Contents

Alternative assets

Exeter Blue launched

Bespoke project finance CLO finds investors

Lloyds TSB has launched a €125.9m self-managed synthetic CLO backed by public private partnership/private finance initiative (PPP/PFI) and project finance loans. While the timing of such a deal has raised questions in the investor community, Lloyds confirms that it placed the deal with a strategic institutional partner - arguing that one of the only ways to successfully complete a deal in the current environment is through close work with investors and partners, and through structuring bespoke deals that will suit their needs.

"We work closely throughout the year with a number of select institutional investors and strategic partners with whom we discuss the deal in detail. We structure the deal to match the deal with the needs of the investor. Working in this way is a powerful tool to service investor clients and manage our balance sheet efficiently. It also means that we can create capacity in order to offer more corporate loans to our clients," says Ton Roeten, head of credit distribution at Lloyds TSB Corporate Markets.

"The PFI asset class is considered by many investors a relatively safe investment, given that there is a low correlation with other asset classes. This provides a welcome source of diversification in investors' portfolios," adds Eva Dolleman, associate director, securitised products group at Lloyds TSB Corporate Markets.

The transaction, named Exeter Blue, references loans predominantly located in Western Europe and North America. The capital structure comprises five tranches of notes due in 2025.

Fitch assigned ratings of triple-A to the €31.875m Class A notes, double-A to the €31.875m Class Bs, single-A to the €26.5625m Class Cs, triple-B to the €10.625m Class Ds and double-B to the €8.5m Class Es (see SCI database for pricing). There is also an unrated equity slice worth €8.5m, with the total reference portfolio amounting to €1bn.

The ratings are based on the credit enhancement available to notes in the form of subordination, structural covenants and excess spread. Although excess spread is used only to offset principal losses on the subordinated notes, the Class A through E notes benefit as losses on the subordinated notes that are offset may partially or fully restore the original credit enhancement levels.

The ratings also take into account the quality and diversity of the portfolio of assets. The closing portfolio has significant concentration in the PPP/PFI, energy and transport sectors, as well as significant single obligor exposure where the top five obligors comprise approximately 23% of the portfolio. The transaction allows for a replenishment period of four years, during which Lloyds TSB may reference additional assets or increase exposure to existing assets as a result of amortisations in the initial portfolio

Lloyds has issued a number of synthetic CLOs in the past two years - the most recent being the privately-placed £1bn-equivalent Doncaster Gold, issued at the end of May (see SCI issue 91). The transaction references SME loans concentrated in the UK real estate industry.

"From a structuring point of view, a synthetic deal - as with the previous few balance sheet CLOs from Lloyds - was the most effective way to carry out the transaction," concludes Reinald de Monchy, director, securitised products group at Lloyds TSB Corporate Markets.

AC

CLOs

Loan trouble

CLO managers face loan replacement quandary

Secondary loan prices have reached unprecedented lows in the past few weeks (circa 75% at time of writing), falling below levels at which CLO managers are typically able to get par value for the loan should it be substituted into a CLO portfolio. Although ways are being found to resolve the problem, CLO managers remain under pressure to avoid replacing loans in the current environment.

The discounted asset haircut, imposed by the rating agencies at the beginning of the decade, is set at around 85% for most cashflow CLOs. It means that if a manager buys loans below that level, the loan is valued at purchase price for the OC test, not at par. According to one European CLO manager, it does not prevent managers from buying loans below that level, but means a CLO does not benefit from valuing the loan at par until it trades above 90% for a 30-day period.

"We are seeing some cases of managers paying 86c for a loan that's offered at 84c, in order to be able to mark the loan to par," says the CLO manager. "In other cases loans are being bought in bundles where some loans cost 90c and others 80c, for an average of 85c."

However, he notes that the biggest issue managers face in terms of low loan prices is selling out of a poorly performing loan. "While it might make economic sense to sell a bad loan trading at 50c and replace it with a better loan that's trading at 60c, in the overcollateralisation test the replacement will show up as a 50% loss of par value and does potentially discourage managers from replacing bad loans."

Another CLO manager agrees: "Some managers may find themselves in a position where they are close to a trigger point, and by substituting an underperforming loan with a better one would result in that trigger being hit as the new loan - bought at under 85% - would result in lost par value."

According to David Matson, md at IKB Fund Management, it may be possible to buy loans whose levels have fallen below 85% by structuring it as a par purchase with a fee. However, this depends on the trustee and/or trader. "Having purchased the loan at that level, the question is whether or not you will be able to mark it up to par in the CLO portfolio. Trustees generally do not permit this to be done," he adds.

Meanwhile, CDO analysts at JPMorgan are fairly downbeat about the drop in secondary loan prices, and suggest it bodes extremely poorly for CLO collateral performance. They note that "technical" price moves have a way of becoming fundamental reality.

In addition to de-leveraging on the financial side, the darker part of JPMorgan's re-assessment of CLO relative value is the realisation that current loan prices probably reflect the sorts of credit losses portfolios should experience as companies start to experience ratings migration and defaults.

AC

Investors

Convexity in vogue

Hedge funds seek differentiation in new strategies

Investors withdrew over US$31bn from hedge funds in September, according to Hedge Fund Research. However, amid the consequent shakeout in the sector, some credit hedge funds are differentiating themselves by focusing on convexity strategies.

Credit hedge funds are pursuing two strategies in the current environment. The majority - distressed/credit opportunity-type funds - are going long, which implies a strong view that the market has reached the bottom.

Those that don't want to make this call are focusing on the second type of strategy - performing irrespective of the direction of credit spreads. "The market will remain volatile over the next year, so we're pursuing credit spread-neutral strategies with a strong convexity profile. The idea is to lock in profit whether spreads go up or down; however, most investors are being offered the first strategy," explains Loic Fery, managing partner of Chenavari Credit Partners.

Two aspects are expected to differentiate credit hedge funds going forward: the perspective of the funds themselves and the perspective of investors. "From the perspective of hedge funds, there will be a clear readjustment in terms of spending money on what is necessary to provide top class services. The emphasis will be on ensuring that the hedge fund has more revenue than costs," Fery says.

He adds: "From an investor's perspective, whatever happens in the future can't erase the past and so the fact that they may have lost money shouldn't affect their decision to invest today. The beginning of a growth cycle is credit-positive, while the end is credit-negative. But when both credit and equity markets fall, the fact that balance sheets will be cleaned up and delevered is good for credit in the long term."

According to Palomar Capital Advisors md George Tintor, investor withdrawals are impacting hedge funds across the board, except for the smart few which began mitigating fund redemption risk over a year ago. "These funds anticipated the market stress and asked their investors to voluntarily extend their lock-up periods by two or three years - investors seemed comfortable with this because they were happy with the fund's performance," he explains. "These same funds began delevering significantly and building up cash balances as far back as the end of 2006 to mitigate financing and liquidity risks."

Tintor adds: "As a general observation, the current turmoil should shake out the mediocre performers - those that ignored or reacted too slowly to the crisis in the financial system as it unfolded. I envisage between 30%-50% of hedge funds eventually disappearing."

Hedge fund outflows in September have resulted in significant liquidations of positions so far during October. "The market has been in sell-off mode, ignoring any positive news flow until the European bailout plan was announced - which finally stopped the market from falling further," notes Andrea Cicione, senior credit strategist at BNP Paribas. "But mass hedge fund redemptions have highlighted the sense that 'crowded' relative value trades may continue to move in counterintuitive ways; in other words, rather than converging, these trades are diverging - meaning that those who haven't liquidated similar positions stand to lose more money."

He explains that because the hedge fund industry exploded on the back of availability of credit, those hedge funds that relied primarily on leverage to generate returns will inevitably be crowded out of the market now that leverage is difficult to come by. "There is value in lots of places, but this situation will last for a while: though there is alpha still to be generated in the market, there is unlikely to be any convergence anytime soon because the market is in deleveraging mode. Consequently, some positions could end up going against the holder simply because of market technicals."

CS

Technology

Vendors step up

Valuation models enhanced

In response to concerns highlighted in last week's issue of SCI (see 'Enhanced services?'), Numerix and Quantifi have released two new valuations offerings that they say are more appropriate for today's volatile market. Both solutions offer the ability to analyse underlying cashflows and 'what-if' scenarios.

According to Numerix svp of marketing Jim Jockle, what has become evident over the last 18 months is that the deployment of the art of valuations isn't in tune with the realities of the structured credit market and the presumption that not all debt is "toxic"; that there is value to be found out there, but you have to identify it. In an attempt to enable such identification, Numerix has partnered with R-Squared Financial to combine its models with R²'s knowledge of valuations to create a product called NxR² (squared).

"The product provides the infrastructure to produce independent valuations and detailed portfolio risk assessments, for both cash and synthetic executions, down to the collateral level, to enable analysis of portfolio data," Jockle explains. "The idea is to provide a more granular view of what an investor owns or, if an investor is coming back into the market via for example TARP, take a view on the quality of the underlying assets."

He adds: "The market developed out of the science/maths/modelling behind structures, but didn't provide the tools or have the technology to enhance transparency. There are many steps needed to restore market confidence, but the first step is understanding the underlyings and shocking the output."

Meanwhile, Quantifi's latest release, Version 9.1, includes a correlated recovery model, which goes beyond the standard correlation model and is appropriate for today's volatile market, according to the firm's founder and ceo Rohan Douglas. "Earlier in the year we extended our model to support correlations greater than 100%, but it wasn't widely taken up by the market, whereas the correlated recovery model has been. This development has been driven by the desire to price/calibrate CDOs in extreme market conditions in an intuitive way; ie, based on the relationship between recovery and defaults," he says.

Another important aspect of Version 9.1 is the ability to produce realistic sensitivities - one of the issues with the standard correlation model is that the deltas tend not to make sense in certain scenarios. But Quantifi's new Scenario Editor tool allows the user to analyse different scenarios, looking at the effects of multiple changes on the portfolio on an intraday basis.

Indeed, portfolio managers and investors are increasingly looking to address the question: 'what-if?' This requires technology to understand the contents and structure of complex securities and their behaviour over a range of scenarios, says Jockle. But there is also a broader theme of connectivity at play here: data and technology solutions have historically been provided on a desk-by-desk basis, but now firms are focusing on - and taking action towards creating - enterprise-wide solutions, employing better technologies to assess underlying risk and concentrations on a portfolio basis (see SCI issue 104).

Quantifi has also introduced a loan modelling tool (applicable to CLOs, LCDS and loans) as part of its new release. "There has been a paradigm shift towards risk managing/marking such products - by borrowing ideas from financial modelling for other asset classes and applying it to the loans. This trend began a year ago when investors began looking at the asset class as an alternative investment, but for regional banks it is more recent - driven by changes in the accounting regime and the desire to better risk manage their portfolios," explains Subadra Rajappa, director at Quantifi.

Douglas adds that the challenge for vendors of pricing software is to provide a model that is sophisticated enough to capture additional market inputs yet is simple enough to be used. "The newest focus for clients and potential prospects is a tool for analysing the effects of possible future defaults on their portfolios," he concludes. "Rated CDO investors, for example, are typically buy-and-hold investors who historically haven't needed sophisticated pricing models. But now the market turmoil has forced them to begin thinking about marking, selling or hedging their positions and so there is a growing need to begin analysing the potential impact of future defaults on portfolios."

CS

Credit analyst resurfaces

The latest company and people moves

Credit analyst resurfaces
Christopher Greener, former credit research analyst at Société Génerale, is understood to have joined Blackrock's fixed income portfolio management group. In his new role he will be a portfolio manager, as well as a non-corporate credit analyst.

NewOak continues hiring spree
NewOak Capital has appointed Vincent Truglia as md of global economic research. Previously, Truglia was managing partner of WHAnalysis.com and md of the sovereign risk unit at Moody's.

Mezz fund launched
FRM Capital Advisors, the hedge fund seeding business of Financial Risk Management, and Beechbrook Capital have announced a strategic relationship on Beechbrook's inaugural mezzanine fund. Beechbrook launched its first fund, a European leveraged loan mezzanine fund - Beechbrook Mezzanine I - in September 2008. FCA via the Catalyst Fund is committing up to US$75m to the fund, which will be raising further commitments for a second closing in 2009.

The investment in Beechbrook's fund is FCA Catalyst Fund's second investment in three months and the first in Europe. London-based Beechbrook Capital was founded in May 2008 by Paul Shea and Nick Fenn to manage and advise funds investing in leveraged finance assets.

Credit sales and trading head appointed
Philippe Rakotovao has been appointed head of credit sales and trading for Calyon's debt & credit markets product line. He replaces Neal Neilinger.

CDPC ratings withdrawn
Fitch has withdrawn ratings on all five of the CDPCs it rates due to what the agency views as the companies' uncertain business prospects, the limited number of active entities and the limited market interest in ratings in this sector. In Fitch's opinion, an inability to post collateral has negatively impacted CDPCs' attractiveness as counterparties and placed the programmes in a de-facto state of suspension for the foreseeable future.

The CDPCs involved are: Aladdin Financial Products; Athilon Capital Corp/Athilon Asset Acceptance Corp; Cournot Financial Products; Invicta Capital LLC/Invicta Credit; and Quadrant Structured Credit Products.

Advisory group formed
The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have created a global advisory group comprising regulators, preparers, auditors, investors and other users of financial statements. The advisory group will help to ensure that reporting issues arising from the global economic crisis are considered in an internationally coordinated manner.

In developing their approaches on issues resulting from the discussions the boards will follow appropriate due process. In the interest of transparency, the advisory group will meet in public session with webcasting facilities available to all interested parties.

The boards have agreed to the following measures:

• Rapid appointment of a high-level advisory group: the boards agreed that the advisory group shall be comprised of senior leaders with broad international experience with financial markets. The boards will task this high-level advisory group with considering how improvements in financial reporting could help enhance investor confidence in financial markets and identifying the accounting issues requiring urgent and immediate attention of the boards as well as issues for longer-term consideration.
• Public roundtables in Asia, Europe and North America: the purpose of these public roundtables is to gather input on reporting issues emanating from the current global financial crisis.
• Common long-term solutions to reporting of financial instruments: in addition to considering the potential for short-term responses to the credit crisis, both boards emphasised their commitment to developing common solutions aimed at providing greater transparency and reduced complexity in the accounting of financial instruments. The boards will use their joint discussion paper, 'Reducing Complexity in Reporting Financial Instruments', the responses received to the discussion paper and the deliberations of the high-level advisory group as starting points for this longer-term objective.

DTCC and LCH.Clearnet to merge
DTCC and LCH.Clearnet Group have signed non-binding heads of terms regarding the proposed merger of the two companies. The merger proposal aims to create the world's leading clearing house, which would operate a user-owned, user-governed model, with LCH.Clearnet moving to an at-cost based structure comparable to DTCC's within three years. As a result of the transaction, LCH.Clearnet shareholders would receive a total consideration of up to €739m (€10 a share), the majority of which would be funded through LCH.Clearnet's revenue.

Euroclear, currently the largest shareholder in LCH.Clearnet, with a holding of 15.8%, intends to support the transaction in principle and remain a shareholder of LCH.Clearnet HoldCo, and to thereby cement a strong partnership in European post-trade solutions.

It is anticipated that the proposed merger will result in significant synergies and efficiency gains, largely derived from technology savings, as well as significantly enhanced economies of scale. In addition, for the first time both the US and Europe would be supported by a common infrastructure. As a result, further reductions in the costs of LCH.Clearnet's and DTCC's services are expected.

Liffe and Markit sign agreement
Liffe has signed a licence agreement with Markit to launch CDS based on the Markit iTraxx Europe indices, allowing the exchange to offer a new iTraxx product which will cleared on Bclear. CDS trades will be negotiated and agreed OTC, before being processed through Bclear and cleared through LCH.Clearnet, which will stand as the central counterparty to all Bclear CDS transactions

SNB to buy UBS impaired assets
The Swiss National Bank has announced it is creating a US$60bn fund to buy impaired assets from UBS, in particular, CDOs of ABS. The fund will issue liabilities guaranteed by the state, while UBS will provide a US$6bn first loss piece to cover potential losses rising from the assets. The move will provide an extra 10% credit enhancement for a senior quality portfolio of US assets. No European assets will be affected.

R3 close Lehman settlement agreement
R3 Capital Management has closed on its settlement agreement with Lehman Brothers Holdings to repurchase Lehman Brothers' minority interest in the general partner (GP) of R3 Capital and its limited partner (LP) investment in R3 Capital's investment fund. Lehman Brothers' GP and LP stakes were repurchased in exchange for US$250m in cash plus a new US$250m LP investment in R3 Capital's investment fund.

As part of the settlement agreement, Lehman Brothers released all potential claims against R3 Capital. The settlement agreement with Lehman was primarily negotiated with Alvarez & Marsal, the restructuring advisor to the LBHI debtors, and Weil, Gotshal & Manges, the attorneys for the LBHI debtors, and was fully supported by the official committee of unsecured creditors of the LBHI debtors.

Dexia reviews FSA's future
The Board of Dexia has indicated that its strategy regarding FSA's role in the group is being reviewed. The Board will maintain the US$5bn unsecured line of credit which the monoline had been granted by Dexia, but a mandate has been given to the ceo "to explore all the options which might enable the specific risk of FSA's activity to be reduced".

Ambac names president and ceo
David Wallis has been named president and ceo of Ambac and Ambac Assurance Corporation (AAC), effective immediately. He succeeds Michael Callen, who was named interim president and ceo in January 2008. Callen will remain in his position as executive chairman of the board of directors.

A 12-year veteran of Ambac, Wallis previously held the title of chief risk officer. As ceo, he has also been appointed a director of both Ambac and AAC.

AC & CS

Credit stability incorporated in rating opinions

A round up of this week's structured credit news

Credit stability incorporated in rating opinions
S&P has confirmed that it is incorporating credit stability as an important factor in its rating opinions; in other words, when assigning and monitoring ratings, it will consider whether an issuer/security has a high likelihood of experiencing unusually large adverse changes in credit quality under conditions of moderate stress. In such cases, the agency says it will assign the issuer/security a lower rating than it would have otherwise. S&P anticipates that the change will have a more pronounced impact in certain areas of the structured finance segment, particularly on its ratings of derivative securities or those where credit risk is primarily a function of market values, such as ABS CDOs and CPDOs.

S&P intends to implement the new approach over a period of about six months. It will apply to ratings on all types of issuers and securities, and to both new and existing ratings.

The agency is incorporating credit stability in its ratings in light of the high degree of credit volatility displayed by certain derivative securities during the past 18 months. By explicitly recognising stability as a factor in our ratings, S&P intends to align their meanings more closely with its perception of investors' desires and expectations.

Transactions and structures that create more significant credit cliff risks would likely experience the largest impact from the action. The change could require modifications to the specific or detailed rating criteria for certain types of issuers or securities.

RMBS recovery assumptions revised
S&P has revised its recovery assumptions for US RMBS collateral backing certain ABS CDO transactions. The agency says it will use the revised recovery assumptions to rate and survey ABS CDO transactions backed specifically by Alt-A, sub-prime, home equity loan and tax-lien RMBS issued in the US during or after Q405.

In addition, S&P will review the expected recovery upon default applicable to CDO tranches that are backed by the affected RMBS collateral on a case-by-case basis. The agency believes the revisions are appropriate, given the observed difference between the originally expected behaviour and the actual behaviour of certain RMBS collateral. These changes reflect S&P's opinion that, based on its current expected losses, the projected credit support for the affected securities is insufficient to maintain its previous recovery assumptions.

To estimate recoveries for the affected RMBS collateral, S&P applied its newly revised RMBS surveillance criteria to sub-prime and Alt-A RMBS issued from Q405 through to Q207. It then calculated the average write-down amount of each rated RMBS that experienced any write-downs in its cashflow analysis.

Fitch reviews counterparty criteria
Fitch Ratings has initiated a review of its counterparty criteria for global structured finance transactions in light of recent market turmoil. Fitch says the aim of the criteria revision will be to make changes which can better mitigate the potential risk of near-term counterparty default from high investment-grade levels, while continuing to maintain a transparent criteria approach.

The review will affect all counterparty criteria and will apply to the structured finance and structured credit transactions the agency rates globally. The documentation is expected to be published by December, initially in the form of an exposure draft to seek market comment.

Fitch's current counterparty criteria generally specifies that only counterparties with issuer default ratings (IDRs) at or above certain levels are compatible with structured finance securities which have been assigned the highest investment grade ratings. The rating levels depend upon the type of counterparty exposure and are detailed in four dedicated criteria reports, addressing hedge counterparties, qualified investments, account banks and liquidity facilities.

In some cases (for example, in the case of Lehman), the bank proceeded to insolvency or receivership from a high investment grade level in a short space of time, with no - or limited - government intervention forthcoming. This meant that, for transactions affected, there was insufficient time for transaction parties to implement remedies provided for in transaction documentation.

Transaction documentation typically provides for a 30-day period following breach of rating triggers to pursue remedies that usually includes finding an alternative counterparty or posting collateral. As a result of the Lehman example, in particular, a number of structured finance transactions with Lehman counterparty exposure have been placed on rating watch negative, with multiple category downgrades possible.

Lehman-related CSOs downgraded
S&P has lowered and kept on watch negative its ratings on 27 tranches from 21 synthetic CDOs. The ratings on six tranches in one transaction have been lowered and removed from watch negative, while the ratings on 12 single-tranche CDOs on were placed on watch negative. The downgrades follow the agency's review of Lehman-related synthetic CDO transactions, where Lehman acts as either the credit support provider or guarantor to various Lehman-related entities that act as swap counterparty to the affected transactions.

At the same time, S&P has withdrawn some ratings for different reasons across five separate deals, either because of lack of information or note redemption with no loss to noteholders, or because of a direct ratings link to Lehman Brothers Holding entities that are no longer rated. A total of 39 deals are affected by these rating actions.

S&P believes that the notes on which it has lowered its ratings will not have enough funds to pay the principal balance and accrued interest on liquidation of the relevant transaction. The tranches with ratings remaining on watch negative reflect its opinion that the notes will be fully paid on the liquidation of the transaction.

These notes benefited from both subordinated swap termination payments and the requirement that Lehman post collateral one period in advance on the coupon owed to the notes. Furthermore, S&P has not taken rating actions on tranches where the proceeds from the liquidation of charged assets and the provision for overcollateralisation is not expected to be lower than the principal of the notes.

Some transactions remain on watch negative while the agency confirms the current status with the trustee. These transactions have features that differ from plain vanilla synthetic CDOs. Depending on the information received from the trustee, S&P may take further rating actions or withdraw its ratings.

Asian CSOs impacted
S&P has also lowered its ratings on seven tranches relating to seven Asia Pacific (ex-Japan) synthetic CDO transactions and kept the ratings on watch negative. The downgraded deals involve Lehman Brothers Special Financing as a swap counterparty and Lehman Brothers Holdings as a swap guarantor. The rating actions reflect the agency's view on the likelihood of loss incurred by the affected transactions.

S&P believes the downgraded notes may not have enough funds to pay the principal balance and accrued interest in full if the supporting collateral is liquidated at present. Once it receives final payment reports, and if the notes experience a loss, S&P will downgrade them to single-D. However, if the notes are paid back in full, it will withdraw the ratings.

ISDA comments on CDS misperceptions
ISDA has emphasised that the Lehman Brothers default and CDS settlement have not created the financial disruption that critics of the CDS business have claimed. First, because the number of CDS trades outstanding on Lehman includes a significant number of transactions that offset each other, settlement payments are only a fraction - about 1% to 2% - of the approximately US$400bn notional of CDS trades referencing Lehman.

Second, because firms are required to mark their positions to market and to post collateral, any additional exposure arising from the cash settlement is incrementally minimal. And finally, despite the failure of this major dealer institution - as well as several other large counterparties - the CDS business continues to function effectively. CDS contracts have been consistently more liquid than their cash market equivalents, ISDA stresses.

In addition, ISDA points out some fundamental misperceptions about the nature of CDS. The biggest misperception facing the CDS business in general is its role in today's financial crisis.

"The root cause of problems of the financial sector is too many bad mortgage loans. While many of the loans were structured into MBS or were repackaged as CDOs and sold to investors around the globe, no individual product or instrument was at fault; the economic fundamentals of those underlying exposures were simply not sustainable," the Association says in a statement.

It goes on to emphasise that CDS, like other privately negotiated derivatives, are bilateral, privately negotiated contracts between counterparties. The business is conducted within a sound policy framework established by policymakers, supervisors and legislators that retains a great degree of market discipline to guide the conduct of swaps participants. Within that framework, CDS trading is subject to extensive regulatory oversight, risk management controls, corporate governance and financial reporting requirements.

"As we move forward, global public policymakers have signaled their intent to review and restructure the global regulatory framework for financial institutions and financial instruments," explains Robert Pickel, ISDA ceo. "The industry welcomes this discussion, and we believe it will provide a forum for explaining and understanding the important benefits that privately negotiated derivatives offer to industry participants around the world. The CDS market continues to operate efficiently and the ISDA framework on which the CDS market arranges settlement of trades is providing legal and operational certainty for the industry in a time of economic uncertainty."

Japanese CSA updated
ISDA has announced the publication of updated documentation for use in arrangements with counterparties or collateral assets located in Japan. The revised version of the 1995 ISDA Credit Support Annex (Security Interest - Japanese Law) has been published to reflect changes in legislation in Japan.

The template is intended for use in documenting bilateral security and other credit support arrangements between counterparties for transactions documented under an ISDA Master Agreement, under which at least one of the parties and/or the collateral is located in Japan as credit support. This Annex assumes that Japanese law will govern questions of perfection and priorities relating to posted collateral located in the country and is designed mainly to provide documentation for parties wishing to minimise exposure to counterparties through collateral arrangements in respect of cash, deposit accounts, Japanese government bonds or other marketable securities situated in Japan.

The revisions made to the 1995 version reflect new netting, bankruptcy and securities clearing system legislation, which were implemented after the Japanese Annex was published in 1995.

Free services on offer for buy-side
Xtrakter has launched XBIS, a series of free information services - including ISIN lookups and traded price data - for buy-side professionals. The service allows users to verify basic reference and pricing data on their desktops without having to install any software. XBIS taps into Xtrakter's new data warehouse and accesses trade information directly from TRAX, an OTC trade matching and regulatory reporting system for the capital markets.

CFOs on watch
Moody's has placed four CFOs backed by equity interests in diversified funds of hedge funds on review for downgrade: Antarctica CFO I (approximately €234m of securities affected), RMF Four Seasons CFO (€211.5m), Sciens CFO I (€240m) and Phenix CFO (€182.5m). The rating actions reflect deterioration in the transactions' overcollateralisation level, due to severe market conditions.

Mixed performance for SME CDOs
Fitch says pan-European SME CDO performance has been mixed, with balance sheet SME CLOs being the best performer while many capital market mezzanine SME CDOs continue to suffer poor performance. These transactions were reviewed using the agency's revised corporate CDO methodology, as their portfolios are much more concentrated compared to typical SME CLOs. Consequently, these deals have not behaved in ways typical of a granular SME CLO transaction.

Despite the continued dislocations in capital markets, six new Spanish SME CLOs have been rated by Fitch between Q108 and Q308. According to the originators, almost all the deals that have been issued are to be used as collateral with the European Central Bank to obtain liquidity.

Since the beginning of the year, negative rating outlooks (NROs) were assigned to 19 tranches from 14 Spanish SME CDOs. The NROs reflect increasing arrears, exacerbated by current concerns regarding industry concentration in real estate and construction-related sectors. The current levels of credit support for the classes on NROs compare unfavourably with the 90+ day delinquency trends when projected forward over the next one to two years.

Outside of Spain, the performance of balance sheet SME CLOs has remained largely stable and has been this year's best-performing segment of the European SME CLO market, according to Fitch. Most of the transactions currently show default levels that are in line with expectations. Collateral pools in these transactions tend to be large and granular, and individual loan defaults do not therefore have an extensive impact on the structure.

Fitch is currently reviewing its SME CDO criteria and methodology to derive default assumptions for non-publicly rated obligors for SME CDOs, as part of its updated CDO methodology approach, and work is expected to be completed later this year. The updated criteria will most likely apply to all SME CLO transactions, except for the capital market mezzanine SME CDOs.

CDO manager ratings updated
Fitch has updated its CDO manager rating criteria to reflect its increased focus on the infrastructure, history, investment processes and related controls of rated CDO managers. Performance as a core metric has been removed to make the analytical approach consistent with the agency's other operationally-oriented asset manager ratings.

The updated framework provides a refreshed, more focused assessment of a CDO asset manager's core operational capabilities, Fitch says. While performance is no longer a standalone rating metric, the agency will continue to assess managers' performance track record in each relevant asset class so that the CDO CAM rating reflects managers' experience through the cycle and its portfolio management capabilities.

Fitch will revise existing CDO CAM ratings to reflect the updated criteria, although the approach is not expected to result in material CAM rating actions in the aggregate. The agency also notes that a significant number of CAM ratings may be withdrawn as a result of significantly reduced CDO new issuance, limited secondary market activity for CDOs and/or reduced investor demand.

WaMu protocol launched
ISDA has launched the 2008 Washington Mutual CDS Protocol, which is open until 20 October. The auction is scheduled for 23 October and will determine the final price for certain Washington Mutual obligations.

"The success of ISDA's protocol and auction process demonstrates a fundamentally important point about our business," comments ISDA executive director and ceo Robert Pickel. "Our industry, working through ISDA, has invested a significant amount of human and financial resources to build a robust framework and infrastructure for the privately negotiated derivatives business. The framework works and is helping the financial industry to negotiate the difficult economic times that have resulted from sub-prime lending issues."

Monolines to benefit from TARP?
A US Treasury spokesperson has denied speculation that the government is considering taking stakes in selected bond insurers. But Michael Cox, credit strategist at RBS, suggests that the monolines may benefit from TARP in other ways. "They may, for example, seek to sell assets in CDOs in which they are the controlling creditor to TARP. TARP may make banks more likely to agree to commutations of CDS, particularly as the credit quality of the monolines falls and hence the value of the protection also falls, as they could sell the assets on which they have purchased protection into TARP. The benefit or otherwise of this will only become clear once we understand how TARP will value assets," he notes.

Portfolio compression runs completed
Markit and Creditex have announced the successful completion of a second round of industry-wide portfolio compression runs for the credit derivatives market in North America. Live portfolio runs took place on 16 October for CDS contracts referencing several widely traded North American technology, media and telecommunications companies. It achieved a 54% gross notional reduction across all participating counterparties, with 13 credit derivatives dealers participating.

Markit and Creditex were selected by ISDA to provide infrastructure to support commitments made by major market participants to the Federal Reserve Bank of New York relating to improved operational efficiency and risk reduction.

The first North American compression run was held on 27 August for widely-traded telecommunications companies. Compression runs for CDS referencing European technology, media and telecommunications companies occurred on 4 September and 11 September.

Corporate CDS under pressure
The number of global companies with five-year CDS trading above 500bp has risen to 271, up from 138 in September and 80 in May, according to analysts at BNP Paribas. Most of the companies are in the financial sector, followed by consumer cyclicals; a geographical breakdown shows that the majority are in the US (200), with fewer in Europe (60) and in Asia (11). "While the distribution of US corporate debt coming due is not particularly front-loaded, more than US$130bn of notional will probably have to be refinanced by 2010. This amount, which would have been easily absorbed before August 2007, will be quite a lot to swallow if the current situation persists," the analysts note.

In Europe, the situation appears to be a somewhat more manageable, with less than €50bn of bonds and loans coming due in the next two years. Nonetheless, the prospect of these companies soon having to go to the markets (or to the banks) to fund themselves in the current environment is of concern.

Markit Metrics data released
According to the latest Markit Metrics report, average monthly credit derivatives deal volume per dealer hit 25,000 in September, with just under 18,000 trades electronically confirmed. On average around 93% of total deal volume was confirmed electronically, with approximately 97% of total deal volume eligible for electronic confirmation (96% of eligible trades were electronically confirmed).

Average outstanding confirmations were just under 3000, and average business days' worth of outstanding confirmations aged over 30 days stood at 0.3 days. Finally, the average number of pre-netted settlements reached 300,000, while the average number of post-netted settlements totalled 25,000.

Monoline risk-adjusted pricing analysed
The risk-adjusted pricing indices associated with bond insurers that underwrote at least a billion dollars of par in H108 illustrate the effects of a financial guarantee market in flux, according to S&P. While insured new-issue volume is significantly lower in all business lines, it appears insured secondary market transaction volume and pricing are the strongest they have ever been. The risk-adjusted pricing index is a measure that shows how much premium has been charged per unit of risk.

S&P believes that new business prospects for existing insurers as well as new entrants are uncertain given that, while the US public finance new-issue market was active in the first half of the year, the insured penetration rate was significantly reduced - and is likely to remain so for the next several years - and the structured finance business for the insurers is dormant. The agency expects that disciplined underwriting will be key for the bond insurers going forward as they develop a book of business that has strong risk/reward characteristics which may generate earnings well into the future.

The risk-adjusted pricing indices are calculated by S&P for financial guarantees written in a given period (usually one year) for each of the four broad financial guaranty business lines: US public finance, US structured finance, international public finance and international structured finance. A book of businesses' weighted average premium rate is divided by its weighted average capital charge to produce the risk-adjusted pricing index. Capital charges are assigned to all insured transactions and are used to determine theoretical losses in S&P's capital adequacy model.

The insured volume trends in each of the three business lines for which there was a meaningful amount of business underwritten highlight a refocus of strategies by bond insurers towards the lower-risk public finance market and away from the higher-risk structured finance market. Reflecting the current disruption for most sectors in the US structured finance market, H108 insured volume was down substantially.

Those sectors experiencing the greatest decline in volume included pooled debt and mortgage-backed and home equity line of credit. With little competition and insurers being very selective in what they underwrite, pricing was very robust and the quality of underwriting, as measured by S&P's capital charges, was sound. For this business line, the agency believes that pricing may remain strong and underwriting quality sound because of the limited number of participants, as most insurers have restricted underwriting in this line.

In the international structured finance business line, most of the production in H108 was in the mortgage-backed and home equity sector, compared with a concentration in the corporate CDO sector for the same period in 2007. Insured par production has long been dominated by private placement corporate CDOs due to what appears to be limited acceptance in capital markets of the financial guaranty product, as illustrated by historically low insured par volume.

The global capital markets' wariness of the financial guarantors, combined with a pullback by the insurers in insuring CDOs, may all but close them out of this market in S&P's view. Proposed insurance regulation may also limit, if not prohibit, activity in CDO sector.

Credit risk stress-tested
A paper entitled 'Stress Testing Credit Risk: Comparison of the Czech Republic and Germany' has won the Financial Stability Institute's Award for 2008.

In quantitative terms, credit risk is the most important risk in banking books, according to the paper. This has recently been evidently shown again in the example of the US sub-prime crisis.

Moreover, the crisis occurred despite various improvements in credit risk management (for example, the progress in the field of credit risk analysis applied by banks on the portfolio level - spurred by Basel II), as well as the increasing availability of a wide range of instruments that make credit risk more liquid (for example securitisation and credit derivatives). Hence, credit risk remains a major threat to financial stability in a globalised financial world, where the cross-border contagion of crises particularly threatens countries with a weak banking sector, the paper says.

Credit risk analysis for the financial sector as a whole can be perceived as a crucial means to prevent the occurrence of financial crises. This can be realised by means of a regular robustness test on a country's banking sector against credit risk; for example, by means of stress tests being carried out by supervisory bodies and central banks providing hints to detect financial system fragility.

Within the framework of credit risk modelling and stress testing, the study investigates and compares two countries - the Czech Republic and Germany. The paper seeks to provide answers to various questions, including: which macroeconomic variables are the most important to explain credit risk; whether there are country-specific differences; and what impact the occurrence of unfavourable macroeconomic circumstances can have on the macro and micro (portfolio) level, respectively.

EVVLF downgraded
Moody's has downgraded the MTNs (US$455m currently outstanding) and capital notes (US$209m) issued by Eaton Vance Variable Leverage Fund from Baa2 and Ca to Caa3 and C respectively. The rating actions reflect the deterioration of the market value of the vehicle's asset portfolio. Moody's will review whether the expected loss of the MTN programme is consistent with the expected loss implied by a Caa3 rating.

EC calls for credit risk mitigation proposals
Charlie McCreevy, the European Commissioner for internal market and services, has called for concrete proposals as to how the risks from credit derivatives can be mitigated to be developed by the end of the year. He also plans to have a systematic look at derivatives markets in the aftermath of the lessons learned from the current turmoil. As such, all the main players concerned are set to convene in order to work through these issues.

"I am aware of the many reasons why more of these derivatives are not exchange-traded," the Commissioner explains in a statement. "However, I am not convinced that more derivatives could not be standardised. This is one of the issues we need to look at in the time ahead. But there is a far more pressing need and that is to have a central clearing counterparty for these derivatives."

CPDOs hit
Moody's has downgraded the ratings of 13 series of CPDO notes, both static and managed, with approximately €714m of debt securities affected. The rating actions are based on a worsening of the net asset value of the transactions, following recent market events.

Separately, the agency has downgraded to C the rating of the Series 8 US$100m SURF CPDO, following the unwinding of the transaction portfolio due to a strategy unwind event that occurred on 9 October. Moody's has also withdrawn the rating of Series 2007-2 €135m Ulisse Capital CPDO because the agency believes it lacks adequate information to maintain a rating.

Analytical tool launched
S&P has launched Rating Review Triggers on its ABSXchange platform. The tool, available free of charge for both ABSXchange users and other market participants, is designed to give investors more information about the ongoing performance of collateral pools backing individual mortgage securities and an early warning indicator of potential future rating actions on these securities.

It is the first time that an analytical tool used by S&P ratings analysts as part of their European RMBS surveillance has been made available for free to the marketplace. Providing it free to the market is one of a number of measures that S&P is taking to improve the transparency of structured finance instruments, including publishing more information about assumptions and stress tests underpinning its analysis and 'what if' scenario analyses that show how ratings might be affected by extreme economic or market conditions.

ABSXchange is an internet-based portal that offers deal performance data, portfolio monitoring capabilities, cashflow analysis, advanced analytics and detailed reporting for the structured finance market. It provides the same quality of data and analytics throughout the life of a structured finance transaction as existed at its initial offering.

The development is part of the first major update to the ABSXchange platform since it was acquired by S&P in September 2007. The platform is run by S&P's new business unit, Fixed Income Risk Management Services (FIRMS), which is separate from S&P's ratings business.

Triggers offers users a desktop view of the credit performance of RMBS transactions tested against specific metrics. It is a user-friendly, web-based application that provides a visual indicator of credit performance to denote a transaction's trends across two positive and four negative tests.

The positive tests assessed are pool factor and credit enhancement ratio, while delinquency ratio, delinquency growth, cumulative loss growth and cumulative loss ratio are monitored as negative tests. At a certain test threshold, Triggers notifies the user that a transaction will need to be reviewed and raises the possibility of a rating review.

IMF calls for coherent response
Restoring financial stability in Europe is the main policy priority for governments, and requires a comprehensive and coherent global approach, according to a new report from the IMF. European policymakers have recognised that coordination of crisis management measures is essential, with several central banks announcing a coordinated interest rate cut in October and expanded liquidity provision.

European leaders also agreed on the principles of crisis management and followed up with a number of measures aimed at stabilising markets, including extended deposit insurance, bank recapitalisation programmes and debt guarantees (see SCI passim). While the various measures retain some country-specific flavor, they represent an important move toward a new coherence in European policy efforts.

"Times are no doubt extraordinarily uncertain, but we are now seeing the concerted response that demonstrates policymakers' awareness that the global crisis needs a global response. For Europe, this crisis provides a catalyst for improved cross-border coordination, and we encourage European leaders to follow up with bold steps on their recent commitment to concerted and coordinated action, to resolve this crisis swiftly," comments Alessandro Leipold, acting director of the IMF's European department.

Beyond immediate crisis management, Europe will need to rethink its financial stability arrangements, the IMF warns. This will require action on a range of fronts, including stepping up joint financial oversight, introducing mechanisms to strengthen market discipline and improving the cross-border crisis resolution frameworks.

Sigma-backed CDOs downgraded again
S&P has lowered to single-D and removed from credit watch with negative implications its credit ratings on nine synthetic CDOs issued by the C.L.E.A.R. vehicle. These rating actions reflect the recent downgrade of the underlying collateral - debt issued by Sigma Finance - which the issuer purchased using note proceeds in each transaction.

Japanese CDOs impacted
S&P has lowered to single-D its ratings on eight other tranches relating to eight Japanese synthetic CDO transactions and removed the ratings from credit watch with negative implications. The agency carried out the aforementioned rating actions after lowering from triple-C minus to single-D the ratings on the transactions' collateral securities on 17 October and removed the ratings from watch negative.

Total return indices launched
Markit has launched the Markit iTraxx Europe Financial Total Return indices. The new indices replicate the performance of a sample portfolio that buys or sells an iTraxx CDS contract and invests the remaining notional amount in money market instruments. The indices have been designed to serve as a benchmark for institutional investors with debt positions in financial institutions.

The new indices are comprised of the following: iTraxx Europe Senior Financials 5-Year Total Return Index; iTraxx Europe Subordinated Financials 5-Year Total Return Index; iTraxx Europe Senior Financials 5-Year Short Total Return Index; and iTraxx Europe Subordinated Financials 5-Year Short Total Return Index. Markit has licensed Deutsche Bank to offer exchange-traded funds on these four products.

Commercial property indices flat for August
Commercial real estate prices as measured by Moody's/REAL Commercial Property Price Indices (CPPI) essentially remained flat in August, posting a small decrease of 0.1% over the level measured in July. August was the second month in a row that the CPPI showed virtually no movement in prices.

"Although we have not seen a significant decline in prices since June, we believe it is premature to call a bottom at this time," says Moody's md Nick Levidy. "Rather, the low transaction volume suggests that the flattening of prices is more likely the result of loss avoidance on the part of sellers."

"At some point," adds Levidy, "with increased pressure on sellers and more distressed assets in the marketplace, we expect that volume will pick up and prices will continue to drop."

Transaction volume was down 25% in August from the previous month, and stands at less than half of what it was at the start of the year.

Overall, the CPPI suggests commercial property values are essentially flat since 2006, while they have increased by almost 9% since 2005 and by nearly 30% since 2004. With the small August decline, prices have decreased by 11.2% from August 2007 and 11.5% since the peak in October 2007. It is important to note, however, that less than 1% of mortgage loans originated in 2007 mature prior to 2010, somewhat mitigating refinancing risk, at least for now, says Moody's.

Carador reports
As at the close of business on 30 September 2008, permacap Carador's unaudited net asset value per share was €0.6497, decreasing by 4.70% in September. This month's calculations include an estimated €545,352.85 worth of net cashflow interest received in the month (to be allocated between capital and income), which equates to €0.0109 per share.

The board has declared a dividend in respect of the six-month interim period ending 30 September 2008. This dividend is payable on 31 October 2008 and has not been accrued for in the September valuation.

Reval releases new upgrade
Reval has released its latest upgrade of HedgeRx Version 8.1. The new version includes new structured interest rate and credit modules and has expanded compliance reporting for IFRS 7, FAS 161 and FAS 157.

Reval's software-as-a-service platform has the ability to upgrade clients to the new version instantly. Its multi-asset class solution now covers foreign exchange, interest rates, exotic interest rates, credit, energy and commodities.

AC & CS

A first look at new accounting rules: possible asset re-classifications under IAS 39

Hans Vrensen, head of European securitisation research at Barclays Capital, assesses the impact of IAS 39 asset re-classification on the securitisation market

On 15 October 2008, the European Commission adopted amendments to certain accounting rules (see last week's issue). These amendments will allow companies to reclassify assets held-for-trading into the other three financial asset categories, namely available-for-sale, loans & receivables or held-to-maturity categories. In this note, we describe the existing rules and take a first look at the newly-adopted amendments in more detail. Finally, we assess their impact on the securitisation market.

The existing rules
We refer to IAS 39 (Financial instruments: recognition and measurement) and summarise its implications. These rules apply to all entities, not just banks. Financial instruments including mortgage loans and ABS bonds are classified at origination based on:

• The nature of the asset, eg, loan asset or a listed bond in an active market; and
• The intent of the asset originator at inception - trade or hold to maturity.

Based on these criteria, assets are classified in five categories, summarised in Figure 1. The assessment of impairment depends on the expectations of future receivable cashflows.

If an adverse credit event has taken place, it is likely that an impairment indicator is triggered. In that case, if the expectations of future receivable cashflows actually result in an expected loss, it is booked through the P&L.

Under US GAAP, there was a recognition that, in rare circumstances, a re-classification could be appropriate. IFRS did not allow any such re-classification in treatment. This difference has prompted the EC to bring IFRS in line to ensure a level playing field for the accounting treatment of European and US companies.

The amendments
Under the newly-adopted rules, companies can re-classify assets under certain conditions. First of all, the re-classification is only possible as a one-time event, so no reversals are possible.

Loans that were originated (or acquired) with the intent of being securitised or repackaged into bonds which were held on the trading or AFS book can be transferred to the L&R category at the current mark-to-market level. Also, in rare circumstances, listed bonds quoted in an active market can also be re-classified from the trading book to AFS, for example. Loans or bonds that were initially designated under the fair value option cannot be re-classified.

The recent extreme turbulence seen in the global financial markets is now widely accepted under both US GAAP and IFRS as an example of such rare circumstances. The amendments are aimed at avoiding financial institutions and other companies having to report mark-to-market losses based on financial markets trading at very low volumes and with pricing reflective mostly of distressed sales, regardless of the continued performance of the underlying.

Any re-classification of assets will have to be disclosed in the financial statements, as well as its impact on the P&L. Banks are likely to want to carefully consider whether a re-classification is appropriate, because the then current mark-to-market loss will essentially be permanently locked in.

Although on re-classification the value can be accrued up to par over the remaining life of the asset, immediate write-ups are not possible in L&R as there is no mark-to-market. Banks are likely to consider the full extent of their assets for potential re-classification.

Also, banks might consider the views of equity investors and analysts as the consistency of comparison between banks will likely suffer. The required disclosures should aid comparison to some degree.

The amendments will become effective per 1 November 2008, but can be retro-actively applied from 1 July 2008. Therefore, they could affect Q3 bank results. In addition, potential losses based on mark-to-market between 1 July 2008 and today can be reversed if re-classification is implemented, assuming no impairment.

Possible impact
Speaking with professionals about these amendments, we would expect further detailed guidance before the effective date to help companies with their implementations. As a result, it is too early to determine the full long-term impact of these amendments on banks and the securitisation market. Banks have not decided yet on the net pros and cons of the possible re-classification, as they consider both the additional complexity in reporting, as well as limited benefit in reporting realised losses.

However, in our view, even if only some banks re-classify ABS assets away from the trading book, it is likely to reduce the supply of these assets to the secondary market. As a result, we could expect the volatility of assets prices to be more limited as fewer investors will look to sell. However, this might no longer be a major factor, as it is offset by the already prevailing lack of willingness by existing investors to sell combined with an increase in flexibility around selling of existing holdings under self-imposed ratings restrictions.

© 2008 Barclays Capital. All rights reserved. This Research Note was first published by Barclays Capital on 20 October 2008.

Trading ideas: still printing

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

US manufacturing numbers released last week signal a deepening economic downturn. As credit spreads in non-financials widened substantially in recent days, this comes as no surprise. Certain credits, such as Xerox Corp, have borne the brunt of the market's fear-based widening.

Though we have largely been bearish on Xerox's credit (when it traded below 200bp) for most of this year, we believe it is great value at a spread above 500bp. Spread compensation based upon equity-implied default probability is at an all-time high for Xerox.

Clearly the company is not immune to the economic downturn and when it reports earnings this week we expect a continued decline in margins. However, current spreads are pricing in a significant earnings miss and deterioration in future profitability, which we think represents a low probability event.

Our biggest concern for Xerox is how aggressively management moves ahead with an authorised US$1.7bn in stock buybacks. We hope they exercise prudence and hold onto cash rather than buy equity in a falling market.

Based on our quantitative credit model, Xerox's credit spread trades 200bp too wide due to decent free cash, accruals and equity-implied factors. We recommend selling protection on Xerox Corp.

Hold on to the cash, please
Xerox is a frequent visitor to the new issuance corporate bond market, with almost US$9bn in total outstanding debt. Going forward, if managed correctly, this will not end up a problem for management.

The second half of the fiscal year is when Xerox generates a majority of free cash from operations which can help buffer cash constraints due to maturing debt (over US$1bn in the next year). This can be a blessing or a curse depending on how management uses its authority to buyback US$1.7bn in equity.

With the credit market essentially on ice and stocks dropping daily, management should be prudent and hold onto whatever cash the company generates over the next couple of quarters. When Xerox announces earnings this week we will be looking for statements of this nature.

Recent comments by management suggest a desire to remain an investment grade rated company. With this in mind, cash conservation will be of necessity.

Looking cheap
Our credit model attempts to replicate how a fundamental credit analyst thinks. While this is extremely arduous, the output provides a great way to select long/short trades.

The model ranks each issuer on a scale of 1 to 10 using seven factors (1 = poor credit, 10 = good credit). Exhibit 1 lists all the factor scores for Xerox. We see a 'fair spread' of 380bp for its free cashflow, accruals and implied volatility factors.

Exhibit 1

Over the past year our credit model has consistently been negative on Xerox's credit spread. We expressed this through a pairs trade with Tyco in April, which performed extremely well.

However, with the recent move of Xerox's credit spread, the model turned decisively positive. As shown in Exhibit 2, Xerox's spread traded through our fair value level a few weeks ago and is now more than 200bp wide of fair.

Exhibit 2

The model does show Xerox's credit risk to have increased in recent weeks but not nearly to the level being priced in the market. More information will be available when Xerox releases earnings this week and we think now is a good time to sell protection.

Spread compensation
A measure we use to find desirable 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).

The SPD for Xerox shot upwards on the back of the recent credit freeze. The spread compensation an investor receives for taking on a long credit exposure to Xerox is at all time highs (Exhibit 3).

Exhibit 3

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

The CDS spread for Xerox recently widened substantially on the back of the credit freeze. Though its credit risk has increased due to the current downturn and tougher credit market, we believe its spread is cheap above 500bp (Exhibit 4).

Exhibit 4

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 increased bid-offer to cross in the neighborhood of 30bp-40bp. The trade has positive carry and roll down, which will offset any potential spread widening.

Entering and exiting any trade carries execution risk and XRX's liquidity is poor at best, given the current market conditions.

Summary and trade recommendation
US manufacturing numbers released last week signal a deepening economic downturn. As credit spreads in non-financials widened substantially in recent days, this comes as no surprise.

Certain credits, such as Xerox Corp, have borne the brunt of the market's fear-based widening. Though we have largely been bearish on Xerox's credit (when it traded below 200bp) for most of this year, we believe it is a great value at a spread above 500bp. Spread compensation based upon equity-implied default probability is at an all-time high for Xerox.

Clearly the company is not immune to the economic downturn and when it reports earnings this week we expect a continued decline in margins. However, current spreads are pricing in a significant earnings miss and deterioration in future profitability, which we think represents a low probability event.

Our biggest concern for Xerox is how aggressively management moves ahead with an authorised US$1.7bn in stock buybacks. We hope they exercise prudence and hold onto cash rather than buy equity in a falling market.

Based on our quantitative credit model, Xerox's credit spread trades 200bp too wide due to decent free cash, accruals and equity-implied factors. We recommend selling protection on Xerox Corp.

Sell US$10m notional Xerox Corp 5 Year CDS protection at 600bp.

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).