit
ISDA has confirmed that it will launch credit event protocols for Landsbanki Íslands (for which the auction is scheduled for 4 November), Glitnir Banki (5 November) and Kaupthing Bank (6 November). At the same time, concern remains that the problems in Iceland may lead to a sovereign CDS being triggered (see also separate news story).

Some analysts suggest that even letting all three banks fail may not be sufficient to offset a sovereign debt restructuring, which could ultimately lead to Iceland's sovereign CDS being triggered.

The UK's freeze order of Landsbanki's assets is nonetheless expected to complicate recovery levels, since the amount of assets frozen is unknown and will be hard to monetise by the receiver. There is growing speculation that a double-digit recovery is unlikely.

Bailouts gather pace
Four more European countries have announced banking sector rescue plans. At the same time, the US Treasury is set to inject US$250bn of TARP cash into bank equity, with nine institutions being forced to participate in order to remove the stigma. These banks will also be required to raise extra capital privately.

"We like the ability of the TARP to carve out bad assets from the banks' balance sheet, which should help restore transparency and thus investor confidence. What the plan lacked so far, in our view, was the ability to address the key issue banks have - undercapitalisation," note strategists at BNP Paribas.

Meanwhile, the Dutch government has announced that it will make €20bn available to "fundamentally sound and viable" institutions. The programme is scheduled to run until 20 January 2009 and is designed to support liquidity and capital reinforcement.

Additionally, Germany is launching a €400bn three-year guarantee fund (that includes a 5% default provision), together with a €20bn contingency fund and €80bn capital injection; and France is creating a €320bn vehicle that banks can repo collateral with and a €40bn recapitalisation fund. Finally, Italy is expected to guarantee bank debt until end-2009 and establish a fund to buy back bank preferreds.

The ECB is also understood to be exploring ways to widen its lending rules in order to establish a similar vehicle to the US' CPFF.

FASB issues fair value FSP ...
FASB has issued a staff position entitled 'Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active', which clarifies the application of FAS 157 where there are limited or no observable inputs for marking certain assets to market. Banks will now be able to discount forced liquidations or distressed transactions as 'observable'. Analysts suggest that banks will be able to use their own assumptions about future cashflows and base their modelling on generally more benign estimates as a result.

... while IASB amends IAS 39/IFRS 7 ...
The IASB has made amendments to 'IAS 39 Financial Instruments: Recognition and Measurement' and 'IFRS 7 Financial Instruments: Disclosures' that permit the reclassification of some financial instruments from 1 July 2008 by companies reporting under IFRS. The deterioration of the world's financial markets that has occurred during Q308 is a possible example of rare circumstances cited in these IFRS amendments and therefore justifies their immediate publication, the IASB says.

Further to loosening the ban of any reclassifications into or out of the fair value category, the amended version of IAS 39 explicitly provides three examples where reclassification from the fair value accounting category are permissible, note analysts at UniCredit. First, a financial asset may be reclassified out of the FVTPL (fair value through profit and loss) category in rare circumstances. The fair value of the asset at the time of reclassification becomes the new amortised cost measure.

Second, a financial asset that would have met the requirements for classification as loans and receivables (L&R) may be reclassified out of the FVTPL category to the loans and receivables category if the bank has the intention and ability to hold the financial assets for the foreseeable future or until maturity. Finally, a financial asset that would have met the requirements for classification as L&R may be reclassified out of the AFS (available for sale) category to the L&R category for the same reason.

In responding to the crisis, the IASB notes the concern expressed by EU leaders and finance ministers through the ECOFIN Council to ensure that "European financial institutions are not disadvantaged vis-à-vis their international competitors in terms of accounting rules and of their interpretation".

... and CESR issues its own statement
CESR has published a statement entitled 'Fair value measurement and related disclosures of financial instruments in illiquid markets', which stresses the importance of appropriate application of measurement and disclosure requirements in illiquid markets. This statement follows a consultation that was launched in mid-July and closed in mid-September, to which 34 responses were received.

CESR's statement has several objectives. It will form the basis for the requested contribution by CESR to the ECOFIN Council, and will assist preparers and auditors when preparing the next financial statements. CESR members have identified improvements in the disclosures included in the latest interim financial statements published.

CESR also welcomes the progress made by the IASB's expert advisory panel on the issues discussed in its consultation paper. In this respect, as suggested by many respondents to the consultation, CESR is submitting the statement to the panel and anticipates that the IASB will take this statement into consideration when deciding the way forward on the topics analysed by CESR.

Fitch proposes SF CDO methodology change
Fitch has announced that it proposes to change its rating methodology for structured finance (SF) CDOs. The proposal expands upon its criteria for the review of ratings of structured finance CDOs with exposure to US sub-prime RMBS, issued in November 2007. The updated approach will apply to CDOs exposed to all types of global structured finance assets.

Fitch has published an exposure draft of its methodology revisions and is seeking market feedback regarding the changes. The agency anticipates issuing final criteria following a four-week consultation period, and consideration and incorporation of market feedback. Fitch has placed 2,068 ratings from 323 structured finance CDO transactions under analysis, reflecting the potential for ratings to be impacted by the proposed changes.

Though the updated approach is unlikely to result in material rating changes to CDOs already exposed to distressed RMBS-related securities, it is expected to affect certain ratings of CDOs exposed to other types of structured finance securities - with the most significant impact to those with concentrations by sector, vintage and/or geography. The exposure draft includes sample rating transition tables for major categories of SF CDOs.

"The updated approach includes a number of material changes that recognise the risks revealed in sector concentrated portfolios, most notably high correlation risk and the potential for extremely low recoveries upon default for certain structured finance liabilities," says Fitch md and head of global structured credit John Olert. "The proposed revisions are intended to provide an updated framework to more appropriately address the drivers of significant underperformance, and ensure that default expectations in higher stress scenarios reflect the credit quality of the underlying portfolio."

According to Olert, the proposed changes will be most relevant for "portfolios that may not have yet been impacted by poor performance of the underlying asset pools. Our primary intention remains to produce CDO ratings that perform similarly in terms of default risk and ratings migration with the market's expectation for other asset classes. This is particularly true for triple-A and other highly rated CDO tranches."

Principal changes to the criteria include:

• Default rate inputs consistent with long-term observations;
• Protection for highly rated CDO tranches calibrated with consideration to historical peak defaulting sectors;
• Increased correlation assumptions, resulting in increased portfolio default estimations for portfolios concentrated in single sectors and single vintages; and
• Lower recovery rate assumptions, and an improved modelling process that applies no recoveries in scenarios where an asset of a senior priority would have also defaulted.

"The approach has been to benchmark model output for concentrated portfolios to observable historical default levels of poorly performing sectors, and to estimate the extent to which diversification can influence the portfolio default potential," says Phil McDuell, md for European structured credit at Fitch in London.

G7 commitments outlined
In a meeting over the weekend, the G7 committed to continue working together to stabilise financial markets and restore the flow of credit, in order to support global economic growth. Ministers agreed to the following five-point plan:

• Take decisive action and use all available tools to support systemically important financial institutions and prevent their failure.
• Take all necessary steps to unfreeze credit and money markets, and ensure that banks and other financial institutions have broad access to liquidity and funding.
• Ensure that banks and other major financial intermediaries, as needed, can raise capital from public as well as private sources, in sufficient amounts to re-establish confidence and permit them to continue lending to households and businesses.
• Ensure that respective national deposit insurance and guarantee programmes are robust and consistent so that retail depositors will continue to have confidence in the safety of their deposits.
• Take action, where appropriate, to restart the secondary markets for mortgages and other securitised assets. Accurate valuation and transparent disclosure of assets and consistent implementation of high quality accounting standards are necessary.

The actions should be taken in ways that protect taxpayers and avoid potentially damaging effects on other countries, the G7 says. Ministers also committed to use macroeconomic policy tools as necessary and appropriate, to support the IMF's critical role in assisting countries affected by this turmoil and to accelerate full implementation of the Financial Stability Forum recommendations.

FSF urges acceleration
The Financial Stability Forum (FSF) has reported that progress is being made in implementing the set of recommendations for the financial system that were put forward in April. However, the FSF notes that, in view of market developments, the implementation of certain recommendations needs to accelerate, namely the implementation of a central counterparty clearing for OTC credit derivatives and the achievement of more robust operational processes in OTC derivatives markets.

In addition, the FSF calls on credit rating agencies to enhance their efforts to comply with the FSF recommendations, including by making industry-wide proposals for providing differentiated information or ratings for structured products.

Fitch takes action on synthetic CDOs
The current global financial crisis has led to a rapid deterioration of highly rated financial institutions globally, with several credit events being called, which has in turn affected a large proportion of investment grade synthetic CDOs rated by Fitch. The agency has, as a result, affirmed 177 and downgraded 422 impacted tranches.

Fitch maintains ratings on 327 IG CDO transactions, all of which were subject to review upon the issuance of the agency's updated criteria in April. Of its currently rated IG CDOs, Fitch had completed its review on 185 of these, and rating resolutions were pending on the remaining 142. The current review of all of these ratings following the recent credit events highlights the significant difference in rating migration between the 185 transactions where criteria-related rating actions had already been completed, and the 142 transactions which had not yet been resolved.

Although both sets of transactions have been downgraded because of the unexpected timing and unprecedented magnitude of the financial institution credit events that have been called, the magnitude of the downgrades for ratings revised following Fitch's criteria update are far less than for those not yet revised. Of the ratings previously revised, 78% of the IG CDO bonds that retained triple-A ratings under the updated corporate CDO framework are being affirmed in the current rating actions, and 52% of all previously revised ratings remain within the same rating category. This is noteworthy, as current distress in the global financial system will likely exceed the historic peak default rates for investment grade reference entities.

Rating activity was heavily influenced by remaining credit enhancement after adjusting for anticipated losses from recent credit events. Other significant factors include portfolio composition, with significant emphasis on proportion of lower rated credits currently in the portfolio, as well as remaining tenor.

For the 142 synthetic IG CDOs transactions whose ratings had not yet been revised, the rating activity is more pronounced - as indicated in the initial rating watches implemented by Fitch, with even greater migration due to the events that have since unfolded. The tranches with the largest downward migration were those previously rated in the double-B category or lower, as the realisation of credit losses make them far more susceptible to any future credit deterioration.

FSA on watch negative
S&P and Fitch have placed the triple-A financial strength rating and counterparty credit rating on Financial Security Assurance (FSA) on credit watch with negative implications. This action follows the downgrade to single-A from double-A of parent company Dexia's core units. In addition, the agency lowered the counterparty credit rating on FSA Holdings to single-A plus from double-A minus and placed it on credit watch with developing implications.

S&P believes that ongoing support from Dexia for FSA is less certain in view of its weaker credit profile and recent changes to ownership and senior management. "These changes raise questions as to whether FSA will still be viewed as a strategic investment going forward. FSA's ability to raise capital and access to liquidity are, we believe, very strongly linked and limited to Dexia," the agency says.

S&P notes that FSA's franchise has been damaged by its mortgage-related losses. Now, with the additional uncertainty about Dexia's credit profile and, potentially, its strategic direction, the agency says business prospects for FSA could be further impaired.

Fitch says that if it were to downgrade FSA, the financial guarantor's rating would be unlikely to fall below double-A. The agency would also consider whether the ratings of FSA Holdings relative to FSA would require a greater differentiation than historically has been the case.

GCS priced off CDS
The UK's Credit Guarantee Scheme (GCS) will provide funding at the median five-year CDS for the past 12 months plus 50bp. Analysts at Credit Derivatives Research suggest that Nationwide and Standard Chartered would benefit the most from the scheme, as that rate of protection exceeds their current five-year CDS cost by 100bp and 12.5bp respectively. Abbey, Barclays, HSBC and Lloyds would pay a 25bp-40bp premium over current five-year CDS to gain the guarantees, with HBOS benefitting the least at only a 5bp-10bp premium over existing protection levels.

The analysts add that this 'median' approach is particularly useful for the British and European institutions which saw their CDS levels hold in tight (outperform) US levels for far longer (therefore shifting the median tighter). However, none of the major US financial institutions would face excess premia in this framework, with Merrill Lynch, Goldman Sachs and Morgan Stanley benefitting significantly.

Nightingale ...
Moody's has downgraded the Euro and US MTN programmes of Nightingale Finance from Aaa/Prime-1 on review to A3 on review, impacting approximately US$150m of debt. The rating action follows continued deterioration in the market value of the SIV's asset portfolio, combined with the downgrade of the vehicle's sponsor AIG Financial Products.

Nightingale's portfolio market value declined to 83% on 3 October 2008 from 88% on 25 July 2008 and 96% on 23 January 2008. AIG FP was downgraded to A3 on review for downgrade from A2 on review for downgrade on 3 October 2008. This rating action on AIG FP followed an earlier downgrade to A2 on review for downgrade from Aa3 on 15 September 2008.

Following the deterioration in market value of the portfolio, Moody's considers that a liquidation of Nightingale's assets may provide insufficient funds to fully repay outstanding MTNs and CP. The ratings of Nightingale debt programmes are therefore highly dependent on the ratings of AIG FP.

In the absence of additional support from AIG FP, a further downgrade of AIG FP's rating below A3 may result in a corresponding downgrade of Nightingale's ratings. If the SIV does not regain a rating of A3 or above within five business days of such a downgrade, this will trigger entry into the restricted funding operating state, potentially limiting further the vehicle's ability to source liquidity. However, while restricted funding generally prevents Nightingale from issuing new senior debt to the market, a senior note purchase commitment allows AIG FP the flexibility to purchase senior debt from the vehicle.

... and EVVLF downgraded
Moody's has downgraded the MTN and capital notes of Eaton Vance Variable Leverage Fund from Aa3 to Baa2 (on review) and from Caa3 to Ca respectively. The actions - which affect approximately US$664m - reflect the deterioration of the market value of the vehicle's asset portfolio.

Kamakura expands risk capabilities
Kamakura Corp has expanded the ability of the Kamakura Risk Manager (KRM) enterprise risk system to calculate and display the risks of each transaction on the balance sheets of major financial institutions. The enhanced transfer pricing capabilities in KRM Version 7.0 allow major financial institutions and corporations to parse the incremental risk of each asset and liability on the balance sheet into liquidity risk, credit risk and interest rate risk components and simulate it forward in a realistic way.

KRM Version 7.0 provides eight different user choices for assigning matched maturity credits and costs of funds so that senior management, internal audit departments and day-to-day risk managers have complete drill-down capability that shows how the total risk of an organisation has been created from the transaction level up.

Loan identification system prepped
Markit is set to introduce by year-end a new comprehensive loan identification system to enable straight-through processing. The initiative will provide individual loan identifiers and a numbering system for loan market participants.

Markit says its new universal set of identifiers for the syndicated loan market will improve accuracy and operational efficiency by ensuring that information transmitted is linked to the correct underlying loan and delivered to the right market participant. The identification system will connect existing disparate data and loan systems, as well as other identifiers to ensure ease of adoption.

At present, financial information is transmitted by fax, email or phone, resulting in operational inefficiency and high error rates. The new loan identifiers will provide coverage from the borrower down to the individual accruals, and will map to other commonly used identifiers in the market.

EDS-backed deals impacted
Moody's has downgraded and/or placed on review for possible downgrade 36 classes of notes and six loan facilities issued by CEDO, and downgraded four classes of notes issued by Edelweiss Capital. The downgrades are the result of equity share price movements of the portfolio of entities referenced by the underlying equity default swaps. All tranches remain on review for possible downgrade, given the current high volatility of the global equity market.

Further SROC figures in
After running its month-end SROC figures, has placed 166 European and 66 Asia-Pacific (ex-Japan) synthetic CDO tranches on credit watch with negative implications. Of the European deals affected, 42 reference US RMBS and ABS
CDOs that have experienced recent negative rating actions, with the remainder having experienced corporate downgrades. The Asia-Pacific rating actions reflect the impact on the relevant CDO portfolios of Washington Mutual being placed into receivership and sold to JPMorgan Chase.

EU reports on systemic risk
The European Parliament says it has adopted a report, which highlights the areas that need attention in the light of the current crisis and after seven years of operation of the current 'Lamfalussy system'. It includes recommendations on the structure of the 'Level 3' Committees of national financial regulators (CESR for securities, CEIOPS for pensions and insurance, and CEBS for banking) and on the mechanisms for managing systemic risk.

MEPs argue that voluntary arrangements are insufficient to streamline the fragmented structure of European supervisors that need to guarantee the stability of the financial markets and protect the real economy against excessive risks. The Level 3 committees need a legal status commensurate with their duties, and national supervisors should have a commitment to executing the decisions of the committees written into their mandates, the report says.

The report also calls for measures to make the securitisation process more transparent and for credit rating agencies to use appropriate terminology, making clear the difference between complex financial products. It says companies should not be able artificially to keep debt vehicles off their balance sheets.

Originators of securitised products should be required to assess and monitor risk and ensure debt-backed securities are transparent enough for investors to be able to understand the risks they are taking on.

More transparency is also required when it comes to the OTC markets, where clearing houses should be encouraged. MEPs want to see lessons learned from the oversight of auditors to be applied to credit rating agencies, notably when it comes to conflicts of interest.

Lastly, financial institutions should disclose their remuneration policy, notably including the packages offered to directors - and market supervisors should assess whether the remuneration policy encourages extreme risk taking when they examine a company's risk management.

LBFP and LBDP downgraded
Moody's has downgraded the counterparty ratings of Lehman Brothers Financial Products and Lehman Brothers Derivative Products from Baa3 with direction uncertain to B1 on review for downgrade. There is continued uncertainty regarding the timing of LBDP's and LBFP's payments to their counterparties.

If the bankruptcy court upholds LBDP and LBFP's legal separateness, Moody's expects that the assets of LBDP and LBFP should not be substantively consolidated with their Parent's bankruptcy estate and therefore counterparties of LBDP and LBFP should ultimately receive payments due to them. According to the agency, the voluntary bankruptcy filings made on 5 October were unexpected due to the fact that both LBDP and LBFP are solvent companies, with adequate capital to cover their scheduled payments, and were structured to be legally separate from Lehman Brothers Holdings.

Japanese CSOs hit
S&P has lowered its ratings on five tranches relating to five Japanese synthetic CDO transactions and kept the ratings on watch negative because they involve Lehman Brothers Special Financing as a swap counterparty and Lehman Brothers Holding as a swap guarantor. The rating actions reflect S&P's view on the degree of likelihood of loss incurred by the deals.

Recursive CDO model released
After having released the large homogenous pool (LHP) and the finite homogenous pool (FHP) CDO models (see SCI issue 106), Dresdner Kleinwort has published a recursive model. This model is capable of dealing with portfolios where credit spreads, notional exposures and recovery rates can be different across assets.

An accompanying guide is divided into two sections, each of them supported with a different spreadsheet model. In the first section, using a heterogeneous pool of 10 assets for demonstrational purposes, structured credit strategists at the bank provide a detailed insight into the recursion algorithm, which is widely used by the Street to derive the loss/recovery conditional distribution.

In the second section, they demonstrate how to restructure a real life CDO. To do so, a more sophisticated C++ based model - which can deal with large heterogeneous portfolios - is necessary.

The advantages of the model are that each asset can be modelled according to its own credit spread and recovery assumption, and replacing, adding and deleting names is feasible. Additionally, valuing the impact at index level of a single name or a set of names by adding or replacing them is straightforward.

ABS issuance rises YOY
Xtrakter has released figures highlighting an increase in fixed income new issuance of 41.2% (US$207bn) for Q308 in comparison to Q307. In total, fixed income new issuance rose to US$710.3bn, with asset-backed new issuance representing 31.7% (US$225bn) of the total share. Overall asset-backed new issuance rose by 61% (US$137bn) year-on-year.

The top issuers for Q308 were: Federal Home Loans, Fannie Mae, Silverstone Master Issuer, Abbey National Treasury, KFW, Arkle Master Issuer, Adriano Finance, European Investment Bank, Freddie Mac & ING Group.

CRE CDO delinquencies increase further
Nine new delinquent loans led to the third straight monthly increase in the US commercial real estate loan (CREL) CDO delinquency rate to 2.39% for September 2008, according to the latest CREL CDO Delinquency Index from Fitch.

"Although this delinquency rate remains relatively low and many CREL CDOs are adequately cushioned to absorb some credit deterioration, some CDOs are experiencing more distress than others," says Fitch senior director Karen Trebach.

CREL CDO delinquency rates range from 0% to 14%. Fitch recently downgraded the below investment grade classes of one CREL CDO, and within the past three months it has also placed classes from two other CREL CDOs on watch negative. Fitch anticipates that more CREL CDOs will be placed on watch negative or downgraded as further problem loans come to the surface.

Commercial real estate loans found in CREL CDOs are generally highly leveraged and backed by transitional properties. In the current state of the economy, these properties often have stalled or failed business plans. As a result, sponsors have found it difficult to refinance and/or fund current loan obligations.

This negative outlook for CREL CDOs is somewhat mitigated by the asset managers' flexibility to change the terms of the underlying assets through continued extensions and modifications. In addition, some asset managers continue to exercise their right to repurchase credit impaired loans.

Blueprint for investment banking released
TABB Group founder and ceo Larry Tabb has released a blueprint for the future of investment banking. He says: "The sub-prime crisis needs to be put into a more immediate perspective, so banks, brokers, industry executives and the entire financial services ecosystem can begin adjusting their business models, support systems and strategies to react to the massive changes affecting the financial markets." He cautions, however, that regulators and legislators must also put these issues into perspective as they begin to implement changes that may inadvertently do more harm than good.

With the independent investment-banking model temporarily on the shelf, once the markets stabilise commercial banks now drawing on deposits and savings accounts as cheap money funding sources will be forced by regulators, legislators and boards to become more conservative, according to the blueprint. Risk and compensation levels will drop and the more highly compensated and risk-tolerant people will leave, setting up or joining the investment banks of the future. Tabb says these will be structured as partnerships, be more adroit and take on much of the risky aspects of the traditional investment banks of the past.

He adds that the nature of these new regulatory structures will place hedge funds at a distinct disadvantage. As a result, TABB Group believes that H208 will see 700 to as many as 1,000 funds - or 15% of the industry - close. However, if market conditions continue to deteriorate and short-selling bans are reinstated, some of these shuttered funds are likely to become self-capitalised market makers or broker-dealers.

New CDS settlement platform launched
Knight Capital Group has introduced NetDelta, an electronic settlement platform for the credit derivatives market. NetDelta addresses market infrastructure inefficiencies and underlying risks inherent in OTC derivatives by providing buy- and sell-side firms with comprehensive, real-time solutions for entering, maintaining and exiting new positions. The platform will also be able to reduce counterparty risk for existing positions in the near future, the firm says.

"NetDelta was designed to address unnecessary counterparty risk, balance sheet inefficiencies, settlement lags, valuation issues and a lack of liquidity," comments Lucio Biase, md of NetDelta. The offering also addresses many of the key principles recently set forth by the Operations Management Group (OMG) and President's Working Group (PWG) - both of which aim to instill a clear, functional and well-designed infrastructure that can meet the needs of the OTC derivatives markets.

The platform's modular technology allows for simple integration into existing trading platforms, settlement services and reporting engines. In addressing market infrastructure and legacy issues, NetDelta renders unwinds and novations obsolete for positions cleared on it. The solution also allows for greater transparency of the value of each position without disclosing pivotal market-making data.

CS & AC

Trading ideas: covered

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at an outright long on Husky Energy

Unprecedented volatility has overwhelmed all markets. During such times, we recommend for those with an appetite for risk to take advantage of the fear and sell credit protection on stable companies with strong cashflow generation and growth potential. Husky Energy fits the bill.

Husky Energy generated US$2.1bn in cash from operations last quarter. Even though crude oil's price has dropped substantially, we forecast Husky's business to generate more than enough cash to fund its aggressive capex and dividend expenditures under bearish scenarios.

As of June 2008, it had an unused US$1.5bn credit facility and no substantial notes maturing in the next few years. With a quarterly interest payment of only around US$45m and recent quarterly EBITDA at around US$2bn, Husky is under no immediate financial constraints.

We do not see any reason for its credit spread to trade near 200bp. As a final note, based on our quantitative credit model Husky Energy's credit spread trades 110bp too wide due to fantastic free cashflow, low leverage and strong interest coverage levels. We recommend selling protection on Husky Energy.

Let it flow
Husky's management is committed to spending US$4bn in capex during 2008 to develop multiple up and downstream opportunities. To keep up with its recent dividend, it also has more than US$1bn in payments to make in the next four quarters. To fund these obligations, it needs to do so mainly from cashflow due to the essentially frozen credit markets.

Last quarter, Husky's CFO was US$2.1bn. We decided it was best to run a few scenarios based upon expected crude and natural gas prices to get an idea of what Husky's future CFO will look like.

Exhibit 1 shows our forecast for future CFOs under four different scenarios. Because crude oil's price dropped substantially in recent months we believe this will have a negative impact on Husky's future revenues, which obviously directly affect its cashflow.

Exhibit 1

However, even under our most bearish scenario with a 20% drop in revenue (quarter on quarter) after Q308, we believe Husky will still have US$1.4bn in CFO for the first quarter of 2009. This is worst case scenario and it does not put the company at any risk, given its capex and dividend targets. Our best case scenario shows its cashflow to be flat over the next few quarters.

Husky Energy's capital structure leaves us feeling confident in its ability to prevail in uncertain markets (see Exhibit 2). It does not have a substantial note due until 2012 and has a total debt-to-LTM EBITDA of 0.2x.

Exhibit 2

Even though we believe there will be some pressure on earnings going forward, we do not envision any substantial deterioration in its credit metrics. Husky also has unused committed long and short-term borrowing credit facilities totalling US$1.5bn.

Top of the heap
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 3 lists all the factor scores for Husky Energy. We see a 'fair spread' of 85bp for its solid margins, leverage, interest coverage, free cashflow and accruals factors.

Exhibit 3

Interest coverage is one of the best determinants of an issuer's ability to meet future liabilities. Husky Energy's interest coverage ratio is 31x adjusted LTM EBIT. If Husky Energy comes under any strain in the near term future, it will certainly not be coming from interest payments.

Risk analysis
This trade takes an outright long position. It is not hedged against general market moves or against idiosyncratic curve movements.

Additionally, we face 10bp of bid-offer to cross. The trade has positive carry and roll down which will offset any potential spread widening.

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

Summary and trade recommendation
Unprecedented volatility has overwhelmed all markets. During such times, we recommend for those with an appetite for risk to take advantage of the fear and sell credit protection on stable companies with strong cashflow generation and growth potential. Husky Energy fits the bill.

Husky Energy generated US$2.1bn in cash from operations last quarter. Even though crude oil's price has dropped substantially, we forecast Husky's business to generate more than enough cash to fund its aggressive capex and dividend expenditures under bearish scenarios.

As of June 2008, it had an unused US$1.5bn credit facility and no substantial notes maturing in the next few years. With a quarterly interest payment of only around US$45m and recent quarterly EBITDA at around US$2bn, Husky is under no immediate financial constraints. We do not see any reason for its credit spread to trade near 200bp.

As a final note, based on our quantitative credit model Husky Energy's credit spread trades 110bp too wide due to fantastic free cashflow, low leverage and strong interest coverage levels. We recommend selling protection on Husky Energy.

Sell US$10m notional Husky Energy Inc 5 Year CDS protection at 195bp.

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).