Contents

CDS

Knowledge gap

Regulators' motivations questioned

The critical knowledge gap between those in the credit derivatives market and those outside is being underscored as plans to regulate the CDS market continue to be espoused. Consequently, there are increasing concerns that such actions are being driven by a desire to control the unknown rather than for more well-founded reasons.

"The urge to regulate CDS comes from a primitive desire to control the 'things-we-don't-understand'," suggests Christofferson, Robb & Co ceo Richard Robb. "But there is no clear notion about why or how the regulation will be undertaken or what problem it is trying to solve."

He says that single name CDS have served a real purpose. From Parmalat to Quebecor World, companies have defaulted, while no bank was stuck with all the risk. This may have lulled some hedge funds, banks, investment banks and their regulators into believing that the financial system was so secure that they were willing to tolerate unsafe amounts of leverage and liquidity risk.

"Even now, when you look at how CDS have allowed banks to hedge single name exposures and spread the risk out to end-users, there's nothing broken in that model. If CDS had never existed, the situation at Fannie/Freddie for example wouldn't be any different," Robb comments.

Brendan Dillon, CDS trader at Aberdeen Asset Management, agrees that the Lehman Brothers auction is evidence that the CDS market is working and spreading risk efficiently. He adds: "While the introduction of a central counterparty is a good move in terms of alleviating counterparty risk amongst the major dealers, it is unclear how additional oversight of the corporate CDS market would improve its operation. Nonetheless, I believe there'll be a political push to regulate insurance activity and the corporate CDS market will likely be included in that push."

Dillon says that a common misperception is to lump what are two separate CDS markets into the same pot: one where corporate risk is traded and one where insurers/monolines were selling protection on structured products. "The latter should be regulated because it essentially allowed insurers to sell insurance without reserving against it by calling the product 'swaps'," he argues. "For any regulatory changes going forward, it will be key to make the distinction between the corporate CDS market and what was going on at the monolines and AIG; in this sense, the New York Insurance Department's move last month was a step in the right direction [see SCI issue 105]."

While AIG FP's use of CDS adversely impacted the market (because it didn't hold enough capital against its super senior exposure), credit derivatives otherwise haven't played a role in the crisis. Rather, the crisis has more to do with investing in illiquid assets and relying too heavily on short-term borrowing. Failing to hold enough capital for liquidity lines, for example, harmed the financial sector far worse than CDS have but no-one's implying that this should be subject to regulatory scrutiny.

However, Robb notes that ultimately the CDS market has grown too large for what it achieves. "There is too much concentration/correlation in trading, for little social benefit," he says. "The market is likely to revert back to something more sustainable, leaving exotic structures behind. FTDs, for example, are essentially two offsetting trades that allow the counterparties to profit from their models. As such, some participants lost their way in terms of why they're trading CDS and ended up tarnishing the rest of the structured credit field, which has a legitimate role."

Understanding of the differences between single name CDS trades and tranches or bespoke products needs to be improved, according to Dillon. "There are significant technical pressures in the CDS market right now," he explains. "In addition to the well-documented potential synthetic CDO unwinds [SCI passim], we have just recently begun to see portfolios of basis trades hitting the market in list form - presumably due to a hedge fund liquidation. Synthetic CDOs and basis books were the largest players in the CDS market over the last few years; as the trades unwind, it is important to know how they will affect the rest of the market."

CS

CLOs

Second wave

Market value CLO restructurings signal further market deleveraging

The unprecedented fall in leveraged loan pricing has triggered a second wave of pressure on market value CLOs. However, analysts report that this is only the latest episode in a broader retreat from leveraged structured credit investments.

"The wave of deleveraging is starting to hit assets that were further removed from being threatened; the troubles in CDOs backed by investment grade corporates are a good example," confirms Nicolas Gakwaya, CDO analyst at Merrill Lynch. "Excessive leverage has meant that defaults have hit deeper and faster than expected - high up in the capital structure in some cases."

Consequently, Gakwaya says, there is an increasing focus on price discovery - involving adjusting expectations on underlyings and taking more and more conservative views for the next few years. "Asset prices are reflecting distressed scenarios, so there are opportunities to identify relative value if you can do the homework. But investors aren't necessarily used to doing this, and supply far outweighs demand for the time being, so that the recovery is likely to be slow."

European and US loan prices have fallen to 68% and 70% respectively from the mid-80s at the beginning of the month, which resulted in pressure on market value CLO ratings last week. Moody's downgraded all tranches of Sankaty High Yield Partners 2006-3A and 2005-2, twice during the week, indicating a risk of default due to OC test failure. In addition to downgrading these same deals, S&P put another 18 tranches from 12 CLOs on its watch list.

One banker notes that the market value transactions that were hit earlier in the year (SCI passim) were in general the more levered TRS-type CLOs. Yet, the fact that loan prices are now in the mid-60s to 70s has triggered a broader number of downgrades - and consequently restructurings - in the sector.

Last week's conversion of CELF Investment Advisors's credit opportunity vehicle CELF European Credit Partners into the cashflow transaction CELF Loan Partners 2008-2 is one example. The CLO comprises €338m AAA/Aaa notes, which priced at 176bp over six-month Euribor, and a hefty €218.3m of equity.

Given the generous subordination, the banker suggests that the equity investors or the manager may have injected some extra capital into the structure as a sweetener to debtholders. "The alternative conceivably would have been for the deal to unwind and crystallise the mark-to-market loss, but with loan prices as low as they are this could have pushed prices even further down. From an investor's perspective, they'll lock in the coupon and be sitting on significant excess discount."

Traditionally, market value CLOs have 25%-30% subordination, but the fall in loan prices will have reduced this cushion dramatically. "Now whether that amount of cushion can protect senior debt depends on the view that you take on default rates going forward," the banker adds.

He continues: "Prices could fall to 50c on average in the downturn both because we're in an unprecedented cycle and because the leverage in some of the underlying companies is high. So far this year there have been two public defaults in Europe - Martinsa Fadesa and Belvedere - whose recoveries were in the high-20s/mid-30s. Though you could argue that they are outliers, it indicates how bad defaults could get - the managers who had these names in their portfolios have certainly been walloped."

However, given that market value CLOs represent only a small proportion of the sector in Europe, asset liquidation/restructuring activity is expected to be more prevalent in the US. Additionally, leveraged non-bank investors dominate as risk holders in the US loan market.

"As prices decline, these mark-to-market sensitive investors become forced sellers, triggering a classic negative feedback spiral effect," note securitisation analysts at Deutsche Bank. "In Europe, term funded natural buy-and-hold investors such as cashflow CLOs and commercial bank loan books outnumber the margined financed funds, dealer warehouses and market value CLOs (better sellers in a price-declining scenario) by three to one, on our count. The comparable ratio is 1.25 to one in the US, by our estimates."

CS

Ratings

Triple-C concerns

Migration to triple-C main worry for CLO managers, not defaults

Wholesale downgrades by rating agencies, whereby leveraged loan ratings are reduced to the triple-C level, are causing a headache for a number of CLO managers who fear that the headroom in triple-C buckets is insufficient. While some suggest that these downgrades may cause CLOs to trip covenants - in a way that is not warranted by actual payment default - and result in CLO unwinds, others are confident that the majority of structures still have plenty of headroom.

Speaking at the European CLO & Structured Products Summit held in Monte Carlo last week, panellists agreed that it is triple-C buckets that remain the main problem in the near-term for CLO managers - not the potential for underlying defaults. "Weak deals may begin to unwind off the back of numerous ratings migrating to triple-C, although this shows that CLO structures are working properly," said one manager.

Further negative rating migration in leveraged loans is still expected by rating agency analysts. According to Manuel Arrive, director at Fitch Ratings, there is potential for further rating migration below single-B minus in leveraged loans. However, he is confident that there is still headroom in CLO triple-C buckets.

"The majority of European CLOs are seeing 1%-2% reached out of a possible 5%-7.5% in their triple-C buckets at the moment," he said. "It will take a very poor manager to bring a European CLO deal to EOD in the next couple of years, given the current headroom on OC tests."

Although a rise in defaults is inevitable over the next 18 months, CLO managers at the conference commented that it would be hard to envisage a situation where triple-A tranches of CLOs would lose money. Ian Perrin, vp at Moody's, noted that there will certainly be an increase in defaults in the near future, but said it is too early to judge how high they will be.

"Some early vintage CLO transactions have been able to build up some par value," he commented. "There will need to be a lot of defaults and very low recovery rates for triple-As [to lose money]."

Default predictions for the next 18 months from conference attendees varied from low single-digit figures to low double digits, although most agreed that defaults in Europe will be lower than in the US this year, with a rise in Europe in 2009 and a peak in 2010/2011. Panellists also confirmed that recoveries would vary in the near term, but expected that they will most likely be lower than in the past.

Fitch's Arrive concluded that he expects a CLO manager performance triage to emerge within the coming months. "Those managers at the top will be those that maintained their credit standards and had the required sourcing capabilities when accumulating collateral in 2006-2007, at the peak of the cycle," he said.

AC

Structured credit team beefed up

The latest company and people moves

Structured credit team beefed up
Oak Hill Advisors has appointed Goran Puljic, TK Narayan and Scott Snell to the firm's structured products group, where they will be focusing on credit market investment opportunities. They join from Lehman Brothers.

Credit trading head appointed
Arne Groes, former global head of credit trading at ABN AMRO, has joined BNP Paribas as global head of credit flow trading.

Credit sales head hired
Aladdin Capital has appointed Neal Neilinger as vice chairman and cio. He was most recently global head of credit sales, trading and syndicate in Calyon's London office. In his new role Neilinger will be based in Aladdin's Stamford headquarters and report directly to Amin Aladin, the firm's chairman and ceo.

CDO veteran hired for structured asset management
Prudential Fixed Income Management has appointed Sara Bonesteel to head its efforts to identify new opportunities for structured asset management and to develop financing strategies and relationships for its many businesses, including its hedge strategy, CDOs and insurance businesses. Before joining Prudential, she was a senior md for Bear Stearns' financial analytics and structured transactions group, continuing in the role following the company's merger with JPMorgan in June.

Bonesteel has more than 17 years' experience covering asset-backed fixed income products and financing techniques across mortgages, CMBS, CDOs and other fixed income assets, and has extensive knowledge of ABCP, SIVs and CDPCs. She has a successful record of accomplishment in developing creative asset financing strategies using structured finance techniques, and has most recently been involved in initiatives to seek solutions for holders of distressed structured finance assets such as SIV liabilities.

Trading head appointed
Jefferies & Co has hired Chander Gupta as head of European ABS and MBS trading. He will be responsible for servicing the needs of European customers on US mortgage products, as well as creating a franchise in European ABS and MBS. Prior to joining Jefferies, Gupta was an md at RBS where he was head of European ABS trading.

Amherst adds MBS salesman
Amherst Securities has hired Peter DiMartino as an MBS salesperson. DiMartino was previously responsible for MBS, ABS and associated derivatives products research at Bear Stearns.

All change at Gramercy
Gramercy Capital has appointed Roger Cozzi president and ceo, replacing Marc Holliday, who is stepping down. Gramercy's cio, Andrew Mathias, and its cco, Gregory Hughes, are also stepping down from their positions at the company, effective immediately. Holliday and Mathias will remain as consultants to Gramercy until September 2009.

Cozzi joins from Fortress Investment Group, where he was md. From 1998 to 2007 he worked at iStar Financial Inc, a publicly traded real estate investment trust focused on the financing of commercial real estate. While at iStar Financial, Cozzi was responsible for the origination of structured financing transactions and he closed over US$3bn of first mortgage, mezzanine and corporate finance investments.

Credit structurer joins energy division
William Gleason has been appointed president of the newly-formed Chinook Energy division within Chinook Sciences. Gleason was previously md at Credit Suisse, where he was responsible for credit structuring. Chinook Energy will be responsible for pioneering Chinook Sciences' energy business in North America, and is looking to finance its first US energy project.

Manager consolidation expected
Conference attendees in Monte Carlo last week commented that the extent of manager consolidation had proved less prevalent than originally expected. While the likelihood of bigger managers buying small managers was not ruled out, some suggested it would be more likely that smaller managers with good backing will be seen building up critical mass by purchasing other small managers in the coming months.

S&P launches FIRMS business
S&P has launched its Fixed Income Risk Management Services (FIRMS) business to deliver solutions that help investors perform greater due diligence on the financial instruments in their portfolios. The move combines several previously separate business and product lines under a unified mandate to provide enhanced analytics and greater context around asset pricing and the inter-related linkages between counterparties and obligors.

"For both investors and regulators, transparency has come to mean not just more data, but also greater analytics and insight around the financial instruments in exceedingly complex portfolios," says Lou Eccleston, executive md of S&P's Fixed Income Risk Management Services. "The mission of FIRMS is to bring greater commercial analytics capabilities to the marketplace, not just in response to market demand, but also to support the many methodological and transparency enhancements we've been making on a company-wide basis to advance the understanding and use of credit research."

FIRMS' provides global investors and markets with:
• Qualitative and quantitative market research and commentary
• Credit ratings information, data distribution and insight
• Real-time coverage of the leveraged loan primary and secondary markets Company cross-tagging of global identifiers, reference data, counterparties and securities to identify global linkages
• Credit risk models and solutions
• Structured finance models, analytics and solutions
• Independent securities evaluations for cash fixed income and structured finance instruments.

AC & CS

Industry working group convened

A round up of this week's structured credit news

Industry working group convened
The European Commission has convened an industry working group to review operational matters in the wholesale derivatives industry. ISDA participated in the initial meeting, alongside a number of other financial industry trade associations.

"Today's discussion was open and constructive in tone," ISDA chairman, Eraj Shirvani, co-head of credit sales and trading at Credit Suisse, notes in statement on the meeting. "Participants are reviewing progress in operational efficiencies and will seek to examine the exact nature and extent of challenges the markets are facing in ensuring operational and systemic security, as well as where further progress might be needed. The first priority of this working group is planning for a centralised clearing counterparty, with a medium-term goal of reviewing market transparency."

ISDA is working with a coalition of trade associations on these issues and confirms that it will work with the Commission to meet any goals that continue to improve operational efficiency and promote legal certainty. To that end, the Association continues to advocate an EU Directive on netting to reinforce the bilateral close-out netting regime in Europe.

Meanwhile, MEPs have stressed that the EU needs a coordinated response on a range of fronts in order to tackle the financial crisis and limit its impact on economic growth, jobs and small businesses. In a resolution on the EU summit, they also called for measures to improve financial supervision.

Lehman CDS settled "without incident" ...
DTCC has confirmed that its Trade Information Warehouse successfully completed the automated credit event processing and settlement of CDS contracts related to the Lehman Brothers Holdings credit event. This processing resulted in approximately US$5.2bn in net funds transfers from net sellers of protection to net buyers of protection.

"The portion of this net funds settlement allocable to trades between major dealers was settled through the normal settlement procedures of CLS Bank for Tuesday, 21 October, without incident," it says.

... while WaMu net funds transfer is detailed ...
The DTCC has announced that, based on gross and net positions maintained at its Trade Information Warehouse relating to the Washington Mutual credit event, the net funds to be transferred on outstanding single name CDS from net sellers to net buyers of protection are expected to be approximately US$1.3bn. WaMu is also a component in approximately 35 indices serviced by the Warehouse, with component percentages ranging from 0.8% to 4.17%. These positions will be incorporated into the net settlement requirements for buyers and sellers of protection between now and the settlement date for the WaMu credit event on 7 November.

The calculated amount is based on the net notional value of outstanding single name CDS with WaMu as reference entity registered in the Warehouse. That value stood at approximately US$2.9bn as of 23 October 2008.

Based on the October 23 credit event auction, which set a price of 57 cents on the dollar for WaMu bonds, the net funds transfer on the single-name CDS amounts to approximately US$1.3bn. Gross notional value of outstanding single name credit default swaps for WaMu registered in the Warehouse stood at US$41bn.

At the time of settlement, DTCC says it will announce final net funds transfer results based on the single name and index contracts registered in the Warehouse.

Fourteen credit derivative dealers participated in the Washington Mutual credit event auction.

... and Icelandic protocols are launched
ISDA has launched protocols to settle CDS referencing Landsbanki Islands, Glitnir Banki and Kaupthing Banki. "These are the first credit events to occur in the European market since ISDA started publishing protocols for settlement," says David Geen, general counsel, ISDA. "The experience of running these protocols successfully for over a dozen North American credit events will be of enormous benefit in ensuring that the process runs equally smoothly in Europe."

The protocols, which are open until 31 October, offer institutions the ability to amend their documentation for various credit derivatives transactions in order to utilise auctions scheduled for 4, 5, and 6 November (for Landsbanki, Glitnir and Kaupthing respectively) to determine the final price for certain obligations of those entities.

ABX gives back price gains
The latest Markit ABX remit data shows that prices dropped by 2-10 points at the top of the capital structure across the indices over the past month, and most tranches are now at their historical lows and well below levels reached in 'the TARP rally'. Structured finance analysts at JPMorgan note that some near-term price recovery is possible, but generalised asset price deflation - brought on by the equity market collapse and associated wealth destruction - seems likely to weigh on ABX prices.

The 07-1.PENAAA sub-index experienced the biggest point decline of 10.64 closing at 54.04 on 27 October, while the 07-2 and 07-1 PENAAA and AAAs, 06-2.AAA and 06-1.AA dropped by 8-10 points each. The rise in cumulative losses continues to ramp up, with the ABX 06-1, 06-2, 07-1 and 07-2 indices reaching 4.79%, 5.67%, 5.12% and 4.12%, respectively.

Higher default rates remain the major driver of total prepayments, with CDRs on ABX 06-1, 06-2, 07-1 and 07-2 at 24.17%, 22.19%, 18.62% and 14.71% respectively. Average defaults increased across the indices by 471bp on 06-1, 219bp on 06-2, 258bp on 07-1 and 59bp on 07-2.

US high yield defaults to surge
A toxic combination of economic and funding pressures has set in motion the beginning of the next cyclical surge in US high yield defaults, according to a new Fitch study. The rating agency finds that the critical supports of low corporate default rates have deteriorated at an alarming pace in 2008 and believes that recent unprecedented events in the credit markets are among a number of factors that suggest the coming high yield default wave may be the most severe on record.

Defaults tend to spike roughly one year following a meaningful contraction in corporate profit growth. This trend re-emerged in 2007, with corporate profit growth continuing to sink in H108. While high yield defaults have already begun their ascent, the erosion in corporate profit growth is expected to have its greatest impact in 2009 and 2010, exacerbated by continued difficult borrowing conditions.

This past July, nearly 60% of banks surveyed by the Federal Reserve reported tightening standards on commercial and industrial loans. Fitch notes that the last time risk aversion among lenders reached this level, in early 2001, borrowing conditions remained constrained for the next three years.

Certain characteristics of the leveraged loan issuance boom of 2004-2007 may also have unintended negative consequences for credit availability. Fitch believes that the possibility of lower recovery rates on loans and bonds, resulting from the trend in recent years towards loan-heavy capital structures, may reduce refinancing opportunities for high yield issuers since new lenders/investors will likely be put off by this additional risk factor.

Fitch believes that the coming default wave will resemble the early 1990s recession, with more industry sectors affected by defaults than in the 2001/2002 downturn due to the broader negative implications of depressed consumer spending, compounded by the leveraged buyout boom of 2004-2007 which pushed up leverage levels across many firms previously better capitalised to withstand a downturn.

The market's aggressive rating mix will also affect the severity of the coming default surge. The triple-C pool, for example, has continued to expand in 2008, and at end-September stood at US$188bn, or a record 24% of the US high yield market.

"Economic weakness will continue to add to the pool of high risk borrowers," says Mariarosa Verde, md of Fitch Credit Market Research. "Add tight credit to the mix and the result will either be a concentrated surge in defaults over the next two years or a protracted period of above-average annual default rates."

On a year-to-date basis, the US high yield default rate of 3.2% through September remains below the average annual default rate of 4.5%, but it has posted the biggest increase in several years - moving up from just 0.5% at year-end 2007 and 0.8% at year-end 2006. The par value of US high yield bond defaults reached US$25bn through September up from US$3.5bn for all of 2007.

"The number of issuers defaulting on their bond obligations more than doubled over the first nine months of 2008 relative to all of 2007, with 35 issuers defaulting through September compared with 15 in 2007," notes Eric Rosenthal, director of Fitch Credit Market Research. In 2001 and 2002, 173 and 165 issuers respectively defaulted on US$78.2bn and US$109.8bn in bonds, resulting in annual default rates of 12.9% and 16.4% respectively.

FGIC on review ...
Moody's has placed the B1 insurance financial strength (IFS) ratings of the main operating subsidiaries of FGIC Corp under review for possible downgrade. The rating action primarily reflects Moody's expectation of further stress on the company's risk-adjusted capital position in light of continued deterioration in housing fundamentals and the related implications on the company's mortgage-related exposures. During the review, the agency will evaluate the impact of revised mortgage loss assumptions on capitalisation in the context of any additional restructuring plans.

Moody's says that because FGIC is meaningfully exposed to the risk of US sub-prime mortgages and other residential mortgage products, its updated mortgage loss assumptions are expected to have a significant impact on estimates of the firm's capital adequacy. As part of a restructuring plan, FGIC has ceded most of its US public finance exposures by completing a reinsurance agreement with MBIA (see separate brief).

FGIC also reached a settlement with the counterparty for a large and poorly performing ABS CDO. According to Arlene Isaacs-Lowe, svp at Moody's, "these events have had a positive impact on estimates of FGIC's capital adequacy but are likely to be more than offset by the impact of increased loss assumptions for FGIC's mortgage related risks".

... while Syncora ...
Moody's has downgraded to Caa1, from B2, the insurance financial strength ratings of Syncora Guarantee (SG), with the ratings placed on review with direction uncertain. The action reflects Moody's expectation of higher mortgage-related losses arising from Syncora's insured portfolio, as well as the possibility that ongoing settlement negotiations with CDS counterparties regarding ABS CDO exposures could result in a comprehensive agreement for the termination of troubled exposures. The ratings were placed on review with direction uncertain to reflect the wide range of potential outcomes resulting from Syncora's restructuring initiatives.

If Syncora is able to reach a favourable settlement, remaining SG policyholders would likely benefit from an improved credit profile at the company. However, Moody's believes that the terms of any such settlement would likely be consistent with a distressed exchange for settling CDS counterparties.

Moody's expects further stress on the company's risk-adjusted capital position in light of continued deterioration in housing fundamentals and the related implications on the company's mortgage-related exposures. The agency says that because SG is meaningfully exposed to the risk of US sub-prime mortgages and other residential mortgage products, its updated mortgage loss assumptions are expected to have a significant impact on estimates of the firm's capital adequacy, which had recently shown signs of improvement following the US$1.8bn settlement with former parent, XL Capital, and the commutation of certain CDS on ABS CDO exposures with Merrill Lynch.

According to Moody's, the ratings review will also focus on the result of ongoing negotiations with CDS counterparties regarding the commutation of remaining ABS CDO exposures at the company. Moody's notes that Syncora has earmarked US$820m from its settlement with XL Capital for the purpose of commuting, terminating, amending or restructuring existing agreements with certain CDS bank counterparties.

To the extent Syncora is able to commute these exposures at a reasonable price, SG's insurance financial strength rating would likely be upgraded, but any upward rating revision would likely result in a non-investment grade rating, given the continued uncertainty with respect to Syncora's remaining mortgage-related exposures and, in Moody's opinion, impaired franchise. Conversely, Syncora's inability to adequately mitigate the potential for further losses on these contracts through negotiated settlements within a reasonable timeframe could result in a confirmation of the rating or a further downgrade, depending on Moody's view of capital adequacy at the firm at the conclusion of our ratings review.

... and CIFG are downgraded
Moody's has downgraded the insurance financial strength ratings of CIFG Guaranty, CIFG Europe and CIFG Assurance North America to B3, from Ba2, and continues its ratings review with direction uncertain. The rating actions reflect its expectation of substantially higher mortgage-related losses arising from CIFG's insured portfolio, as well as the possibility that certain troubled exposures could be commuted.

CIFG and its parents have entered into a non-binding memorandum of understanding (MOU) with approximately 75% of CIFG's CDS counterparties (based on par outstanding) regarding the commutation of approximately US$12bn of ABS CDOs and certain CRE CDOs. The financial guarantor indicated that it expects the contemplated commutation transaction to close before the end of 2008.

Separately, CIFG has also reached a definitive agreement to reinsure approximately US$13bn of US municipal risks with Assured Guaranty (see separate brief); the deal is still subject to some closing conditions. Moody's says that if CIFG is able to reach a favourable settlement and complete the announced transactions, remaining CIFG policyholders would likely benefit from an improved credit profile at the company. CIFG's insurance financial strength rating remains on review with direction uncertain to reflect the wide range of potential outcomes resulting from the firm's restructuring initiatives.

Moody's believes that the terms of the troubled CDO commutation may have some elements that are typically associated with a distressed exchange, though such a determination is ultimately a matter of judgment. To the extent CIFG is able to commute these exposures at a reasonable price, CIFG's insurance financial strength rating would probably be upgraded, but any upward rating revision would likely result in a non-investment grade rating given the continued heightened risks with respect to its remaining mortgage-related exposures and, in Moody's opinion, uncertainty about the medium to long-term strategy of the group given its impaired franchise.

Conversely, CIFG's inability to adequately mitigate the potential for further losses on these contracts through negotiated settlements within a reasonable timeframe could result in a confirmation of the rating or a further downgrade, depending on Moody's view of capital adequacy at the firm at the conclusion of its ratings review.

CIFG offloads public finance business ...
Assured Guaranty Corp has entered into a definitive agreement with CIFG
Assurance North America, under which Assured will assume, via reinsurance, approximately US$13bn of net par insured from CIFG's US public finance business. As part of the transaction, Assured will receive unearned premium reserves of approximately US$88m. After closing, Assured and CIFG will work together to novate the reinsured policies from CIFG to Assured to provide policyholders with Assured's direct guaranty of their obligation and eliminate CIFG's obligation under its current guaranty policy to any participating policyholder.

"We are pleased to have the opportunity to provide CIFG NA's policyholders with the safety and security of Assured's financial strength," comments Dominic Frederico, president and ceo of Assured Guaranty. "Public finance investors will benefit from an upgrade of the rating on their investment if they agree to the novation of their current policy with CIFG NA, and we look forward to helping them make the novation process as quick and efficient as possible."

The agreement is subject to the receipt of regulatory approvals as well as other closing conditions and is expected to close in Q408. The agreement is not subject to a financing contingency.

... while FGIC's reinsurance is rated
S&P has assigned a double-A rating and negative outlook on MBIA Insurance Corp to S&P-rated issues that are part of MBIA's recent reinsurance transaction with FGIC. The rating action does not include any variable-rate transactions, which are under review to determine the impact to the dual ratings.

"The assignment of MBIA's rating is based on the cut-through provisions of the reinsurance agreement," says S&P credit analyst David Veno.

The New York State Insurance Department approved the transaction and the use of the cut-through clause that obligates MBIA to perform in accordance with the original terms of the covered policies and pay 100% of any claim due and payable by the FGIC. The cut-through provision allows the trustee, paying agent or other third-party fiduciary acting on behalf of bondholders to submit a claim directly to MBIA.

Athilon debt downgraded
Moody's has downgraded the ratings associated with five of Athilon Capital Corp's senior subordinated deferrable interest notes from Aaa to A1 and three of its subordinated deferrable interest notes from Aa2 to Ba1. The negative rating actions are the result of the deterioration in the credit quality of two ABS CDOs against which Athilon Asset Acceptance Corp has written credit protection. Moody's will continue to monitor the credit quality of Athilon's portfolio, including the ABS CDOs.

The last rating action was taken on 9 July 2008 when the counterparty rating of AAA Corp and the counterparty and debt ratings of Capital Corp were placed on review for possible downgrade. The counterparty ratings for AAA Corp and Capital Corp are not affected by the above rating actions and each continues to be rated Aaa, on review for possible downgrade.

Further CDO model released
Dresdner Kleinwort structured credit strategists have released their fourth CDO model - one that is designed to cope with copulas, analyse default risk and manage tail risk. "The current credit crisis has highlighted the importance of tail events in risk management," they note. "This model gives credit investors the tool to analyse the behaviour of their credit portfolio under stressed market conditions."

Monte Carlo (MC) techniques are used in the model to simulate joint default events. Within a MC approach, copulas allow for a general and flexible way to directly model the dependency within the portfolio, the strategists add.

XO to peak in six months
Leveraged finance analysts at Barclays Capital believe that high yield cash will sell off by another 7-10 points and loans by another 5-10 points before any recovery occurs. They expect the Crossover index to peak at around 1100bp-1200bp in the next six months.

"Once loans reach the low-60s on average they will be a buy, especially relative to high yield, where there is a bond below the loan in the capital structure. The LevX could underperform Crossover during the sell-off, but post sell-off LevX versus Crossover should be reconsidered," the analysts note.

Moody's reports on bond-implied ratings
Bond-implied ratings are highly accurate predictors of default, outperforming bond yield spreads over a one-year time horizon, according to a new study released by Moody's Analytics. The report finds that bond-implied ratings are superior stand-alone predictors of default, and that bond spread information adds little to no predictive power when analysed together with bond-implied ratings and other variables correlated with default risk.

"In addition to reflecting firm-specific credit risk, credit spreads reflect systematic market movements as well as other non-credit related factors, such as liquidity. Consequently, spreads are a rather noisy signal about any particular firm's default risk," says David Hamilton, senior director in Moody's Capital Markets Research group and lead author of the study. "When market-wide default risk is increasing, as it is now, investors want to know which firms are becoming riskier relative to the market, not riskier on an absolute basis."

With the global credit crisis spilling over into the real economy, Moody's believes that it is increasingly likely that corporate default rates will spike sharply in the coming months. Moody's default rate forecasting model predicts that the global high-yield default rate will increase from its current 2.8% level to 7.9% one year from now.

Moreover, Moody's forecasting model does not yet indicate when a peak in the default rate may occur, suggesting that defaults will continue to mount well into 2009. This increasing risk is reflected in spreads on high-yield bonds, which have widened from about 300bp at the start of the year to over 1,400bp as of October.

Moody's bond-implied ratings are derived using bond yield spreads and Moody's ratings. Bond-implied ratings show how a bond is trading relative to similarly-rated peers on Moody's Aaa-C rating scale.

The study, which covers the 1999-2007 time period, also analysed whether bond spreads and bond-implied ratings are predictive of default when analysed in conjunction with other firm-specific data, such as accounting ratios. The report shows that bond-implied ratings are statistically significant predictors of default, while spread levels have little to no additional predictive power once other factors are accounted for. Credit ratings also provided strong and statistically significant signals of default.

CLO basis risk exacerbated
Recent volatility in short-term rates has exacerbated the mismatch between interest rate resets of CLO assets and liabilities, which structured credit strategists at JPMorgan refer to as 'basis risk'. "In severe scenarios, to the extent CLOs can mitigate these shocks through basis hedges and other derivatives, the impact to debt should be minimised - though the cost of such a strategy would impact equity return," they note. "While many companies typically hedge a majority of their interest rate risk (so it's unclear how many would take advantage of benchmark flexibility), there nevertheless remains the reset timing mismatch from the CLO perspective."

Considering a scenario in which a CLO's assets reset over time as Libor increases and decreases but the liabilities reset as Libor peaks; in this idealised example interest income could be below liability cost. Generally, the mismatch is exacerbated by the flexibility certain corporate loan borrowers have to switch benchmarks, such as Libor to Prime and across Libor/Euribor terms. The JPMorgan strategists have evaluated in a new report the potential impact to excess spread as rates remain volatile, which is especially relevant for equity investors as the motivation to purchase at current prices is dependent on receiving the initial cashflows.

Financial crisis polled
Excesses in the securitisation industry coupled with a failure of valuation practices and risk management were among the leading causes of the global financial crisis, according to the majority (54%) of respondents to a Sybase/Financial Times survey. Half of the senior financial executives polled agreed that the crisis, while far-reaching in scope, can be fixed through the kinds of government intervention and bailout programmes that are being implemented.

In addition, some 38% of those surveyed believe that the financial industry, while structurally sound, will also require adjustments to regulatory and accounting practices to return to an even keel. Notably, 53% of the survey's respondents see a long-term challenge in trying to formulate regulations that can keep up with the dynamic, innovative nature of the financial industry - and Wall Street in particular.

Sinan Baskan, financial markets director at Sybase, comments: "Public policy will be key to a recovery. Successful public policy could lead to larger trading centres and greater stability internationally. If these policies are not well implemented, market disruption and dislocation will most likely be prolonged."

BIS reports on banking activity
In Q208 international banking activity, which had been sustained mainly by banks' inter-office loans in Q1, decreased by 3%, according to figures released by the BIS. The reduction in assets was centred on short-term interbank credits in US dollars.

In contrast, loans to banks and non-banks in emerging markets continued to grow. Banks' other exposures, such as credit derivatives and guarantees, also rose, the bank adds.

In Q208 BIS reporting banks' total international claims declined by US$1.1trn at constant exchange rates (or 3%) to US$39.1trn. The largest previous contractions occurred in Q201 in the aftermath of the bursting of the dotcom bubble (US$125bn or 1% of the total at the time) and in Q498 following the demise of LTCM (1.2%). Cross-border claims fell by US$862bn (2%) and foreign currency positions with local residents dropped by US$231bn (5%).

Consolidated claims on an ultimate risk basis, which takes account of net risk transfers related to guarantees and collateral, declined by 2% to US$30.1trn. Banks' other exposures increased, mainly those related to derivatives (3% or US$128bn) and guarantees, which include credit protection sold via credit derivatives (5% or US$444bn). Credit commitments declined by 2% (US$116bn), however.

Revised data, together with a detailed commentary, will be made available in the next BIS Quarterly Review to be published on 8 December 2008.

Fitch confident on senior CLO ratings
Fitch says that continued stability of senior CLO ratings and the fact that only a few CLOs were downgraded as a result of its recent corporate CDO criteria revisions demonstrates continued resilience of senior tranches of European CLO structures. In a recent report the rating agency says senior CLO ratings are expected to remain more stable than investment grade synthetic CDOs even as the operating and financing environment for some of the underlying obligors deteriorate.

"Many companies only have limited debt amortisation at present and companies that refinanced in recent years have a long refinancing horizon," says Philip McDuell, head of structured credit at Fitch for EMEA and Asia-Pacific. "However, there is a risk of increased negative rating migration on the underlying assets as some leveraged loans issuers begin to struggle to meet their financial projections in an increasingly difficult business environment. The weakest credits or those whose business model is heavily reliant on the economic cycle are therefore exposed to earlier refinancing risk."

Meanwhile, Fitch notes that European SMEs are also experiencing financial and operating pressure. "Although SME default rates have been low in recent years, in the current environment banks may be less willing to provide support to struggling borrowers than in the past, which could impact default rates negatively," says Lars Jebjerg, senior director, European Structured Credit at Fitch. "Recovery prospects are also likely to be negatively affected as, for example, real estate collateral in some areas is subject to market value decline."

Impact of macro-economic conditions explored
Fitch says that the deteriorating global macro-economic conditions are likely to affect the performance of many European structured finance sectors. However, the agency expects the majority of negative rating migration to be limited to the more junior classes of notes.

"Rising unemployment, falling house prices and decreasing access to finance are expected to have a marked impact on the ability of consumers to service and refinance their secured and unsecured debt, even if headline interest rates have fallen from their peaks," says Philip Walsh, md in Fitch's European Structured Finance team. "Falling asset values - from residential properties to auto residual values - will not only have a marked impact on consumers' propensity to default, but will also push up the extent of losses in the event of default across the board."

However, Walsh adds: "The subordination in most structural finance transactions is designed to absorb negative performance beyond the transaction base cases, and to protect the higher rated tranches. Consequently, any downward rating actions will occur first at the most junior levels and only in cases of severe underperformance is this likely to extend to high investment grade notes."

Few, if any, sectors of the European structured finance market will be immune from these influences. As the downturn bites deeper into the economy, more corporate defaults can be expected, bringing further downgrades to corporate CDOs and introducing challenges to CMBS cashflow performance as tenant defaults rise.

The rapidly changing landscape is impacting not just underlying assets' performance and transaction ratings, but has also resulted in a series of negative rating actions for the world's major banks over the course of the credit crisis. This introduces a further source of challenges to European structured finance performance, given extensive exposure in the sector to counterparty risks via hedge instruments, guaranteed investment contracts and other counterparty exposures.

LSS deals impacted
Moody's has downgraded three EMEA leveraged super-senior transactions with spread plus loss triggers, representing approximately €184m of debt securities. These transactions have been further impacted by the most recent spread movements for corporate and financial names underlying the transactions.
Spreads on the underlying portfolios have continued widening over the last month, with the weighted average credit spread of the underlying portfolios now ranging between 231bp-480bp.

The current ratings are mainly driven by the probability that the portfolio spreads will reach the spread triggers, leading to an unwind of the structure and an approximate 100% loss to investors. The average credit rating on the underlying portfolios is in the Ba1 to Baa3 range.

Model coverage increased ...
NumeriX has introduced new functionality and greater model coverage within its cross-asset pricing and risk analytics solutions. The upgrade, version 7.2, includes new dynamic credit basket loss models for pricing forward-starting CDOs and options on CDO tranches, support for calibration weights in the Heston model with time-dependent coefficients and support for pricing LCDS, index swaps and tranches.

The valuation of financial products is coming under close scrutiny due to the recent events on Wall Street (see last week's issue). As a result, there will be a major movement toward what NumeriX defines as "analytic straight-through processing", whereby financial institutions ensure best practices of utilising consistent analytics for pricing valuation and risk management throughout the lifecycle of a trade from the front to back office.

"The current market environment has forced institutions to rethink the way they approach valuation and risk management from an enterprise perspective. As firms implement new pricing and risk policies, the use of consistent analytics is integral, as processes need to be uniform and repeatable from pre-trade to audit," says NumeriX president and coo Stephen O'Hanlon. "The firms who take a hard look and re-evaluate their practices will be best positioned to weather the current volatility and prosper once the markets are healthier."

... while modelling functions are enhanced
Smart Financial Data Hub (SFDH) has enhanced its offering with a range of functions for modelling and managing the fundamentals of these CDS, special purpose vehicles, complex underlying instruments and the various financial stakeholder players. Thanks to the flexibility of the application's data model and because the product's various repositories (SFDH Third Party and SFDH Transaction) can interoperate, all characteristics can be looked at in detail - debt portfolio management, credit enhancement, assets and liabilities, and rating information.

 CS & AC

And the winners will be...credits!

Philip Gisdakis, director and senior strategist at UniCredit, finds that investors should currently be pursuing capital preservation strategies rather than hunting for yield

We are in the eye of a credit storm. Banks suffered huge losses from misguided investments in credit investments in the US housing markets and the hurricane of defaulting companies has not even started - and credits should be the winner of all this? Yes indeed, but not now.

Obviously, we do not want to encourage investors to buildup strategic long positions during these times. To remain crystal clear at this point: we remain underweight in non-financials from a strategic perspective and in financials from a tactical perspective.

Although it is clear that the recent liquidity squeeze creates opportunities for some investors, we do not want to focus on tactical plays in this publication, but on more longer-term strategic ideas. The name of the game right now is capital preservation and not yield hunting. However, investors should keep their powder dry in order to reenter the credit battlefield further down the road.

The theme for the coming years is deleveraging. However, deleveraging in a cyclical downturn, with melting asset values, always comes at the cost of equity holders. But the upcoming deleveraging trend will be different from the one in the years after the bursting of the new economy bubble.

At that time, deleveraging meant balance sheet repair of non-financials, especially in the technology and telecommunication industry. This time, deleveraging will be more focused on the financial world, albeit with vast implications for all other industries.

Following the new economy bubble, the problem was isolated to some - nevertheless major - industries. A deleveraging of financial players puts pressure on almost every other asset class.

One driver of the upcoming deleveraging is that banks and other financial institutions offloaded large parts of the risks onto unregulated off-balance sheet vehicles. Before the crisis, regulators, auditors and investors believed that these risks could be handled much more efficiently outside bank balance sheets and also thought that the risk transfer from bank balance sheets was efficient. These hopes were disappointed during the crisis.

The capital base for the off-balance sheet vehicles was far too slim to be able to withstand a systemic crisis, and the structural inflexibility of these special purpose vehicles showed that investors have limited ability to fight a crisis within such off-balance sheet structures. Finally, the risks were transferred back onto the balance sheets of the sponsoring banks, mostly due to the liquidity facilities that were provided by the banks.

However, similar reasons for a costly deleveraging apply to other building blocks of the shadow banking system: the money market funds that were heavily invested in structured finance exposures; the investment banks; the commercial and real estate financing specialists that needed to subsidise their unprofitable core business with aggressive bets in their refinancing structure; and last but not least the hedge funds. All of these structures will be unwound, and this comes mostly at the expense of the equity providers.

However, in addition to the expected losses that companies are facing in a recession, there are other factors that will create problems for shareholders. Banks will demand higher spreads or will even cease to provide unprofitable loans (please refer to the charts below for the ECB statistic regarding loans to households and non-financials). While the former has been declining for several quarters, the latter contracted strongly in the last few months.

Moreover, credit investors will demand more capital as a cushion for their risks, which will lead to a dilution of shareholders or the termination of shareholder-friendly activities, such as share buybacks, etc. Hence, even when the trough of the recession is reached, the prospects for shareholders will remain bleak, as a declining overall leverage in the economy and higher cost for the leverage will lead to a lower return for shareholders.

In other words, the equity component that is embedded in credit risk will result in a higher relative return than the return on the equity itself. Hence, we recommend investors to keep their powder dry.

The time when credits will become attractive will come sooner or later. But it will definitely come sooner than for equities.

However, as can be seen from the charts below, the period in which credits and equities decouple from their fundamental relationship (credit spreads up, equities down and vice versa) is typically short. Usually, such a decoupling (credit spreads down, equities down and vice versa) occurs when the business cycle turns.

At the end of the business cycle, company management typically tries to boost share prices via shareholder-friendly measures (dividend increases, share buybacks, debt-financed M&A, etc). However, while this might be beneficial for shareholders in the short term, credit spreads begin their widening trend due to the increasing leverage of the balance sheet. But a late-cycle rally in stocks typically doesn't last very long as stock prices follow credit spreads quite quickly.

At the beginning of the credit cycle, when credit spreads peak and the prospects for debt investors are starting to improve, credit spreads start to tighten. However, when fears about a potential insolvency fade, stock investors also start to return to the marketplace. Since credit spreads tend to overshoot in a cyclical downturn, they retighten quite rapidly in case the situation improves.

Consequently, the corresponding decoupling also does not last for a long time. However, this time around, things might be different.

In the last credit crisis, the excessive over-leveraging occurred on the balance sheets of companies, while the balance sheets of investors themselves were not too leveraged. Those problems could be solved quite rapidly, as the banks were not heavily impacted and were able to provide the debt that was needed to restart the business cycle.

However, now the situation is exactly the opposite. Company balance sheets are in reasonable shape, but the balance sheets of financial investors are over-stretched and need to be repaired.

This has painful consequences for the whole economy as the overall risk-bearing capacity is limited. Moreover, in order to repair investors' balance sheets, more capital is needed. But it will be hard to get, as the prospects for the corresponding return are not too bright.

Voluntary long-term investors that do not expect rapid returns will be needed. In this respect, sovereign investors - either from the corresponding governments or from sovereign wealth funds - will be an important piece in the puzzle.

Nevertheless, this recapitalisation and balance sheet repair process will take longer than during the last crisis. The major risk for this scenario is clearly that the huge government intervention across the globe will create hyperinflation further down the road. In case such a scenario materialises, the allocation should be exactly the other way around; i.e. equities should outperform credits.

However, in the current environment inflationary pressure should be limited, at least over the next couple of quarters (see the plunging inflation expectations for Europe and the US above). First things first: after resolving the recession, inflation fears might return to the agenda, but not before.

© 2008 UniCredit Global Research. All rights reserved. This Research Note was first published by UniCredit Global Research on 24 October 2008.

Trading ideas: dead ringer

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

Motorola is in a bind. Its revenues are falling, margins compressing and free cashflow is in the red. The company reports earnings this week and we recommend taking a short position ahead of the announcement.

We forecast decreases in revenue for the next quarter and due to relatively stable R&D costs, its bottom line will be completely eroded. Its margins are scraping the bottom of the barrel and its interest coverage levels are anaemic.

The holiday selling season will be miserable at best, making Q4 results embarrassing. Though the company has a healthy cash balance of US$2.7bn and marketable securities of US$4.4bn (we wonder what those securities are), an unprofitable company can eat away at a healthy balance sheet quickly.

Our quantitative credit model has been bearish all year on Motorola. The consistency of the model output may be a signal that the model is not picking up an element of the company that the market prices in.

Therefore, we adjusted the fair value spread by removing a piece of the spread differential that we believe is due to factors outside the model. In the past few weeks, the adjusted spread turned decidedly bearish on Motorola.

Flailing fundamentals
After revenues peaked in Q406, Motorola's sales have been on a one-way street downhill (Exhibit 1). We forecast a continued drop in revenues during Q3 and believe the holiday selling season will not help. Motorola has rather sticky R&D costs, which drive margins and profitability into the ground.

Exhibit 1

Exhibit 1 also shows Motorola's earnings margins. They have been decreasing recently and we see the trend continuing into negative territory.

The decrease in revenues and margins also affects the company's free cashflow and interest coverage. Motorola's free cash is well in negative territory for 2008 and we do not see that turning around for the remainder of the year.

Based on earnings, its interest coverage levels are close to zero. Motorola has a healthy cash balance and therefore is not at risk of being unable to fund expenses; however, an unprofitable company with decreasing revenues and margins is open to all sorts of unidentifiable risks.

Adjusted market model
Our quantitative credit model attempts to replicate how a fundamental credit analyst thinks. While this is extremely arduous, the output provides a great way to select long/short trades. The model ranks each issuer on a scale of 1 to 10 using seven factors (1 = poor credit, 10 = good credit).

Exhibit 2 lists all the factor scores for Motorola. We see a 'fair spread' of 984bp for its extremely weak equity-implied default probability, margins, free cashflow and interest coverage factors.

Exhibit 2

The difference between the credit spread and expected spread can be broken down into three parts: mispricing by market, element outside of the model, and a forecast of changes to company fundamentals by the market. We essentially want to capture the first part, the mispricing, and reduce our exposure to the other two.

Motorola is a good example where our quantitative model has been persistently bearish. The chart shows that the fair value spread was greater than actual spread for all of 2008 (Exhibit 3).

Exhibit 3

The consistency of the model output is a signal that the model is not picking up an element of the company that the market prices in. Our goal is to then extract that piece of valuation.

In order to do this in a simple manner, we subtracted the average spread differential from our expected spread. Essentially we are removing the piece of spread differential that has been present all year.

Exhibit 4 shows the time series of adjusted fair value spreads for Motorola. Recently, the adjusted spread jumped significantly wider than current CDS levels after trading close to fair in September. This reinforces our short recommendation.

Exhibit 4

Spread compensation
A relative value measure we use to compare issuer risk/return profiles is SPD (spread per unit default probability). As its name suggests, SPD is the amount of spread (in basis points) that we earn for each unit of default risk that we take.

This simple risk-to-reward ratio is akin to the complete MFCI model but limits its scope to only one factor used within the model, equity-implied default probability (EiPD). Motorola's spread compensation dropped throughout all of 2008 (Exhibit 5). This means that the equity-implied bankruptcy risk is not being reflected in its credit spread and therefore now is a good time to buy credit protection on Motorola.

Exhibit 5

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

Summary and trade recommendation
Motorola is in a bind. Its revenues are falling, margins compressing and free cashflow is in the red. The company reports earnings next week and we recommend taking a short position ahead of the announcement.

We forecast decreases in revenue for the next quarter and due to relatively stable R&D costs, its bottom line will be completely eroded. Its margins are scraping the bottom of the barrel and its interest coverage levels are anaemic.

The holiday selling season will be miserable at best, making Q4 results embarrassing. Though the company has a healthy cash balance of US$2.7bn and marketable securities of US$4.4bn (we wonder what those securities are), an unprofitable company can eat away at a healthy balance sheet quickly.

Our quantitative credit model has been bearish all year on Motorola. The consistency of the model output may be a signal that the model is not picking up an element of the company that the market prices in.

Therefore, we adjusted the fair value spread by removing a piece of the spread differential that we believe is due to factors outside the model. In the past few weeks, the adjusted spread turned decidedly bearish on Motorola.

Buy US$10mm notional Motorola Inc 5 Year CDS protection at 370bp.

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).