Contents

Investors

Risk reappraisal

Improvements in the cash sector to reignite investor interest?

Short-term risk aversion and 'forced' rebalancing after recent falls in other asset classes appears to be driving redemptions among a minority of real money credit investors. However, it is hoped that recent improvements in cash trading and market volatility could begin attracting such accounts back to the structured credit sector.

Respondents to Citi's monthly credit survey last week reported the largest net cash outflows in its five-year history. "Without wishing to overplay it, a small number of asset managers have experienced some outflows over the last month, but it's certainly not the case that the real money sector is seeing significant redemptions," explains Hans Peter Lorenzen, credit strategist at Citi.

He adds: "The level of outflows obviously differs significantly between institutions and countries, and in some cases is simply natural flow due to rebalancing portfolios."

Priya Shah, structured credit strategist at Dresdner Kleinwort, suggests that such sentiment is similar to what drove recent hedge fund redemptions: real money investors are looking to move into safer, more understandable assets because the valuations of more sophisticated products remain unclear. "Funds are in general diversifying their portfolios due to mark-to-market concerns and so there has been a gradual change in allocation strategy. There is also a rating implication in that investors will switch to higher quality assets in the event of an asset being downgraded because many have to maintain a rating target," she says.

Under this scenario, the more liquid or fairly-priced assets are likely to be initially redeemed, so as not to affect performance significantly due to crystallisation of large losses. But if this trend were to intensify, it could become problematic, according to Lorenzen.

He observes: "The severity of the impact of real money redemptions will depend on market conditions and the magnitude of redemptions. If it occurs in a positive environment, the impact should be negligible; however, it could have an outsized effect on asset prices if it occurs in a worsening environment - as exemplified by the leveraged loan sector recently."

Real money investors are core holders of cash assets and liquidity in this sector has been poor over the last three weeks, and so a significant rise in redemptions could put asset valuations under renewed pressure. Such redemptions would also likely drive the basis between cash and CDS valuations even wider.

One portfolio manager reports that she hasn't personally seen any real money redemptions, but her accounts are pension funds that tend to be sticky with their cash. However, she indicates that retail investors may be withdrawing their money from other funds due to a need for liquidity and that is also affecting some insurers, which are in turn beginning to sell credit. "Additionally, in the US lots more cash is tied up in prime-type funds, which generally show more redemption volatility anyway," she adds.

Ultimately, from a long-term perspective investors should find current valuations attractive. But, while trading activity in the cash sector has improved slightly over the last week, demand remains thin.

"Credit funds, for example, should be seeing inflows because there are good opportunities out there to take advantage of, and we expect that will happen in the medium term," confirms Lorenzen. "But there may be a lag between investors remaining concerned about their exposure to risk assets and the time when they're willing to re-enter the market. There have already been a couple of 'false dawns', where some investors got their fingers burnt."

Nonetheless, Shah notes one positive development in that - because the structured credit market has been less volatile over the last few weeks - investors have had more time to undertake fundamental analysis rather than simply reacting to technical impacts. "In addition, a large proportion of real money investors are pension funds, which are typically slow to react - so any redemptions, and hence deleveraging, is likely to occur gradually over time rather than as a fire-sale," she concludes.

CS

Monolines

Satisfaction guaranteed?

Monolines set to benefit from TGP

After much speculation (see SCI issue 109), the US Treasury looks set to establish a Treasury Guarantee Programme for Troubled Assets (TGP). Analysts expect the development to be a net positive for those monolines that take advantage of it.

Indeed, a monoline participating in such a scheme is likely to benefit from increased income - and therefore claims-paying resources - and from the perception that the US government is supporting it, according to RBS credit strategist Michael Cox. "Furthermore, the rating agencies are likely to view the new business generation as a positive, since the lack of new business had been one of the drivers of recent downgrades," he says.

The Treasury is currently consulting on whether and how such a facility should be used. Ambac and MBIA have responded by submitting proposals as to how they believe it should work.

Ambac has called for the initiative to consist of two sub-programmes: an excess of loss portfolio guarantee programme offered to entities that traditionally buy and hold credit risk; and a guarantee programme that will directly guarantee existing securities. The first group would include US financial guarantors, whose credit ratings have been threatened and whose access to the capital markets has been denied due to the potential volatility of the performance of their portfolios. On the other hand, the buyer of the guarantee envisaged in the second sub-programme will minimise further potential capital risk due to future rating downgrades of the securities or additional performance deterioration of the underlying collateral.

"To be effective, the programme should limit its exposure to risk by only guaranteeing senior securities and should further limit participation in this programme to entities whose participation will assist in meeting the multiple objectives of the Act; e.g., better access for consumers to mortgage loans and/or freeing liquidity that will be used to generate additional lending or guarantees or other extensions of credit," Ambac says.

It seems clear that if the Treasury accepts Ambac's proposal as the model it will adopt, then it is likely to be a net positive for those monolines using it. According to Cox: "For the monolines with the potential to have to collateralise their GIC business on a downgrade, the second element of the plan would be a key benefit. The obvious beneficiaries of this would be Ambac and FSA; MBIA has already collateralised its GIC portfolio. This may explain why MBIA was less keen on the guarantee programme than Ambac."

Meanwhile, MBIA has recommended that the Treasury considers eight important aspects: the definition of the programme's objective; eligible assets; pricing; tenor; the application of a limit under EESA; optional termination provisions; eligible institutions; and homeowner relief. The monoline says it should be made clear that the guarantee programme is designed to provide stability to financial institutions with exposures to troubled assets by limiting their ultimate potential loss.

MBIA adds that financial institutions participating in the programme should be required to retain an alignment of interest with the Treasury and taxpayers by retaining a material portion of the losses to be incurred on these assets through either the payment of an upfront premium sized against current expected losses, or through the establishment of a deductible - after which coverage would be provided. Under the proposal, eligible assets should be defined as securities or securitisations backed by financial obligations of US consumers and corporations, including RMBS, ABS CDOs and CMBS. Financial guarantee insurance policies and/or CDS issued by financial guarantors with respect to pools of such assets should also be accepted.

CS

Regulation

Fair value embraced

Accounting amendment effects to be felt by cash and synthetic assets

The preliminary effects of amendments to the IAS 39 and IFRS 7 accounting rules (Reclassification of Financial Assets) are beginning to filter through as banks announce their third-quarter results. While the accounting changes are being seen as a positive for money-good triple-A structured finance paper, such as CLOs, synthetic assets are unlikely to benefit.

Martin Knocinski, regulatory & accounting specialist at UniCredit, suggests that the amendments will have a positive effect for bank trading books as a whole insofar as it takes the pressure off assets and banks can show their trading books at a more comfortable level. "But the reclassification only applies to classical non-derivative trading assets," he points out.

"The new rules do not apply to derivatives. Therefore there will be hardly any positive effect on structured credit instruments that comprise a combination of a host contract and one or more derivatives. They will continue to be marked to market," Knocinski adds.

The reclassification of assets makes most sense for high quality assets likely to repay at par, according to Birgit Specht, md of securitised products strategy at Citi. "For instance, the majority of SIV assets stranded on banks' balance sheets - either following an exchange for debt or equity, or the managing bank's support of senior debt - some (but not all) of banks' conduit assets, trading book assets and some loans," she says.

"Assets that may be impaired are still more likely to be sold off, in particular if a bank chooses to clean its books," she continues. "While we have not seen much triple-A selling from European banks, and hadn't expected to see much either, for those looking for fire-sale assets, these changes probably mean fewer investment opportunities."

While Knocinski says there are few downsides to the implementation of the amended accounting rules, he points out that banks will have to comply with certain disclosure requirements - making their strategy transparent to the market. "Despite the fact that the new rules shall be applied only in rare circumstances, lacking enforcement of the rules to a certain extent also bears the risk of cherry-picking, i.e. using fair values when market values go up and amortised cost when market values decline," he notes.

Not all banks are choosing to implement the accounting changes in their Q3 results (such as Société Générale), but those that have were able to mitigate significant losses.

For example, Deutsche Bank's Q3 results showed that the bank had averted €845m of negative fair value movements through the use of the accounting amendments. The bank elected the option only for a small portion of its debt issuance, resulting in a gain of €146m during the quarter. However, the bank said that election of the fair value option on all of its own debt would have resulted in a gain in excess of €2bn for Q3.

"The extent to which banks will choose to reclassify assets will depend on banks' individual portfolios," concludes Knocinski. "It is hard to tell how many banks will use it, but given the positive effects of applying the new rules it could be a significant number. Those banks that do use it will have an advantage, as they will have a healthier looking balance sheet. However, like the government bailout packages, those banks that do not use it might give the impression that they have stronger balance sheets than those that do."

AC

Recovering losses

Anthony Riem, partner at PCB Litigation, explores how hedge funds and their investors can recover assets internationally

The multi-jurisdictional nature of many hedge funds, their investors and the companies in which they invest can make any associated litigation a daunting prospect. Nonetheless, in the current financial climate parties involved in or with hedge funds are increasingly looking to litigate in order to recoup funds lost to negligence, fraud or simply a falling market.

A startling example of what can happen when things go wrong is the recent Hermitage Capital Management (HCM) fraud. This complex fraud involved three investment companies belonging to HCM which were allegedly re-registered by fraudsters.

Bogus court claims were made against the companies, which then claimed huge losses as a result of the litigation and themselves claimed US$230m from Russian tax authorities. The Russian authorities have since raided the offices of several of HCM's lawyers in an apparent attempt to link them to the fraud.

So, if the worst happens, what can be done? Contrary to the common perception that nothing can be done, courts in a number of jurisdictions have developed a number of wide-ranging powers that are capable of international enforcement to enable victims of fraud and other wrongdoing recover their losses.

In particular, the courts recognise that fraud victims face a number of very specific hurdles that need to be overcome if they are to recover their losses. These losses include the fact that the fraudster will act covertly in committing the crime, concealing his identity and assets - the latter of which he will transfer internationally at a touch of a button.

To overcome those hurdles, certain courts have developed powers that enable the victim to establish the extent of the fraud and identity of the fraudster, his assets and freeze them, all without notifying him that these steps are being taken.

To maximise the prospects of recovering assets, it is important to adopt the appropriate strategy - which, in turn, requires the instruction of a specialist recovery team. The team should comprise a lawyer to formulate and execute the strategy and to ensure compliance with local laws; an investigator to carry out enquiries; a digital forensic expert to investigate and preserve the integrity of electronic evidence; and a forensic accountant to evaluate the extent of the fraud and losses.

The first steps to take, even before issuing any claim, are to comply with any obligations - such as to report the matter to insurers - and to comply with any statutory or regulatory obligations. It is then to evaluate the extent of the fraud and the prospects of recovering any losses, as this will assist in determining whether it is commercially worthwhile doing so.

This will invariably involve consideration of considerable electronic documentation to determine whether the fraud is ongoing, the extent of the losses and whether the fraudster can be identified, as well as the location of his assets and the stolen money.

Given that about 80% of frauds are committed by or with the assistance of a director/senior manager or employee, it is important that any investigation is carried out without tipping off the fraudster or his accomplice and that the integrity of electronic evidence is preserved. Investigations often need to be carried out in a number of countries and it is important that they are carried out in accordance with local laws. Where unusual steps are contemplated, then consideration should be given to whether there is a need to obtain the court's sanction beforehand.

Investigations can often involve obtaining court orders requiring third parties that have been unwittingly involved in the commission of the fraud or wrongdoing to disclose all information in their possession regarding it to the victim. This obligation extends to provide the victim information to enable him to formulate his claim.

These orders are often obtained against banks and internet service providers. They are regularly combined with gagging orders that prevent the party against whom the order has been obtained from disclosing the existence of the order and the fact that information has been provided pursuant to it.

A combination of disclosure orders and investigation will normally enable the victim to establish the extent of the fraud, the wrongdoer and the location of assets which the victim may be able to freeze. A decision can then be made as to whether it is commercially viable to bring proceedings. This will include consideration as to which country or countries in which it is most appropriate to bring proceedings and the legal policies within those countries.

In England and a number of other countries, it may be possible to bring proceedings against not only the fraudster but also others who assisted in the commission of the fraud, such as recipients of the proceeds of the fraud. Widening the potential targets increases the prospects of recovering losses.

English and other courts are willing to freeze assets held nationally and internationally and by individuals other than the defendant, provided it is shown that they were obtained using the fraudster's assets. At their most basic, the criteria for a freezing order are: a good arguable case, a real risk that the potential defendant will dissipate the assets, a connection with the jurisdiction and full disclosure by the applicant.

These are strict requirements due to freezing orders being some of the more draconian orders which the court can make - breach of which may put the defendant at risk of criminal sanctions. There is also a requirement for the applicant to give a cross-undertaking in damages, which could prove to be costly if it subsequently transpires that the defendant suffers loss as a result of the granting of a freezing order which should not have been granted.

However, freezing orders are very effective remedies. They prohibit the defendant dealing with his assets, taking steps which will reduce the value of them or taking any steps to remove them from the jurisdiction.

Where a claimant wishes to enforce a freezing order abroad, they must also obtain permission from the English Court to do so. In those circumstances, the court requires compliance with a set of guidelines as set out in Dadourian Group Inc v Simms.¹

These guidelines stipulate that for permission to be granted to enforce a worldwide freezing order abroad, it must be just, convenient and not oppressive. Additionally, consideration must be given to the grant of relief to compensate for the costs incurred and the proportionality of the proposed steps to be taken abroad.

The penultimate guideline requires that the interests of all parties, including those likely to be joined to foreign proceedings, must be balanced against each other. Finally, permission will not normally be granted in terms that would enable the applicant to obtain relief in the foreign proceedings, which is superior to the relief given by the worldwide freezing order.

The US financial regulators are taking an increasingly proactive attitude to tackling business irregularity through the courts. The regulators' reach extended even further to our shores in May when the US Securities and Exchange Commission (SEC) applied to the High Court to continue a worldwide freezing order against a defendant and to dispense with the need for a cross-undertaking. The second element was required partly because US law prohibits it from making an unlimited cross-undertaking in damages.

Briefly, the SEC alleged that Glenn Manterfield, a UK citizen and resident, was one of a group of people who created Lydia Capital, a hedge fund that was US based and registered with the SEC. The SEC alleges that through Lydia, Manterfield and another defrauded about 60 investors, who had invested approximately US$34m in the hedge fund between June 2006 and April 2007.

It is alleged that Lydia defrauded investors by: "(1) materially overstating and in some instances completely fabricating the Fund's performance; (2) inventing business partners, offices, and investors in an attempt to legitimatise the firm and concealing the truth as to why key vendors and banks ceased relationships with the defendants; (3) lying about Manterfield's significant criminal history, and failing to disclose a February 2007 criminal asset freeze in England; (4) lying about the fund planned to address certain material risks and failing to disclose others; and (5) misstating the nature of the Fund's assets and its investment process."²

As if that were not enough, there are allegations of the misappropriation of millions of dollars of funds, wrongfully withdrawn by Manterfield and another. The High Court ruled that the freezing order should continue until the resolution of the SEC's pending enforcement action in the US.

The use of civil powers by regulators is a welcome development in assisting victims of fraud or financial mismanagement. In the recent past, hedge funds and the financial markets as a whole have enjoyed growing economies, banks which were only too willing to offer leverage and investors who were able to invest using readily available credit.

One of the consequences of the credit crunch has been a re-evaluation of those transactions and the discovery that collateral provided is either non-existent, suffers from undisclosed defects or was never as valuable as originally represented. There may also be issues as to whether prospectuses and other financial advice given was misleading. It is important that those who have lost out are aware that there are effective legal weapons available on an international basis which, when properly exercised, can maximise the prospects of recovering losses that are suffered.

Footnotes:
1. [2006] 1 WLR 2499
2. United States Securities and Exchange Commission v Manterfield [2008] All ER (D) 218 (May)

Light at the end of the tunnel?

David Matson, md at IKB Fund Management, answers SCI's questions

David Matson

Q: When, how and why did your firm become involved in the structured credit markets?
A: IKB has been arranging and investing in leveraged loans to support private equity-sponsored leveraged buy-outs across Europe since the mid-1990s and structured its first Bacchus CLO to securitise these leveraged loans in 2006. Prior to then, IKB has been focused on long-term lending to SME 'Mittelstand' companies since its foundation in Germany in 1924 and began structuring SME CLOs via the synthetic Promise platform in 2000. IKB Fund Management has built on this securitisation expertise to become one of the top-ten European managers of leveraged loans with over €2bn assets under management through five Bacchus CLOs that were closed between 2006 and 2008.

Q: In your view, what has been the most significant development in the credit markets in recent years?
A: The emergence of institutional investors in the European LBO market in 2005-2006 had a huge impact on the demand-supply balance in the LBO market. It upset the equilibrium that had existed for many years, leading to strong competition for assets and an unsustainable premium for secondary loans.

This in turn led to many deals being refinanced with weaker credit structures and lower risk pricing. In my opinion, the LBO market was heading towards disaster in the first half of 2007. The only reason why the LBO market was saved from disaster was because another asset class, US sub-prime, fell over the cliff's edge first and caused a global liquidity crunch.

The liquidity crunch beginning in mid-2007 completely transformed the credit markets. The leveraged loan and CLO markets changed from being over-leveraged and under-priced to a world where there was no appetite for leverage.

New deals can not compete with the ever-falling secondary market prices for existing deals. Any structured finance product with exposure to mark-to-market pricing has suffered from the downward spiral of forced sales, which have driven prices lower and forced more sales.

Traditional cash CLOs have been relatively insulated from these problems, as they have no mark-to-market triggers and benefit from locked-in funding. However, the CLO investor base is exposed to these problems and this has led to the complete disappearance of most triple-A investors and a reduced risk appetite from all other types of investor. This has made it virtually impossible to issue CLOs by raising new money.

Q: How has this affected your business?
A: The liquidity crunch led directly to the collapse of IKB on 31 July 2007, due to its exposure to US sub-prime exposure via its Rhineland Funding conduit. IKB was rescued by its major shareholder, the KfW Bankengruppe, and recapitalised before being sold to the US financial investor Lone Star on 29 October 2008.

IKB has refocused on its core businesses of long-term lending to the SME 'Mittelstand' in Germany and to Mid Cap companies across Europe. We regard IKB as being one of the "first in and first out" of the financial crisis. During this period, IKB Fund Management has grown in strategic importance because it is able to reduce the bank's balance sheet exposure and provide liquidity through securitisation.

Q: What are your key areas of focus today?
A: We have experienced the impact of recession starting in Spain in late-2007 and spreading across Europe in 2008. We are focused on the successful management of our existing CLOs for all investor classes. This entails increasing diversity and minimising exposure to watch-list or triple-C rated assets.

For almost the first time, we are having to earn our management fee through proactive management of the leveraged loan assets. As selling assets in the secondary market is not an attractive option, our focus is on the work-out of deals through restructuring in order to maximise recoveries.

This is made especially difficult as the liquidity crunch restricts the options available for refinancing or sale of the underlying businesses. We are making progress with restructuring a number of deals and were beginning to see the 'light at the end of the tunnel' by September 2008; however, it is possible that we may see a new wave of defaults caused by the latest financial crisis starting with the bankruptcy of Lehman Brothers.

Q: What is your strategy going forward?
A: We need to demonstrate to all our investors that we can manage CLOs successfully through a period of recession. Our main strategy is to build par value in each CLO as a cushion for potential future defaults, while carefully improving portfolio credit quality and diversity as well as equity distributions. We regard this successful performance as an essential prerequisite before we can ask investors for new money.

However, the execution of this strategy will also need the return of the CLO arbitrage and the return of some appetite for risk from investors. We do not see this occurring in the near future.

Q: What major developments do you need/expect from the market in the future?
A: The leveraged loan market in 2009 will be focused on Mid Cap deals with less than €500m total deal size. This will be financed mostly by the newly recapitalised European banks, including IKB. The Bacchus CLOs have a focus on Mid Cap companies and so are ideally positioned to take advantage of this market trend.

There will not be many new CLOs issued in 2009; however, we may see the emergence of different structured vehicles with new money to invest. These vehicles will have less leverage and no mark-to-market triggers. They will be structured on a case-by-case basis to meet the needs of those investors who have survived the financial crisis of 2007-8 with money to invest.

About IKB Fund Management
IKB Fund Management forms part of the London Branch of IKB Deutsche Industriebank AG, which in turn is 90.8% owned by the US financial investor Lone Star. IKB Fund Management is the collateral manager for the Bacchus CLOs, with over €2bn assets under management across five CLOs.

CDO head hired

The latest company and people moves

CDO head hired
Deutsche Bank has appointed Peter Hornick to its institutional client group (ICG) within the global markets division as md and head of credit sales for North America. Hornick is based in New York and oversees the distressed debt, convertible bond, high grade, high yield and structured product sales groups.

Hornick joins from Lehman Brothers and reports to Lou Jaffe, md and head of ICG debt sales for the Americas. He spent six years at Lehman Brothers, where he was most recently global head of the CDO group, overseeing trading, sales and research.

Prior to that, he was global head of levered credit sales at the firm. Before joining Lehman, Hornick was a derivatives trader at Merrill Lynch in New York and London.

Distressed fund launched
Highland Financial has recently launched a new fund focused on distressed opportunities. Dean Smith, member of HFH Group's investment committee responsible for all credit-related investment activities, is senior portfolio manager for the HFH Distressed Credit Fund.

Smith has structured and traded a wide range of structured securities and whole loans, including residential and commercial mortgages and home equity loans, aircraft, oil tankers, student loans, credit cards and auto loans. He has special expertise in the design and development of sophisticated computer models for evaluating mortgages and other financial assets, including MBS and ABS and derivative instruments related to them.

Bank hires in structured credit sales
Stephen Patterson has joined Standard Chartered as a director of structured credit sales. Based in Asia, he reports to Chookiat Rujanapornpaje, md and head of sales - Singapore and Thailand. Patterson was previously senior director and structured credit product manager at RBS, South East Asia.

Fortress and Quicken Loans in JV
Fortress Investment Group and Quicken Loans Inc have entered into an exclusive joint venture. The partnership will help Fortress implement a comprehensive refinancing and loan modification strategy for its mortgage portfolio and investments. Quicken Loans has the capacity to deploy up to 2,600 of its team members to refinance borrowers in all 50 states into many different loan programmes, including conventional, FHA and reverse mortgages, from its state-of-the-art centralised Web Centres.

Pete Briger, Fortress president, says: "It is our belief that the joint venture will be a win-win for both Fortress investors and existing borrowers. This partnership will help bring needed liquidity to homeowners facing increasingly limited options, while at the same time providing investors in Fortress funds with a competitive advantage."

Derivatives team expanded
Daiwa is continuing to build up its global derivatives team, following the appointment of Dominique Blanchard as global head of derivatives earlier this year. Christophe Tezier, previously global head of FID Quants at Bear Stearns, has joined as global head of quantitative research. Joining the derivatives infrastructure team is Andrew Wallhead from Mitsubishi UFJ Securities and Duncan Stuart-Reid from Citi.

Over the next few weeks, Murielle Maman (formerly at Merrill Lynch and ceo at Lyxor Asset Management) will join to take responsibility for product structuring and wrapping. Finally, as a result of the expanding derivatives business, Daiwa has recruited Francois-Xavier Faure to head up its risk management division in London. Faure was previously head of European fixed income market risk for Lehman Brothers.

Asset management ratings withdrawn
Deerfield Capital Corp is to withdraw its asset management subsidiary, Deerfield Capital Management, from Fitch Ratings' CDO Asset Manager (CAM) rating programme. Deerfield's decision to leave the programme is based on the company's near-term outlook for new issuance in the CLO market and its decision that the programme does not currently justify the added expense of maintaining the rating. The company says it will continue to monitor the prospects for new issuance in the CLO market and may contract with Fitch to be re-rated if market conditions warrant.

CDS clearing solution moves closer
IntercontinentalExchange (ICE) and The Clearing Corporation (TCC) have announced new agreements intended to advance their joint global clearing solution for CDS. Together with nine dealers in the CDS markets, ICE and TCC have entered into memorandums of understanding (MOUs) to develop a joint global clearing solution and to effect the acquisition of TCC by ICE. Under the terms of the new agreements, ICE will acquire TCC and will form ICE US Trust (ICE Trust), a New York limited purpose trust company and subsidiary of ICE, with the support of Bank of America, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan, Merrill Lynch, Morgan Stanley and UBS

Structured finance lawyer changes firm
Law firm Schulte Roth & Zabel International has hired Nick Terras, a fund and structured finance lawyer, in London as a partner in the investment management group. Terras advises on the establishment and structuring of alternative investment funds (including hedge funds, private equity funds and funds of funds) and UCITS funds (including exchange-traded, derivatives-based funds), the structuring of investment products based on hedge fund strategies, related structured finance transactions and corporate matters.

His clients include leading investment funds, European and US investment banks, and proprietary and structured products' trading platforms. Prior to joining Schulte Roth & Zabel, Terras was a partner in the London office of McDermott Will & Emery.

Monoline appoints ceo
FGIC is expected to appoint John Dubel as ceo at the next meeting of the board of directors, replacing Frank Bivona whose contract is expiring at the end of the year. Bivona has been ceo since December 2003.

Dubel has been FGIC's chief risk officer since January 2008, with responsibility for credit risk management, the special exposure group and portfolio risk review. From 2006 until 2007, Dubel was an md of Gradient Partners, a single strategy distressed hedge fund.

GRC launched
Risk executive search consultancy GRS Group has launched Global Resource Consulting Limited (GRC), which it describes as "a new force in risk consultancy". GRC will be headed up by Richard Lumley, who was previously director of European structured finance at CIFG. GRC will focus on complex risk management projects across credit, market and operational risk for a range of financial institutions. Among the services offered will be advisory work on counterparty and structured credit risk management, reporting and analysis.

Lumley comments: "I want to offer institutions an experienced and all-encompassing consultancy resource in an increasingly complex risk management environment. It is clear that a growing number of organisations have the need for a professional and specialist risk management consulting service to provide additional support to their existing risk departments. As current market turmoil continues, demand will only increase further for experts who can work with financial institutions and develop their staff and systems to cope with the changing financial atmosphere."

AC & CS

Dealers net long credit

A round up of this week's structured credit news

Dealers net long credit
DTCC has begun publishing weekly aggregate market data from its Trade Information Warehouse. The data includes the outstanding gross and net notional values of CDS contracts registered in the Warehouse for the top 1,000 underlying single name reference entities and all indices, as well as certain aggregates of this data on a gross notional basis only. The data is intended to address market concerns about transparency, the clearer says.

Credit Derivatives Research has released a 'first cut' analysis of the DTCC's Trade Information Warehouse data for the week ended 31 October. Aggregating at the reference entity type, the analysis shows that dealers are generally (long credit) net sellers of protection (in order of gross notional magnitude) in consumer services, financials, industrials, consumer goods, basic materials, technology/telecoms, sovereigns, oil & gas, healthcare and CMBS. Non-dealer/buy-side participants are (long credit) net sellers of protection (in order of gross notional magnitude) in LCDS, utilities and 'other'.

Financials are the largest gross notional exposure, followed by consumer services and consumer goods. CMBS, LCDS and RMBS are the lowest gross exposures, with healthcare, oil & gas and utilities the lowest in the corporate space.

"Reading much into this is tough as these are gross and not net notionals, but it is interesting to see that dealers are still net long credit in general (with their traditional pos-carry, steepener, roll-down positions probably intact, despite the deleveraging)," CDR analysts note. "As we might expect, dealers are net buyers of LCDS protection (hedging their loan books), but being net short utility credits is perhaps more related to the concerns over refinancing stress and hedging that risk (on the side of dealers)."

The DTCC data also breaks down gross and net notionals at the single name level, with the largest net notional exposures based on sovereigns (Italy, Spain, Brazil, Germany, Russia, Greece, Turkey, Korea and France are all in the top 20). The rest of the top 20 are financials: Deutsche Bank, GECC, Morgan Stanley, Merrill Lynch, Goldman, Countrywide Home Loans and Citi.

Based on the data, CDR estimates a total gross notional of around US$15trn, which nets down to under US$2trn of total global exposure.

The DTCC data is shown in two sections. Section 1 shows the outstanding notional values at a given point in time (the end of each week). Section 2 shows data relating to the weekly confirmed trade volume, or 'turnover', with respect to the same underlying reference entities and indices, as well as similar aggregations of such data. Section 2 data will be published beginning the week after the initial publication of outstanding notional values.

Housing prices to reach bottom?
The market has woken up to the inevitability of principal forgiveness as the way forward in finding a bottom for housing prices, according to structured finance analysts at JPMorgan. "In our view, the sooner the outstanding debt levels are re-aligned with the value of the core underlying asset, housing, the sooner home prices can stabilise and economic growth can return to sustainable levels," they note.

The analysts add: "To help smooth the process, the government seems likely to provide some form of mortgage insurance to debt once a lender has provided at least partial principal forgiveness or forbearance to the borrower. For MBS investors, two realities are emerging. Bond cashflows will be altered in a meaningful way; and moral hazard and legal risks are escalating." At a minimum, timing of collateral losses is likely to be accelerated.

In sub-prime, to the extent the modification is loss-neutral, the acceleration of loss recognition should benefit last cashflow senior tranches at the expense of current pay tranches, as principal payments have greater likelihood of shifting to pro-rata allocation. Moral hazard risk likely will impact higher quality mortgages, the analysts say, as borrowers who may otherwise not have defaulted now feel like that may be the optimal economic course to address negative equity positions.

JPMorgan announced a restructuring plan for US$110bn troubled US mortgages on Friday, which aims to avoid foreclosures by reducing mortgages interest rates or principal amount. 400,000 families should benefit from this plan and other large US mortgage houses are expected to follow suit.

Moody's reports on CDS market
The bankruptcy of Lehman Brothers has put the CDS market to an unprecedented test and has resulted in losses in the hundreds of millions dollars for a number of Moody's-rated firms, but these CDS market disruptions have not, in and of themselves, resulted in the downgrade of any rated company to date, Moody's says in a new report. However, the agency also sees the possible failure or failures of other large CDS market participants as a continuing source of systemic risk. In Moody's opinion, it is highly unlikely that the CDS market would have been able to deal effectively with a simultaneous default by AIG - probably the largest net seller of CDS protection.

A survey conducted by Moody's of the major Moody's-rated banks and insurance firms active in the CDS market suggests that the overall market has fared better than many observers had anticipated. "Lehman's bankruptcy, although resulting in sizable losses for a number of market participants, did not lead to the unravelling of the CDS market," says Moody's avp/analyst Alexander Yavorsky.

Still, he adds that the emergency unwinding of Lehman's CDS book by major dealers and hedge funds though a risk reduction trading session on the weekend preceding Lehman's anticipated bankruptcy filing demonstrates that the OTC CDS market is "ill-equipped to reliably deal with such events".

Given Lehman's role as a major CDS dealer, its default and the resultant credit spread widening left its CDS counterparties needing to replace lost protection at much higher prices. For a number of the major CDS dealers, this resulted in losses that, while substantial, did not fall outside of the range that could be tolerated at any company's rating level at the time.

Moody's notes that major dealers also did not suffer losses in excess of their ratings-tolerance on CDS contracts referencing Lehman Brothers as an obligor, despite the low auction-determined settlement price of 8.625 cents on the dollar for Lehman's senior bonds. "Many dealers had flat or net short CDS exposure to Lehman's credit as a way to hedge their counterparty exposure to the firm," Moody's Yavorsky explains.

The report also discusses what Yavorsky characterises as "encouraging progress" among market participants and regulators to move the CDS market, or at least a portion of it, to a central counterparty model. If implemented effectively, a central clearinghouse could substantially reduce, although not completely eliminate, counterparty and trade replacement risks. It could also impose economic limits on effective leverage and excessive credit exposure by requiring protection sellers to post appropriate initial margin.

S&P MCRS reports on valuations
The market, credit and risk strategies group (MCRS) - S&P's newly-formed, separate and independent research team - has released a report entitled 'Valuing Structured Finance Assets 101: What Are These Things Really Worth?' The aim of the study is to cut through the rhetoric surrounding the valuation of complex securities by focusing on their cashflows, credit risk and 'risk of ruin'.

According to the MCRS team: "The difference between carrying a mid-tier RMBS on the balance sheet at 80 cents on the dollar and less than 10 cents on the dollar can be as little as a 5% difference in assumptions over future default rates."

A central challenge currently facing global investors is the appropriate and fully disclosed pricing of, and the risks associated with, Level 3 assets - also known as mark-to-model assets. The MCRS team believes these assets can be valued in a meaningful and transparent manner that is largely dependent on investors' perceptions of current and future credit risks. To show how this can be done, it conducted a case study that sheds light on the difficult and complex, but not insurmountable, nature of valuing esoteric structured finance Level 3 assets.

Among the team's key findings was that not all RMBS tranches are created (i.e., structured) equally. While some deserve serious consideration by even the most risk-averse money managers, others should be avoided by all but the most sophisticated institutional investors.

While structured finance assets can be difficult to price due to the multiple input variables that must be considered and modelled, investors can nonetheless price them in a transparent and meaningful way. In true 'buyer-beware' fashion, investors should individually determine an appropriate valuation for each risk factor associated with a given structure by analysing multiple factors drawn from a pool of existing market conditions, and assumptions about future conditions in the credit and real estate markets.

This is akin to an equity investor determining the appropriate price/earnings valuation assumption that should be assigned to the equity market, the report says. As in any distressed auction, the bidder with the most optimistic assessment of future valuations will submit the winning bid.

Further CRE CDO buyback
Concord Debt Holdings, a joint venture debt platform among Winthrop Realty Trust and a subsidiary of Inland American Real Estate Trust, has repurchased US$2m of the Class E bonds and US$2m of the Class F bonds issued by Concord Real Estate CDO 2006-1 for an aggregate price of US$1m, representing a discount of approximately 74%. In July mortgage REIT Gramercy Capital bought back US$37.8m of CRE CDO bonds that it had previously issued, generating gains of US$17.6m in the process (see SCI issue 99).

Landsbanki price determined
Creditex and Markit, in partnership with 14 major credit derivative dealers, have determined a price to facilitate the settlement of credit derivative trades referencing the debt of Landsbanki Islands in Europe's first-ever credit event auction. The final price for Landsbanki senior debt was determined to be 1.25% and 0.125% for subordinated debt.

The auction was conducted in accordance with the ISDA 2008 Landsbanki CDS Protocol. Creditex and Markit will conduct credit event auctions to facilitate the settlement of CDS contracts referencing Glitnir Banki today, 5 November, and Kaupthing Banki on 6 November.

ISDA applauds industry operational efforts ...
ISDA has applauded a number of industry initiatives that have had the beneficial effect of reducing notional amounts outstanding in CDS, significantly reducing operational, legal and capital costs for industry participants and improving operational efficiency in the market. In 2008 efforts to reduce notional outstanding amounts have been rewarded by a decrease of over US$25trn in CDS notionals, reflecting a range of activities, including compression exercises run by Trioptima, Creditex and Markit.

This year to date, Trioptima has reduced by US$24.5trn the amount of CDS notional outstandings through its series of compression cycles (also known as tear-ups), which have included index, tranche and single-name trades. Additional efforts implemented by Creditex and Markit that focus on the single name space began as recently as September and now account for US$550bn in compressions.

According to ISDA's semi-annual survey to mid-year 2008, the notional amount outstanding of CDS decreased by 12% in the first six months of the year to US$54.6trn from US$62.2trn. For the same period, Trioptima reported US$17.4trn in completed CDS tear-ups. Subsequent notional reductions would bring CDS notional outstandings to US$46.95trn before accounting for new trades since 1 July 2008.

... and submits operations letter to the Fed ...
ISDA - together with the Operations Management Group, the Managed Funds Association and SIFMA - has submitted a letter to Timothy Geithner, president of the New York Fed, in an effort to improve derivative market processing and scalability, as well as augmenting risk mitigation and transparency. The ISDA initiatives outlined in the letter include: CDS auction hardwiring; conferences in New York, London, Sydney, Tokyo and Hong Kong to promote awareness of industry commitments in respect of operations matters; and the release of various best practices and guidance notes, relating to individual asset classes and collateral matters.

... while further CDS portfolio compressions are undertaken
Four industry-wide CDS portfolio compression runs were completed in North America and Europe last week, report Creditex and Markit. Compression runs were completed in North America for CDS contracts referencing consumer products companies and in Europe for CDS contracts referencing industrial, energy and utilities companies as well as European sovereigns. Compressions carried out across a total of 61 reference entities achieved a gross notional reduction of 44%, or US$150bn, across all participating counterparties.

Meanwhile, TriOptima says it has offered 39 compression cycles since the beginning of the year and will offer nine additional compression cycles in November and December.

Asian ...
S&P has downgraded the ratings on 92 tranches of Asia-Pacific (ex-Japan) synthetic CDOs, of which 66 were also placed on credit watch with negative implications. The agency has also lowered its ratings on 93 tranches relating to 66 Japanese synthetic CDO transactions and placed its ratings on 13 tranches relating to 12 deals on watch with negative implications. The rating actions reflect its revision of certain assumptions, including industry classifications and correlation assumptions, which are applied to the financial services sector in rating CDOs and CDS.

The downgrades and watch placements follow several recent events: Washington Mutual's Chapter 11 bankruptcy filing; the appointment of receivership committees for Kaupthing Bank, Landsbanki Islands and Glitnir Bank; the auction results of ISDA's protocol being taken into consideration for the evaluation of Fannie Mae, Freddie Mac, Lehman Brothers Holdings, Tembec and WaMu; and negative rating migration of reference entities.

... and European CDOs hit
S&P has also taken credit rating actions on 77 European synthetic CDO tranches. Specifically, the ratings on 57 tranches were lowered, and 20 tranches were lowered and remain on watch negative. Of the 57 tranches lowered, 35 reference US RMBS and US CDOs that are exposed to US RMBS that have experienced recent negative rating actions; and 22 have experienced corporate downgrades in their portfolios.

The rating actions include the following recent developments: revised correlation assumptions for CDOs that reference financial intermediaries; assumed recovery valuations of 91.51% for senior Fannie Mae debt and 99.9% for subordinated debt; assumed recovery valuations of 94% for senior Freddie Mac debt and 98% for subordinated debt; and assumed recovery valuations of 8.625% for Lehman Brothers debt. S&P says it will continue to review transactions that reference Fannie Mae, Freddie Mac, Lehman and other credit events, and will update the ratings in due course.

Synthetic schuldscheine launched
Moody's has assigned Aa3 ratings to two credit-linked schuldscheine issued by LBBW and due in 2015. Though the issuance size is very small - at €2m and €14m - the deals represent an interesting new twist on the use of schuldscheine in securitisations (see SCI issue 97).

According to Moody's, the transactions are synthetic CDOs referencing corporate and sovereign entities, comprising 2.5% thick tranches with 4% subordination. Substitutions of the underlying portfolios may be made by LBBW, but require consent of the creditors. The deals allow trading gains or losses to adjust the subordination.

Counterparty credit deterioration threatens HFA issuance
The credit deterioration of counterparties and the current global credit and liquidity crisis have heightened the risks associated with variable rate bonds issued by housing finance agencies (HFAs), says Moody's in a new report. The proceeds of HFAs bonds are used to finance mortgage loans for low- and moderate-income borrowers.

"In some cases, disruption in the short-term debt markets has resulted in an inability to remarket variable-rate demand bonds, exposing some programmes to higher interest rates and possible acceleration of principal repayments," says Moody's analyst Omar Ouzidane, author of the report. "Failed re-marketings have led to payments by banks under liquidity facilities for tendered bonds resulting in what are known as bank bonds, which may have higher interest rates than the bonds in the primary market and many require a more rapid bond principal amortisation, possibly diminishing an HFA's available funds and weaken its financial performance."

Recent downgrades of several counterparties, most notably Depfa Bank and to a lesser extent Dexia Credit Local, have led to a substantial increase in bondholder tenders of variable rate demand bonds that have not been successfully remarketed.

"The current global credit and liquidity crisis have resulted in the downgrades of some of the HFAs' counterparties, including liquidity providers and swap providers," adds Ouzidane. "Material exposure to a swap or other counterparty facing credit stress could result in swap termination payments, placing strains on the affected HFAs' balance sheets." Both Lehman Brothers Derivative Products and AIG Financial Products were active in providing swaps to HFAs.

"Though the usual real estate risks, including higher delinquency and foreclosure rates, remain manageable because most programmes have sufficient resources to mitigate these risks, the downgrades of the counterparties may put pressure on those resources and challenge future profitability," continues Ouzidane. "Moody's has created a framework to identify the emerging credit challenges faced by each HFA bond programme and will undertake an assessment of each HFA programme."

Factors which might mitigate identified risks, such as substantial fund balances or large amounts of liquidity, are currently being assessed, and are not reflected in the portfolio scoring reported in the article. Consequently, Moody's says, it is possible that the actual impact on some HFAs may be different from the perceived impact.

"Many of the HFAs have adequate liquidity, strong management and plans in place to weather the current market turmoil," concludes Ouzidane. "Where that is not the case, Moody's will take appropriate rating action and update the market on further developments."

S&P reports on Athilon ...
S&P has released a transaction update on Athilon Capital Corp/Athilon Asset Acceptance Corp and has placed the CDPC's issuer credit rating on credit watch negative. The rating action is based on S&P's stressed scenarios analysis on the company's exposure to certain ABS assets. However, the rating action will not cause Athilon to post collateral to the counterparties because its operating guidelines don't permit it to enter into swaps that require it to post collateral.

... and 47 Quay
S&P has withdrawn its AAA/A1+ counterparty credit rating on 47 Quay and the preliminary ratings on the senior/junior mezzanine floating-rate (AAA/AA) and senior/junior capital notes (A/NR) issued by the CDPC. The action follows 47 Quay Capital's withdrawal of its CDPC vehicle and issuer transactions.

Troubled companies index deteriorates sharply
Kamakura Corporation reports that its index of troubled public companies deteriorated in October at the sharpest rate since the index began in January 1990. The Kamakura global index of troubled companies jumped by a record 5.6% from 16.4% of the public company universe to 22% of the universe during the month. This is the highest level reached by the index since January 2003, and it comes close to the 28% all-time high in the index, recorded in September 2001.

The Kamakura index has now shown declines in credit quality in 14 of the last 15 months. At the 22% level, the index shows that credit conditions are better than only 8.1% of the monthly periods since the start of the index in January 1990. The all-time low in the index was 5.4%, recorded in April and May 2006.

Kamakura defines a troubled company as a company whose short-term default probability is in excess of 1%. The index covers more than 21,000 public companies in 30 countries using the fourth-generation version of Kamakura's advanced credit models.

"The wide-spread recognition that a severe recession is underway affected the corporate universe across the board," comments Warren Sherman, Kamakura president and coo. "Among rated public companies, Anglo Irish Bank Corporation, Bank of Ireland, Citadel Broadcasting Corporation and Thomson (of France) showed the greatest rise in short-term default probabilities during October."

New CDS ETFs launched
Deutsche Börse has launched four new credit derivative exchange-traded funds (ETFs) - which make the iTraxx benchmark indices tradable in the format of UCITS III funds - issued by db x-trackers II on the pan-European Xetra trading platform. The iTraxx Europe Subordinated Financials 5-year TRI ETF and the iTraxx Europe Subordinated Financials 5-year Short TRI ETF are based on Markit's iTraxx Europe Subordinated Financials 5-year Total Return Index (see SCI issue 109). The iTraxx Europe Senior Financials 5-year TRI ETF and the iTraxx Europe Senior Financials 5-year Short TRI ETF are based on Markit's iTraxx Europe Senior Financials 5-year Total Return Index.

The two long ETFs measure the return for a credit protection seller of holding iTraxx Europe Financials credit derivative transactions with a tenor of five years. The underlying indices comprise the subordinated and senior debt respectively from the 25 finance companies referenced in iTraxx Europe index. With the two short products, on the other hand, investors participate in the development of the return for credit protection buyers.

The management fee for the first two ETFs is 0.21%, while it is 0.18% for the second two.

Central counterparty novation of existing CDS "essential"
Structured credit strategists at UniCredit suggest that the novation of existing CDS trades to a new central counterparty is essential, in particular for single name short protection CDS. "Without knowing the details of the complex margining models, it seems that a diversified portfolio of single name CDS is necessary to avoid disproportionate margin calls," they note.

The strategists warn that a suitable margining of single name CDS is harder to determine than for index CDS, adding that whether the market is willing to switch to a fixed-coupon contract for such instruments remains unclear.

Mixed week for ABX
Analysts at Barclays Capital note that the Markit ABX index had a mixed week last week - rallying at the top of the capital structure, while selling off at the bottom. PAAAs/AAAs rallied by up to one point across indices and BBBs/BBB-s fell modestly across all vintages.

"Overall, the market-implied risk premium compressed by 121bp, reflecting the strong performance of the 06 vintage PAAAs and AAAs," the analysts observe. "However, overall market-implied loss expectations increased across all indices by almost 1%."

Project finance CDO launched
Sirrah Funding II, a senior-subordinate cash CDO of project finance and utility bonds, has closed. The deal, arranged and retained by Hypo Real Estate and managed by Depfa, is rated by S&P.

The transaction is not the first of its type, although there have not been many portfolios focused solely in these sectors. S&P notes that the asset analysis is more bespoke, focusing more on the relationships between the sectors and sub-sectors than a diverse portfolio would warrant, as well as the impact that bond characteristics of these sectors have on the liability structure.

Curzon MTNs downgraded
Moody's has downgraded the MTNs issued by Curzon Funding to Aa3 from Aaa on review for possible downgrade. Curzon Funding is a credit arbitrage ABCP conduit that is able to issue ABCP and several different types of MTNs, including conventional notes and non-credit linked structured notes. Its rated liabilities are fully supported by total return swaps provided and guaranteed by Curzon's sponsor, AIG Financial Products Corp.

The ratings of the notes were placed on review for possible downgrade on 16 September 2008, following the downgrade of AIG and AIGFP to A2 on review for possible downgrade from Aa3 and the placement on review for possible downgrade of their Prime-1 issuer ratings. The long term ratings of AIG and AIGFP were further downgraded to A3 on 3 October 2008 and remain on review for possible downgrade.

Moody's also placed the Prime-1 rating in respect of the ABCP issued by Curzon on review for possible downgrade on 16 September 2008.

Pursuant to the terms of the TRSs, the first downgrade resulted in a requirement for AIGFP to post collateral (or take other remedial action) within 30 business days. On 14 October AIGFP executed a credit support annex (CSA) for each TRS and posted collateral in an amount equal to the nominal/face amount of the notes plus, in the case of interest bearing notes, six months' of interest.

As part of its ongoing review, Moody's is investigating whether, following an insolvency of AIG, Curzon will be legally entitled to access the entire amount of collateral posted under the CSAs in order to repay the notes, as well as the potential impact on loss severity associated to index-linked products .

ABS issuance to increase in 2010
A new report from Wachovia Capital Markets highlights that the credit crunch is the first serious test of the ABS market. Securitisation of consumer assets was still in its infancy during the last credit crunch of 1990-1991 and the rapid growth of securitisation as a financing tool was in part a response to that contraction of credit.

"As households work to repair their own balance sheets, consumers and mortgage debt outstanding is likely to fall. This should translate into a smaller ABS market in 2009, but an increase in 2010," structured finance analysts at the bank note.

ECB hosts CCP meeting
The European Central Bank (ECB) has hosted a meeting with European stakeholders concerning the establishment of central counterparties (CCPs) for CDS. Participants included the potential providers of such CCPs, their regulators and the main users (dealers and buy-side). The meeting complemented initiatives by the Federal Reserve Bank of New York and the European Commission in this field.

The Eurosystem shares the views of the Financial Stability Forum and of the European Commission on the importance of reducing counterparty risk and of enhancing transparency in OTC derivatives markets, especially in those parts of the market that are of systemic importance (e.g. credit derivatives). The Eurosystem sees the introduction of CCPs for OTC derivatives as an appropriate solution to tackle the aforementioned issues because CCPs, by virtue of concentrating outstanding positions in one place (i) reduce the counterparty risk to which market participants are exposed; (ii) increase market integrity, transparency and the availability of information; (iii) standardise the criteria for evaluation of exposures; and (iv) free up collateral.

Participants at the meeting underlined the merits of multiple solutions in general and of at least one European solution.

Fitch reports on Chinese ABS
Fitch reports that China's securitisation market is moving forward gradually, despite the complex domestic environment and the current global financial crisis. Although regulators have made efforts to advance the market's development, and steady progress of the second batch of pilot programmes is noticeable, corporate ABS - which is thought to have the most potential in the country - is missing from the picture.

The low liquidity of securitisation notes in the interbank market, mainly as a result of investment restrictions by regulators, is another concern for market development. However, the agency expects an additional securitisation transaction to be issued in 2008, and another round of formal reviews on the market by regulators to follow.

ISE increases transparency
The Irish Stock Exchange has taken measures in response to market concerns around transparency and particularly the provision of all documentation on one website which is easily accessible to market participants. The exchange is to invest resources in ensuring that its website can be used as a best-in-class access point for all investors to gain more information on securities issued and related documentation.

The new transparency service offering by the exchange is available for all issuers with securities listed on the ISE. Issuers can now publish investor reports, transaction documents and financials on the ISE website.

CS & AC 

Trading ideas: glass half-empty

Dave Klein, senior research analyst at Credit Derivatives Research, looks at a capital structure arbitrage trade on Corning Inc

Corning Inc (GLW) reported earnings on 29 October warning of slowing demand. While the company's share price has dropped since the euphoric rally the day before, its CDS underperformed equity over the past few weeks. This led to a disconnect between GLW market and fair value CDS.

Given the recent wild swings in both the credit and equity markets, we are not willing to take an outright bet on which market has things right. Rather, we prefer relative value trades that anticipate some combination of CDS rally and equity/vol deterioration. Both our directional credit model and our CSA model point to a rally in GLW CDS.

Additionally, we believe GLW volatility is too low. This presents an excellent opportunity to sell CDS protection and hedge with the purchase of equity puts.

Delving into the data
Our first step when screening names for potential trades is to look where equity and credit spreads stand compared to their historical levels. To judge actual richness or cheapness, we rely on a fair-value model and consider the empirical relationship between CDS, implied volatility and share price.

Exhibit 1 plots five-year CDS premia versus fair value over time. If the current levels fall below the fair-value level, then we view CDS as too tight or equity as too cheap. Above the line, the opposite relationship holds.

Exhibit 1

Since the middle of October, GLW's CDS has underperformed its equity and now GLW CDS trades well above our modelled fair value. GLW also trades well above its expected level, according to our directional credit (MFCI) model, but this modelled level has not yet taken the company's earnings announcement into account.

Exhibit 2 charts GLW market and fair CDS levels (y-axis) versus three-month at-the-money vol levels (x-axis). The green square indicates our expected fair value for both CDS and implied vol when CDS, equity and implied vol are valued simultaneously. The orange square indicates the current market values for CDS and equity.

Exhibit 2

The green line is the modelled relationship between equity and vol when equity level is ignored. With CDS too wide compared to vol, we expect a combination of vol rising and CDS tightening.

Risk analysis
The main trade risks are a drop in the volatility of CDS and equity, or if one of the names begins trading under a different regime and the current vol-equity-CDS relationship no longer holds.

Each CDS-equity position does carry a number of very specific risks.

Recovery and 'default' stock price assumption: In the default scenario the cheapest-to-deliver CDS obligation may have a higher than expected market value and the stock price might not fall as assumed.

CDS present value (PV): The CDS PV is an expected value, but not necessarily a realised outcome. In practice, the CDS may trade on an up-front or running basis.

Corporate actions: Spinoffs and private equity buyouts, for instance, could radically change the equity-CDS relationship, leaving investors with a mishedged position.

Mark-to-market: In our view, credit and equity markets operate largely independently and this can lead to trade opportunities. At the same time, any relative mispricing may persist and even further increase, which could lead to substantial return fluctuations. Additionally, the trade faces a fairly substantial bid-offer to cross in CDS.

Overall, frequent rehedging of this position is not critical, but the investor must be aware of the risks mentioned above.

Liquidity
Liquidity (i.e. the ability to transact effectively across the bid-offer spread) in the bond and CDS markets drives any longer-dated trade. Our data on liquidity, created from the volume of bids, offers and trades that we see each day, reassure our trading in GLW. GLW is a reasonably liquid name and CDS bid-offer spreads are around 15bp-20bp.

Sell US$1m notional Corning Inc. 5-Year CDS at 215bp.

Buy 70 lots Corning Inc. US$10.00 Strike Jan 09 Puts at US$1.30 (100 multiplier per contract) to receive 215bp of carry.

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).